Why Napster is Right: Monopoply and Competition with Sunk Costs

Details
 

Counterpoint
 

Example
 

Growth
 

Discussion
 

References

We have argued in the  main essay  that the current controversy over Napster and the more general discussion about keeping, modifying or altogether abolishing the copyright law is mostly about distributive issues. By casting the problem in this form, we somehow renounce using that most familiar among economists' yardsticks, Pareto Efficiency. After all we do recognize that somebody (recording and distribution companies, mostly) would loose, should our point of view be implemented. Still, to the extent that consumers and creators of intellectual products constitute about 99.9% of the population, we actually claim that dramatically reducing downstream copyrights protection to increase competition in the reproduction, distribution and circulation of art/information/entertainment products is socially beneficial. To put it the other way around: current restrictions on downstream usage do not serve a socially useful purpose and, contrary to the commonly accepted view, are not necessary to achieve a social efficient outcome. They are in the copyright law mostly, or solely, to protect some powerful monopolies. A socially efficient outcome in the production and distribution of cultural products can be achieved without the wasteful monopolies generated by current copyright restrictions, and  by means of market competition and competitive pricing. In this essay we try to elaborate on this point further, without getting too technical (Examples or Growth  contain more technical material).

It should be clear by now, that the arguments exposed here are not restricted to either the case of Napster, or to music, or even to the copyright law per-se. Most of what we argue extends, almost verbatim, to the legislation establishing patents and monopoly rights over goods which can be produced at near constant marginal cost, once their first copy or sample or prototype has been made available. That means, all those goods for which (a) reverse-engineering is either simple or in any case cheaper than re-discovering the original design anew, (b) for which, once the blueprint is available, large scale production and distribution is feasible at roughly constant marginal cost and, (c)  for which demand is elastic. A large number of extremely valuable medicines belong, for example, in this category. The general case for (against) patents, though, is generally not as strong and clear cut as the case for (against) copyrights. To avoid claiming too much and generating unpleasant misunderstandings, the arguments exposed here will be restricted to copyrighted products. We leave it to forthcoming work ("forthcoming work" may mean a few months ... come back often!) the appropriate extension to the case of patents.

We accept as a fact that for ideas, books, paintings, music and so forth, two half-baked ideas are not the same as one fully baked. Technically this means not that there is a fixed cost, as it is often argued, but that there is an indivisibility in the form of a minimum scale for any selected  idea. Notice, before proceeding along, that the words "selected idea" should be qualified to mean "selected quality of a given abstract idea". The qualification is relevant, because also half-baked ideas (that is: different qualities of the same idea) have positive social value. The initial design of the idea we call "car" would  be classified as a very low quality idea for today's standards. The same goes for radios, TVs and what not. This implies, on the one hand, that the indivisibility of ideas needs not be exagerated and that, on the other hand, the incremental aspect of "technological discovery" should be given much more emphasis when modeling innovative activity and its economic implications. Technological breakthroughs, after all, almost always consist of some thousands of "half-baked" ideas fitting together just right! But this line of thought would lead us too close to, among other things, modelling patents, which we promised to avoid for the time being. So let us go back to copyrighted ideas.

Before getting carried away with patentable ideas, we were saying that we accept as a fact  that, for any given quality of a new product, there is a constraint that no less than one full unit has any value. However, as we have pointed out in  Examples, this need not matter in a number of relevant cases: the constraint may simply not bind. The cost of coming up with (at least) one sample of the idea may be a lot smaller than the quasi-rents the same producer(s) will collect when his stuff is priced competitively. Think, for example, at the opportunity cost of recording a new lyric and the rents needed to compensate for it. The mere presence of sunk costs, in other words, does not justify giving a government monopoly to the creator of the first copy. This is because under competitive pricing the creator(s) of the first copy may earn enough rents to recover its initially fixed, then sunk, cost. However, it is perfectly possible, especially for material that has only limited social value, that the constraint could bind, i.e. under competitive pricing the quasi-rents are not enough to compensate for the initial cost and, foreseeing this, the potential creator would abstein from turning in the first copy. Hence, under our proposal, art products of very little social value may not be produced without giving copyright protection to their creators. This may be OK after all: issuing copyrights for stuff that almost nobody would like to read, watch or listen to may not be such a damaging thing to do. Even better: copyright protection would lead to higher prices and, therefore, even fewer people listening to or reading bad stuff. Everybody gain!

In addition, we can ask as the technology for replication and distribution improves, whether the minimum size constraint becomes more or less binding. The answer to this latter questions is a firm: it depends. If demand for the product is elastic, meaning that a 10% reduction in price will increase demand by 10% or more, then reducing the distribution cost will not reduce the competitive rents earned by the originator. In this case reducing production and distribution costs would make the minimum size constraint even less binding. It is reasonable, however, to presume, that when distribution costs become low enough, demand becomes inelastic. That is, at some point the market is so saturated, with every individual in the world having copies of a particular song on every musical device he owns, that reducing the price further calls forth little if any more demand. From a practical point of view, though, it does not seeem unreasonable to argue that the latter case should not worry us so much: if most people already have access to the product at a low enough price the social gains from reducing its cost of distribution would be relatively small. We are also willing to argue that, for most products covered by the copyright law, this is not the case. Their demand is quite elastic and the social gains from reducing production and distribution costs of additional copies are likely to be large. Competitive pricing achieve such reduction.

Is it possible then, that a technology like Napster may make it impossible for competitive pricing to recover costs? Allowing downstream sales effectively eliminates the originator's natural monopoly: As soon as the originator has sold just a few copies, she faces a competitive market in which copies of the original product are sold at much lower prices.These initial copies may not command a very high premium since they purchasers know that, in a short span of time, they will also have to compete with each other, the originator, and their own customers. So is this not an argument for allowing the originator to use licensing agreements that enable her to maintain her original monopoly? For, only through the power of monopoly can she hope to recover her costs, and so be willing to produce the good in the first place?

The answer again is a firm: not necessarily. The radio and television industry, which have substantial sunk costs, give their products away for free. In the case of creative activity, we might wish to look at the market for art products. A signed original painting commands an enormous premium over a very good imitation. People eagerly seek out authors at book signings; autographed baseballs sell for prices that seem to us to be absurd. Consider that the same digital technology that lowers distribution costs, makes the sale of personalized copies quite practical. That is, I can by my music/book/movie, with a personal message from the author to me, signed by the author. As long as I am willing to pay a premium for this, the author has an opportunity to recover his unique production costs.

But isn't this a contradiction you say? Why can't the purchaser resell his signed copy? Well he can - but what he should not be able to do legally, is to change the inscription so that the book is personalized to the new purchaser rather than himself. So which do you prefer? A CD from your favorite artist personalized to you, or to me? They sell at very different prices, you know! Notice also that while copy protection is technologically difficult, making personalized copies that cannot be forged is relatively easy. Your personalized copy is encrypted with the private key of the author. Anyone can decrypt it and play the music, but they will see your name. Of course they can change the name, but they cannot reencrypt it with the private key of the author, so it will be evident that the copy was not really personalized to them.

Finally: why not considering the fact that advances in the technology for production and distribution of intellectual products may allow the original creators to produce and directly distribute the objects in which their creativity is contained, avoiding the parasitic gatekeepers and earning much higher rents (on average) than under the current arrangement? In this circumstances, creators would have an incentive to figure out quite precisel yhow successful their product may be and try charging quite a lot for the first few copies they sell, or for those personalized copies demanded by aficionados. At the end of the day, we bet more products of art would be produced and distributed to consumers. Which is what matters from the social viewpoint.

So is not obvious that creators of original work need to have government grants of monopoly power to recover their costs. Ultimately the issue is an empirical one: what is the elasticity of demand? What are the costs of production? What clever methods can authors use to command a premium over downstream rivals? The fact is that those in favor of more copyright protection for producers have never given one bit of empirical evidence to support their point of view. They merely make theoretical arguments. Since their theoretical arguments are weak at least and wrong more often than not, it is up to them to produce empirical evidence that the monopoly power they crave has some social justification.

In fact: existing evidence points the other way. Copyright protections for producers have been strengthened without doing anything but reducing supply and enriching the monopolists. In addition the opportunity cost of authors and singers is low, and they get almost none of the revenue from their works, so it is difficult to imagine that we couldn't cover their production costs in a competitive system.

What then is the policy we are suggesting? We are simply suggesting that the copyright law be changed to prohibit downstream licensing agreements. This would not mean that you would be free, for example, to change the author's name to your own and redistribute the modified work: that would be profiting from a lie, and is and should be considered to be fraud. Similarly, you would not be free to repersonalize an inscription certifying you bought the material from the originator to show that someone else did. Nor would authors be prevented from trying to restrict downstream consumption by technological means: they would still be free to sell you copies that explode in 24 hours, or phone home for permission to play, or whatever. On the other hand, you, as the purchaser, would be legally entitled to reverse engineer or crack whatever silly thing they did, and redistribute the result for a profit, so if authors were foolish enough to think that their product was so special that people would put up with all sorts of silly restrictions ... they would quickly and legally be disabused of this notion.

If you are interested in pursuing these issues, you might want to read the  examples our, if you are patient, our paper "Perfectly Competitive Innovation". Among other things, it shows what competitive market prices look like with sunk costs. Although a bit technical, it is pretty nice. And it tells you also about a bunch of other interesting things, such as when it might be an advantage for a country to have a technological disadvantage.