Network externalities, price discrimination and profitable piracy

Recent papers have argued that a monopoly firm might be able to maximize its profit by allowing some customers to steal its product. In particular, with network externalities, it is claimed that allowing piracy can be profitable because it increases the user base of the product and raises the willingness-to-pay of other customers. In this paper we analyze these claims when the producer can freely choose the degree of piracy prevention. We consider profit maximizing equilibria and show that allowing piracy cannot raise profits if the monopoly producer can directly price discriminate between potential-pirates and other customers. In the absence of price discrimination, allowing piracy will only maximize profits when the ability to pirate is inversely related to customer willingness-to-pay. Even in this situation, there is no profit maximizing equilibrium where some potential pirates buy while others pirate the product. Thus, even though potential pirates differ in their ability to illegally gain the product, the profit maximizing outcome involves either no piracy or complete piracy.  2002 Elsevier B.V. All rights reserved.