"Just enough piracy"

It's not news that the main reason the movie and television industries are wary of BitTorrent is that they're freaked out by the music industry's experience with piracy. Although they see the economic advantages of P2P distribution, they're concerned that once they put their stuff out there, even wrapped in triple layers of kryptonite DRM, it might be cracked and then circulate in unprotected form. For movies, that's lost revenues. For TV shows, that means ads could be stripped out, expiration routines could be removed and  (gasp!) content could be modified or remixed.

All that counts as Very Scary Stuff to industry executives, and as a result they're looking for "strong" DRM before they consider letting their premier content circulate online. This is a mistake, for two reasons:

The first is about the user experience: Any protection technology that is really difficult to crack is probably too cumbersome to be accepted by consumers.

We've seen all sorts of failures of this sort before, from dongles to laborious and confusing registration schemes. Each seems better at annoying consumers than at building markets. The lesson from these examples is that zero-percent piracy is not only unattainable, it's economically suboptimal. If your content is uncrackable, it means you've probably locked the market down so tight that even honest consumers are being inconvenienced.

Instead, efficient software and entertainment markets should exhibit just enough piracy to suggest that the industry has got the balance of control about right: not too loose and not too tight. That number is not zero percent (which requires protection methods so invasive they kill demand), and it's not 100% (which kills the business). It's somewhere in-between.

The second reason the quest for zero-piracy is a mistake is an economic one: piracy can actually let you raise your prices.

I'll give you a surprising example. I was chatting with a former Microsoft manager the other day and he revealed that after much analysis Microsoft had realized that some piracy is not only inevitable, but could actually be economically optimal. The reason is counterintuitive, but intriguing.

The usual price-setting method is to look at the entire potential market, from the many at the economic lower end to the few at the top, and set a price somewhere in between the top and bottom that will maximize total revenues. But if you cede the bottom to piracy, you can set a price between the top and the middle. The result: higher revenues per copy, and potentially higher revenues overall.

(This is, by the way, the opposite of the conventional economic approach to developing-world piracy, which is to lower the cost of a product closer to the pirate version, closing the pricing gap to try to win customers over to the official version. In practice, however, the pirate price is so low that it's rarely possible to close that gap enough to make much of a difference.)

Add to this the familiar (if controversial) argument that piracy helps seed technology markets, and can be a net benefit. Especially in fast-developing countries such as China and India, the ubiquity of pirated Windows and Office have made them de-facto national standards. Few users could have paid for the retail versions at the start, but now that the spread of cheap technology, including free software, has led to an economic boom, Microsoft is finding a nice market for commercial software at the very top, in big companies and government offices.

When all these effects are considered, it appears that there actually is an optimal level of piracy. That right level would vary from industry to industry. Today the estimated piracy rates are 33% for CDs and 15% for DVDs. The industries say that's too high, but most anti-copying technologies they've brought in to lower that figure have proven unpopular. Would even tighter lock-downs help? Probably not. Maybe 15%-30% is simply the market saying that this is the optimal rate of piracy for those industries, and any effort to lower that significantly would either choke demand or push even more people to the dark side.

So the moral for video content holders and others considering DRM: be careful what you ask for, because you just might get it. "Uncrackable" DRM could make the P2P problem worse, by driving more users underground and depressing prices. Don't imagine that if you release content in a relatively weak DRM wrapper (like today's DVDs) and copies get out that the whole market will collapse. Instead, you may find that piracy stays constant at relatively low levels, leaving the rest of the market happier and more profitable.

The lesson is to find a good-enough approach to content protection that is easy, convenient and non-annoying to most people, and then accept that there will be some leakage. Most consumers see the value in paying for something of guaranteed quality and legality, as long as you don't treat them like potential criminals. And the minority of others, who are willing to take the risks and go to the trouble of finding the pirated versions? Well, they probably weren't your best market anyway.

Comments

[Derek Slater]

Chris, interesting post. I think you could/should make an even stronger argument with regard to preventing piracy - DRM, strong or weak, isn't much good at preventing widespread infringing file-sharing in our efficiently networked world.

You note, rightly, that preventing all infringing online distributions is impossible. But you then seem to say that there's Goldilocks DRM that will be not too restrictive, not too light, but just right to prevent SOME piracy.

I contest that DRM can even do that. See, e.g., the MSFT Darknet paper: crypto.stanford.edu/DRM2002/darknet5.doc
See also Fred von Lohmann, "Measuring the DMCA Against the Darknet," http://www.eff.org/IP/DMCA/DMCA_against_the_darknet.pdf

Strong and weak DRM is evadable, and it only takes one unencrypted copy up online to make DRM basically worthless in preventing widespread infringing distribution.

Which is not to say that DRM can't be used for other purposes. Regardless of the inevitable availability of infringing unencrypted copies or circumvention devices, some people will continue to purchase encrypted copies and will not remove the DRM. As such, restrictions on usage or compatible software/hardware WILL impact these users. So business models that monetize those restrictions - e.g., through price discrimination based on usage - can use DRM.

On that score, there is a tricky balance between making the DRM too cumbersome that it encourages people to head to the darknet. But let's not confuse that issue with DRM's ability to prevent widespread infringing file-sharing.

[David Palmer]

Chris, I'm not sure I understand your pyramid approach to pricing as regards piracy. When you look at "the entire potential market, from the many at the economic lower end to the few at the top, and set a price somewhere in between the top and bottom", does the pyramid represent their incomes or the price they'd be willing to pay? I'm not sure there's a direct correlation between income level and piracy, and if you're looking at the pyramid as representing the price someone's willing to pay, the pirates are already at zero.

[chris anderson]

David,

Fair point. The pyramid illustrates that world market in numbers of people, segmented by income. But you're right that the usual economic calculation would to run a normal price elasticity curve, based on the potential revenue pools in each segment. Removing the bottom end of that has the same effect as I've described. But it's confusing, so I'll probably just delete the pyramid reference in the post.

[For those coming to this after the change, I had originally said the market looked like a pyramid, like this:
http://longtail.typepad.com/the_long_tail/2005/03/long_tail_vs_bo.html]

[Abbi Vakil]

Chris
I respect your work but now you are in Fantasy Land. Your quote "Most consumers see the value in paying for something of guaranteed quality and legality" doesn't apply to MOST of this world's population, just visit Phillipines or China and you will see vendors selling software (DVD, CD, Video Games, etc.) for so cheap that I don't know anyone who actually PAYS for content in those countries. If the same street vendors were allowed to operate in the US, most of the morality you are counting on would go out the window. An inverse way of looking at this would be to wonder what would happen if all the hassles involved in file sharing of music CDs were to go away, how much MORE piracy would exist in the US?

[Piotrr]

Interesting idea. But what about legal and moral points of view ?

In your argument, DRM technologies are essential in the process of adjustement : not too complicated, no too easy to circumvent.

In law, piracy is criminal and that's it. In law, you're guilty or not. Of course, in many cases, illegal activities (such as use of certain drugs, prostitution or speed over) are tolerated depending on circumstances and we can imagine that's the same for piracy.

But who pays the price of adjustment in that case ? Who bears the uncertainty of flexible tolerance according to corporate interests ? Consumers of course, who have to evaluate wether they will or won't be prosecuted because they are on one or other side of the graphic. That's unfair and, in the long term, suboptimal at the global economic level.

Therefore, the next step, if you want to get out of some hypocrisy, is to decriminalize IPR, to withdraw protection of law whose contradiction with economic logic is counterproductive. Well. Many problems ahead.

Oh, by the way. What about DMCA ? It seems very hypocrit to tolerate a limited efficiency of DRMs and to criminalize so harshly every mean to limitate this efficiency.

(sorry for my english ; not my mother tongue)

[chris anderson]

Piotrr,

You raise some interesting points, but I think the drug and prostitution examples are a different sort of case. Some countries have legalized or decriminalized those, mostly on the grounds (whether you agree or not) that they're "victimless crimes". Rights-holders, in contrast, argue that they they are indeed the victims of piracy and generally push hard for crack-downs. So it's hard to imagine the law changing.

The question is how hard those rights-holders should push for enforcement of the law, and how much they should lock up their content to help prevent piracy. I'm arguing that a somewhat loose policy there can actually be beneficial in the long run.

[T J Neville]

Microsoft is selling applications, not content. Moreover, much of the upper and middle part of the MSFT customer base consists of corporations and small-business professionals who get to deduct the expense on their taxes.

Many of these are US and Western European-based knowledge businesses that also rely upon respect for intellectual property rights, (…and have large law departments that specialize in worrying about this stuff.) Also, a large chunk of Microsoft's consumer business comes from middleman PC manufacturers who buy bulk, and treat it as just another manufacturing expense.

Think about it, when was the last time you (as a consumer) ponyed-up for a brand new full price copy of Office?

Ergo, you can solve the piracy problem by marketing music and movies to large corporations and business professionals, and/or bundling it into the hard drives of new PCs. And then all you have to do is get a law passed to make these expenses tax deductible.

[perfectlyGoodInk]

But if you cede the bottom to piracy, you can set a price between the top and the middle. The result: higher revenues per copy, and potentially higher revenues overall.

This makes no sense to me. When you pick a price, you are always ceding demand. At a price of free, demand is higher than at whatever price you actually pick. The whole point of picking a price is to cede some demand to increase gross margins. If you can increase your revenues by raising the price with piracy, I don't see why you wouldn't have been able to do the same without piracy.

The only argument I can see is that piracy can increase demand as a form of viral marketing, but you're not making that point here.

[chris anderson]

Fling,

Yes, from an economic perspective you're right. But when Microsoft sets its prices, it's not just thinking about maximizing revenues. It's also thinking about growing its user base, avoiding criticism for price gouging, and driving overall PC penetration. That's why, when considering the bottom of the market, it might set the price lower than a simple price/demand curve would dictate. And why, when it cedes much of that market to the pirates, it can raise prices.

[Ray Lawton]

What's being missed here is the fact that complete piracy of movies already exists, to the point that ANY major movie is online in some format before it leaves the theaters. Interestingly for the long tail, piracy does not and maybe CANNOT support the whole long tail - there's just too much there with too little demand for piracy of it all to exist.

Just look at mp3s. The reason people so readily started using iTunes is consistent quality and ready access to the long tail. Most importantly, iTunes created a legitimate market out of something people wanted. I think that the piracy numbers should actually go DOWN if there's a legal option for DVD or TV downloading. ADDING a legal download option for movies doesn't aid piracy, which is already in full swing, but fulfills an economic need that honest consumers want and have no options for.

[Matt]

At the momnet when I get my Netfilx DVDs I rip them to my Hard drive with DVD Decryptor and send them back the next day .Becuse I can then time shift and burn them to a DVD+RW of if they are for the kids a DVD-R .

I there where a service like Netflix proposes to offer in a few months where you pay a fee for downloads and a solution like Greencines Burn to rent Model I wouldnt have to bother to strip the "encryption' form the DVD becuse I could have Video on Demand .
I wouldnt be waiting on the netflix 3 day turn around the videos would be there in less than 5 mins with 'streaming ' dowloads.
.

[neelakantan]

Great post thats amazingly counter intuitive. I also believe that some amount of piracy might actually be good, but then there are mixed responses to this about what is right and wrong and so on. I had captured this in a post a few weeks back, though not in the context of protection technology and perhaps not as lucidly as you have. http://ecophilo.blogspot.com/2005/07/piracy-why-some-of-it-is-good.html

[Tobias Schmidt]

I also think that your economic argument requires the presence of externalities to work, a theme that has been extensively dealt with in the literature.

If there are no externalities from usage of the pirated good, then there is no reason to believe that a company would be able to extract higher revenue from a market with piracy than from a market without piracy. In this case, piracy simply reduces overall demand for the good and thus decreases profits.

But with network externalities (people value the fact that other people are using the same good, e.g. for reasons of compatibility), for example, the optimal level of piracy is indeed higher than zero. Firms then profit from piracy, because they can extract more money from people with a high willingness to pay than they loose from those people that do not buy the good anymore. The level to which these effects are present in different markets is a subject of much debate though.

There are countless other economic models like this one that all show the potentially positive effects of some piracy. If you're interested, "The Economics of Network Industries" by Oz Shy or the less technical "Information Rules" by Varian and Shapiro might be good places to start

[Cory Doctorow]

Chris, I'm curious to read your response to Derek's excellent comment, especially since this echoes a discussion we've had on many occasions.

A downloader never encounters DRM, because by definition, she is downloading a cracked copy. It may be that too much DRM will *drive* her to download (as you note), but even lesser amounts of DRM can't *prevent* her from downloading.

Now, *uploaders* might be inconvenienced by DRM. But in the real world, uploaders are often possessed of enormous time and resource (even when that resource is clever 15-year-old Norwegians). Moreover, even the most restrictive DRMs are vulnerable to attacks on their analog outputs. Hollywood is trying to pressure tech vendors to eliminate or downrez their analog outputs, but that hasn't been very effective -- somewhere in the chain, there's a wire on which analog waveforms travel, and our uploader is generally only one screwdriver and alligator clip away from that wire.

DRM can potentially raise to cost of making the first copy, but people who make the first copy are very cost-insensitive. However, no amount of DRM can effectively raise the cost of subsequent copies beyond zero.

[chris anderson]

Cory,

I've assumed that no DRM is uncrackable, and thus there will always be some cracked version in the wild. The question is what fraction of users chooses that one vs. the protected version.

It's a simple risk/benefit calculation. You weigh the cost of the commercial product (both in money and DRM inconvenience) against the cost of the cracked version (in quality risk, time spent finding it, and and legal/moral considerations you may feel).

In the scenario you describe, if her perception is that that the cost of the DRM version in terms of inconvinience or lost utility is low, she may be willing to shift to that version for the reasons above even though she has access to the cracked version. (I do this all the time in music for reasons as simple as consistent metadata.)

In a sense, lowering the "cost" of DRM by making it less invasive can have the effect of raising the relative "cost" of the cracked version (ie, the "all things being equal I'd rather not take the risk" argument), potentially shifting demand to the commercial product.

So, using "cost" this way, less DRM *can* actually raise the net cost of the cracker version. Less DRM can't *prevent* her from downloading, as you say, but it can encourage her not to by making the alternative more attractive.

Does that answer the question?

[John Thacker]

But if you cede the bottom to piracy, you can set a price between the top and the middle. The result: higher revenues per copy, and potentially higher revenues overall.

Almost certainly not higher revenues overall from a static point of view. If you look at the entire market, then you should price in order to maximize profit (which for software generally means maximize revenues, due to the minimal marginal cost of producing a new copy).

Consider it from the reverse point of view. Suppose we set a price that maximizes revenue considering only the middle and top of the market. Now add in a bunch of people who will only pay some amount lower than that price. Now we take those people into account as well. If it raises revenue to lower the price, then we'll lower the price when we take those people into account. If, however, revenue either stays the same or decreases when we lower the price, then we'll keep the price at the same higher level, even "taking into account" the bottom of the market.

Thus we see that ignoring part of the market cannot cause one to increase total revenue by setting a different price than one would set by considering the entire market. The profit-maximizing price for a portion of the market has to bring in at least that much revenue when considering the entire market.

The distribution effects are real, though. The idea is that each piracy sale produces some small benefit to Microsoft through network effects and standardization. By this argument, it's really a form of price discrimination, with a full price product that produces more profit for Microsoft, and a low price pirated product that produces some value with each "sale" for Microsoft. Price discrimination, selling different customers the product at different prices determined by what they'll pay, does produce benefits for the company.

[Cory Doctorow]

I still don't get it, Chris.

Let's take a for-instance.

1. I am someone who intends to download a song without paying for it. There's a DRMed version I can pay for, too. The way that the DRM works is irrelevant to me, since I'm not planning on buying that version.

2. I am someone who intends to buy a song. It has DRM on it. I find the DRM invasive and switch to scenario 1.

3. I am someone who intends to buy a song. It doesn't have DRM on it. I buy the song. I don't defect to scenario 1.

4. I am someone who intends to buy a song. It has DRM on it. I don't find it invasive. I buy the song and don't defect to scenario 1.

Where does the "strength" of the DRM come into play here? The DRM being more or less crackable is irrelevant, as near as I can work out, to whether I ultimately embrace scenario 1.

The *invasiveness* of the DRM matters. The most invasive of the DRM invasions, in my mind, is the most subtle: less competition and slower innovation. Non-DRM CDs have experienced a slew of innovation (for example, the iPod and every other MP3 player is an offshoot of the fact that DRM-free CD music can be lawfully transcoded to MP3). DVD players have not seen a single substantial new feature in their decade in the market.

So in the case of music, you have people whose "invasiveness" criteria includes things like, "Will this play on my MP3 player?" and "can I make this into a ringtone?"

I think that the factors leading to a scenario-1 defection are inevitable with any DRM system, because all DRM systems restrict which vendor's equipment you can use, and what that vendor's equipment can do.

[Ray Lawton]

Another interesting perspective is that piracy is simply caused by price point. In some instances, a person's price point is $0, and even a price point of $.25 would be unreasonable for the hassle involved for the consumer. But there are other ways to capture the piracy market legally - for example, offer a lower quality streaming video version of movies with TV-like commercials for FREE. You would STILL make sales on the DVDs and the higher quality downloadable versions, but piracy would drop quite a bit. You could make some revenue from the commercials, but that's not the point - most importantly you would prevent people from looking to pirate in the first place.

When they want to watch a movie on the big screen or to "own" it, a service like this would encourage them to buy, put the purchase option in front of their face, allow them to explore the long tail comfortably and easily. Think of the plush chairs at Barnes & Noble. There's certain differences online, but I think the logic of it makes sense. DRM is the opposite of what a company should do to encourage sales and prevent piracy.

[chris anderson]

Cory,

My mistake; I used "stong" ambiguously. What I mean is "invasive"--limiting, awkward, confusing, annoying. Again, I assume it will all be cracked. But the rights-holders, in a misguided hope to avoid that, often construct complicated schemes to make that harder. My point is that this is a mistake, because it just pisses off users. And it's economically unsound, too.

[John "Z-Bo" Zabroski]

Folks, what is "DRM"? Think about it, the term is Digital Rights Management. Just with any genre of corporate governance, there is a branch of managament that handles the incompleteness of corporate control in that area. Considering that, let us try and establish a definition of DRM that fits into the corporate world.

Digital Rights Management, I would define as, managing the incompleteness of digital rights. The operative word is incompleteness because digital rights are not complete, even with laws like DMCA (Chris's post pronounces and powerfully demonstrates that digital rights are not secure even with the DMCA).

So, what Microsoft is effectively doing is, managing the incompleteness of digital rights. That, in itself, is a DRM solution. It's not one you want to necessarily celebrate but I would argue only bad corporations are foolish enough to believe they have total control over any aspect of their business. The thin veil of confidence businesses have in their good times is easily usurped in their bad times -- particularly in a bad economy. What is most intriguing about the Microsoft example of a chaotic DRM solution is Microsoft faired relatively well after The Dot Com Collapse.

[Aaron]

The argument for increasing total revenues in the static model is just wrong. As other posters point out, if raising the price and abandoning the lower segment of the market increases profits, the firm would do just as well if piracy was not available. This simple model indicates that piracy at best will do nothing to profits, but likely lower them.

Some other economic models (see Varian in Journal of Economic Perspectives 2005, for example) discuss some ways in which piracy may actually help and there seems to be a drive among economists to show this. When Betamax came out, the entertainment industries were worried that it would hurt profits - but they were very wrong (not because betamax never caught on, but because the video industry is a huge area of profit).

One example is the "free-sample" model, which says that if consumers are able to taste more variety of downloaded software/music/movies, they acquire a taste for it and will purchase more than without available samples. (Alternatively, consumers may better know which flavors they like and make fewer purchases making less poor purchases).

The most accepted model of sharing is similar to used book markets. Used book sales don't necessarily lower the profit to publishers. If I am willing to pay $50 for a book without sales, I will pay $75 for the book if I know I can sell it for $25 when I am done. The model predicts that sharing will decrease the number of sales, but allow for a higher price since the sharing element adds value.

[John Brandon]

Yeah, I don't think they are waiting for DRM. I think you are giving them too much credit for being smart enough to even know how the content is cracked and distributed. I think this is a case of the techies coming up with techie issues. Movie studios are waiting until there's an audience, so not just the Movielink.com and Netflix crowd, but my mom, who doesn't even own a computer yet. And, they are waiting until 8 out of 10 TV watchers have an HD hooked up to a laptop.

They already know that Microsoft has DRM, and yes they want to make sure Shrek 3 will be safe. But these are slimy Hollywood marketing types who still use Internet Explorer. They read Variety, not Wired. They want to know that, when they sell Shrek 3 online in digital form, that there will be more people who buy it there than at Target. Otherwise, who gives a flying fudge? Heh, just us guys.

[John "Z-Bo" Zabroski]

@Aaron

You say the arguement is wrong, but what about the conclusions?

@everyone

(I believe as of today), CNet recently wrote an article about 10 real PC games you can download for free. These are classical titles that have historical replay value. Interestingly, CNet is marketing for the companies who give these games away for free -- CNet is suggesting to users that if they like the old version of a game, try the newer version "with better-everything" as the saying goes. This is an example of Digital Rights Management in an obscure sense, but it is an example I think we will see a lot more of in the future.

[dan]

With regard to priracy as a "victimless crime" (Piotrr and Chris comments above) from my experience in South America, it is exactly that. The vast majority of people in Bolivia, for example, make very little money (maybe $1 a day), yet find enough to buy ripped DVDs from vendors at many street corners in Santa Cruz, Cochebamba, or La Paz... In these cases I do not think the entertainment industry (Hollywood) can consider themselves a victim, since these people would never have the money to buy authentic DVDs (about $20US there, a month's wage for some people).

Rather than a victim, Hollywood is actually gaining mindshare with the populace in Latin America, gaining loyal fans of "Hollywood entertainment". As economic development continues in these countries (Chile is a great example), a growing middle class of consumers buy movie theater tickets, authentic DVDs (for the bonus/extras), CDs(for the original artwork), and other media. Piracy is building a market of fans among people who could otherwise not afford such entertainment... a long-term market that Hollywood can sell to with value added authentic products -- a market of people who otherwise would not care about Six Feet Under on Blu-Ray, Shrek 8, or Batman Oblivion.

[Brad]

But if you cede the bottom to piracy, you can set a price between the top and the middle. The result: higher revenues per copy, and potentially higher revenues overall.

As others have pointed out, this is just plain false (see trackback entry: 'Economics, Piracy, Bullshit'). I have argued previously that piracy can be good for software companies due to network externalities. http://panopticologist.blogspot.com/2005/07/why-piracy-is-good-for-microsoft.html
I think some music and movies could benefit from increased word-of-mouth advertising because of piracy.