New Strategies for Property Rights:
Gray Markets and the Net

Draft Version

Part 2: Solutions to the Paradox

So, in a nutshell, here’s the total paradox digital producers face – or at least think they face. On the one hand, massively multilateral negotiations raise negotiation and enforcement costs so high that negotiating property rights isn’t feasible. On the other hand, when they obviate these negotiations, and impose property rights, via technology or legislation, the Net enables gray markets to arbitrage those property rights away. But, at the same time, it’s clear that there is a desperate need for some kind of property rights on the Net. Without it, producers will never have the incentive to provide digital goods.

What’s necessary is a radical shift in digital business models, based on new kinds of property rights. These property rights have to provide consumers value when bundled with goods, where current licenses only subtract value when bundled with goods. What makes licenses like this possible, for the first time, is that firms can use the Net to overcome the coordination failure in offering massively multilateral contracts.

Of course, these licenses also have to do two further things. First, they have to set the incentive for consumers to internalize the externality they impose on producers. Second, they must remove the incentive for consumers to create gray markets where property rights get arbitraged away. But the important point is that new property rights must provide incentives for consumers to use them.

The revolution really began with licenses like Creative Commons. It’s a big first step. The problem with such licenses is that transactions costs implicit in them are still too high for them to enable producers to negotiate and distribute value to consumers.

For example, I can choose a license that specifies no commercial use, as well as forces attribution (if you use the work, you must link back to me). But ultimately, the license encapsulates the same old dichotomy as copyright: commercial versus non-commercial. In doing so, it means that you and I face high transactions costs in reaching a deal about how much I might demand from you if you use my work. This creates a disincentive for people to use my work, because the cost of negotiating an agreement is high. Buyers and sellers of goods based on these property rights still face high transaction costs if they are to use them commercially and on a wide scale.

Let’s examine two different kinds of models to help flesh out the argument. First, the iTunes model – a simple market for digital goods with embedded property rights which users derive negative value from. Second, Amazon’s Associates program.

The predominant competitive dynamic in iTunes’ marketplace is likely to be price competition – in fact, rivals are already underbidding iTunes. What will the impact of the price competition that’s already taking shape in this marketplace likely to be?

Let’s start by noting that the price competition isn’t for the value of the digital good itself – in fact, it’s price competition for the value of the embedded property right and the digital good. Consumers may be willing to pay for the good – but they’re most likely not interested in paying for restrictions in consuming the good. So price competition in this case is not only destructive to industry margins but also because it bids away the value of property rights. And this is exactly the same thing that gray markets do.

In essence, price competition means that consumers will be able to pay what they value for the bundle of the property right and the digital good. Since they derive negative value from the property right, this value of the bundle to them is less than that of the good itself. Now, remember that the point of property rights is to internalize externalities – to force people to bear the costs of their actions. This kind of price competition means that digital industries don’t force consumers to internalize the externality they impose via replication – because it’s exactly the value of the externality that’s being bid away.
As price drop in iTunes like models, price-competitive producers are making side payments to consumers, but getting nothing in return. The highest price these side payments will reach is the value of the harm that externalities cause the record industry – the sales lost to replication. This is, to use a simple economic example, like paying one factory not to pollute – but not paying neighboring factories not to. While this is an economically viable outcome, it’s a strategically suicidal one.

So in iTunes models, unlike DVD players, it’s consumers rather than complementors such as hardware manufacturers that appropriate all the value from the property right. In both cases, digital industries end up back at square one – markets like this, rather than protecting digital goods through technologically elaborate rights mechanisms, will instead force producers to bid away the value of property rights via price competition.

Now, let’s look at a model where property rights provide consumers value: Amazon’s Associates program. The Associates program gives book sellers a cut of the revenues in exchange for using Amazon’s engine and supply chain to sell books.

But what does this program really do? First, it establishes a property right to use Amazon as the infrastructure to sell books. Second, it attaches a price to the right to sell books through Amazon. It’s a steep price: Amazon appropriates most of the value (80%) from book sales.

Why doesn’t Amazon’s program face the two problems – gray markets and high transactions costs obstructing the development of new property rights – we’ve talked about? Largely because it sets the right incentives.

Think of Amazon’s program as a monolithic contract for property rights that anyone can buy from Amazon. This program developed exactly as the economics of property rights predicted: in order to internalize the externality consumers imposed on Amazon. The externality was that consumers could utilize Amazon’s infrastructure to search for and evaluate books, and then buy them from a lower bidder.

Amazon uses the Net to solve the first problem we’ve discussed, coordination failure among buyers. The Net provides the infrastructure that makes such a program possible, by slashing the otherwise high transaction costs of such a massively multiparty contract. It lets Amazon keep negotiation and enforcement costs at a relatively low level, because all users are buying the same contract from the same seller, in an automated marketplace.

Amazon’s program works because in effect, like price competition in iTunes models, it makes a side payment to consumers. But unlike iTunes, Amazon gets something in return – it’s effectively paying consumers not to create a gray market. By locking in sellers, it also locks in the search externalities they produce, and could turn against Amazon.

So Amazon’s consumers – both book buyers and book sellers – won’t create a gray market because they derive more value from buying and selling goods bundled with the property right than without it. Buyers realize search economies from the large number of Amazon associates; the associates realize a side payment from Amazon. Both implicitly purchase the property right Amazon is selling.

The above discussion is fairly opaque. Here’s the point. The future of licenses lies not with technological solutions which impose totalitarian rights regimes on consumers, or with legislated rights systems which only encapsulate the same old incentives for consumers. Both of these are irrelevant in the face of mechanisms to unbundle embedded property rights from goods and gray markets.

Instead, the future of licenses lies in innovation about property rights themselves. Revolutionaries understand that the only way to ensure the consumption of property rights is to make them add value for consumers. Otherwise, consumers simply won’t consume them – and, unlike in the past, they now have ways to dispose of them, via gray markets and hacks.

Right now, innovators are doing this by redistributing revenues. In the future, more sophisticated schemes might expand the pie and add value to property rights in a multitude of different ways. For example, innovative licenses might pay dividends, might be options with expiration dates and strike prices, might offer structured, locked-in benefits via frequent-flyer program like subsidies, or might even offer terms like in the Japanese Ring trilogy – replicate this good virally…or else.

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