SOFTWARE PIRACY AND ITS IMPACT ON SOCIAL WELFARE 1

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1 SOFTWARE PIRACY AND ITS IMPACT ON SOCIAL WELFARE 1 Toomas Hinnosaar Software piracy involves usage, copying, selling and distributing computer programmes without the permission of its producer. Software piracy is an illegal activity and in Estonia the issues related to that area are regulated by the Copyright Act. Ever since the dawn of wider spread of computers and computer software some 20 years ago piracy has been considered to be one of the most crucial problems for the software industry. To protect software against illegal copying numerous different technical solutions have been worked out so as to enable eventual abolishment of software piracy or make it so costly that the notion of using pirate software would vanish. Attempts to implement different anti-piracy mechanisms have indeed been made, but time has shown that radical protection measures are eventually abandoned. Therefore, this is a paradox which economists are trying to find an explanation to why do software makers not bar piracy of their products, even though it is technologically fully practicable? The objective of this article is to introduce some economic-theoretical reasonings to explain why piracy can still exist. The author is not trying to substantiate or justify usage of illegal software, rather to contemplate on the possible reasons as to why software companies or the government do not take more serious steps to exclude it. Software Piracy in Figures 2 In 1994 the rate 3 of software piracy in the world was 49%; by 2002 the indicator had declined to 39%. In North America and Western Europe the rate of piracy has been consistently smaller while in Eastern Europe it has been the largest. In Estonia the gauged rate of piracy in 1996 and 1997 stood at 90 and 92%, respectively, which even outpaced the average in 1 This article is based on the author s Master s thesis that he defended at the University of Tartu in The thesis is available in Estonian on the web site of the Bank of Estonia at publikatsioonid/seeriad/muud_uuringud/thinnosaar.pdf With his thesis Toomas Hinnosaar won a scientific research contest and was awarded the first ever Urmas Sepp Reward that the Bank of Estonia introduced this year. U. Sepp, a long-term Head of the central bank s Research Department, died tragically and in his honour a 30,000 kroon reward is awarded to a young researcher in the field of economics or a group of researchers. 2 The data has been derived from the research Eight Annual BSA Global Software Piracy Study, International Planning and Research Corporation, The rate of pirate software is gauged as a ratio of computers running illegal versions of the most widely spread software packages to the total number of computers. In the studies mentioned only corporate computers have been taken into account. 17

2 KROON&ECONOMY No 3, 2003 Eastern Europe. However, in recent years the percentage of piracy in Estonia has considerably declined and according to the data derived from a research in 2002, it stood at 53%. The rate of pirated software in Estonia and in different regions of the world in has been illustrated in Figure % 90% 80% 70% 60% 50% 40% 30% 20% Figure 1. The share of pirated software by regions Estonia Western Europe Eastern Europe North America Latin America Asia and Pacific Ocean Region Middle East Africa World Source: Eight Annual BSA Global Software Piracy Study, International Planning and Research Corporation, Losses from the use of pirated software or the revenue that software producers did not get stood at 12.3 billion dollars in The figure has remained stable for a long time, eg in 2002 it was 13.1 billion dollars. Even though utilisation of pirated software is the steepest in Eastern Europe, the revenue forgone in that region accounts for a comparatively small amount of the total losses that software producers sustain, since the markets in Asia as well as in Western Europe and North America, where the piracy rate is much smaller, are significantly larger. While interpreting the figures one has to denote that upon coming to such conclusions, researchers have proceeded from presumptions the accuracy of which gives ground for doubt. When evaluating the rate of pirated software researchers possess accurate data on software sales and the number of computers. However, regarding the software that an average new or used computer might run, evaluations are based on interviews carried out in the United States. There is reason to believe that the consumers in North America and Western Europe are, because of their much larger incomes, willing to invest more in commercial software while in the regions with smaller incomes besides pirated software also comparatively more free software is used, and people just cannot afford to have some programmes. Thus, these figures might be somewhat overestimated. Also, as for interpretation of the amount of revenue not received, the figure represents the upper margin of revenue forgone it is evident that the users of pirated software are not 18

3 willing to pay retail prices for legal software and at least some of them would give up using the software or opt for an alternative solution. Regarding revenue forgone, one can often hear the argument that besides the earnings not received by software companies also the government has lost part of its tax revenue. Such a claim, however, is quite naive for instance in the Estonian context, as local production of software packages is essentially non-existent, which means that sales revenues go abroad and the money saved due to piracy is spent on something else bringing the government at least as much tax income and quite likely creating more jobs. Figure 2 indicates a negative correlation between the rate of software piracy and the prosperity of the inhabitants 4. Such a correlation is logical and functions because of several reasons naturally, people in richer countries find it easier to obtain legal software along with accompanying value added. Also, software companies have a weightier motive to fight against software piracy namely in the countries where potential income of companies are larger and, as we will later see, sooner allow piracy in poorer countries. 100% 90% share of software piracy 80% 70% 60% 50% 40% 30% 20% 10% 0% Figure 2. Correlation between software piracy and the prosperity of inhabitants y = -1E-05x R 2 = ,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 annual GDP (USD per capita) Sources: Eight Annual BSA Global Software Piracy Study, International Planning and Research Corporation, 2003; World Development Indicators, World Bank, Economic-theoretical Idiosyncrasies of the Software Market Compared to traditional goods computer software is somewhat different the value of it is fully represented by the information it includes (programme lines). Such goods are called 4 For assessing the wealth of the inhabitants the GDP per capita indicator has been applied (in US dollars). 19

4 KROON&ECONOMY No 3, 2003 information goods. Software as an example of information goods is characterised by three relevant effects that will be elaborated below. Increasing returns to scale on the supply side a large initial investment has to be made to develop the product while its marginal cost, ie the cost per each new copy, is in effect close to zero; Increasing returns to scale on the demand side for all consumers network effect; Increasing returns to scale on the demand side for one consumer, which is created due to very high switching costs. Close to zero marginal cost means that after producing the product the manufacturer can make an unlimited amount of copies whithout significant additional costs. It is known from economic theory that in the context of perfect competition the price will fall to marginal cost, which in the case of software would mean free distribution. With many programmes it is indeed noticeable while most software makers possess sufficient market force to make profit and cover the costs sustained while developing the product. Network effect represents an increase in utility that software users can enjoy if the number of users, ie the network, expands. The network effect is divided into direct effect (eg more people to exchange files with) and indirect effect (eg the number of additional software components with programmes, training opportunities, etc increases). The network effect significally changes the operating mechanism of the market. With traditional goods the demand curve is declining the higher the price, the fewer consumers, and vice versa the more you want to sell, the lower the price has to be. With the network effect the impact is initially the opposite the more products are sold, the more new consumers are willing to pay for them. There are several equilibriums in the market operating with the network effect if the number of consumers is small, nobody is willing to buy the product even at a low price, but if the number is big, also such consumers who attach comparatively little value to the product will buy it. Switching costs are producer- or product-specific investments that have to be made again with a new seller/product while no costs are involved when continuing the old way. Switching costs are divided into transactional (the costs related to any change, eg the cost of time upon re-installment) and informational (one-off costs that do not have to be made when returning to the old product, eg training costs). A frequently given example is a computer operation system that involves very high replacement costs application software has to be replaced, also all the existing documents have to be converted into a new format, you have to learn how to use the new system, etc. If switching costs are big enough, the consumer will never use another product and will be locked to one product. This in turn means that the producer has to some extent monopoly power over the consumer. The Impact of Piracy on Software Producer s Profit A direct impact that the existence of software piracy has on the profit of the producer is, naturally, smaller demand, since some potential users of legal software opt for pirated 20

5 software. On the other hand, surveys on pirated software 5 have indicated that the existence of pirated software also involves positive effects. Besides the fact that making anti-piracy protection mechanisms more efficient is inconvenient for the consumers, the principal negative impact of restricting piracy proceeds from the significant network effect prevailing in the software market: the value of software for each user depends on the number of users of the specific software and compatible software, ie on the size of the network, while pirated software increases the number of users, ie the network. In other words, the direct and indirect impact can be described as follows: Competition effect the producer has to compete against the pirated version of its product. Therefore, the producer cannot put a potential maximum price on the product but has to opt for a price that would not induce too many consumers to switch over to the pirated version; Price discrimination effect discrimination through price generally enables to obtain more out of consumer surplus, ie the aggregate value the consumers derive from the product. Pirated software as a free version enables to sell more units of the product and even if the producer does not derive direct revenue from it, each software user expands the network and thus also demand for legal software, which in turn translates into increased earnings for the producer. Figuratively speaking, the impact might materialise as follows: it might be useful for a software company to let price-sensitive groups (eg household consumers) use its software free of charge, since from the point of view of legal consumers (eg companies) it adds value if computer users related to them use the same software. Therefore, these entrepreneurs are willing to pay considerably more for the software, which compensates for the revenue not received from a few most affluent household consumers who might otherwise have purchased the software. Besides the above-mentioned impact, it has been established that if there were several competing software producers, tolerating the use of pirated software might translate into a competitive advantage and thus be allowed by all competing producers. If one of the competitors barred piracy while the other one tolerated it, a large number of users would opt for pirated software thus expanding the network of the company that tolerates piracy. This in turn would boost demand at the expense of the competitor. Taking into account the time dimension, one might assume that if an increase in consumer affluency or toughening of legislation is expected, in order to maximise profits it is strategically right for software companies to tolerate the use of illegal software in the early years and 5 Economic-scientific discussion was set in motion by the article by K. R. Conner and R. P. Rumelt, Software Piracy: An Analysis of Protection Strategies, Management Science, 1991, Volume 27, No 2, pp A longer overview is available in the author s Master s thesis. 21

6 KROON&ECONOMY No 3, 2003 later make the control mechanisms more effcicient, so that the people who are already accustomed to their software would start paying for it. Such an effect is noticeable regarding differect countries, time and people. The most efficient anti-piracy measures are in place specifically in developed countries where sizable fines are applicable while for instance in China, Russia and Argentina respective legal acts have not yet been implemented in practice. Looking at Estonia, the same phenomenon is noticeable if strict anti-piracy mechanisms had been applied ten years ago, only very few companies and private persons (and naturally also government institutions) would have been able to afford computers and software. However, in recent years supervision has been made considerably more efficient and as a result piracy has decreased. Looking at the same effect from the user point of view, an example one could refer to are students who are generally not willing to buy any software, let alone design programmes targeted at professionals, etc, but if they learn and get used to some programmes, they might later turn into valuable clients. As indicated above, the direct impact of software piracy on software producers is negative while the indirect influence is positive. Whether the total effect is positive or negative depends on different demand factors, primarily on the extent of the network effect. If the overall effect is very negative, the producer is incapable of covering the costs of developing software, which means that in the longer run there will be fewer software available. Software Piracy and Social Welfare It has been indicated that from the point of view of software producers piracy can be either good or bad. But what is its impact on the welfare of consumers and the society at large? The consumers who would not apply software without the option of using pirated software would probably win from its existence they would receive value added without additional costs. For the consumers of legal software the existence of pirated software is also positive: due to the network effect they benefit more from applying legal software and, obviously, they can choose whether to use a legal or illegal version. Knowing that for all users of software the existence of pirated software is sooner positive than negative and if software companies also benefit from it (the network effect is big enough, etc), the existence of piracy is by all means socially optimal. But what happens if the condition is not met but the company itself cannot or will not bar piracy (eg it has a much larger and more important market in mind when writing the programme)? Regarding Estonia, one might conclude that from the point of view of social welfare gain should not be very important for software producers, since software companies are far away and are focusing on much larger markets. If from the point of view of social well-being only the welfare of (all) the citizens of the country is important, it is evident that the existence of piracy enhances it, since the impact on consumer welfare and the overall number of consumers is positive. If it is the users of 22

7 legal software who are more important than others, then the socially optimum level of piracy does exist. Making it more difficult or costlier to use pirated software will boost the number of legal software users on the one hand while lessening their welfare by diminishing the network on the other hand. In addition to the motivation of the interest groups, their impact on the decisions of the state regulator should be taken into account. Consumers can influence government decisions for example through voting at elections, but their impact on the government s resolve either to boost the fight against piracy or not is clearly very indirect and insignificant. Meanwhile, software companies have set up organisations and exert comparatively extensive influence. In fact the fight against piracy is being intensified across the world, which leads to the conclusion that the impact of software producers on the governments is more significant than representation of consumer interests. The afore-mentioned fact would well illustrate the situation in the Ukraine and China. Because of the absence of any anti-piracy activities, the United States imposed trade restrictions on the Ukraine in 2001 and opposed its accession to the World Trade Organisation. In January 2001 the parliament of the Ukraine adopted a new act that is expected to reduce piracy considerably. A similar tendency is noticeable in China, where the government recently adopted a new anti-piracy act since otherwise the country s accession to the World Trade Organisation would have been seriously hampered. Conclusion Even though piracy has for more than 20 years been considered to be the biggest problem facing the software industry, there are no visible signs indicating that it would disappear nor have any efficient efforts been made towards its abolishment. A possible economic-theoretical reason behind the existence of piracy is the network effect characteristic of the software market, which leads to the point that software producers do not actually want to shut out piracy. Also, the users of either legal or pirated software are not interested in the abolishment of piracy, since, due to the network effect, piracy enhances the welfare of them all. From the point of view of social welfare it is optimal to make efforts towards abolishing piracy only when it has a negative impact on the profits of the producer and if the producer s profits exert a considerable influence on social welfare eg if it is a local or influential producer. 23

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