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International Journal of Production Economics 206 (2018) 184–195

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International Journal of Production Economics


journal homepage: www.elsevier.com/locate/ijpe

Digital pricing with piracy and variety seeking T


a b,∗ b c
Yu Ning , Su Xiu Xu , Mian Yan , George Q. Huang
a
College of Management, Shenzhen University, Shenzhen, China
b
Institute of Physical Internet, School of Electrical and Information Engineering, Jinan University (Zhuhai Campus), Zhuhai, China
c
HKU-ZIRI Lab for Physical Internet, Department of Industrial and Manufacturing Systems Engineering, The University of Hong Kong, Hong Kong

ARTICLE INFO ABSTRACT

Keywords: This paper aims to explore behavioral digital pricing which incorporates realistic consumer behavior into firms'
Digital pricing pricing and anti-piracy investment models. We consider a duopoly market with an original company and a
Piracy pirated group selling digital products. The demand is sensitive to both parties' prices. We extend the traditional
Protection investment Hotelling model by taking into account the effects of externality on both parties. We then propose three types of
Variety seeking
price competition games: (I) Cournot model, (II) Stackelberg model with the original company as the leader, and
Externality
(III) the Stackelberg model with the pirated group as the leader. In model II, if the value of externality effects is
lower than a threshold, the original company will benefit from the government anti-piracy policy that tolerates
some piracy. Finally, we investigate the behavior of consumer variety seeking in a two-period Cournot model. With
the presence of variety seeking, both the original and pirated parties will adopt higher prices in the first period.
Surprisingly, variety seeking brings higher profits to both parties in two periods.

1. Introduction the original companies has been identified by a number of studies (e.g.,
Khouja and Smith, 2007; Khouja and Rajagopalan, 2009; Liu et al.,
Piracy has been one of the biggest challenges facing digital in- 2011), there are some researchers standing on the opposite side. For
dustries such as software, music, e-movie, e-book, and mobile appli- example, Jeong et al. (2012) find that despite the presence of ex-
cation. According to a recent report (FACT et al., 2017) which collates ternality, digital piracy causes negative effects to the media and music
expert insights from FACT (www.fact-uk.org.uk), the City of London industries. Simply, network externality means that the utility of each
Police, Entura International, Intellectual Property Office (IPO), Police consumer from using a product is positively related to the total number
Intellectual Property Crime Unit (PIPCU), and Police Scotland, 25% of of the consumers using it (Shapiro and Varian, 1999). The existing re-
British people watch or download illegally pirated movies, TV shows search focuses on the effects of externality on the legal side. In reality,
and footage of live sporting events. With the universality of computers the externality will naturally affect the pirated groups, and in turn such
and smart phones, piracy has become more serious and threatening the effects may hurt the original companies and public welfare.
public and creative industries. The original companies therefore have to This work considers a duopoly market consisting of an original
invest a large amount of capital in product protection. company and a pirated group. They sells a digital product to the con-
The operations management literature has recently suggested that sumers. We incorporate the externality into a Hotelling model
pricing strategies will play a pivotal role in cracking down digital piracy (Hotelling, 1929) and impose the effects of externality on both parties.
(e.g., Kogan et al., 2013; Avinadav et al., 2014; Waters, 2015; Huang Unlike the traditional Hotelling models (e.g., Hotelling, 1929; Osborne
et al., 2017; Herings et al., 2018). In the existing models, the original and Pitchik, 1987), we assume a zero transportation costs of digital
company is a monopolist selling digital goods and has to invest in products based on realistic observations. The demand is sensitive to the
combating piracy. The original company needs to figure out a solution prices of both the original and pirated companies.
to the pricing and anti-piracy investment problems. The optimal pricing We take into account various power balances between both parties
decision is usually determined subject to an investment in the fight and various orders of their decisions. We thus propose three types of
against piracy. Indeed, the literature has ignored the importance of price competition games: Cournot model, Stackelberg model with the
government in digital piracy. original company as the leader, and the Stackelberg model with the
Furthermore, although the positive effects of network externality on pirated group as the leader. We also investigate the role of government


Corresponding author.
E-mail address: xusuxiu@gmail.com (S.X. Xu).

https://doi.org/10.1016/j.ijpe.2018.09.026
Received 13 April 2018; Received in revised form 28 July 2018; Accepted 20 September 2018
Available online 26 September 2018
0925-5273/ © 2018 Elsevier B.V. All rights reserved.
Y. Ning et al. International Journal of Production Economics 206 (2018) 184–195

in digital piracy. In the Stackelberg model where the original company pricing policy and protection investment. We employ a Stackelberg
is the leader, the government can better suppress the piracy. If the value price competition game where the original company is the leader and
of externality effects is lower than a threshold, the government policy the pirated group is the follower. Of course, if the government stands in
that tolerates some piracy will be more beneficial for the original the position of public welfare, the complete combating policy which re-
company. sults in zero spread velocity of digital piracy should be the best.
In addition, we observe a phenomenon called consumer variety However, given the government stands in the original company's place,
seeking, which implies that the type of consumers shifting from using it is optimal to adopt the incomplete combating policy which tolerates
one product to other ones after a period of time (e.g., see Klemperer, some piracy when the value of externality effects is relatively small.
1987; Sarigollu and Schmittlein, 1996; Seetharaman and Che, 2009; Some recent studies deal with digital piracy from the supply chain
Sajeesh and Raju, 2010). To our best knowledge, there are few studies perspective. Avinadav et al. (2014) focus on a software supply chain
devoting to the effects of variety seeking on digital piracy. This paper with a manufacturer and a retailer, and address the pricing and product
therefore fills this gap by exploring behavioral digital pricing. In par- protection strategies subject to uncertain demand. Similarly, Chernonog
ticular, we consider the variety seeking behavior in a two-period set- et al. (2018) also consider a two-echelon supply chain of a virtual
ting. The second period is indeed viewed as the last phase of the finite product, consisting of a manufacturer and a retailer. However, the
horizon. Thus, in the second period the original company will stop in- supply chain members face the random demand, which depends on
vesting in the anti-piracy activity. We prove that both parties will adopt both price and quality of the product. Given the random demand
a higher price in the first period. In this sense, our result is consistent function and the members' risk attitudes, the optimal pricing and
with the skimming strategy suggested by the existing studies such as quality investment policies are obtained. Due to the variety of selling
Khouja and Smith (2007) and Waters (2015). We further find that the channels, Huang et al. (2017) consider a digital goods supply chain
variety seeking behavior brings higher profits to both parties in a game- with a supplier, a digital retailor and a traditional retailor. A Stackel-
theoretical setting. Our results implies that if consumers are variety- berg game is utilized to analyze the effects of piracy on demand and
seeking, it is rather challenging to put an end to digital piracy. pricing.
This paper is organized as follows: In Section 2, we present a review In this paper, the demand depends on the prices of both the original
of related literature. The problem description is given in Section 3. We and pirated digital products. Network externality is incorporated into a
conduct the model analysis in Section 4. Numerical results are pre- Hotelling model. Another key difference from the traditional Hotelling
sented in Section 5. Section 6 contains conclusions and suggestions for models (e.g., Hotelling, 1929; Osborne and Pitchik, 1987) is that we
future research. assume no transportation costs for the digital products. In reality, there
are always some variety seeking consumers shifting from using one pro-
2. Literature review duct to other ones after a period of time (e.g., see Klemperer, 1987;
Sarigollu and Schmittlein, 1996; Seetharaman and Che, 2009; Sajeesh
There are a number of literature on the piracy of digital products in and Raju, 2010). We hence consider the behavior of consumer variety
various industries such as software, media, and music. Although the seeking in a two-period pricing model. To our best knowledge, the
digital piracy will differ in terms of product characteristics, temporal importance of variety seeking has been ignored in the literature of di-
and economic factors, the majority of relevant research focuses on the gital piracy. Our results show that with the presence of variety seeking,
pricing and anti-piracy investment decisions, as well as the impact of both the original and pirated parties will adopt higher prices in the first
externality. period. In addition, variety seeking brings higher profits to both parties
Indeed, the effects of externality are double-edged. Intuitively, the in two periods. In other words, piracy cannot be wiped out if there
original company will lose some consumers due to digital piracy. On the exists variety seeking consumers.
other hand, piracy can advertise the product to more users and the
original company thus benefits from externality (e.g., Khouja and 3. Problem description
Rajagopalan, 2009; Liu et al., 2011). A different voice from Jeong et al.
(2012) is that regardless of network externality, digital piracy is causing Consider a duopoly market consisting of an original company
harm to the media and music industries. Unlike the above studies, we (Company 1), a pirated company (Company 2), and a number of con-
assume a duopoly market with an original company and a pirated sumers. Company 1 and Company 2 sell a certain product to consumers.
group, and investigate the effects of externality on both parties. The unit cost of Company 1 is larger than that of Company 2, i.e.,
Another stream of literature use pricing policy as a powerful tool in C1 > C2 . Without loss of generality, we assume the following linear
the fight against digital piracy. Khouja and Smith (2007) consider the market demand function
pricing problem faced by a monopolist offering an information product.
Q (P1, P2 ) = Q0 1 P1 2 P2 (1)
They present the profit-maximization models with combining the ef-
fects of piracy and saturation, as well as the investment in combating Let I be the investment of Company 1 in combating piracy, we have
piracy. Numerical results show that when the effects of piracy and sa-
I = I0 V (2)
turation are strong, a skimming strategy is suboptimal. In the work by
Khouja and Rajagopalan (2009), there is no investment in product From (2), one may find that the greater the capital invested by
protection, and a two-price strategy and dual distribution channel are company 1 in combating piracy, the smaller the growth velocity of
recommended for restricting digital piracy. Kogan et al. (2013) consider piracy (e.g., see Khouja and Smith, 2007). As shown in Table 1, the
a monopolistic producer selling a periodically updated software, and by investment of Company 1 is a decision variable. If the original company
the end of one period a pirated version will appear at a transaction cost. wants to completely crack down the piracy (V = 0) , he has to invest a
They find that when the transaction cost is exogenous, the fully pricing sufficiently large capital (I0 ) into such economic activity.
out piracy is not the monopolist's optimal strategy. Waters (2015) According to the Hotelling model (Hotelling, 1929), we assume that
presents a dynamic pricing model for information goods with piracy the utility, as well as the net utility of a consumer to purchase the
and heterogeneous consumers. Three pricing strategies, namely, skim- product from Company 1, are equal to those from Company 2.
ming, compressing price changes, and delaying product launch are in- If a consumer purchases the product from Company 1, then his net
vestigated. Most recently, Herings et al. (2018) adopt a dynamic sto- utility is
chastic pricing model for music recordings in the presence of P2P file-
u =u (a + x ) P1 (3)
sharing networks cutting down their sales.
In this paper, we emphasize the importance of government in where (a + x ) represents the value of network externality, which is a

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Y. Ning et al. International Journal of Production Economics 206 (2018) 184–195

Table 1 1 P1 P2 Q0 2b P1 1 P2 2
V= [ + ]
Notation and definition. 2 2 (8)
Decision variables The profit of Company 1 ( 1) is given by
x The increased market share of the original company
I The investment of the original company in combating piracy, 1 = (P1 C1)(a + x ) I
I = I0 V P2 P1 Q0 P1 1 P2 2 P1 P2 Q0 2b P1 1 P2 2
P1 The price of the original product
= (P1 C1)( 2
+ 2
) I0 + ( 2
+ 2
)
P2 The price of the pirated product
(9)
Other variables
a The fixed market share of the original company Similarly, the profit of Company 2 ( 2 ) is as follows
b The fixed market share of the pirated company
y The increased market share of the pirated company, y = V 2 = (P2 C2 )(b + V )
V The growth velocity of piracy = (P2 C2)(
P1 P2
+
Q0 P1 1 P2 2
)
Constant, > 0 , representing the impact of the growth velocity of 2 2 (10)
piracy on y
Q (P1, P2) Market demand function, Q (P1, P2) = Q0
By finding the first-order partial derivative of 1 with respect to P1,
1 P1 2 P2
Q0 The fixed market demand when P1 = P2 = 0 we have
1 Constant, 1 > 0 , representing the impact of the price of the original
1 1
product on market demand = [P2 + Q0 P2 2 + (C1 2P1)( 1 + 1) ( 1 1)]
2 Constant, 2 > 0 , representing the impact of the price of the pirated P1 2
product on market demand (11)
C1 The unit cost of the original product, C1 > C2
C2 The unit cost of the pirated product By finding the second-order partial derivative of 1 with respect to
u A consumer's utility P1, we have
u A consumer's net utility
2 1
Constant, > 0 , representing the impact of network externality on the 1
= ( 1 + )
purchase intention of consumers P12 (12)
I0 The investment when V = 0 ; and I0 is a sufficiently large constant
2
Constant, > 0 , representing the impact of the growth velocity of Since P1
1
< 0 , the optimal pricing of the original company P1 is
piracy on the investment in combating piracy
1 The profit of the original company solved by P = 0 . 1
1
2 The profit of the pirated company Similarly, calculating the first-order partial derivative of 2 with
The percentage of consumers with variety seeking behavior, 0 < < 1 respect to P2 , we get
2 1
= [P1 + Q0 P1 1 + (C2 2P2 )( 2 + 1)]
part of the consumer's utility u . Network externality means that the P2 2 (13)
utility of each consumer from using a product is positively related to the Calculating the second-order partial derivative of with respect to
2
total number of the consumers using it (Shapiro and Varian, 1999). P2 , we get
Similarly, if a consumer purchases the product from Company 2,
2 1
then his net utility is 2
= ( + ) <0
2
P22 (14)
u =u (b + y ) P2 (4)
By solving the equation set: 1
= 0 and 2
= 0 , we obtain that
where (b + y ) represents the value of network externality, and P1 P2

y = V. 2C1 (1 + 1 )(1 + 2 ) + C2 (1 2 2
2 ) + Q0 (3 + 2 )
Note that, unlike the traditional Hotelling models (e.g., Hotelling, 2
+ (1 1 )(1 + 2 )
1929; Osborne and Pitchik, 1987), digital products are often trans- P1 =
ported without any cost, and we thus do not consider the positioning 3+5 1 +5 2 +3 1 2
2
(15)
problem of the two companies. 2 2
2C2 (1 + 1 )(1 + 2 ) + C1 (1 1 ) + Q0 (3 + 1 ) + (1 1 )2
P2 = 2
3+5 +5 +3
4. Model analysis 1 2 1 2

(16)
4.1. Cournot price competition model Therefore, we have the following main result:

Suppose that the status of the original company is comparative to Theorem 1. Assume that the original company and pirated company make
that of the pirated company, and they make the pricing decisions si- the pricing decisions simultaneously. Then, there exists a unique Nash
multaneously. The price competition between the two companies fol- equilibrium. The optimal pricing strategy is given by (15) and (16). The
lows the Cournot model. optimal expansion strategy of the original company x is
In the duopoly market, we have P2 P1 Q0 2a P1 1 P2 2
x = +
Q (P1, P2 ) = Q0 1 P1 2 P2 = a + x + b + V (5) 2 2 (17)

Observe that in the general model, the market demand Q (P1, P2 ) is


not fixed. If Q (P1, P2) = Q0 , then the increased market share of the The optimal anti-piracy strategy of the original company I is
original company should be equal to the reduced market share of the
pirated company; that is, x = y. P1 P2 Q0 2b P1 1 P2 2
I = I0 ( + )
From (3) and (4), it follows that 2 2 (18)

P1 + (a + x ) = P2 + (b + V ) (6) We next consider a special case: Q = Q0 . In other words, the total


market demand is fixed and has nothing to do with the pricing strategy
Thus, we obtain of the two companies, i.e., 1 = 0 , 2 = 0 . Based on the results of
P2 P1 Q0 2a P1 1 P2 2
Theorem 1, we have the following corollary:
x= +
2 2 (7) Corollary 1. Assume that Q = Q0 , and the original company and pirated

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Y. Ning et al. International Journal of Production Economics 206 (2018) 184–195

company make the pricing decisions simultaneously. Then, the unique Nash 1
P1 = (C1 + C2 + 3Q0 + )
equilibrium solution (P1 , P2 , x , I ) is given by: 2 (27)

2C1 + C2 2 1
P1 = + Q0 + P2 = (3C2 + C1 + 5Q0 + )
3 3 (19) 4 (28)

2C2 + C1 C2 C1 3Q0
P2 = + Q0 + x = + a
3 3 (20) 8 8 8 (29)

C2 C1 Q0 C1 C2 5
x = + a I = I0 ( + Q0 b+ )
6 2 6 (21) 8 8 8 (30)

C1 C2 Q0
I = I0 ( + b+ )
6 2 6 (22) We use 1Leader 1 to represent the profit of Company 1 which is the
market leader in the Stackelberg price competition model, and 1Cournot
to represent the profit of the Company 1 in the Cournot price compe-
tition model. Similarly, let 2Leader 1 represent the profit of Company 2
when Company 1 is the market leader, and 2Cournot represent the profit
4.2. Stackelberg price competition model
of Company 2 in the Cournot price competition model.

4.2.1. The original company as the market leader Theorem 3. Assume Q = Q0 , we conclude that
In Section 4.1, we assume that the powers of the original company
and pirated company in the market are fair, and their decision-making (a) 1Leader 1 Cournot
1 ;
processes are simultaneous. Usually, the original company occupies the (b) When C2 > C1 3Q0 + , we have Leader 1
2 > Cournot
2 ; when
dominant position in the market and plays the role of the “leader”, C2 < C1 3Q0 + , we have Leader 1
< Cournot
; when
2 2
while the pirated company is the “follower” whose market power is
C2 = C1 3Q0 + , we have Leader 1
= Cournot
.
relatively weak. That is, the original company determines his optimal 2 2

pricing strategy in the first place, the pirated company then makes Proof. Obviously, we can get the following formula:
decision accordingly. Note that, the original company must take into
1 C2 C1 3Q0
account how the pirated company would react to his pricing strategy.
Leader 1
1 = (C2 C1 + 3Q0 + )( + ) I0
2 8 8 8
We first analyze the response strategy of Company 2. By solving
C1 C2 5
P
2
= 0 , we get + ( + Q0 b+ )
2 8 8 8
C2 P (1 1 ) + Q0
P2 = + 1 C2 C1 2 C C1 Q
2 2(1 + 2 ) (23) Cournot
1 =( + Q0 + )( 2 + 0 ) I0
3 3 6 2 6
Substituting formula (23) into Company 1's profit function 1, and C1 C2 Q0
we find that + ( + b+ )
6 2 6
2 3 +3 2 + 2 +1
1 1 1 2
= <0
P12 2 (1 + 2 ) (24)
Next, by solving 1 = 1
Leader 1 Cournot
1 , we have
The optimal pricing of Company 1 (P1 ) is obtained from 1
= 0 , i.e.,
P1 9Q02 2 2 + 6Q0 (C2 2 C1 2 ) + 2 + 2 C1 2 C2 + (C1 C2)2 2
1 =
2 2 144 2
C1 C2 (1 2 ) + Q0 (3 + 2 ) + (1 1 )(1 + 2 )
P1 = + ( + C1 C2 3Q0 )2
2 2(3 +3 + 2 + 1) = 0
1 2 1 2 144 2

(25)
Thus, Theorem 3 (a) is proved. □
Let: A =
5 1 +5 2 +3 1 2 2+3
and B = , Then,
7 2 +3 1 + 1 2 2+5
. Similarly,
3(3 1 + 3 2 + 1 2 2 + 1) 5(3 1 + 3 2 + 1 2 2 + 1)
substituting (25) into (23), we obtain the optimal pricing for Company Leader 1 1 C1 C2 5Q 0
2 = 4 (C1 C2 + 5Q0 + )( + + )
2: 8 8 8
Cournot 1 C1 C2 Q0
2 2 = (C1 C2 + 3Q0 + )( + + )
3 C (1 1 ) + 5Q0 B (1 1 )
3 6 2 6
P2 = C2 A + 1 + 2
4 4(1 + 2 ) 4 (3 1 +3 2 + 1 2 + 1) Leader 1 Cournot
2 = 2 2
(26)
( + C1 C2 + 5Q0 )2 ( + C1 C2 + 3Q0 )2
=
Thus, we have the following main result: 32 2 18 2

Theorem 2. Assume the original company is the market leader and the Because C1 > C2 , the sign of 2 depends on the sign of
pirated company is the follower. Then, the Stackelberg price competition ( + C1 C2 3Q0 ) . Thus, Theorem 3(b) is proved. □
model has a unique Nash equilibrium. The optimal expansion strategy x
and anti-piracy strategy I of the original company are given by (17) and 4.2.2. The pirated company as the market leader
(18), respectively. The optimal pricing strategy (P1 , P2 ) is given by (25) and In fact, the piracy of certain digital products (e.g., digital movies,
(26). operating software) is very rampant and a remarkable number of con-
sumers are using pirated digital products. In this situation the pirated
When Q = Q0 , we have 1 = 2 = 0 , A = B = 1. According to
company has become the “temporary” market leader. How to react to
Theorem 2, we obtain the following corollary.
the adversity and effectively combat piracy has been a key challenge for
Corollary 2. Assume that Q = Q0 , and the original company is the market the original company, which acts as a follower in the market. For this
leader. Then, the Stackelberg game model of the digital product pricing has a particular phenomenon, we should discuss the optimal pricing strate-
unique Nash equilibrium solution (P1 , P2 , x , I ), i.e., gies for both the original company and pirated company.

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Y. Ning et al. International Journal of Production Economics 206 (2018) 184–195

Simply, the optimal pricing of Company 1 P1 is solved by 1


P1
= 0, 3 = Leader 2
2
Cournot
2
i.e., ( + C1 C2 + 3Q0 )2
= 0
144 2

C1 P2 (1 2 ) + Q0 + (1 1 )
P1 = + Thus, Theorem 5(a) is proved. □
2 2(1 + ) (31)
1
Similarly, we obtain
Then, by substituting the optimal pricing of Company 1 (P1 ) into Leader 2 1 3 C2 C1 5Q0
Company 2's own profit function 2 , and calculating the second-order 1 = 4 (C2 C1 + 5Q0 + )( 8
+ 8 8
) I0
partial derivative of 2 with respect to P2 , we find that + (
C1 C2
+ 8 Q0
3
b+ )
8 8
2 3 +3 2 + 2 +1 2
2 1 1 2 Cournot C2 C1 C2 C1 Q0
= <0 1 =( + Q0 + )( + ) I0
P22 2 (1 + 1 ) (32) 3 3 6 2 6
C1 C2 Q0
+ ( + b+ )
By solving 2
P2
= 0 , we derive the optimal pricing of Company 2 (P2 ) , 6 2 6

2 2 Leader 2 Cournot
C2 C1 (1 1 ) + Q0 (3 + 1 ) + (1 1 )2 4 = 1 1
P2 = + 1
2 2(3 1 +3 2 + 1 2
2 + 1) (33) =
288 2
[7( + C1 C2 ) 2 6Q0 ( + C1 C2 ) 81(Q0 ) 2]
7 1 +3 2 + 1 2 2+5
Let: B = 5(3 1 + 3 2 + 1 2 2 + 1)
. According to (31), we have Note that C1 > C2 , the sign of 4 depends on the sign of
3 [7( + C1 C2 ) 27Q0 ]. Thus, Theorem 5(b) is proved. □
3 C2 (1 2 ) + 5Q0 B + (1 1 )A
P1 = C1 A +
4 4(1 + 1 ) (34) 4.3. The anti-piracy government
The above result is summarized as follows:
In this part, it is assumed that the government stands on the side of
Theorem 4. Assume that the pirated company is the market leader and the anti-piracy and that there is sufficient capital to combat piracy. From
original company is the follower. Then, the Stackelberg price competition the public welfare point of view, the government's optimal strategy is
model has a unique Nash equilibrium. The optimal expansion strategy x I = I0 (called the complete combating strategy), i.e., the growth velocity
and the optimal anti-piracy strategy I are given by (17) and (18), of piracy V = 0 .
respectively. The optimal pricing strategy (P1 , P2 ) is given by (33) and (34). If I = I0 , we have
We now consider the situation Q = Q0 : = = 0 , A = B = 1. We Q (P1, P2 ) = Q0 (38)
1 P1 2 P2 =a+x+b
1 2
have the following corollary:
P1 + (a + x ) = P2 + b (39)
Corollary 3. Assume Q = Q0 , and the pirated company is the market
leader. Then, the Stackelberg game model of the digital product pricing has a Q0 a b ( +
1 2 ) P1 2 (a b)
unique Nash equilibrium solution (P1 , P2 , x , I ), i.e., x=
2 +1 (40)
1 3
P1 = (3C1 + C2 + 5Q0 + ) P1 (1 ) + ( Q0 2b)
4 (35) P2 = 1

2 +1 (41)
1
P2 = (C2 + C1 + 3Q0 + ) Then the profit of Company 1 ( 1) is
2 (36)
1 = (P1 C1)(a + x )
C2 C1 5
x = + Q0 a Q0 ( 1 + 2) P 1 + b ( 2 1)
8 8 8 (37) = (P1 C1)[ ]
2 +1 (42)

C1 C2 3 The optimal pricing of Company 1 (P1) is solved by 1


= 0 , i.e.,
I = I0 ( + Q0 b+ ) P1
8 8 8 (38)
C1 Q + b( 2 1)
P1 = + 0
2 2( 1 + 2) (43)

Let represent the profit of Company 1 when Company 2 is the Then, we derive the profits of Company 1 and Company 2,
market leader, and 2Leader 2 represent the profit of Company 2 which is
[Q0 C1 ( 1 + 2) + b ( 2 1)]2
the market leader. 1 =
4( 1 + 2)( 2 + 1) (44)
Theorem 5. Assume Q = Q0 , we conclude that
P1 (1 1 ) + ( Q0 2b)
= b (P2 C2) = b [ C2 ]
(a) Leader 2
2
Cournot
2 ; 2
2 +1 (45)
27
(b) whenC1 < C2 + 7 Q0 , we have 1
Leader 2
> Cournot
1 ;
27
If the government's investment is I , and I < I0 (called incomplete
whenC1 > C2 + 7 Q0 , we have 1
Leader 2
< Cournot
1 ; when combating strategy), then the growth velocity of piracy V > 0 . In this
27
C1 > C2 + 7 Q0 , we have 1Leader 2 = Cournot
1 . situation, (7) and (8) are still valid. We next consider the Stackelberg
model where Company 1 is the market leader.
Proof. First solve the following equations
We first analyze the response strategy of Company 2. By substituting
Leader 2
= 2 (C1
1
C2 + 3Q0 + )(
C1 C2
+
3Q0
+ ) (23) into the profit function of Company 1 ( 1) , we find that formula
2 8 8 8
(24) is still valid. Therefore, the optimal pricing of Company 1 (P1 ) is
Cournot 1 C1 C2 Q0
2 = 3
(C1 C2 + 3Q0 + )( 6
+ 2
+ 6
) solved by 1/ P1 = 0 , i.e.,
2 2
C1 C (1 ) + Q0 (3 + 2 )
P1 = + 2 2
2 2(3 1 + 3 2 + 1 2 2 + 1) (46)
Then, by calculating the difference 3 between Leader 2
2 and Cournot
2 ,
we have By substituting (46) into (23), we have

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3 C (1 1 ) + 5Q0 B II
= (P1II C1)[(a + x )(1 ) + (b + y ) ]
P2 = C2 A + 1 1
4 4(1 + 2 ) (47) 1 P1II P2II 1 P1II P2II
= (P1II C1)((a + x )[ 2 + ] + (b + y )[ 2 ])
2(P1I P2I) 2(P1I P2I) (50)
In the Stackelberg model where Company 1 is the marker leader,
Company 1's optimal expansion strategy x and government's optimal Similarly, the profit of Company 2 in the second period ( II
2 ) is
anti-piracy strategy I are expressed by formula (17) and (18), re- II
spectively. The optimal pricing strategies, P1 and P2 , are given by (46) 2 = (P2II C2 )[(b + y )(1 ) + (a + x ) ]
P1II P2II P1II P2II
and (47), respectively. = (P2II C2)((b +
1
y )[ 2 +
1
] + (a + x )[ 2 ])
In order to differentiate the above mentioned two situations, let 1
2(P1I P2I) 2(P1I P2I) (51)
be the profit of Company 1 when V = 0 , let 1 be the profit of Company Given that Company 1 is the original company and Company 2 is
1 when V > 0 . Our main result is summarized as follows: the pirated company, we may only consider the situation where P1I > P2I
and P1II > P2II . For example, when C1 > C2 , we have 0 < < 1/2 and
Theorem 6. Assume that the government stands in the position of the
b + y > a + x . Thus, 2 1II/ (P1II)2 < 0 and 2 2II/ (P2II) 2 < 0 .
original company, the optimal anti-piracy strategy I is II II
By solving 1
P1II
= 0 and 2
P2II
= 0 , we get that
I0 if 1 1
I = 2C1 + C2
I0 (
P1 P2
+
Q0 2b P1 1 P2 2
) if < P1II = + Q0
2 2 1 1 3 (52)

where P1 and P2 are expressed by (46) and (47), respectively. 2C2 + C1


P2II = + Q0
3 (53)
Note that, when 1 = 1 , the government is on the stand of public
welfare and chooses the complete combating strategy I = I0 , which 1 C1 C2
=
makes the growth velocity of piracy V = 0 . When 1 < 1 , the govern- 2 6(P1I P2I) (54)
ment is on the stand of the original company and chooses the in-
complete combating strategy (V > 0) . Indeed, our numerical result Now we analyze the first period. The total profit of Company 1
further shows that when the value of externality effects ( ) is less than a ( Total
1 ) is
threshold, the incomplete combating strategy (V > 0) is always better Total
= I
+ II
1 1 1
for the original company. In practice, network externality allows more
consumers know the products, whether they are standing closer to the = (P1I C1)(a + x ) I0 + V
original or pirated market. The presence of some digital piracy can
I
1
make the whole market bigger, and hence the original company will + (P1II C1)[(a + x )(1 ) + (b + V ) ]
benefit from such a bigger market.
(55)
II
1

4.4. Variety seeking consumers where x and V are given by (7) and (8), respectively. Similarly, the total
profit of Company 2 ( 2Total ) is 2Total = 2I + 2II .
In this section, we incorporate the variety seeking behavior of Notice that the profit of Company 1 in the second period 1II can be
consumers into the Cournot model. Consumer variety seeking implies that simplified as
the consumers have great arbitrariness in purchasing products and
C2 C1 Q0 C C1
often do not have in-depth knowledge of the brands and product in-
II
1 =( + Q0 )( + 2 )
3 2 6 (56)
formation, and hence switch to using the products of other brands after
a period of using one product (e.g., Klemperer, 1987; Sarigollu and Also, the profit of Company 2 in the second period II
2 can be sim-
Schmittlein, 1996; Seetharaman and Che, 2009; Sajeesh and Raju, plified as
2010).
C1 C2 Q0 C C2
Suppose that a portion of consumers purchased Company 1's pro-
II
2 =( + Q0 )( + 1 )
3 2 6 (57)
ducts in the first period but found that their actual values were lower
than their consumption expectations after a period. Hence, these con- It is known from (56) and (57) that 1Total / P1I = 0 and 1I/ P1I = 0
sumers select the products of Company 2 in the second period. have the same solution, Total
2 / P2I = 0 and 2I/ P2I = 0 have the same
Likewise, the same proportion of consumers purchased Company 2's solution.
products in the first period and switch to using the products of In addition, (54) can be simplified as
Company 1 in the second period.
1 (C1 C2)
Let be the proportion of consumers with variety seeking behavior =
2 2[ (C1 C2) + ] (58)
(0 < < 1) . Let the superscript ‘I’ represent the first period and ‘II’ re-
present the second period. Note that, since we only consider two per- From (58), it follows that satisfies 0 < <
1
.
2
iods, the second period is indeed equivalent to the final period of the The above main result is summarized as follows:
product lifecycle. Therefore, Company 1 will no longer invest in com-
bating piracy in the second period. Theorem 7. Assume Q = Q0 . In the two-period Cournot price competition
To simplify the analysis, we assume Q = Q0 and first analyze the model with variety seeking consumers, the optimal pricing of Company 1
(P1II) and Company 2 (P2II) in the second period are expressed by (52) and
second period. According to the assumptions of the Hotelling model
(53), the optimal proportion of variety seeking consumers (0 < < 1/2) is
(Hotelling, 1929), we have
expressed by (58), the unique Nash equilibrium solution of the two
P1II + [(a + x )(1 ) + (b + y ) ] companies in the first period is given by (19), (20), (21), and (22).
= P2II + [(b + y )(1 ) + (a + x ) ] (48) By comparing (19), (20), (52), and (53), we have the following
From (6) and (48), we obtain that corollary:

P1II P2II Corollary 4. Assume Q = Q0 . In the two-period Cournot price competition


=1 2 model with variety seeking consumers, both Company 1 and Company 2
P1I P2I (49)
adopt a higher price in the first period and adopt a lower price in the second
The profit of Company 1 in the second period ( II
1 ) is period (i.e., P1I > P1II , P2I > P2II ), and (P1I P2I) > (P1II P2II) .

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Y. Ning et al. International Journal of Production Economics 206 (2018) 184–195

Indeed, when there are variety seeking consumers, as compared corollary:


with the situation in the first period, not only the price difference be-
Corollary 7. Assume Q = Q0 . In the two-period Cournot price competition
tween the two companies in the second period will reduce, but also the
model, the net utility of each consumer under the uniform and non-uniform
difference between their market shares will be declined. This implies
pricing strategies is the same and equals to
that the two companies will become “similar” because of the variety
2u 3Q0 (C1 + C2 ) /(2 ) .
seeking behavior.
Based on the above results, and using the formula (3) or (4), we The corollary above implies that a non-uniform pricing strategy that
obtain the following corollary: considers consumers' variety seeking behavior not only increases the
profits of the two companies but guarantees the net utility of each
Corollary 5. Assume Q = Q0 . In the two-period Cournot price competition
consumer in two periods unaltered.
model with variety seeking consumers, the net utility of each consumer in the
first period is given by u 3Q0 /2 (C1 + C2)/2 /(2 ) , and the net
utility of each consumer in the second period is u 3Q0 /2 (C1 + C2)/2 . 5. Numerical results

The above corollary shows that when there exists consumers' variety 5.1. Parameter setting
seeking behavior, the net surplus of each consumer in the second period
will be enhanced due to a decrease in the product prices. In the setting of experimental parameters, the unit cost of Company
If there is no consumer variety seeking behavior ( = 0) , we assume 1 is obviously greater than the unit cost of Company 2, i.e., C1 = $10
that the two companies adopt a uniform pricing strategy in the two and C2 = $2 . Intuitively, compared to the unit cost of original digital
periods, marked as P̂1 and P̂2 . The total profit of Company 1 ( 1Total ) is products, the unit cost of pirated products should be small. In the de-
mand function, the price coefficient of Company 2 is significantly
Total
= I
+ II
= 2(Pˆ1 C1)(a + x ) I0 + V (59)
greater than that of Company 1 ( 2 = 200 ). Put another way, if the pi-
1 1 1

The total profit of Company 2 ( Total


2 ) is rated company increases the price of $1, the total demand will decrease
by 200; and if the original company increases the price of $1, the total
Total
2 = I
2 + II
2 = 2(Pˆ2 C2)(b + V ) (60) demand will only decrease by 30. This is also in line with the actual
By solving Total
1 / Pˆ1 = 0 and Total
2 / Pˆ2 = 0 , we can get situation. According to the consumer expectations in reality, the price
of pirated products tends to be lower, once the price increases slightly, a
2C1 + C2 considerable portion of consumers will give up using pirated products.
Pˆ1 = + Q0 +
3 3 (61) Table 2 presents the values of all parameters in the benchmark case.
Based on the parameter setting in Table 2, the optimal solution of
2C2 + C1
Pˆ2 = + Q0 + the Cournot price competition model is as follows: P1 = $64 , P2 = $17 ,
3 6 (62)
x = 605, V = 28.75, y = 575, I = $8,562.5, 1 = $51,107 , 2 = $23,625. It
Our main result is summarized below: is seen that the price of the original company is significantly higher
than the price of the pirated company, and the profit of the original
Theorem 8. Assume Q = Q0 . In the two-period Cournot price competition
company is also significantly larger than that of the pirated company.
model without variety seeking consumers, the original company's optimal
Compared to the maximum investment in combating piracy
expansion strategy x and optimal anti-piracy strategy I are expressed by
I0 = $10,000 , the original company has paid 85.64% of efforts (I / I0 ) in
(17) and (18) respectively. The optimal uniform pricing strategies P̂1 and P̂2
the Cournot model.
are given by (61) and (62) respectively, and satisfy that P1I > Pˆ1 > P1II and
P2I > Pˆ2 > P2II .
5.2. Cournot model vs Stackelberg model
Notice that by comparing (19), (20), (52), (53), (61), and (62), one
may easily check that P1I > Pˆ1 > P1II and P2I > Pˆ2 > P2II . In other words, in In Sections 4.1 and 4.2, we have presented the results of a com-
the two-period Cournot price competition model, as compared with the parative analysis of the Cournot model and the Stackelberg model
uniform pricing strategies, the existence of consumer variety seeking under a fixed market demand (see Theorems 3 and 5). We next discuss
behavior makes both companies price higher than the uniform price in the comparison between the Cournot model and the Stackelberg model
the first period but price lower than the uniform price in the second under a linear demand function through numerical analysis. Specifi-
period. cally, we should examine the impacts of the network externality coef-
Based on Theorems 7 and 8, the following corollary can be obtained: ficient ( ) and the price coefficient of the pirated company ( 2) on the
Corollary 6. Assume Q = Q0 . In the two-period Cournot price competition investment in anti-piracy, the profits of the two companies, and the
model, as compared with the uniform pricing strategies, a pricing strategy prices.
that incorporates consumers' variety seeking behavior will bring higher Fig. 1 shows the impact of the network externality coefficient ( ) on
profits to the two companies. The increase in the total profits of both the profits of the two companies, where [0.01, 0.5]. It is seen that
companies is the same and equals to 2/(36 2 ) . the six curves in Fig. 1 almost intersect at one point (but not strictly
intersect at one point), and the corresponding of the point is close to
The above corollary can be checked by comparing the total profits 1/30 . In fact, if = 1/30 , we have 1 1 = 0 . It can be known from
of both companies under the two kinds of pricing strategies. This result (15), (16), (25), (26), (33), and (34) that when 1 1 = 0 , the prices
implies that the non-uniform pricing strategies increase the total profits of the two companies are irrelevant to / and the price of Company 2
of the two companies due to the behavior of consumer variety seeking. is irrelevant to C1. Therefore, when = 1/30 , the product price and
This is because that in the variety-seeking setting, both parties' market market share of each company does not change much in the three kinds
shares are changed and they have to use the non-uniform pricing of game models, and the profits of the two companies are relatively
strategies. Clearly, if there are no variety seeking consumers, both
companies will adopt the uniform pricing strategies. Thus, our result is Table 2
consistent with the realistic observation; that is, the non-uniform pri- Parameter setting.
cing strategy is usually better than the uniform pricing strategy for the
Variable Q0 a b C1 C2 I0
sellers. Since we consider the “symmetric” consumer variety seeking, 1 2

the increase in the total profits of the two companies is the same. Value 8000 30 200 500 1000 $10 $2 0.1 $10,000 20 50
Based on Corollary 5 and Theorem 8, we have the following

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Y. Ning et al. International Journal of Production Economics 206 (2018) 184–195

Fig. 2. The impact of network externality coefficient on the prices.


Fig. 1. The impact of network externality coefficient on the profits.

price of Company 2 decreases in the Cournot model and the


close. Stackelberg model with Company 1 as the market leader, and
According to Fig. 1, we have the following main observations: slightly increases in the Stackelberg model with Company 2 as the
market leader;
(1) With the continuous increase of , the profit of Company 1 in- (4) When > 1/30 + , with the continuous increase of , the following
creases, while the profit of Company 2 decreases; findings are even more pronounced: P1Leader 1
(2) When < 1/30 , the profit of Company 2 is greater than that of >P1Cournot > P1Leader 2 > P2Leader 2 > P2Cournot > P2Leader 1.
Company 1, and the profit of each company does not change much
in the three game models, where is a sufficiently small number; Based on the results of Figs. 1 and 2, it seems that for each company,
(3) When > 1/30 + , the profit of Company 1 is greater than that of when > 1/30 + , the comparison result of the prices under different
Company 2. With the continuous increase of , the following ob- game models is consistent with the comparison result of the profits;
servations are even more pronounced: 1
Leader 1
namely, leader > Cournot player > follower.
> 1 Cournot
> 1Leader 2
> 2Leader 2
> 2Cournot
> 2Leader 1
. Fig. 3 demonstrates the impact of the network externality coefficient

When piracy becomes the mainstream consumption in the market


(Company 2 is the market leader), the profit increase of the Company 2
is indeed not obvious, but the strike to the original company is critical,
resulting in a remarkably significant reduction in its profit.
When < 1/30 , the unit gross profit (price minus unit cost) of
the two companies is similar, while Company 2 has a larger consumer
group and Company 1 needs to invest in the fight against piracy. In such
a case, the profit of the pirated company is greater than that of the
original company. With the continuous increase of , the profit of
Company 2 will decrease, and the profit of Company 1 will exceed the
Company 2's profit. Therefore, the main findings of Fig. 1 extend the
results of Theorems 3 and 5.
In Fig. 2, we can find the impact of the network externality coeffi-
cient ( ) on the prices of the two companies. The three curves of
Company 1 almost intersect at one point, and the three curves of
Company 2 also nearly intersect at one point. Similar to Fig. 1, the
corresponding of the two points is close to 1/30 . As explained in Fig. 1,
when 1 1 = 0 , the product price and market size of each company
do not change much in the three game models.
According to Fig. 2, we summarize the following main findings:

(1) The product price of Company 1 is higher than that of Company 2,


and the product price of Company 1 increases with ;
(2) When < 1/30 , the product price of each company does not
change much in the three game models; Fig. 3. The impact of network externality coefficient on the anti-piracy in-
(3) When > 1/30 + , with the continuous increase of , the product vestment.

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Y. Ning et al. International Journal of Production Economics 206 (2018) 184–195

Fig. 5. The impact of price coefficient on the prices.


Fig. 4. The impact of price coefficient on the profits.
profit is greater than that of Company 2. Our findings also imply that
( ) on the investment of Company 1 in combating piracy. In general, the price coefficient 2 only has a significant influence on the
Company 1 invests a relatively large amount of capital in combating Stackelberg model when the pirated company is the market leader.
piracy, and the investment ratio is more than 60% compared to the Fig. 5 illustrates the effect of price coefficient 2 on the product
largest capital invested to combat piracy. With the increase of , the prices of the two companies. Observing all the price curves, one may
cost of combating piracy increases significantly. When < 1/30 , in see that all prices decrease with 2 . When 2 is small enough, the pro-
the Stackelberg model with Company 2 as the market leader, Company duct price of Company 2 is higher than that of Company 1. With the
1's investment cost in combating piracy is lower than the corresponding increase of 2 (e.g., 2 40 ), the product price of Company 1 is sig-
costs under the other two game models. When > 1/30 + , we have nificantly larger than that of Company 2. In particular, when 2 is large
I Leader 2 > I Leader 1 > I Cournot . In fact, when > 1/30 + , compared to enough (e.g., 2 40 ), we have the following finding:
the other two game models, the price difference between the two P1Leader 1 > P1Cournot > P1Leader 2 > P2Leader 2 > P2Cournot P2Leader 1. It is
companies is the smallest under the Stackelberg model with Company 2 noted that this finding is similar to the comparison result of the prices in
as the market leader, and thus the cost of combating piracy is the Fig. 2, but the two curves of P2Cournot and P2Leader 1 are almost overlapped
highest (see (18)). If the original company is the market leader and in Fig. 5.
> 1/30 + , it is relatively easy to guarantee a high profit. Hence, the Fig. 6 presents the impact of price coefficient 2 on the cost of
cost invested in combating piracy will be higher than the corresponding
cost under the Cournot model.
In Fig. 4, we can see the impact of Company 2's price coefficient on
the profits of the two companies. Note that the price coefficient of
Company 1, 1 = 30 , and 2 [20,200]. Thus, the result of Fig. 4 indeed
reflects the impact of the difference in the two price coefficients on the
companies' profits. The main findings of Fig. 4 are summarized as fol-
lows:

(1) The profit of each company decreases with 2 ;


(2) 1Leader 2 is significantly less than 1Leader 1 and 1Cournot , while and
1
Cournot
are close; 1Leader 1
(3) is significantly less than 2Leader 2 and 2Cournot , while 2Leader 2 and
Cournot
2 is close;
(4) When 2 2Leader 1 is small enough (e.g., 2 40 ), the profit of
Company 2 is greater than that of Company 1; when 2 is large
enough (e.g., 2 80 ), the profit of Company 1 is greater than that
of Company 2.

With the increase of 2 , the total market demand decreases, so that


each company's profits are reduced. When 2 is small enough (e.g.,
2 40 ), the difference between 1 and 2 is not large. Since Company 1
needs to take the expenses of combating piracy, his profit is smaller
than that of Company 2. On the contrary, when 2 is large enough (e.g.,
2 80 ), Company 1 will attract a larger consumer group, and thus his Fig. 6. The impact of price coefficient on the anti-piracy investment.

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Y. Ning et al. International Journal of Production Economics 206 (2018) 184–195

>0 =0

Fig. 8. The impact of network externality coefficient on the government in-


vestment.
Fig. 7. The impact of government anti-piracy strategies on the profits.

number (e.g., < 0.3647 ), the incomplete combating strategy will bring
combating piracy. When 2 [20,200], we have more profit to the original company. In addition, Fig. 8 clearly shows
ILeader 2 > ILeader 1 > ICournot . From this point of view, the results shown the impact of the network externality coefficient on the government
in Fig. 6 are partially similar to Fig. 3. In the Stackelberg model where investment in combating piracy.
Company 2 is the market leader, the cost function of combating piracy
is almost linear with respect to 2 , and the cost increases with 2 .
Whereas in the Cournot model and the Stackelberg model where 5.4. The impact of variety seeking consumers
Company 1 is the market leader, with the increase of 2 , the investment
in combating piracy decreases first and then increases. However, the In Section 4.4, we have proposed the two-period Cournot price
impact of the price coefficient on the investment in combating piracy is competition model under a fixed market demand, and many important
not as significant as the influence of the network externality coefficient. results have been presented in terms of theorems and corollaries. In this
experiment, we as well let the total market demand be fixed and
5.3. The impact of the anti-piracy government Q = 2000 , while keep the setting of other parameters unchanged.
Fig. 9 shows the impact of the network externality coefficient on the
Fig. 7 illustrates the effect of different government anti-piracy profits of the two companies with the consideration of consumer variety
strategies on the profits of the two companies. Recall that 1 represents seeking behavior, where [0.01, 0.1]. A key difference from Fig. 1 is
the profit of Company 1 when V = 0 , 1 represents the profit of Com- that under a fixed market demand, the profit of Company 2 is always
pany 1 when V > 0 , 2 represents the profit of Company 2 when V = 0 , higher than that of Company 1, and the profit of Company 2 increases
and 2 represents the profit of Company 2 when V > 0 . Also, Company 1 with . All profit functions are almost linear with respect to . In ad-
is the market leader, and the government is standing in the position of dition, the profit of Company 1 in the second period is higher than that
Company 1. The main results of Fig. 7 are summarized as follows: in the first period, whereas the profit of Company 2 in the two periods
does not change significantly.
(1) When < 0.3647 , then the government adopts the incomplete It is seen from (58) that the network externality coefficient has no
combating strategy (V > 0 ), i.e., 1 > 1 ; effect on the proportion ( ) of consumers with variety seeking behavior.
(2) When > 0.3647 , then the government adopts the complete com- As shown in Fig. 10, if C2 [0,10], then [0.1, 0.5], and increases
bating strategy (V = 0) , i.e., 1 < 1 ; with C2 . Obviously, with the increase of C2 , the profit of the pirated
(3) When 2 is strictly less than 2 and > 0.4197 , then 2 = 0 . company will reduce, and the profit of the original company will in-
crease.
If the government stands in the position of public welfare, it will Our results indicate that when market demand is fixed, it is not only
adopt a complete combating strategy against piracy. It is obvious that necessary for the government to act as a third party to combat piracy
the total profit of Company 2 in the complete combating strategy is more effectively, but to increase the penalties for the dissemination of
strictly less than its profit in the situation where incomplete combating pirated digital products. Moreover, the original company should focus
strategy is adopted ( 2 < 2) . In particular, when is large enough on technological innovations, making piracy less easy to survive and
(e.g., > 0.4197 ), the piracy will disappear in the market ( 2 = 0) . It thus increasing the cost of piracy. However, on the other hand, it is
can be seen from Fig. 7, as compared with Company 1's own efforts to rather arduous to achieve a complete crackdown on piracy because of
combat piracy, it would be more effective if the government can offer the consumer variety seeking behavior. Therefore, how to avoid or
Company 1 some anti-piracy subsidies or the government could devote reduce consumers from using original digital products to pirated ones is
to cracking down the piracy of digital products. a key challenge in future research.
Interestingly, if the government stands in the position of the original
company when the network externality coefficient is less than a certain

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Y. Ning et al. International Journal of Production Economics 206 (2018) 184–195

Stackelberg model with the pirated group as the leader. Regarding the
effects of externality on profits and prices, we find that for each party,
the profit and price differences among the three games are significant
only when the value of externality effects is higher than a threshold. We
also show that when the market demand is variable, as the externality
coefficient increases, the profit of the original company increases, while
the pirated group's profit reduces. When the demand is fixed, with the
increase of the externality coefficient, both parties' profits will be en-
hanced.
From the perspective of government protection, our results indicate
that in the Stackelberg model where the original company is the leader,
it is more effective for the government to crack down digital piracy.
Interestingly, the original company will benefit from the government
anti-piracy policy that tolerates some piracy if the value of externality
effects is lower than a threshold. Finally, we consider the behavior of
consumer variety seeking in a two-period Cournot model where the de-
mand is fixed. With the presence of variety seeking, both the original
and pirated parties will adopt higher prices in the first period. Perhaps
surprisingly, variety seeking brings higher profits to both parties in two
periods.
At a practical level, our results demonstrate that the original com-
panies should focus on technological innovations and security mea-
sures, making piracy pay a heavy price. Although it is tough to com-
pletely suppress piracy due to the nature of variety seeking, how to
Fig. 9. The impact of network externality coefficient on the profits when there avoid or reduce consumers from using original digital products to pi-
exist variety seeking consumers. rated ones is a key challenge in future research. Nevertheless, based on
the game-theoretical methods, our work provides a scientific support
for the original company and the government in combating digital pi-
racy. Another important extension is to incorporate demand un-
certainties (e.g., Xu et al., 2013; Avinadav et al., 2014; Chernonog et al.,
2018) into our behavioral digital pricing. In addition to variety seeking,
the demand may change over time because of other factors such as
financial risks and the effects of complementary products. Finally, one
can use some financial engineering tools such as NPV (net present
value) and VaR (value at risk) to address the multi-period digital piracy
problem introduced in this paper.

Acknowledgements

The authors thank the reviewers and editors for their critical but
constructive comments.

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