The Knockoff Economy

by Kal Raustiala

  As many studies have found, individuals are very bad at assessing their own future prospects. They have a pronounced optimism bias.36 They think they will succeed where others have not, and they heavily discount the prospect of failure. Nearly all newlyweds, for example, believe they will not get divorced, when in fact a large minority will—and often within a few years. Likewise, students wildly overestimate their likely grades, even in the face of stiff competition. Like the residents of Lake Wobegon, we all want to believe we are above average.

  Optimism bias has been shown to apply broadly to life events, and there is no reason to think it does not also apply to innovation.37 Indeed, two laboratory studies conducted by one of us (Sprigman) and Christopher Buccafusco of the Chicago-Kent College of Law showed that creative artists believe their work is far more valuable than do potential buyers.

  In the first study, several hundred subjects were given the opportunity to buy and sell chances to win a haiku contest. The subjects were randomly assigned to be Authors or Bidders. Authors were told that they would be competing in a contest with nine other writers. A poetry expert would select the winner, who would receive a $50 prize. Each Bidder wrote down the amount he would be willing to pay to purchase a specific Author’s chance to win. Similarly, each Author wrote down the amount she would be willing to accept.38 On average, Authors were willing to sell their chance of winning the haiku contest for $22.90. But Bidders’ average willingness to pay was less than half: only $10.38.

  These results are consistent with the hundreds of other studies that have confirmed optimism bias in a wide variety of settings. Authors believed that they were roughly 30% likely to win a contest where in reality they had, on average, a 10% chance. They were irrationally optimistic about the reward they expected.

  These results were replicated with would-be professional artists—painting students from the School of the Art Institute in Chicago. The students were invited to enter a medium-sized painting into a contest. The Painters were told that they would be competing with nine other entrants for a $100 prize judged by an expert. Each Painter was matched with one of 10 additional subjects acting as Bidders.

  Here too there was a huge gap between bidders and creators—in fact, the gap was quite a bit larger, which suggests that would-be professional creators tend to over-value their work even more than do ordinary people. The Painters demanded on average nearly $75, while the Bidders were willing to pay less than $18. And again, the biggest cause of the widely diverging variations was over-optimism. Painters believed that they had more than a 50% chance of winning the contest. The real number, since there were 10 of them, was (on average) 10%.

  We see behavior like this all the time. Most people think they’re a better-than-average driver, not to mention smarter than average. And the haiku and painting experiments suggest that creators may be even more prone to this sort of optimism bias. Optimism bias, in short, leads many innovators to think they will gain a greater return from their intellectual creations than they actually do.

  Why is this important to understanding the interaction between copying and creativity? Because optimism bias likely acts as a subsidy for innovation. Creators who have an unduly strong belief in their ultimate prospects for success should be willing to invest more in their creativity. And this increased willingness to invest is likely, in turn, to lead to increased creative output as compared with a world in which creators rationally calculated the odds—odds that may include expected losses from copying.39

  We began this Conclusion by noting that many artists and inventors toil because they are driven to, not because they expect riches. But many do expect—or hope—for some tangible reward. For these people the widely noted phenomenon of optimism bias is as likely to work its magic as effectively in the creative world as it does in assessments of marriage or job prospects. They expect more, and so they work to create more.

  Tournament Markets

  There is another important, and related, factor that skews how innovators assess their expected return on innovation. Many contemporary markets for creative goods are what economists call “winner take all” or “tournament” markets.40 In these markets, a huge reward goes to a few at the very top—the superstars—while much less goes to those just below them. This dynamic is easy to see in areas like professional sports: just think about Major League Baseball, where the very best players receive enormous salaries, while those who are merely excellent languish on AAA farm teams, earning a tiny fraction of what the true stars do.

  Tournament markets amplify small differences in performance into enormous disparities in reward. Given this basic dynamic, we might expect people to shy away from competing in markets like these—the risk of failure is great, competition can be very intense, and the difference between success and failure hard to determine until years of effort have been invested. Yet we see large numbers of individuals competing to become a sports star, a national politician, a CEO, or, most important for our purposes, a musician, writer, or inventor of the next huge Web concept.

  Many markets for creative goods are tournament-like. A hit song can yield huge sums for the right creative artist. Yet the vast majority of songs go nowhere, commercially speaking. Likewise, books and screenplays can rake in enormous revenues if they are truly successful, but New York and Los Angeles are awash in the tens of thousands of authors who tried and failed. Perhaps the best example is in the realm of patent. Whether it is a new drug or a new widget, “the firm that wins the patent race is awarded a patent and even a close second-place finisher earns no reward whatsoever from the patent system.”41

  As this suggests, the tournament nature of creative work is to some degree driven by IP law: patent and copyright, by creating the reward of a lucrative monopoly, help to make the market tournament-like. If others could copy the good without restraint, the size of the “prize” will not be nearly as great, since there will be more and stronger competition. But this is not an all-or-nothing phenomenon: we see tournament effects even in markets featuring a substantial amount of copying.

  Fashion, for example, is not a winner-take-all market; it is more like a winner-take-most market, in which the winning designs are effectively “shared” with other competitors, making the entire market a bit less volatile.42 Yet even in the fashion industry there is a big disparity between the superstars and the also-rans, with the top designers and brands raking in outsized profits. Tournament markets require that winners appropriate at least some of their winnings. But complete appropriability is not required. Markets like fashion and food, in which there is relatively little IP, suggest that high levels of IP protection are not essential for the tournament dynamic to take hold.

  Like optimism bias, tournaments induce more investment than is rational. So both optimism bias and tournament markets push innovators toward high levels of innovation. And this makes innovation more resilient to copying. Why? Copying may lower individual innovators’ return (even if it raises the overall return of a given industry). If creators rationally calculated their returns, the prospect of being knocked off might dissuade them from creating in the first place. But if they instead overestimate their returns, as so many of us seem habitually to do, they may still have sufficient incentive to invest in creation.

  To be sure, these effects are hard to measure. There is good reason, however, to think they are not insignificant. With respect to optimism, just think of the painting study, which found that painters were, on average, five times more optimistic than they would be if they were accurately calculating the odds.43 And with respect to tournaments, just think of the ultimate tournament game—the lottery. People are drawn to the lottery in droves, even though it is clearly, on average, a losing bet. Tournament effects are powerful, and even if they cannot be precisely measured, it is hard to believe that they do not drive creative activity as well.

  The important point is that both of these effects exaggerate anticipated benefits. And it follows that exaggerated expectations of benef
it will tend to keep innovation buoyant, beyond what a rational calculation of return would predict.

  The Costs of Creation

  The supply of innovation depends not just on anticipated benefits but also on expected costs. As innovation gets cheaper and easier, we should see more of it. As we noted earlier, not all innovation costs the same. Yet these costs are not fixed; technology can lower the costs of innovation in many industries, sometimes dramatically.

  Consider music. Not that long ago—as recently as the mid-1990s—producing an album required an expensive studio and skilled engineers. Today artists can produce music at home using a computer loaded with Pro Tools, Abelton Live, or even Garageband, which comes free on Apple computers. These tools have markedly reduced the cost of producing music. Perhaps more important, the cost of distribution has also fallen tremendously. Distribution in the music business used to be complex—recording tapes were transferred to vinyl (or later compact discs) and then shipped around the world to record stores. Today, digital files can be instantly uploaded to an artist’s Web site, or to a commercial site like iTunes, and distributed easily anywhere there is an Internet connection.

  Sometimes technological advances like these make it possible for one person to do what many did before, as with music recording. Other times they allow many individuals to do what one (or a few) did before, by permitting large-scale tweaking (as in Wikipedia) and more generally what might be understood as open-source production or “crowd-sourcing.”44 Perhaps the most important effect of technological change, however, is how it reduces the cost of making and distributing creative work.

  A great example of this is the recent effort by comedian Louis C.K.—he of the Dane Cook joke-copying powwow described in the Introduction—to offer a comedy show directly to fans for download. Louis C.K. produced and filmed the show himself, and sold it for an inexpensive $5 per copy. As he wrote to fans on his Web site, $5 is

  less than I would have been paid by a large company to simply perform the show and let them sell it to you, but they would have charged you about $20 for the video. They would have given you an encrypted and regionally restricted video of limited value, and they would have owned your private information for their own use. They would have withheld international availability indefinitely. This way, you only paid $5, you can use the video any way you want, and you can watch it in Dublin, whatever the city is in Belgium, or Dubai. I got paid nice, and I still own the video (as do you).45

  Louis C.K. recently stated that he’s collected more than $1 million from sales of his self-released comedy show. The success of efforts like this (and Louis C.K. is not the first nor, surely, the last to try this approach)* is obviously bad news for distributors like record companies. But it is great news for fans, and if Louis C.K. is to be believed, great for artists as well. Similar if less marked changes in film, literature, and even areas like fashion and financial innovations have also significantly reduced the costs of both creation and distribution.

  This fundamental shift in the cost of distribution has two very important effects. One, if the costs of creation are lower, the expected returns that are necessary to spur innovation can also be lower. And that means the creator can absorb more copying-related losses without erasing the incentive to innovate. Two, lower costs permit lower prices, and lower prices make consumers more likely to buy and less likely to copy. The price of an item (like an album or show) can now be so low that many people are happy to just pay it and not bother illegally copying—even if illegal copying is easy to do.* The phenomenal success of Apple’s iTunes illustrates this latter principle well. There have been over 16 billion paid downloads since the service began, in an industry that is the self-proclaimed poster child for illegal, Internet-enabled copying. Make it cheap and easy enough, and crime just doesn’t pay any more.

  Now, new digital technologies have made illegal copying easier as well, so the aggregate effect of technological change is not clear (and hard to measure accurately, in any event.) Still, the beneficial effects of technology are often ignored, and any serious analysis must consider them.

  The key point here is simple: many of the same technologies that promote piracy also promote creativity. Technological change can and often does make innovation cheaper, and it is Economics 101 to note that lower costs generally lead to higher production. This is one more reason to think that, in our current technological environment, copying is not nearly as fearsome a prospect as many believe.

  WRAP UP

  Let us recap our argument briefly. In this book we have explored many industries where creativity is sustained even though copying is common and often legal. These industries are not dying; they are thriving. This is a mystery for conventional thinking about innovation and the role of intellectual property, which rests on the belief that imitation kills innovation. Explaining why fields like fashion, fonts, and finance remain creative despite pervasive copying is the major puzzle that animates this book.

  We have described these industries and have drilled down into the details of how (and why) they work. In this conclusion, we’ve sketched six broad lessons drawn from these varied case studies. No one lesson applies to every industry we have looked at. But together, they help explain why there are so many successful industries that exhibit both imitation and innovation. And, we hope, they offer a set of ideas for making other creative industries—even those that have traditionally relied heavily on copyright and patent to battle copying—more resilient to copying. Finding workable sources of resilience is essential because, whatever you may think of copying, it is not going away.

  In the last few pages we brought two other factors into the equation. First, innovation, like any economic good, is the product of costs and benefits. The benefit side encompasses more than just money; many create out of love or compulsion. But over the long term, financial expectations matter, and there are many reasons to believe that innovators are overly optimistic when assessing benefits. The tournament market qualities of many creative industries accentuate this bias. Like a subsidy, these twin forces act to promote innovation.

  Second, in the debate over copying, the cost side of creation has been given little attention. Technology can certainly lower benefits by enabling copying. But it can also lower the costs of innovation and distribution. Like raising returns, lowering costs can turn an “unprofitable” act of innovation or distribution into a profitable one. Which effect is more powerful depends on the industry and the technology. But to date, the focus has almost entirely been on the downside of technology. We see a substantial upside as well.

  All of these observations point in the same direction: toward a perhaps counterintuitive, but fundamentally positive, message. As we have shown in a wide range of fields, creativity can persist even in the face of widespread copying. Indeed, in some instances creativity occurs because of copying. In short, copying has underappreciated virtues. And even when copying is neither benign nor beneficial, it is often not nearly the threat many perceive. The knockoff economy already exists. The important question is how to understand, and ultimately harness, the power of imitation to further innovation.

  EPILOGUE: THE FUTURE OF MUSIC

  Sean Parker (co-founder of Napster): I brought down the record companies with Napster….

  Eduardo Saverin (co-founder of Facebook): Sorry, you didn’t bring down the record companies. They won.

  Sean Parker: In court.

  Eduardo Saverin: Yeah.

  Sean Parker: You wanna buy a Tower Records, Eduardo?

  —The Social Network, 2010

  Copying has been the bane of the music industry for many years—well before Napster, or even Sean Parker, were born. But something changed in 1999. That was the year that the first online filesharing service, Napster, exploded.

  Suddenly, millions of people were sharing music freely with one another. In the eyes of the recording industry, this was mass criminality and a grave threat. The industry reacted swiftly. It lobbied governments to streng
then intellectual property protections. It hired more lawyers. And it tried to use the courts to stop Napster. These strategies had some success. Congress passed increasingly restrictive laws, and the courts ruled in ways favorable to the record companies. But these victories were superficial and barely dented the problem. Filesharing—that is, copying—continues on a mass scale, and copyright enforcement appears ever more expensive and less effective. The future path of technology is impossible to predict, but if the past is prologue, tomorrow’s technologies are likely to make copying even harder to stop.

  In this Epilogue, we’ll look at the music industry’s long-running battle against mass copying. In a decade, the industry’s revenues shrank by over 60% (adjusted for inflation) as millions of fans took for free what they used to pay for. Today, the music industry’s revenues continue to plummet and piracy continues, largely unabated. And yet—this is crucial—musical creativity is flourishing. It is not far-fetched to say that music, in the midst of its alleged decline, is more creative than ever.

  The story of the music industry’s war against online piracy has been told at length elsewhere.1 But we do want to use the basic outlines of the story to make two important points.

  First, copying has clearly harmed some parts of the music industry. Yet music itself is not going to disappear. In fact, quite the opposite: some of the very changes that enabled widespread copying of music have also dramatically lowered the costs of producing and distributing new music. That is one reason the supply of new music is up, not down.

  Second, the music industry’s plight is not irreparable. Perhaps the industry can restructure itself by mimicking some of the practices of industries such as fashion and comedy. This new tack can be a useful supplement to vigorous copyright enforcement or, in some instances, can substitute for it. The music industry can change the way it works, with the goal of building resistance to copying—and perhaps even the ability to benefit from it—into its business model.