Download Trade-Offs ch. 4

4 What’s Yours is Mine
Trade-Offs
by
Harold Winter
A Primer on Pricing
• The three main factors that simultaneously
determine a firm's price.
– Demand: The Consumer's Willingness to Pay for
the Product
– Supply: The Costs of Production
– Market Structure: The Number of Competing
Firms
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Demand
• The maximum amount a consumer is willing
to pay for a product determines the
consumer's value for that product.
• The more a consumer is willing to pay for a
unit of the product, the higher the product
price may be.
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Supply
• The maximum amount a consumer is willing
to pay for a product must exceed the
minimum amount a firm needs to be willing to
sell the product.
– Generally, a firm needs to at least cover its costs
of production to reap the gains from trade of a
sale.
• The greater you can set your price above the
incremental cost, the more gains from trade per unit
you can receive.
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Market Structure
• In a competitive market where there are many
firms, price is usually driven down close to the
incremental cost of production.
• A monopolist can set a price above the
incremental cost and earn a per unit profit
without fear of a rival undercutting that price.
– A monopolist's best price is the one that yields the
maximum profit.
• This implies that a monopolist must be concerned with
setting too low a price or too high a price.
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Copyright Protection: A Classic
Trade-Off
• Copyright protection assigns exclusive rights
over the sale and distribution of intellectual
property to the owner of that property.
– Copyright protection leads to a classic economic
trade-off.
• The benefit of the protection is that it can provide
incentives for creators of intellectual property to
continue to create.
• The cost of the protection is that it can lead to
monopoly pricing in the selling of the property.
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Social Cost of Monopoly
• The downside of copyright protection is that it
creates monopoly power.
– With monopoly power comes monopoly pricing, and that
can reduce social welfare.
– By raising price above the incremental cost, a firm with
monopoly power simply has the ability to reap more gains
from trade than does a competitive firm.
• If a consumer's willingness to pay is greater than the incremental
cost, but below the monopoly price, then there are gains from
trade that will not be realized because the price is too high.
• This loss in gains from trade is the social cost of monopoly power.
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Do We Need Protection?
• The key social argument in favor of copyright
protection is that it provides incentives for the
creation of intellectual property.
– But copyright protection is not the only means of
providing such incentives.
• Several factors influence the creation of intellectual
property, and if these factors are effective, they can
weaken the argument in favor of copyright protection.
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We Might Not Need Protection
• Poor quality of copies
• Copying takes time
– Time lag may be enough for the original producer to recoup the upfront cost, and then some.
• High production costs of copies
• Copying may enhance the value of the original product
– A consumer's willingness to pay for a product may depend
on the consumer's ability to make copies. (e.g., Journal
subscriptions)
• Nonfinancial motives for creating intellectual property
– Funding needed to create intellectual property may come
from sources other than eventual sales, such as family
support, private donations, or public subsidies.
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Music Industry and Digital Files
• Without copyright protection, the music
industry may be substantially harmed by filesharing technology, and this may reduce the
quantity and quality of music creation.
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Is Copyright Protection Desirable?
• The key issue is whether or not copyright
protection is necessary to encourage the
creation of intellectual property.
– If it is necessary, that still doesn't deal with the
main cost of copyright protection: the creation of
monopoly power.
– The argument for or against copyright, however,
does not have to be absolute.
• There is a legal gray area that allows for copyright
protection and legalized copying.
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Is It Efficient to Be Fair?
• Government subscribed to journals, then distributed
thousands of photocopies.
• The government's defense was that they were not
infringing on copyrighted work because the copying
was legally protected by a doctrine known as fair use.
– The economic rationale for fair use is similar to the
rationale for organ conscription.
– Fair use can facilitate the movement of a resource, or more
accurately a copy of the resource, from one party to
another.
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There is a Difference
• In the organ transplant example, there exists no
current market mechanism for moving a resource
from one use to another, and conscription is
presented as an alternative to a possible market
solution.
• In contrast, the sole purpose of fair use is to allow
copiers to circumvent an existing market mechanism.
– Consumers who would purchase the good at a competitive
price, but not at a monopoly price, can now copy the good
without infringing on the firm's copyright.
– This is a strong economic rationale for fair use.
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What did the Court Decide?
• The court did not feel that the publisher was
adversely affected by the copying.
• Because of the self-imposed restrictions the
library placed on copy requests, and because
many requests were for back issues that were
not readily available from the publisher, the
court decided that fair use would not greatly
reduce the value of the copyright to the
publisher.
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Video Cassettes and Napster
• Sony won
• Napster lost
• Why?
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Drugs and Patents
• Demand factors that cause a high price.
– The decision to purchase a drug may not be made
by the consumer, but instead it is often made by a
physician.
– Because drugs are used to combat illnesses, the
willingness to pay tends to be high.
– Many consumers have their drug purchases
subsidized by insurance plans.
• To the extent that a consumer doesn't bear the full cost
of the drug, the price can be higher.
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Supply Side Factors
• Supply side factors.
• Up-front costs and incremental costs.
– In the case of pharmaceuticals, the up-front costs
can be phenomenal.
• It is not uncommon for it to cost hundreds of millions of
dollars and to take up to twelve years to bring a new
drug to the market.
– The incremental costs of drug production, on the
other hand, are generally quite modest.
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Patent Protection
• Patent protection in this case gives the firm some
monopoly power and the ability to set a price above
incremental cost.
• But, as with copyright, are there alternatives to
patent protection that give a pharmaceutical
company the ability to cover all of its costs?
– Companies have up-front costs for both drugs that are
marketed and those that do not make it to the market.
– Price controls and lack of patent protection in foreign
countries means that Americans pay the up-front costs.
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Should Americans Bear The
Up-Front Costs?
• The higher prices at home may be beneficial to
Americans.
• If the United States does away with patent
protection, a pharmaceutical company may have no
markets at all in which it can successfully recoup all
of its costs.
– Americans may be unhappy with high drug prices, which
exclude some consumers from the market.
– It comes back to the classic trade-off: the high prices may
be necessary to encourage drug production, but the high
prices may also create a monopoly social loss.
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Patent Protection Trade-Offs
• F. M. Scherer, one of the leading economic
scholars on patent protection:
– Should a trade-off be required between modestly
excessive prices and profits versus retarded
technical progress, it would be better to err on the
side of excessive profits.
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