A Network Effects Perspective on Software Piracy

I Introduction

The software industry devotes considerable efforts to combat software piracy. The industry's trade organizations, such as the Software and Information Industry Association (SIIA) and the Business Software Alliance (BSA), fight unauthorized use of copyright not only in the courts but also through extensive lobbying in the legislative and executive branches of government and by influencing public opinion through media campaigns. Even religious leaders have been harnessed to contribute to these efforts and issued religious edicts banning software piracy.¹ The main obvious and rather intuitive complaint of the software industry is that software piracy is a source of huge losses to the industry.² These efforts on behalf of the industry, as well as similar efforts on behalf of sectors of the information industries, have yielded significant achievements in the form of new international treaties, such as the TRIPS Agreement³ and the WIPO Copyright Treaty;⁴ new legislation at the national level (such as the Digital Millennium Copyright Act in the United States);⁵ and increased government spending on enhanced public enforcement of copyright laws.⁶ Surprisingly, and in sharp contrast to the industry's vociferous complaints about it, the use of technology to combat software piracy is limited, and many popular software products are distributed without any means of protection, rendering their unauthorized copying and distribution quite an easy task.

This lack of protection is puzzling. Software piracy is often analogized to theft. A BSA brochure, for example, opens with the following statement: 'Most people would never consider stealing something that did not belong to them. But those who copy software without authorization are, in fact, stealing someone else's property – their intellectual property.'⁷ But if one follows the analogy, the corresponding statement is also correct: most property owners would never consider leaving their property unprotected unless they do not particularly mind if it is stolen. So when a person chooses not to adopt any technically available protective measures with regard to his property, and confines his protection efforts exclusively to heavy spending on lobbying and legal proceedings, something seems odd; something does not fit with our everyday life experience. If an individual leaves his valuable new car on the street with the keys in the ignition and the car is stolen, it is likely that nobody will pay serious attention to his complaint, even if there is no doubt that his property rights were violated. If a group of people who wish to live in an urban community where members do not have to lock their homes were to lobby the government to spend more resources on policing their neighbourhood, their demand would likely be seriously questioned.

Why, then, do many software publishers choose not to protect their software and enable de facto free use, while at the same time complaining so much about that free use? The conventional answer is that software protection is technically and commercially impractical. This article advocates an alternative explanation: that the failure to protect software is a conscious business profit-maximizing strategy. This strategy is based on three elements. The first element is cross-sectional price discrimination, in which the lower tier of customers 'purchases' illegal versions for a zero price. In the face of network effects that exist in many software markets, such a strategy achieves the most expeditious and widest dissemination of software, maximizes the value of the network, and may also accelerate a tipping of the market in favour of the more dominant publisher. As a result, publishers are able to increase their profits compared to those earned in a smaller and less valuable network. The second element is dynamic pricing in a multiple-period setting. At a second stage, due to a lock-in phenomenon, higher than market prices can be charged to potential ex-pirates who face a threat of litigation and wish to legitimize their software. The...