Contributions to Economic Analysis & Policy

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1 ontrbutons to Economc Analyss & Polcy Volume, Issue Artcle Pracy and the Legtmate Demand for Recorded Musc Ka-Lung Hu Ivan Png Natonal Unversty of Sngapore, Natonal Unversty of Sngapore, opyrght c by the authors. All rghts reserved. No part of ths publcaton may be reproduced, stored n a retreval system, or transmtted, n any form or by any means, electronc, mechancal, photocopyng, recordng, or otherwse, wthout the pror wrtten permsson of the publsher, bepress. ontrbutons to Economc Analyss & Polcy s one of The B.E. Journals n Economc Analyss & Polcy, produced by The Berkeley Electronc Press (bepress).

2 Pracy and the Legtmate Demand for Recorded Musc Ka-Lung Hu and Ivan Png Abstract Publshers of computer software and musc clamed losses of over $7. bllon to pracy n. Theoretcally, however, pracy may rase legtmate demand through postve demand-sde externaltes, samplng, and sharng. Accordngly, the actual mpact of pracy on the legtmate demand s an emprcal ssue. Addressng ths ssue n the context of recorded musc, we develop and test hypotheses from theoretcal models of pracy on nternatonal data for musc Ds over the perod Emprcally, we fnd that the demand for musc Ds decreased wth pracy, suggestng that theft outweghed the postve effects of pracy. However, the mpact of pracy on D sales was consderably less than estmated by ndustry. We estmated that, n 998, actual losses amounted to about.% of sales, or % of ndustry estmates. But, we found evdence that publshers would have rased prces n the absence of pracy, suggestng that the actual revenue loss would have been hgher. KEYWORDS: pracy, copyrght, musc We gratefully acknowledge contrbutons to a prevous verson of ths paper by Yan u, dscussons wth Yehnng hen, Keth Joplng (IFPI), Tom S. Y. Lee, and Poonam Ramchand (Euromontor), and advce from the edtor, anonymous revewers, and semnar partcpants at the Amercan Economc Assocaton Annual Meetng, Oho State Unversty, Stanford Unversty, ULA, Washngton Unversty, St Lous, Natonal Unversty of Sngapore, and Nanyang Technologcal Unversty.

3 Hu and Png: Pracy and the Legtmate Demand for Recorded Musc. Introducton Publshers of computer software and recorded musc clam to have suffered staggerng losses to pracy. Software publshers clamed that, n, the worldwde pracy rate for P busness software was 9%, whch translated nto a $.8 bllon loss n revenue (Internatonal Plannng and Research orporaton ). For the same year, the recorded musc ndustry estmated that a total of.8 bllon unts were prated worldwde, representng a loss of $. bllon to recordng studos (Internatonal Federaton of the Phonographc Industry ). All these fgures ndcate sgnfcant losses to the relevant copyrght owners. Such huge losses dlute the ncentve for development of nformaton product. However, the losses clamed by the computer software and recorded musc ndustres may be excessve. If pracy could be prevented, many of those who used prated products mght not swtch to buyng the legtmate tem. Instead, they mght smply not use the product. Wth no reducton n prce, t s not lkely for all the llegal users to swtch to the legtmate tem. The harm caused by pracy also depends on publshers prcng strateges. When prvate copyng rases the beneft to the buyer of a legtmate product, publshers could rase the prce of the legtmate tem to extract the ncreased consumer surplus. If ths happens, drectly treatng all prated copes as lost sales would overstate the harm caused by pracy. However, f publshers delberately set low prces to dscourage copyng, then the number of copes would understate the lost revenue (see Besen 98, 987). Theoretcally, there are several addtonal reasons why publshers losses to pracy mght not be as large as clamed. Pracy may actually boost the demand for legtmate nformaton products through postve demand-sde externaltes. Some people just lke to conform (Festnger 9) owng to nformatonal nfluence, normatve nfluence, or nternalzaton (Burnkrant and ousneau 97; Deutsch and Gerard 9). Others beneft from drect and ndrect network externaltes (onner and Rumelt 99; Nascmento and Vanhonacker 988; Shy and Thsse 999; Takeyama 99). Musc Ds provde a good example of ndrect externaltes: By ncreasng the provson of recorded musc, hgher pracy mght ncrease the ownershp of D players, whch n turn stmulates the demand for legtmate musc Ds. Even n settngs wthout demand-sde externaltes, pracy may beneft the legtmate producer of an nformaton product. The legtmate demand may derve from the buyers supply of copes to others (Besen 98; Besen and Krby 989; Lebowtz 98; Varan ) and sharng among peer users (Bakos et. al. 999). Prated tems may facltate samplng of the nformaton product (Fader ; Hall ). For all these reasons, pracy may rase buyers wllngness to pay and hence the demand for the legtmate tem. Shapro and Varan (998) defne nformaton products to be goods, such as software, musc, vdeos and books, that can be dstrbuted n dgtal form. Emprcal evdence for hardware-software complementarty n demand has been found for D players and musc Ds (Gandal et al. ), as well as DVD players and dgtal vdeo dsks (Karaca-Mandc ). Produced by The Berkeley Electronc Press,

4 ontrbutons to Economc Analyss & Polcy Vol. [], No., Artcle Further, pracy may rase the legtmate demand for nformaton products by enablng producers to credbly commt to not reduce ther prce n the future (Takeyama 997). When consumers antcpate a producer to reduce prce, they may delay purchasng n the current perod. The presence of cheap prated copes, however, dssuades the producer from prce skmmng. Hence there s no ncentve for future prce reducton, whch n turn leads hgh-value consumers to buy the legtmate tem. Fnally, pracy may serve as an nstrument of prce dscrmnaton for the legtmate producer to drve out potental compettors (Jacob and Ben-Shahar ). Therefore, on the one hand, pracy steals from the legtmate demand as potental buyers swtch to prated products. On the other hand, pracy rases the legtmate demand by nducng more people to buy and rasng ther wllngness to pay. The balance of these effects s an emprcal queston. A related ssue s how the legtmate producer should adjust prce n response to the encroachment of prated products. As Shapro (988) noted, ths s not a trval queston. For nstance, f pracy s severe, the producer mght maxmze proft by sellng a small quantty at a hgh prce and concedng the rest of the market to prated copes. In ths paper, we present a smple model of pracy that accounts for the producer s prce and other market factors. We apply the theory to nternatonal panel data for musc Ds. Owng to data lmtatons, nstead of separately dentfyng the demands for legtmate and prated musc Ds, we estmate an ntegrated equaton that reflects the net mpact of pracy on the legtmate demand. Accordng to our estmates, on a per-capta bass, a one-unt ncrease n musc D pracy was assocated wth a reducton n legtmate musc D sales by. (±.) unt. The overall effect of pracy on the legtmate demand for musc Ds was negatve. Apparently, the postve nfluences of pracy, f any exsted, dd not outwegh the drect substtuton of prated for legtmate Ds. However, our results do contradct the ndustry clam that every prated unt would reduce legtmate sales by one unt. We fnd that the losses of musc D sales caused by pracy were 8% lower than the ndustry estmates. Assumng that the ndustry dd not adjust D prces, t lost about. (.8 or.) % of sales to pracy n 998. Usng an analytcal model, Gopal and Sanders (997) show that, n the computer software ndustry, no more than % of revenue would be lost to pracy. However, they dd not provde emprcal valdaton of ths asserton. Emprcally, natonal software pracy rates have been shown to be related to ncome and culture, among other factors (Gopal and Sanders 998 and ; Holm ; Husted ; Marron and Steel ; Rodrgues-Andres ). We report all pont estmates wth a range of mnus/plus one standard error. In the case of the loss due to pracy as a percentage of sales, the end-ponts of the range are calculated as the pont estmate mnus/plus the standard error of loss dvded by the actual sales plus the pont estmate and mnus or plus the standard error respectvely. Accordngly, the range s not symmetrc about the pont estmate. For brevty, we use postve nfluences to nclude all the possble ways by whch pracy may rase the legtmate demand for nformaton products, ncludng postve demand-sde externaltes, supply to others and product sharng, samplng, and provdng a prce commtment mechansm.

5 Hu and Png: Pracy and the Legtmate Demand for Recorded Musc Realstcally, musc publshers would have reduced ther prces to mtgate the mpact of pracy. The prces that we observed were the outcomes of such adjustments. Accordngly, the actual revenue loss to publshers would have been larger than.%. The rest of our paper s organzed as follows: Secton presents our theoretcal model and the resultng hypotheses; Secton descrbes the econometrc model and the data; Secton presents the estmaton results; Secton dscusses the mplcatons of our research fndngs. Fnally, Secton concludes the paper.. Theory We frst present a model that addresses the pracy of nformaton products. Because the model consders copyng as an alternatve to buyng the legtmate tem, t explctly captures the theft aspect of pracy. We then expand the model by ncorporatng the postve nfluences, and formulate our research hypotheses based on the comparatve statcs derved from the model.. Theft onsder the market for an nformaton product that has been developed and produced by a sngle proft-maxmzng publsher. 7 For potental users, there are three possble actons: Buy the product, copy the tem, or not use. Snce the publsher s aware of the possblty of llegal copyng, t may choose to nvest effort to detect pracy and take enforcement acton aganst prates. Let the resultant detecton rate be µ. If a user s detected wth a prated tem, she wll be subject to a legal penalty, whch s denoted by f. The publsher sets prce p to maxmze proft. We assume a dstrbuton Φ(v) of potental users, who dffer n ther value, v, for the tem. All potental users are rsk neutral, and they make ndependent decsons regardng buyng, copyng or not usng the tem. If a user does not use the tem, she wll enjoy reservaton utlty, r. For smplcty we assume zero cost of copyng. If a user wth value v buys the legtmate product, she receves a net beneft of U L v p. () We suppose that, f she copes the tem, she enjoys a proportonately lower beneft, ( δ ) v, nstead of v. The parameter δ (,) captures the qualty dfferental between the legtmate and prated tems. For nstance, the prated tem may lack features such as the user manual, prnted lterature, and attractve packagng. For brevty, we only present a model that addresses copyng by ndvdual end-users. The model can readly be adapted to encompass re-seller pracy by lettng the re-seller bear the legal consequence of copyng and sellng the prated tem. All the comparatve statcs results reman unchanged n the re-seller model. Accordng to the Busness Software Allance, re-seller pracy occurs n the Unted States and Europe as well as n Asan countres lke hna and Malaysa. 7 hen and Png (999; ) develop a model n whch the end-user, f caught copyng, would be deprved of usng the software. Produced by The Berkeley Electronc Press,

6 ontrbutons to Economc Analyss & Polcy Vol. [], No., Artcle Further, f the user copes the tem, she wll be caught wth probablty µ and must pay a fne f. Let X represent the expected fne, or X µf. Hence her net expected beneft wll be [ δ ] v X. () U For a potental user to buy the tem, t s necessary thatu L U, whch, by () and (), mples p X v v. () δ Therefore v defnes a cut-off value: those wth values v v buy the legtmate product, whle those wth v < v choose to copy or not use the product. The demand for the legtmate product s then L dφ( v) Φ( v). () v For a potental user to copy the tem, t s necessary that the net expected beneft be less than that from buyng the legtmate tem, U L < U, and no less than that from not usng the tem, U r. The latter condton defnes a cut-off value, r X v v. () δ Those wth values v satsfyng v v < v copy the product, whle those wth v < v choose not to use the tem. The demand for copyng (choosng the prated product) s v dφ v) Φ( v ) Φ( v ). () v ( From equatons () to (), we can easly derve the followng set of comparatve statcs relatonshps: v v L >, < and >, (7) p p p p v v L <, > > and <. (8) X X X X. Postve nfluences Pracy may rase the demand for a legtmate nformaton product by ncreasng the overall user base n several ways. Some people just lke to conform (Burnkrant and ousneau 97; Deutsch and Gerard 9; Festnger 9), whle others beneft from drect and ndrect network externaltes (onner and Rumelt 99; Nascmento and Vanhonacker 988; Shy and Thsse 999; Takeyama 99). Followng onner and Rumelt (99) and Shy and Thsse (999), we model these postve nfluences through an addtve term e( L, ), where the functon e s

7 Hu and Png: Pracy and the Legtmate Demand for Recorded Musc ncreasng n each of ts arguments, L and. Recall from () and () that L and denote the demands for the legtmate and prated tems respectvely. 8 If an end-user buys the product, she enjoys a net beneft of v e( L, ) p. If she copes, her net beneft s [ δ]v [ λ]e( L, ) X, where λ denotes the proportonate reducton n the postve nfluences for the user of a prated tem. 9 Then, smlar to (), n the case of end-user pracy, the ndvdual just ndfferent between buyng and copyng would be that wth p X λ v e( L, ). (9) δ δ Further, as n (), the ndvdual just ndfferent between copyng and not usng would be that wth r X λ v (, ) e L δ δ. () Then, the demands for the legtmate and prated tems would follow () and () respectvely. Now, the postve nfluences mply that e/ L > and e/ >, and hence by (9), v /. Usng ths and mplctly dfferentatng () wth respect to, we have, < L >. () By contrast, our theory does not predct the sgn of / L. Ths functon depends on the dstrbuton Φ and the relatve magntude of δ and λ, and may be postve or negatve.. Hypotheses We used a very smple model of pracy and postve nfluences to derve the comparatve statcs relatons (7), (8), and (). However, t should be noted that the results are robust to alternatve modelng assumptons, such as assumng that prated tems are confscated. Further, other than expected penalty, the varable X could represent copyng costs or any other factor that has opposte effects on the demands for the legtmate and prated tems. Based on the above analyss, our frst hypothess focuses on the mpact of the expected penalty as derved n (8): 8 The general formulaton e( L, ) encompasses both stuatons where the legtmate demand ncreases wth the absolute extent of pracy and those where the legtmate demand ncreases wth the pracy rate, /[ L ]. Note that the extent of the postve nfluences depends on the scale of e; f the scale of e s very small, havng a hgh (legtmate and prated) demand does not add much value to the tem. 9 Users of prated tems derve relatvely less beneft from the postve nfluences as they may be nhbted n openly showng or sharng wth others. Supposng that Φ s lnear (.e., v s unformly dstrbuted), t can be shown that, f δ > λ, then / L > ; f δ λ, then / L ; and f δ < λ, then / L <. Produced by The Berkeley Electronc Press,

8 ontrbutons to Economc Analyss & Polcy Vol. [], No., Artcle H (Theft): The demand for the legtmate (prated) nformaton product s ncreasng (decreasng) n the expected penalty. Note that the substtuton between the legtmate and prated tems depends on the magntude of the expected penalty, whch s exogenously determned. If the expected penalty s low, ceters parbus, pracy would preval. Therefore, H ndrectly mples the stealng of legtmate demand by prvate copyng. The next hypothess s based on the comparatve statcs relaton (): H (Postve Influences): The demand for the legtmate nformaton product s ncreasng n the extent of pracy. Because H and H hypothesze opposte effects, the net mpact of pracy on the legtmate demand s unclear. It could be postve or negatve.. Emprcal Investgaton. Econometrc Model Prevous theoretcal research has emphaszed that pracy could potentally ncrease the legtmate demand. As we showed n the analyss leadng to (7) and (8), the extent of pracy s endogenous t depends on the prce of the legtmate tem and the expected penalty. Accordngly, to study the real mpact of pracy, t s mportant to begn from the underlyng varables that shape the demands for the legtmate and prated tems. It would be wrong to treat pracy as an exogenous factor and drectly relate the legtmate demand to the extent of pracy. Before ntroducng the emprcal model, we frst explan why we chose the musc D market as the context for testng. The only avalable sources of data on pracy were studes by the IFPI (Internatonal Federaton of the Phonographc Industry), and the BSA (Busness Software Allance) and SIIA (Software and Informaton Industry Assocaton). These report pracy on a natonal bass, whch led us to specfy the unt of emprcal analyss as a country. We were only able to collect suffcent longtudnal data on volume of sales and prce of the product at the natonal level for musc Ds. Further, recorded musc products are qute closely prced across dfferent artsts and labels. By contrast, there s wde prce dsperson wthn the categores of computer software and books. Ths prce dsperson would add nose to the effect of prce on demand, and mght possbly obscure the estmated effect of pracy. Apart from the varables consdered n our theory, we ncorporated three exogenous demand-sde factors personal dsposable ncome, ownershp of musc D players, and the worldwde number of MTV subscrbers. Generally, we expect the demands for both legtmate and prated musc Ds to ncrease wth ncome, D player ownershp (Gandal et al. ), and the MTV subscrber base.

9 Hu and Png: Pracy and the Legtmate Demand for Recorded Musc 7 Accordngly, based on (7), (8), and (), we set up the followng structural demand equatons: L, t pt X t Yt N t M t, t ε t, (), t pt X t Yt N t M t L, t ut, () where ndexes the countres and t ndexes the years of observaton, the ndependent varables are prce (p), expected penalty (X), ncome (Y), D player ownershp (N), and worldwde MTV subscrptons (M), and ε and u denote random errors wth zero means. By (7) and (8), the coeffcents,,, and are predcted to be postve. By the general theory regardng the mpact of ncome, D player ownershp, and MTV subscrptons, the coeffcents,,,,, and are predcted to be postve. By (), the coeffcent s predcted to be postve. Fnally, we do not predct the sgn of for the reasons stated n Secton.. We could not observe the expected penalty X t on a country-year bass. Indeed, even f we had nformaton on enforcement rates and penaltes, t would be dffcult to transform the data nto a common operatonal scale. How would a $, fne on an end-user compare wth a oneyear jal term for a re-seller? Absent the data on the expected penalty, we substtuted for the X t n () from () to arrve at the followng equaton, L, t pt Yt N t M t, t ψ t, () where, () η, () η, (7) η, (8) η, (9) η, () η and ψ t ε t ut () η s a mean-zero random error term; η () Produced by The Berkeley Electronc Press,

10 8 ontrbutons to Economc Analyss & Polcy Vol. [], No., Artcle denotes a constant, whch we fnd below to be postve. The equaton () contans parameters from the demands for both legtmate and prated musc Ds. The coeffcent of pracy n (),, () η conssts of two parts: > represents the postve aspect of pracy (H), whle < represents the substtuton between the legtmate and prated tems due to the expected penalty (H). Absent the data on expected penalty X t, we could not dentfy the structural demand equatons () and () and so, we could not separately test H and H. However, by estmatng the ntegrated equaton (), we can gauge the net mpact of pracy on the legtmate musc D demand. To elmnate country-specfc factors that mght affect musc D demand, we specfy equaton () wth country fxed effects. Ths would effectvely control for persstent, countryspecfc factors, such as natonal culture, that were stable over the perod of study. Wth the fxed-effect specfcaton, n () represents a vector of natonal constants rather than a sngle ntercept.. Data We compled a set of musc D data for 8 countres. Generally, our dataset ncludes countres from all the major contnents, and t also samples representatve countres n every band of pracy level defned by the IFPI. To estmate (), we need natonal data on musc D prce (p), musc D demand ( L ), pracy level ( ), D player ownershp (N), MTV subscrptons (M), and personal dsposable ncome (Y). We collected these data from multple sources. Frst, data on natonal musc D sales revenue and volume, D player ownershp, and personal dsposable ncome for were acqured from Global Market Informaton Database (GMID), whch s a comprehensve statstcal archve compled from varous trade sources by Euromontor Internatonal. From sales revenue and volume data, we calculated the average prce of musc Ds across the varous countres and years. As a check, we compared the GMID wth IFPI musc D data for 998, the year for whch the IFPI began publshng musc D sales and volume nformaton. The two data sets were hghly consstent: the correlaton coeffcents were.99 (p <.) for D sales volume and.99 (p <.) for D sales revenue. The specfc countres are lsted n Table below. The IFPI ( wth a membershp of, record producers and dstrbutors n 7 countres, represents the nternatonal recorded musc ndustry. It publshes a wde range of ndustry statstcs. urrently, the IFPI classfes countres nto four pracy bands: less than %, -%, -%, and above %.

11 Hu and Png: Pracy and the Legtmate Demand for Recorded Musc 9 For data on natonal pracy, we used the IFPI s musc D pracy rates (prated quantty as percentage of legtmate and prated quanttes). The IFPI estmated pracy by combnng estmates from specalst market researchers for the dfference between D producton capacty and legtmate sales by country, and drect estmates of pracy by the respectve natonal recorded musc organzatons. These estmates were then moderated and combned by the IFPI management to produce the offcal numbers for each country. Applyng the IFPI pracy rates to the yearly sales of legtmate musc Ds, we could calculate the prated quantty,t. Fnally, we compled the worldwde number of MTV subscrbers from varous ssues of the annual report of VIAOM, the parent company of MTV Networks, and converted the subscrber base nto per capta terms usng the world populaton, obtaned from the U.S. ensus Bureau. All the other ndependent varables, except musc D prce, were converted nto per capta terms usng the respectve country s populaton as reported by the GMID. Note that we could not extend our dataset beyond 998 because n the followng years, Euromontor Internatonal ncluded estmates of prated quanttes n ts calculatons of musc D sales volume and revenue. Therefore, accurate data for L,t and p t were not avalable after 998. Because we could not locate systematc pracy nformaton before 99 (the year that the IFPI pracy data started), the scope of our nvestgaton was lmted to 99-98, a perod n whch musc Ds were ganng popularty and replacng musc cassettes. Table reports descrptve statstcs of the sample. Per capta consumpton of musc Ds was slghtly more than one unt per year, whle only around % of people owned D players. The standard devatons of both D player ownershp and personal dsposable ncome were large, ndcatng that the countres had dfferent ncome and demographc characterstcs. The worldwde per capta MTV subscrpton was low, but ncreased steadly over the years. Table. Descrptve Statstcs Varable Unt Mean Std. dev. Max Mn Prce US$.7... Legtmate sales Per capta Prated quantty Per capta..7.. Personal dsposable ncome US$ D player ownershp Per capta Worldwde MTV subscrptons Per capta..7.. Table reports the average musc D prce and per capta consumpton of legtmate and prated Ds by country over the studed perod. The demand for both legtmate and prated Ds vared wdely across the countres, whch could possbly be attrbuted to dfferent natonal cultures and ncomes. The per capta purchases of legtmate musc Ds was hghest n the Unted States and lowest n Inda over all fve years. By contrast, the Unted States exhbted The IFPI estmates and formulae are propretary. As far as we know, the IFPI s the only organzaton that systematcally publshes data on musc D pracy across countres. Produced by The Berkeley Electronc Press,

12 ontrbutons to Economc Analyss & Polcy Vol. [], No., Artcle low consumpton of prated Ds. The consumpton of prated Ds was hgh n both Hong Kong and Sngapore. Wth a few exceptons (e.g., Inda and Japan), the average prce of musc Ds vared moderately across the countres. Table. Musc D Prce, Demand and Pracy ountry Average Prce (US$) Legtmate Sales Prated uantty Argentna Australa 7... Brazl.97.. anada hle..9. olomba.97.. zech Republc..7.9 Fnland France Greece Hong Kong, hna Hungary... Inda.8.7. Indonesa Ireland Israel Japan..7. Malaysa.99.. Netherlands New Zealand Norway Poland Portugal Sngapore Sweden Unted Kngdom USA Venezuela Instruments The prce of musc Ds mght be endogenously determned. Accordngly, we sought an nstrument that could capture the varatons n D prce whle not beng correlated wth the quantty demanded. The deal canddate would be supply-sde cost shfters, but such data were not avalable. Lackng compellng cost data, we used the prce of non-tradeables as our prce nstrument. Presumably, the effect of musc demand on the prce of non-tradeables would be

13 Hu and Png: Pracy and the Legtmate Demand for Recorded Musc mnmal, whle the prce of non-tradeables would reflect the cost of land and labor. These determne the cost of retalng, whch n turn nfluences the prce of musc Ds. We constructed ths nstrument as the rato of each country s purchasng power party (PPP) rate to ts exchange rate relatve to the US dollar. As defned, PPP rates reflect dfferences n purchasng power. By contrast, exchange rates depend on dfferences n the prces of tradeables. Accordngly, the rato of the PPP to exchange rates should reflect dfferences n the prces of non-tradeables. We obtaned data on PPP and exchange rates from EIU ountry Data, whch contans major economc ndcators publshed by the Economc Intellgence Unt. Lke the prce of musc Ds, the prated quantty mght be endogenously determned from (),,t s drectly related to u t, whch s part of the composte error ψ t n (). Our challenge was to acqure nstruments that would be correlated wth the prated quantty but not the legtmate sales. We selected two groups of nstruments based on dfferent reasons. Frst, we used the pracy rates of two other nformaton products, musc cassettes and busness computer software. Snce the pracy of these two nformaton products and musc Ds would be nfluenced by the same set of natonal characterstcs (ncludng expected penalty for sellng or usng prated tems and culture), t s qute lkely that they are correlated wth but not affected by the demand for each other. Second, by (), the prated quantty s a functon of the reservaton utlty, r. Any exogenous factors changng r would affect the cut-off value v but not v, and hence, are sutable nstruments for the prated quantty. We ncluded the unemployment rate and total consumer expendture, whch are related to the reservaton utlty, as such nstruments. Data on musc cassette pracy rate and busness computer software pracy rate were obtaned from the IFPI and BSA/SIIA respectvely. 7 We acqured the consumer expendture and unemployment data from the GMID.. Results We estmated equaton () for the musc D market usng ordnary least squares (OLS) and two-stage least squares (SLS). In the SLS estmatons, we appled the prce of non-tradeables as the nstrument for the musc D prce, and the musc cassette pracy rate, BSA/SIIA software pracy rate, total consumer expendture and unemployment rate as nstruments for the prated quantty. Essentally, we seek exogenous varables that shft the prated quantty, but that are not affected by the legtmate demand for musc Ds. When the reservaton utlty r s hgh, the opportunty cost of gettng a prated musc D s hgh. Hence, a varable that s reflectve of r would correlate wth the prated quantty, makng t a sutable nstrument for the latter. 7 The BSA/SIIA busness computer software pracy rates are avalable at Produced by The Berkeley Electronc Press,

14 ontrbutons to Economc Analyss & Polcy Vol. [], No., Artcle We frst estmated a baselne model, whch ncluded all model varables except pracy. The OLS and the SLS estmaton results are reported n the frst and second columns of Table respectvely. For SLS, the R of the frst stage regresson was.9, and the coeffcent of the prce of non-tradeables was sgnfcant (p <.). Hence, the prce nstrument was effectve. The prce coeffcent was consstently negatve, and ts magntude was larger n SLS as compared wth OLS, supportng the vew that SLS provded consstent estmatons of the model parameters. In subsequent analyss, we focus on the SLS estmates. The four model varables, p t, Y t, N t and M t, were jontly sgnfcant (χ., p <.). All parameters exhbted the expected sgns. The coeffcent of prce was negatve, whle the coeffcents of D player ownershp, personal dsposable ncome, and MTV subscrptons were all sgnfcant and postve. Hence, we retaned all varables (prce, D player ownershp, personal dsposable ncome, and MTV subscrpton) for the baselne D model. We next estmated the full research model, whch ncluded the pracy varable. Estmaton results usng OLS and SLS are shown n Table, columns three and four. The R of the frst stage regresson n SLS was.8. The coeffcents of both unemployment rate (p <.) and total consumer expendture (p <.) were sgnfcant, but the coeffcents of musc cassette and BSA software pracy rates were not sgnfcant. These ndcate that the nstruments could explan only part of the varatons n the prated quantty. The fve ndependent varables n equaton (), p t, Y t, N t, M t and,t, were jontly sgnfcant (χ., p <.). The coeffcent of ncome was postve and sgnfcant. Recallng (7), ths mples that >. (7 ) η Snce ncome has a postve effect on the legtmate and prate demands,.e., > and >, the fndng that > mples that η >. Lkewse, the results that > and > also suggest that η >. From Table, column three, the coeffcent of pracy was negatve and margnally sgnfcant (coeffcent., p <.). Referrng to (7), snce η >, we nfer that pracy was a sgnfcant and negatve factor n the demand for legtmate musc Ds. A one-unt ncrease n per capta pracy was assocated wth a fall n per capta legtmate sales by. (±.) unt. The negatve mpact of pracy was comparable to that of prce. Specfcally, a one standard devaton change n the pracy varable would have resulted n per capta demand changng by. (±.8) unt, whle a one standard devaton change n prce would have changed the per capta demand by. (±.8) unt. It should be noted from () that the coeffcents of prce, ncome, D player ownershp, MTV subscrptons, and pracy combne the drect effect of each varable on the legtmate demand wth the ndrect effect through the demand for the prated tem. Accordngly, the coeffcents cannot be drectly assocated wth elastctes of the legtmate demand.

15 Hu and Png: Pracy and the Legtmate Demand for Recorded Musc a d b c Table. Demand for Musc Ds a Baselne model Full model Fxed onstant Non-zero obs. Spltncome Yeardummes Varable OLS SLS b OLS SLSc SLS c SLS c SLS c SLS c () () () () () () (7) (8) Prce (.99) (.7) (.79) Personal dsposable ncome (.) (.) (.8) D player ownershp (.88) (.887) (.98) Worldwde MTV subscrptons (.7) (.) (.9) Pracy -.7 (.) Pracy (Hgh ncome countres) Pracy (Low ncome countres) ** ** ** -.77.).8 (.97).89 (.9).9 (.7) * -. (.8) -.9 (.9). (.).988 (.7) 8. (.) -.7 (.88) ** * ** -. (.).9 (.8) **.97 (.8). ** (.) -.7 (.78) -.89 (.) d -.9 (.9).8 (.). (.8) 9.97 (.77) -.8 (.7) ** ** -. (.).9 (.7).78 (.) -.8 (.8) Y9. (.) Y9.97 (.8) Y97 **.8 (.9) Y98. (.89) N Adjusted-R Whte s heteroscedastcty-consstent standard errors n parentheses. All sgnfcance levels calculated usng two-taled tests. ountry fxed effects and constants are not reported for brevty. ross-country prce of non-tradeables was used as nstrument for musc D prce. Musc cassette pracy rate, BSA/SIIA software pracy rate, unemployment rate, per-capta expendture and cross-country prce of non-tradeables were used as nstruments for the pracy and prce varables. p-values slghtly exceeded.. p <., ** p <., * p <.. * c ** Produced by The Berkeley Electronc Press,

16 ontrbutons to Economc Analyss & Polcy Vol. [], No., Artcle As already revewed, n theory, pracy may rase the demand for a legtmate nformaton product (H). If the postve nfluences were strong enough, they could outwegh the negatve effect of pracy due to the theft of customers. However, our results for musc Ds suggest otherwse. The coeffcent of the pracy varable was negatve and sgnfcant. Apparently, even f such postve effects exsted, they were more than offset by the harm caused by the loss n sales due to theft. In terms of our hypotheses, the results were consstent wth H (Theft). Our analyss further allowed us to nvestgate n detal the presence of an ndrect network effect, by whch hgher pracy ncreases the ownershp of D players, whch n turn stmulates the demand for legtmate musc Ds. onsstent wth Gandal et al. (), our results n Table showed that the demand for legtmate musc Ds was ndeed postvely assocated wth hgher D player ownershp. However, the correlaton between the prated quantty and D player ownershp was qute modest, and not statstcally sgnfcant (Pearson correlaton., p.). Apparently, prated musc dd not have a sgnfcant complementary effect on the demand for D players, and hence t mght not have contrbuted to rasng the legtmate demand through an ndrect network effect. To assess the robustness of our emprcal analyss, we estmated alternatve specfcatons of equaton (). Frst, we regressed the legtmate demand on one constant nstead of 8 country fxed effects. The SLS estmaton results are reported n column fve of Table. All model parameters mantaned the same sgns and smlar statstcal sgnfcance. ompared wth the results n column four, the adjusted R dropped substantally from.97 to.9, ndcatng that the country fxed effects accounted for substantal varatons n musc D demand. A Wald test suggested that the country fxed effects were preferred over an overall constant (χ.78, p <.). Next, because the countres exhbted wde varatons n ncome, and ncome affects musc D consumpton, we splt the countres nto two groups accordng to ther ncome levels. The hgh-ncome group conssted of fourteen countres that had personal dsposable ncome exceedng $, per year; the rest of the countres were classfed as low-ncome countres. Two separate pracy parameters were then estmated accordng to the ncome levels, and the SLS results are reported n Table, column sx. The pracy parameter for the low-ncome countres was not sgnfcant, but the one for the hgh-ncome countres was near sgnfcant at p.7. A Wald test suggested that the two pracy parameters could be combned (χ <., p.99). Hence the full SLS model (column four) was preferred. Further, our dataset contaned a number of country-year observatons wth zero pracy. Snce zero pracy seems mplausble, we repeated the full model estmaton wthout the zeropracy observatons. The results are reported n Table, column seven. The sgns of the coeffcents were dentcal to those obtaned wth the complete dataset (Table, column four). The (absolute) magntudes of all parameters were slghtly smaller than those estmated wth the complete data set. The pracy coeffcent dropped around % from. to.8, and ncreased n sgnfcance to the 99% level. Fnally, we used the worldwde MTV subscrptons to gauge the overall consumer exposure to musc. Because the MTV subscrpton varable (M t ) was tme- (but not country-)

17 Hu and Png: Pracy and the Legtmate Demand for Recorded Musc dependent, an alternatve approach was to use yearly dummy varables n estmatng equaton (). The results of such estmaton are reported n Table, column eght. Generally, the parameters were smlar to those estmated usng MTV subscrptons. The pracy coeffcent was close to sgnfcant at p., and t was negatve at.8 (cf.. n column four). The year dummes ndcated an ncreasng trend of musc D purchases, whch was consstent wth the postve coeffcent of MTV subscrptons n the full SLS model (Table, column four).. Implcatons Gven the prevalng pracy levels, how many unts of legtmate musc D sales were lost to pracy? Table reports the estmated losses n the year 998 based on the IFPI pracy data and the assumpton that every prated D caused a unt loss n legtmate sales. By ths calculaton, the average loss n per capta D demand due to pracy was.7 unt. 8 By contrast, we estmated the true loss to be only around % of ths quantty, or specfcally.9 (±.9) unt per capta. 9 Our method was, for each country, to multply the coeffcent of pracy n the demand equaton,., by the extent of pracy n that country. The estmate by ths method was (±) % of the IFPI number. By Table, column one, legtmate sales were. unts per capta. Hence, assumng that prces remaned constant, the average revenue lost to pracy would have been.9/(.9.). (-.8 or.) %. Ths estmate under-estmates the actual revenue loss because, as we dscuss below, we expect the recordng studos to have reduced prces n response to pracy. The prces that we observed were the outcomes of such adjustments. Accordngly, the actual revenue loss to publshers would have been larger than.%. The dfference between the IFPI s estmates and ours can be attrbuted to several factors. Frst, end-users dffer n ther beneft from musc Ds and hence ther response to the possblty of copyng and avalablty of prated tems. Absent pracy, some are prced out of the market and do not swtch to buyng the legtmate tem. Second, the postve nfluences of pracy mght offset part of the substtuton ( theft ) from legtmate to prated tems. Fnally, f publshers follow a lmt-prcng strategy, lowerng ther prces where pracy s hgh, then a hgher pracy level would nduce a lower prce, whch stmulates legtmate sales. How would recordng studos adjust prces n response to pracy? We consder two cases where the natonal ndustry s a monopoly and where t s an olgopoly. In both cases, we suppose, for smplcty, that producton requres zero fxed and margnal cost. 8 Table reports averages for 998 only, hence these dffer from the averages for as reported n Table. 9 The extent of pracy n Hong Kong was substantally hgher than that n the rest of the countres. We also estmated the full model wthout the Hong Kong observatons. The coeffcent of pracy was negatve, but wth reduced sgnfcance. Wth the omsson of Hong Kong for 998, the average nternatonal sales was.8 unts, the average prated quantty was.8 unt, and the mpact of pracy was to reduce legtmate sales by.8%. Produced by The Berkeley Electronc Press,

18 ontrbutons to Economc Analyss & Polcy Vol. [], No., Artcle Table. Losses n Per-apta D Sales, 998 ountry Sales IFPI a Model b Argentna (.8) Australa (.8) Brazl (.) anada (.) hle.8.. (.8) olomba.7.8. (.9) zech Republc.7.. (.) Fnland (.) France (.8) Greece (.8) Hong Kong, hna.8..9 (.89) Hungary (.9) Inda.9.9. (.) Indonesa..7.7 (.) Ireland... (.) Israel.8.. (.) Japan.9.. (.) Malaysa.9.8. (.) Netherlands (.7) New Zealand.97.. (.) Norway..8. (.78) Poland..9. (.) Portugal.88.. (.9) Sngapore (.9) Sweden.7.. (.) Unted Kngdom (.9) USA (.) Venezuela..8.7 (.) Average..7.9 (.9) a alculated from musc D sales and the IFPI musc D pracy rates. b alculated usng the estmated pracy parameter, -. (prated quantty). Standard errors n parentheses, computed usng the standard error of the pracy parameter,.8.. Monopoly onsder a monopoly publsher facng the legtmate demand (). Its revenue and proft would be R pl p p py pn pm p pψ, () where, for brevty, we omt the ndexes for country and tme. It maxmzes proft at the prce where dr / dp,.e.,

19 ψ dp d p M N Y p. () By () and (), dp d dp d dp d L. Hence, by (), (), and (),. dp d () Let p * represent the proft-maxmzng prce. Usng (), the frst-order condton () smplfes to ] [ * ψ M N Y p, or ] [ * ψ M N Y p. () Substtutng nto (), the proft-maxmzng sales s ] [ * ψ L M N Y. (7) By Table, column four, emprcally, the coeffcent of prce n (),.77 <, and the coeffcent of pracy n (),. <. Snce and are postve, t s easy to verfy that the margnal effects of n () and (7), < (8) and <. (9) Therefore, both * p and * L are decreasng n the extent of pracy.. ournot Olgopoly As our data set dd not nclude busness-level nformaton, we could not study actual prcng under condtons of prce competton. The best that we could do was to consder the mpact of pracy on prcng and sales n a ournot-nash equlbrum. Specfcally, suppose there are n musc D publshers n each country. Then, the aggregate demand s 7 Hu and Png: Pracy and the Legtmate Demand for Recorded Musc Produced by The Berkeley Electronc Press,

20 n L. () From (), the nverse demand functon can be wrtten as ψ t n M N Y p. () For each seller, the revenue and proft would be t n M N Y p R ψ. () It maxmzes proft at the quantty where / d dr,.e., ψ t n j j d d M N Y. () By () and (), d d d dp d d. Hence, by (), (), and (),. d d () Then, () smplfes to ] [ ψ n j j M N Y. () In a symmetrc equlbrum, the sellers select dentcal quanttes. Therefore, we have ] [ ) ( ψ M N Y n, or ] [ ) ( * ψ M N Y n n. () Substtutng ths nto (), the equlbrum prce s ] [ ) ( * ψ M N Y n n p. (7) Agan, the margnal effects of on prce and quantty are negatve, whch means that the publshers tend to reduce prce and sell fewer Ds n the presence of pracy. Also, compared wth () and (7), the negatve effects due to are smaller. Each ournot publsher loses less revenue from pracy as compared wth a monopoly. Obvously, for n suffcently large, the whole ndustry would also lose less revenue than the monopolst. 8 ontrbutons to Economc Analyss & Polcy Vol. [], No., Artcle

21 Hu and Png: Pracy and the Legtmate Demand for Recorded Musc 9. oncludng Remarks In ths study, we demonstrated that pracy reduced the demand for legtmate musc Ds across a number of countres durng the perod Specfcally, we estmated the mpact of pracy on legtmate musc D sales to be. (-.8 or.) % of sales, or (±) % of the musc ndustry s estmate. We beleve that publshers would have reduced prces n the presence of pracy, suggestng that the true revenue loss would have been hgher. In our emprcal estmaton, we characterzed the effect of pracy by a sngle varable, whch was common to all countres. Whle we employed a fxed-effect specfcaton to capture natonal dfferences n overall demand, t dd not account for natonal dfferences n the mpact of pracy on demand. A more complete model that ncorporates nteracton varables or random coeffcents across countres mght help uncover such dfferences. Unfortunately, wth our small sample sze and short tme frame of study, t was not practcal to estmate such a model. In our estmated demand equatons, the coeffcent of the pracy varable was negatve and sgnfcant. We note that the coeffcent s subject to bas arsng from errors n the measurement of pracy. To the extent that the IFPI s musc pracy rates are subject to error, the coeffcent of pracy would be based towards zero, hence under-state the actual mpact of pracy. Further, f the IFPI s musc pracy rates are nflated by a fxed proporton, then the true mpact of pracy on the legtmate demand would be our estmated coeffcent multpled by the nflaton factor. The frst stage regresson n the SLS estmaton also shows that our pracy nstruments may not be satsfactory. learly, fndng good measures of pracy and approprate nstruments s a major challenge n any research nto pracy of nformaton products. We nferred from the negatve pracy coeffcent that the postve nfluences of pracy on legtmate demand were outweghed by substtuton of prated tems for the legtmate product ( theft ). However, we admt that our emprcal analyss dd not effectvely address the mpact of pracy through drect network and demand-sde externaltes, where pracy ncreases the user base and thereby drectly stmulates the demand for the legtmate tem (onner and Rumelt 99; Nascmento and Vanhonacker 988; Shy and Thsse 999; Takeyama 99). These are unlkely to arse n the case of musc Ds. More sutable testng grounds for the mpact of pracy through drect network externaltes would be the markets for communcatons software and hardware. Further, several of the postve theores emphasze that pracy helps the legtmate producer by enablng more effectve prce dscrmnaton (Bakos et al. 999; Besen and Krby 989; Jacob and Ben-Shahar ; Lebowtz 98; Takeyama 997; Varan ). It s possble that ths gan may be ndependent of an ncrease n the potental users wllngness to pay for the legtmate product. To ths extent, our emprcal estmates may not have completely tested these theoretcal arguments. We would need a more detaled data set to nvestgate the mpact of pracy on prce dscrmnaton. Gvon et al. (99) appled aggregate data for sales of busness P software n an nnovaton dffuson framework to estmate the mpact of prated software on legtmate sales n the Unted Kngdom. They, however, had no data on prated software, and ther results reled on an nterpretaton of coeffcents of lagged legtmate sales n the dffuson equaton. Produced by The Berkeley Electronc Press,

22 ontrbutons to Economc Analyss & Polcy Vol. [], No., Artcle Fnally, our data set dd not extend beyond 998, owng to a change n Euromontor s statstcs of musc D sales volume and revenue. The data pre-date the wdespread adopton of broadband Internet connectons and the related boom n onlne fle-sharng. Accordngly, our results do not address the mpact of Napster and other onlne fle-sharng systems on sales of legtmate recorded musc (Fader ; Hall ). An mportant drecton for future work s to comple data for the more recent perod so as to nvestgate ths ssue. References Bakos, Yanns, Erk Brynjolfsson and Douglas G. Lchtman Shared Informaton Goods, Journal of Law and Economcs, Vol. No., Aprl 999, 7-. Besen, Stanley M. Prvate opyng, Reproducton osts, and the Supply of Intellectual Property, Informaton Economcs and Polcy, Vol. No., 98, New Technologes and Intellectual Property: An Economc Analyss, RAND Report N-, and Shela N. Krby Prvate opyng, Approprablty, and Optmal opyng Royaltes, Journal of Law and Economcs, Vol., October 989, -8. Burnkrant, Robert E. and Alan ousneau Informatonal and Normatve Socal Influence n Buyer Behavor, Journal of onsumer Research, Vol. No., December 97, -. hen, Yehnng and I.P.L. Png Software Prcng and opyrght Enforcement: Prvate Proft vsa-vs Socal Welfare, Proceedngs, th Internatonal onference on Informaton Systems, December 999, and ---- Informaton Goods Prcng and opyrght Enforcement: Welfare Analyss, Informaton Systems Research, Vol. No., March, 7-. onner, Kathleen R. and Rchard P. Rumelt Software Pracy: An Analyss of Protecton Strateges, Management Scence, Vol. 7 No., February 99, -9. Deutsch, Morton and Harold B. Gerard A Study of Normatve and Informatonal Socal Influences Upon Indvdual Judgment, Journal of Abnormal Socal Psychology, Vol., November 9, 9-. Economst Intellgence Unt. EIU ountry Data. ( Euromontor Internatonal. Global Market Informaton Database. ( Fader, Peter S. Expert Report, A&M Records, Inc. v. Napster, Inc. F. Supp. d 89,. ( Festnger, Leon An Analyss of omplant Behavor, n M. Sherf and M.O. Wlson, eds., Group Relatons at the rossroads, New York, NY: Harper, 9, -.

23 Hu and Png: Pracy and the Legtmate Demand for Recorded Musc Gandal, Nel, Mchael Kende and Rafael Rob The Dynamcs of Technologcal Adopton n Hardware/Software Systems: The ase of ompact Dsc Players, RAND Journal of Economcs, Vol. No., sprng, -. Gvon, Moshe, Vjay Mahajan and Etan Muller Software Pracy: Estmaton of Lost Sales and the Impact on Software Dffuson, Journal of Marketng, Vol. 9 No., January 99, 9-7. Gopal, Ram D. and G. Lawrence Sanders Preventve and Deterrent ontrols for Software Pracy, Journal of Management Informaton Systems, Vol. No., sprng 997, and ---- Internatonal Software Pracy: Analyss of Key Issues and Impacts, Informaton Systems Research, Vol. 9 No., December 998, and ---- Global Software Pracy: You an t Get Blood Out of a Turnp, ommuncatons of the AM, Vol. No. 9, September, Hall, Robert E. Expert Report, A&M Records, Inc. v. Napster, Inc. F. Supp. d 89,. ( Holm, Håkan J. an economc theory explan pracy behavor? Topcs n Economc Analyss & Polcy, Vol. No.,, Artcle ( Husted, Bryan W. The Impact of Natonal ulture on Software Pracy, Journal of Busness Ethcs, Vol. No., August, 97-. Internatonal Federaton of the Phonographc Industry (IFPI). The Recordng Industry ommercal Pracy Report, July. Internatonal Plannng and Research orporaton. Eghth Annual BSA Global Software Pracy Study, June. Jacob, Assaf and Danny Ben-Shahar Preach for a breach: selectve enforcement of copyrghts as an optmal monopolstc behavor, Workng Paper, Radzner School of Law, Interdscplnary enter Herzlya, Israel, August. Karaca-Mandc, Pnar Network Effects n Technology Adopton: The ase of DVD Players, Workng Paper, Department of Economcs, Unversty of alforna, Berkeley, June. Lebowtz, Stanley J. opyng and Indrect Approprablty: Photocopyng of Journals, Journal of Poltcal Economy, Vol. 9 No., October 98, Marron, Donald B. and Davd G. Steel Whch ountres Protect Intellectual Property? The ase of Software Pracy, Economc Inqury, Vol. 8 No., Aprl, 9-7. Nascmento, Fernando and Wlfred R. Vanhonacker Optmal Strategc Prcng of Reproducble onsumer Products, Management Scence, Vol. No. 8, August 988, Rodrgues-Andres, Antono The European Software Pracy: An Emprcal Applcaton, Workng Paper, Unversty of Southern Denmark,. Shapro, arl. Economc Effects of Home opyng, mmeo, Prnceton Unversty, May 988. Produced by The Berkeley Electronc Press,