William Fisher, CopyrightX: Lecture 4.2, Welfare Theory: The Incentive Theory of Copyright

William Fisher, CopyrightX: Lecture 4.2, Welfare Theory: The Incentive Theory of Copyright


Hello, I’m Terry Fisher. This is the second segment of a lecture
on the welfare theory of copyright. In this portion, I’ll examine in
more detail how copyright law works– specifically, how it functions from
the standpoint of the welfare theory. Along the way, I’ll point out a few
of its advantages and disadvantages, again, viewed from the
standpoint of welfare. For this purpose, we’ll be
using a slightly fictionalized real-world example. Cambridge Documentary Films is a
small documentary filmmaking company. It’s run by two people, Margaret
Lazarus and Renner Wunderlich. It’s called Cambridge
Documentary Films because it used to be based here, in
Cambridge, Massachusetts. But it’s now housed in
Santa Barbara, California. Cambridge Documentary Films,
or as we will call them, CDF, produces very high-quality,
short documentaries. One of those documentaries
is Defending Our lives. It’s 30 minutes long. Its subject is the scourge
of domestic violence. Domestic violence is a phenomenon
that, as many of you know, is global in character. If anything, it’s
increasing in severity. This film examines the subject by
talking with, doing interviews with, many of the women who’ve been
subjected to domestic violence. It won the Academy Award for
Short Documentary in 1993. Because of the continued
salience of the social problem and the quality of the
film, demand for the film remains sizable and fairly constant. And as a result, CDF continues
to sell copies of it. So that’s the real-world case. We’re going to use an adapted,
simplified version of that case to explore the way in which
the copyright system works. First question– suppose CDF wants
to make some money by distributing copies of the film in DVD format. How much should CDF
charge for each copy? To answer that question intelligently,
CDF would need some more information. I’m going to supply you hypothetical,
but reasonably realistic, data of the sort they would need. For simplicity and clarity, I’m going
to present that information graphically. To those of you who’ve
studied some economics, graphs of the sort you see on your
screen will surely be familiar to you. The x-axis, the horizontal
axis, represents quantity– in this case, the quantity
of DVDs containing the film Defending Our Lives. The vertical axis is
money– we’ll use dollars, but we could use any currency– to
represent first the cost of those DVDs, and then the revenue that
they could generate for CDF. The first thing we’d
want to know in order to determine how much CDF should charge
is the cost of producing the DVDs. CDF surely doesn’t want to charge
less than the cost of generating them. So here are some numbers. It turns out that producing and
distributing a DVD is inexpensive. It costs approximately $1 to reproduce
the film in the physical disc, $0.90 to package it, and $0.80
to distribute it to customers. So roughly speaking, $2.70 is the cost
of making and distributing each copy of the film. That cost doesn’t vary much
with how many copies you make. Expressed graphically, this
means that the marginal cost of producing DVD copies
of Defending Our Lives is low and flat– flat because it
doesn’t change, as I indicated, materially as the total number of
copies produced increases or decreases. Now, this is not true of
all cultural products. With respect to some, there
are economies of scale, meaning that the marginal
cost of making copies of them goes down the more you produce. There may be a few types
of cultural products, though examples are hard
to think of, in which the marginal cost of
making copies goes up if the materials used to
produce them are scarce. But many, perhaps most, will
have marginal cost curves that look roughly like
this, low and flat. But this information actually
doesn’t get us very far. As any business school professor will
tell you, the seller of a commodity should be paying primary attention
when pricing that commodity not to the cost of producing it, but to
what potential buyers of the commodity are able and willing to pay. How would CDF get
information of that sort? Perhaps through consumer surveys,
focus groups, or projections on the basis of what
earlier films sold for. To keep things simple, we’ll supply them
with the information they are seeking. If CDF set the price of
the DVDs up here, where the red dot is located on the vertical
axis, a modest number of people would pay for it each month. The high price would keep it out of
the hands of most potential customers. If, by contrast, it’s
priced at a lower point, the number of people who
would purchase it is larger. Still lower price, still
larger a number of purchasers. And if CDF priced it
at 0– in other words, if they just gave the DVDs away–
this even larger number of people would accept it and watch it each month. The number here is not
infinite, because not everyone is interested in domestic violence. Put differently, there are other things
they’d rather do with their time. But as one might expect, the
total number of copies sold would be greatest if the price were 0. It will turn out to be
helpful to plot these pairings on the two-dimensional
space of the graph. This is a representation of the
combination of price and quantity associated with the red option. Here’s the blue, and here’s the green. Finally, yellow is already
marked at the bottom. When you connect up all these
dots, the result is a demand curve. To keep things simple, I’ve chosen
combinations of price and quantity that would generate a straight
line, rather than a curve. In the real world, the shape of this
line would, of course, be more complex. But a simple straight line enables us
to illustrate the basic principles more clearly. The demand curve, to repeat,
is merely the accumulation of many observations of
the sort we just did; namely, for any given price,
how many copies of the movie could CDF sell each month. Having built the curve, we can
now remove the scaffolding. OK, so against this backdrop, what
should CDF charge for the DVDs? In other words, where along this
curve should CDF position itself? We’ll try to answer that question first
in a hypothetical environment in which copyright law does not exist, and
then in a hypothetical environment in which copyright
protection is available. If copyright law does not
exist, then the CDF managers will quickly recognize
that, sooner or later, if they wish to sell
significant numbers of DVDs, they will have to set
the price very low. They could, of course, begin
by setting the price up here. The result will be that,
in the first month, they would sell a modest number of
copies and earn a fair amount of money. More specifically, they would
earn the amount of money equal to the number of copies sold times
the price of each copy; in other words, revenue equal to this area. But if they did this,
CDF would very quickly face competition, because a rival
would purchase one of their copies and then replicate it, selling
the knockoffs for a lower price. So let’s suppose that this
occurs in month number two. By choosing this price,
the competitor would sell a much larger number of DVDs. But even more seriously, it would
eliminate or largely undermine the demand for the CDF
authorized version. CDF’s market would more or less go away. So to respond, CDF would
be obliged, if they wished to continue to sell
films at all, to lower their price in the third month. In the fourth month, the rival
would respond by lowering its price, and CDF will be obliged
to lower its price, and so forth, until the price
of the copies of the film fell all the way down to almost the
marginal cost of producing copies. The general point illustrated
by this simple sequence is that, in the absence of
copyright, copying and competition will drive the price down to
marginal cost or nearly so. In two related respects,
this is socially beneficial. Indeed, in most contexts,
antitrust law is designed to generate
exactly this behavior. First, the total number of
DVDs produced and distributed in this scenario is very large,
meaning that a lot of people get the benefit of access to the film. Second, the consumer surplus generated
by this pricing pattern is very large. Consumer surplus is just
a term that represents the difference between the
price that a given consumer pays for the product and the
value of that product to the consumer, measured most easily
by the maximum amount the consumer would be willing to spend. A rough measure of the total surplus
generated by a particular marketing practice is the area between
the demand curve, which represents consumers’
willingness and ability to pay, and the price of the
product; in other words, the green zone in the
graph in front of you. So you might think, great, we hope
this scenario does indeed occur. The trouble is that the CDF
managers, anticipating this effect, won’t produce Defending Our
Lives in the first place, because they will
recognize that they will be unable even to recoup their costs. Or, perhaps more
realistically, they won’t make any more of their
wonderful films in the future. So the seemingly large
social benefits associated with the absence of copyright
protection turn out, unfortunately, to be illusory. Very few films will be produced
in this legal environment. So wait a minute, you
may be thinking, won’t some of the alternative motivations
that are sources of revenue for filmmakers that I discussed in
the first segment of this lecture prompt CDF to keep making films? Perhaps, for example, CDF
can get a government grant. Or perhaps private
philanthropists will come forward. Maybe. But for the time being, we’re
focused exclusively on the incentives that the copyright system can generate. So ignore for the moment the
possibility of other sources of funding. Returning to our story, the purpose of
copyright law is to avoid this outcome. How? By suppressing competition in
the production and distribution of embodiments of the creative work; in
this case, the film– in other words, to eliminate CDF’s rivals. If the managers enjoy protection
against competition, how, then, will they price the film? Well, if they have very good and
detailed information concerning the ability and willingness to
pay of every individual customer, plus the capacity to vary
the price of the DVDs, then the managers will charge
each customer the maximum amount that they can. So for example, if the managers know
that X is able and willing to spend PX, they will charge that much. If they know that Y is able and willing
to spend PY, they’ll charge that much. If they know that Z is able and willing
to spend PZ, they’ll charge that much. And the result is that they will
enjoy, the managers will enjoy, through this pricing strategy, monopoly
profits that occupy the same area in our graph that, in the competitive
model, was devoted to consumer surplus. From the standpoint of the CDF
managers, this, of course, is wonderful. It gives them a very large return
on their original investment. From a social welfare standpoint,
it’s beneficial in two respects. The total output, meaning the number of
consumers who get copies of the film, is maximized. And the prospect of these
large potential profits will induce CDF to keep making the
films from which we all benefit and will draw many other aspiring
documentary filmmakers into this field. On the other hand,
consumers are much less happy with this outcome, because each
individual consumer has paid the most that he or she would be willing to pay. The result– the large
amount of consumer surplus, generated by the competitive
scenario, has been altogether replaced here by producer surplus. In other words, all of the benefit
that, in the previous narrative, was reaped by consumers in this
scenario goes to CDF, the producer. So what we’ve just illustrated
is profit-maximizing behavior by a copyright owner who can
engage in so-called perfect price discrimination– in other
words, differentiate perfectly among buyers– charging
each one the maximum amount that he or she would be willing to pay. Now, as you can imagine,
this never happens. Perfect price discrimination
is impossible. Later in this lecture series,
I’ll discuss some circumstances in which, aided by copyright law,
the producers of informational goods can engage in imperfect forms
of price discrimination. But for now, let’s assume that CDF
doesn’t have good information about their consumers and thus cannot
and does not discriminate at all. In other words, we’ll
assume that CDF will charge the same price for
every copy of the DVD. OK, so now how much will
the managers charge? Well, they might determine
the price by experimentation. Remember, the demand for
Defending Our Lives is stable. So the managers could experiment. In month one, they could
set the price at p. They discover that u
number of consumers buy it. They earn revenues of this amount. This zone is, of
course, the cost to them of producing and distributing the DVDs. But that still leaves them
a quite generous profit. So they try an alternative approach. The next month, the managers lower
the price slightly to q, here. They discover that v number of
consumers buy it, a larger number, not surprisingly, because
the price is lower. They make this much more
money in the second month, because they’ve sold more copies. They forfeit this much
money, because they’ve had to reduce the price for everyone. But notice that the purple zone
is larger than the orange zone. So it was a good idea to
have reduced the price. Put differently, the size of the
monopoly profits in the second month is larger than the amount that
CDF enjoyed in the first month. Suppose that, encouraged by
this beneficial price reduction, the managers lower the price more
dramatically in the third month. An even larger number of people buy it. Again, the result is a revenue
gain that exceeds the revenue lost. Once again, the profits enjoyed are
larger than in the previous month. So the managers try
this strategy once more. They reduce the price
of the DVD from r to z. An even larger number of people buy it. This time, the price reduction
turns out to have been a mistake. The revenue gained
through increased quantity is smaller than the revenue lost
because of diminishing the price. What I’ve just outlined is
a possible experimental way of discovering the profit-maximizing
price for copies of the film. Notice that the profit-maximizing
price, when it finally emerges from this experimental process,
is still well above marginal cost, but not as high as the managers might
initially have been inclined to charge. Now, let’s change the
assumptions once more. Suppose that the CDF managers have
no practical way of differentiating among individual consumers, but
on the basis of their experience making and selling other
documentaries in the past, they are able to estimate the
overall shape of the demand curve for Defending Our Lives. If they knew that, then they can
determine the profit-maximizing price in a less haphazard, less
trial-and-error fashion. They would do so by plotting
the marginal revenue curve. What’s that? It’s a representation of the impact
on their total revenues caused by each change in the price. Here’s what it looks like. The reason why this curve drops
more steeply than the demand curve is that, as we’ve seen,
each price decrease benefits CDF by expanding the
set of people who purchase, but also injures CDF by
forfeiting some of the profit that CDF could’ve enjoyed by
targeting a smaller set of customers. So on the highly simplified
assumptions embodied in this graph, the marginal revenue curve
will bisect the angle between the demand curve
and the vertical y-axis. By plotting this line,
the CDF managers are able to locate the place where the
marginal revenue and marginal cost curves cross. They should then select
the price for their DVDs that will reach a set of
consumers that, in turn, will cause those curves to intersect. If they drop the price any
further, the marginal revenue they gain through
additional purchases will be less than the marginal cost
of producing the additional DVDs. If they increase the price, they
will forfeit in potential revenue more money than they save in costs. So they should settle at this point. If they do, the number of consumers who
purchase the DVD each month will be q. p on the graph is the corresponding
profit-maximizing price. And q is the profit-maximizing output. This strategy, to repeat,
will generate each month profits measured by the blue zone. The strategy I’ve just
outlined will have two crucial side effects– one
of them good, the other one bad. The good one is that, unlike
perfect price discrimination, which we discussed a minute ago, this
more familiar and feasible strategy will leave many consumers happy. Specifically, the people who buy
the DVD at price P feel better off. Specifically, they
experience pleasure measured by the difference
between what they paid– that’s price p– and the
maximum amount that they would have been willing to pay. The sum of all of the
benefits enjoyed by all of the consumers who bought
the DVD– in other words, the total consumer surplus–
is represented on the graph by the green zone. The bad side effect is
that many of the people who would have purchased the
film, had it been priced at the actual cost of
making the copies, won’t, because they can’t afford price p. The result is what economists refer to
as deadweight, a somewhat grim term. In this case, it refers to consumer
surplus that could have been gained, but is sacrificed or foregone as a
result of the pricing strategy pursued by CDF. So the green zone is
socially beneficial, while the red zone is unfortunate. Why do we tolerate the red zone? The conventional justification is
that films, like Defending Our Lives, will only exist if potential
creators, like CDF, are attracted by the opportunity to enjoy
profits, measured by the blue zone. In short, the red zone
is regrettable, but is necessary to enable us to
reap the blue and green zones. That, in brief, is the core of
the justification and explanation of the copyright system seen from
the standpoint of welfare theory. Now, those of you who are
economists have undoubtedly recognized respects in which
this scheme is oversimplified. Some of those respects I’ll address
in the remainder of this lecture. Others I’ll examine in subsequent
lectures in this series. And still others I won’t address at all. But this is enough to get us started. It’s very important that
you feel comfortable with the primary features
of this argument. To repeat one more time,
the heart of welfare theory is the proposition that,
unless creators can recoup the costs of their creations,
their so-called costs of expression, they won’t produce those
creations in the first instance. And the way that the law enables them
to recoup their costs of expression is to suppress competition
in the creation and distribution of their works. The absence of competition,
in turn, enables the creators to price copies of their
creations well above the costs of making and distributing
them, which enables the creators to reap monopoly profits. That still leaves consumers who are
able to purchase the goods better off than before, but has
the unfortunate side effect of pricing out of the market a
significant set of potential consumers. That’s regrettable, but
we tolerate it in order to stimulate creativity
in the first instance. Some confirmation for this approach
can be gleaned from the fact that actual pricing practices
in the film industry align reasonably well with the
predictions generated by this model. Here, for example, is
the price on amazon.com of a DVD of Schindler’s List,
which, like Defending Our Lives, won an Academy Award in 1993. Like Defending Our
Lives, Schindler’s List remains popular, so there’s
still considerable consumer demand for copies of it. So how was it priced? Well, as you can see,
the list price is $15. Amazon sells it for $10. As you’ll recall, the
cost of producing a DVD, including one containing
Schindler’s List, is roughly $2.70. So P, on this graph, which, you’ll
recall, emerged from our analysis as the profit-maximizing price, is
more or less in the zone of $10 to $15. Now, interestingly, the film that we’ve
been discussing thus far, Defending Our Lives, is not priced at $15. On the screen is the website
for Cambridge Documentary Films from which you can purchase
the copies of the DVD. Enlarging it a bit, you can see
that CDF is selling it for $175. That’s hard to explain on the basis of
the analysis we’ve conducted thus far. It would seem that CDF has chosen
to set the price way up here. A price this high will earn
CDF some monopoly profits. But the CDF managers seem to be
forfeiting a large potential market. So why do they do this? A clue is provided by their website,
which indicates, as you can see, that the prices of their DVDs
include public performance rights. To understand the significance
of that statement, I need to provide you a
preview of some material that we’ll discuss in much more detail
in lectures number seven and number eight. When you buy a DVD, you’re permitted
to do a lot of things with it, including, of course, watch it at
home in your living room or den. But you’re not permitted
to use that DVD to display the film on a screen in a public place. The reason is that the owner
of the copyright in the film enjoys, among other rights, the
exclusive right to perform it publicly. Your ownership of a
copy of the DVD does not authorize you to encroach upon the
copyright owner’s public performance right. So if you want to show it to people
other than your family and friends, you have to get a
separate license to do so. So what CDF is doing here is selling a
bundle of two things– a physical DVD and a separate public
performance license. The latter is worth much
more than the former. Another inference we can draw from
this somewhat unusual pricing strategy is that the customers that
CDF has primarily in mind are not ordinary consumers,
people who buy DVDs in order to play them on
televisions in their dens. Rather, the CDF managers
are aiming primarily at teachers or institutions that want to
educate people about domestic violence. Put slightly differently, it seems that
there are two quite different markets for Defending Our Lives– regular
consumers and institutions. To represent the two markets, I have to
adjust the graph that I’ve been using, first by shrinking it and
then by expanding the scales. The institutional market
for Defending Our Lives would then look something like
this, while the market consisting of ordinary consumers
would look like this. Why is the demand curve for
the former so high and steep? Because the institutions anticipate
showing it to lots of people repeatedly in educational settings. And at least some of those
institutions are thus able and willing to spend quite
a bit for that opportunity. Individual consumers, by contrast, are
able and willing to spend much less. If CDF’s customers are clumped this
way, then CDF’s pricing practice makes a lot more sense. The managers are setting
the price way up here. They are, to be sure,
forfeiting a significant number of potential consumers. But this price is indeed
profit-maximizing. Now, there’s a nuance lurking here. Why don’t the managers
separate the two markets and charge the two sorts of
customers different amounts? That would represent a form of price
discrimination, not the perfect price discrimination of the sort we considered
before, but imperfect discrimination. it would not be as lucrative
as perfect discrimination, but it would generate higher
profits than flat pricing. Indeed, my brief discussion a few
minutes ago of public performance rights may alert you to one way in which
the CDF managers could separate the two markets. They could offer the DVDs with public
performance rights for one price, $175, and then DVDs without such public
performance rights for much less, say $10. Not only would that practice
currency df more money you would also be socially beneficial
because more people would have access to the film. So why don’t the CDF managers do this? The most likely explanation
is unenforceability. Even though copyright
law, on its face, seems to give them the power to
differentiate prices in the two markets by granting to some buyers
public performance rights and denying those rights
to others, in practice, CDF could not detect and punish
violations of their public performance rights by institutions that
purchase the plain DVDs. Anticipating this, some teachers would
buy the inexpensive, plain copies and then unlawfully perform
them for their classes. And the result would be to
corrode CDF’s high-end market. The result in loss of
revenue would exceed the gain that CDF gets for making the simple
DVDs available to non-teachers. Several important themes
lurk in this last example– the merits and demerits
of price discrimination, the marketing possibilities created
by the various exclusive rights held by a copyright owner,
and the limitations on those options created
by the difficulty in some settings of
enforcing copyrights. We’ll return to all of these
themes later in the course. This concludes our initial exploration
of the welfare theory of copyright. In the third and final
segment of this lecture, I’ll discuss a few applications and
refinements of the welfare approach and then step back from
the details and ask you, through these lenses, what are the
strengths and weaknesses of copyright.

Daniel Yohans

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