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The New Economics of Copyright Law

December 7th, 2006 by David Kronemyer · No Comments

It is not overstating the case to say the single most influential article about copyright law is Landes, W. & Posner, R., “An Economic Analysis of Copyright Law,” 18 J. Leg. Stud. 325 (1989). It should be required reading for anyone interested in intellectual property rights. In it, Landes and Posner state the cost of producing a copyrightable work has two components.

“The first is the cost of creating the work. We assume it does not vary with the number of copies produced or sold, since it consists primarily of the author’s time and effort plus the cost to the publisher of soliciting and editing the manuscript and setting it in type. Consistent with copyright usage we call the sum of these costs the ‘cost of expression.’”

It makes sense from an economic standpoint to think of this as a “fixed cost.” In other words, it’s something the commercial exploiter of the work will incur, regardless of whether the work actually is exploited. In film parlance, it is the negative cost, plus advertising; in record parlance, the sum of an advance plus recording costs, and associated expenditures such as tour support and video.

Landes and Posner continue:

“The second component of the cost of producing a work increases with the number of copies produced, for it is the cost of printing, binding, and distributing individual copies. The cost of expression does not enter into the making of copies because, once the work is created, the author’s efforts can be incorporated into another copy virtually without cost.”

Again from an economics standpoint, this can be regarded as the “variable cost” or “marginal cost” of exploiting the work. In that it can be calculated on a per-unit basis, once the fixed costs have been incurred. For film, it is the cost of prints (in the case of a theatrical release), or DVDs (upon release to video). For records, it is the cost of fabricating CDs. It also would include some aspects of their marketing and promotion; for example, customer and consumer advertising (but not the retention of marketing and promotional staff, which is a fixed cost).

Landes and Posner continue:

“For a new work to be created, the expected return—typically, and we shall assume exclusively, from the sale of copies — must exceed the expected cost. … The creator will make copies up to the point where the marginal cost of one more copy equals its expected marginal revenue. The resulting difference between price and marginal cost, summed over the number of copies sold, will generate revenues to offset the cost of expression. Since the decision to create the work must be made before the demand for copies is known, the work will be created only if the difference between expected revenues and the cost of making copies equals or exceeds the cost of expression. If we assume that the cost of creating (equivalent) works differs among authors, the number of works created will increase until the returns from the last work created just covers the (increasing) cost of expression.”

In other words, what Landes and Posner refer to as the “cost of expression” – that is, the fixed cost – must be amortized effectively over the number of units sold. The “true” cost of creating the work is the sum of the fixed cost plus each unit’s marginal cost. It wouldn’t make sense to release a film, for example, if the negative cost was $25 million but you expected the sum of all net revenues to be less than this amount. The reason why is, you wouldn’t recover your fixed cost of making the film, plus the marginal cost of each “unit” sold. Even though the cost to manufacture individual DVDs might be low, that number is illusory, because you need to consider the cost of the work embodied on the DVD, too. The same thing is true with records – CDs cost little to fabricate, but you still need to recoup the advance and all other fixed costs.

Landes and Posner continue:

“This description of the market for copies and the number of works created assumes the existence of copyright protection. In its absence anyone can buy a copy of the book when it first appears and make and sell copies of it. The market price of the book will eventually be bid down to the marginal cost of copying, with the unfortunate result that the book probably will not be produced in the first place, because the author and publisher will not be able to recover their costs of creating the work. The problem is magnified by the fact that the author’s cost of creating the work, and many publishing costs (for example, editing costs), are incurred before it is known what the demand for the work will be. Uncertainty about demand is a particularly serious problem with respect to artistic works, such as books, plays, movies, and recordings. Even with copyright protection, sales may be insufficient to cover the cost of expression and may not even cover the variable cost of making copies. Thus, the difference between the price and marginal cost of the successful work must not only cover the cost of expression but also compensate for the risk of failure. If a copier can defer making copies until he knows whether the work is a success, the potential gains from free riding on expression will be even greater, because the difference between the price and marginal cost of the original work will rise to compensate for the uncertainty of demand, thus creating a bigger profit potential for copies. So uncertainty generates an additional disincentive to create works in the absence of copyright protection.”

To paraphrase: when a work is counterfeited, or copied, the person doing so experiences some marginal cost, such as the cost of a blank CD or DVD. That person, however, does not participate in the over-all amortization of fixed costs. Because that person’s contribution is zero, the creator of the work might be disincentivised to create the work, to begin with. The reason why is, widespread counterfeiting or copying of this nature reduces the prospect of effectively recovering fixed costs. This problem is exacerbated by the fact, nobody really knows for sure how a creative work will be received in the marketplace. While there are a variety of hedging mechanisms potentially deployable by different entities in the production-distribution chain, the simple fact of the matter is, sooner or later someone will have to bear the market risk of commercial failure. The counterfeiter or copier doesn’t absorb any of this risk, because they’re only going to counterfeit or copy commercially-successful works. In economic terms, they’re “free riders.”

I would like to suggest that, while Landes’ and Posner’s explanation has considerable utility for “old media” works such as film and records, it is far less applicable to the new digital era. This is true for two reasons.

First, many works now are self-created by users. Examples include musical works on MySpace; together with videos on YouTube. While it is true there is some fixed cost to create such works, often it is minimal. Although it isn’t entirely eliminated, I don’t think anyone would disagree with the proposition, it’s far less than the amount a “media company,” conventionally understood, would incur to create the same work. The trend towards self-created works is pervasive. “As more Americans connect to the Internet each year, increasing numbers are posting their own content on line … the public for the first time is not relying as heavily on big media companies to give them news and information,” Woodson, A., “User-made content booms – Reverses 450 years of media trends,” Hollywood Reporter (Nov. 29, 2006). As a consequence, fixed cost effectively is reduced to zero.

Second, for most users, marginal cost also now approaches zero, or, if not zero, an amount far less than the cost of replication, classically understood. Marginal cost for most consumers might be as low as their monthly bill for Internet services. One of the main elements affecting this process is broadband proliferation, with as many as 50% of all Internet users now on broadband connections. “‘That’s critical mass,’ Gerbrandt said of the statistic. ‘That’s one of the reasons YouTube has been so successful; you don’t want to try to access streaming video via a dial-up connection,’” Woodson, A., op. cit. (Larry Gerbrandt is a senior vp and general manager at Nielsen Analytics). As a consequence, we also can regard marginal cost as effectively reduced to zero.

According to some commentators, the combination of zero basis plus zero marginal cost has far-reaching ramifications. It “represents a remarkable, even revolutionary, democratization of the means of production,” Rothenberg, R., “Power to YouTube’s people,” Los Angeles Times (Oct. 28, 2006). Mr. Rothenberg continues: “[I]t’s just as likely to subvert business as to support its reinvention.” The reason why is because production no longer “is industrial, requiring concentrated resources.”

In other words, nascent film-makers no longer need millions of dollars to create a movie. The advent of inexpensive digital cameras solved that. And, aspiring musicians no longer need thousands of dollars to make a record. This trend started with the Alesis ADAT and the Mackie mixer, and now has evolved to the point where the recording process can, if one wishes, be completely computerized.

This will, of course, lead to a plethora of consumer entertainment alternatives. The “old media” “push” culture, in which consumers were spoon-fed whatever works were being offered by the mass media, is falling by the wayside. In its place is a “new media” “pull” culture, where consumers can select what they want, no matter how obscure, from potentially hundreds of thousands of different offerings.

As one commentator has stated, “The potent combination of Google’s search savvy and YouTube’s handle on Internet video will yield the first viable new-media successor to broadcast and cable television, which for decades have squandered the ad-supported critical mass they have enjoyed in what was once the only home screen,” Mermigas, D., “GoogTube deal shifts paradigm on-demand,” Hollywood Reporter (Oct. 17, 2006).

The consumer’s main problem is locating interesting works, which may be the most important contribution a new-media company can make. “[T]he explosion of user-generated content, combined with the proliferation of broadband offerings, could create an environment that confuses consumers. … [T]his presents a need for middlemen to present multiple entertainment options in simple, convenient formats and at the same time filter out the increasingly cluttered environment,” Woodson, A., “Old media still in the game,” Hollywood Reporter (Dec. 4, 2006) (quoting Bear Sterns analyst Spencer Wang). States Ms. Mermigas: “[I]t isn’t enough just having interesting or desirable content, and it isn’t enough just having an interactive platform on which some community congregates. The tools for functionality such as search and management that make content more valuable – flowing among consumers, platforms, devices and advertisers – are mandatory but not as easy to come by,” Mermigas, D., op. cit.

An interesting consequence of this phenomenon – that is, zero basis and zero marginal cost – is, creators should be maximally incentivised to produce works. The reason why is, they shouldn’t be concerned if the sum of fixed costs plus marginal costs isn’t effectively amortized over the number of units sold. Empirical evidence of this is the incredible growth of sites such as MySpace and YouTube.

Another perhaps less-obvious result is, the economic incentives to the counterfeiter and the pirate also are reduced dramatically. There can be no “free riding” by definition, if the fixed cost basis is negligible; a potential creator shouldn’t care if a free rider doesn’t contribute to basis, under such circumstances. Furthermore, for this same reason, there is far less risk in creating an aesthetic work, regardless of demand uncertainty. There probably is an element of gratification if the public listens to the creator’s songs on MySpace, or watches the creator’s videos on YouTube. However, that has more to do with personal utility considerations (i.e., how the creator spends his or her time, versus undertaking other, potentially more satisfying tasks) than “risk,” per se.