Managing Piracy: Pricing and Sampling Strategies for Digital Experience Goods in Vertically Segmented Markets

Abstract

This paper models the pricing of digital experience goods such as online video in a vertically segmented market under threat of piracy. By definition consumers know the true fit of an experience good only after they have consumed it and piracy offers an illegal consumption method. We develop a two-stage model of piracy where some consumers pirate in the first stage thus updating their perception of a product's fit while deciding to keep the pirated copy or buy a legitimate one in the second stage. Our results show that the effect of piracy can be mitigated by suitable pricing strategies and some externality benefits of piracy can be internalized through product sampling. Counter to intuition, we show that losses due to piracy are more severe for products that don't live up to their hype rather than for products that tend to be valued in the market, thus requiring a greater investment in deterrence for the former. Further, our analysis points out that sampling strategies are optimal only under narrowly defined conditions for vertically segmented digital experience products, unlike physical goods where sampling is always beneficial when valued attributes have been underestimated by consumers.

Keywords: Digital products, experience goods, pricing, piracy, sampling

JEL Classification: D42, D82