Argh, kiddies!  Today we’re going to be taking on a particularly contentious issue in modern day society: Piracy!  So, polish up those peg legs, get out your eye patches, and teach your parrot to say ‘Walk the plank, you bilge rat’, because today is all about the costs and ethics of piracy!

Well, actually, the type of ‘piracy’ we’re looking at today has less to do with stealing doubloons from passing galleons and more to do with illegally downloading music, movies and software.  While not quite as romantic (well, at least until Johnny Depp portrays a software copyright infringer in a movie), it is probably more pertinent to the modern reader (those who will be passing by Somalia aside). The ethics of the issue are a bit outside my per view (to paraphrase DeForest Kelley as Dr. McCoy, ‘I’m a money blogger, not an ethicist’), but, since I’m always up for a spirited debate, I figured I’d dive into the money portion of the piracy debate.  Just how much impact does piracy have?  To find out, let’s look at the numbers.

The Economic Impact of Piracy

An odd thing happens if, like me, you start to search for solid, reputable numbers on just how much of an economic loss piracy causes modern society: you find them nearly as hard to pin down as a greased pig.  The most commonly cited numbers of both overall economic loss and the number of jobs lost as a result of intellectual property are $250 million and 750,000 jobs, respectively, which certainly sounds like quite an impressive amount.

"Avast, Ye Scurvy Bilge Rat!"

But the truth is that those numbers are, well, fabrications.  A rather detailed report on Ars Technica notes that neither of the organizations most commonly cited as the source of the given numbers (the U.S. Customs and Border Patrol for the job figure, the Federal Bureau of Investigation for the economic loss) have anything to do with creating them.  In fact, the best source for reliable numbers on both counts, a survey done by the International Trade Commission, indicates losses to the economy of (at most) $61 million and 13,774 jobs, and this report dates back to the Reagan era (no more recent reports seem to be available).

Why the wide discrepancy?  Well, given the illicit nature of piracy, it’s awfully hard to come up with accurate numbers, and there are numerous problems with trying to do so.  First, most figures for the loss caused by piracy typically use self-reports from the businesses affected, whom, as you might guess, have an incentive to maintain that those losses are quite substantial.  Second, there’s the assumption made by most companies that every incident of piracy indicates a lost sale; that is, if there was perfect enforcement of copyright laws, everyone now pirating music/movies/games would go out and buy a copy of everything they currently pirate.  This is absurd, if for no other reason than the fact that people who earn $500 a month simply don’t have to the ability to buy the 50 games/movies/CDs per month that they currently illicitly download.  (Of course, the pirate supporters can take this argument too far the other way, claiming that nobody who currently pirates media would buy anything if they could not obtain it through piracy.  The truth is somewhere in the middle; in a no-piracy world, there would likely be more sales, but not nearly up to the number of copies currently pirated.)  Finally, as Ars Technica notes near the end of their report, the money that pirates don’t spend on the music/movies/games they download doesn’t disappear from the broader economy; it gets spent (or saved or invested) elsewhere.  Calculating the actual loss to the total economy, then, is a much more complicated process than figuring out the number of units not sold as a result of piracy, multiplying by the MSRP, and spitting out a number.

In Summary

So, what does all of this mean for the monetary impact of piracy?  Well, it’s kind of hard to tell, frankly, as both sides of the debate have reasons to over- or underestimate the impact to make it seem like their side is more justified.  That said, piracy almost certainly costs software and media companies some income, as the pirates don’t always purchase products they pirate; but the costs in lost sales are probably not as high as the company estimates claim.  (Both because not every pirated copy represents a truly lost sale, and because some pirates do end up purchasing the media they really like, although likely not as many as the pirates who claim that piracy enables a good ‘trial period’ would seem to believe).  For larger, established media firms, this undoubtedly leads to a decrease in revenue (although, smaller firms and bands that are just starting out might see a rise in revenue if piracy helps get the word out).  Which explains the rising number of such firms that attempt to use anti-piracy devices in order to minimize their losses, as well as increased pushes for stricter punishments for pirates.

Which side will eventually triumph is uncertain (although my money is on the pirates, both due to their numbers and due to the fact that international law makes catching some of them all but impossible), but the money aspect of media piracy, while interesting, is certainly quite murky.  Here’s hoping that, if nothing else, this article encourages you to take a closer look the next time you hear a statistic about media piracy (or really, any statistic).

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If you’re like many people today, you’ve probably played online games at one point or another.  If you’ve done so in the past 12 years, you might have even played a little game called Starcraft, a strategy game where you control one of three competing alien races.  If you happen to live (or were willing to move) to South Korea, though, you could have made a career of playing and competing against other players.

I’ll give you a moment to read all about the players, their groupies, and their (six figure) salaries (including the fact that the tournaments are attended by more people than the Superbowl).  I’ll give you a few more moments to shake your head in disbelief and contemplate the unfairness of life.  Ready to go on?

As crazy as it is for the players of a computer game to make so much money, it’s really not that unprecedented for the top performers in certain fields to make incredible profits.  Is it really that different (or more bizarre) for players in physical sports (football, baseball, soccer, etc.) to earn multi-million dollar salaries?  Or for top movie actors to have earn millions per movie, while the average actor has to get a side job as a waiter/waitress just to pay the bills?  In all these cases, the top performers benefit from the Superstar Effect.

The Superstar Effect

The Superstar Effect is the economic term for when the top performers in some fields are able to get phenomenally large salaries.  In order for you to be a superstar, your field needs to meet three criteria:

• The market must be fairly large; if only a few hundred people are interested in your field, you’re  not going to become a superstar, regardless of how good you are.  (This is why there are superstar singers, but no superstar nose flutists.)
• Everyone in the market wants the good provided by the top performer.  This is usually not an issue; if all other things are equal, the average person is going to want the goods or services that are the best.
• The good is provided with technology that enables everyone to enjoy the services of the top producer.  (This is why there aren’t any superstar plumbers, but there are superstar singers; wide distribution of songs allows everyone to enjoy the performance of, say, Katy Perry, but plumbers can only fix so many sinks during the week.)

What? I'm a Katy Perry fan.

These characteristics mean that the easiest fields in which to become a superstar are those that involve performing in one method or another.  It’s easy to record something like a a movie (or a professionally played Starcraft game) and distribute it as widely as needed.  The costs of adding one more copy to the number already being produced (the marginal cost of increasing the distribution) is relatively small, meaning that it’s easy to expand the number of people who watch (or play, or otherwise enjoy the product).  The same logic holds for some physical goods, as well; more people want to read the latest book by Stephanie Meyers than alternative books, and so she becomes ever wealthier.

Of course, it’s not possible for every profession to develop superstars; for fields where you need to be there in person (everything from plumbers to doctors to lawyers), it’s impossible to reach true superstar status (at least with our economics-provided definition).  While the market might be large for their skills, and everyone wants service from the top performer, it’s usually not possible for doctors or lawyers to provide service to everyone who wants their help.

The Downsides of the Superstar Effect

In the modern age, though, there are some downsides to meeting the qualifications for being a superstar.  Everyone wanting to enjoy your products, cheap and easy methods of distribution and lots of fans are a recipe for both superstardom and widespread pirating.  It shouldn’t be a surprise that the fields where most superstars develop (music, movies, and other recorded performing arts) are also the fields most afflicted by piracy.

Unfortunately, there’s a tricky balance that needs to be struck.  Too much effort put into making it impossible for pirates to to copy your work can also make it harder for legitimate users to access your products; too little effort can result in your product being rampantly pirated, decreasing your profit.  Finding a balance between these two extremes can be tricky, and you can see how various groups have run into trouble going to one or the other extreme (The RIAA, the Record Industry Association of America, is (in)famous for their prosecution of people who download music from illicit websites; they’re also the butt of numerous jokes and snide comments as a result.)  All of that said, though, it’s the sort of problem I’m sure most of us would like to have; figuring out how to make some money off the incredible throng of people eager to enjoy our products.

That’s the Superstar Effect in a nutshell; the explanation for how superstars can develop in every field from movies to music to yes, playing a decade-old video game really, really well.  Next time someone starts to complain about the outrageous salaries commanded by professional athletes, feel free to point out the salaries commanded by professional Starcraft players and the universal tendency to (over)pay people who play games.

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One of the basic principles of economics is that, in most cases, allowing private parties motivated by personal greed and a motive for profit to make decisions makes for the best results.  If you are trying to sell your car, and I’m attempting to buy said car, we can both get what we want by coming together and agreeing to a price for your car.  No need for outside intervention; since we are both selfish people, we’ll do everything we can to get maximize the benefits from our buying and selling.

However, not all transactions are limited to affecting only the participants.  If our agreement has effects on others, others who are not part of the transaction process, we might end up making a decision that affects them and is NOT the most efficient outcome.  Such an effect on outsiders to a financial transaction is known in economics as an externality, since these effects are related to those external to the financial transaction, the bystanders.

Externalities can be either positive or negative, depending on whether the bystanders benefit or are harmed by the transaction.  Positive externalities include spillover benefits from advancing technologies.  One example would be this blog; the Internet started as a way for the government to preserve information in case of an attack, back in the days of the ARPA-net, and now it’s changed how we communicate and gain information.)  Negative externalities are things like pollution, which affects many people who are not benefiting from the pollution-generating enterprises.  (If it sounds like negative externalities are similar to the Tragedy of the Commons, well, they are related concepts; in both cases, the market fails because not everyone who is affected has a hand in making the decision.)

A commonly cited externality

How are externalities resolved?  Well, the easiest way is by having all the parties involved sit down to negotiate a solution that benefits everyone according to how much value they place on the solution.  This is the heart of the Coase theorem, which states that when there are no transaction costs and trade is possible, a market-based solution to an externality is possible, no matter how the property rights are initially distributed.  If a town is worried about pollution in a nearby lake, the townspeople can negotiate with the polluters and work out a solution that meets everyone’s needs, perhaps by paying a stipend to the company if it is able to reduce pollution below a particular limit.

The Coase Theorem is one method of solving externalities, but it has its limits; high transaction costs (the expense of creating and enforcing a contract, for example), difficulty in performing a trade, or simply a large number of potentially affected parties with different ideas of what constitutes a solution can make a market based trade impossible.  In such a situation, one solution is to internalize the externalities (usually through government action).  Positive externalities can be internalized by allowing those who create benefits for outsiders to capture some of the profits, for example with patents that allow the inventors to market their new developments.  Methods like pollution taxes enable negative externalities to be internalized, forcing a person or business that generate adverse effects on surrounding individuals to consider the costs of those adverse effects in the price of doing business.

Of course, not every externality can be so easily internalized.  Take the effect of a property’s condition on the neighboring house prices.  A well-maintained, beautiful property can prop up the prices of other houses in the neighborhood, while a run-down or ramshackle house can drag down property values through out the neighborhood.  But internalizing the effects of your house’s condition on other houses would be difficult; unless you cut a check for all your neighbors next time you sell your house, there’s few ways for you as an individual to motivate your neighborhood to keep clean and well maintained.  Here again, the government can be a solution, rather than the problem.  Passing ordinances requiring houses to be kept up to a certain standard of cleanliness is one way that governments are able to improve the results of the market.

The moral of the story: while the government is not always the solution, it can play a role in making the market work as efficiently as possible.

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Perhaps the biggest financial news this week was that Australia, the Land Down Under, is the first G20 country to raise interest rates since the current (or just recently passed, depending on whom you ask) financial crisis began.  Yes, earlier this week Australia raised the interest rate offered by their central bank to 3.25% from the previous value of 3.0%, reflecting a strong Australian economy.  But the obvious question becomes: how does this affect me?

Well, if you’re an Australian, obviously what your central government does will have a large impact on your life and your finances.  The strength in your country’s economy indicated by the rise in interest rates will make it a more attractive target for investors, drawing in more foreign money and increasing the value of your currency (in fact, the above linked article noted the increase in the Australian dollar versus the US dollar).  The problem is that such an influx of foreign currency and also lead to bubbles in assets like real estate and stocks, as the foreign investors drive up the demand for your assets.

A satellite's eye view of the Land Down Under

Changes in foreign exchange rates will also affect the import-export balance, particularly in Australia.  For your Australians, this currency strengthening means that imports to your country will cheaper, since you’re trading more expensive Australian dollars for cheaper American dollars, British pounds, Euros or other currencies, depending on your particular trade partner at the time .  The downside, of course, is that your own exports will get more expensive, making it harder for other countries to import products produced by your country.

So, that’s what Australia can expect; what about the rest of the world?  Basically, you will see the exact opposite situation if you are from the United States, Great Britain, or the European Union.  The Federal Reserve (and its counterparts in other countries) has been keeping rates low for a while now, and is not expected to increase those rates until well into 2010.  This makes it easier for companies (and people) to borrow money, which will hopefully spur economic growth; but it means there’s a higher risk of inflation once the economy recovers.  Low interest rates also lead less response from investors, both domestic and foreign, complicating any plans that rely on heavy non-governmental investment.

But, What Should I Do?

Ah, that is the $64,000 question.  Being the cautious type, I would recommend doing more reading and research for the time being, ideally starting with some of the commentary I’ve linked to in this article and expanding your research from there.  Based just on what I’ve already mentioned in this article, you can probably see that even something as subtle as a one-quarter of one percent rise in central bank interest rates can have a ripple effect, not only in the central bank’s own country, but throughout the world.  I’ve only scratched the surface of how this can affect the global economy, and I’m sure a bit more research will leave you much more informed on what to expect.

As for actual investment suggestions, I would tend to stay fully invested in a diversified portfolio.  If you are a citizen of Australia (or Israel, Norway, or Brazil, all countries that have survived this downturn better than most), you might want to increase your domestic exposure a bit, to benefit as your economies take the first steps toward recovery much before the rest of the world.  Similarly, if you’re not a resident of one of the aforementioned countries (or another country that is actually doing well in the current economic environment), it’s probably worthwhile to consider expanding your stake into faster recovering countries, as companies there will have a competitive advantage over those in countries that are still struggling.  Just watch for signs that other economies are starting to recover, and you can shift your portfolio accordingly to take advantage of growth no matter where it occurs.  Happy investing!

(As always, it’s worthwhile reminding everyone that I am an amateur financier, not an expert.  Before you go shifting around your investment portfolio, be sure to do plenty of your own research, draw your own conclusions, and make the choices that feel right to you.  Attempting to profit from a single country ETF or stocks based in said country can be a way to benefit from differing rates of recovery, but they are also more volatile than broader funds, and should be handled with care.  Be sure that an investment plan is right for you before you enact it, and talk to a financial professional if you are uncertain of what to do.)

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It’s an assumption common to just about every human on the planet: in order for one person to benefit, someone else has to lose.  For example, if you’re playing poker with your buddies on Friday night, any profit you make off of the game will be exactly equal to the total losses of your friends.  When you have a hot streak and turn your twenty dollar stake into a fifty dollar pot, it means your buddies must have lost thirty dollars collectively.  Similarly, if you have a horrible night and lose all your money, then one or more of your buddies will walk out the door twenty dollars richer.   As a group, you and your friends will still have the same amount of money with which you came into the game; the only difference will be how that money is distributed.

Such a situation is known as a zero-sum game; the amount of money (or other object of value) is limited to the amount available at the start of the game, and the only effect that the game will have is to shuffle around the money to the various players involved.  (Of course, it doesn’t have to be a literal game; the term is applied to any situation where the only money involved comes from other participants.)  In addition to our poker game example, you can also find zero-sum games in any form of gambling (the money that is won comes from other gamblers, less the casino’s profit margin).  In most sports, any win by one team means a lose by the other; the number of wins is fixed each season, and only so many wins will be distributed.  Even sharing a dessert is a zero-sum situation: if you take a bigger piece of pie, there’s less left for me.

With examples of zero-sum situations abundant in the rest of life, it’s not surprising that many people assume that our entire economy is a zero-sum game.  There’s the underlying belief that there is only a fixed amount of money, and every dollar I get is one less dollar available to you.  You can hear this assumption embedded in our language, with talk about one group or another (usually the already well off) getting ‘a bigger piece of the pie’, as if the economy was served warm and flaky, with a whipped cream topping.  According to this belief, any benefit to another person or group hurts you, cutting down the money supply and decreasing the amount of pie left for you.

Luckily, this is not the case.  It’s possible to create situations that do benefit all the parties involved, something that’s not possible in a zero-sum situation.  (Unless you’re playing with someone who WANTS to lose money, but that rarely happens if all your friends are rational.)  Let’s go back to our pie example.  If you have a piece of pumpkin, which I love but you loathe, and I have a piece of coconut creme, which you enjoy but I detest with the fiery fury of ten thousand suns, we’ll both be better off by trading than we would by keeping what we have.  Similar trades can occur with money; if you put a value of $5 on my piece of coconut creme pie whereas I put a price of $3 on that same piece, we can both benefit when I sell you the piece of pie for, say, $4.  Every voluntary trade between people will increase the wealth of the participants, if only by the cost of a piece of pie.

Furthermore, the economy is not a fixed system; it’s growing all the time.  The pie is getting bigger with each passing decade, ensuring that, even if the pie is not divided as fairly (and of course, if we are not the richest people on the planet, we’re going to assume the division is unfair) as we would like, the size of piece will continue to get bigger.  As more people contribute to the economy, the amount of everything, from desks to microchips to blogs to, yes, pie, increases, making everyone who shares in the economy wealthier.  Things become cheaper, money is easier to acquire, and the quality of life slowly rises, as it has through most of history.  In a word, growth.

What does all of this mean to you, the individual investor?  In a nutshell, money is a tool, nothing more, nothing less.  There is nothing evil about money; it’s simply a medium of exchange, so you don’t have to carry ingots of gold or a flock of sheep with you whenever you want to acquire some other goods.  Money is only as evil as the purpose to which it is put; pay people to kick orphans and stomp on puppies, and you’ll be a pretty bad person, but it’s no more the fault of the money than would be the philanthropy of another wealthy person.  Mostly relevant to our topic, if you have more money, it doesn’t necessarily follow that everyone else has to suffer with less.  In fact, assuming you use your money well, everyone who trades with you can become wealthier in the process, including you.

If you follow the dictates of your conscious and religion as best you can no matter your level of wealth, you will be a good person, regardless of whether your net worth is one million dollars or one thousand dollars.  Do that, and remember that just because you have money, doesn’t mean you took it away from someone else.  (Unless you’re a thief or Bernie Madoff; in those cases, I can’t help you.)

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If you are a mutual fund investor, you’ve probably heard talk of the Efficient Markets Hypothesis (EMH, not to be confused with EMT or Emergency Medical Technician) being bandied about at one point or another.  In a nutshell, EMH maintains that the stock market and similar markets are efficient.  That is to say, the price of a stock at any given time will express ALL the information available about the stock at the time, and will usually match the fair value of the company.

Obviously, not every stock will exactly match the fair value of the underlying company at every moment; if they did, there would be little change in stock prices on a daily basis, rather than the swings that we see.  EMH holds that these variations are random and unpredictable, and will revert to fair value as a result of investors attempting to exploit the deviations from fair value.  In a liquid, large market with low costs and people looking to gain advantage from these (temporary) variances, the stock price will soon revert to fair value, at least until the next inefficiency arises.  While it’s possible for some investors to benefit from these inefficiencies, doing so depends on luck and not skill, according to EMH.

As with any such hypothesis, of course, there are challenges to EMH.  The most obvious examples are investors such as Warren Buffett who proved able to beat the market repeatedly.  There are also runs on the market, both on the upside (such as the tech boom) and the downside (as during 2008) where investors end up distorting the market in ways that pull prices away from their fair values in a concerted way.  That the stock market is efficient is far from a settled fact.

Efficient Markets and the Individual Investor

All this might seem like just an academic argument, but it has some very real consequences for your portfolio.  If the EMH theory is correct, your best (and in fact, only sensible) investment is in index funds; barring some lucky (and unpredictable) breaks, neither you nor a mutual fund manager can hope to beat the market, and the best you can do is match the market gains while spending as little money as possible.  If EMH does NOT hold, then beating the market via skill could be possible, and finding good stock investments or a solid mutual fund manager looks more reasonable.

So, which is it; do EMH principles apply or not?  I hold that the answer depends on what segment of the stock market we are considering.  Remember, there are several points that need to be true for markets to be efficient:

-Liquid: It should be possible for shares to be bought and solid easily, enabling the price to easily move back to the fair value for the stock.
-Large: A large market both increases liquidity and helps to ensure that information is widely disseminated, enabling changes from fair value to be easily discerned.
-Low Costs: Low costs increase the liquidity of the market, as well as decreasing the shift in value needed for the investment to be profitable.
-People Looking to Profit from Variances: Without people buying undervalued stocks and selling (or shorting) overvalued ones, the stock prices will stagnate, preventing the stocks from returning to fair value.

The closer a particular segment of the stock market is to meeting these criteria, the more efficient it will be.  For large cap stocks, the market is pretty dang efficient; the market for the AT&Ts and Wal-Marts of the world is large, liquid, and filled with people who will pounce on undervalued or overvalued stocks, pushing them towards their fair value.  On the other end of the spectrum, penny stocks tend to be illiquid, have a small market, and typically have added fees that increase the investment costs; all of which point to a really inefficient market that could potentially be exploited by a savvy investor.  (Although, I’d tend not to recommend penny stocks, as the lack of regulation and easy manipulation by unscrupulous charlatans makes the penny stock market highly risky.)  Most other markets fall somewhere in between; small-cap stocks are going to be less efficient than large-caps, but more efficient (and I would add, safer) than penny stocks.

What does this mean for your portfolio?  If you seek market inefficiencies, look for shares that are rather illiquid (think small cap); it’ll be longer before the market as a whole attempts to change the incorrect valuation, allowing the them to get further from the fair value (and potentially increasing your profit, with a well-chosen stock).  When investing in larger-cap stocks, don’t expect market adjusted to drastically and permanently shift your investment value, all public news will be priced into the stock already.

If you’re more of a mutual fund investor, you’ll likely have an easier time finding mutual funds that beat their respect indexes if you look at smaller cap funds.  A fund manager limited to picking from the S&P 500 for the companies in which the fund invests will have to deal with a liquid market keeping the valuations from getting too far out of touch with the fair market value. Larger cap investments should be considered more for the expected growth and possibly dividends.

The Efficient Markets Hypothesis provides some insight into the method behind creating index funds in the first place.  Whether you believe it’s a fact of investing life, think it’s a load of crock, or somewhere in between will impact just how much of your money you want to put into actively managed investments.  Regardless, the more you learn, the better an investor you’ll become, so enjoy the new knowledge!

(Image Taken from The Daily Gazette at Swarthmore)

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