Counterfeit Trade
A growth industry

Trade in counterfeit products is reaching epidemic proportions and has recently been described as 'perhaps the world's fastest growing and most profitable business'. Casual observers are becoming increasingly aware of the presence of fakes in the markets for a wide variety of products. These include not only the luxury consumer goods such as designer clothing, watches, and perfumes, which have traditionally been subject to forgery; but also higher-technology consumer electronic products such as computers and stereo equipment. There is also mounting evidence of substantial counterfeiting in the markets for records and tapes, foods, pharmaceuticals and an expanding range of industrial goods, including parts for automobiles and airplanes, fertilizers, pesticides, military hardware and medical devices. The growth in counterfeit-product trade has attracted the attention of the international trade community, including corporations, governments, and the international organizations.

Despite the growing importance of counterfeiting, economists have paid little attention to modelling counterfeit-product trade. In Discussion Paper No. 103, CEPR Research Fellow Gene Grossman and Carl Shapiro remedy this neglect by analysing deceptive counterfeiting, i.e. the sale of fakes that consumers cannot easily distinguish from genuine items. This type of counterfeiting must be analysed as a problem in the economics of information, involving the twin problems of imperfect information on the part of consumers and imperfect property rights on the part of trademark owners.

Grossman and Shapiro study international trade in counterfeit products, using a two-country, equilibrium model of counterfeiting. In the home country firms produce high quality, brand-name goods. In Grossman and Shapiro's model, each home firm selects a price and quality for the output it will produce. It also advertises a quality 'claim'. This can differ from the true quality of its output since consumers have only imperfect information concerning product quality, but this quality claim must be credible to consumers. In the foreign country firms only produce 'generic', minimum-quality versions of the good concerned. Although only one version of the good is produced, however, foreign firms can choose to label the good honestly as one of minimum quality. Alternatively a foreign firm can mimic the label of the home producer; a good so labelled is a counterfeit. Counterfeiters produce abroad and enjoy a cost advantage, but face the possibility of confiscation at the border.

In order to establish a benchmark, the authors first consider equilibrium in a market with imperfectly informed consumers but where counterfeiting is not feasible. They then introduce the possibility of counterfeiting, analysing not only the direct effects of counterfeiting that arise when a consumer purchases a fake instead of a genuine product, but also the induced effects on the behaviour of legitimate producers.
Counterfeiting harms consumers of brand-name products who may unwittingly purchase a fake. It also alters the price/quality mix offered by brand-name producers. If quality enhancement by home firms greatly increases the chance that customs agents will catch counterfeits at the border, then counterfeiting leads domestic firms to raise their quality (and price). If, however, the probability of detection and confiscation is insensitive to product quality, then counterfeiting causes trademark owners to lower their price (and quality) in an effort to compete with the counterfeiters.

Under conditions of free entry into the production of brand-name merchandise, Grossman and Shapiro find that counterfeiting lowers domestic and world welfare, although it raises foreign welfare as the terms-of-trade become more favourable to the foreign country. This result need not occur if the number of trademark owners is fixed, however. In that case the presence of counterfeiters may induce domestic firms to upgrade their products in an effort to escape counterfeiting. This upgrading may raise welfare, as quality is initially 'undersupplied' due to the presence of imperfect consumer information. Grossman and Shapiro observe that this is an example of the general theory of the second-best: in the presence of imperfect information on the part of consumers, incomplete property rights, that is the presence of counterfeiting, may raise welfare.

Policy responses to counterfeiting may have unintended consequences due to the changes they induce in the quality of brand-name products. Tighter border inspections, for example, benefit the home country by reducing the price of legitimate imports and lowering the market share of counterfeits. Grossman and Shapiro find that it may also lower domestic welfare as it causes the quality of brand-name products to increase, perhaps excessively. Should the government sell or destroy confiscated counterfeit merchandise? An obvious advantage of selling such items is that doing so raises revenue for the government. A drawback, however, is that confiscated products sold by the government (after being properly labelled) compete with imports of legitimate generic products from the foreign country. Such sales therefore shift foreign production into the counterfeiting subsector, and raise the market share of counterfeits. Grossman and Shapiro's model suggests that the optimal policy is either to destroy all or to sell all confiscated products. Selling, they find, is preferable when the difference in quality between domestic and foreign goods is small.


Counterfeit-Product Trade
Gene M Grossman and Carl Shapiro

Discussion Paper No. 103, April 1986 (IT)