It is commonly believed that piracy of information goods leads to lower profits, which translate to lower incentives to invest in innovation, and eventually to lower quality products. Manufacturers, policy-makers, and researchers, all claim that inadequate piracy enforcement efforts translate to lower investments in product development. However, we find many practical examples that contradict this claim. Therefore, in order to examine this claim more carefully, we develop a rigorous economic model of the manufacturer’s quality decision problem in the presence of piracy. We consider a monopolist who does not have any marginal costs but has a product development cost that is quadratic in the quality level produced.
The monopolist faces a consumer market that is heterogeneous in its preference for quality, and decides on a quality that maximizes its profit. We also allow for the possibility that the manufacturer may use versioning to quell piracy. We unexpectedly find that, in certain situations, a lower piracy enforcement (or, equivalently, a lower piracy cost) increases the monopolist’s incentive to invest in quality. We explain the reasons and welfare implications of our findings.