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On Software Piracy 175




Chapter IX



On Software Piracy*
Sougata Poddar
National University of Singapore (NUS), Singapore




Abstract
The pervasiveness of the illegal copying of software is indeed a worldwide phenomenon.
Economists argue that when the piracy takes place at the end-users™ level, the original
software developer finds it profitable to allow limited piracy when the effect of network
externality is reasonably strong in the users market. We argue when the piracy is of
retail in nature, the same logic cannot be extended as the reason for piracy and show
that it is always optimal for the original software developer to protect its software even
when the effect of network externality is strong in the end-users™ market. We suggest that
piracy depends on more fundamental issues like demand environment, market structure,
nature of piracy and nature of competition. The other issue we cover here is the
economic impact of piracy on the welfare of a society. We discuss various policy
implications on regulating piracy in developing as well as developed markets.




Introduction
In this age of digital technology, the heavy use of computer-related jobs using various
software packages in our day-to-day activity has become a rule rather than exception.
With the advent of digital technology and the popular usage of software packages, one



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176 Poddar


thing that is also making headlines at the same time is software piracy. The pervasiveness
of the illegal copying of software is indeed a worldwide phenomenon. It is not only having
a profound effect on the users of the software, but also on the software industry as a
whole. It is also having a tremendous effect on the development of digital intellectual
properties and technologies. Software piracy is rampant because of the very nature of
the product. Software production incurs large development costs, but once developed,
the manufacturing costs of fabricating a copy of the software program are almost
negligible. In other words, replicated copies of the original software incur zero costs and
this is precisely why software piracy presents such a lucrative and effective option for
those who are out to make a quick profit.1 This implies a huge loss of potential customers
of original software buyers, which directly translates into revenue losses for the software
industry. Software manufacturers, through their trade organizations, have been assert-
ing the huge damage inflicted on their businesses by the illegal use of software. In 1995,
the Business Software Alliance (BSA) claimed that the industry lost “$13 billion per
year,” “$35 million per day,” and “$407 per second” from software piracy. The 1998
Global Software Piracy Report released (in May 1999) by the BSA and the Software &
Information Industry Association (SIIA), the two leading trade associations for the
software industry, estimates that of the 615 million new business software applications
installed worldwide during 1998, 231 million “ or 38% “ were pirated. In other words, one
out of every three software applications installed worldwide was pirated! In 2001, the
corresponding figure remains at 40%.2 Revenue losses to the global software industry
due to piracy were estimated at $13.08 billion in 2002. Asia, North America, and Western
Europe accounted for the majority of world revenue losses. In 2002, the combined total
losses for these regions stood over $10.5 billion, and within that Asia alone accounted
for a loss over $5 billion. These losses not only pose a serious constraint on the growth
of the software industry but also adversely affect investment decisions and limit the
development of new software products. At the same time, rampant piracy inhibits job
creation and government revenue contributions. As a matter of fact,
PricewaterhouseCoopers (1998) estimated that if world governments had reduced
software piracy rates to benchmark levels3, direct and indirect employment would have
increased by 521,663 jobs and tax revenues by as much as $13.7 billion in 1996/97 alone
for the non-U.S. economy. For the U.S. economy, reducing piracy would have generated
an additional 130,000 jobs and nearly $1.0 billion in tax revenues in 1996. And this problem
of software piracy only gets bigger with the revolution and intensification of the Internet.
“What Do You Want To Pirate Today?” reads a banner at one of the many sites that can
be found by any user doing a basic Internet search for the word “warez” “ the online term
for unlicensed programs. The emergence of the “Web” has added a new dimension to
software piracy by permitting electronic sales and transmissions of illegal software on
a grand scale.
Given this, conventional wisdom suggests the need for the legal software firms and
governments to take a harsh approach on piracy of software. Interestingly, a group of
economists would ask the question, in reality, is the original software developer or the
government or the controlling authority seriously interested to stop piracy? In their
recent work they actually show that the answer is not necessarily positive. This strand
of literature (Conner and Rumelt (1991), Takeyama (1994), Slive and Bernhardt (1998), Shy
and Thisse (1999)) provides us with the unconventional wisdom on the issue of software



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permission of Idea Group Inc. is prohibited.
On Software Piracy 177


piracy. It shows that in some situations even the original software developer may not
necessarily want to clamp down on piracy “ even when it has the means to do so. In other
words, it is actually profitable for the original software developer to allow limited piracy.
The arguments to establish this basically stand on the feature of network externality that
is observed in the software user market.4 It is true that the occurrence of network
externality is a very prevalent feature in the software market and the existence of it plays
a central role for this (piracy) phenomenon. But, in this chapter, we argue that all these
unconventional results cannot be accepted as a general explanation for the existence of
software piracy in the real world. To prove the point, the chapter comes up with a model
where its shows that even in the presence of strong effect of network externality,
protection as opposed to allowing piracy is always optimal for the original software
developer. It also shows that the incentive to protect is even higher with the presence
of network externality as opposed to the case without any network externality. Therefore,
to understand the real reason for existence of software piracy, one needs to have a closer
look to the more fundamental economic issues that lie behind this phenomenon. The main
message is whether piracy is profitable or not to the original developer depends on the
market structure, demand environment and the nature of the competition.
The whole chapter will be done in three parts. In the first part (part I), we begin following
the existing literature, why network externality could be a reason for the existence of
software piracy in certain situations. After that a game-theoretic model of price compe-
tition between an original software developer and a pirate will be studied and analyzed
in detail to see the effect of network externality on piracy. In this part, we will assume that
both of the competitors move simultaneously, i.e., choose their strategies for operation
simultaneously. In the second part (part II), a game of sequential moves will be focused,
where the original firm acts as a leader and the pirate as the follower. The mode of piracy
that will be considered in both of these analyses is retail piracy. A retail piracy takes place
when a pirate (just like another firm) competes with the original software developer by
producing a copy which may not be as reliable as the original product, but comes with
a cheaper price. In the third part (part III) of the chapter, a complete welfare analysis will
be done by assuming (i) when a pirate is present in the market, and (ii) when the pirate
is absent. The question we ask, if there is a social planner (say, the government) whose
objective is to maximize society™s welfare, then what would be the policy recommendation
with respect to piracy? In other words, the question is whether allowing piracy is welfare
improving or welfare reducing from the society™s point of view. In this part, a rigorous
analysis will be done on this issue. This will be followed by a general discussion on the
welfare aspects of software piracy in a wider perspective. Towards the end, we highlight
the contribution of this chapter to the academic as well as business practitioners, like
managers and entrepreneurs. Finally, we conclude the chapter with a brief summary of
the main findings and by pointing out some future directions of research.
The whole study that will be done here is a theoretical analysis. Tools of economic theory
and game theory are used to model various economic situations. It will develop analytical
models in order to explain and understand the important economic issues of software
piracy. The study will also provide testable hypotheses for empirical and applied work.
Before concluding the introduction, we would like to say a few words on game theory
and the aspect of network externality that we consider here. Firstly, for those readers who



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178 Poddar


are not that familiar with game theory (some reading material is listed in bibliography),
game theory is a formalization of strategic thinking. It is useful in a situation where the
number of players (e.g., firms, economic agents) is not very large. In a situation like this
every player thinks strategically to maximize his/her payoff knowing about the fact that
every other player is doing the same. In such a situation, the payoff to one player not
only depends on his/her action (strategy), but it also depends on other players™ actions
(strategies) as well. In real life, in industries where there are only a few firms operating,
game theory could be a useful tool to analyze the strategic behaviour of firms. Examples
of such industries are: airline, pharmaceutical, telecommunication, banking, computer
(hardware and software) and so on.
The second issue is pertaining to the feature of network externality that we have already
talked about. We would like to emphasize that when we talk about network externality,
we are not limiting ourselves to the physical internal or external network among users,
but a network in much broader sense. All possible users (whether or not they are
physically connected by some network) of particular software or generally an operating
system (e.g., Windows, Linux, etc.) potentially form a group/network, where they can
gain much by sharing information/files among themselves. Naturally, the greater the
number of users in the network, the higher the gain from sharing, hence, the higher the
utility to the individual user. 5 As we will see, this aspect of network externality is going
to play a major role in our forthcoming analysis.


Part I

Network Externality “ A Reason for Piracy

We start with the assumption that consumers™ willingness to pay for software increases
with the total number of consumers who use (legally or illegally) the same software. That
is, the presence of network externalities reflects the fact that software users place a high
value on compatibility and file sharing. Suppose now that software is protected, and let
us assume that installed protective devices make it prohibitively costly for any consumer
to pirate the software. In this case, some consumers buy the software, whereas all others
simply do not use any software. Notice that if firms keep prices fixed, legal users have
all the incentives in the world to give this software for free to non-users, thereby
increasing the compatibility value of the software. However, legal users are prevented
from sharing their software by the protective devices installed into the software. If,
however, firms would remove protection from the software, then some consumers may
be willing to pay a higher price since the value of the software increases with the total
number of legal and illegal users. This is the core of the argument developed in the
section.
In particular, Takeyama (1994) considers a model of unauthorized reproduction of
intellectual property in the presence of demand network externalities and shows that
unauthorized copying can induce greater profits to the original firm. She considered a




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On Software Piracy 179


discreet demand model with two groups of consumers who have different valuations for
a good. She analyzed the situations when copying is easily possible by the users and
when cost of copying is prohibitively high, hence copying is not possible. In these two
contrasting situations, she showed that if the network effect is sufficiently large, profits
for the firm are higher with copying than without copying. The result follows from the
fact that unauthorized copying can be relatively efficient means of increasing network
size. In effect, unauthorized copying allows the firm to price-discriminate among different
classes of consumers. With copying, large network size can be achieved by the existence
of marginal consumers who make reproductions (at zero cost to the firm), while infra-
marginal consumers purchase originals at a price that may largely appropriate the
externality of increased network size created by copiers. Without copying, the same
network size may only be obtained at a possibly lower price on all existing units. Increase
in network size increases the value of the product unambiguously to all consumers
therefore enabling firms to raise price to those who buy it from the firm. In other papers,
Conner and Rumelt (1991) and Slive and Berhardt (1998) come up with a similar finding
explaining why a software manufacturer may permit limited piracy of its product. These
studies concentrated in a situation where there is only one original manufacturer, in other
words, a monopolistic industry. On the other hand a strategic approach to software
piracy is found in Shy and Thisse (1999). They show that there is a strategic reason why
software firms have followed consumers™ desire to drop software protection. They
analyze software protection policies in a price-setting duopoly software industry selling
differentiated software packages, where also consumers™ preference for particular
software is affected by the number of other consumers who (legally or illegally) use the
same software. Their results show when firms protect their software a low-price equilib-
rium emerges if network effects are strong, whereas a high-price equilibrium arises under
weak network effects. Therefore, all firms are better off with software protection when
network effects are weak. In contrasts, firms prefer not to protect their software when
network effects are strong. In another set of results which deals with a market situation
where firms choose to protect or not, prior to price competition they found that for very
weak network effects, both firms choose to protect their software because the impact of
piracy on sales is insignificant. For the intermediate value of the network effects, one firm
chooses to protect whereas the other does not. This is because the network effects are
now strong enough to induce one firm not to protect, thereby benefiting from the larger
network size, whereas these effects are still too low for the other firm to be able to afford
to do it. Furthermore, the non-protecting firm earns a higher profit than the protecting
firm. Finally, when network effects are sufficiently strong, both firms choose non-
protection.
Hence, all these studies unambiguously try to make a point that the existence of strong
demand network externalities is the central reason for the existence of piracy. In the
following section, we lay out a model of software piracy with the feature of network
externality and show that above arguments are not generally valid.




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180 Poddar


Network Externality “ A Reason for Protection

The Model

Consider an original software firm and a pirate software firm. The pirate has the
technology to copy the original software. In reality, we know that the cost of copying
software is negligible, hence we assume the cost of copying is zero for the pirate. The
probability that a pirated software works is q, q∈(0,1) and this probability is common
knowledge. Therefore q serves as a proxy for the quality of the pirated software. Usually
pirated copies does not come with the supporting services, so one can think even if the
pirated software is exactly same as the original one (because of digital coping), but the
lack of supporting service does not allow the user to get the full value of the pirated

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