How serious is the threat of online piracy?

On the one hand, legal music download services are proving to be much more of a success than the music industry had thought possible. On the other, illegal music file swapping is still alive and well, and the industry claims it is depriving it of billions of revenue. So, how should the music industry tackle the internet challenge?

So far, one cannot accuse the music industry of being imaginative. Instead of adapting to the internet, it is using the law to try to change the very features of the internet that make it so successful, filing highly publicised lawsuits against those potential customers who happen now to tap specialised websites to get, for free, the music they want to hear.

The music industry might be better advised to take a look at two successful attempts to use the internet as a new source of revenue by legally permitting the downloading of songs for a fee. Apple's iTunes has already topped the 15 million download mark, while Napster 2.0, the reinvented iconic service than started the music download furore, has a strong brand that will guarantee it an equally massive penetration.

They might also consider reading the CESifo Working Papers published by Martin Peitz, an economist at the International University in Germany who has dedicated much effort into understanding and characterizing the music download market. In a first paper, Piracy of Digital Products, Peitz and his co-author Patrick Waelbroeck of the Université Libre de Bruxelles analyse the particularities of the fact that music can circulate as a digital product. Being digital, songs have the property that they can be copied almost costlessly. This makes them natural candidates for non-commercial copying by end consumers. Furthermore, because the copy of a copy typically does not deteriorate in quality, copying tends to be widely replicated. The authors conclude that some models with network effects are well-suited for the analysis of software copying, while other models incorporating the feature that copies provide information about the originals may be useful for the analysis of copying digital music.

In a second paper, The Effect of Internet Piracy on CD Sales: Cross-Section Evidence, the authors provide an empirical application of their analysis by examining the effect of music downloading on the downturn in CD sales. While they offer evidence in support of the claim of losses due to internet piracy made by the music industry, their findings suggest that internet piracy played a significant role in the decline in CD sales only in 2001, but can hardly account for the subsequent drop in 2002, or thereafter.

End-user piracy, which is different from for-profit piracy, seems to be quite difficult to control. The industry and policy makers have addressed this issue by reinforcing copyright laws, by implementing technological protection and by actively enforcing legal protection through lawsuits targeted at developers and users of P2P ("peer-to-peer") networks. Yet, defenders of online distribution technologies have argued that MP3 downloads offer a new way for consumers to try new music, a typical experience good, in order to make more informed purchases, which could increase CD sales, the so-called sampling or exposure effect. On top of that, the lawsuits have created public-relations problems, intensifying the public view of the industry as greedy.

The authors proceeded in two steps to assess the effect of internet piracy on CD sales. First, they used data on music downloads gathered in 16 countries for the period 2000-2001 to find a significant effect of MP3 downloads on CD sales. Second, they assessed the plausibility of their estimates by analysing survey data on MP3 downloads in the U.S

Depending on the substitutability between MP3s and CDs and the multiplier effect of offline piracy, MP3 downloads can account for a large part of the CD decline in the US market in 2001. However, using an estimated elasticity of CD sales with respect to MP3 downloads, they found that internet piracy only accounts for less than 25% of the CD decline in 2002 in the US.

So, back to iTunes and Napster 2.0 as the way forward? Or, perhaps, follow the example set by Universal Music Group, the world's biggest record company, which reduced CD prices for consumers by nearly a quarter? A further paper by our expert authors will surely help the record companies find their way to profitability in the world of digital music: it explains every relevant trend, term and technical process, and describes the role the internet will play in the future of music distribution.

At any rate, whatever the results, it appears like the days of fat, fat profits for the music industry are over, and that listening to their customers' preferences might not be such a bad idea after all.

• Other CESifo Working Papers by Martin Peitz
• Check out papers presented at the CESifo Conference on the Digital Economy

Note: This text is the responsibility of the writer and does not necessarily reflect the opinion of either the CESifo Working Paper author(s) cited or the CESifo Group Munich.