In the advent to this chapter, we pointed out the breakup that Napster, a firm that assisted in the sharing of music. Napster provided file-sharing software that enabled computer individuals to re-superstructure music files over the Internet. A music file, like any kind of other computer system file, is just information: a collection of bits and also bytes. It expenses nothing to make a copy of a music file. What Napster did, in other words, to be to do it less complicated for music papers to be spread at marginal cost. You can think that the antitrust authorities would have been delighted. Yet the dispute in this situation was that there to be an infringement that the rights of the music producers. The courts organized in their favor: the legislation came under on the next of the monopolists. Us now think about why federal governments sometimes proactively support and also promote monopolies.

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To understand the Napster case, we start by recognizing the creating, producing, and also recording a brand-new song is a an extremely costly process. Very first of all, there is the time invested by the band in writing and also arranging the song. Skilled recordings also need the solutions of a producer and an expensive record studio. A an excellent deal of time and resources must additionally be expended to produce an MP3 record of the song. Financial experts say the the first-copy costsThe costs involved in creating the initial version of a good. Room large. As the name suggests, these space the costs connected in producing the initial version of a good. They are a particular type of entry cost. Goods that involve a large amount of study and advance or other intellectual input, such as books, computer system software, and also pharmaceutical products, have huge first-copy costs.

As we simply pointed out, though, once a song is produced, it deserve to be reproduced at zero cost. The fixed costs of creating a song are very large, vice versa, the variable costs are zero. Possibly you can now see the problem. If songs were sold in a vain market, their price would be zero. Producer of the music would certainly earn no revenues. Composers would certainly earn no money. In this world, no one would have an inspiration to produce music uneven they to be doing that purely for their very own pleasure.

Similar tensions can be discovered in many other industries. Practically anything that can be stored as a computer document has high first-copy costs accompanied by low variable costs. A newspaper post takes time to research and also write yet can be copied at zero marginal cost. Computer system software can be an extremely expensive to build but—once created—can be copied at no extr cost. Pharmaceutical compounds are very expensive come develop: they first involve the work-related of very trained research scientists in high-quality laboratories and then call for years of testing on animals and also humans. When a drug has been developed, however, that is regularly quite cheap come produce.

The Decision trouble of one Innovating Firm

perform we innovate or not? A decision come innovate is a decision to incur details costs: the costs of study and advance and the expenses of beginning a market. Just how much must we produce during the years of patent protection? What do we do once the patent security ends?

Our ultimate goal is to evaluate the development decision in ~ the first stage, yet to execute so, we should start at the end and work backward.

Figure 14.5 The stages of Innovation


The last Stage: Competition

Once a firm’s patent expires, other firms can produce a comparable or an the same product. The firm will then be operating in a compete market and also can no longer expect to obtain any specific advantage indigenous its innovation. When the patent because that a medicine product expires, because that example, various other companies deserve to step in and also produce chemically identical copies of the product, known as generics.

In a vain market, we suppose the price the the product will certainly decrease till it equates to marginal cost. For this reason, the innovating firm can not anticipate making an extremely much benefit at this stage. Because that simplicity, we can think that the certain making no profits. Although there may be some benefit in gift the original producer the a product, any kind of excess profits that stay after the patent expires room unlikely to be substantial. More precisely, the firm would certainly earn no much more than a “normal” level the profit—the same as it might earn in any type of other activity. Together normal profits would not provide any advantage to justification the early innovation, therefore we have the right to ignore them.

The center Stage: Patent Protection

If the innovating for sure is going come make revenues to justification the prices of arising its product, these profits should come in the center stage when the firm has actually patent protection. During this period, the for sure has syndicate power through virtue that the patent. Us know how the firm behaves in this situation.

that will produce a level of output such that marginal revenue equates to marginal cost. That will set the price equal to the market’s willingness come pay because that this output level.

This is exactly what we saw previously in figure 14.4 "Distortions because of Market Power". The monopolist produces less output than is efficient and also earns syndicate profits.

Notice that a this firm decision about how lot to develop and around what price to collection does not rely on the costs that that paid because that researching and developing its product. After the firm it s okay to this second stage that its decision, those expenses are in the past. They are sunk costsA cost that, as soon as incurred, cannot be recovered.. They have no affect on the marginal price of production and also the price/output decision of the monopolist.

To calculation the full profit that a for sure earns in this monopoly stage, we should do two things: (1) calculate the firm’s benefit in every year and also (2) add these profits over the whole time that the firm has actually patent protection. The firm’s earnings in any given year are given by

earnings = revenues − full cost = earnings − variable expense − solved operating cost.

The area presented as “monopoly profit” in figure 14.4 "Distortions because of Market Power" corresponds to earnings minus change costs. (Businesspeople and accountants call this a this firm profit contribution.) In any kind of given year, the syndicate will also typically incur some expenses of operation in any type of given year that are constant, regardless of whether of how much calculation it produces. Examples incorporate rent ~ above a building and other long-term contracts. These room the firm’s solved operating costsCosts of operating a service that carry out not vary through the level the output., which likewise must be subtracted from the firm’s earnings to calculate its profits.

Because the monopolist earns profit in annually of its patent protection, we include these revenues together. We perform so utilizing the device of discounted existing value. This calculation takes right into account the money earned later is less an important than money this day whenever the price of interest is positive. Hence the appropriate measure that the earnings at this stage is the discounted present value the the sum of the profits made during the duration of patent protection. Determinants that would rise the discounted worth of a that company profits incorporate the following:

reduced marginal costs an ext inelastic demand much more years of patent protection reduced interest rates

The an initial Stage: Innovation

We are lastly in a place to evaluate whether or not a firm must innovate. The gains from innovation are measure by the current discounted value of the flow of profits. A firm have to compare these gains come the expenses of innovation to determine whether or not the creation is worthwhile. These innovation expenses are identified by the costs of the research and advance (R&D) procedure together with any other expenses of industry entry. For example, a firm should pay scientists and engineers, money research laboratories and R&D departments, and so on. Having done the difficult work of analyzing stage two, the decision for phase one is straightforward. The firm must follow this rule: “innovate if the discounted current value of revenues is greater than the costs of innovation.” The firm have to innovate as lengthy as the monopoly profits it will certainly earn in the second stage (appropriately discounted) are better than the prices of innovation in the an initial stage.

Think again around a pharmaceutical firm. Such firms invest an massive amount that money on the research and development phases of brand-new pharmaceutical compounds. This occurs in stage one. When the product goes to market, however, the costs of advancement are sunk and have no impact on the that company profits during stage two. The same point applies come the manufacturing of a music CD. The prices of producing, marketing, and distributing a usual CD are estimated to be approximately $500,000. That this, at the very least $100,000 represents the prices of production.

One thing that we have neglected in our discussion is the the payoff from study and advancement efforts is generally uncertain. Numerous promising medicine compounds turn out, on additional testing, to it is in ineffective or have unacceptable next effects. A tape recording a brand-new song cannot know for sure if it will sell hundreds of copies, countless copies, or countless copies. The decision around whether or not to innovate should be based upon a firm’s finest estimates the the meant valueThe measure of just how much you would mean to victory (or lose) on average, if the situation were to it is in replayed a huge number the times. Of its profits.

An Example

Table 14.1 "Calculating the Discounted current Value of intended Profits" gives a numerical instance of the development decision. The very first year is the innovation stage: we mean the price of invention is $150. The firm earns no profits in the year and also incurs no costs, for this reason its first year profits are −$150. In the 2nd year, the for sure finds out if its invention was successful. We suppose there is a 50 percent chance that that is successful, in which case the for sure has syndicate power for the 2nd and third years. That earns the revenues and incurs the costs detailed in the 3rd and fourth columns that the table. If the development is unsuccessful, the earns no profits. After the 3rd year, the certain earns no profits. Suppose finally that the interest rate is 10 percent.

Table 14.1 Calculating the Discounted present Value of expected Profits

Year Innovation price ($) total Revenues ($) complete Operating costs ($) benefit If effective ($) profit If Not effective ($) meant Value of revenues ($) Discounted current Value of Expected profits ($)
1 150 0 0 −150 −150 −150 −150
2 0 200 68 132 0 66 60
3 0 400 158 242 0 121 100

The profits in the second year if the innovation is successful room $132. The supposed value of profits in the year is because of this given by (0.5 × $132) + (0.5 × 0) = $66. These have to be discounted back one year using the 10 percent attention rate. In other words, we division the second-year revenues by 1.1. The discounted value of the second-year revenues in the very first year is because of this $60. The meant value of the third-year profits, by a comparable calculation, is $121. These must be discounted back two years, every the method to the first year. To perform so, we an initial divide through 1.1 to get the worth of meant third-year revenues in the 2nd year ($121/1.1 = $110). We then discount this ago another year by separating by 1.1 again. The discounted worth of meant third-year profits in the an initial year is therefore 110/1.1 = $100.

We have the right to now legitimately include together the numbers in the last column, and also we discover that the discounted existing value that the firm’s present of profits is $160. This exceeds the expense of innovation ($150), for this reason the firm must go ahead through the project. That expects to knife $10 from the project.

The duty of Patents

Imagine because that a minute that we went through the same analysis in the ahead section yet without patent protection—that is, expect that as shortly as a firm innovates and introduces a brand-new product right into a market, that can automatically be copied and produced and marketed by any type of other firm. This method that the 2nd stage is completely eliminated: the industry goes right from development to competition.

This has actually an evident benefit. There is no much longer a monopoly in the second stage. We recognize that syndicate causes inefficiency: the firm sets that is price above marginal expense to earn syndicate profits. However there is a problem: the invention will no occur. The firm innovates only if the discounted current value of revenues exceeds the expense of innovation. If we eliminate stage two, climate we get rid of the profit flows the justified the innovation in the an initial place. There is no the profits, there will certainly be no innovation. It is the patent protection that offers the incentive for innovation.

The trade-off have to be clear. Patents

administer incentives because that innovation, yet create monopoly power and hence distortions.

The gain from patent protection is the it gives the basis for the 2nd stage that the development process. Without this protection, the gains from innovation would not exist. Looking ago at figure 14.4 "Distortions because of Market Power", this gain comes at the price of an inefficiently low level of output and also a consequent ns of gains indigenous trade.

Lawmakers need to trade turn off this cost and also this gain. Under current US law (, patent security for most assets lasts because that 20 years. The optimal length of patents remains an active area of study in economics and an energetic area of plan concern. That is really hard to keep the ideal balance between incentives for innovation and also eliminating industry distortion.


Perhaps the government can both encourage innovation and also avoid the monopoly distortion. Expect that, after modern technology had been introduced, the government removed the patent protection. As an example, many individuals in the human being suffer native HIV/AIDS but cannot afford medicine at present prices. This trouble is specifically severe in much of sub-Saharan Africa. As a issue of society policy, one would like to have actually the medicine companies first develop HIV/AIDS treatments and also then sell those products at marginal cost.

Currently, some pharmaceutical providers have emerged treatments that are still defended by patents. Eliminating these patents seems prefer it might be an excellent social policy, provided that the resides of millions of world are at stake, but it would certainly come v a far-ranging cost. If the government ignores patent protection for a specific product today, innovators will suspect the the federal government can no much longer be relied on to provide patent defense in the future, i beg your pardon would have a large impact on fix up activity. For this reason by failing to administer patent protection for one product, the government threats destroying its reputation for patent protection in general. This is an instance of a commitment problem. Before stage among the innovation process, the government promises patent protection to administer an incentive for innovation. After phase one is finished and the product is introduced in the market, the government’s incentives change: it wants to remove the sector distortions. Due to the fact that the creation stage is over, the government could potentially renege top top its promise that patent protection.

Pharmaceutical companies choose GlaxoSmithKline, which develop the antiretroviral drugs offered for treating HIV, have actually in fact offered to make their commodities available more cheaply. However, pharmaceutical companies have actually strongly opposed proposal that their patents not be honored. A far better policy suggest by economists and others is a patent buyout. This would occupational as follows. The government would salary the pharmaceutical agency a reasonable industry price because that its patent and then permit other carriers to come right into the market and produce generics. A associated idea is that governments could offer come buy future patents if drug carriers came up through treatments for particular maladies. Because that example, even though malaria is a major killer in the world, pharmaceutical carriers have small interest in researching its treatment. The reason is one of harsh sector economics: many sufferers native malaria room poor, for this reason a malaria drug would not be very lucrative. If governments readily available a considerable patent buyout because that a malaria drug, however, firms can find it precious investing in this disease area after ~ all.

International dimension of Patents

If you have actually a united state patent for a an excellent that you have invented—for example, a brand-new kind of printer—then girlfriend are safeguarded in the unified States. However, us patent legislation does not protect you if friend are selling in other countries. A firm in one more country might take your press apart, analyze just how it functions (this is called reverse engineering), and also then create the great itself. If the certain tried to market the good in the united States, you can take it to court, yet if that is selling elsewhere in the world, you have very small protection.

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Other nations (such as Japan) and also regions (such as the european Union) have patent legislations that are similar to those in the joined States. (Indeed, among the earliest biotech patents saw the famous biologist luigi Pasteur in 1873 because that his technique of producing yeast.) These laws are structured, as space those in the united States, to balance the gains from innovation against the expenses of monopolization of the market. Hence producers who sell across the world will generally seek patent protection in many different countries.

Checking her Understanding

attract the diagram because that a competitive market where marginal cost is zero. What walk the it is provided curve look like? who gets the surplus in the market? usage this diagram to describe the tension between innovation and competition. The subsection ~ above patent protection ended with a perform of components that would rise a that company profits. Explain why every of this would reason the current discounted value of the firm’s profit flow to increase.