Optimal Digital Rights Management with Uncertain Piracy

Many firms that sell digital copies of copyrighted materials online face a common dilemma: the use of Digital Rights Management to impede pirates often also has negative implications for legitimate customers. We introduce a two-period model in which the use of DRM in the first period affects the probability of consumers encountering pirated copies in the second period, the threat of legal action affects the probability of consumers obtaining pirated copies, and firms choose whether to sell, and at what prices, either strongly or weakly DRM protected copies, or both. We are able to explain a range of observable firm behaviors with this model, including the use of price discrimination to offer both strongly and weakly protected files simultaneously, with weaker protection commanding a higher price, and the eventual abandonment of DRM protections, both of which have been observed at various times, for example, with Apple´s iTunes service.