New Strategies for Property Rights:
Gray Markets and the Net

Draft Version

Part 0: Summary and Introduction

this is a quick summary and review of concepts.
to read the paper itself, click here


In the past, developing new property rights for digital goods was costly. This is because it entailed coordinating and enforcing massively multilateral contracts among a huge number of buyers. So producers attempted to obviate such costly contracts by imposing property rights through mechanisms like copy protection and EULAs.

Consumers derive negative value from these kinds of property rights producers of digital goods have imposed on them. When such property rights are bundled with digital goods, consumers have little incentive to consume the rights, but large incentives to consume the good.

In the past, even when sellers have been able to separate rights and goods, high transaction costs have blocked markets from forming efficiently. But the Net slashes transaction costs, enabling such buyers and sellers to contract with one another, in effect forming parallel or ‘gray’ markets for unbundled goods without property rights. In these markets, the value of property rights is arbitraged away.

The existence of such gray markets implies that consumers will only consume bundles of goods and rights from which they derive at least the same value as equivalent goods without bundled rights. In other words, bundled property rights must provide consumers some value. Such value might be provided by side payments or other mechanisms.

Furthermore, The Net changes the dynamics of digital goods markets, by slashing the transaction costs of massively multilateral contracts. In essence, it offers producers a strategic opportunity to define new kinds of property rights based on providing consumers additional value when bundled with digital goods.

What are Property Rights?

Broadly speaking, property rights are what you can do with a good or asset. Can you sell it? Can you extract value from it? Can you subdivide it?

Generally, three kinds of property rights are delineated. Use rights – the right to use (and stop other from using) a good; income rights – the right to earn income from a good; and exchange rights – the right to transfer (or sell) the right to another party.

Firms often see property rights as an ‘appropriability mechanism’ - a way to lock in profits generated by strategic assets. But property rights are also goods which economic actors can exchange in markets with low transaction costs. In fact, it’s only the past that makes us see property rights as exclusionary mechanisms. They don’t have to subtract value by excluding consumers from consumption – in fact, they can, as we will see, add significant value for consumers.

The Economics of Property Rights

Property rights generally develop to internalize externalities – to force others to bear the true costs of their actions – when the benefit from doing so is greater than the cost of doing so. Externalities in this case can be broadly defined as effects external to a transaction that one party imposes upon another – such as pollution from a factory, or the overfishing of a stream.

Externalities often arise because of transactions costs. This is because if transaction costs were zero, the harmful effect could be negotiated away, by simply trading property rights. So for property rights conflicts to arise, the transaction costs implicit in a contract must be greater than the gains from trade.

In short, property rights will be developed or redeveloped when the economic value that can be realized from a good or asset is disrupted – via externalities or other mechanisms – and when the transaction costs are small relative to the value of the good or asst. Changes in property rights often accompany periods of technological change and market expansion.

Gray Markets

Gray markets happen when unauthorized sellers sell goods to buyers. The classic example is what’s often called parallel importation: cheap Canadian pharmaceuticals, for instance. Usually, gray markets are obstructed by transaction costs. Firms impose transaction costs on gray market participants via a variety of strategies, like supply-chain interference, acquisitions, and legal tactics designed to increase transaction complexity.

The Net enables gray markets for all kinds of goods, because it reduces exactly the kinds of transaction costs firms hope to impose between gray market buyers and sellers. Now, buyers and sellers can easily find each other. For example, the costs of finding a seller of various kinds of pornography, before the Net, used to be fairly high; now, such sellers are not only easy to reach, but contact most of us every day, via spam – transaction costs are zero.

Digital goods gray markets are markets for parallel consumption in the sense that consumers can choose to consume goods with embedded property rights or without them. How do embedded property rights for digital goods get separated from the goods they are bundled with? Usually, a number of mechanisms such as hacks, cracks, and simple misuse are responsible.

The larger point is that firms cannot always and everywhere ensure digital goods are consumed on the terms that they wish, because enforcement costs are prohibitive. In fact, at no time in the history of digital goods have firms been able to rigorously enforce any scheme for embedded property rights with any degree of success. As I will argue later, the best way to enforce property rights systems is to provide consumers the incentive to use them.

Go To: Part 1 - Property Rights as Strategic Errors




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