Managing Digital Piracy

(Research Seminar, March 27, 2003)

Arun Sundararajan

NYU, Stern School of Business

Abstract

This talk will present my research on some economic aspects of digital piracy. I'll provide a brief overview of three related problems:

1. Choosing optimal pricing and protection levels.

2. The effects of piracy-induced negative usage externalities.

3. Digital distribution, DRM standards and social efficiency.

Subsequently, I'll present a model that analyzes the first problem in some depth. It models nonlinear pricing in the presence of piracy, when the value for the pirated good varies across customers, and when the seller of the legal good can choose different degrees of copy protection through the level of DRM (digital rights management) technology that they implement. The seller’s optimal pricing schedule can be characterized as a simple combination of optimal contract in the absence of piracy, and the piracy-indifferent contract (which is an incentive-compatible contract that makes customers indifferent between the legal good and the pirated good). Increases in the quality of the pirated good cause a downward shift in price for all customers, and, interestingly, may also induce increases in the fraction of legal users, and the level of legal usage.

I also show that when the seller cannot price-discriminate, the optimal level of DRM is at the quality-efficient level. This is the level of protection where the difference in quality between the legal good and the pirated good is maximized. However, when the seller can choose their optimal pricing schedule, the profit maximizing level of protection is strictly lower, and choosing the quality-efficient level results in the seller overprotecting their product. In addition, as the effectiveness of a DRM implementation reduces over time, which typically occurs due to the protection scheme being progressively hacked, the optimal response of a seller may be to reduce (rather than increase) their level of DRM protection.