Digital Rights Management and Technological Tying

1. Digital Rights Management and Technological Tying Jin-Hyuk Kim May 8, 2009 NET Institute Conference on Network Economics

2. Introduction • Digital Piracy • Public protection • Private protection • Digital Rights Management • Encryptiontechnology • Needs authentication • Restrictive nature

3. Introduction • DRM • Prevents copying • Leveraging effects • iPod/iTunes • Market pioneer • “Closed” system • refusal to license • Other relevant markets (e.g., e-book)

4. Introduction • Raising the Rival’s Costs • By making the rival’s hardware incompatible with DRM-protected legal content, the tying firm forces consumers to obtain illegal copies in order to use the rival’s device • Monopolization • Closed system • “Open” Policy • US vs. EU

5. Model I • 2 firms (j=A,B) sell hardware • MC=c • Single content firm, C • zero MC • Consumers can copy at zero cost without DRM • Firm A owns DRM technology • when in use, increases copying cost to h • can make B’s device incompatible with the content • Illegal copies are compatible with both devices

6. Model I • Unit measure of identical consumers where is the value of the content is the cost of obtaining the content is the price of hardware j. • for original content for illegal copies • denotes the market price of the legal content

7. Model I • Apart from DRM issue, devices are identical • Firms engage in Bertrand competition when active • Stage 1 • A offers DRM to C if C sells the legal content at some • If C accepts, A can offer to share DRM with B, which B accepts or rejects • Stage 2 • Firms set their prices (content price subject to contract) • Consumers make choices

8. Model I • Consumer choices: {A,buy},{A.copy},{B,buy},{B.copy},{0,0} • Three possibilities at Stage 2: 1. No DRM: A and B have equal market shares and consumers buy legal content 2. Closed DRM: i) consumers choose {A,buy}, ii) A and B have equal market shares and consumers make copies 3. Open DRM: A and B have equal market shares. Consumers either i) buy, or ii) make copies

9. Model I • Equilibrium A offers DRM to C and sets the content price at . C accepts the offer; A does not make an offer to share DRM with B. Hardware prices are and . All consumers choose hardware A and buy the legal content. • Open policy Consumers are better off under open DRM, whereas the tying firm is worse off. Regulation to open a closed DRM system, however, has no effect on aggregate welfare.

10. Model II • Heterogeneous consumers • This would imply that some consumers abstain • Firm A still monopolizes the market (closed DRM) • Both hardware and software prices are above mc • Open policy, either expected or unexpected, would increase social welfare. • Conflict of interests: Firm A prefers closed system whereas firm C would prefer open system

11. Model III • Divergent views on Apple: • …european antitrust pursuit “provides a useful illustration of how an attack on IPRs can threaten dynamic innovation.” • Two-period model • Each firm can invest to upgrade their product’s quality • Consumer “switching cost” • Fixed cost of innovation, Quality improvement, • Firms can price-discriminate s.t. efficient

12. Model III • Equilibrium Closed DRM system emerges in the first period, A captures the entire market, and then A invests and sells its upgraded product to all consumers in the second period. • Open policy either weakly or strictly decreases expected social welfare • Closed system avoids duplicating investment of the two firms • If B could produce higher quality upgrades, then the welfare implication could be ambiguous

13. Conclusion • Technological tying • Gains market power in a competitive market • IPR vs. Competition