What follows is an excerpt of the results of a longer paper on The Effect of Increased Availability of Online Piratable Copies of Films on Box Office Revenue. The paper goes on to use the framework described below to conduct some analysis of the film piracy. The results are available in the the full paper and will also be part of a later post.
It is impossible to tell merely from the presence of sharing whether each participant values the good in question more than its full price; we can only say that he values the good more than the price required of him by the group plus the transaction costs associated with forming and participating in the group.
Transaction costs are an essential factor in examining whether and which groups form. These account for costs associated with gathering information, finding people who want to join a group, and determining what good or goods the group will consume. The magnitude of transaction costs can be diminished by technology, such as the Internet. If there is insufficient technology to overcome transaction costs, then sharing groups cannot form. For example, groups are limited by geography; I cannot easily share a DVD with someone 100 miles away from me without spending large amounts of time and money to meet up with him. Those transaction costs are high enough to keep sharing from occurring. That is, they are too high until transportation technology enables travel to take place at an affordable price, thus overcoming the time and money cost of traveling great distances.
Given all this, it is safe to say that sharing will occur when multiple people (with sufficiently low transaction costs and the technology to overcome them) each value a good less than its price, but the sum of how much they value the good exceeds its price.
Sharing may also occur even when a participant values the good more than its price. Because each buyer wishes to minimize his opportunity cost, he will enter into a sharing-group if doing so will decrease his cost more than it would decrease the marginal utility of the good. This decrease in marginal utility will necessarily occur, when the good in question is rivalrous, because of transaction costs.
Given that people often act in groups to consume a good, there are two basic ways those groups can acquire that good. Either all (or some fraction) the members of the group pay part of the costs or one member pays the cost for everyone else.
All Members Pay (AMP) GroupsBefore the proliferation of the Internet, transaction costs typically limited the size of sharing groups to a few people who already knew each other; e.g. you and your friend combine to buy a DVD. The cost of the DVD and the revenue to the seller is half of what it would be if you had each bought your own DVD. For any sharing group, the cost to the participants and the revenue to the producer is equal to 1/n (where n the number of participants in the group) the cost and revenue if each member bought a separate instance of the good. While the producer would prefer greater revenue by selling a separate good to each member of the group, his net revenue is only decreased if more than one member of the group already valued the good more than its full price, meaning that they would have purchased it anyway if the group had not allowed them to minimize their cost.
One Member Pays (OMP) GroupsIn some cases, groups involve one individual paying the full price for a good and sharing it with multiple other people who pay no portion of the price of the good. For example, one might buy a DVD and screen it for three friends. In such a scenario the effect on producer revenue is the same as in AMP groups because all members of the group consume the good even though he has sold only one instance of the good. The effect on the consumers’ values is altered in an OMP group, however. The non-paying members get to consume the good without paying the producer anything and with only the opportunity cost associated of spending time watching the film instead of doing something else and transaction costs associated with the existence of the group in the first place (both of which would still exist even if they had to pay). The paying member does bear the brunt of the cost, but he also derives social value either by increased esteem from his friends or simply from his enjoyment of the experience or something else.
Group sharing also occurs via the Internet which represents a massive increase in both technology and information acquisition, two of the prerequisites of overcoming transaction costs to form a group. Where before a group was limited to those who could actually possess the physical medium containing a film, now one legally (or illegally) acquired DVD can provide millions of people with a substitute experience. Additionally, the Internet has reduced transaction costs associated with forming and acting as a group. Internet users are more easily able to find others who want to be part of the group, and members do not need to spend time getting to know each other or assembling in the same temporal and geographical location.
Both kinds of groups discussed above (AMP and OMP) exist on the Internet. Firms like Netflix facilitate the spreading of costs in an all members pay setup. In many cases, however, internet sharing takes the form of an OMP group. Although such actions are often illegal, one user can upload a good which can then be consumed by many others without payment.
In the context of films, the Internet’s reduction in barriers to group formation has allowed groups to become very large. Thus, using the 1/n formula above, costs to consumers and revenue to producers are greatly decreased in the short term as n reaches numbers in the millions. The Internet has also reduced the diminution in utility from sharing since digital files are non-rivalrous and become even less so as more copies are made.
The result is a decreased demand for consumption of the film by means that produce revenue directly for the producer (i.e. going to the theater or buying a DVD/digital copy) even though the product may be consumed by more people. This is true even of AMP groups; film producers don’t get more money if many people watch their movie on Netflix. So demand for the good per se may increase while demand for the good sold directly by the producer decreases in the short term. This phenomenon will, in many cases, eventually lead indirectly to more demand to the original producer in the long term, however, because licensees will have a higher demand for content which makes them a profit.
This long run benefit to producers may exist even for illegally uploaded content shared in an AMP group because that content started as legal content sold by the original producer, and members of the group will generate higher demand for the original, legal good. Besen (1984) makes the point this way:
The effect of introducing copying is to increase the demand for originals, either because their costs can be shared or copies can be sold, but the increase in demand will be less than proportional to the number of copies made.To understand this point consider an AMP group in which an individual buys a DVD and uploads it to the Internet to share with other users who pay the uploader a fee. This is pirating, but the effect of this arrangement may be to increase the price of DVDs (i.e. revenue to film producers). As the number of group members (i.e. demand for the pirated content) increases, the uploader will experience an increase in revenue. Assuming his black market businesses is profitable, the uploader will then increase his demand for DVDs so that he can continue to upload them and, thereby, generate more revenue. The increased demand for DVDs will result in an increase in the price of DVDs, and, therefore, an increase in revenue to film producers. Such an effect will only occur, however, if the uploader’s demand for originals increases more than the demand for the originals decreases because the group members now consume copies through the group rather than purchasing an original. The exact dynamics that would produce such a group is a topic worthy of study, but it is outside the scope of this paper.
In Internet based OMP groups, however, revenue to the original producer would generally not increase with demand for pirated content because the paying member generally derives no great amount of utility from his sharing. Obviously he derives some value from his actions (otherwise he would not undertake them), but the understandable social benefits of sharing in OMP groups in which the members are acquainted with each other do not exist in expansive, anonymous Internet based groups. The payer’s demand for the original, legally consumed content is, therefore, unaffected by other group members’ demand for the uploaded, pirated content. Such a group would seem, on its face, to be detrimental to film producers insofar as members of the group value the film more than the price of an original.
Yet even that conclusion is not certain, because the behavior of pirates does not occur in a vacuum. Regardless of their valuation of the good, non-paying consumers of a film may still contribute to producer revenue by talking up the film to their friends some of whom may then engage in paid consumption. It is very difficult to determine how this effect might be working in the current environment, but it surely is happening to some degree. If non-paying consumers become walking advertisements for the good, it is quite possible that unpaid consumption benefits producers regardless of the value scales of those consumers. Even if the non-payer would have paid for the film if piracy had not been an option, the lost sale could be seen as a profitable, if involuntary, marketing expenditure.
 It is worth noting that not all OMP groups are illegal. I can legally show a DVD to a few friends but not a few thousand friends. I can lend the DVD to as many people as I want, but I can’t make copies of it and lend those. I can watch it on my computer, but I can’t upload it to the Internet. Whether these legal lines should exist and, if so, whether they are correctly situated is, however, beyond the scope of this paper.