Liebowitz tried to provide theoretical evidence in several papers (2002, 2003, 2005) that there is negative impact of P2P file sharing on record sales. The most elabatored paper is his article in the Journal of Law and Economics, which fused earlier research on this topic (Liebowitz 2006). Liebowitz’s arguments are based on microeconomic theory and he identifies four effects of file sharing that might have an impact on record sales: substitution, sampling/exposure/penetration, network effects and indirect appropriability. Liebowitz analyses all four effects and concludedthat the substitution effect is dominant over the sampling effect, which can be also negative under specific circumstances. All other effects that are positively correlated with record sales are negligible. Further, he investigated other factors that might affect record sales, but none of them are able to explain the decrease of record sales in the past 10 years.
(1) Substitution effect: The argument is straightforward. “The copy is treated as a substitute for the original. If the copy is identical or close in quality, and if the cost of making the copy is low, the copy for a price of zero dominates the original at its positive price” (Liebowitz 2004: 9). In other words: “[U]nauthorized downloading of a copyrighted file can be a substitute for the purchase of that copyrighted work. The substitution of a dowloaded copy for the purchased original obviously has a negative effect impact on sales” (Liebowitz 2006: 17).
(2) Sampling/exposure/penetration effect: Since music is an experienced good, the music consumer has to listen to the piece of music in order to decide if she/he likes it or not. Therefore, the intent to purchase pre-recorded music involves costs of information, opportunity costs, search costs, etc. In other words, consumers have to sample music to arrive at a better decision basis. If music is now freely available it is not only a subtitute for the original but also an instrument to value unknown music pieces, music genres, as well as artists. The sampling hypothesis argues that file sharing lowers sampling costs and, thus, more consumers become familiar with to date unknown music/artists. Hence, more consumers buy music from legitimate distribution channels.
However, Liebowitz’s argues that sampling has an ambigious effect on record sales, and in his 2004 working paper he states “(…) that sampling would lead to a decrease in sales (…)” (Liebowitz 2004: 4). Liebowitz’s argument is based on a two-page article by Hirshleifer (1971). According to Hirshleifer, prescreening of music by consumers provides a greater utility. Initial music purchases, therefore, will provide more utility than later, which will raise the price. Thus, the satiation of music demand can be achieved with a smaller number of music titles, which decreases the number of purchased units. Even if there is no satiation of demand, consumers’ time to listen to music is limited. Since consumers spend more time listening to music they value more, the number of units consumed (albums, music tracks) is limited by the fixed amount of time available to the consumer. “Therefore, even if a large subset of file sharers engaged in sampling, there would be no reason to believe it would counterbalance the negative impacts of the substitution effect” (Liebowitz 2006: 18).
(3) Network effects: Under certain conditions the unauthorized use of intellectual property might create additional value to buyers of the original that firms profit from unauthorized use. The best example is the spread of “pirated” systems software of Microsoft-Windows, which enables legitimante buyers to easily change files within a world-wide network of users. Microsoft, thus, owes its dominant market position to the widespread and mostly unauthorized use of its software.
However, Liebowitz questions whether there is a network effect in music consumption. If a network effect exists, it is questionable whether it is able to increase demand and therefore the size of the music market. Finally, radio already allows unlimited music listening at zero cost and Liebowitz finds neither a positive impact of radio airplay in a historical context nor an empirically tested positive network effect on record sales (Liebowitz 2004, 2006).
(4) Indirect appropriability: This concept was coined by Liebowitz (1985) himself. “If the copyright owner knows which originals will be used to make copies, a higher price can be charged for them, allowing the copyright holder to capture part, all, or more of the revenue that might have been appropriated through ordinary sales if unauthorized copying would be prevented” (Liebowitz 2002: 4). However, there are two conditions that have to hold if indirect appropriability should have a positive impact. (1) The variability in the number of copies made has to be small; (2) The seller of the original is able to identify those originals from which the copies are made in order to charge a higher price for them. Since both conditions do not hold with P2P file sharing – there is a great variability in the copies and no possibility to charge a higher price for the original – the mechanism of indirect appropriability does not work.
Liebowitz thus concludes that “(…) economic theory provides only a very thin foundation on which to support any expected impact of file sharing on sales of sound recordings other than negative one” (Liebowitz 2006: 19).
In addition, Liebowitz (2003, 2005, 2006) investigated alternative explanations for the sales decline in the market for sound recordings. However, (1) list prices adjusted for inflation were constant in the relevant years; (2) the recession of 2001 only accounted for a small part of the sales decline; therefore, variation in income cannot explain the downturn in the record industry; (3) substitutes such as video games and movie box office revenue did not change around 2000; (4) the increased portability increased the sales of prerecorded music, but there was no apparent decrease in portability; in fact, the iPod actually increased portability of music dramatically; (5) there was no noticeable impact of librarying from vinyl/cassettes to CDs; (6) radio listenership has fallen over the period, but the decrease was centered on old music; instead, listenership for contemporary music actually increased; (7) DVD growth is also not responsible for the fall of CD sales. (Liebowitz 2006: 21).
Since there was no considerable change in prices and income, no decrease in the portability of music, no impact of substitutes, no change in music and in the audience, “[w]e thus appear left with no viable alternative explanation other than file sharing” (Liebowitz 2006: 24).
Hirshleifer, Jack, 1971, “Suppression of Inventions.” Journal of Political Economy, Vol. 79: pp. 382-383.
Liebowitz, Stan J., 1985, “Copying and Indirect Appropriability: Photocopying of Journals.” Journal of Political Economy, Vol. 93; No. 5: pp. 945-957.
Liebowitz, Stan J., 2002, “Policing Pirates in the Networked Age.” Policy Analysis, No. 438 (May 15, 2002): pp. 1-28.
Liebowitz, Stan J., 2003, Will MP3 downloads Annihilate the Record Industry? The Evidence so Far. Working paper, University of Texas at Dallas, School of Management.
Liebowitz, Stan J., 2004, Peer-to-peer networks: Creative Destruction or just Plain Destruction? Working paper, University of Texas at Dallas, School of Management.
Liebowitz, Stan J., 2005, “Pitfalls in Measuring the Impact of File-sharing on the Sound Recording Market.” CESifo Economic Studies, Vol. 51, No. 23/2005: pp. 439-477.
Liebowitz, Stan J., 2006, “File Sharing: Creative Destruction or just Plain Destruction?” The Journal of Law and Economics, Vol. 49, No. 1, pp. 1-28.
In part 6 of this series I will discuss Ibrahiim Bayaan’s theoretical model of the impact of music file sharing on record sales entitled: “Technology and the Music Industry. Effects on Profits, Variety and Welfare”.