Counterfeiting and negative consumption externalities —a closer look

Counterfeiting is a growing problem in national and international trade. We extend the work of Grossman and Shapiro (1988) on consumption externalities in prestige goods markets, and model a general aversion towards large levels of output interacting with a firm-specific aversion towards copies. We show that these externalities play the role of protecting the market share of the producer of originals. This can explain why counterfeiting appears to be a greater problem in markets where prestige externalities are weak, e.g., market for music, software and films, compared to markets for prestigious luxury goods. We use the model to re-visit some policy issues discussed in the literature. The government would typically want to allow for some counterfeiting for competition reasons. Hence, the well-established result under positive network externalities, that piracy is an equilibrium, seems to extend to the case of negative consumption externalities. When externalities are pronounced enforcement should be strict, while in markets subject to weak externalities there are no strong arguments in favor of a strict policy. This implies that a large market share for the firm producing originals is not necessarily an indication of a well-functioning market On the contrary, in our framework, consumer welfare concerns suggest that enforcement should be especially strict in such markets. JEL: L13; D62