Competition, commercial piracy and innovation

The issue of digital piracy for commercial profit has received a lot of attention in the industrial organisation literature over the last few years. Illegal competition from pirates reduces the revenue of the legal firm and this has been a concern of the digital media and software industry globally. This thesis is motivated by the observation of three important gaps in the literature on commercial piracy. First, pirated products are usually imperfect substitutes of the legal product. This implies that the impact of a change in the legal product’s price on the demand for the pirated product will be different from the impact of a change in the price of the pirated product on the legal firm’s demand. The existing literature on product differentiation, however, does not consider such kind of asymmetric product differentiation. Second, empirical evidences show that firms often need to incur costs to document and report signs of piracy, and then the regulatory authority decides whether or not and how much to invest in monitoring which, in turn, affects the probability that the pirate is being caught and convicted. The implications of costly reporting by the legal firm and ex-post monitoring by the authority have not been investigated. Third, while the importance of piracy in affecting innovation has been widely recognised, there has not been much work that directly models the impact of piracy on firms that engage in competition for innovation. This thesis presents three theoretical essays that attempt to fill these gaps in the literature. The first essay analyses the effects of the degree of asymmetric product differentiation on the profit ordering of two competing firms in a Stackelberg model to investigate whether a leader earns a higher or a lower profit than a follower. The model captures asymmetric product differentiation by two cross-price effect parameters, and this two-dimensional model generates novel results that are absent in the literature on profit-ordering with symmetric product differentiation. For example, we find that for every level of the cross-price effect of the change in the leader’s price on the follower’s quantity there exists a critical value for the cross-price effect of the change in the follower’s price on the leader’s quantity, such that below this critical level the leader earns a higher profit than the follower, but the reverse is true above this critical value. The second essay introduces piracy in a market with asymmetric product differentiation. It examines the regulatory authority’s decision on whether to monitor piracy following the legal firm’s report of the presence of a pirate in the market. In the model, the authority decides whether or not and how much to invest in monitoring in order to maximise a politically motivated objective function. We show that with ex-post monitoring the government will monitor piracy under both price and quantity competition if the legal firm’s political influence is sufficiently high. We also find that, when holding the cross-price effect of the legal firm’s price on the pirate’s output constant, there exists a unique level of the cross-price impact of the pirate’s price on the legal firm’s output, above which monitoring will be higher under quantity competition, and below which monitoring will be higher under price competition. Moreover, we show that when the government can credibly commit to monitor piracy the legal firm’s investment on innovation is higher under quantity competition than under price competition. The last essay analyses the effect of piracy on innovation when two legal firms engage in R&D competition. When a single firm is deciding how much to invest in R&D which will stochastically determine whether innovation will be successful, piracy unambiguously retards innovation. However, we show that when two legal firms are engaging in a patent race, piracy may enhance innovation. We also show that if the difference between the efficiency parameters of the innovating firms is relatively large then piracy increases aggregate R&D investment and the profit of the less efficient firm.