The piracy of copyright protected digital goods is a large and growing problem in the music, computer software, videogame and film industries. Digital piracy includes the purchase of counterfeit products at a discount to the price of the copyrighted product, and illegal file sharing of copyright material over peer-to-peer computer networks. The International Federation of the Phonographic Industry (IFPI) claims that about 34% of all recorded music products sold worldwide in 2004 were pirated copies and that piracy costs the industry over $4.6 billion per annum. Not included in these figures is the cost of file sharing over peer-to-peer networks, which the IFPI blames for a fall in global music sales of some 22% between 1999 and 2004. According to an OECD study, 2.6 billion songs are downloaded every month in over 90% of cases the files swapped infringe on copyright protections. One estimate suggests that online file sharing reduced CD sales between 2000 and 2003 by as much as 30%, or about $ 4 billion per annum. In the computer software industry, research by the Business Software Alliance suggests that software worth $32 billion was pirated in 2005. The percentage of software that was pirated ranged from a low of 21% in the United States to 90% in China and 92% in Vietnam. In the film industry too, piracy is ion the rise. The Motion Picture Association of America estimates that piracy costs the industry some $3 billion annually; a figure excludes the cost of piracy over the Internet.
The scope of the piracy problem may get larger in the next decade. The rapid diffusion of broadband connections to the Internet and the rise of peer-to-peer networks make it much easier to download large files, such as those for videogames and motion pictures, raising fears of higher piracy rates. In 2004, broadband adoption by citizens in OECD countries past 100 million, suggesting that the technology has now reached a critical mass that is capable of supporting significant piracy based on peer-to-peer file swapping. The publishing industry is also worried that the much anticipated digitalization of print media, when coupled with the development of a functional e-book reader, may be accompanied by a rise in piracy rates as digitalized texts are swapped via file sharing technology.
Ever since the introduction of Napster gave consumers the ability to trade digital music files across the Internet, the impact of file sharing on the sales of music has been the focus of intense debate. To some, file sharing has been the root cause for the recent decline in the size of the music industry, while others contend that file sharing need not necessarily cause sales to fall. This ambiguity concerning even the signs of the effect stem from the fact that economic theory cannot tell us whether the potential positive effects of file sharing are stronger or weaker than the potential negative effects; thus the question of whether or not file sharing helps or hurts the sales of recorded music is an empirical question. Nevertheless, there is reason to reexamine the theoretical underpinnings of this debate. In particular, while the discussion up to this point has been completely assuming that the effect of file sharing is uniform across artists; economic theory tells us that this is not true.
File sharing burst into the public consciousness in May of 1999, with the release of the software program Napster, which provided a simple to use interface with which consumers of music could share and download digital copies of songs. Napster became a huge success with a reported user base of over peak, with routinely more than 500,000 unique IP addresses connected at any time (CNN-Money 2000). Up to the introduction of Napster, the recorded music industry in the United States was experiencing a huge period of growth, which is demonstrated in Appendix A.
However, the gains made in the years prior to 1999 quickly...