The effects of theft or destruction of goods on a monopoly

Firms are always complaining about theft and how there are enormous economic impacts associated with it. From the recent Stop Online Piracy Act (SOPA) and the Protect IP Act (PIPA), it is clear that the politicians have been paying a lot of attention to the issue. For an economist, there’s a lot of questions to be had here. Below is a basic profit maximization model modified to accommodate destruction or theft of goods.

Before I begin my analysis, I must make clear that the model assumes that α, the percentage of goods received by the firm, is a completely independent variable, meaning it is not affected by other variables. One could account for the obvious notion that price and the willingness of people to steal (and conversely the amount of goods paid for) by having α be a function of price. However, that adds a fair amount of math, and so we’ll leave that out. Furthermore, the demand function is linear.

If we look at where MC is low, the effects of destruction and theft on quantity produced is minimal. It makes intuitive sense. If it’s cheap to produce a good, then who cares if half of what you make gets destroyed; just make more! So at a MC of 2, even when the firm only receives half of what it makes, the quantity produced is barely affected with a change of only 1.

Now when MC gets high, the firm produces a fair amount less. But when the firm receives only half of what it makes along with a high MC, there is another massive reduction in quantity produced. From this relationship, it seems that if government desires to benefit society, they should focus on removing theft, piracy, or destruction of goods on firms with high MC than firms with low MC.

Another interesting note we should examine is how profits have changed for the firm. Remember how the firm with low MC produced nearly the same amount despite receiving payment for only half of its goods? Its profits have fallen by about 50%. As we can see, firms have a huge incentive to complain about theft. In the case of firms with low MCs, theft hurts them more than it hurts society.

Software firms fit the model very well. For the most part, software tends to be monopolistic and in many cases, full blown monopoly. Their MC is also very low. If we take the above model to be true, then it’s no wonder that a lot of the lobbying has been about online piracy. Software firms have a lot to lose in profits.


Why Steam is so successful

Online digital distributor giant, Steam, has become a household name for gamers across the world. Shrewd business practices on the part of Valve, the makers of Steam, has kept the users of Steam generally happy and its competitors out. The very nature of Steam prohibits most users from using other digital distribution services. Who wants to run a handful of memory demanding programs in the background? In this respect, Steam already has a major advantage because it was the first to embed itself on our desktops.

To better understand why so many people use Steam, we need to first address the concept of network externality. Certain goods and services increase in value as more people use them. Take for instance, the classic example of the telephone. When one person has a telephone, he has no one to call. When there are two people, they can call each other. Each additional person raises the value of the telephone. Economists call this effect, network externality.

Valve understands very well how network externalities impact markets. Thanks to Steamworks, Valve has taken a step further to cementing our feet. Steamworks is the community building function of Steam; it encompasses everything from your friends list to your profile. Most of all, it’s a free service with the caveat that you have to purchase at least one game on Steam. Consider the telephone example. If you were the only person using Steamworks, how valuable would the service be? Since so many people already use Steam, the network externality must be immense, strong enough to prevent a competitor such as Impulse, another digital distributor, from entering. Impulse can technically match everything Steam does, but it cannot replicate the network externality effect without a substantial user base.

It is interesting to note that Steam is not flawless in its design. Origins, Electronic Arts’ digital distribution software, has begun hitting Steam in the one area where it is not invulnerable, titles. Origins has taken the approach of pulling away its loyal and diehard consumers in the hopes that it can build its own user base. While it is notably more successful than Impulse, it is unlikely that Origins will be able to sport enough exclusive titles to pull people off of Steam. Electronic Arts and Valve can realistically only make titles published under them exclusive. For the vast majority of titles, Electronic Arts and Valve will have to compete for sales licenses.