Price Discrimination and Copyright Law: Evidence from the Introduction of DVDs

This paper examines the welfare effects of market segmentation using the example of the video rental and sales markets (both VHS and DVD formats). I consider a market with two types of buyers: institutional and individual buyers. Institutional buyers rent the good to low-value individuals, while relatively high-value individuals purchase the good directly rather than renting it. Copyright law in the U.S. effectively prevents market segmentation according to use of the product. As a result, rental and sales markets for VHS cassettes are traditionally segmented by pricing VHS cassettes intertemporally: first setting a very high price for the institutional buyers, and lowering the price six months later for sales to end-users. For selected products, especially children’s movies, this two-tiered pricing strategy is discarded in favor of an immediate low price to stimulate early sales to end-users. When pricing the DVD format over the past three years, firms have chosen to discard the two-tier pricing model completely. Using data on the rental and sales activities of video rental stores for both VHS and DVD formats, I estimate a model of intertemporal price discrimination which rationalizes the use of such different pricing policies for the same movie on two different formats. I use the estimated parameter values to predict whether or not the elimination of intertemporal price discrimination will remain the optimal strategy as DVD hardware penetration evolves, and to estimate the effects of the restrictive copyright law for firms and consumers. Preliminary Draft: Please do not cite without author’s permission. ∗Department of Economics, Harvard University, Cambridge, Massachusetts 02138. E-mail: [email protected]. †I thank John Asker, Gautam Gowrisankaran, Ariel Pakes, Richard Mortimer and Paul Walsh for helpful discussions. I also thank seminar participants at the 2002 Workshop for Business and Economics Scholars at Florida Atlantic University for helpful comments. The data for this study were generously provided to me by Rentrak Corporation, and I thank Ellen Dannenberg and Amir Yazdani for their help in collecting the data. Any remaining errors are my own.