by Jurgen Brauer and Nicholas Anglewicz, September 2005
Copyright: J. Brauer. No reproduction without permission.

Our world's digital advances are making Hollywood studios rethink their business model. One notable catalyst for this change is the spread of intellectual property "piracy." To deal with the threat piracy poses, Warner Brothers has reduced its DVD prices in China and has released a movie DVD on the same day the movie premiered in the United States. Disney's new CEO, Robert Iger, has suggested the same universal release style for movies released in America. And by turning CD-based products into an online service in China, Electronic Arts next year aims to offer the same or even enhanced gaming experience with less opportunity for piracy.

The fundamental problem is that the up-front costs of production are huge while the costs of producing additional copies are minimal.

What lies behind these dramatic shifts is not just "piracy" but the economics of producing creative works. The fundamental problem is that the up-front costs of production are huge while the costs of producing additional copies are minimal. It is making the movie or composing and recording the music that is expensive but every subsequent copy made for sale is relatively cheap. To reimburse the artist for the cost of producing the original each copy sold thus must be sold above the cost of making the copy. For the film industry, the same film is released on different formats at different times and different prices not only to recoup up-front costs but also to exploit consumers' differential willingness to pay and thus to maximize profits.

But customers do not care about the cost of producing the original, and they don't like price discrimination either. Instead, they care about the cost of the copy and when it becomes available. So they search for ways to minimize the cost and the wait time of getting that copy - hence the emergence of digital-based piracy and file-sharing services.

A solution to the problem has been found in the music industry by making legal music copying so cheap and attractive that it is hardly worth one's time and effort to get the music illegally (iTunes' famous 99c per song is the prime example). The music industry, and before it the software industry, is onto the right business model, a model that the film industry will need to follow. Essentially, there are only two ways to solve the piracy problem in particular: make illegal copying more expensive and simultaneously make the product so easily available and cheap that illegal copying isn't worthwhile.

The first option is unlikely to succeed in perfection as the software industry found out in the 1980s: all one gets is an "arms race" between copy-protection and copy-breaking mechanisms. But if anti-copying will never be perfect, it can certainly be made more expensive to discourage all but the most dogged illegal copiers. The other shear of the scissors is to make the goods widely available and cheaply, but also to brand it by providing useful support services and selling add-on or tie-in products that enhance the use of the product to the end-user. The enhanced online gaming services to be provided by Electronic Arts in China next year serve as an example.

The film industry should follow a similar route. At present, consumers can either buy often bad-quality, pirated copies of the latest movies at a low price, or wait months to buy high-quality, high-priced legitimate copies. But the digital trend inevitably will allow consumers to get ever higher quality illegal copies so that the producers force themselves out of the market unless they change their underlying business model. In essence, as one economist observed, the possibility of easy, if illegal, "sharing" acts as if there were effective competition in the market which leads to lower prices. So while using digital management tools to increase the cost of copying, the industry also needs to drop prices, go for volume, and sell tie-ins. Currently, DVDs offer bonus features such as artist interviews or additional scenes. Going this route becomes an effective and cheap marketing tool and can be combined with loyalty programs, i.e., discounts, on further legitimate downloading of movies from the same studio or a studio alliance. Studios could also sell movie site licenses to universities, colleges, or other collective outlets (e.g., cable TV companies) - as software sellers already do - whereby all customers can watch the latest flick over an intranet that the selling studio can more easily monitor for abuses. Studios could also use legitimate downloading of movies as a broad distribution method for films not yet released on DVD.

It is the obligation of conservatives to think with care about what it is that they wish to conserve.

As always, it is the obligation of conservatives to think with care about what it is that they wish to conserve. In the film industry, it appears that "conservative" studios merely wish to preserve monopoly rights, and monopoly profits, that current copyright legislation gives them. But the smart money, in our view, would be placed on abandoning that model. While artists deserve a living, society deserves the benefit of competition that helps spread artists' work at low prices. Warner Brothers and Disney are moving in the right direction.