We analyse how piracy affects the choice of quality of a monopolist producing a digital good. A digital good is a special kind of information good, for example a music CD, a DVD or an electronic magazine available online. An important feature of digital goods is that they can be copied without a decline in the copy's quality. We define piracy as both the production and the sale of illegal copies and the practice of file sharing through the Internet. Recently, the introduction of fast Internet connections and peer-to-peer technologies (like Napster and Gnutella) has caused a huge increase in the copies and firms are adopting various measures to counteract this phenomenon. In this paper we focus on a firm's incentive to vertically differentiate the quality of its products in the presence of piracy. We show that without piracy and in the absence of production costs the monopolist never differentiates its product. With piracy, the monopolist might introduce a second, lower-quality good in order to induce consumers who acquire a pirated copy to buy the original. Hence differentiation may arise in equilibrium. This type of vertical differentiation is relatively widespread in the software market (consider the practice of distributing versions of a software with less features) and also in the music market (for example, selling music online). We consider a model of vertical differentiation where consumers differ in two aspects. They have both different will-ingness to pay for quality and different costs of accessing a pirated copy. Moreover, those with a greater cost of pirating also have a higher willingness to pay for quality. In this framework we show that the monopolist has two different strategies. On the one hand it can produce just one quality and sell it only to consumers with a high willingness to pay whereas those with low willingness to pay for quality obtain a pirated copy. On the other hand, the monopolist can produce two different qualities, pricing them so that consumers with high willingness to pay buy both whereas those with low willingness to pay either buy the low quality or acquire a pirated copy. The introduction of protection devices that prevent copying or the enforcement of copyright laws increases quality levels, prices and therefore profits. Given that the monopolist sets a higher price for the low quality, the most interesting aspect of protection is to render differentiation more attractive, so that the main impact of protection is on product differentiation rather than on the extent of illegal demand.
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