Strategies for a discontinuous future.

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New Strategies for Property Rights:
Gray Markets and the Net

Draft Version

Part 1: Property Rights as Strategic Errors

'Suppose an owner of a communal land right, in the process of plowing a parcel of land, observes a second communal owner constructing a dam on adjacent land. The farmer prefers to have the stream as it is, and so he asks the engineer to stop his construction. The engineer says, “Pay me to stop.” The farmer replies, “I will be happy to pay you, but what can you guarantee in return?” The engineer answers, “I can guarantee you that I will not continue constructing the dam, but I cannot guarantee that another engineer will not take up the task because this is communal property; I have no right to exclude him.” What would be a simple negotiation between two persons under a private property arrangement turns out to be a rather complex negotiation between the farmer and everyone else. This is the basic explanation, I believe, for the preponderance of single rather than multiple owners of property. Indeed, an increase in the number of owners is an increase in the communality of property and leads, generally, to an increase in the cost of internalizing.' – Harold Demsetz

The Net has only delivered on half it’s promise. It’s having an unparalleled impact on efficiency: entire industries are being ripped apart, in the name of cutting costs. Without the Net, the costs of outsourcing would be prohibitively high, rendering it and the gains it has produced strategic impossibilities.

But on the flip side, the Net is creating less innovation-driven wealth than it should – instead of creating new markets for digital goods, it’s led to a market failure for digital goods. This is largely because property rights for digital goods are inadequate. This paper is an attempt to help remedy this situation, by focusing on what’s wrong with digital property rights, and recommending new strategies for innovation in property rights.

The point of this essay is to argue that both the geeks and the beancounters are wrong about property rights and the Net. The geeks’ vision of a totally plastic Net where there are no boundaries around digital goods – they’re just bits after all – isn’t tenable to stimulate business, or, more importantly, innovation. On the other hand, the beancounters’ vision of a locked down Web isn’t sufficient to stimulate demand, and, again, innovation. Both sides often agree that copyright is broken – but what they miss is the crucial point that what’s necessary is a redefinition of property rights for digital marketplaces.

The first strategic problem in negotiating new property rights for digital goods is that transaction costs between producers and consumers can be incredibly high. This is because digital goods are non-rival in consumption: in a sense, they’re communal goods. Tim, Bob, and Joe can all listen to the same netcast at the same time – but they can’t all drink the same vodka martini at once. So EMI might be able to stop Bob from downloading a track, but what about Joe and Tim? Ultimately, the negotiation for property rights must be coordinated among a huge number of actors, each of whom adds their own negotiation and enforcement cost.

This is why record labels, software producers, and economists feel firms can’t negotiate property rights with consumers, and must instead impose them via legislation or other means: because there’s a coordination failure in selling and enforcing a massively multilateral contract. In fact, as we’ll see later, innovators are using the Net to correct the coordination failure, and effectively offer massively multilateral contracts that work.

But before the Net, such a complex negotiation was an issue. Tech firms, no dummies, decided to obviate such negotiation: they began bundling the goods they were selling with the rights to use those goods as well. The problem was that since users derived negative value from those property rights, firms were caught in a strategic trap.
Here’s the catch-22: without property rights, digital goods become public (or quasi-public) goods – it’s impossible to exclude anyone from consuming them, assuming easy access to digital technology. But when property rights are bundled into goods, they get arbitraged away. By this, I mean that gray markets develop, where the property rights get traded away.

Of course, this is an economically efficient outcome, since consumers are trading value for property rights. But it’s a bad strategy – because the money doesn’t flow to digital content producers, but instead to others, such as platform providers and hardware manufacturers. Lately, the players that have benefited from rights management solutions, ultimately, have been mostly hardware sellers – because the property rights have usually been bundled with the hardware itself.

Let’s take a quick detour through the history of rights management to examine this. The first rights management system bundled into digital goods was copy protection. Copy protection seems like a rational response: it attempted to limit the externality consumers could impose by allowing them limited access to the goods they had bought.

But consumers disliked copy protection hugely. Many who owned copy protected goods still opted to use cracked versions. In fact, copy protection’s biggest strategic effect was to create a gray market for goods without it. This response to copy protection clues us in to how consumers value digital goods.

The problem with copy protection was that it imposed new kinds of costs on consumers: inflexibility and compromise costs. These are the kinds of costs incurred when a user found out that, for instance, she needed a dongle to run a piece of software. In such a case, users did what was rational: chose the kind of software that imposed the least costs on them – in this case, software without the property right.

And that’s the point: at the same price, any bundle of property rights and goods must provide at least as much value as the good by itself. Any less, and consumers have a disincentive to consume the property rights with the good.

This is why DRM systems are doomed. From an economic point of view, DRM solutions are just massively distributed copy protection. Like copy protection, they offer consumers nothing in exchange for the negative value they impose. This is why bundling digital goods with the DRM systems typical today has been a strategic failure: because consumers have no incentive to consume the property right with the good, and, furthermore, the means not to, because of the Net.

Firms are currently using another tactic to attempt to impose property rights as well: EULAs. EULAs (aka clickwraps/shrinkwraps) are the best example of where information industries would like the property rights wars to end up. What’s the point of such a tactic?

EULA’s are basically written to try and provide total control over a good. Property rights scholars call the rights that fall through the cracks in contracts residual control rights - rights to do things with goods that aren’t covered by original contract – and often argue that such residual control rights are in fact the basis of ownership. Because the nature of ownership in digital markets is itself undefined as yet, EULA’s are an attempt to co-opt residual control rights. But what most firms seem not to understand is that whether EULA’s will win battles in court or not is strategically irrelevant.

This is because from an economic point of view, EULA’s and DRM are equivalent: neither compensates consumers for the restrictions they place on consumption. Consumers derive negative value from EULAs just as they do from DRM – so in both cases, consumers have no incentive to consume property rights with goods.

Here’s the point: the Net enables gray markets, because it reduces search and transactions costs among buyers and sellers. In fact, if we think about it, we can see that DRM systems almost always create gray markets. Think about Macrovision’s region encoding scheme for DVD players. Not only did it fail, but it also created a gray market for region-free DVD players, which were priced at a premium. What was this a gray market for? Not DVD players, but for property rights – in this case, property rights to digital films. Most people were willing to pay an extra few bucks for the property right of playing films across regions. Despite the film industry’s best attempt to price discriminate, consumers demanded a market – and one was created.

This is why mechanisms such as EULA’s and DRM are fundamentally flawed from a strategic point of view. In the past, transaction costs made it difficult for buyers and sellers of property rights to create parallel markets, where property rights are irrelevant. Now, the Net means that the opposite is true. So if users derive negative value from property rights, they can trade them away in markets.

What happens in these gray markets? Basically, such gray markets arbitrage the price of property rights. Sellers profit from the difference in the value of the same good with and without property rights. What this means is that the price of non-rights-managed goods gets driven up – the same thing that might happen with a digital media tax – and social welfare is maximized. But from a strategic point of view, this is terrible – because the profits don’t flow to digital media producers, but to other firms entirely.

This is why systems like the Broadcast Flag are strategically misguided and economically doomed. Gray markets doom them to economic irrelevance; that consumers aren’t being compensated for the negative value they derive from simplistic property rights being imposed on them dooms such systems to strategic irrelevance.

Go To: Part 2 - Solutions to the Paradox



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