Some random thoughts on the controversial issue of intellectual property laws and the Internet …

The reason we protect intellectual property via legal institutions like patents and copyrights is that developing ideas or content is costly, but without intellectual property rights it’s hard to recover those costs. Writing a book takes time and effort, but if people can freely copy any book once it’s published then there won’t be much money to be made writing books, and not many people will write them, so society suffers from a lack of books.

However, intellectual property rights create economic efficiency losses too. Once a book has been written, economic efficiency requires that anyone who is willing to pay the marginal cost of another copy of the book should be able to buy a copy. For books in digital format this marginal cost is practically zero, thus the book should be given to everyone who can be bothered to spend the time reading it. Giving the book author a copyright over his or her work means that he or she will want to sell it for a price greater than marginal cost, to maximise profits from the book, which is inefficient.

So at the heart of the economics of intellectual property is a tradeoff. We sacrifice some economic efficiency by allowing what is created to be sold at a price above marginal cost of reproduction, while gaining from the creation of the ideas or content in the first place. When we’re deciding how strong to make our intellectual property rights, we have to think about this tradeoff. Stronger property rights (such as making patents or copyrights last longer) means that more profits can be made from producing intellectual property, so more of it will be produced, but the inefficiencies from above-marginal-cost pricing will persist for longer.

Now, the Internet reduces the cost of reproducing content such as books and music. A lot of the cost of reproducing a book or music CD is the physical reproduction, distribution, and advertising. Delivering goods in digital form obviously reduces the cost of reproduction to zero and distribution to almost zero. In addition, I think there is a significant effect on advertising costs. In the past, music or book publishers had to spend a lot on advertising to make consumers aware of new CDs or books. The Internet is a much more efficient medium for allowing consumers to ’sample’ these goods and find the ones they like. Social networks, blogs and so on also provide powerful ways for people to inform many others of new songs or books that they have discovered and they like. Thus so much expensive advertising is no longer required.

So given that reproduction of content becomes cheaper in an Internet world, we don’t need such strict intellectual property protection to obtain the same incentives to generate creative works in the first place, everything else equal. However, everything else is not equal, so any revision of intellectual property laws needs to account for the existence of the Internet in at least two ways. One is to acknowledge the greater ease of copying, and ensure that the rights of content creators can be respected. The other is to examine the strength (e.g. the length) of intellectual property protection in light of the reduced costs of reproducing content in electronic form.

Remember, the objective of intellectual property laws is to generate efficient creation of new content, not necessarily to make content creators rich. To me, it’s not obvious that the existence of the Internet means that we need stronger intellectual property protection to achieve this objective. It’s beyond the scope of a blog post to examine the tradeoffs fully and reach a definitive conclusion one way or the other. But it’s conceivable that an optimal outcome could be to toughen up on preventing copying, while at the same time reducing the duration of copyrights, for example.

I came across an interview with a 9 year old girl (I presume American) about her thoughts and behaviour regarding file sharing on TorrentFreak, a blog about file sharing. Some of the interesting parts:

TF. Ok, so a bit like copying school work?….Hmm….ok, let’s talk about copying on the computer again. When you started using LimeWire, did anyone ever mention that if you did certain things you might be breaking some laws?

- Why would they put it [music] on the internet and invent mp3 players if it was against the law?

TF. Confusing isn’t it?….You mentioned you like Sean Kingstone - what if I told you that Sean Kingstone’s boss might send you a letter asking for money because you shared his album on LimeWire? What would you say to him?

- W.E! [whatever!]

TF. Come on, play along with me. What would you say if he did?

- I’d say “tooooo strict!” and anyway he can’t make me do anything. He’s not the boss of me, he’s the boss of Sean Kingstone.

TF. What do you think might happen if you didn’t pay him?

- Nothing. I’m too young to be charged by the government so he can’t charge me.

You can read the entire interview here.

Radiohead is selling the download version of their new album In Rainbows for whatever you want to pay for it, including a price of zero. When you go to buy it on their website, they just ask you to put in the price that you want to pay. It’s an interesting concept that plays on people’s honesty. I wish they will release the data about what people were willing to pay, but I suspect they won’t. It would be interesting to see how many people paid a positive price, the average price paid, and whether anyone paid more than what the equivalent price would be on a download service such as iTunes.

It would also be very interesting to monitor how much this album is swapped on file-sharing networks. If people can legitimately download the album for a voluntary price, will they stop paying for it? It’s important to realise that the price of an illegally downloaded song from a file-sharing network is not zero. There’s inconvenience and risks such as getting computer viruses, and getting sued by the RIAA. Thus, in theory, at a price of zero everyone should prefer downloading the album from Radiohead’s website rather than pirating it. And in fact, many people who would have pirated it should be willing to pay a positive price to download it from Radiohead’s website. The key question is: will that extra revenue make up for the lower prices paid by people who would have bought the CD anyway?

From a personal perspective, I would certainly feel a bit guilty to take the download for a price of zero, and would probably choose to pay a positive price. As a benchmark I should pay an amount equal to the value of the guilt that I would suffer if I set a price of zero. On top of this, music consumers seem to have a lot of negative feelings towards record companies for charging what some people feel are high prices, and for restricting people’s use of music that they purchased by using DRM technologies. A cynic might say that Radiohead is trying to capitalise in this, and generate some goodwill for not being greedy. Maybe consumers will reward their public spirit by not pirating this album so much and voluntarily pay a price for it. Also, the download version is only one out of two CDs that you get if you buy the CD version. So part of this strategy could be interpreted as advertising — if people really like the downloaded album then they might go and buy the boxed version to get the second CD.

Overall, it’s a very interesting experiment and I hope some economic analysis of the outcome can be carried out.

This video shows Trent Reznor (of Nine Inch Nails) encouraging his fans to steal (copy/download) his music (warning - contains swear words):

Actually, Trent isn’t the first musician to think of this idea, Robbie Williams thought of it back in 2003. It’s interesting for two reasons. First, why would a musician want to encourage fans to copy his CDs? Doesn’t he get royalties for each CD that sells? Second, as Trent observes, the price of CDs has not reduced over time. Why not?

The answer to the first question is that musicians have many other sources of revenue aside from selling CDs. You may notice that Trent is at a concert. Popular musicians can earn a lot of money from concerts, and the record label that sells their CDs typically doesn’t get any of that money. Taking into account other potential revenue sources such as merchandise and advertising, musicians have a greater incentive to make themselves popular than their record labels do, since all the labels care about is selling CDs. By encouraging people to copy his CDs or share MP3s, Trent will lose some royalties on those CDs, but he might become more popular, and more people will want to come to his concerts, driving up the price of concert tickets and earning more revenue for him. Thus the incentives of musicians and record labels aren’t always aligned with regards to encouraging or discouraging people to illegally copy music.

The answer to the second question of why CD prices haven’t changed is less clear. The introduction of file sharing networks represents a substitute good for legitimately purchased CDs. It’s reasonable to assume that this substitute is inferior — at the same price people would probably prefer the legitimate CD over an illegal download, and the quality of downloaded files can be variable. But the price is not the same, of course. Downloaded files are ‘free’ in that you do not have to pay for them, but CDs must be paid for. Although downloading is not competely free in the sense that there are opportunity costs — it takes time to find and download the appropriate files, it can expose your PC to viruses, and there’s the risk of being sued, among other things. Nevertheless, taking everything into account, at the prevailing price of CDs before file sharing became common, it seems safe to assume that some people will choose illegal downloads over CD purchases if the price of CDs remains unchanged.

One rational response of a record label to the introduction of this (albeit somewhat inferior) substitute to legitimate CDs is therefore to lower the price of CDs. This could help to offset some of the negative impact on its profits of the availability of illegal downloads. Of course, the label still suffers compared to when there was little piracy, but a price reduction can help to soften the impact by offsetting some of the demand reduction for CDs. However, it seems that CD prices have remained more or less constant over the past five years or so. What explains this? Are music labels stupid or evil? One possible explanation is that instead of cutting their own price, labels have been trying to raise the ‘price’ of the substitute illegal downloads by suing people who share files. This raises the perceived price of downloading and makes it less attractive, which can be an alternative strategy instead of cutting the price of CDs. The second possible explanation is that labels have been ‘entering’ the substitute market, through selling legitimate downloads such as through Apple’s iTunes service. This will help them to capture some sales from some consumers who would have chosen illegal downloads if there was only a choice between illegal downloads and legitimate CDs.

So there are plausible legitimate strategies that music labels may be following to respond to the invention of file sharing networks without lowering the price of CDs. As an economist I like to believe in these rational explanations. However, a part of me can’t help thinking that it may also be due to stubbornness on the part of music label executives to recognise that file sharing is now part of the business environment that they operate in, and that they should respond to that optimally.

Over at the Google Public Policy Blog the latest post is about the economic value of fair use. Fair use is a provision under copyright law that permits certain uses of copyrighted works without seeking permission from the copyright owner. These uses include things like the freedom to quote from and comment on copyrighted works.

Some people argue that some of Google’s services violate copyright law because they go beyond what is permitted by fair use. For example, Google book search has scanned copies of a huge number of copyrighted books. Copies of the text of the books are stored on Google’s servers, and you can search the text via their website. Unless Google has gained permission from publishers (or the works are out of copyright), they do not however display the entire contents of the books on their site, but rather small ’snippets’ relevant to what you searched for. Whether or not this violates copyright law is not clear, and I’m not a lawyer so I won’t comment on it, but there does seem to be some doubt.

Another service at issue is Google’s cache. When Google indexes web pages for its search engine, it may also store a copy on its servers. When you search for something on Google, if you click the ‘cached’ link in the search results, you will be presented with the copy of the page that Google has copied to its servers, rather than sent to the original website. It is possible for websites to prevent their pages from being cached, but the default is to be added to the cache unless you specifically set otherwise, which is easy to do. Nevertheless, this cache also raises some copyright questions, because the ‘default’ of copyright law is that permission to copy must be granted, rather than the copyright owner having to take explicit steps to prevent copying.

Anyway, we can leave the definition of fair use for the lawyers to sort out. Turning to economics, on the public policy blog Google refers to a recent study by Capital Trade, Inc prepared for the Computer & Communications Industry Association (of which Google is a member) that estimates the “economic value” of industries that depend on fair use to some extent for their operations. The headline results are that such industries contributed US$2.2 trillion (16%) of total US GDP in 2006, and employed 17 million workers, who were paid US$1.2 trillion in wages. Big numbers indeed.

Aside from exactly how you define “fair use industries”, I want to stress that it’s important to be very very careful about the interpretation of these numbers. Assuming no mistakes were made, these figures do estimate the fraction of economic activity that can be attributed to these industries. However, it is not possible to say that US GDP would shrink by 16% or that 17 million people would become unemployed if all fair use were suddenly banned. As far as I can tell, the study does not make such claims, which is good, but it is easy for people to interpret these figures in an invalid way. For example, Google concludes its blog post by saying:

This study suggests that [fair use is] also an important part of the U.S. economy.

Strictly speaking, this is not quite true, because if fair use were to vanish, then in a well-functioning economy like that in the US, the resources that are used in the fair use industries will be picked up and re-used in other alternative uses. Those 17 million people won’t be sitting around idle (at least not for very long) as there are plenty of alternative things for them to do. An economic impact analysis such as the Capital Trade study that Google refers to does not take into account the possible economic responses to any kind of policy changes regarding fair use. All it tells us is how much these industries contribute to current economic activity, but not how economic activity would change in their absence.

To properly assess the effects of any changes in policy towards fair use, we need to use a more sophisticated economic model that takes account of how the resources used in fair use industries would be re-allocated to other industries if fair use were restricted. The key then is the difference in productivity of resources in fair use industries versus their productivity in their next best alternative use. Since this alternative productivity will be greater than zero, the loss in GDP, employment and other measures of economic activity will be far smaller than the measures of economic impact that Google cite.

And one other thing … never never never use 3D charts, especially not 3D pie charts.