Exploring the impact of software and other digital piracy

Last semester I wrote a short paper that explores the impact of piracy on industry, with a focus on the software industry. I found some surprising results, especially when I dug into the reports that government and industry look to for estimations of the financial cost of piracy. Turns out the papers the figures they cite are... inflated due to the overly-simplistic way they calculate their figures. I'll post the paper here for a general overview and may later return to certain areas in more detail. It's a bit dry, but informative. References will be published in Part 2


The Internet is seen as a threatening challenger to the profits of many industries. The Business Software Alliance (BSA) reports that in 2008, the worldwide piracy of software accounted for losses of over $50 billion. [2] Other equally large estimations are reported from organizations representing other information industries. The Recording Industry Association of America (RIAA), which represents American musicians, cites a report that states yearly financial losses to the music industry in the United States due to online piracy is $3.7 billion.[20] The Motion Picture Association of America, which represents the film industry, cites another report which states that, in 2005, American motion picture studios lost $2.3 billion to online piracy.[10] Online piracy is certainly a concern for many information industries, and there have been many investigations of the impact and prevention of digital piracy. It has been both likened to theft [19]and praised as a new form of product distribution, although the opinion taken by lawmakers and industry lobbyists is more often the former. It is absolutely imperative that we fully understand the effects of piracy before resorting to severe measures to prevent it.

“Piracy,” in this particular sense, is the illegal distribution of protected intellectual property (IP) products. Piracy and counterfeiting is present in all industries from fashion to pharmaceuticals, but it is special in the case of digital products because of the nature of digital information. [8] Piracy of information goods can be spurred for more reasons that the usual financial ones. The ease of making perfect copies of an original has created an environment wherein it can be more beneficial to a consumer to not pay for a product, especially in a situation where a pirate has more freedoms of use than a legal user does. Digital Rights Management systems, which are software “locks” used to protect IP on digital goods, often prevent users from effectively using their legally purchased property. Users can – and do – turn to cracked and hacked versions of digital products to “unlock” the copy protection so they can actually use the product as desired. [3, 16]

The situation with digital piracy is much more complex than would first appear. This is not a simple case of consumers stealing goods. Digital piracy causes curious economic phenomena and in many cases actually has a positive effect on both the consumer and the producer. The claims of industry representatives rarely account for the positive impact of both piracy and the networks that support it. Even though software development is a relatively new field, we can still examine the effects of software piracy by looking at parallel cases to determine in what ways estimates of the economic impact could be incorrect.

Why do People Pirate?

Before the impact of illegal distribution of copyrighted goods can be examined, we must first understand what causes people to obtain illegal versions of protected IP. Piracy of digital media, including software, is a global phenomenon and is most prevalent in developing countries. [4, 23] Software piracy rates range wildly, with some countries being surveyed with piracy rates as high as 95%. [4] Piracy is clearly widespread and far reaching.

Piracy of software is correlated with two main factors: the cultural values and the financial standing of a country. [4, 23] The many ways cultures can differ from each other – religion, political leaning, education, etc – makes comparing cultures difficult. One measurement is the Hofstede index, which ranks cultures based on scores of five traits – individualism, masculinity, power distance index, uncertainty avoidance index and long-term orientation.[6] Individualism and masculinity were the only traits correlated with software piracy rates. [23] Individualism describes a culture wherein the individuals concern themselves with the wellbeing of their self and immediate family instead of forming close-knit larger groups. Individualistic cultures place greater value on privacy. [6]Masculinity is attributed to traits such as materialism, high work ethic and tendency to be more ego-oriented.[23] Countries that have a culture that favour individualism over the reverse trait of collectivism experience lower levels of software piracy. The hypothesis put forth in [23] for this is that a higher rate of collectivism encourages sharing and feelings of duty to one’s peers. Similarly, higher rates of masculinity are correlated with decreased levels of software piracy. The proposed explanation in [23] is that this creates a competitive atmosphere and discourages sharing. A high amount of corruption is also correlated with a slower decline in software piracy rates. [23] Countries that experience less government-level corruption and have more individualistic tendencies see lower rates of piracy.

More importantly, levels of software piracy are strongly correlated with financial wellbeing. Gross National Income per capita (GNI) is used to compare the financial status of a country. It roughly represents the average wealth of the citizens. Countries with low GNI have higher piracy rates, and individuals who pirate copyrighted works or purchase counterfeit products describe themselves as “financially deficient.”[4] One study [5] found that the difference in piracy rates between countries was related to GNI by a factor of 73%. These findings are significant when trying to estimate the amount of sales lost to piracy of digital media.

A Barrier to Estimating True Lost Sales

If the primary motivation for software piracy is financial difficulty, it cannot safely be assumed that the pirate would be able to afford a legal version of the software they are using. In the curriculum it created for school children, the RIAA makes this very mistake in an exercise to demonstrate the losses to the music artists every time someone illegally downloads a song. [19] The BSA figure (that there is over $50 billion in losses to the software industry due to piracy) also comes from improper methodology, where it is assumed all illegal versions of software is a lost sale. [2]The percentage of pirates who would have actually bought a legitimate version had the illegal one not been available can be called the percentage of “substitutions”. Some studies concluded that substitution rates for illegally downloaded music were between 10-20%. [13, 22] In comparison, physical piracy of music – mostly the sale of counterfeit CDs – has an estimated substitution rate between 45 and 65%. [20, 22]

The only difference between these two situations is the physical manifestation of the music and the initial investment made in the illegal version. For downloaded music, the sunk cost is $0, while with pirated CDs some money is paid – although likely less than the average retail price. It is both easier and cheaper for someone to download a CD than to purchase a physical counterfeit. It is logical to conclude that people who would pay money for something are more likely to pay a little more if the cheaper option were not available, while people who are accustomed to getting it for free are more reluctant to make the financial commitment.

The substitution rate for software is not as well documented as the substitution rate for music. In a recent report, [22] a substitution rate of 50% is used to calculate losses in the software industry. This figure is left uncited and the authors do not explain why they decided to use this rate. In reality, the substitution rate for software may even be much lower than the one for digital music. The existence of open source and free software alternatives to commercial products may push the substitution rate down.

Part 2

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