Can Piracy Increase Innovation? Software Firms' Responses to Online File Sharing

Existing theory predicts two possible and opposing competitive responses by firms to digitalpiracy, resulting in an ambiguous impact on innovation. We resolve this tension by using a naturalexperiment stemming from a shock to file-sharing technology, which led to a sudden increase inpiracy in the early 2000's, to analyze the impact of piracy on innovation in the software industry.Using difference-in-differences and instrumental-variables estimators to compare a treatmentgroup of consumer-focused software firms with a matched control group of enterprise-focusedsoftware firms, we find that piracy led to an increase in subsequent R&D spending, copyrights,trademarks, and patents for large, incumbent firms. However, we find that firms decreased theirrate of new product releases following the rise in piracy. We conclude that piracy pushes firms todevelop new products that are superior to those available as pirated substitutes, but this innovationmay reach the public at a slower pace. Our findings have implications for managers pursuing valueappropriation in knowledge-based industries while faced with the threat of digital piracy