Thursday, March 11, 2010

The social optimal level of video game piracy

I have been thinking a lot about video game piracy lately, especially in terms of microeconomics. Putting the legal and moral issues aside it's interesting to consider if it's hurting or benefiting society as a whole. There is no doubt piracy is hurting the industry but it is also obviously benefiting those who get the games for free. Looking at the welfare of society as a whole it would be wrong to only consider one group, such as video game developers. It is possible that some level of piracy is needed if we want to maximize society's welfare.

The interesting thing about software is that it is a non-rival good. After creating one program we can make a copy of it at virtually no extra cost. So the optimal quantity of a video game, lets say Half Life 2 is one for every gamer since the cost of one more unit is zero. For every gamer to want the game however the price needs to also be zero. If Valve charged one dollar for the game there would still be some gamers who would consider it too expensive, they would rather spend their dollar on something else like a candy bar. Since the cost of making one more copy is zero and those candy loving kids would get some enjoyment from playing Half Life 2, society would be losing out the benefit of having those kids playing Half Life 2.

The benefit to the producers of video games, that is the developers, publishers etc is the money they get paid for their game. So the optimal price for them is that which earns them the most money, it seems that for a new game it is $60. So since the cost of making one more copy in the age of digital distribution is zero, the benefit (the producer surplus) from selling one more game for producers would be $60.

What is the benefit in dollars for a gamer in buying a game? It depends on what they are willing to pay for it. If I am willing to pay $100 for a copy of Half Life 2 and I get it for $60, the benefit to me (the consumer surplus) is $40. The added welfare to society from me buying a copy of Half Life 2 would be the $60 the producers benefit plus my $40, which adds up to $100 in added welfare.

The problem for society is that if I had only been willing to pay $20 for Half Life 2 I wouldn't have bought it. Since the cost of making a copy of the game is $0, society has just lost out on $20 worth of enjoyment I could have added to the pool of society's welfare. If I instead had pirated it, I would have created $20 worth of enjoyment at no cost. It follows from this reasoning that society is better off if consumers who would not have purchased the game pirated it.

If we go back to my first example where I valued Half Life 2 at $100, if I had then pirated the game the benefit to me would be $100, the same as the combined benefit of the producers and me if I had bought the game ($60 + $40). So as far as the welfare of society is concerned it doesn't matter if I pirate Half Life 2 or buy it, I contribute just as much to the combined welfare of society. Any harm done to developers is compensated for by an equally large welfare increase for pirates. From this reasoning we can see that the benefit to society from everyone pirating their games, assuming that developers keep making them is one way to the optimal level of welfare.

But of course that scenario is an impossibility since if everyone pirated their games, game development would be unprofitable and no one would make games. Another possible scenario to maximize the combined level of welfare is if everyone who valued the games above or at the price developers maximize their profits at buy the game and everyone else pirate it. That means everyone who value Half Life 2 at $60 or more buy it and everyone else pirate it. If piracy isn't an option for those who value Half Life 2 at less then $60, they wouldn't get to play it and society would experience a loss of combined welfare.

A third possible scenario in which society's welfare is maximized is one where developers make just enough money to keep making games, their revenue covers their costs but leave nothing over for economic profit. So in this scenario a portion of society buy their games and they are just enough to finance the development of video games. Everyone else pirate their games. It makes sense because everyone paying for the game value it over or at its price, otherwise they wouldn't buy it. The important thing is that everyone else pirate it so we don't lose out on their potential contribution to society's welfare.

We could imagine other possible scenarios somewhere in between scenario two and three that would maximize societies welfare, they just have to fulfill two criteria. (1) Enough people who value the game over the price producers charge buy the game so that producers can cover their costs. And (2) Everyone who value the game at less then the price suppliers charge pirate the game.

1 comment:

Leon said...

In the words of Quagmire:
"Fat chicks need love too. But they've gotta pay!"

The most important thing to me is that the games get made, society's welfare, not so much. Of course as many people as possible should play the game, but common sense and psychology learned from tv dictates that if you have the choice to pay for a game or get it for free, even if you have the money to go around, maybe that money would be nice to use for a new couch.

The best way to make costs more acceptable to the masses is to lower the production costs, as in salaries (same for movie industry). Start cutting from the top and even out the salary gaps a little on the way.
This, of course, won't happen because businesses aren't driven for the sake of a prospering market, but because of the acquisition of wealth, and when given the opportunity for a big pay-check most people, especially in executive positions, cannot see the bigger picture. In the same way communism failed, capitalism fails, only in capitalism it's accepted, but communism is obviously built with a very contradicting purpose. The problem lies in the human psychology, one chooses for himself without concern for others. If somehow everyone could realize that many buyers is the only possible way for a positive outcome, we could start buying games for a third of the current price and double the sales. They will earn less money for now, but come on, it's the fastest growing market in town and new generations will be added to the equation while older ones will stay.

Been a while since I last saw you, gotta have this conversation in the real world. Gonna catch up on your twitter now.