Piracy on the Internet: Accommodate it or fight it? A dynamic approach

This paper uses a dynamic stochastic model to solve for the optimal pricing policy of music recordings in the presence of P2P file-sharing networks eroding their sales. We employ a policy iteration algorithm on a discretized state space to numerically compute the optimal pricing policy. The realistically calibrated model reflects the real-world figures we observe and provides estimates of the optimal pricing policy as well as comparative statics figures. The pricing policy is such that, for a given P2P network size, prices are increasing in the number of buyers of the product and, for a given number of buyers of the product, prices are non-monotonic in the P2P network size. Surprisingly, in the presence of P2P networks, increases in production costs and decreases in the valuation of the product increase the consumer and total surplus. A higher valuation of the product leads to a lower steady state price. Increased switching costs have a negative effect on prices and profits, so the long term incentive to attract new consumers dominates the short term incentive to harvest loyal consumers. The full enforcement of intellectual property rights has adverse effect on both consumer surplus and total welfare.