Trade-Offs by
Harold Winter

• 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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• 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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• 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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• 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 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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• 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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• 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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• 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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• 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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• 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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• 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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• 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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• 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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• Sony won
• Napster lost
• Why?
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• 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.
• 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 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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• 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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• 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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