Will We Get a Second-Hand Market for Digital Goods?

Harvard Business Review

When the U.S. Supreme Court rendered its decision on Kirtsaeng v. John Wiley & Sons, it dipped a toe into waters that run much deeper. As I discussed in an earlier post, that case addressed the question of whether a book buyer, having taken ownership of a physical book, is at liberty to turn around and sell it. But that question is, to slightly mix metaphors, only the tip of the iceberg. The decision says little about the much bigger fight brewing over ownership of digital products — e-books, digital music files, and electronic copies of movies and software.

Does the "first sale" doctrine the court applied in Kirtsaeng also apply to these goods? Do consumers have the right to resell songs purchased from Apple's iTunes store, or books downloaded to their Amazon Kindles, or other media accessed entirely through the cloud — goods, that is, of which they never took possession as a physical copy, standalone or embedded? What role will first sale play in a future where all information products, like software, are increasingly produced and distributed entirely through the cloud?

For the past decade, emerging digital markets have operated under the assumption that, despite the obvious similarity between a music CD and an MP3 downloaded from iTunes, digital goods are different. Despite what is often sloppy use of terminology, Apple, Amazon, and others maintain that you don't "buy" a copy of an e-book, nor do you "own" the music in your iTunes library or the copies of apps loaded on your mobile phone. You rent them. Or, to use the legal term, you license their use.

How does that happen? The short answer is through terms-of-service agreements and other click wrap. When you check the "I agree" box, you enter into a contract with the seller, including a litany of conditions that restrict how you can make use of the licensed good. Depending on the license, that includes how long you can use it, how many users can simultaneously access it, and, notably, what rights you have to transfer your license to someone else.

The short answer to that last question? In most cases: no (re)sale.

The disproportionate bargaining power of licensors and licensees aside, there are sound economic reasons why producers of digital media have insisted — so far successfully — on licensing rather than selling their goods. In brief, resale markets are dangerous, especially for information goods. If they are particularly robust, they can drive down the price for first sales, undermining the opportunity for copyright holders to recover their high sunk costs. Which is, in turn, the whole point of copyright's "exclusive rights" in the first place.

Publishers and media companies may not have worried much about second-hand stores when it came to physical goods. Used physical goods deteriorate rapidly and, in the days before near-perfect market information, were relatively hard to find. Since media purchases are often impulse buys, customers tended to be willing to pay a premium price to avoid even a short delay — buying hardcover instead of paperback. Likewise, many music lovers are willing to just click the "buy" button for a music track rather than wait for the song to come around again on Pandora.

But a digital copy of the latest "Iron Man" movie is a perfect replica, and infinitely reproducible at a marginal cost of zero. Stored in the cloud, it will remain a perfect copy so long as there is software that understands the format it's been encoded into. (Which may not be as long as nervous media executives think.) An unrestricted ability to resell could, therefore, easily lead to efficient second-hand markets that directly compete with first sales. The result could be, ironically, less original content in the first place — a lose-lose outcome.

So the media industry's slow acquiescence to allow their copyrighted works to be distributed in digital form at all has come with the quid pro quo that reselling is forbidden. In theory, consumers have implicitly traded the right to resell for a lower price and more content to choose from.

Courts have so far upheld license terms that forbid resale against arguments that they violate "first sale." Kirtsaeng, as copyright scholar Eric Goldman notes, is of no help. In the licensing of digital goods, after all, there was no sale, not even a first sale. Just a rental.

But even if courts and legislatures continue to support licensing agreements that bar resale, that doesn't end the discussion. Market pressure has long been building for changes in the relationship between media companies and their customers, and customers are gaining the upper hand, thanks again to near-perfect market information. Many of those customers prefer, if only for sentimental reasons, to own rather than to rent their digital goods. Today, they cannot do so — at any price.

Several start-ups have foundered on the rocks of copyright law trying to bridge the gap. In 2000, for example, MP3.com lost a life-or-death case over a service that allowed consumers to "register" music CDs they owned and access the contents from the company's servers. The court found that whatever the "equities" involved, MP3 could not lawfully make and distribute copies without permission "simply because there is a consumer demand for it."

A more recent start-up, ReDigi, is now facing its own existential struggle with copyright law. The company's beta service allows users to barter MP3 files licensed from iTunes (and soon other digital sellers) to other ReDigi users at discounted prices. In effect, ReDigi operates a market for license transfers among iTunes users.

According to the company's website, the value of such transfers can only be used to acquire other licenses — users cannot cash out whatever price they can get from each other for used iTunes licenses. They are simply "recycling" their music purchases. Everything stays within the iTunes universe.

Not surprisingly, the company's self-imposed limits didn't satisfy the highly litigious music industry. Capitol Records quickly sued the company, and the case now awaits decision in a New York federal court. Capitol argued that the service necessarily makes copies of protected works without permission — straight-up copyright infringement. ReDigi argues that no copy is made — that it transfers the "exact file" from the seller's device to its servers. More to the point, the transfer of the licensed file does not violate the copyright holder's exclusive distribution right, because, like Dr. Kirtsaeng, they are immunized by the first sale doctrine.

ReDigi is another good example of a business model I would call "barely legal by design." Here, the company is putting its eggs entirely in the "first sale" basket. If the court decides there is no "particular copy" that an iTunes customer "owns," the first sale defense will fail. It's hard to see how the service can continue in that event. For what it's worth, the relevant case law, if applied, bodes poorly for the startup. (The company did not respond to a request for a comment.)

But even if ReDigi becomes the latest casualty in the war between media companies and their customers, it will hardly be the final word. The merchants themselves may find that a carefully designed second-hand market can generate profit without undermining primary markets. According to a recent New York Times article , both Amazon and Apple have filed patent applications for systems that would create digital resale systems, at least for the digital goods they respectively market. (Amazon's patent has already been granted.)

Reading between the lines of the applications, the companies seem to have in mind markets that would allow their customers to transfer licenses to other customers within the system. You might someday be able to trade, sell, rent, or even loan out your Kindle books to other Kindle readers, in other words, but only under the watchful eyes of Amazon.

Will that be enough? Perhaps you, like many consumers, have a visceral reaction to the very idea that you have not purchased but merely rented your digital goods, and under highly restrictive terms. "I bought it," you might be thinking even as you read this, "It's mine. And I can dispose of it any way I like." That, of course, is the essence of the consumer mindset, one that manufacturers have strongly encouraged ever since the Industrial Revolution made possible identical, cheap goods sold at fixed prices.

But operating in parallel with the consumer paradigm, there have always been markets for licensed goods. When you buy a ticket to a movie, you are licensing the use of a seat in the theater, for one particular showing of the film. Your ticket is yours to keep, but it doesn't give you the right to watch the movie again, or to sell someone else that right. No one feels outraged or cheated when they have to vacate the seat.

That's the only workable model, content companies believe, for digital goods. As books, entertainment, and software are being distributed less and less in physical media, the companies argue that what you are paying for is much more like a movie ticket than a manufactured gooda limited right to use, but nothing to own. You can listen to the music, read the book, watch the movie, or access the software. But only at agreed-upon times and places.

Economically, they may be right. If so, however, the reeducation of consumers from buyers to renters will be a long, uphill battle. Consumers will resist, and start-ups will try to push the legal envelope to help them. The courts, in any case, are on the side of the incumbents. At least so far.

Long term, however, media companies can take heart in the realization that our digital future is one in which the benefits of owning for consumers are being quickly outweighed by the costs of storing, maintaining, and replacing quickly outmoded and inferior versions. Licensing is also more flexible than ownership, and that could mean that in the future we'll see more rental options (pay-as-you-go, all-you-can-eat, subscriptions, ad-supported, hybrids), each with its own price.

We may be more comfortable emotionally with ownership, in other words, but may soon come to see the superiority of licensing. For ourselves, not just the producers.
Author Kevin Kelly argued in a provocative 2009 essay that the very idea of ownership for digital goods is an anachronism, an unnecessary and expensive way of thinking about information which is quickly losing relevance. Indeed, says Kelly, usage rights are far more consistent with the economics of information than the ownership of copies. "An idea can't be owned in the way gold can; in fact an idea has little value unless it is shared or used to some extent. Its value paradoxically can increase the less it is owned privately. But if no one owns it, who gains the benefit of that increase in value? In the new regime users will often assume many of the chores that owners once had to do. And so in a way, usage becomes ownership."

Kelly may be further up the evolutionary ladder than the rest of us. For many consumers, outright ownership still matters, whether an information good takes physical form or not. So it should matter to them, too, what role the courts and legislatures play in deciding how such questions are resolved.

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