Economics of piracy at the limit

I was reading the comments on a recent blogpost on the freakonomics blog. Someone suggested (tongue firmly in cheek, I hope) that if libraries were invented today, copyright enforcement bodies (the DMCA was labelled directly) would hunt down anyone who tried to set one up.

The comparison of the lending of books to the piracy of electronic media is disingenuous.

Why pirating books is a limited problem

Books are generally sold under the “licence” that allows them to be resold or loaned. Although there is arguably a different value/cost associated with a book purchased for a single reader versus one for a library, the scalability of a printed book is naturally limited. A physical book can only be read by a single person at a time, and transport and distribution are not costless.

The need for careful agreement between buyer and seller around what is allowed is not critical and probably not worth the cost of having separate licences to cover individual consumers versus libraries.

At the limit, pirating of electronic media implies no production

For electronic media, the scalability of copying and redistribution is, for most practical purposes, limitless if we assume perfect, universal, costless reproduction and distribution.  For impractical purposes (and pedants, you know who you are) there are limitations around the total population of earth, the market for that particular work, and costs of distribution are not zero. While I haven’t gone through the entire process of relaxing these assumptions to understand the impact, this theoretical framework is still instructive.

Thus, without careful agreement between buyer and seller, buyers will be inclined to extract maximum value. Taken to the extreme, this implies that only one copy of the work will be bought. I’ll explain how we get to this now. In the rest of this example, I am assuming no restrictions on copying, which includes no social pressure or stigma attached with using or distributing pirated media.

Once there are two sellers in the market, the market price will be pushed down due to competition between the two sellers. If one seller wants to sell the product at any price above zero, the competition will undercut that price since profit can still be made until the price hits zero. The aggregate supply curve is effectively horizontal at a price of zero since the marginal costs of production are zero.

In this analysis I am implicitly assuming that perfect competition will result even when there are only two suppliers in the market. Ordinarily this would be a poor model for this type of market. However, for two reasons, this is probably a good first order approximation:

  1. The “goods” being supplied, the creative work in this case, are exactly identical in every way. The differences or perceived differences of monopolistic competition and other market forms do not apply.
  2. Every additional buyer instantly becomes a potential supplier. Thus, the number of suppliers in the market grows exponentially by doubling every “turn” of the process. It should be relatively clear that the market will inevitably fall into perfect competition in a relatively short amount of time.

With a typical downward sloping market demand curve, this implies that an infinite amount of the product will be “sold” at a “price” of zero. This is approximated through current distribution and pricing of pirated media.

The creator of the work knows that he or she will only ever be able to make one sale (where I define “sale” to be a transaction with a positive price). All future sales will have zero total revenue. So the price at which that first sale is transacted must be very high if it is to be worthwhile to the creator to produce. However, the first purchaser knows that once he or she has purchased the work, competitive forces mean that he or she will not be able to sell the work for more than 0 in future. Thus, the price paid by the first purchaser will only be equal to the consumptive value to that purchaser.

Any creative work that will cost more to the creator to create than the value that one purchaser places on it (albeit the purchaser who values the item most) will not be created. Not for commercial reasons anyway.


I am wary to conclude too strongly on an area that is new to me and where I haven’t necessarily thought through all the consequences, or understood the impact of relaxing certain assumptions. However, this little thought experiment naively suggest that, under these strict assumptions, a huge variety of creative works may never see the light of day.

The start of a practical solution

Live concerts cannot be perfectly replicated. If one assumes that a large portion of the value derived from a live performance (or live “creation”) is being there in person, then that “first sale” can be made to many consumers simultaneously. That same instance of creation cannot be resold since a live performance cannot be stored. However, a second, third and Nth live performance could be sold where the creator has pricing power due to the natural monopoly created through their own talent, brand and creative abilities.

Several performers (including Madonna) have signed huge financial deals with concert promoters (e.g. Live Nation, suggesting that the real world is already tackling the changing economics of artistic creation in an electronic media world.

This is unlikely to be the only solution that is tested, but it will be interesting to see how this section of the economy develops through this testing phase.

In this post I haven’t expressed an idealogical view on whether piracy is “good” or “bad” according to some normative standard. The hope is that we can follow the logical, economic arguments to their conclusion rather than be sidetracked by emotion and politics.

Published by David Kirk

The opinions expressed on this site are those of the author and other commenters and are not necessarily those of his employer or any other organisation. David Kirk runs Milliman’s actuarial consulting practice in Africa. He is an actuary and is the creator of New Business Margin on Revenue. He specialises in risk and capital management, regulatory change and insurance strategy . He also has extensive experience in embedded value reporting, insurance-related IFRS and share option valuation.

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  1. “Books are generally sold under the “license? that allows them to be resold or loaned.”

    It would be helpful if you actually understood the subject matter.

    Copyright only covers the reproduction or performance of a work. You don’t need a license to use or dispose of the physical media (your property) as you see fit.

    In fact to speak of a book being sold under a license at all is meaningless because no such license exists books actually have a printed disclaimer that tells you that they are no such license.

  2. Also consider that technology can lower the cost of production of creative works to the point where the satisfaction of creativity may be value enough to encourage the production of such works.

  3. Thanks for the comments Michael. I intentionally used inverted commas around the word licence because, as you correctly state, the strict definitions of licence don’t apply. Your comment doesn’t deny my point, in fact doesn’t even address the point I’m making. Books are created, published and sold with the understanding that the physical item is owned and can be loaned out.

    You are arguing legal points, when I am making economic points.

    Your second comment is also valid, but again doesn’t address my analysis. Again, I specifically state that the disincentives to production would be be for commercial considerations only. A great deal of the most fantastic art works we have were not created necessarily for commercial reasons. I don’t think that lowered costs of production from technology is even core to this argument.

    We all know that a tremendous amount of creative works (artistic and software) have been produced for the joy and challenge of creation and “academic peer review and recognition”. This is interesting but in no way detracts from the argument I put forward above.

    It is quite typical in discussions around electronic media for people to have knee-jerk reactions, discarding any analysis based on irrelevant thoughts from a particular idealogical viewpoint. My “not understanding the subject matter” is not the same as my “analysis not agreeing with your idealogical viewpoint”. The reality is that these sorts of comments do not further constructive debate around the role of patents, licences and copyright in society and when it is good and when it is bad. All the same, I appreciate you taking the time to comment.

  4. Michael wrote:
    “In fact to speak of a book being sold under a license at all is meaningless because no such license exists books actually have a printed disclaimer that tells you that they are no such license.”

    I’ve had a quick scan through the covers of a few of my books and haven’t been able to ascertain what precisely it is to which you are referring, yet. Could you please provide guidance?

    I’m also struggling to see the relevance of the distinction to the analysis.

    Michael further wrote:
    “Also consider that technology can lower the cost of production of creative works to the point where the satisfaction of creativity may be value enough to encourage the production of such works.”

    I may be wrong, but I’m not entirely convinced that you considered the opportunity cost of engaging in creative acts when you stated the above. Do you believe that technology will eventually grant us significant amounts of free time?

    I introduce this because from personal experience I choose at this stage of my life not to satisfy a lot of my creative urges (primarily music) because of the opportunity cost to me of the time required.

    I can thus imagine a situation where the opportunity to make a greater economic reward (assuming I was better than I am now!), over and above the reward for engaging in an act of creativity, would allow me to further pursue my desires with a clearer conscience (being able to provide the kids with a good education and all that).

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