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.

*****

[*] 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.

Book Review: The Company of Strangers

If you've been reading about economics for long enough, sooner or later you will come across reference to the miracle that is the production of a lead pencil. Perhaps you'll read about it in the context of a Milton Friedman interview (like here), or perhaps a reference to the original, Leonard Read's 1958 book I, Pencil (see here). Either way, the story is about spontaneous order and/or interdependence - how the actions of hundreds or more people interact produce a single pencil, without any one of them necessarily caring about the end product, or even knowing how it is produced.

Over the years, I've seen several references to Paul Seabright's book, The Company of Strangers, in a similar context to I, Pencil. So, I finally took the time to read it (or rather, the revised edition from 2010 - the original was published in 2001). The essence of the book can be summarised as follows, from the introduction to the book:

• First, the unplanned but sophisticated coordination of modern industrial societies is a remarkable fact that needs an explanation. Nothing in our species' biological evolution has shown us to have any talent or taste for dealing with strangers.

• Second, this explanation is to be found in the presence of institutions that make human being willing to treat strangers as honorary friends.

• Third, when human beings come together in the mass, the unintended consequences are sometimes startlingly impressive, sometimes very troubling.

• Fourth, the very talents for cooperation and rational reflection that could provide solutions to our most urgent problems are also the source of our species' terrifying capacity for organized violence between groups. Trust between groups needs as much human ingenuity as trust between individuals.

Trust is central to the modern economy, and has been central to social interactions for as long as Homo sapiens has gathered into groups. In my ECONS101 class, I always wish we had more time to consider repeated games in our game theory topic, where trust and reputation become key features of the resulting outcomes. 

The book is thoroughly researched and very deep. Seabright draws from a range of sources from biology to anthropology to economics. Every paragraph made me think, which made for a long read (in case you were wondering why I haven't posted a book review since early September). Seabright also provided me with a number of novel ways of explaining some key concepts in my classes.

Some readers may find the book quite dry, but there are also some lighter highlights, such as this:

There is a lost look sometimes that flits across the brow of those senior politicians who have not managed to attain perfect facial self-control. It is the look of a small boy who has dreamed all his life of being allowed to take the controls of an airplane, but who discovers when at last he does that none of the controls he operates seems to be connected to anything, or that they work in such an unpredictable way that it is safer to leave them alone altogether. Politicians have very little power, if by power we mean the capacity to achieve the goals they had hoped and promised to achieve.

If only more politicians, and voters, understood this point! And this as well:

As the twenty-first century develops, "globalization" has become a convenient catch-all term to sum up the multitude of different, often contradictory reasons people have to feel uneasy about the way in which world events are developing.

Since the book is really about trust between people, and globalization is ultimately about connections between people, there are some good underlying discussions to be found in its pages. Seabright also provides an interesting perspective on the Global Financial Crisis (which was contemporary at the time of writing the revised edition). However, at its heart this is a book about people, and our interactions in a world where we don't know the majority of people with whom we interact. Like spontaneous order, such interactions are at the heart of economics. If you want to develop a deeper understanding of these interactions, this book would be a good one to read.

Petrol prices and drive-offs

The New Zealand Herald reported yesterday:

Due to increasing costs of crude oil, the New Zealand dollar falling and increasing fuel taxes, petrol pumps are forcing a strain on Kiwis.

Some motorists are taking drastic actions to avoid the economic sting, putting in fuel and driving away from stations before paying.

Over the last few weeks, Z Energy has witnessed a small increase of motorists getting behind the wheel instead of the cash register.

"At a high level we have seen a slight increase in the number of drive-offs," a spokeswoman said.

Why the increase in drive-offs? Gary Becker (1992 Nobel Prize winner) argued that criminals are rational, and they would weigh up the benefits and costs of their actions (see the first chapter in this pdf). It is rational to execute a drive-off if the benefits of the drive-off (the savings in fuel costs because they fuel wasn't paid for) exceed the costs of the drive-off (the penalty for being caught, multiplied by the probability of being caught).

How often will people engage in drive-offs? We can think about that question in terms of the marginal benefits and marginal costs of drive-offs, as shown in the diagram below. Marginal benefit (MB) is the additional benefit of engaging in one more drive-off. In the diagram, the marginal benefit of drive-offs is downward sloping - the first drive-off provides a relatively high benefit (filling an empty tank), but subsequent drive-offs will likely provide less additional benefit, because the car's tank is already close to full. Marginal cost (MC) is the additional cost of engaging in one more drive-off. The marginal cost of drive-offs is upward sloping - the more drive-offs a person engages in, the more likely they are to get caught. The 'optimal quantity' of drive-offs (from the perspective of the person engaging in the drive-offs!) occurs where MB meets MC, at Q* drive-offs. If the person engages in more than Q* drive-offs (e.g. at Q2), then the extra benefit (MB) is less than the extra cost (MC), making them worse off. If the person engages in fewer than Q* drive-offs (e.g. at Q1), then the extra benefit (MB) is more than the extra cost (MC), so conducting one more drive-off would make them better off.

Now consider what happens in this model when the price of petrol increases. The benefits of drive-offs increase, because the value of fuel cost savings from driving off increases. As shown in the diagram below, this shifts the MB curve to the right (from MB0 to MB1), and the optimal quantity of drive-offs increases from Q0 to Q1. Drive-offs increase.

Regular readers of this blog will recognise that this situation is quite similar to the increase in honey thefts reported earlier this year. Petrol prices are expected to increase further through the rest of this year. Petrol stations should be preparing themselves for increases in drive-offs. Consumers can probably expect more petrol stations to move to having their pumps on pre-pay.

Read more:

• Why honey thefts are on the rise

Nobel Prizes for Paul Romer and William Nordhaus

The 2018 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (aka Nobel Prize in Economics) has been awarded to William Nordhaus of Yale "for integrating climate change into long-run macroeconomic analysis" and Paul Romer of NYU "for integrating technological innovations into long-run macroeconomic analysis."

Marginal Revolution has excellent coverage as always, on Nordhaus and on Romer. Romer's work on endogenous growth theory hasn't had much influence on my teaching as I don't teach macroeconomics or growth, but here is an excellent video from MRU that summarises many of the key contributions:

As you might expect, Nordhaus' work on the economics of climate change is picked up in my ECONS102 class in the topic on externalities and common resources. Here is my review of his book The Climate Casino - it's good that I finally read a laureate's most recent book before they received the award for once! Nordhaus has also contributed to our understanding of the economics of intellectual property rights, which Marginal Revolution didn't mention, but which I have talked about briefly here and here. His approach, in terms of the trade-off between having weaker (or shorter) intellectual property rights, which would lead to under-investment in intellectual property development, or having stronger (or longer) intellectual property rights, which would lead to under-consumption of intellectual property, is what I follow in teaching that topic in ECONS102.

This was a very well deserved (and overdue) prize for both men. However, I was a little surprised that they shared the prize together (in the Economics Discussion Group poll, both this year and last year, I picked Romer and Robert Barro to win). Nonetheless, an excellent choice.