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Copyright Law and Economics in the Digital Era

COPYRIGHT LAW’S ACCOMMODATION TO DIGITAL TECHNOLOGY

The principal justification for copyright is captured in the U.S. Constitution (Article 1, Sec. 8), which grants Congress the power ‘‘to Promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries.” This language authorizes Congress to create private rights for authors and inventors for the public purpose of advancing social progress. As the Supreme Court has explained, “[t]he economic philosophy behind the clause . . . is the conviction that the encouragement of individual effort by personal gain is the best way to advance public welfare through the talents of authors and inventors.” (Mazer v. Stein, 347 U.S. 201, 219 (1954)). Under copyright law, that encouragement takes the form of “valuable, enforceable rights” that motivate the production of literary or artistic works “of lasting benefit to the world.” (Washington Co. v. Pearson, 306 U.S. 30, 36 (1939)). Recognizing that progress in creativity depends critically on the freedom to build upon the ideas and expressions of others and that exclusive rights can at times impinge upon freedom of expression, the evolution of copyright law has required tailoring and balancing to ensure access, facilitate subsequent creativity and innovation, and promote knowledge, democracy, and social discourse.

Although motivations to create and disseminate vary from industry to industry—as do the levels and types of investment required for various types of works—at least some individuals and organizations will



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2 Copyright Law and Economics in the Digital Era COPYRIGHT LAW’S ACCOMMODATION TO DIGITAL TECHNOLOGY The principal justification for copyright is captured in the U.S. Con- stitution (Article 1, Sec. 8), which grants Congress the power ‘‘to Promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries.” This language authorizes Congress to create private rights for authors and inventors for the public purpose of advancing social progress. As the Supreme Court has explained, “[t]he economic philoso- phy behind the clause . . . is the conviction that the encouragement of individual effort by personal gain is the best way to advance public welfare through the talents of authors and inventors.” (Mazer v. Stein, 347 U.S. 201, 219 (1954)). Under copyright law, that encouragement takes the form of “valuable, enforceable rights” that motivate the production of literary or artistic works “of lasting benefit to the world.” (Washington Co. v. Pearson, 306 U.S. 30, 36 (1939)). Recognizing that progress in creativity depends critically on the freedom to build upon the ideas and expressions of others and that exclusive rights can at times impinge upon freedom of expression, the evolution of copyright law has required tailoring and balancing to ensure access, facilitate subsequent creativity and innovation, and promote knowledge, democracy, and social discourse. Although motivations to create and disseminate vary from indus- try to industry—as do the levels and types of investment required for various types of works—at least some individuals and organizations will 15

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16 COPYRIGHT IN THE DIGITAL ERA likely forgo such investments if they are unlikely to recoup them due to infringing copying and distribution by others who seek to profit with- out compensating the copyright owners. The economic justification for copyright—and for most other forms of intellectual property—thus lies in ensuring that creators have appropriate incentives to engage in creative activities by granting them a bundle of exclusive rights to use their works. Although copyrighted works can be commercial failures, this proprietary approach affords copyright owners the opportunity to charge a price above the cost of the medium—e.g., film, recording, screen, network, or printed page—on which the copyrighted work is distributed. Exclusive rights for authors can also impinge on subsequent creators and techno- logical innovators, however. The key to ensuring that copyright serves the public welfare lies in balancing the social benefits and costs of providing economic incentives for creation by limiting the duration of copyright, making exceptions, and ensuring that copyrights are mandatorily avail- able for licensing in some circumstances. For those readers less familiar with the origins and evolution of copy- right protection, an appendix to this report summarizes this history and compares copyright and patent law. In the remainder of this section, we focus on legal developments in the digital age. Advances in the technologies for creating and distributing works of authorship have played a critical role in shaping copyright law through- out its history. Although computer technology became a reality more than half a century ago, it is only in the past two decades that the digi- tal age has begun to disrupt the foundations of the traditional content industries—publishing, music, film, photography, and television. Their long-standing business models—selling books, newspapers, magazines, and recordings, exhibiting films (and later selling and renting home videos and DVDs), and broadcasting music and television shows—had proven quite resilient to the early generations of computer technology. The relatively late onset of the digital piracy threat can be attributed to the sheer informational magnitude of music and film and the ability, only fairly recently, to bring to market affordable, high resolution means for listening to and viewing digital content. Even with the introduction and rapid popularity of digitally-encoded compact disks (CDs) and the prolif- eration of microcomputers beginning in the early 1980s, content industries did not appreciate the dramatic changes that would be brought about by the emerging digital technologies. Availability of microprocessors, the low fidelity of computer peripherals, and limitations of memory storage capacity prevented content from being stored, perceived, and reproduced efficiently on computer devices until the mid-1990s. The rollout of the World Wide Web, with its unprecedented ability to distribute digital content instantly and broadly and at no additional or

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COPYRIGHT LAW AND ECONOMICS IN THE DIGITAL ERA 17 very little cost, marks the beginning of the digital age for many of the con- tent industries. The emergence of peer-to-peer and related decentralized content storage and distribution technologies disrupted the traditional functioning of many content industry business platforms. These technolo- gies have afforded Internet users a growing number of sources of content outside of the authorized distribution channels. Although copyright’s protections provided a theoretical means for enforcing rights to copy and distribute protected works, various features of the Internet—such as the relative anonymity of file sharers—have made copyright enforcement against end users difficult in many contexts. As a result, copyright owners have sought to prevent infringing dis- tribution higher up the distribution chain. This has brought into play the online service provider safe harbors that Congress introduced into copyright law in the Digital Millennium Copyright Act of 1998. Subject to several exceptions and limitations, the DMCA afforded copyright own- ers rights against those who circumvent copy protection technologies but insulated online service providers from liability for infringing acts of their subscribers. The Supreme Court had already begun to address the issue of indirect or secondary liability—that is, the standards by which defendants can be held liable for infringing behavior by other people such as employees, ten- ants, or customers which were not clearly defined in the 1976 Copyright Act. In Sony v. Universal City Studios, 464 U.S. 417 (1984), the Court con- sidered whether Sony should be held liable for manufacturing and mar- keting video tape recorders for home use. The Supreme Court held that “the sale of copying equipment, like the sale of other articles of commerce, does not constitute contributory infringement if the product is widely used for legitimate, unobjectionable purposes. Indeed, it need merely be capable of substantial noninfringing uses.” The Court concluded that Sony’s Betamax device was “capable of substantial noninfringing uses,” including “time-shifting” of broadcast television programs for private home use, which the Court held to be noninfringing fair use. The Sony decision represented an early attempt to grapple with the balance to be struck between protecting copyrights and technological innovation. The Court explained that the law should “strike a balance between a copyright holder’s legitimate demand for effective—not merely symbolic—protection of the statutory monopoly, and the rights of others freely to engage in substantially unrelated areas of commerce.” The Supreme Court revisited this balance again in its 2005 opinion in MGM v. Grokster, 545 U.S. 913 (2005), where it considered whether the operators of file-sharing networks could be held indirectly liable for infringing distribution of copyrighted works by users of their services. Notwithstanding the potential noninfringing uses of such services, the

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18 COPYRIGHT IN THE DIGITAL ERA Court rejected the lower court’s holding that the Sony rule insulated the defendants from liability. The Court held that the defendants’ intent to cause and benefit from infringement, demonstrated in part by internal communications, could expose them to liability for inducing infringement even if the defendants’ service were capable of non-infringing use. The Grokster decision held that “[o]ne who distributes a device with the object of promoting its use to infringe copyright, as shown by clear expression or other affirmative steps taken to foster infringement, is liable for the resulting acts of infringement by third parties.” In reaching this conclusion, the Court stated that “[t]he more artistic protection is favored, the more technological innovation may be discour- aged; the administration of copyright law is an exercise in managing the trade-off.” The Court concluded that imposing inducement liability maintains a proper balance, while emphasizing that “mere knowledge of infringing potential or of actual infringing uses would not be enough here to subject a distributor to liability. Nor would ordinary acts incident to product distribution, such as offering customers technical support or product updates, support liability in themselves. The inducement rule, instead, premises liability on purposeful, culpable expression and con- duct, and thus does nothing to compromise legitimate commerce or dis- courage innovation having a lawful promise.” In the wake of Grokster and continuing rapid advancement in digital technology, the doctrine of indirect liability is among the most critical, subtle, and important features of digital copyright protection. Other key areas affecting the balance among technological advance, freedom of expression, and copyright protection include fair use and the DMCA’s online service provider safe harbor provisions, where statutory ambiguity and the challenge of applying even recently adopted law to unanticipated technological advances leave significant leeway for judicial interpretation. THE ECONOMIC VALUE OF COPYRIGHT-AFFECTED INDUSTRIES AND COPYRIGHTED WORKS In recent decades there have been several industry-led efforts to quan- tify the economic scope of copyright and its exceptions, following meth- ods recommended by WIPO (2003, 2012). Two principal sponsors of these studies are the International Intellectual Property Alliance (IIPA) (Siwek, 2011), representing the recording, motion picture and television, computer software, and publishing industries reliant on copyright, and the Com- puter and Communications Industry Association (CCIA) (Rogers and Szamosszegi, 2010), representing Internet publishing and broadcasting, Internet service producers and search engines, data services, computer equipment and components, computer services, telecommunications, and

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COPYRIGHT LAW AND ECONOMICS IN THE DIGITAL ERA 19 other industry segments that “would not exist, or be much smaller, but for the limitations and exceptions to copyright law.” Both trade associations have documented their members’ large contributions to gross domestic product, exports, and employment and their high growth and labor com- pensation rates. The U.S. Commerce Department recently used a similar methodology to estimate the contributions of all types of intellectual property protection to the U.S. economy (U.S. Department of Commerce, 2012). These analyses provide some insight into the scale of economic activ- ity in the United States affected by copyright, although none addresses the contribution of the copyright legal framework to these industries’ economic performance as distinct from many other factors. Nor do they tell us what the creative economy would look like under different copy- right rules. The committee considered another approach to measuring the economic impact of copyright protection—the value of the capital stock of copyrighted works themselves in relation to other so-called intangible or intellectual capital assets such as research and development, work- force skills, organizational competence of business enterprises, and other components. A 2006 analysis by the staff members of the Federal Reserve Board, since expanded and extended to other advanced economies, esti- mated that private and public investments in intangible assets exceed investments in physical capital and are a major driver of economic growth and productivity but have been under-represented in national economic accounting because traditionally they have been treated as immediate expenses of businesses and government rather than investments with payoffs over a long term (Corrado et al., 2006a, 2006b). For more than a decade the Commerce Department’s Bureau of Eco- nomic Analysis (BEA) has been addressing the challenge of treating long- lived intellectual capital as investments and incorporating estimates of their value with an appropriate depreciation rate in the National Income and Product Accounts (NIPA). Treating computer software in this fash- ion was the first major step (Parker and Grimm, 2000). An accounting of research and development has been developed as a so-called “satellite” account and is scheduled to be incorporated in the NIPAs in 2013 (Lee and Schmidt, 2010). And recently, BEA staff members have been developing estimates of long-lived copyrighted “entertainment originals,” including books and movies. The committee asked the BEA to bring together their estimates of the revenue and capital value of copyrighted works and compare them with other categories of intellectual capital, and the BEA agreed, incorporat- ing estimates of prepackaged, custom, and own-account software, video games (included in software estimates), movies, television programs, music, books, commercial photography, and playscripts.

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20 COPYRIGHT IN THE DIGITAL ERA Some of the key findings are presented below, but a few caveats should be noted. Excluded from their analysis are short-lived (less than one year) copyrighted works such as newspaper and magazine articles, some television and radio programs, and amateur artwork and software, which may have considerable cultural and personal importance but not high market value and therefore are not easy candidates for inclusion in the national economic accounts. Included is federal government gener- ated software not covered by copyright. BEA also includes many works that are subject to other forms of protection (e.g., patent and trade secret) in addition to copyright. For these and other reasons, it would be unwise to conclude that all of the value of the works counted by the BEA can be attributed to copyright protection. It is nevertheless the case that changes in the value of copyrighted works might reflect changes in the effective- ness of copyright law more directly than would total industry revenues, employment, or other factors captured in the IIPA and CCIA studies described above. Among the BEA findings: • In 2007 U.S. businesses and governments invested $278 billion in software (approximately $83 billion prepackaged, $93 billion custom, and $102 billion own-account) and U.S. artists produced $71 billion worth of long-lived entertainment originals. These assets yield returns over varying periods of time, roughly 15 to 50 years for artworks and 3 to 5 years for shorter-lived software. The accumulated capital stocks of these assets in 2007 are estimated to have been $486 billion for software and $536 billion for entertain- ment originals. • The same year, software accounted for 2 percent of nominal GDP (rising from zero in 1959), treating it as an asset rather than an expense raises GDP. Entertainment investment has accounted for roughly the same share of GDP, 0.4 percent, since the 1920s and therefore does not affect GDP growth when treated as a capital asset. • In addition to the long-lived entertainment originals, approxi- mately $96 billion of short-lived artistic products—television, radio and Internet programming, and magazines and newspapers were produced in 2007. With a lifespan of less than one year, these are not candidates for capitalization in the NIPAs. • The shares of different categories of artwork have changed dra- matically over time with technological change such as the advent of television and the Internet and the decline of newspapers and magazines.

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COPYRIGHT LAW AND ECONOMICS IN THE DIGITAL ERA 21 • The software and artistic original values compare with the Corrado et al., 2000 estimates for other intangible capital: $200 billion for all U.S. scientific research and development, $140 bil- lion for advertising contributing to brand equity, and $365 billion for spending on firm-specific worker training and business orga- nizational change. Without question, copyright-affected industries contribute signifi- cantly to GDP employment, especially higher payment employment, and trade. Some copyrighted works, especially software, contribute as well to innovation and higher economic and productivity growth. These data do not tell us anything specific about the role that copyright plays in generat- ing these assets nor about the impact of any particular copyright policy choices, but they encourage us to pursue better answers to those ques- tions. In the absence of copyright, not all of the value of creative works would disappear. Firms would be and are coming up with other means of protecting their investment in creative activities. THE IMPACT OF DIGITAL TECHNOLOGIES ON CONTENT CREATION, DISTRIBUTION, AND USE IN SELECTED INDUSTRIES1 The relatively recent onset of the digital piracy threat can be attrib- uted to the sheer informational magnitude of music and film and the inability, until about two decades ago, to bring to market affordable, high resolution means for listening to and viewing digital content. Even with the introduction and rapid popularity of digitally-encoded compact disks (CDs) and the proliferation of microcomputers beginning in the early 1980s, the record industry did not appreciate the dramatic changes that would be brought about by the emerging digital technologies. Available microprocessors, the low fidelity of computer peripherals, and limita- tions of memory storage capacity prevented music from being stored, perceived, and reproduced efficiently on computer devices until the mid- 1990s. The proliferation of file-sharing technologies and unauthorized streaming services such as cyberlockers, in conjunction with advances in data compression and broadband penetration during the past 15 years, have dramatically shifted the market for many copyrighted works. 1The sections below on music, films, and book publishing draw upon a commissioned paper by Lisa Cameron and Cameron Bazelon, “The Impact of Digitization on Business Models in Copyright-Driven Industries: A Review of the Economic Issues,” 2013. The sec- tion on scientific publishing draws on a commissioned paper by Michael McCabe, “Online Access and the Scientific Journal Market: An Economist’s Perspective,” 2013.

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22 COPYRIGHT IN THE DIGITAL ERA Technological advances associated with the Internet and digitization have had profound effects on both the rewards available to creators and the costs they face in bringing works to market. The ease of infringing digital copying and distribution often weakens sales and reduces the rev- enue available to creators for a given level of legal copyright protection. On the other hand, marginal manufacturing and distribution costs have fallen drastically and in some circumstances shifted to intermediaries as digital products come to replace physical goods. The Internet enables near instantaneous and free distribution to mass audiences in conjunction with robust advertising networks. The costs of creating and promoting new works may also have fallen in some cases and risen in others. The results have been complex. Authors can more easily create and distribute works of authorship using digital technology and networks, yet they and their distributors have substantially lost the ability to prevent or pursue infringing distribution of copyrighted works. The magnitude of these effects on different creative sectors are difficult to quantify, but dis- ruptive changes in traditional supply chains and the destruction of some older business models and enablement of new ones are easy to identify. And they have had profound consequences not only for intermediaries and consumers but also in some cases for content creators. That is not to say that all industries based on copyrighted materials have experienced disruptive change. Architectural designs and certain specialized engineer- ing products have likely been much less affected by the Internet. Nor on the other hand is the digital revolution confined to the copyright pro- tected industries. Online retailing has had profound effects on brick and mortar retail stores that specialize in non-content based goods. The committee commissioned efforts (Appendix B) to summarize qualitatively the changes in five large content industries—music recording, film production and distribution, book publishing, scientific publishing, and software—and supplemented the analysis with committee members’ own direct experiences in those industries. The following descriptions, which draw on these papers, are meant to be illustrative, not exhaustive. Other fields such as still photography have faced unusual challenges in the digital era that are very much worth exploring in research. Music Digital technologies and Internet distribution have profoundly affected the creation, marketing, and distribution of sound recordings in the global music business. These technologies enabled distribution of sound recordings as digital files separate from the physical media on which they were fixed, which enabled the unbundling of the song from the industry’s dominant consumer product, the album-length CD. Con-

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COPYRIGHT LAW AND ECONOMICS IN THE DIGITAL ERA 23 sumer preference for downloading of individual songs further dimin- ished the importance of the industry’s previously most lucrative product. Supply of sound recordings has also greatly expanded in the digital age. Low cost audio and video production tools have lowered musicians’ costs to create musical works, adding to supply, and online retailers’ low marginal cost of digital storage has allowed these retailers to offer for sale millions of sound recordings, whereas floor space constraints of brick and mortar retailers limited inventory carried to fewer than 10,000- 15,000 albums. Digital technologies have also changed the ways that consumers dis- cover music and this, in turn, has altered the industry’s marketing and promotion strategies. Traditional mass market promotion channels, such as radio, that focused on a fewer number of songs, have been augmented by targeted, user-user driven social marketing that is available to all recording artists whether or not they are signed to a record label. Social networks are used to create digital word-of-mouth among communities of fans and these services (Facebook, Twitter, YouTube, and others) can be used with equal effectiveness by record company-financed celebrity musi- cians and self-financed amateur bands. Digital streaming technologies in conjunction with a statutory license created by the Digital Millennium Copyright Act, has allowed customers to receive highly customized Inter- net radio channels. Finally, the continuing wide availability of infringing music on the Internet has forced legitimate Internet music services to expand other services—playback on mobile devices, library management, and navigation—to make it more attractive for consumers to listen to legally obtained sound recordings than illegal substitutes. New business models in music include: • Digital music stores, such as iTunes and Amazon, selling online the works of musicians and record companies, but competing with file-sharing and other unauthorized versions of the same music; • Ad-supported Internet radio services, such as Pandora, enabled by statutory compulsory licenses of the underlying copyrighted content; • Paid music subscription services, such as Spotify, that do not con- vey the full rights of music ownership and provide greater rev- enue to copyright owners than ad-supported streaming services; • Music video plays on YouTube providing the copyright owner a portion of advertising collected on each video view; • Social networks enabling major label recording artists and unsigned bands to organize fans to purchase downloads, watch videos, and attend concerts;

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24 COPYRIGHT IN THE DIGITAL ERA • Do-it-yourself distribution and marketing platforms, such as ReverbNation, providing emerging and established bands new tools to market, promote, and monetize their copyrights at a grass roots level; • Crowd-sourcing funding platforms, such as Kickstarter, enabling musicians to solicit voluntary contributions to fund studio record- ings, video production, and tours; • Software authoring tools, such as ePub3, enabling musicians to create digital boxed sets that include text, video, photos, Internet links, potentially bundled with sale of concert tickets. To preserve as much as possible of the traditional industry model and revenues associated with copyright, major record companies have looked to legal enforcement and various rights management software that prevents consumers from accessing music outside of their rights. For example, paid subscription services limit copying music and prevent access after the subscription period ends. Profits from record companies’ incumbent business models have been a disincentive to embrace disrup- tive innovation. However, the industry did adapt to the pressures of the digital revolution with both 99 cent downloads and ultimately unpro- tected downloads. It is unclear whether traditional recorded music companies will con- tinue to dominate the industry as they have in the past, having lost much of their distribution function to increasingly powerful online retailers, file-sharing, and do-it-yourself marketing platforms. Functions such as discovering new talent, promoting and marketing musicians, all mainly the preserve of the record companies in the past, remain critical, but are now contested by a variety of new players that give artists a greater share of revenues. It is not certain how music composers, performers, and consumers fare under the new business models compared to how they fared under the previous system. Broadcast performances account for a smaller share of composers’ earnings, and they are relatively unaffected by changes in distribution; but the lion’s share of their earnings are associated with mechanical licenses, which are affected by changes in distribution. Like- wise, some performers make significant income from concerts, which are not affected by digital business models. Moreover, artists are not homo- geneous. The smaller number of superstars fare very differently in supply chains than do unknown or emerging musicians. We also do not know how the baseline for determining the optimal supply of new music has been changed by the digital age. It could be the case that artists’ incomes and consumer welfare could rise under a better

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COPYRIGHT LAW AND ECONOMICS IN THE DIGITAL ERA 25 functioning music copyright system, particularly one more accommodat- ing of innovation enabled by technological change. On the other hand, it would be that better enforcement could result in lower consumer surplus and artist income, with more profit reaped by intermediaries. Film The motion picture supply chain is comprised of multiple stages— development, financing and production, distribution and marketing, exhibition in theaters, and post-theatrical release—home entertainment sales and rentals, television, and cable. Although digitization has affected all stages of the motion picture supply chain, from a revenue perspective, its greatest impact has been on post-theatrical release. Online distribution is becoming more important as broadband and 4G wireless increases and more consumer electronic devices such as televisions and Blu-ray play- ers are integrated with Internet connectivity. Sales of tablets and smart- phones also contribute to the growth of online services. Consumers now have the choice to download or stream from dozens of online services using subscription, rental, sell-through or advertiser-based business mod- els. Content now available through third party applications is available across many platforms including Android, iOS, and Windows. Prominent examples include • Subscription online video services previously dominated by Netflix are now being offered by a variety of online service providers such as Amazon Prime, Microsoft Xbox, HBO Go, Xfinity, and Hulu Plus. In November 2002 Hollywood studios launched the first online video rental service. Since then, as broadband penetration increased, additional online services have launched—iTunes, Amazon, PlayStation, Xbox, Walmart/ VUDU, Blockbuster, Comcast, DirectTV, AT&T, Verizon, and many others. • Digital sell-through has also flourished. Consumers can now col- lect content in their own personal cloud service, called Ultravio- let, and watch their movies and TV shows anytime and anywhere on any Internet-enabled device. Consumers no longer need to be locked into to a proprietary service and/or device. • The advertising-based model uses the same technology as the online video store but relies on advertising revenues rather than subscriptions or pay-per-view. This has attracted a large number of entrants, Hulu and Crackle being the most successful, although it is moving toward a subscription business model.

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26 COPYRIGHT IN THE DIGITAL ERA • Cable and satellite and telephone companies provide additional film distribution outlets. • Major studios have also launched new online services offering movies and television shows directly to consumers, competing with traditional intermediaries. Digital distribution through Blu-ray, DVD, and cloud services such as Ultraviolet, and authorized online services described above provide a promising opportunity for motion picture distributors to offer consumers the ability to access movies on the platform of their choice but also for independent and niche filmmakers lacking access to theatrical distribu- tion to reach a broader audience. However, the persistence of Bittorrent file-sharing platforms and ad-supported cyberlockers continue to have a significant destabilizing effect on this market. Although copyright law and other remedies under the DMCA remain an effective tool against infringing services located in the United States, most, if not all illegal services have moved off shore to territories that lack effective enforce- ment mechanisms making it nearly impossible to slow the proliferation of infringing download and streaming services. While the motion picture industry has embraced more distribution channels than ever before, the greatest threat facing the industry is the illegal distribution of movies while still in theaters. This has had the greatest impact on independent filmmakers that have struggled to achieve financial success and reliable financing. Book Publishing In the traditional supply chain model, authors seek out publishing houses that pay them an advance and royalties, sometimes find and groom authors, and finance the editing, reviewing, printing, marketing, and distribution of the book. Despite slim profit margins, this model persisted more or less unchanged since the introduction of large-scale production of low cost printing technologies, until the appearance of e-books, which began to increase market share in 2007 and are likely to surpass physical book sales within a few years. Following the example of Apple, which marketed its iPod as the device on which consumers could enjoy music purchased from the iTunes store, book retailers adapted to digital technology by marketing e-readers, Amazon’s Kindle and Barnes and Noble’s Nook, as well as e-books with lower prices but higher profit margins than physical books. Apple fol- lowed in 2010 with the iBooks app on the iPad, followed now by Google on Android devices. E-books eliminated a publisher’s physical produc- tion and distribution costs. Moreover, digital distribution enables authors

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COPYRIGHT LAW AND ECONOMICS IN THE DIGITAL ERA 27 to create and distribute their works cheaply or freely through online book- stores without the intermediary publisher. “Self-publishing” has been highly successful for some authors but is unlikely to be the most advanta- geous path for all. Major publishers continue to provide marketing and promotion that an individual author cannot do alone or as efficiently. But e-books and other digital materials have led to conflicts between book publishers and libraries, with charges of price-gouging, limiting the num- ber of readers of an e-book copy before a new license must be purchased, and withholding titles. Scientific Publication The impact of copyright extends well beyond what are tradition- ally regarded as the creative domain—music, film, art, literature, and photography. We illustrate this impact here with two examples: software (discussed in the next section), and the publication of scientific research results. This is far from an exhaustive treatment of copyright’s reach out- side of the traditional creative realms. Indeed, with the advent of research tools such as text and data mining, copyright can reach into the conduct of scientific and medical research itself. Scientists increasingly use automated tools to mine and recombine vast amounts of data and literature. The capacity to link collections of articles and data to integrate research results across several scientific disciplines and to develop data-mining tools for application across vari- ous fields offers immense new opportunities for science in the digital era, including opportunities to build field-specific repositories to advance new research directions. In short, the digitization of scientific information offers unprecedented opportunity to significantly enhance the speed of dissemination of research results, facilitate development of highly effec- tive research engines that diminish search time for publications, and for automated cross-linking, text mining, and data aggregation. The role of copyright law in this growing digital infrastructure is contested, and it is unclear whether the existing framework is sufficiently aligned to enable maximization of these opportunities to enhance and facilitate new direc- tions for scientific research. The role of copyright in the dissemination of scientific information is also debated in the wake of digital publishing and associated disruptions of the classic publishing model that has dominated the sciences since the 17th century when scientific journals emerged to perform the important functions of establishing scientific priority, certifying quality through peer review, communicating results, and providing archival records. It is rare that publishers compensate scientific publication authors, who are moti- vated, in part, by their employers’ criteria for selection, promotion, and

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28 COPYRIGHT IN THE DIGITAL ERA tenure decisions. In some sectors, publishers charge both author fees and reader fees, although the latter are generally paid by institutions through subscriptions. A variety of factors affect pricing on both the author and the reader side of the publishing “platform.” Many journals are published by firms that own or manage multiple titles; a few large firms control portfolios numbering in the hundreds or thousands. The modern print era has been characterized by rapidly rising subscription prices in excess of inflation and straining library budgets. The shift to electronic distribution of content that began in 1995 low- ered distribution costs and enabled the emergence of commercial and non-profit open access (OA) journals that can be accessed at no charge and that recover their costs through a combination of author fees, grant monies, and government subsidies. The Social Science Research Network (SSRN) was founded in 1994 and distributes over two million academic papers. The Public Library of Science (PLoS), founded in 2001, is the best known online scientific publishing platform based entirely upon the open access business model. The Directory of Open Access Journals (DOAJ) currently lists more than 6,000 titles. Many research universities and fund- ing organizations—notably, the National Institutes of Health under a con- gressional mandate—have adopted open access mandates; and Google Scholar, introduced in 2004, quickly became a powerful complement to online access. The OA journal movement has grown rapidly in the past decade. Earlier, commercial publishers adopted a strategy of bundling mul- tiple titles in large deals negotiated with each institution. This strategy took advantage of the fact that although online distribution lowered dis- tribution costs, it did not change the basic inelastic demand conditions of the market. Annual price increases from the major, for-profit publishers of scientific, technical, and medical journals have been running at mul- tiples of the U.S. consumer price index for several years. Although open access journals continue to proliferate, their long-term viability in the absence of subsidized author fees is uncertain unless additional contractu- ally imposed access conditions become integrated into funders’ research grants. Open access has the potential to expand the dissemination and impact of the scientific literature, benefiting scientists and society. Early stud- ies of this question showed large positive benefits, generally in terms of increased citations and downloads. More recent studies taking into account the differences between open access and traditional journals find little or no impact of open access on citations. Citation rates do not nec- essarily fully reflect the impact of open access, however, which might include wider readership, use of results in therapeutic settings, and other developments. These are important questions for further study.

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COPYRIGHT LAW AND ECONOMICS IN THE DIGITAL ERA 29 Desktop publishing techniques and online digital transmission have reduced costs and enabled new publication and licensing models allow- ing for more differentiated approaches to formal and informal peer pro- duction of scientific information. In this environment there is a need for data-driven research to inform policy choices that will take advantage of these new opportunities for scientific research, aggregation, and dissemi- nation, avoid fostering monopolies over non-substitutable, non-replicable scientific information, and preserve the most useful functions that inter- mediaries provide. Software An arcane field 50 years ago, software has become an integral part of almost every process, product, and service we use both directly and indi- rectly. Often it is the principal differentiator of one product or service from another. Software represents a growing share of the intangible assets that account for the wide gap between the book value and the market value of many public corporations. Although patent protection for computer software has gained salience during the past decade, copyright has long been the principal form of protection for computer software products. Even open source software relies upon copyright as the means to enforce compliance with the terms of the open source license. As is true with other types of copy- righted content, software comes in a variety of forms sold under a variety of business models. Consumer software is actually licensed and not sold, but to the consumer the transaction is much like that for a book, movie, or song, so parallels are easily drawn. This was a $21 billion industry in 2010 including personal computer games. Just as with music, books, and video, more and more software of this sort is licensed and delivered via electronic download, and the optical media historically used for this is fading away. Gaming, a particular class of consumer software, is a huge industry in its own right. Starting with simple video arcade games, gaming has evolved to cover a wide spectrum from simple games to pass the time or facilitate social interaction to first-person action games such as Call of Duty or massively multiplayer online games such as World of War- craft. Nintendo, Sony, Microsoft, and others have created multibillion dollar businesses around specialized game-playing computer consoles, but games can and are played on any computer including smartphones and tablets. Whether online or on a device, copyright is the basic legal protection for games. Vendors have resorted to numerous proprietary mechanisms to further secure their games to prevent infringing use with varying degrees of success. One great advantage of gaming consoles is

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30 COPYRIGHT IN THE DIGITAL ERA that a game designed for a particular console can only be played on that console, and the vendor is able to fully control that device to inhibit any illegal use. Online games are operated as a service with different issues around uncompensated use. Another rapidly growing consumer software market consists of apps (applications) for mobile devices. Vendors, except for devices running Android software, have made unauthorized copying of apps difficult by requiring that all packaged software be acquired through a single autho- rized store. This trend is now moving to personal computers. Consumers lose choice but gain convenience and, arguably, security. Enterprise packaged software is also vulnerable to infringing copying but is more dependent on specialized skills, installation and maintenance. The total market was estimated at $267 billion in 2011. Platform packaged software is more difficult to measure because its value is intertwined with the hardware with which it is coupled. Microsoft Windows has long experienced massive copying in some international markets, but in most developed markets the software is either bundled with the hardware or licensed on an enterprise basis. Unlicensed use remains significant, and most major business software vendors rely upon periodic audits of their customers to enforce their licensing terms. Notwithstanding these audits, unlicensed use of business software is by far the most economically dam- aging infringement problem facing the business software sector today. The emergence of the “cloud,” however, has made all of these tradi- tional methods much more complex to operate. Instead of having a small number of computers each running a designated set of applications with licensing tied to something with a physical serial number, a “computer” today is an “instance” running somewhere in a massive complex and never really existing in a physical form. Moreover, because contemporary systems often use hundreds or thousands of computers running for very short periods of time, the challenges of licensing enforcement are large. Valuing custom software is difficult. Use of the cost of the labor to produce it as a metric, is incomplete, inasmuch as the costs of testing and implementing software usually greatly exceed the costs of development. While copyright, trade secret, and contractual protections are used to protect custom software, the value of this work may lie in the algorithms the software implements and not in the code itself. These algorithms can potentially be protected by patent or trade secret law but valuing them is extremely difficult. Developing methods of accurately valuing in-house and customized software across different types of organizations, and evaluating the role of copyright, relative to patenting, in shaping invest- ment in and the productivity of such software is an important area for future research.

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COPYRIGHT LAW AND ECONOMICS IN THE DIGITAL ERA 31 THE LIMITS OF OUR KNOWLEDGE ABOUT THE ECONOMICS OF COPYRIGHT2 The final and most important project commissioned by the commit- tee is an evaluation of the existing empirical research literature on the economics of copyright. The evaluation draws upon an earlier survey by the same author sponsored by the United Kingdom’s Strategic Advisory Board for Intellectual Property Policy (Handke, 2010). The work was intended to be comprehensive up to the time of its completion, taking into account studies conducted and published in the English language. Here we summarize only the key findings. The Effects of Infringing Copying The effects of Internet-enabled infringing use have received con- siderable attention from empirically-oriented economists, most of them addressing the phenomenon in specific content industries, mainly com- puter software and recorded music and more recently film. Studies of the extent of infringing digital copying of software focus on the ratios of legitimate users to users of pirated software but do not quantify the likely effects on rights holders’ revenues. Although the software industry thrives in spite of infringing digital copying, the advent of digital copying coincides with a sharp drop in revenues in the primary market for sound recordings over the last decade. As a result, infringing copying of music, especially via file-sharing of MP3 files, has received much attention. As simple as the question seems—the extent to which unpaid con- sumption of recorded music cannibalizes paid consumption—the answer is rather difficult to establish empirically, for two reasons. First, data, especially data on unpaid consumption, are difficult to obtain. Second, even with good data on consumption patterns, it is difficult to draw causal inferences. For example, an observation that a song with a high volume of unpaid consumption is also purchased frequently could mean that unpaid consumption stimulates sales or, more likely, that the song is simply popular and that its popularity manifests itself in high volumes of both paid and unpaid consumption. Against the backdrop of this research challenge, empirical studies provide a range of estimates of the impact of unpaid on paid consump- tion. But the majority of empirical studies of the effect of unpaid music consumption on paid music consumption show a depressing impact and it is likely that infringing copying contributed significantly to the down- 2This section draws upon a commissioned literature review by Christian Handke, “Eco- nomic Effects of Copyright: The Empirical Evidence So Far,” 2011.

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32 COPYRIGHT IN THE DIGITAL ERA turn in recorded music sales since Napster. Studies of paid versus unpaid consumption of movies are not as numerous but also tend to find results consistent with a depressing effect of unpaid consumption. It remains to be seen if studies of other industries—books, newspapers, video games, and photographs—also reveal this pattern. On the other hand, some of this work takes an overly simplistic view of substitution effects, assuming that consumption of unlicensed works displaces only the consumption of licensed works and not other activities. Hence, there is a need for further research to determine the nature and magnitude of sales displacement caused by infringing distribution across the range of copyrighted works. In any case, it is hard for academic studies to keep up with swift technological change. In the past two years, the emergence of cyberlock- ers has rapidly changed access to copyrighted works. Thus, the growing number of studies of peer-to-peer technology do not adequately address the economic realities currently facing content industries. Furthermore, the rapid rollout of tablet computing will undoubtedly affect the publish- ing market. A variety of factors, data limitations foremost among them, compli- cate the analysis of revenue impacts on intermediaries and creators in the digital environment and how that changes with technology. But even if there were a more conclusive answer, it would be only one consideration in framing copyright policy. User welfare effects, especially benefits and costs to end-consumers, also deserve attention as does the distribution of rewards to artists and other creators. Determinants of Infringing Copying To determine the desirable scope and intensity of copyright protection it would be useful to know what factors influence the extent of infringing copying. Again, with only a few exceptions, the studies have focused on single industry—software, music, or films. In software, the practice has been found to vary inversely with level of economic development and income, the strength of the legal and judicial system, and retail prices of authorized products, although not consistently with education. Sev- eral empirical studies find that the perceived probability and severity of penalties have a strong effect on file-sharing. Moral considerations also play a role in the sense that concern for rights holders and artists reduces the propensity to engage in file-sharing, and this varies by coun- try. Most studies conclude that students, young adults, and young males in particular are more likely to engage in infringing copying than other demographic groups.

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COPYRIGHT LAW AND ECONOMICS IN THE DIGITAL ERA 33 Effects of Copyright Law Empirical research has mainly focused on infringing copying and distribution, but effects of key aspects of copyright law are also of inter- est, including what aspects of creative works are protected, the type and intensity of enforcement measures, the duration of rights, the scope of copyright exceptions and limitations, the liability standards imposed on intermediaries and third-parties, the availability of easily accessible and affordable legal copies, and the role of digital rights management techniques. Despite the fact that promotion of innovation and the creation and distribution of new works are the principal rationale for intellectual prop- erty protection, very few empirical studies address the effects of changes in the copyright system on their supply of creative works. The handful of studies of copyright term extensions have found no significant effect, although the complexities of isolating such effects are formidable. In any case, such studies are of relatively little significance to the policy debate over online enforcement because such behavior most prominently affects newly released works. Costs of the Copyright System The costs of administering the copyright system also need to be con- sidered in designing appropriate copyright policy, but neither these nor the costs of transacting or enforcing rights have been studied directly. This would be useful in evaluating alternative voluntary collective rights administration schemes and proposed changes to enforcement systems. In view of the likelihood that the effects of infringing copying and distribu- tion are not evenly distributed across the population of artists, we need to understand better the impact of copyright arrangements on the markets for artistic works as well as on innovation in distribution and other activi- ties downstream from creation. Conclusions Overall, the picture that emerges from research is still ambiguous, patchy, and in some respects contradictory. There is inconclusive evidence of how infringing copying and distribution affects social welfare or what kind of copyright regime would redress the problem without excessive unintended consequences. In addition to the characteristics of the litera- ture noted above, the following gaps and limitations, many of them the result of or exacerbated by data limitations, are particularly pronounced:

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34 COPYRIGHT IN THE DIGITAL ERA • In studies of some copyright sectors, the principal focus is on intermediaries’ revenues rather than the impact on creators, pro- fessional and amateur, and consumers of content. • There has been uneven industry coverage, with a great deal of attention to music, moderate attention to scientific publishing and film, much less attention to news and book publishing and software. • Variations across industries, countries, and time are poorly understood. • There has been very little emphasis placed on the ease or diffi- culty of transactions to obtain use rights. • Little consideration has been given to the relative costs and effec- tiveness of legal remedies (injunctions, civil damages, notice and take down, and criminal penalties) vis-à-vis technical protections (digital rights management and filtering). • There has been little analysis of the incidence and cost of litigation and what impact litigation costs have on willingness to bring or settle complaints. • Despite continuing rapid technological change, rendering even some recent findings obsolete, very little work has been moti- vated by hypotheses about future developments. • Studies lack a historical perspective on how the copyright system has adapted to technological change in the past. • Alternative enforcement mechanisms, such as, graduated response and filtering, have received little attention. • There have been few transnational studies of enforcement mecha- nisms and their impact on local production. • There is little understanding of how copyright protection tech- nologies affect the deployment of new general purpose technolo- gies (e.g., cloud computing).