A Digital Economy: Laws of Economics in a Digital World

Brad Kovach Intro to Humanities Mr. Rick Kempa 18 December 2008

Kovach ii I. Introduction
A. Anecdote “The World is Flat” story. B. Thesis sentence: “Traditional laws of economics and definitions

regarding ownership are ineffective in a society that exchanges intellectual property via the Internet.” C. Background information 1. The Internet is extremely ubiquitous.
2. The Internet is allowing people to distribute digital goods. II. The Body A. Piracy isn’t as bad as it seems. 1. Piracy’s definition has changed over time.

2. Piracy may be causing a loss of profit, but the losses are being offset by record-breaking profits. B. Digital Rights Management is crippling digital goods.
1. Digital rights management restricts and takes rights away from

ownership. 2. Digital rights management is a hassle for the consumer. a. Spore’s long-awaited launch was hurt by aggressive DRM policies. b. Sony-BMG’s DRM-laden audio CDs left users with security vulnerabilities, attracting the attention of the Department of Homeland Security.

Kovach iii 3. Digital rights management is absent from the world’s largest online environment—Second Life. a. Users create and distribute content, while keeping intellectual property rights. b. Businesses in Second Life are extremely profitable.

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C. Supply and demand are broken in a digital economy.

1. Digital goods are in virtually infinite supply with fixed demand. 2. CyWorld and iTunes are proving that consumers desire digital convenience.
III. Conclusion

A. Digital goods are already extremely popular. B. Current economic laws do not effectively govern in a digital economy. C. Online piracy and rights management are causing huge problems regarding the ownership of digital goods and property.

Kovach 5 New York Times columnist and author Thomas Friedman scurried down the stairs and whispered to his wife, “Honey, I think the world is flat!” (Qtd. in Friedman 5). Friedman was referring to the way the global economy has been (and will continue to be)reshaped by technology. Friedman’s revelation is shockingly relevant to society’s addiction to digital consumption. In a society where consumers create, exchange and share content online—free, easily and anywhere—it really appears that the world has become “flat.” Our society has exchanged digital goods—information, namely—since the dawn of the Internet. We’ve been using it efficiently for retrieving information quickly and accurately, thanks to search engineslike Google. We even started using the Internetto shop online. Sites like Amazon.com have become the Internet-only parallel to Wal-Mart by offering convenience and affordable prices at the click of a mouse. More and more, however, society will be exchanging intellectual property online. Immediate access to purchased materials can be granted via the Internet. But what will the convenience do for the structure of our economy? What happens to national economies as we drift toward the idea of a “flattened” global economy? And as goods are increasingly distributed online, society needs to know what will be done regarding the theft and unauthorized distribution of these digital assets, what value the digital assets have in a tangible economy, and how where the digital assets fit into supply-side economics. Traditional laws of economics and definitions regarding ownership are ineffective in a society that exchanges intellectual property via the Internet. The maritime definition for piracy, according to Webster’s Online Dictionary shows piracy as “an act of robbery on the high seas” (). In an economic playing field where theft involved the physical heist of tangible

Kovach 6 things, piracy was considered taboo by everyone—except the pirate. But now, where theft is intellectual, rather than physical, the definition of piracy has shifted. Piracy is defined by the Motion Picture Association of America (MPAA) as “the unauthorized taking, copying or use of copyrighted materials without permission” (). In recent years, piracy, and especially Internet piracyhas increasingly invaded society and our vernacular. Internet services like Kazaa, BitTorrent and Limewire have made it trivial to obtain virtually any media without payment and without properly licensing the copyright holders of the media (). The media producers lose billionsas a result of piracy. Piracy does swindle a sizable portion of money from the market. The Recording Industry Association of America (RIAA) estimates that in the US alone, music piracy results in a loss of $12.5 billion in sales(). They estimate that the loss in profit due to piracy has taken $2.7 billion away from the people that work in the industry. According to the MPAA’s website, the film industry lost over $18 billion in revenue due to piracy(). Although these numbers are impressive, is piracy really destroying the music industry? According to the numbers, no. Since the MPAA’s 2005 assertion that piracy has been causing multi-billion dollar deficits to the entertainment industry, the numbers have shown a steady increase in profit since that time. From box-office proceeds alone, the MPAA has seen an increase of over 9%

Kovach 7 from 2005 to 2007 (). Consumers are, however, getting acquainted with digital distribution, much more than previously so. Increasingly, people are paying more and more for goods that they’ll never see physically manifested. People can buy digital “copies” that are easier to distribute without the ecological impact of packaging and shipping. Instead, digital copies offer the same functionality instantly, effortlessly. Digital copies are frequently burdened with restrictions, dubbed as DRM, which stands for Digital Rights Management (). One intense restriction? With DRM-bound copies, you may not transfer or duplicate the digital copies. Ownership is defined by Princeton University’s WordNet as “possession with the right to transfer possession to others.” According to the traditional definition of ownership, people don’t own DRM-bound digital copies. They rent them. Digital copies, being frequently burdened with DRM, lack the ability to be reintroduced into the marketplace because they have been rented for a one-time fee. This means that the purchasers of DRM-bound media are unable to sell the content they paid for because it isn’t allowed by the copyright holder. And where user’s rights are curiously absent, consumers will revolt. Spore, a heavily anticipated video game designed by Wil Wright, creator of The Sims, proved to the world that property is worthless when the owner isn’t in control. The problem wasn’t with the game itself. It was with the game’s deployment. Spore, distributed by EA Games, came bundled with “three-strikes, you’re out” licensing. A copy of Spore was able to be

Kovach 8 activated three times. Activation required online connectivity to EA Games’ licensing servers which would determine whether or not users were allowed to install the game. Users quickly realized that their purchases wouldn’t work if EA’s licensing servers were down or went missing (for example, if EA went out of business). And that made them very mad. And they let EA know: thousands of disgruntled EA customers bombed the Amazon product page with poor product ratings subsequently causing poor sales (). DRM has even received the attention of the Department of Homeland Security. On October 31, security researcher Mark Russinovich discovered that an audio CD he inserted for playback in his Windows-based computer was leaving invasive digital rights management software on his computer. Russinovich discovered that the disc, manufactured by Sony-BMG, was prompting users to install a “custom media player.” Little did users know, the Sony-BMG technology, called XCP, was serupticiously installing rootkit software on their computers (). Rootkitsoftware is used to obtain and maintain complete administrative command over a computer. In addition to potentially complete control over a user’s system, rootkits often use evasive maneuvers to hide. In the XCP rootkit, any file beginning with “$sys$” was immediately hidden from the system and from the user (Roberts). Hackers quickly released spyware and viruses to leverage the slyly implemented rootkitsystem. The software that was meant to manage the copyright holdings of Sony-BMG quickly became an attack vector for thousands of users (Roberts).

Kovach 9 The Department of Homeland Security (DHS) gained an interest in the case after it quickly escalated from the shy tech community to the mainstream media. In a meeting held with Sony-BMG executives, DHS officials made a statement that "was certainly delivered in forceful terms that [rootkit-based DRM] was certainly not a useful thing" (Qtd. in “Homeland”). In an effort to silence critics, Sony-BMG quickly discontinued the XCP-protected discs and offered a rootkit removal tool on their website(). Sometimes content isn’t bound by DRM. Sometimes the content is easy to distribute, but intensely difficult to earn. Enter Second Life. With the rise in broadband availability, online gaming’s popularity has soared (citation needed). Many games offer online functionality at little or no cost to the consumer. One such free game is called Second Life, and it has completely changed the way we imagine a digital exchange of goods. Second Life allows people to create content and maintain intellectual property rights, in a way that parallels owning tangible property (“What is Second Life?”). Now, people from all over the world log in to live a second life insideSecond Life. People buy and sell property, provide services and carry out the functions of society. Second Life puts virtually no limitations on its “citizens.” Second Life allows the free market of created goods that has helped it blossom. It is estimated that the creators of Second Life, Linden Labs, have created less than one percent of the content in Second Life. The

Kovach 10 users, however, collaboratively create for 23,000 man-hours every day—far more than the development team at Second Life can provide(). Here’s the kicker: money earned in Second Life can be exchanged for currency. Inversely, world currency can be exchanged into the Second Life currency, Linden, by entering a credit card number. Because of this digitalto-analogbusiness model, many businesses have cropped up. Businesses inside of Second Life sell possessions, land, clothing, and virtually every commodity found in the real world. These items are easy to produce (secondlife.com). On average a Second Life virtual business owner earns twenty-thousand dollars per year(). Traditionally, in the United States, the health of an economy is dictated by Supply and Demand—two economic theories that have been very accurate in free-market economies. Quite simply, if there is a large supply, the price will go down. Inversely, however, if there is a limited supply, the price rises, because demand is also high. Large supply leads to a small price. Small supply leads to a large price. These simple correlations have been effective in letting the market decide what they want to pay for a product. But now, with digital distribution of digital goods, supply and demand are horribly broken. In a digital situation, supply is unlimited, but demand is still fixed. Even when every demand has been satiated, supply remains infinite. Typically, a problem wouldn’t exist, but the supply and demand also helps content producers

Kovach 11 decide how much to charge for their goods. So where does that leave supply and demand in digital distribution? The answer is “nowhere.” Traditional laws of economics are useless for determining how much to charge for digital goods. Digital goods are virtually free to replicate, but digital goods have upfront production costs that need to be offset by a higher amount in sales (). Struggles in digital goods distribution can be demonstrated with the iTunes Music store and Cyworld. (Example Number ONE: iTunes) iTunes made history by offering licensed (and therefore legal) digital downloads of music that could be easily copied to an iPod music player or burned to a CD for playback in a CD player or car audio system. iTunes prices digital music downloads at 99 cents. iTunes’ very successful launch on April 23, 2003 demonstrated that price still had power over consumers. iTunes sold one million songs within its first week of being “online”. (“Apple Launches the iTunes Music Store”). In the five years since the launch, the iTunes store has become the number one music retailer in the United States—surpassing marketing behemoth Wal-Mart in total quarterly album sales (“iTunes Top Retailer in the US”). . But iTunes isn’t the only company making massive profits selling digital assets. Cyworld, a Korean company, is changing the way people interact with their friends, and they’re making huge profits in the process.

Kovach 12 Based out of North Korea, Cyworld was founded in 1999. The company maintains a website that allows members to easily keep track of friends, exchange photos, and create virtual spaces (). Cyworld generates profit by allowing users to exchange gifts. The gifts, bought with the site currency of “acorns” allow users to decorate their minirooms—a digital expression of the user’s personality. Gifts, however, are not earned in the micro-society with the currency. Currency is bought using real money. Gifts usually cost users approximately one dollar (Schonfeld). However, the gifts are intensely profitable for Cyworld. Cyworld does almost nomanufacture or design of the virtual goods. According to Business 2.0 writer Erick Schonfeld, an army of “small graphic design shops and license-holders” create the gifts. Cyworld shares in profits generated from the virtual gifts, usually keeping 30 to 50 percent of the profits for themselves. Cyworld was estimated to earn over $140 million in 2007— meaning that its users spent approximately $100 million on “virtual inventory” (Schonfeld). Cyworld’s business model has allowed them to rapidly expand. Cyworld, originally providing networking services to North Korea, has expanded their networking service to the “United States, China, Japan, Korea and Taiwan” with plans to continue expansion to “Europe, South America and India” in a short period of time (). Whether it’s music downloads, or environments, digital assets, digital goods have value to consumers. Although difficult to determine an effective

Kovach 13 selling point for digital goods, online vendors are finding ways to market these goods, and are thriving in this new marketplace. As a digital economy is becoming increasingly imminent, it is also becoming very obvious that our economic structures are outdated and not suited to govern in the digital millennium. When we see digital goods being exchanged online in apparently lucrative venues, we realize that society will need new laws and new economic models to accommodate these venues. Also, when theft and ownership are considered as they apply to the Internet, massive discrepancies can be drawn between ownership of tangible items versus the ownership of digital goods. So far, businesses online have experienced little to no trouble making an online economy successful. But as long as supply and demand continue omnipresent guidance over the health of an economy, a booming Internet economy may never exist.

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Works Cited Anderson, Nate. "What piracy crisis? MPAA touts record box office for 2007." 5 March 2008. Ars Technica. 7 December 2008 <http://arstechnica.com/news.ars/post/20080305-for-movie-biz-tales-ofpiracy-and-record-profits.html>. Apple, Inc. "Apple Launches the iTunes Music Store." 28 April 2003. Apple, Inc. 2 December 2008 <http://www.apple.com/pr/library/2003/apr/28musicstore.html>. —. "iTunes Top Music Retailer in the US." 3 April 2008. Apple, Inc. 2 December 2008 <http://www.apple.com/pr/library/2008/04/03itunes.html>. Cyworld, Inc. "Frequently Asked Questions." Cyworld. 7 December 2008 <http://us.cyworld.com/main/aboutus/aboutus.php>. Friedman, Thomas. The World is Flat. New York: Farrar, Straus and Giroux, 2005. Kirkpatrick, Marshal. "Massive Korean Social Network CyWorld Launches in US." 27 July 2006. TechCrunch. 9 December 2008 <http://www.techcrunch.com/2006/07/27/this-is-nuts-cyworld-us-opens-foruse/>. Kuchera, Ben and Mark DeSanto. "Ars puts Spore DRM to the test--with a surprising result." 16 September 2008. Ars Technica. 2 December 2008 <http://arstechnica.com/news.ars/post/20080916-ars-puts-spore-drm-to-thetestwith-a-surprising-result.html>. Motion Picture Association of America. "Anti-Piracy." Motion Picture Association of America. 29 November 2008 <http://www.mpaa.org/piracy.asp>. —. "Who Piracy Hurts." Motion Picture Association of America. 10 December 2008 <http://www.mpaa.org/piracy_WhoPiracyHurts.asp>. "Piracy." 2008. Merriam-Webster Online Dictionary. 29 November 2008 <http://www.merriam-webster.com/dictionary/piracy>. Recording Industry Association of America. "For Students Doing Reports." Recording Industry Association of America. 2008 December 10 <http://www.riaa.com/faq.php>.

Kovach 15 Roberts, Paul F. "DRM software uses root-kit techniques." eWeek 22.44 (07 Nov. 2005): 29-29. MasterFILE Premier. EBSCO. Hay Library, Rock Springs, WY. 10 Dec. 2008 <http://proxy.lib.wy.us/login?url=http://search.ebscohost.com/login.aspx?dire ct=true&db=f5h&AN=18878918&site=ehost-live>. —. "Sony Suspends Rootkit DRM Technology." 11 November 2005. eWeek. 5 December 2008 <http://www.eweek.com/c/a/Security/Sony-SuspendsRootkit-DRM-Technology/>. Schonfeld, Erick. "CYWORLD ATTACKS!." Business 2.0 7.7 (Aug. 2006): 84-89. MasterFILE Premier. EBSCO. Hay Library, Rock Springs, WY. 9 Dec. 2008 <http://proxy.lib.wy.us/login?url=http://search.ebscohost.com/login.aspx?dire ct=true&db=f5h&AN=21750486&site=ehost-live>. Tapscott, Don and Anthony D. Williams. Wikinomics: How Mass Collaboration Changes Everything. New York: Penguin Group, 2008. The Register. "Homeland security urges DRM rootkit ban." 17 February 2006. The Register. 8 December 2008 <http://www.theregister.co.uk/2006/02/17/rootkit/>. "What is Second Life?" Second Life. 7 December 2008 <http://www.secondlife.com/whatis/>.