Managing Digital Piracy: Pricing and Protection

This paper analyzes the optimal choice of pricing schedules and technological deterrence levels in a market with digital piracy where sellers can influence the degree of piracy by implementing digital rights management (DRM) systems. It is shown that a monopolist's optimal pricing schedule can be characterized as a simple combination of the zero-piracy pricing schedule and a piracy-indifferent pricing schedule that makes all customers indifferent between legal usage and piracy. An increase in the quality of pirated goods, while lowering prices and profits, increases total surplus by expanding both the fraction of legal users and the volume of legal usage. In the absence of price discrimination, a seller's optimal level of technology-based protection against piracy is shown to be at the technologically maximal level, which maximizes the difference between the quality of the legal and pirated goods. However, when a seller can price discriminate, its optimal choice is always a strictly lower level of technology-based protection. These results are based on the following digital rights conjecture: that granting digital rights increases the incidence of digital piracy, and that managing digital rights therefore involves restricting the rights of usage that contribute to customer value. Moreover, if a digital rights management system weakens over time due to the underlying technology being progressively hacked, a seller's optimal strategic response may involve either increasing or decreasing its level of technology-based protection. This direction of change is related to whether the DRM technology implementing each marginal reduction in piracy is increasingly less or more vulnerable to hacking. Pricing and technology choice guidelines are presented, and some welfare implications are discussed.