Slicing the Gordian Knot: A Novel Mechanism for Providing Innovation Incentives for Digital Goods

Digital goods can be reproduced without cost. Thus a price of zero would be economically efficient in terms of eliminating deadweight loss. Unfortunately, zero revenues would also eliminate the economic incentives for creating such goods in the first place. We develop a novel mechanism which solves this dilemma by decoupling the price of digital goods from the payments to innovators while maintaining budget balance and incentive compatibility. Specifically, by selling digital goods via large bundles, the marginal price for consuming an additional good can be made zero for most consumers. Thus efficiency is enhanced. Meanwhile, we show how statistical sampling can be combined with tiered coupons to reveal the individual demands for each of the component goods in such a bundle. This makes it possible to provide accurate payments to creators which in turn spur further innovation. In our analysis of the proposed mechanism, we find that it can operate with an efficiency loss of less than 0.1 percent of the efficiency loss of the traditional price-based system. Innovation incentives in our mechanism are, of course, dramatically improved relative to the zero-price approach often favored by content consumers. However, it is surprising to find that the innovation incentives are also substantially better than those provided by the traditional system based on excludability and monopoly pricing which is often favored by content owners. The technology and legal framework for our proposed mechanism already exist and portions of it have already been implemented, although not in any coordinated fashion.