Maximizing Value in the Digital World

The information age has created a host of digitized products — in the realms of software, databases, music, videos and electronic books — that can be produced and distributed with low variable costs, resulting in high gross margins. The key to profitability for creators of these products is to generate enough unit sales to offset their high development costs. But the ability to produce and distribute these products quickly and cheaply is not limited to the original content creator, and the potential for piracy, defined as duplication and distribution of a product without the permission of or payment to the content owner, is extremely high. One of the greatest challenges to digital business is figuring out how to maintain a profitable model in the face of widespread unauthorized competition.

Up to now, efforts to control piracy have relied on the assumption that creators of digital products have absolute ownership rights to the digital content they create. For example, on the basis of that assumption, recording companies and their artists have pursued an aggressive, allegedly successful legal challenge against the file-sharing sites MP3.com and Napster. Under the same assumption, several software firms have sought to limit piracy with contractual as well as technological safeguards such as click-wrap contracts, encryption, password-limited access to distribution sites and copy proofing.

However, because the belief in absolute ownership of digital content is incorrect from a legal standpoint, antipiracy tactics that rely upon it will ultimately prove ineffective. What’s more, these tactics can risk the profitability of the business model by actually reducing authorized usage by paying customers. A far better solution is to recognize the dynamics of the marketplace, segment that market into innovators (potential pirates) and the mainstream (potential paying customers), and address each segment differently to gather information and establish market leadership.

The Case Against Absolute Ownership

A single-minded emphasis on enforcing absolute ownership rights not only raises serious practical impediments to effective enforcement, but also the very assertion of those rights rests on a misunderstanding of the objectives of copyright law.

Even in 1789 the nation’s founders recognized intellectual products such as writings or inventions as “public goods,” products that take considerable time and resources to create, but can subsequently be cheaply and quickly appropriated in an unfettered free market. Consequently, the framers added the “intellectual property clause” to the U.S. Constitution, expressly authorizing the U.S. Congress to create patent and copyright law, giving authors and inventors the legal right to control use and distribution of their writings and discoveries.1

The Constitution makes it clear, however, that the author’s control is not granted to protect the creator’s natural right to profit from his or her efforts, but to encourage investment for the betterment of society as a whole.2 Therefore, unlike real estate or personal property law, which starts from a premise of the owner’s absolute dominion and control and carves back, copyright law, despite the notion of intellectual “property,” expressly rejects owner primacy. Instead, intellectual property “ownership” will exist only to the extent that social benefits resulting from giving the author control will likely exceed the social costs of denying access and use to others. That is, whenever the balance tips in favor of public access, the copyright “owner” has no right to restrict the activities of others with regard to his or her creation. For example, to ensure eventual free public access, copyright ownership exists for only a fixed, limited term. Moreover, even during that term, the “fair use” doctrine denies any right to prohibit certain socially beneficial follow-on uses of creative content, such as commentary and criticism, educational use, research and news reporting. Similarly, the “first sale” rule ensures free flow of copyrighted works by permitting the owner of an authorized copy to dispose of that copy free of the copyright owner’s normal control over redistribution.

Clearly, the concerns of today’s digital content provider align well with basic “public goods” copyright policy. Dramatic reduction of copying and distribution costs in the digital online marketplace makes recovery of even modest development investments highly improbable.3 Additionally, follow-on competition often occurs almost immediately after initial publication, destroying any natural lead-time protections and with them any market-based incentives to invest.4 However, a strategy that defines piracy as any unauthorized copying and distribution and seeks to eliminate it under an assumption of absolute ownership fundamentally misreads copyright law and is ultimately doomed to failure for both practical and policy reasons.

The Practical Limitations of Copyright-Based Legal Strategies

Any purely ownership-based legal strategy against piracy depends on the ability to obtain and enforce favorable court rulings in a cost-effective and timely fashion. The restricted nature of copyright ownership means enforcement actions are unlikely to satisfy either condition. Each claim of copyright infringement requires detailed review by the courts to ensure that the appropriate policy balances are respected. Moreover, legal institutions, hardly renowned for quick and low-cost action, remain unfamiliar with the complex and rapidly changing electronic technologies and have little experience with the novel legal issues pivotal to many digital piracy cases. Consequently, educating and convincing a court regarding the merits of a case will frequently be a lengthy and expensive process. For instance, the music industry took more than 18 months to receive enough support in the courts to shut down Napster.

Second, even if the process could be accelerated, the unique nature of digital content exacerbates the difficulties of reliance on ownership-based enforcement. Effective anticounterfeiting programs require ready identification and pursuit of the targets. But, unlike traditional manufacturing, which requires significant physical assets, digital content production or reproduction requires only minimal computing resources. Similarly, distribution order fulfillment can be on a just-in-time electronic basis, eliminating the need for physical inventories and warehousing. Such activities are difficult to identify, even when operating on a relatively large scale. Moreover, because siting decisions are largely free of physical restraints, piracy operations can be easily moved, including locating or relocating in “haven” jurisdictions with relatively weak intellectual property laws and local enforcement mechanisms.

Finally, and most importantly, with recent advances in technology, the core piracy problem is no longer unauthorized competitive entities, but widespread, decentralized peer-to-peer consumer activities.5 Because peer-to-peer systems can offer significant non-infringing, socially beneficial uses such as sharing of commentary or opinions about a piece of music or a new book, copyright law does not prohibit them. Even when they can potentially be used for copyright infringement, such operations are far less vulnerable legally when they expressly leave it to the individual participants to engage in whatever sharing and copying they believe is lawful or appropriate.

Ironically, the legal “choke-point” strategy of shutting down central distribution of infringing material or facilitating providers will likely only accelerate the transition to more fully dispersed distribution through less trackable, more legally immune systems. The effect is already visible in the marketplace. By the time the music companies obtained legal relief against Napster, new peer-to-peer companies like Aimster and Gnutella had already been created, which have been quickly followed by myriad others.6 Such scenarios give content providers only one remaining copyright law alternative: direct enforcement actions against the infringing end-users. Not only would that approach require substantial investments of time and money to locate such end-users, but also, as we will discuss later, suing one’s own customers is a highly problematic business strategy.

The Limitations of Contractual and Technological Strategies

Many digital content providers are attempting to obtain through contractual and technological means the absolute rights of ownership explicitly denied them under copyright law. These control mechanisms face considerable practical and legal drawbacks.

Click-Wrap Contracts

Content creators have adopted online “click-wrap” contracts, whereby the purchaser, with a single mouse-click, acknowledges agreement to electronically available terms of sale. In contrast to copyright claims that rely on an ambiguous and at best poorly understood social compact regarding appropriate incentives to creation, these contracts —even when predicated on precisely the same restrictions on copying or distribution — provide a straightforward claim in court based on the defendant’s personal agreement. Individual waivers can also be incorporated into the contract to eliminate problematic copyright exceptions, such as the fair use or first sale defenses, or even to provide protection to digital content not covered by copyright law. In theory, contract law appears to provide a vehicle for creating more easily enforceable protection for content creators.

However, opponents argue that buyers rarely read the terms of click-wrap agreements and to the extent they do, little actual negotiation is possible in the online environment. Consequently, they say, enforcement of click-wrap agreements rests on an unfair fictional consent designed to encourage “take it or leave it” terms favoring overreaching content providers.7 Additionally, as a growing number of scholars have convincingly argued, such contracts, even though nominally agreed upon, unacceptably interfere with the express social policy objective of copyright law to strike an appropriate balance between incentive (ownership control) and public access.8 These concerns undermine the legal enforceability of such contracts. When combined with the practical difficulties of identifying violators (who are likely to be customers surprised and incensed at the purported reach of the asserted contract terms), they make click-wrap contracts a poor commercial substitute for intellectual property rights assertions.

Technological Fences

Faced with the limitations of intellectual property law and contract law, content providers have started to pursue technological safeguards against piracy.9 These strategies include front-end access controls, such as digital content encryption, gated online communities (Web sites open only to subscribers with authorized passwords) and systems embedded in the digital content that electronically close off access upon detecting unauthorized copying or access. While on the surface these seem to be straightforward solutions, they also face significant practical and legal barriers to effective use. The practical concerns are, of course, already legion, reflected in the growing number of stories regularly published about hackers. The legal impediments are again firmly rooted in the limited nature of copyright ownership; that is, technological safeguards designed to protect copyright must also respect rights of socially beneficial access and individual privacy.

For example, the very notion of a gated online community flies in the face of the socially desirable and important right of the public at large to engage in “fair use” comment, criticism, news reporting and educational use as expressly allowed by copyright law. Additionally, the only way to obtain access to such communities is to let the owner know who you are and what you wish to access. That type of individual monitoring and information gathering has already come under attack in the more general Internet environment, and use of technological antipiracy systems is likely to raise similarly serious privacy concerns.10 Although the debate continues, it is clear that some significant limitations will be implemented that will adversely affect the usefulness of technological protection as an antipiracy tool.

The Negative Effects on Authorized Users

Any content provider considering legal or technological safeguards against piracy must also consider the likely adverse effects on the potential authorized users that comprise its customer base. For example, one frequently expressed view of the music industry’s current antipiracy activities — unaccompanied as they are by any significant effort to provide the alternative service desired by the public — is that they are twisting the legal system to squelch innovation, protect entrenched positions and poor value propositions, and generate excessive profits, all at the consumer’s expense.11 This public frustration is heightened when the mainstream press and academic literature characterize the resulting access limitations in “anti-free speech” terms.12

In this environment of disintegrating respect for content providers, legal and technological solutions to piracy raise serious marketing concerns. Turning copyright litigators loose on peer-to-peer end-users not only risks the obvious consequence that former defendants rarely purchase from plaintiffs, but also it transforms unauthorized copying from “stealing” into an honorable form of “fighting back.”13 Using click-wrap contracts similarly places a company in the position of suing current customers and seeming to manipulate the legal system to take advantage of them. Also, a business that tries to restrict access through technological means runs the risk that consumers will view these mechanisms as elitist at best and a violation of the legal rights of the citizenry at worst.

Aggressive pursuit of ownership-control-based strategies can at most offer untimely, and extremely costly, if not outright unenforceable, remedies, while simultaneously alienating current and potential customers.

An Alternative Approach: Using Life-Cycle Theory To Segment the Market

Because legal and technological approaches cannot eliminate unauthorized copying and distribution, how can digital content providers limit the effects of those activities and maintain a profitable market of legal purchasers? We believe that can be accomplished by specifically segmenting the market into innovators and the majority and then by focusing on how the gap between them can be used to generate an effective “priced” value proposition for the majority.

One of the key tenets of marketing theory is that all products and innovations go through a life cycle and that different kinds of consumers adopt innovations at different parts of the life cycle. Innovators are the first adopters of a new technology or product. They are less intimidated than others by technology and less frustrated when things don’t work exactly the way they want them to. Innovators may, in fact, see it as a challenge to make the technology work the way they think it should. Though they comprise approximately 3% of the market, their word of mouth inordinately influences the market, encouraging wider adoption of the innovation. The majority of consumers tend to adopt innovations later, after the bugs have been worked out. They are concerned more with the benefits of technology than with the technology itself. They tend to get frustrated when things don’t work well. They are not risk takers. These are people who weigh costs and benefits carefully. If they see greater value in a product that costs money than in a similar free product, they are likely to pay for that extra value. The majority constitutes approximately 68% of the total market.14

Life-cycle theory suggests that psychographic differences between these two groups cause a significant gap between when the innovators adopt the technology and when the majority adopts it. Moreover, innovators have a difficult time translating their intuitive understanding of technology to the majority. We propose that in the consumer markets for digital products this gap between innovators and the majority offers significant opportunities for content creators.15

Implications of the Gap for Content Creators

Consider the nature of the hard-core digitized community. A segment of the new Internet culture maintains that realizing the true promise of a networked world requires that “information be free,” a position hardly compatible with control over digital content distribution. What’s more, significant portions of this segment of the digital marketplace are also classic innovators, technologically capable and motivated to circumvent security efforts not only on moral grounds but also because playing with the new technology is fun. This combination leads to a relatively short effective life of any security measure being erected.16

This behavior would not be a particularly serious problem if it were confined to the relatively small innovator (or pirate) segment of the market. Most digital content customers have sufficient difficulty running their VCR and Internet browser and have neither the ability nor the interest to develop new sharing technologies or to circumvent security systems. The majority simply wants the best value proposition, one that affords the ability to locate and obtain desired products efficiently through the simplicity and consistency conferred by industry standards. However, recent theories of information economics suggest that the value of information and information technologies increase exponentially with the number of people who adopt them due to network effects.17 This theory, known as Metcalfe’s Law in the digital world, provides significant incentive for enterprising innovators to broadcast their new technology to the broader (majority) market.

To illustrate these principles, consider the evolution of digital distribution of music. The first digital innovation opposed by the music industry was the MP3.com service, which allowed compressed music in MP3 format to be downloaded for free over the Internet from a central server. Anecdotal evidence suggests that many people who attempted to use this technology were initially frustrated by the technological sophistication or the hardware required to make it work.18 Nevertheless, the technology was quickly adopted by a small group of the music-buying public who, as innovators do, undertook to make MP3 technology better and accessible to the masses.

The time between introduction and when the MP3.com downloading service became generally appealing to the risk-averse majority was, fortunately for the music industry, long enough to allow the regulatory markets to work before the majority got used to the notion of free music. However, by this time a new innovation for electronic music sharing had evolved: Napster. Many of the same innovators who had been early users of MP3 technology gravitated to Napster. Because of their MP3 experience, they had a better understanding of the core technologies associated with digital sharing of files. Thus, their ability to make the technology accessible to the majority was greater and the gap between innovators and the majority was smaller. The inventor of Napster, who stood to benefit from its widespread adoption and use both personally and commercially, gave away the related software online. Consequently, by the time the legal battles against Napster were won, a significant part of the majority had already adopted it for free (by some estimates as many as 60 million users19).

The crucial question, then, for the content creator is: Who is going to establish the standards for distribution and at what price?

For instance, before the legal battles were over, at least one music company, Bertelsmann, had started to negotiate with Napster on how to use its technology to distribute music. If Bertelsmann had succeeded prior to the widespread adoption of the technology, the music industry would have had a legitimate opportunity to set the price. Instead, by the time Napster was shut down, the majority of consumers had benchmarked the price of digitally transferred music as essentially free. And once the majority market has set its reference price at zero, it will be difficult for the music industry to start charging for a similar product or service.20

This same process is under way with Gnutella and other peer-to-peer file-sharing services, but on an accelerated basis. There is even discussion of Gnutella-like technologies becoming a standard for the transfer of digital content of all kinds. Even assuming that the legal system would support the music companies (which is highly unlikely), it will be too late. The reference price of zero will be set in the majority segment of the marketplace.

Generating Effective Pricing for the Majority Market

The key to setting an effective, “priced” value proposition for majority users lies in focusing on how the gap between them and the innovator segment is utilized.

Don’t Eliminate Innovators — Monitor and Incorporate Them

The digital content innovator segment, in and of itself, is not large, and it is generally unwilling to pay for content. However, that does not mean it should be ignored. There are at least two positive characteristics of unauthorized usage. First, some forms of piracy can lead to significant legal purchase of the related goods.21 For instance, a study by Givon, Mahajan and Muller on the adoption of word processors and spreadsheets in the United Kingdom found that word-of-mouth by pirates led to approximately 80% of authorized purchases. Second, and more important, the pirate innovators can actually identify technologies that ultimately provide value to the mainstream. For instance, MP3.com and Napster were of value to music consumers not only because they allowed free music downloads, but also because they offered convenience by eliminating a trip to the store and allowing end-users to sample music at home. An observant content owner could have chosen to offer the same conveniences preemptively, capturing the high ground in providing value and setting a fair price for it.

The strategic focus for dealing with the threat of piracy should therefore be to reduce the innovators’ impact on the reference price of the majority and maximize the number of paying customers. With proper communication strategies (discussed below), the content provider can incorporate value originally developed by the innovator as a highly visible component of its own standard for service. That limits the impact of the unauthorized provider on the majority market. The movie industry has recently taken this approach. A consortium led by Sony, MGM, Paramount, Warner Bros. and Universal Studios plans to introduce downloadable movies for a fee.

Influence the Majority by Building a Brand

Remember, most consumers are not risk takers and, in general, do not have a good grasp of technological products. Thus, they are likely to rely on broader judgments and rules of thumb to assess the value and quality of electronic delivery of digital products. A strong brand encourages the vital early adoption of the content owner’s value proposition, which is critical to displacing the innovator’s ability to control the reference price to the majority. Having a strong brand is also crucial to employing a “second-in” strategy: incorporating the innovator’s technology before it reaches the mainstream. In such a scenario, brand identity encourages the majority quickly to recognize the content provider as the standard source for the product.

A strong, recognized brand not only allows majority users to assess value quickly, but facilitates strong word-of-mouth and follow-on adoption. Interestingly, the brand need not be associated with high technology. For instance, Lego recently introduced a software-based toy called Mindstorm based on its original, low-tech building blocks. Hackers immediately deciphered Mindstorm’s proprietary code, posted it on the Internet and began writing enhanced software and even a free alternative operating system for the toy. Nevertheless, Lego brought no action against the hackers and the legitimate adoption rate of the toy accelerated. Indeed, Lego has incorporated many of the hackers’ best ideas into new versions of Mindstorm.22

Complementary Tactics

In strengthening the brand, a number of complementary tactics may be used to capture and maximize cash flows from the majority market:

Price Fairly for the Majority.

Keeping the price as low as reasonably possible will encourage rapid adoption. The cost efficiencies of electronic production and distribution must be recognized and passed on to the majority purchasers, meaning that high premium prices cannot be sustained. Pricing for a cost-justified return will make it substantially more difficult for innovators to compete for the attention of the majority.

Enhance the Product for the Majority.

As a part of the branding strategy, visible benefits to the majority should be introduced to clearly and positively differentiate the branded, authorized content from the pirated content. This added value should limit risk for the majority consumer and provide real benefit for the incremental cost. Most importantly, it should be easy for the majority user to adopt. Recall that innovators intuitively understand technology and initially have a difficult time translating their understanding to the majority. Branded content providers who are focused on the majority market can exploit that limitation. The content site itself should be extremely easy to use, with useful problem-solving assistance. It should emphasize breadth and reliability of the content, including warranty and ease of return. In cases where the reference price of the basic product or service has already been set at zero by innovators, these additional protections and services could be bundled at a price, allowing some sales of the content to risk-averse mainstream buyers.

Leverage the Brand Through Alternative Distribution Channels.

There is distinct and separate value associated with the creation of digital content and with its distribution. However, because both the content and its mode of distribution are electronic in nature, the end-user tends to see the value as a package, often making it difficult for the content creator to generate a fair return on the creative component, especially when distribution is subject to piracy. The content creator can mitigate that by selling its content to another entity to distribute, simultaneously guaranteeing fair value for its content creation and passing along the problems associated with distribution.

In general, three distribution arrangements are available to the content creator. It can license the content to a distributor and obtain a royalty every time the distributor makes an authorized sale. This tactic is of greatest use when the content creator does not provide technological safeguards and wants to transfer the risks associated with piracy. The problem is that the content creator’s return is a function of the distributor’s ability to discourage unauthorized usage. Alternatively, the content creator could develop a long-term relationship with a distributor in which it receives a one-time fee for each piece of content it creates. In this way the content creator obtains a reasonable return up front for its products and transfers most of the risk of loss due to piracy to the distributor.

One potential problem with either the licensing or the long-term distribution deal, however, is that the content creator’s brand could be tightly linked to the distributor’s brand and, therefore, to any antipiracy action taken by the distributor that alienates end-users. To avoid that linkage, the content provider could auction each piece of content for a one-time fee to the highest bidder, either a consortium of end-users and/or a business that intends to sell to the end-users. The winner of the auction would then distribute the content as it sees fit. By not tying its content to any specific distributor, the content creator maintains the independence and integrity of its brand.

These tactics all rely on the content creator possessing a strong brand. The amount of value recouped by the creator will depend on the perception that the content provided is of high value. Since the distributor is taking on more of the risk of piracy, it must be assured of having content that has a good chance of rapid, authorized adoption, which will, in turn, limit piracy opportunities.

The Proper Role of Legal and Technological Strategies

Although legal and technological mechanisms are becoming, at best, increasingly irrelevant and, at worst, counter-productive, they can still play a useful role. Both approaches, if implemented in a way to make them acceptable to the targeted majority market segment, can increase the gap between innovator and majority adoption of “pirate” technologies, and thereby bolster a market segmentation approach.

Technological security measures can be used to limit casual piracy by majority users. However, effectiveness should always be sacrificed to ensure such measures remain invisible and irrelevant to the majority so as not to cause them frustration or dilute efforts to encourage content adoption. Similarly, lawsuits should not seek elimination of parallel channels or innovator activity. They should be brought only against readily identified, traditional pirates with the objective of reinforcing the need to protect social and majority-user interests. Having retaken the moral high ground by offering clear benefit for reasonable payment, content providers can use legal activity to clearly communicate and emphasize the socially beneficial aspects of respecting copyright law. It is too easily forgotten that the power of the law goes beyond the threat of sanctions. When the law is properly explained and understood, many people, particularly those in the majority market, willingly obey because they understand the self-interested value of permitting society to function efficiently.