Profits from piracy

Evidence is mounting that cracking down on software copyright infringement may not be good for business. Case study: Microsoft in China.

Published September 26, 2002 7:30PM (EDT)

Call it a strange case of quid pro quo without the quo.

Earlier this summer, Microsoft and China, two inscrutable monoliths waging a protracted cold war over copyrights and software pricing, finally decided to settle their differences via a three-year, $750 million "memorandum of understanding," the largest deal ever between the Chinese government and a foreign software company.

Details of the "understanding," announced in June, were both vague and open-ended. About the only overlap between both parties' descriptions was that Microsoft was supplying the $750 million and China was supplying the human resources. Still, given the background of the relationship, it seemed a safe bet that China's 92 percent software piracy rate -- second worst in the world, according to the Business Software Alliance -- had been a central issue during the negotiations.

Or maybe not. Asked about the glaring lack of a copyright enforcement clause in the new deal, Microsoft president and CEO Steve Ballmer did a quick Nixonian shuffle.

"Certainly, software piracy rates in China are high, but there is nothing in the agreement specifically around that," Ballmer told a reporter from Reuters shortly after the June announcement. Rather, the company was pouring its resources into China's nascent proprietary software industry, knowing that it would be in China's long-term interest to secure "a good domestic market" for "intellectual property."

Although most news accounts depicted the Ballmer response as a cop-out, there's at least one other explanation for his comments -- and Microsoft's strategy. Between copyright battles at home and the challenge to conquer emerging markets abroad, the company may have good reasons to revamp its longtime hard-line stance on copyright enforcement. Indeed, there are some who make the case that, in a place like China where the competition in the software market features both state-backed companies and open-source software companies that allow public access to their code, a proprietary software company such as Microsoft might actually benefit from illegal copying. In other words, casting a blind eye toward piracy may simply be good business.

"It's ultimately a question of strategy," says Carlos A. Osorio, a Harvard researcher and author of a recent working paper examining the "Catch 22" facing proprietary software companies in developing markets. "For a closed-source company competing with open-source companies, the optimum strategy is often to use its illegal user base in addition to its legal user base."

Representatives of Microsoft and other leading American software vendors refused to discuss the Osorio paper with Salon. Still, the numbers coming out of China certainly make a case for strategic flexibility. The latest Five Year Plan put out by the Chinese government calls for a gradual investment shift from hardware to software. It also calls for a 30 percent annual growth rate in the overall IT sector, with an ultimate target of $20 billion in total sales by 2005. Chinese industry leaders are even more ambitious. According to a July 30 story in People's Daily, the China Software Industry Association hopes to control 3 percent of the global software marketplace by 2005 -- currently Chinese software accounts for 1.2 percent of market sales -- and 60 percent of the domestic marketplace. Factoring in growth, those two numbers translate to $30 billion in software sales and services by 2005. Throw in a recent well-publicized anti-piracy crackdown on the eve of China's admission to the World Trade Organization, and proprietary software companies have little reason to complain.

For Microsoft, a company that has taken on, and beaten, pirates in the Chinese courts -- in April, 2001, the company scored a $36,000 victory against one major counterfeiter -- the numbers offer two investment options: Hire more lawyers and hope for more nickel-and-dime settlements or invest in a new generation of companies willing to tame the Chinese software marketplace on Redmond's behalf. If the June agreement is any indication, the company, wisely, seems to be shifting its cash resources towards the latter.

Microsoft's friendlier stance in China parallels an overall softening of anti-piracy rhetoric in recent months, at least on the part of tech industry. Give most of the credit for that to Hollywood, which, in its hard-line efforts to clamp down on copyright infringement in the U.S., has succeeded in alienating many high-tech companies. Witness this spring's flare-up between Disney and Apple over the iPod, a portable MP3 player, and Apple's "Rip.Mix.Burn" ad campaign, which was labeled a tacit endorsement of unauthorized copying by Disney chairman Michael Eisner.

The Hollywood/high-tech tiff seemed to reignite in mid-September during a panel discussion at the International Broadcasting Convention in Amsterdam. Speaking on behalf of Microsoft, Brad Brunell, marketing and business development director of the Windows New Media Platforms division, wondered aloud why Hollywood execs insisted on setting the piracy threshold down to the level of individual users. Instead of fighting consumer enthusiasm, "why not just embrace it?" Brunell said. "Why not just flood the peer-to-peer services with legitimate content?"

Such questions highlight the philosophical differences between an industry that wants a no-leak copyright protection system and an industry that views leaks as a cost of doing business, says Joe Kraus, co-founder of the fair-use advocacy group (and co-founder of the now defunct portal company Excite.)

"The software industry learned its lesson in the 1980s," says Kraus. "They copy-protected a ton of software only to find that the only people inconvenienced were the legitimate customers who wanted to make backup copies. The real pirates always found a way around the copy protection. [Software publishers] learned the hard way that law enforcement and groups like the Business Software Alliance were better ways to handle the piracy issue."

Indeed, many software companies have learned to avoid the issue altogether. Whether through free downloads, copyrights that allow for unrestricted copying or a simple unwillingness to equate computer users with thieves and cutthroats, the term "pirate" has lost a bit of its sting in recent years. Legal embarrassments such as a 2001 French court decision against Microsoft, fining the company 3 million francs for illegally incorporating another company's code into the Softimage 3D animation package, have further dulled the term's once-sharp edge.

Finally, there are those who simply view the term as too one-sided, especially in an industry where companies quite often benefit from illegal copying.

The argument for allowing piracy boils down to two words: network effects. Without a critical mass of users, most software products tend to wither and die. Conversely, the more users a software product acquires, particularly a consumer-oriented software product, the more valuable it becomes. This is especially true for operating systems, which require significant third-party support from application developers to stave off obsolescence. In fact, it was Microsoft's overwhelming dominance of the P.C. software marketplace in the mid-1990s that forced many economists to reexamine the issue of software pricing.

Starting with a 1994 paper by Amherst researcher Lisa N. Takeyama, economists and policy researchers began advancing the argument that having a large illegal user base might actually boost vendor profitability. In a 1999 paper titled "A Strategic Approach to Software Protection" economists Oz Shy and Jacques Thisse examined instances in which companies faced with certain duopolistic market settings dropped software protection as a marketing strategy and benefited from the decision.

Osorio's working paper, which has yet to be published, advances the argument into a new realm. Instead of looking at competition between proprietary software vendors, Osorio looks specifically at competition between proprietary and open-source software vendors unhindered by piracy concerns. Not surprisingly, his research takes him to the Chinese marketplace, where recent government investment in software research has resulted in a number of open-source spinoffs, most notably the Beijing-based operating systems vendor Red Flag Linux.

Factoring in the presence of open-source competition, Osorio's offers a "threshold" rate -- 81 percent according to statistical models laid out in the paper -- above which fighting pirates becomes a less optimal strategy than allowing piracy to occur. In other words, in developing markets, companies stand to make more money if they view each new illegal user as one more mouthpiece for the software and one less customer for the competition.

In its headline description of the Microsoft-China MOU, the Register, a UK Web site known for its cheeky coverage of the IT industry, summed up the Osorio argument even more succinctly: "Ballmer to China: 'Steal all the software you want, so long as it's ours.'"

Not everybody buys the "network effects" theory. An August, 2000 paper put out by Singapore researchers Chua Li Tze and Sougata Poddar dismisses most pro-piracy arguments as mere "artifacts" of statistical models that bear little resemblance to actual markets. The paper goes on to argue that even if network effects are given the fullest weight possible, "protection" of copyright "is always optimal."

Despite such counterarguments, the evidence coming in from the marketplace suggests that some companies are erring on the side of larger markets. For example, Apple, which declined a request for comment on Osorio's paper, distanced itself from market rival Microsoft by releasing the latest version of its MacOS, code named Jaguar, without any copy activation mechanisms. Microsoft XP, in contrast, includes a "product activation" feature designed to limit copying and suffered a minor PR embarrassment this spring when versions leaked out onto the Internet anyway.

Osorio, who doubles as a visiting research scientist at the MIT Media Lab, prefers to call his paper a "preliminary result" for the moment. He is currently exposing it to the harsh criticism of the peer-review process to make sure he hasn't missed anything. Still, he says, the feedback has been largely positive.

"I've had talks with people at proprietary software companies," he says. "They say, 'Yeah, you're right on this, but we cannot say that publicly.'"

One person who does speak out publicly in favor of the paper is Carl Howe, a senior analyst who follows the software industry for Forrester Research. Howe describes Microsoft's recent anti-piracy efforts in China as a prolonged exercise of "shooting itself in the foot" and wishes the company would spend less time obsessing over lost revenues and more time obsessing over new customers.

"I think they're actually acting against game theory," says Howe. "They're doing what's not in their interest by cracking down on piracy."

Then again, as the recent MOU indicates, Microsoft executives aren't exactly ignorant when it comes to game theory. As a company, Microsoft has shown an impressive willingness to modify corporate ideology in the face of market momentum. It is also a company willing to give away its products for free -- Internet Explorer anyone? -- for a share of future profits. Added together, it isn't hard to envision a kinder, gentler Microsoft, at least where China is concerned.

Although Microsoft representatives declined to comment on the Osorio paper, a company spokesperson was more than happy to reiterate the company's policy on copyright infringement. Like the Ballmer response in June, the statement included no mention of the word "piracy" -- a term once reserved specifically for just such occasions:

"Microsoft believes it is essential that intellectual property rights be protected and respected in the digital age so that worldwide economic growth and Internet commerce can continue to flourish," said the spokesperson.

By Sam Williams

Sam Williams is a freelance reporter who covers software and software-development culture. He is also the author of "Free as in Freedom: Richard Stallman's Crusade for Free Software."

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