Peer To Peer Sharing On Media Industry

Published Date: 02 Nov 2017

The Internet has become a major source of music and video content

over the past decade. This has been facilitated by the creation of

digital formats for inexpensive media storage and distribution, wide

availability of computers and high-speed Internet connections, and

the evolution of peer-to-peer (P2P) file-sharing networks. P2P networks enable

computers to connect directly to each other and utilize specialized software

(such as eDonkey and Kazaa) to locate and trade a variety of digital files, including

music, movies, video games, and computer programs.

The U.S. music industry enjoyed healthy growth during the 1990s. Shipments

increased from $7.5 billion in 1990 to a high of $14.6 billion in 1999,

dropping thereafter to $8.5 billion in 2008.1 The decline in overall music sales

coincided with a large increase in swapping of digital music files over the Internet,

beginning with the introduction of Napster in 1999. A large majority of

these exchanges occurred over P2P file-sharing networks and were illegal, i.e.,

copyright-protected material was reproduced and transmitted without payment

to artists and music labels.2 The music industry holds P2P file-sharing systems

responsible for a 25% decline in music sales after 1999, and it has identified

unauthorized file sharing over the Internet as a major threat to its long-term

survival with large negative effects on the broader economy as well. While revenues

for the motion picture industry have not experienced similar declines and

incidence of downloading of movies over P2P networks has been much lower,

video piracy is increasing with greater availability of high-speed Internet connections

and more efficient software for sharing larger files. This activity directly

affects the market for home videos, now the largest source of revenues for the

motion picture industry.3

While the media industry blames Internet file sharing for large economic

losses, there is little consensus in prior research on its impact on industry

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revenues.4 Some studies attribute the downturn in music sales almost entirely

to piracy,5 while others find that the economic impact of illegal file downloads

on media sales is negligible.6 In the latter case, the drop in sales may be triggered

by a decline in quality of new music or change in the way people listen to music

(e.g., more streaming and fewer CD purchases).7 Another stream of research

indicates that listeners’ ability to sample files for free on P2P networks may

increase music sales.8

The media industry has responded to unauthorized file sharing by lobbying

(through its trade associations, RIAA and MPAA)9 for stricter laws and

by prosecuting Internet providers as well as the most active file-sharers, while

maintaining high product margins and adding encryption software that restricts

duplication and playback (Digital Rights Management). These measures have

failed to check widespread file sharing over P2P networks and have antagonized

many influential industry constituents (e.g., students, college faculty, technology

developers, legal scholars, and present and potential customers), who view this

as a futile effort by the industry to resist change, stifle creativity, and prolong the

use of an unsustainable business model.10

In view of this controversy, we conducted empirical tests to ascertain

whether the financial market perceives the industry’s efforts to tighten and

enforce copyright legislation as having positive consequences for the long-term

profitability and survival of member firms. Our tests used stock price as a measure

of the aggregate views of sophisticated investors on the media industry’s

expected future cash flows. We documented positive stock price reactions for a

broad sample of media stocks to the passage of copyright legislation and news of

enforcement action against copyright violators, which suggests that the market

believes that legal measures taken by the industry to safeguard its intellectual

capital will enhance its future cash flows.

Hence, we regard future business strategies

based on charging for artistic works as viable,

even in the face of current availability

of free substitutes over P2P networks.

There are several business strategies

to check Internet piracy and utilize

new technology to cater to evolving customer

tastes. These include educating the

public about the need to pay for copyright-

protected works in addition to tighter

copyright laws and stricter enforcement,

simplifying the process of obtaining copyright

permissions to encourage legal use of artistic works, and adoption of new

business models that move the industry away from sale of CDs and DVDs and

towards monetizing access to music and movies that may be experienced at any

time. This can be done through a variety of devices and as part of a larger experience,

which includes social networking, playing music in games such as Guitar

Hero and Rock Band, and creative generation of new content through remixes.

Sanjay Goel is an Associate Professor in the

School of Business and the Director of Research

at the NYS Center for Information Forensics

and Assurance at the University at Albany, State

University of New York. <[email protected]>

Paul Miesing is an Associate Professor of

Management in the School of Business at the

University at Albany, State University of New York.

Uday Chandra is an Assistant Professor in the

Department of Accounting and Law in the School

of Business at the University at Albany, State

University of New York.

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Theory and Background

Economic theory defines public goods as those whose consumption by

one person does not reduce their availability to others, and where it is impossible

to prevent anyone from using these goods. Traditionally, it has been possible

to restrict access to music and video works (available through concerts and theaters

as well as CDs and DVDs) and hence impose a charge on them. However,

virtually costless search, duplication, and swapping of digital media files over the

Internet enabled by P2P networks imbues these products with properties of public

goods. Consequently, the media industry is exposed to a "free-rider problem"

where non-commercial users have little economic incentive to pay for artistic

works that are costly to produce in the private sector but available for free. This

may lead to under-production and market failure.

One way to compensate media firms and artists (and hence ensure sufficient

production) is through general tax revenues or specific levies on products

that benefit from artistic works such as audio and video players,11 or to bundle

media products with those not subject to a free-rider problem, e.g., cellular

phones. An alternative solution to the free rider problem is through legislation

to enforce property rights. Copyrights enable producers to capture revenues

from their creative works by making it illegal for purchasers to duplicate and

distribute their work over a specific time period without prior permission, for

which they may charge royalties.

The major players in the media industry have so far focused on a strategy

of lobbying for greater copyright protection and deterrence by selectively prosecuting

large-scale violators and publicizing these cases. However, it is hard to

curb file sharing of copyright-protected material through legal means for several

reasons. One, copyright violators are millions of individuals who are distributed

across many national boundaries and legal jurisdictions. Listeners have historically

preferred unauthorized downloading from P2P networks to purchasing

from legal sites (such as Apple’s iTunes) because it is free; there is greater

variety; it is easier to locate a particular song using an Internet search; and the

downloaded file may be shared with others because it is free of Digital Rights

Management (DRM) restrictions.12 Two, Internet culture is largely creative and

anti-establishment, and Internet file-swappers appear to have no moral compunction

in infringing copyrights.13 Three, a majority of these individuals are

present or potential customers. According to the RIAA, more than half of U.S.

college students frequently download music and movies illegally from P2P networks.

Punishing such violators generates negative publicity and alienates the

customer base. Four, culpability is distributed over those who provide the tools

to share files (e.g., P2P networks and Internet service providers), those who

download files, and those who make copies of files available on networks. Lastly,

technology to prevent unauthorized copying (DRM) has been ineffective so far

as hackers have quickly cracked the protection codes or found other ways to

circumvent it.

Although the media industry perceives unauthorized file sharing as a

major threat to its survival, it may not be detrimental to society as a whole.

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For instance, a majority of those who download media files may be unwilling

or unable to purchase them. Preventing free downloads by such users results

in lower social benefits without any increase in revenue for media providers.

14 Further, large media companies may historically have stifled creativity by

having excessive influence on deciding what types of works get produced and

marketed15 as well as maintained artificially high prices—e.g., by paying radio

stations to play certain numbers, selling more expensive albums rather than the

single tracks desired by music fans, and promoting more popular artists at the

cost of those with niche followings (and smaller potential profits). Lower search,

promotion, and distribution costs associated with the Internet may loosen the

stranglehold of large companies and promote creativity while providing works

that better cater to diverse consumer tastes at competitive prices. Because Internet

piracy may increase public welfare in the short term, the media industry

has a primary role in ensuring an environment where artists are adequately

compensated so that they continue to supply an appropriate volume of creative

work.16

Unauthorized downloading of music files over P2P networks may actually

increase sales of legitimate products. This is because these are "experience"

goods, i.e., potential customers need to try them to reliably assess their value.

P2P networks provide listeners with a convenient means of sampling music, and

they may increase their total purchases by discovering items or artists they may

otherwise be unaware of.17 The practice of payola, where music labels pay radio

stations to play new music to boost CD sales, reflects this phenomenon. Selling

digital media files over the Internet permits firms to customize their products to

meet individual tastes and instantly gratify customers, besides providing them

with the opportunity to use music and video in creative ways (e.g., through

remixes). Thus, selling digital files over the Internet has the potential to increase

flexibility, reduce distribution costs, increase industry profits, and offer consumers

more choices. However, media companies have been slow to embrace

emerging technologies and are struggling to find a viable business model, likely

because of lack of requisite technical knowledge and expertise.

Media Industry Structure

The media industry is dominated by large conglomerates that finance the

development of new music and movies, maintain extensive libraries of media

products, and often own broadcast and cable television as well as retail outlets

to distribute their content. Major record labels and film studios have long been

very concentrated and have developed diverse portfolios of stars and product

brands under a variety of labels.

Producing a motion picture usually involves a distributor, a production

company, and a number of artists and technical personnel. The distributor

typically rents movies to theaters and sells videos to retailers for home viewing.

Movie theaters typically keep half of the receipts from ticket sales, and the

remainder is paid to distributors as rental fees. Major players in this diverse,

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global industry (movie studios they control are within parentheses) are Time

Warner (Warner Brothers), Viacom (Paramount Pictures), Sony (Columbia Pictures),

GE (Universal Pictures), News Corp (Twentieth Century Fox), and Disney

(Buena Vista). The six largest film studios normally account for more than 70

percent of box office sales in North America. Distributors segment the market by

releasing films first to theaters, and then (in turn) to home video, pay-per-view/

video-on-demand, and cable/broadcast TV markets, charging successively lower

prices. Other firms involved in distribution include Carmike and Regal cinemas,

Blockbuster, and Hollywood Entertainment. Revenue streams from video sales

and rentals are now twice as large as those from theater ticket sales.

In the music industry, between three and six companies have dominated

the industry globally over the past century.18 Currently, four major distributors

account for approximately 80% of retail recording sales: Universal Studios

Group (controlled by Vivendi), Sony Music Group (until recently a joint venture

with Germany’s Bertelsmann Music Group), Warner Music Group, and

Britain’s EMI. Artists are generally under contract to record for a single label

and company for a number of years. They are paid an upfront fee for recording

an album, and additional amounts (royalties on sales) are paid only after the

recording company has recovered its costs.

An analysis of the media industry based on Porter’s Five Forces model

is presented in Figure 1.19 The five forces are: rivalry among existing competitors;

bargaining power of buyers; bargaining power of suppliers; threat of new

entrants; and threat of substitute products or services. We include complementors20

and disruptive technologies21 in the figure to facilitate our discussion, as

these represent strong forces in the transformation of the media industry. Key

success factors in the media industry include protecting and exploiting intellectual

capital, developing brands, access to capital, creative promotion, and

maintaining artist relationships. New entrants have traditionally faced significant

entry barriers due to industry concentration, where entrenched major players

control the bulk of their value chain from production to distribution, and their

size and cash flow from older products provides risk diversification and easy

access to financing for risky projects.

While competition for market share between major industry players

has historically been strong, they have relied on trade associations (RIAA and

MPAA) to look out for their collective interests. This has permitted them to

maintain high product margins by avoiding channel conflict and cannibalization.

Recently, big-box discount chains such as Wal-Mart and Best Buy have increased

their market share at the cost of conventional record stores, and forced music

companies to standardize and lower prices. CD/DVD players and personal computers,

online services that facilitate transactions, and virtual communities fuel

industry sales but can also create new competition by offering music and video

products online. Conversely, while substitutes such as video games, cable television,

and music and video sharing websites can compete for market share with

traditional media products, they may also be used as complementors to earn

royalties and increase sales by providing increased exposure to artistic works.

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Historically, the media industry has required high investments upstream

in developing stars and producing music and motion pictures, but incurred low

marginal costs and generated large margins downstream providing economies

of scale and risk minimization for large and balanced portfolios. With recent

development of digital files that can be easily reproduced and transmitted over

the Internet, control over downstream activities has weakened because of low

barriers to entry, low investment needs, and relatively lucrative returns. The

new technology has greatly increased the power of individual consumers who,

in the absence of significant switching costs, can download singles (as opposed

to expensive albums favored by music labels) for free (albeit illegally) over

the Internet or listen to music over social networks or sites that stream music

on demand, and of artists who can record quality music without the need for

elaborate studio facilities and distribute it over the Internet. The industry’s

Disruptive Technologies

• P2P File-Sharing Systems

• Digital Recording and

Reproduction

Potential Entrants

• Online Music/Video Stores

• New Artists

• New Studios

Complementors

• Audio/Video/TV Recorders

• iPods and Other Devices

• Internet

• Agents/Publicists

• Pay Pal, Netflix, Online Jukeboxes

• ISPs and Portals (e.g.,. AOL)

• Virtual Communities (e.g., chat

and searches)

Substitutes

• Internet

• Video Games

• MTV

Suppliers

• Artists/Writers

Guilds

• Production Staff

• Media/

Equipment

Manufacturers

Buyers

• Channels (e.g.,

retail/rental

stores, movie

theaters,

television/radio,

online stores)

• End Users

Industry Competitors

Intensity of Rivalry

• Promotion, Publicity,

Branding, Loyalty (e.g.,

concerts, DJs)

• Changing Tastes, Demographics,

Attitudes

Synergy of Interests

• DRM Technologies

• RIAA/MPAA

• Litigation, Lobbying

• Education

FIGURE 1. Competitive Analysis of the Media Industry

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distribution is shifting from physical CDs and DVDs in brick-and-mortar stores

to the Internet from where digital music and videos can be downloaded onto a

variety of devices. Product promotion, publicity, branding, and loyalty are similarly

shifting from concerts and radio disk jockeys to online communities and

user chat groups.

Tech-savvy startup firms able to leverage technological innovations to create

an efficient distribution system are potential new entrants that may threaten

current industry players.22 In the motion picture industry, the greatest threat

comes from unauthorized recording of films in theaters and copies of DVDs that

are sometimes made available for download or sale on P2P networks prior to

their official release.23 Pre-release piracy has a large negative effect on box office

receipts as well as revenues from video sales and rentals.24

A Note on P2P File-Sharing Systems

Perhaps the greatest threat to the media industry’s current business model

comes from unauthorized file sharing over Peer-to-Peer networks. The purpose

of this section is to provide a primer on the design and structure of P2P file-sharing

networks, especially as they pertain to the ability of the media industry to

argue its legal cases and assess culpability of P2P software developers and users.

In a pure P2P model, all the participants (peers) store resources and directly

communicate with each other without relying on a central server or gatekeeper.

While in the conventional client-server systems the address of the server is fixed,

a search mechanism is provided in P2P systems to locate the appropriate node in

real-time. Several architectures for P2P systems have evolved that differ primarily

in their approach to search and storage.

Napster, the first of a new generation of P2P file-sharing networks, used

a centralized directory to store and search for files on the network. In the Napster

model, peers connect to a central database where they publish information

about the content they wish to share. A user seeking specific content queries

this database, obtains IP-addresses of the nodes where the resource is located,

and downloads the resource directly from one of the identified nodes. It is easy

to identify the location of all the files in such a centralized system and trace

those supplying and downloading files, which increases exposure of developers

to litigation.

To partly address issues of anonymity and accountability in Napster,

Gnutella was created as a decentralized P2P system where each node maintains

a list of only its own files. To search for a file, the user sends a query to its

immediate neighbors who in turn transmit the query to their neighbors until

the resource is obtained. Since the query traverses from peer to peer without

maintaining a record, this network makes it difficult to track user activity. Additionally,

since the resources are distributed across the network and their access is

controlled by users, the culpability of developers in abetting copyright infringement

is greatly reduced, albeit at the expense of increased exposure of users.

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Freenet enhances anonymity of users by obfuscating their identity and

encrypts provider information. Each peer in the network is assigned a randomly

generated identification number and each file stored in the network is assigned

an ID based on its name or content. Files are stored on nodes whose IDs most

closely match file IDs. A file request is directed to the node with an ID most similar

to the ID of the requested file, and the routing table is dynamically updated.

Due to randomly assigned IDs for both users and files, it is hard to track the

activity of any user or provider. Exposure to litigation is low for both users and

developers under this architecture.

Since files are stored on network nodes independent of network capacity

in distributed P2P systems such as Gnutella and Freenet, downloads can be slow.

Several P2P networks have been developed to make routing and downloading

more efficient. Kazaa uses a hierarchical approach with preferred storage on

nodes with high network capacity, making downloads faster. BitTorrent software

was developed to transmit larger files quickly by splitting files into segments and

storing them on different nodes. Portions of a file are concurrently downloaded

from different nodes and then assembled on the user’s computer. Since BitTorrent

directly connects to peers while downloads are in progress, anonymity of

file sharers is not well protected.

Network architecture is a key factor in copyright infringement cases

involving P2P networks. Prosecution is especially difficult when files are fragmented

and stored on several computers that cannot be easily identified and/or

users have no knowledge of which files are stored on their disks.

Public Policy

In order to counteract the threat of unauthorized copying and distribution

of media files over P2P networks, the media industry has sought protection

from copyright laws, which are designed to foster creation and dissemination of

knowledge. Traditionally, copyright laws have shown a preference for authors’

rights (over those of distributors and the public) in order to provide sufficient

economic incentive for creating artistic works. Copyright laws initially focused

on print media and subsequently evolved to cover audio and video recordings.

Legislation evolved piecemeal as sharing of copyright-protected music and video

files over the Internet became widespread. Each new law has added to the level

of complexity, creating a legal quagmire that hinders both the ability of authors

to be compensated for their creative works and their wide dissemination to the

public.25 Several media distribution firms that adhered to copyright laws were

unable to survive as the copyright owners were inflexible in pricing royalties and

creating alternative revenue generation models.26 While the media industry has

successfully lobbied Congress for increased legal protection and higher penalties

for infringement, some legal scholars have questioned the need for copyright

protection in an industry where search and distribution costs are low and users

are prepared to bear them.27

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Legislative Acts

The Copyright Act of 1976 extended automatic protection to all creative

work when reduced to tangible form (such as a drawing, sheet music, photograph,

or movie script) without the need for registration. The Act made it legal

for copyright owners to file civil lawsuits and for the government to file criminal

charges against infringers. The Communications Act of 1984 and later amendments

provided copyright protection for material on cable TV and satellite services

as well. Copyright law was amended in 1989 to remove the requirement

that a formal notice of copyright be attached to the work. This was followed by

the Audio Home Recording Act (AHRA) of 1992, which prevents creation of

serial copies of digital audiotapes and also shields manufacturers of audio recording

equipment meant for non-commercial use from litigation.

Several major pieces of legislation provide copyright protection specifically

to digital media. The No Electronic Theft (NET) Act was enacted by Congress

in 1997 to facilitate prosecution of copyright violators on the Internet.

This act makes it a federal crime to reproduce, distribute, or share copies of electronic

copyrighted works such as songs, movies, games, or software programs,

regardless of whether the person copying or distributing the material receives

a financial benefit. Through the NET Act, the maximum penalty for copyright

infringement was increased to three years in prison and a $250,000 fine. The

NET Act was superseded by the Digital Millennium Copyright Act (DMCA) in

1998, which makes it a crime to circumvent anti-piracy measures built into most

commercial software and outlaws the manufacture, sale, or distribution of codecracking

devices used to illegally copy software. It limits liability for Internet Service

Providers (ISPs) from copyright infringement, but holds them responsible

for stopping illegal sharing of copyrighted materials over their networks once the

copyright holder informs them of an infraction. It also limits liability of nonprofit

institutions of higher learning for copyright infringement by faculty members or

students who utilize Internet services for educational purposes. The World Intellectual

Property Organization (WIPO) Copyright Act (included in the DMCA)

amends Federal copyright law to grant copyright protection to sound recordings

that were first produced in parties to specified international copyright and other

agreements. The Family Entertainment and Copyright Act signed in 2005 makes

it a federal felony to use a camcorder in a theater.

Several bills to further strengthen digital copyright legislation are under

consideration by Congress. The Protecting Intellectual Rights Against Theft and

Expropriation Act of 2004 (the Pirate Act) stipulates commencement of civil

action against anyone who engages in copyright infringement. It also provides

a directive to develop a program to ensure effective implementation and for civil

enforcement of copyright laws, and establishes new penalties for pirating works

prior to their commercial release. The Digital Media Consumers’ Rights Act bill

(initially introduced in 2003) assures that consumers who purchase digital media

can enjoy a broad range of non-commercial uses. This bill directly challenges

portions of the DMCA and would intensify Federal Trade Commission efforts to

mandate proper labeling for copy-protected CDs to ensure consumer protection

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from deceptive labeling practices. Another pending bill is the Inducing Infringement

of Copyrights Act that seeks to put technology creators and users on

notice that they may face liability even if they do not intend to cause copyright

infringement or know about actual infringement. It is written broadly enough

to alert those who invest in such technologies that they might also face liability.

Legal Battles

At the current juncture, digital copyright legislation is still a work in

process. Several landmark cases have provided clarification on digital copyright

protection. In the pioneering Betamax case, Universal Studios and Walt Disney

Productions through the Motion Picture Association of America argued that the

ability of Sony’s Betamax to copy programming off the air constituted a copyright

infringement.28 Sony countered that a consumer has the right to record

programs at home for private use, drawing analogy to the audiocassette recorder

in use since the 1960s. The U.S. District Court ruled in favor of Sony, stating

that taping off the airwaves for entertainment or time shifting constituted fair

use and plaintiffs did not prove that use of VCRs caused economic harm to the

motion picture industry. This ruling was used as a precedent for subsequent

cases filed by media companies against P2P developers.

One of the first battles in the file-sharing industry occurred when the

RIAA accused Napster of copyright infringement through illegal distribution of

its members’ music.29 Relying on the 1984 Betamax case, Napster argued it was

not committing a copyright violation because it did not reproduce copyrighted

works and file sharing by its users constituted "fair use" under the Copyright

Act because they did not derive any economic benefit from it. After a protracted

legal battle, Napster was found guilty and ordered to stop allowing sharing of

copyright-protected material without adequate compensation to owners. Napster

lost the case largely because it used a central server that provided transparency

to its operations and the ability to control the flow of music.30

In another landmark case, 28 entertainment companies sued Streamcast

Networks—which distributes Morpheus and Grokster—for copyright infringement.

31 Here, the 9th U.S. Circuit Court of Appeals in San Francisco ruled that

file-sharing services are not liable for the illegal activity of their users, citing

the 1984 Betamax case as precedent. The ruling noted that file-sharing systems

have significant legal uses, not unlike videocassette recorders, such as allowing

consumers to make copies of copyright-protected works for the purpose of timeshifting.

Also, developers of Grokster had no way of knowing and controlling

the actions of its users. It was, however, subsequently ruled that Grokster could

be sued for inducing copyright infringement for actions taken in the course of

marketing file-sharing software. Eventually, Grokster settled for $50 million and

shut down its music sharing service.

Since passage of the DMCA, the RIAA has been instrumental in issuing

subpoenas to identify people suspected of illegally distributing music. Verizon

was sued when it refused to comply with subpoenas against Verizon Internet

Services. In 2003, the RIAA won a landmark case against Verizon that would

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have forced the company to release the names of subscribers suspected of copyright

infringement under the provisions of the DMCA. Verizon appealed the

judgment, arguing that the RIAA subpoena did not fall within the scope of the

extraordinary subpoena authority created by the DMCA. In December 2003, the

U.S. Court of Appeals for the District of Columbia Circuit sided with Verizon.

The court ruled that copyright music owners could not issue subpoenas under

the DMCA that would identify users engaged in illegal P2P file sharing. After

Verizon’s victory, the RIAA shifted its efforts to identifying and pursuing users

who maintain large repositories of pirated files rather than pursuing developers

of file-sharing technology or the ISPs over which files are illegally transferred.

It is evident from the above that the media industry has been fairly successful

in lobbying for legislation to protect its intellectual property rights and in

lawsuits against P2P file-sharing networks, forcing many to shut down.

Empirical Evidence

We investigated the impact of the media industry’s efforts to protect its

intellectual capital by curbing unauthorized file sharing over P2P networks

through legal initiatives on the future prospects of its members. Our tests used

event study methodology to document informed public opinion on this issue.

The efficient markets hypothesis (in its most widely-accepted form) states that

all publicly available information is reflected in stock prices quickly and in an

unbiased manner.32 Event studies use stock price changes in a small window

of time around an event as a summary measure to assess the impact of the

event on the expected future cash flows of affected firms.33 This methodology

is especially powerful for large groups of similar events and affected firms, where

these events are staggered in calendar time and where the period during which

news of the event reaches the financial market can be determined with reasonable

precision. If a strategy of protecting copyrights through legislative and legal

action is regarded as dysfunctional for media firms in the long run, their stock

price will fall on average around these events.34

Our sample was a basket of stocks representing the media industry listed

on the New York and American stock exchanges and on NASDAQ. These companies,

identified using the Standard and Poor’s industry survey for Movies and

Home Entertainment,35 included both media providers (e.g., Vivendi, Disney)

and distributors (e.g., Blockbuster, Carmike Cinemas). The events we considered

were passage of copyright legislation related to the media industry and lawsuits

filed against individuals and companies that facilitate illegal file sharing. These

events occurred during the period 1991-2006.36 We obtained filing dates of lawsuits

from public sources and confirmed them with the courts where they were

filed. The enactment dates of legislation were collected from government and

other sites on the Internet and other literature. Data on stock prices is from the

Center for Research in Security Prices (CRSP) daily stock returns file compiled at the

University of Chicago.

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We examined abnormal stock price changes for 22 publicly traded firms

in the entertainment industry around the dates of 59 events for a total sample

of 1,298 firm-events (59 events x 22 firms).37 We used two standard measures

of abnormal stock returns from the finance literature: market-adjusted returns,

and market- and risk-adjusted returns (the latter are computed using a market

model to estimate normal returns).38 Definitions of terms and computational

details are provided in the Appendix.39

Table 1 shows the results of our analysis. News of the filing of a lawsuit

or enactment of legislation probably affects stock prices on the trading day after

the filing/enactment, when it appears in the financial press. We label this trading

day as the event date (day 0) and examine stock price changes on this day and

in the surrounding two-week period.40 We also examined stock price changes in

the pre-announcement window (-5, -1) and post-announcement window (+1,

+5) around each event. In case our event date does not accurately reflect the day

that information on the lawsuit first reaches financial markets, a portion of the

price response can be captured in these windows. We conducted both parametric

and non-parametric tests to assess whether stock price changes in the event windows

were abnormal. The T1 statistic is a skewness-adjusted t-statistic associated

with a test of the hypothesis that the mean cumulative abnormal return (CAR)

during the event window is zero.41 The generalized sign Z-statistic42 is associated

with a nonparametric test of the hypothesis that the ratio of positive abnormal

Event Window Mean CAR T1-statistic

Generalized sign

Z-statistic

Panel A: Market Model

(–5,–1) 0.07% 0.49 1.72

(0, 0) 0.24% ** 3.66** ** 3.31**

(+1,+5) –0.04% –0.27 –0.11

Panel B: Market Adjusted Returns

(–5,–1) –0.13% –0.94 –0.60

(0, 0) 0.23% ** 3.47** ** 3.23**

(+1,+5) –0.35% *–2.49* –1.82

TABLE 1. Abnormal Stock Price Changes around Filing Dates of Lawsuits and Enactment of

Copyright Legislation by Media Companies

* significant at p<.01 (1-tail test)

** significant at p<.001 (1-tail test)

Note: The above computations are based on 1,037 firm-year events. Day 0 is the trading day that follows the filing date of each lawsuit or

enactment date of legislation. CAR denotes the cumulative abnormal stock return over the specified period, measured in trading days around

an event. The T1-statistic pertains to a test of the hypothesis that mean CAR during the specified period equals zero. The generalized sign

Z-statistic tests the hypothesis that the percentage of positive CARs in a period equals the percentage of positive CARs in a 255-trading day

(approximately 1 calendar year) estimation interval prior to the event date.

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returns is the same in the event window being examined as in a 255-trading day

estimation period (approximately one year) that precedes the event period.

Our results show a positive, abnormal stock price change on the event

date on average. This price change is statistically significant for both parametric

and nonparametric tests as well as for both methods of computing abnormal

returns.43 Mean CAR on the event date, although statistically significant, is small

in magnitude (approximately one quarter of 1%) probably because the potential

benefits of each lawsuit may not accrue to all of our sample firms, and because

several sample firms (e.g., GE) have major operations in lines of business outside

of media. The price changes are generally insignificant in the pre- and postannouncement

windows.44 Separate tests conducted over the three types of

events (lawsuits filed against individuals and firms, and enactment of legislation)

suggest that the stock price reaction to each type of event is of similar magnitude,

i.e., of the order of a quarter percent.45 These results are consistent with

the contention that current and past efforts by the media industry to check illegal

file sharing over P2P networks through stricter copyright laws and lawsuits

against violators have a significant positive impact on expected long-term profitability

and economic viability of major media firms. Further, they suggest that

future scenarios where the media industry successfully protects its intellectual

capital and charges for content are considered viable by sophisticated investors.

Business Strategies and Models

A successful future business strategy for media firms would focus on

an integrated approach to monetizing access to musical and video works (as

opposed to only selling CDs or DVDs) coupled with combating infringement

of copyright violations through tightening legislation, better enforcement strategies,

and initiating programs to increase public awareness of the necessity of

copyright protection and damage caused by unauthorized file sharing over P2P

networks. An effective business model in most future scenarios would aim to

capture all possible cash flows from artistic works through promotion of brands,

sponsorship, advertising, syndication, royalties (e.g., from ringtones, games, and

public performances), and development of portals for distribution and networking.

Following are several approaches the media industry may consider to fight

piracy over P2P networks and benefit from recent technological advances—legislation,

enforcement, education, and business models. These approaches are

not mutually exclusive; on the contrary, they represent distinct elements of an

overall strategy.

Legislation

The legal strategy of the media industry has so far consisted of seeking

stronger copyright laws with wider coverage. Piecemeal evolution of digital

copyright law has resulted in an overly complex system that arguably benefits

neither media creators nor users. For instance, user rights are currently distributed

across multiple industry players requiring complex negotiations for

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legal use with each player demanding a royalty. This increases transaction costs

unduly in an environment where obtaining and sharing digital files illegally is

easy.

The industry will benefit from an overhaul of the Copyright Act of 1976

with a focus on simplification and removing obstacles to rapid dissemination of

artistic works. This comprehensive reform should include one-stop shopping for

copyright permissions. Doing so will require undoing the present system of multiple

layers of copyright ownership (ending the compulsory mechanical license

for musical works provides a suitable starting point) and setting up an alternative

system to ensure that all involved in the process are suitably compensated.46

We also recommend that the scope of copyright protection should be limited

for non-commercial activities, e.g., the use of music and video clips to enhance

videos made for personal use, or for sharing among friends, should be exempt.

Additional simplification involves replacing the current system of protecting all

artistic work upon creation with one that requires renewals after an initial term

of automatic protection.47 This system would clearly identify ownership rights

and restrict need for copyright permissions to works with significant commercial

value.

Further, the media industry should take new initiatives in capturing revenues

from industries that use its products without payment. For example, the

corporate radio industry in the U.S. (which includes firms such as Clear Channel

and Radio One) earns its revenues largely by playing recorded music, but pays

no royalties to the artists and labels providing the content. This is surprising,

as property rights to artistic creations are otherwise well respected in the U.S.48

Given that the U.S. is the world’s largest music market, media companies should

lobby Congress to reform the law.

Enforcement

As previously mentioned, the media industry’s enforcement efforts have

so far been directed at dissuading unauthorized file sharing through lawsuits

against P2P software creators and users together with restricting copying and

playback through DRM technology. While the industry has been successful in

shutting down several P2P networks, its strategy has been largely unsuccessful

in deterring illegal file sharing.

An alternative to prosecuting individual downloaders is to enlist the

assistance of ISPs in curbing exchange of copyright-protected files. ISPs may be

able to identify pirated files using filtering software already in place—e.g., deep

packet inspections that ISPs engage in for security reasons and to locate habitually

large consumers of bandwidth may also help in detection of potentially illegal

music and video files. ISPs may assist in blocking access to illegal websites,

identifying and warning users responsible for the bulk of piracy, and discontinuing

(or slowing) Internet access if the illegal behavior continues despite warnings.

We consider limiting Internet connectivity to be a better approach than

criminal prosecution in deterring online piracy. While laws in most countries

(including the U.S.) already require ISPs to curb illegal activity by users, the role

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of government in facilitating agreements between the media industry and ISPs is

critical.49

Education

Millions of people share files illegally over P2P networks. However, a

majority do not view this activity as criminal or one that stifles creation of artistic

works. This is due to two reasons. One, file-sharers have grown up in an

environment where recording of movies (on VCRs and DVRs) and music (on

cassette players) was legal, items downloaded from the Internet for personal

use were free, and a majority of their peers engaged in swapping files over the

Internet. Consequently, they view file sharing over the Internet as morally permissible.

50 Two, typical copyright violators tend to believe in the free flow of

information and are suspicious of regulations and bureaucracies. They consider

downloading of media files as a protest against media companies whom they

regard as monopolies that charge unduly high prices and restrict market access

by emerging artists.51 Many do not realize that in illegally downloading media

files, they also prevent artists and technicians from getting fair compensation

for their work and ultimately inhibit the creation of artistic content. Furthermore,

given that unauthorized file sharing is widespread, risk of prosecution

does not provide sufficient deterrence as individual downloaders perceive this

risk to be low.52 Hence, apart from tightening copyright laws and enforcing them

more effectively, the media industry must educate consumers about why swapping

copyright-protected files over P2P networks is illegal and why they need

to pay for them in order to change current social norms in the Internet community.

Media firms through their trade associations must enlist the support of

government, parents, and teachers, as well as artists and other opinion leaders,

to expand their current efforts worldwide in educating the public on intellectual

property rights through such activities as developing curriculum materials,

television advertising, and documentary production as well as dissemination of

information on legal download sites.

Business Models

While media firms may fight the threat from Internet piracy through new

legislation, better enforcement, and public education, they also need to consider

new business models to benefit from emerging technology and cater to changing

customer tastes. In order to structure our discussion, we identify four alternative

future scenarios and discuss business models appropriate to each in the context

of the overall business strategy under that scenario. The business models are not

mutually exclusive. On the contrary, most media firms would build a flexible,

integrated strategy incorporating several business models that could be successfully

implemented for different operating segments in a variety of scenarios. An

individual company’s strategy choice will depend on its forecast of the future,

ability to influence the environment, core competencies, risk propensity, and

ability and willingness to change, among other factors.

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The scenario analysis is illustrated in Figure 2. The horizontal axis is

Public Policy. The two left-hand quadrants reflect scenarios where the industry

is successful in protecting its intellectual capital among non-commercial users,

whereas it is unable to curb widespread unauthorized file sharing in the two

right-hand quadrants.53 The vertical axis is labeled Technological Change. The

Continuous Change

Strong Copyright Protection

Scenario 1:

• Copyrights protected

• Current business model preserved

Business Strategies/Models

• Reform and tighten copyright law,

strengthen enforcement

• Invest in DRM technology

• Online sampling and distribution

Outcome

• Gradual transformation of media firms via

technology infusion

• Moderate profit margin

Scenario 2:

• Copyrights not enforceable

• Business model changes without industry

disruption

Business Strategies/Models

• Revenue from surcharges and taxes on

ISP and cell phone subscriptions, sale of

audio and video players

Outcome

• Gradual transformation of media firms via

technology infusion

• Moderate profit margin

Weak Copyright Protection

Scenario 3:

• Copyrights protected

• Current model business obsolete

Business Strategies/Models

• Reform and tighten copyright law,

strengthen enforcement

• Web portals

• Revenues from syndication and licensing

• Invest in DRM technology

Outcome

• Strategic alliances and licensing

agreements with technology and other

media firms

• Lower profit margin/higher volume

Scenario 4:

• Copyrights not enforceable

• Current business model obsolete

Business Strategies/Models

• Music provided as a free good

• Revenue generated through advertising,

merchandise sales and bundling with

excludable products

Outcome

• Industry shifts focus to upstream activities

• Dramatic change in industry competitive

structure

• Creative destruction

Disruptive Change

FIGURE 2. Scenario Analysis

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upper quadrants reflect situations where there is little immediate change in the

basic industry model ("continuous change"), whereas in the lower quadrants,

technological change dramatically transforms the business model and resources

needed to succeed in the industry.54 Our earlier analysis of stock price changes of

a sample of industry members around dates of legislative and legal events indicates

that sophisticated investors regard quadrants 1 and 3 as viable, at least for

the near future. We describe each scenario in more detail below.

Scenario #1

This is our base scenario, where the media industry is successful in protecting

its intellectual capital, which enables it to essentially maintain its current

business model. We do not necessarily assume that Internet piracy is fully controlled.

Rather, we posit that the industry is able to retain its high-value customers

through a combination of activities designed to increase the cost of illegal file

sharing, such as tightening legislation and enforcement as well as incorporating

technology into digital files that degrades copies and makes duplication harder.

The bulk of industry revenues under this scenario continue to accrue from the

sale of CDs and DVDs demanded by customers who like to listen to high-quality

music and view movies at home on their CD and DVD players (especially when

packaged with lyrics, information on artists, and other complementary material),

and who avoid engaging in illegal activity as well as the risk of downloading

viruses and poor-quality products.55 Any losses from online piracy in this situation

are made up by lower distribution costs and higher volume through sales of

niche products and sampling enabled by the new technology. In this situation,

the industry would continue its price differentiation strategy, charging progressively

lower amounts for deluxe albums, CDs, online downloads, and streaming

(for music) and theater tickets, video sales/rentals, and cable/broadcast TV for

movies.

Evolutionary changes currently occurring in the motion picture industry

that may enhance the viability of its current business model include improving

the theatrical experience (e.g., through crisper 3-dimensional technology,

advanced sound systems, and fancier restaurants at movie theaters), increasing

the selection at video distribution outlets through kiosks that burn DVDs from

large repositories of digital files stored on hard disc, and selling movies on SD

cards and USB devices that may be viewed on a variety of devices such as computers,

cellular phones, DVD players, and television sets.

In this scenario, the media industry will continue its efforts towards

reforming and enforcing copyright laws, invest in DRM and watermarking technologies,

educate the public on copyright law and build support for anti-piracy

measures, develop portals that facilitate free sampling and online distribution,

and tap new revenue streams that become viable with lower distribution costs,

all while maintaining control of both production and distribution of artistic

content.

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Scenario #2

Here, copyright protection for non-commercial purposes is effectively

lost due to availability of free music and video files over the Internet, and

they become "public goods"—i.e., while artists and media companies expend

resources in producing music and motion pictures, there is no market mechanism

to obtain fair payment from individual customers given their ability to copy

and distribute digital files worldwide virtually without cost. In this situation,

payment to content providers must come from general government revenues

and/or levies on users and beneficiaries. A viable model here is to impose a surcharge

on subscriptions to ISPs in exchange for the right to download and share

music and video files over the Internet on a non-commercial basis.56 A similar

surcharge may also be imposed on cellular phone subscriptions and the sale of

digital audio and video players, blank CDs, computer hardware, and P2P software

and services. Such a tax is justifiable on the grounds that since these items

facilitate file sharing and demand for them is enhanced by copying and sharing

copyright-protected works, losses to copyright owners should be recouped

by taxes on them.57 The proceeds from these taxes and surcharges would be

remitted as royalties to media companies in proportion to usage, as measured

by digital tracking and sampling technologies. This strategy would decriminalize

file-sharing activity while providing a mechanism for paying content producers

and owners in a manner that causes minimal disruption in the media industry.

Scenario #3

Under this scenario, the industry retains its ability to charge non-commercial

end-users (as in Scenario #1),58 but its current business model must

change dramatically to cater to new public tastes in accessing and using media

products. The new business model must permit customers to locate, sample,

and share music online and play it at any time on any device, and it must also

provide fans with the ability to access information on artists and musical compositions

and share their preferences and opinions with peers. This may be

achieved by establishing proprietary portals that facilitate selection and streaming/

downloading of their products or, alternatively, by licensing distribution to

intermediaries who pay royalties to the music labels.59 In the former case, the

music sites should be linked to popular search engines (such as Google) and

social networking sites, and must themselves provide community features consistent

with evolving preferences. This includes providing music fans with the

ability to interact with artists and with each other; share their opinions, reviews,

and playlists; remix music and share their creative work; and furnish information

on artists, their songs and concerts, polls and rankings, as well as permit

access to profiles of other fans.

Several business models are viable in this scenario. In the "subscription

model," consumers pay a monthly fee to stream and/or download a certain (or

unlimited) number of music singles, while there is a charge for each play/download

in the "a la carte" model. The downloads may or may not come with limitations

on reproduction and playback (DRM). Apple’s iTunes Store, an example of

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the à la carte model, permits download of music from all four major labels using

a 3-tier price structure. Anti-copying restrictions were removed in early 2009, so

the downloaded music may be played on iPhones, computers, and a variety of

digital players. Current examples of music sites based on the subscription model

are Rhapsody, which permits unlimited streaming, and Kazaa, which permits

unlimited downloads. Both sites charge fixed monthly fees.

With regard to motion pictures, consumer tastes are evolving away

from DVDs viewed on TV sets and towards on-demand viewing over a variety

of devices that include computers and smartphones. The biggest impediments

to online distribution of motion pictures are the inability of devices other than

computers to access and play movies off Internet sites, limited availability of disk

space on these devices, and restricted bandwidth. Technology has now become

available to stream movies directly to DVD players and television sets. Media

firms may consider working with consumer electronics companies to develop a

standard format for streaming movies directly from their portals. This will make

a wide selection of motion pictures available for easy viewing compared to the

limited selections currently available via video-on-demand, while avoiding the

risk of piracy associated with purchased digital files.60 Another business model

that may be considered in this regard is provided by Keychest, currently under

development by Disney.61 This technology enables a user to purchase viewing

rights to a movie online from a number of vendors and then play it over any

licensed device via streaming from a server belonging to an ISP or a phone or

cable company. "Watch with a friend" functionality is also becoming available

on television channels for group viewing.62

Moving from current distribution channels to online distribution involves

significant investments in software, hardware, and infrastructure. In order to

compete effectively against P2P networks, legal online sites must offer simple

and secure payment, quick downloads, superior file quality, a reasonable price,

free sampling, and the opportunity to interact with peers.63 Most importantly,

these sites should be easier to use—e.g., they must be better integrated with

players (such as iTunes with the iPod) and permit easier file naming and tagging.

64 Under this scenario, the music industry would continue to invest in

better DRM technologies to prevent illegal copying and distribution and watermarking

to identify sources of illegal copies as well as its efforts to reform copyright

law and strengthen enforcement.

Scenario #4

In this