Archives for November 2004

Continuing yesterday’s discussion of the new Rob/Waldfogel filesharing study, let’s look at the possible effect of authorized downloading services.

As we saw yesterday, one of the main findings of the study is that people derive lots of benefit (about $45 annually per capita for the study’s sample population) from downloading songs that they don’t value enough to buy. In the absence of filesharing, this would have been deadweight loss.

Suppose that CDs cost $15 and that the (marginal) cost of producing and distributing one more CD is $2. Suppose further that Alice would be willing to pay $9 for a particular CD. If the record company could somehow sell Alice the CD for a price between $2 and $9, Alice would buy it and both parties would be better off. The total welfare gain would be $7, the difference between Alice’s valuation of the CD and the cost of providing it to her. But if the record companies have to charge everybody the same price for a CD, they would be foolish to lower everybody’s price below $9 – that would increase their unit sales but lower their total profit. So they’ll keep the price at $15 and a mutually beneficial sale to Alice won’t happen – that’s deadweight loss.

If it’s impossible to sell Alice the CD at a price she is willing to pay, then there is economic benefit in letting Alice download the album without paying – Alice gets the music, and the record company doesn’t lose anything since it wouldn’t have made a sale anyway. Some value that would have been lost is instead being captured by Alice.

But if the record companies can price-discriminate, that is, if they can charge different prices to different people, then they might be able to sell Alice the CD for $8 without lowering the price they charge anybody else. If they can somehow do this, they can eliminate the deadweight loss. But they can only do this if (a) they have some way of guessing how much individual customers are willing to pay, or at least some way of segmenting the customer population into groups that are willing to pay different amounts, and (b) they can prevent people like Alice from buying the CD at $8 and then reselling it to somebody who is willing to pay more.

It’s hard for record companies to price-discriminate in the traditional CD market, but maybe it’s easier for them to price-discriminate by using online music services. Maybe they can cook up a pricing plan that causes people who like a song more to pay more for it. I don’t think anybody really knows how well the industry could price-discriminate in such a scenario.

If, somehow, the industry could price-discriminate perfectly, so that they charged each user just exactly the maximum he was willing to pay for each song, then the deadweight loss would vanish – into the industry’s pockets – and downloading would turn out to be harmful. (Remember, if our goal is to maximize total welfare, we care only that the deadweight loss is gone; we don’t care who pockets it.)

But if we assume, more realistically, that the industry’s price discrimination strategy will have only limited success, then we can’t say whether filesharing will turn out to be harmful. We know that filesharing eliminates $45 (per capita) of deadweight loss. If price discrimination eliminated less than $45, then filesharing would still look like a good idea, considering only direct effects. We know the indirect effects (less music being produced, because of reduced industry incentives) of downloading will be negative, but we don’t know if they’ll be large enough to overcome the positive direct effects.

At the end of the day, the Rob/Waldfogel study doesn’t tell us whether filesharing is helpful or harmful, from the standpoint of total welfare. (Nor, to its credit, does it claim to do so.) What it does tell us is that downloading eliminates a lot of deadweight loss. And so it weighs on the scale – very lightly, to be sure – against the proposition that downloading is harmful.

There’s a new study out, by Rafael Rob and Joel Waldfogel, on the effect of filesharing on music sales. The news headlines will say that the study shows that filesharing hurts CD sales (as the BBC story does); but the full results are more complicated.

The study relied on surveys of college students: a preliminary survey of a large group at four institutions, and a more detailed followup survey of undergraduates at the University of Pennsylvania. The most interesting results come from the smaller Penn survey.

It’s worth noting that this kind of study is likely to overestimate the negative impact of filesharing. The survey samples only college students rather than all filesharing users – and, contrary to popular myth, students account for only a small minority of filesharing activity. As I’ve explained before, surveys of younger people will tend to overweight the harmful effects of filesharing. (Rob and Waldfogel are upfront about the limitations of their study.) For the sake of discussion, I’ll set aside the drawbacks in the study for now, and assume it is correct and it generalizes to the population as a whole.

The heart of the study is an economic comparison, based on the survey data, between the current world, where students do a certain amount of filesharing, and a hypothetical world where filesharing is impossible. The availability of filesharing decreases consumer spending on music from $126 to $101 annually. That’s $25 of lost revenue for the music industry. But it’s only half of the picture.

The other half is the effect of filesharing on consumers. The average consumer is $70 better off with filesharing than without. Of that $70, $25 comes from downloading music rather than buying it, but $45 comes from getting access to music that the consumer wouldn’t have bought anyway. (In econo-speak, deadweight loss is reduced by $45. For more details, see pp. 26-27 of the report.)

This raises an interesting public policy question. The proper goal in this policy area is to maximize total welfare, and not simply to maximize industry profit. (Industry profit is good only insofar as it creates incentives for industry to do things that increase total welfare.) The direct effect of filesharing is to increase total welfare by $45 per capita (increasing consumer welfare by $70 and reducing industry welfare by $25, for a net gain of $45). If direct effects were the only effects, then the right policy would be to allow filesharing.

But of course there are indirect effects, most obviously that the drop in industry revenue reduces the incentive to create new music. The predictable result is that less music will be made. There can be little doubt that the loss of this music will reduce total welfare. The key question is how much welfare loss these indirect effects will cause. If they cause less than $45 per capita of harm, then allowing filesharing may still be a good idea. If they cause more than $45 of harm, then allowing filesharing seems to be harmful. $45 is a lot of welfare to offset – based on the study’s numbers, reducing the production of commercial music all the way to zero would reduce total welfare by only about $125 per capita.

So it’s certainly not right to say that the report shows filesharing should be illegal. (Nor is it right to say that the report shows the opposite.) The report doesn’t quite reach the most interesting policy question.

(Tomorrow I’ll write about the effect of authorized online music services on this analysis.)

The big copyright owners have gotten pretty sophisticated about monitoring P2P applications to gather evidence for lawsuits. But now P2P traffic seems to be shifting to the BitTorrent system, which works differently from other P2P systems. This will affect the copyright owners’ monitoring strategy in some interesting ways.

Most P2P systems allow users to choose between being only a receiver of files, and being both a receiver and a provider. (The default is typically to do both.) BitTorrent, by contrast, tries to enforce a kind of reciprocity between its participants, so that you have to provide parts of a file in order to receive other parts. If this works as designed, there is no way to be a passive, receive-only participant in the BitTorrent system. And that fact has important implications.

Copyright owners typically monitor a standard P2P system by joining the system as a receiver. That allows them to see who is providing which files, without requiring them to provide copyrighted files to anybody. If BitTorrent’s reciprocity scheme works, then the copyright owners will have to participate in the P2P distribution of their own copyrighted files in order to monitor who is providing those files. That’s a step they might not be willing to take.

On the other hand, BitTorrent reciprocity will require that ordinary users who want to receive files will have to contribute to the distribution of those files. They won’t have the option of being silent receivers, as they can be on standard P2P systems. Every user will be exposed to detection by the big copyright owners.

This will foil one of the more subtle features of the copyright owners’ P2P strategy. Their decision to monitor and sue the providers of files, but to leave receivers alone, created an incentive for P2P users to shift to receive-only mode. The idea was that if enough users did this, a larger number of receivers would contend for the services of a smaller number of providers, reducing the overall effectiveness of the P2P system. This plan has a certain elegance, but there’s not much evidence it has worked.

These changes are all interesting, but they will happen only so long as the BitTorrent reciprocity mechanism works – only so long as BitTorrent users are actually forced to provide parts of files in order to receive what they want. People who are threatened by these changes – a category that would seem to include the big copyright owners as well as many users of BitTorrent – will have a growing incentive to defeat the reciprocity system so that they can passively monitor BitTorrent, or passively receive files.

My guess is that somebody will figure out how to be a passive BitTorrent user, albeit with lower performance than active providers get. The knowledge of how to do this may change BitTorrent in important ways. If I were a big copyright owner, I might even consider developing releasing a BitTorrent-leech application.

(For more thoughts on copyright owners and BitTorrent, see Cuong Nguyen’s post on CopyFutures.)