Wednesday, October 24, 2007

8 Funding Models to Support Digital Goods Creation

As America shifts from an industrial to a knowledge economy, digital goods and content become more important. Consumers want access to as many digital goods as possible. For this to occur, there must be incentives for people to create them.

Digital goods are items that can be replicated many times without requiring additional effort or modification, such as software or .mp3 music files. They are produced by digital goods creators such as software engineers, musicians, writers, actors, and scientists. These goods are non-rivalrous meaning that one person consuming them doesn't stop another from doing the same. One can have their cake and eat it too (or one can listen to their music files and share them too). Digital goods require a large initial investment to create, but then little or nothing to replicate millions of times.

While markets works well in creating the societal optimal amount of goods and services, they don't work well with digital goods as the underlying economics are different. With goods and services the socially optimal price and quantity occurs where the supply curve intersects with the demand curve. This occurs when the cost to produce another widget is equal to the price price someone is willing to pay (where marginal cost is equal to marginal benefit). But with digital goods the marginal cost of production is 0 as it costs nothing to make additional copies. This leads to a price of zero allowing anyone who wants the digital good to have access to it. But, at a price of 0 there is no incentive for people to create digital goods. Hence, the key problem with digital goods is that they are underproduced.

One way to handle this market inefficiency is to use intellectual property (IP) rights: copyright, patents, and trademarks. This gives the creator the exclusive right (for a limited time) to sell the good. This short term monopoly allows the author to be compensated for the effort they put in. It allows digital goods to be treated like rivalrous goods and to be sold in markets.

Bypassing the IP and using the digital content without compensating the creator is known as piracy. It can occur by end users who access the content without paying or by bootleggers who sell the content for their own benefit without compensating the creator.

There are also other way of incentivizing digital goods creators that do not require IP. Digital goods can be created and given away free as a form of advertising to sell other goods and services. Digital goods creators can be supported by the government or donations allowing them to give the goods away for free. Digital goods can also be created by volunteers motivated by something other than money.

There are 8 different models for compensating digital content creators:
1) sell the digital good directly (iTunes), 2) sell a subscription to an unlimited use library (Netflix), 3) tie it to a physical good (books), 4) advertising (TV), 5) sell an associated service (music concerts), 6) donation (shareware), 7) government funding (science research), 8) volunteer (blogs)

For each one lets look at how the model works, the types of goods it produces, who pays, who can access the digital goods, and what piracy look like.

1) Charge for Digital Goods Directly
Examples: iTunes, Amazon e-Documents, goods in Second Life

In this model, consumers directly purchase a single instance of a digital good: a song, a digital book, a version of software, or a piece of clothing in a digital world. Because there is no physical good associated with this, the customer is really purchasing access to the digital good (or license) which could expire after a given amount of time. The content creator is paid from these revenues.

Because of the price, access is limited. Instead of everyone who wants it having access, only those who are willing to pay the price will get it. All those who would like to have it, but not enough to pay the price lose out in this system.

Music is at the forefront of using this model as $2 billion worth of music was sold online or through mobile phones in 2006. Digital worlds are starting to generate real revenue selling virtual goods as seen by the $25 million a month spent on goods in Second Life.

Piracy by end users is common in this model. File sharing allows music, movies and software to be transferred between end users without compensating the creator. In Second Life, Copybot, allows users to copy clothing and other goods for free without compensating the creator.

Piracy by bootleggers can be seen in AllOfMp3, which sells .mp3 music files, but does not compensate the creators of that music.

To stop these forms of piracy, IP copyright laws are used. They are augmented with digital rights management (DRM) which restricts how the content can be used. DRM typically has the side effect of making it harder for people to use the digital content in legal but non-standard ways.

2) Unlimited Access Subscription (library)
examples: Rhapsody, Netflix, Wall Street Journal Online, HBO

In this model the consumer pays a subscription fee to get unlimited access to a library of digital goods. The consumer just pays a monthly fee and then can listen to any and as many songs, movies or articles that they wish that are in the library. There is no additional fee for accessing content. The digital content creators are compensated from the subscription fees.

Charging for digital goods directly (#1) had the problem that people who wanted access to a digital good but not enough to pay the price couldn't. With this model, if there is an article that you are not sure you will find interesting, or a song that you are not sure if you will like, you can try it out without additional cost.

The problem with this model is that if you don't access much content, it is not worth the money. Also, each library has a limited amount of content. Rhapsody doesn't have rights to all music out there so you still might need other ways to access music. The cable company has different tiers of service which give you access to different channels. If you would only watch a particular channel once a month, it would not be worth paying for access to it, but this is unfortunate as there would be no additional cost to the cable provider for allowing you access. A trend toward larger libraries (for example a single subscription that allowed access to all online newspapers) would cut down on this problem.

Netflix has over 6 million subscribers and revenues of $1 billion a year. The Wall Street Journal has close to 1 million online subscribers paying $100 a year. HBO has 28.7 million subscribers and profits of $1 billion a year.

Piracy by end users takes the form of illegal access. This could be sharing a username and password to an online service, republishing an article for free access on the internet, or using a descrambler cable box. Piracy by bootleggers would occur if there was a subscription service that didn't pay the content creators (think of a Netflix in China that had all pirated DVDs). IP laws are needed to prevent these forms of piracy.

3) Tie it to a Physical Good
Examples: books, CDs, DVDs, video games, medical drugs

In this model the digital content is tied to a physical good which is then sold. The content creators are compensated from the sale of the physical good. Because it is a physical good, it is rivalrous and therefore easier to control and sell.

The amount of value that is in the physical vs. the digital portion of the good varies, and some goods couldn't exist without their physical version. For goods such as CDs, DVDs and video games the value is all in the digital part. For goods such as books and magazines, there are digital alternatives, but much of the value is in the physical. For goods such as food, clothing, medical drugs and cars, the vast majority of the value is in the physical (the digital part of these goods being the recipe, the style, the drug design and the engineering, respectively).

For some goods, giving the digital version away for free allows for more copies of the physical version to be sold (the digital version acting as advertising). For example, one could sell books and at the same time allow a .pdf version of the book to be available for download free.

"Free sells books," affirmed Dan Weiss of Barnes & Noble's study guides, SparkNotes. "Everything that's in print is free online," he said, and over half his site's traffic comes from Google search.
Some musicians give .mp3 files away for free and charge for CDs. In fact researchers in Canada have shown that the piracy actually boosts CD sales, with one additional P2P download per month increasing music purchasing by 0.44 CDs per year.

IP is not available to the fashion or restaurant industries. Food and clothing sales support the designers and chefs as they create new styles and recipes. It is legal for a chef or designer to "steal" the work of their competitors. These industries are full of innovation, but it is not clear if lack of IP is a hindrance or a boon to those designing new clothes and new recipes.

End user piracy depends on how much of the good's value is digital. For goods that have a digital format that contains most of the value, such as music and software, the digital portion can be ripped from the physical one and then traded via file sharing.

Besides ripping it is also possible to make illegal copies of the physical goods themselves, such as copying a CD. One way to combat this is to add a levy to all blank media like CD and iPods that can be used to copy digital goods like the Canadians do. The proceeds from the levy are split among songwriters, performers, and record production companies. Even if Canadians are obtaining their music through file sharing and copying, the artists still get compensated.

As more of the value of a good is in the physical rather than digital, the less likely end user piracy is. With magazines and books, for example, it is often times more expensive to make photocopies of books or magazines then it is to just buy another one.

Second hand sale of these goods, such as used books on Amazon, could also be thought of as a form of piracy in that they do not compensate the content creator. On the other hand the argument could be made that people will buy more hardcover books if they know there is a resale market for them (allowing them to just ebay rent the book). Used CD seller LaLa deals with this issue by donating 20% of revenue to music foundations. Similarly loaning CDs or books to friends, could be thought of as piracy to the extent it lessens how much you buy.

Piracy by bootleggers of physical goods is rampant. Music CDs, movie DVDs, and books can all be purchased from bootleggers at lower prices which do not compensate the goods creator. Unpurchased software is often loaded on new computers.

Even in goods where most of the value is physical, bootlegging takes place in the form of stealing trade secrets and patent theft. Drugs under patent can be produced without compensating the drug discoverer. New engineering on cars can be stolen and added to a competitor's version. IP laws are needed to stop these forms of bootlegging.

4) Advertising
Examples: Google, NBC, commercial radio, Boing Boing

In this model, companies pay for access to eyeballs in order to sell their product. Part of this revenue funds the digital content creation. The content is available to everyone and the consumer does not have to pay for it, with the exception of their time to view the advertising.

Advertising is a major funder of content, supporting TV, newspapers, magazine, radio and many websites. But, this model is limited by the amount of money that advertisers are willing to pay. Currently there is a $177 billion domestic ad budget, and a $550 billion global market. This includes $46.6 billion in print advertising, $54 billion in TV advertising, and $16.4 billion in online advertising. Even video games are getting into the action with $76 million in advertising. An economy can only spend a certain percentage on advertising, which limits how much content can be funded with this method ($177 is 1.4% of the $12 trillion US economy). But, this is much more than the $10 billion video game market, $12 billion music industry, $25 billion book publishing industry.

Because it is free, the content is accessible to everyone and there is no reason for end users to pirate it. But, as money is only generated when people view the advertisements, not watching the ads (perhaps with the help of Tivo) could be thought of as a form of piracy. If enough people did this it would ruin the model.

To ensure that those receiving the advertising (NBC) support those who make the content (The Office), IP is needed to stop bootleggers. Otherwise, anyone could display the content (or copy it) and make advertising money off it and not compensate the creators.

5) Sell An Accompanying Service
Examples: concerts, book lectures, consulting, teaching

In this model you give the digital good away for free (the music, the software, or the written material) and charge for a corresponding service. The digital goods work as advertising for the services you can provide, and creating them gives you expertise. Purchases of the service support the creation of the digital good.

For example, with software you can allow everyone to download it for free but charge for customization, consulting and support as seen with Red Hat Linux. With music you can give your songs away for free but charge for a concert as demonstrated by Prince. Concerts generated $3.1 billion in revenue in 2005 and $9 billion worldwide. With written material you can allow free downloads but charge for lectures. With science you can give your research away for free but charge for teaching.

Because the content is given away for free, anyone who wants the digital good can have them, it doesn't require IP and piracy is impossible. The downside of this model is that since the creator gets paid for the service and not the digital good, the amount of time the creator can spend developing them is limited.

6) Donation
Examples: shareware, blogs, WWF reports

In this model, the content creator is supported by donations from individuals, foundations or corporations. This model allows everyone free access to the content. It therefore does not require IP and piracy is impossible. The downside to this model is that the number of people who choose to donate might be small and therefore not be able to support many content creators.

American's donated $260 billion in 2005. While non-profits spend much of this money on goods and services, part of it goes to create digital goods such as report by the WWF on the Living Planet Report.

Shareware is another example of donation funded content creation. It is similar to charging for the digital goods directly (#1), but people decide how much to give. Those that have more money or derive more benefit can give more, while those with less money or don't really use the software much can use it for free.

Ongoing blogs and magazines, can also fund themselves by donations. In this case it is similar to the subscription(#2) and service (#5) models, but people decide how much to give rather than having a fixed price. The funding allows for the ongoing creation of content.

7) Government Funding
Examples: Science research, libraries, BBC, C-Span

This is similar to the donation model(#6), but money put into the system is based on taxes. The government pays for the content to be created which is then made freely available to all citizens. In this model, IP is not needed. The amount of funding and the number of digital content creators is determined by the political process. Piracy take the form of those who avoid paying the tax.

Donations have a free rider problem, where everyone benefits regardless of who pays. Government can solve this problem by imposing a tax. A tax makes sense if a majority of people would be willing to pay but only if others are forced to do so as well. On the other hand, a blanket tax will charge even those who don't use the digital goods.

One example of this model is science research. The federal government spent $25 billion on academic R&D funding in '03. This funded science research which was then available to other scientists and citizens. Well, except that most academic journals end up charging for access, but hopefully that will change with open source journals such as Public Library of Science.

Public libraries are another way the government helps to fund content creators. $1.1 billion was spent on public library collections in the US in 2003. The money spent purchasing books, CDs and DVDs supports those content creators.

The BBC collects a £10 monthly license fee on every TV in order to fund the BBC and allow for 8 TV channels free of adverts (that's English for commercials) and independent of advertisers, shareholders or political interests. The content from the BBC is then available for all to use in non-commercial ways as they see fit with the BBC Creative Archive. Piracy here takes the form of those who don't pay for the TVs they have.

There is currently an idea in the EU to tax broadband Internet and mobile phones around €4/month and allow consumers to download and consume all the music they want without DRM.

8) Volunteer
Examples: Linux, Wikipedia, Flickr, Blogs, YouTube (user generated content)

This isn't really a funding method as no one is getting paid (or you could think of it as the creator paying himself to make the digital good). Instead the digital content creators do so for non-monetary reasons such as status, enjoyment or experience. These content creators must have jobs elsewhere in order to support them. That job could have something to do with the content they create (see model #5) or it could be completely different.

There were 19.9 billion hours volunteered in 1998. If every American spent 1 hour a day creating content, that would work out to 110 billion hours a year which is only a little less that 1/2 of the approximately 250 billion hours of paid work performed by the US workforce a year. As I wrote in the Hybrid Economy, volunteers can make up a substantial portion of content creators.

Digital content created by volunteers is accessible by everyone and does not require IP.

The main problem with this model is that volunteers must have another way to support themselves and can only work on the digital goods creation part time. If they are really good, society would be better off if they were working on it full time.

Pirated content such as .mp3 file sharing could be thought of as a type of unintentional volunteering. The user gets to listen to the music, but the creator doesn't get compensated. The RIAA estimates they "donate" music worth $4.2 billion a year. An interesting idea would be to change the tax code to allow them to write this off as donations.


There are 8 funding models for digital goods creation:
1) sell the digital good directly, 2) sell a subscription to an unlimited use library, 3) tie it to a physical good, 4) advertising, 5) sell an associated service, 6) donation, 7) government funding, 8) volunteer.

It is also possible to combine models. For example, cable TV uses both subscription and advertising. PBS is funded via donations and government funding.

Content creators can use any one or possibly all of these methods to fund their work. Musicians, for example, can be compensated using all 8 models: iTunes, Rhapsody, CDs, advertising based radio, concerts, donation based .mp3s, EU music tax, and free .mp3s. Different content creators might choose different models based on how they like to work and whether they are trying to maximize the amount of money that they make of the number of viewers of their content. Of course, not all models might be available based on the type of digital good and the IP laws regarding them.

Funding models are also likely to change as technology changes. Software used to be distributed by floppy disks and the physical model made sense. Now with the internet more models can be used such as subscription, volunteer, direct digital good sale and advertising. TV went from an advertising only model to a subscription model with cable, and radio is making the same progression with satellite radio. Newspapers need to change their model with viewers going online, but what exactly that model will be is not yet clear.

Philosophical outlooks could also determine which model is used. When it comes to developing new medicines, the NIH could do the drug discovery (funded via taxpayers) and then have the drugs sold as generics at the price of production or drug companies could fund the drug discovery and then sell the drugs at higher prices to customers (selling a physical product using IP laws). While both models have their pros and cons, academic scientists might prefer the government funded solution, while business men might prefer using IP for philosophical reasons.

As a society we need to balance the right of creators to be compensated with the right of end users to access digital content. This means looking at IP laws to make sure they are strong enough to encourage creation but not too strong to limit access. It also means taking a look at each industry and seeing if other models might allow for more content to be created.

I will leave you with some questions I was unable to answer. If anyone has any thoughts on these, please leave a comment.

1) How much money is spent, how much content is generated and how many creators are supported by each of the 8 models?
2) Under what scenario is each model the best choice?
3) How do you measure the output? Does GDP capture it, or do digital goods require a different way to measure as the often are priced at zero? If Rhapsody's library goes form 50,000 songs to 500,000 songs, how do you value the greater access to consumers?
4) How do you determine the socially optimum number of full time content creators?

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