Sympathy for the IP Industry

| Gabriel|

[Cross-posted at NR‘s Agenda blog]

In the arguments over SOPA, I’ve seen a few arguments from people I respect that piracy basically doesn’t matter. These arguments strike me as somewhat plausible but probably wrong and grounded in wishful thinking that a solution being unpleasant means that the problem it addresses is nonexistent. This is not to say that I support SOPA, for I do not. My main intuition on this is that an industry that sponsored the Sonny Bono Copyright Term Extension Act has forfeited its claim to our sympathies. Thus even when it has a legitimate grievance, I am inclined to give it only mild weight. Thus I tentatively favor the Megaupload suit but I’m gonna say “sucks to be you” when the industry demands escalating the fight against piracy into the top priority of US trade diplomacy and a total war waged on the terrain of the internet’s low-level infrastructure. Nonetheless I think it’s important to clarify just how complicated estimating the effects of piracy are.

Much of the debate centers on first-order effects of immediately displaced sales. That is, at a micro-economic level how much does a pirated copy of work i substitute for a legitimate copy of work i. Early on the IP industries had some estimates premised on the idea that each pirated transfer represented a foregone retail sale, which implied the absurd counterfactual that absent piracy we would have seen a massive boom in sales. Critics have appropriately rebutted these studies with the reminder that demand curves slope downwards so quantity demanded at price $0 will be considerably higher than quantity demanded at price $14.99 (at least if we assume low search costs).

I would say that a more important issue is the second-order effects. This appears in some of the anti-anti-piracy arguments as some variation of “people won’t pirate if you make content available in a convenient format at a reasonable price” or “piracy is a customer service issue.” I think this is basically true as an empirical matter and it’s certainly a very parsimonious description of my own behavior. The trick is that you can rephrase the argument as “the threat of piracy has forced distributors to lower their price points and adopt formats that are less desirable to the producer.” As Kernfeld notes in Pop Music Piracy, this is a very old pattern. Basically, producers create some kind of format at a high price point and consumers buy it until a pirate comes along and both undercuts them on price and introduces format innovations. At this point the incumbents try for awhile to suppress it, before giving up by adopting the pirate’s format innovations and dropping their price point. That is, the incumbents ultimately realize that the only way to deal with piracy is a “convenient format at a reasonable price.” Kernfeld emphasizes mid-20th century pirated songbooks as competition for legitimate individual pieces of sheet music but he also applies it to the more familiar case that the music industry only gave in to low price (and eventually DRM free) digital singles to replace high price CDs as a desperate rearguard action against music file-sharing.

Recorded music revenues have dropped precipitously since the late 1990s but only a minority of this was the direct result of sales substituted by piracy. Rather the great bulk of the drop was from the shift from CD albums at a price point of $15 to digital singles at a price point of $1. We have in fact seen a large increase in units shipped, but mostly in digital singles at the low price point. You can see this clearly by looking at Census Statistical Abstract table 1140 and contrasting the unit sales in the top half with the dollar value in the bottom half. To fully make up retail sales we would’ve needed a 15-fold increase in volume and this has not happened. Even if we appreciate that there digital implies lower costs (no inventory) and think about wholesale rather than retail, we’d still need something like a 5-fold increase in sales to make up for lower revenues.

One important consideration of second-order effect is that it means you have to think at the macro rather than the micro and this makes analysis difficult. That is, many researchers have looked at how often a song is pirated and tried to estimate elasticities with legitimate sales. This is a good way to estimate the proximate effects of piracy but it misses the much more substantial second-order effects since the record industry has not dropped its price point only for heavily pirated songs, but for all songs. Let’s assume that lots of people would pirate Eminem but nobody would pirate Norah Jones. If the record industry switches to a digital downloads model to protect sales of Eminem, this will still decrease the dollar value of Jones’s sales. Conversely if higher concert revenue helps make up for declining recorded music revenue this shift applies in nontrivial ways at the micro level.

We also see second-order effect in the film industry. As Reihan has noted (in discussing Doctorow’s summary of Waldfogel and Danaher), one of the ways the movie industry has responded to piracy is by accelerated releases. It would be a mistake to claim that opening wide is driven entirely by piracy. The fact is that it’s a long-term trend since the mid-1970s and also has to do with supply side issues of promotion and a screen glut. However piracy is a part of opening wide, particularly in terms of major releases opening simultaneously world-wide. Dubbing, prints, and promotion on a global scale is extremely expensive and if studios had their druthers they’d rather postpone it until they had an estimate of how well the film does domestically. As you can see by looking at the breadth of release dates, they did in fact drag out foreign releases in the 1970s and 1980s, but in the 1990s and 2000s they’ve been getting increasingly close to a simultaneous world-wide release. This is not so much an issue of foregone sales as it is of increased expenses but it is a way that providing better customer service so as to avoid piracy does cost the industry. That’s not to say that this is conclusive, as Reihan and Doctorow observe it is probably more efficient and just to have Hollywood bear the private cost of accelerated release than to have governments (and private ISP companies) worldwide bear the costs of aggressive enforcement.

Now for the sake of argument let’s take as granted that direct costs of piracy and indirect costs in the form of better “customer service” are costly to the industry and ask what are the consequences for what gets made? We actually have some evidence that this has not much affected the quantity and quality of music but I find it difficult to be as optimistic about film.

The difference has to do with how money gets spent in both industries and in particular appreciating how promotion is the key resource in the entertainment industry. In the music industry the ratio of promotion to production costs is about 10:1. Some of this is about creating fame, but much of it is about allocating fame. This is important because to a first approximation fame is inherently scarce. As Ricardo argued in his analysis of the Corn Laws, when quantity is fixed any change in demand accrues to factor producers. That is, if the sales of pop music decline over the long-run this will cash out as increased consumer surplus and declining value prices for advertising. A very high proportion of music promotion costs does not occur in the general advertising market but in specialized markets, including payola. This means that over the long-run a drop in music revenues will in large part be felt by radio stations and others who specialize in promoting music.

In contrast, the promotion to production ratio in Hollywood is about 1:2. That is, the rule of thumb is that prints and promotion are about half again the cost of getting the film in the can. This means that decreased profits will mostly hit Hollywood itself rather than a related industry. Since stars are residual claimants and below-the-line workers make solid middle class livings, some of the pain will hit in the form of lower labor compensation, however you can’t lower production costs without eventually hurting production values. [Update: Also see Yglesias and my own follow-up on this issue].

More broadly, I think we need to be skeptical of free lunch thinking that if a policy has undesirable consequences this doesn’t mean we have to pretend there is no real problem it is addressing. It’s a common position to say “I don’t like bullying tactics, bad faith arguments, and rent-seeking of the IP industry, therefore piracy is not a problem.” I sympathize with this frustration but it’s more intellectually honest to take seriously that there might be a problem that we decide it is better to leave unsolved.

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