The economics of trademark protection

Last week, William Nordhaus won the Nobel Prize in economics and as I mentioned at the time, one of his contributions to economics was a recognition of the trade-offs inherent in the protection of intellectual property rights. Strong intellectual property rights provide an incentive for investment in creation or development of new intellectual property, but they also provided a limited monopoly to the holder of the intellectual property rights. The trade-off (as we'll see a little later in this post) is between under-creation of intellectual property if there is weak protection, and under-consumption of the intellectual property if there is strong protection.

Intellectual property rights can be protected through patents or copyright, or through trademarks as this article from last week notes:

Trademark protection is available to businesses of all sizes and there are very good reasons for traders to use that protection...

The registered owner is deemed to have the exclusive right to use the mark throughout New Zealand in relation to all the goods and services it covers; the owner's rights are on a publicly searchable register, which may have a deterrent effect on copy-cats; and it has the right to sue under the the [sic] Trade Marks Act 2002...

...the trademark system also has wider economic benefits.

Providing legal protection for brands incentivises businesses to invest in building goodwill and reputation by producing high quality goods and services.

Trademarks provide an incentive for Firm A to invest in building goodwill, because Firm A's goodwill can't be captured by other firms that are pretending to sell Firm A's goods. Consider the diagram below, which shows the market for a firm selling a trademarked product. The trademark makes the firm a monopoly (in this particular trademarked product). It gives the firm some market power. The trademark is costly to obtain (it involves the cost of the trademark itself, but also the cost of building consumer awareness of the brand the trademark protects), and that fixed cost leads to some economies of scale. This is why the average cost (AC) curve is downward sloping. If the firm is maximising its profits, it will operate at the point where marginal revenue meets marginal cost, i.e. at the quantity QM, which it can obtain by setting a price of PM (this is because at the price PM, consumers will demand the profit-maximising quantity QM). The firm makes a profit that is equal to the area PMBKL. [*]

Now consider what would happen if there was no trademark protecting the product. Other competing firms would realise that this product is quite profitable, and they would start to sell it (since there is no trademark stopping them from doing so). We end up with a market that is more competitive, which would operate at the point where supply (MC) meets demand. This is at a price of PC, and the quantity of QC. Notice that the price is now below average cost - the firm that developed the product sells at a loss (equal to the area JFEPC). [**]

So, if there is strong intellectual property rights protection (trademarks in this case, but a similar analysis applies to patents or copyright), there would be less consumption of intellectual property (because QM is much less than QC). But, if there is weak intellectual property rights protection, there would be less development of intellectual property in the first place (because the developer would face the costs of development, but could not easily profit from it).

Trademarks are clearly valuable for firms, but the article also argues that they are valuable for consumers:

Trademark protection also has a consumer welfare aspect. Trademarks are "badges of origin" for consumers, a sort of guarantee to indicate that a product or service comes from a trusted, reliable source.

Regulating their use (and misuse) helps to protect the buying public from confusion and, at worst, physical harm.

At the extreme end of the spectrum, counterfeit products can pose an active risk to health.

Last month, the BBC reported hundreds of thousands of pounds of counterfeit cosmetics had been seized in the UK, some of which contained chemicals such as highly toxic mercury and the illegal levels of the skin-whitening agent hydroquinone.

Intellectual property rights is an interesting topic that I cover in my ECONS102 class, particularly because it involves a difficult trade-off. It isn't clear how strong intellectual property rights protection should be, in order to balance under-consumption (relative to an economic-welfare-maximising point) against under-development (because of the lack of profits from developing intellectual property). Clearly, we still don't have the balance right if we are still facing drug pricing that works like this.

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[*] This is different from the producer surplus, which is the area PMBHPC. The difference between producer surplus and profits arises because of the fixed cost - in this case, the cost of the trademark and product development.

[**] The producer surplus in this case is zero. This is because the diagram shows a 'constant cost' firm, where marginal cost is constant (so every unit costs the same to produce), and the equilibrium price is equal to marginal cost. Also, more realistically if you don't create the trademark in the first place, the fixed cost is eliminated. So there is no loss, but there is also no profit because every unit is sold at its marginal cost.