The Economics of Intellectual Property: Theory...(with a rough sketch) to MGA. MGA offers him a consulting agreement and he resigns from Mattel. • 2001-04: Bratzline of products

The Economics of Intellectual Property: Theory

Prof. J. BarnettUniversity of Southern California

June 11, 2018

© Jonathan M. Barnett

Agenda1. Almost everything you always wanted to know

about IP in about 20 minutes or less

2. Law and economics of IP: the conventional approach

3. Law and economics of IP: new approaches

4. Q&A

Part I: Everything About IP (Almost)

• IP Universe

• Paradigm Problems– The Departing Employee– The Pitch– The Make/Buy Decision– The Patent Thicket

IP Universe• Patents• Trade Secret

• Copyright• TM

• Contract (in interaction with IP)

Common Characteristics of IP Rights1. Subject matter: What’s covered?

2. Novelty: what’s new?

3. Formalities: what are the fees and paperwork?

4. Scope: how broad?

5. Duration: how long?

6. Remedies: what can I get in court? Injunctions Damages

Overview of Trade Secrets and PatentsTrade Secret Patent

Formalities None A lot – patent prosecution costs est. $10-20K on average.

Duration Perpetual, until information is disclosed or otherwise becomes publicly available

20 years from date of application, subject to payment of mtc fees

Rev. engineering; indep. invention

Permitted Prohibited (but technology must be substantially disclosed)

Subject matter Broadly defined as non-public information, subject to satisfaction of required secrecy precautions

Broadly defined, excludes abstract ideas and natural phenomena

Novelty Must not be public knowledge in the relevant industry

Must be novel and “nonobvious” relative to existing “prior art”

Remedies Injunctive relief; compensatory damages; supercompensatory damages

Injunctive relief; compensatory damages; supercompensatorydamages

Patents v. Trade Secret• Why not just patent everything?

– Costly and uncertain to obtain, maintain and enforce.– Discloses info to competitors.– Time-limited (20 years from filing).

• Why not just keep everything secret?– Sometimes you can’t. Trade secret law does not block

reverse engineering.– Hard to transact. With some exceptions, disclosure

kills trade secrets.

Overview of Copyright and TMCopyright Trademark

Formalities Minimal. Minimal.

Duration Life of author + 70 years. Corporate author: 95 years.

Perpetual, based on continued use by trademark holder.

Subject matter

Broadly defined to cover all forms of expression, including software. Excludes facts, ideas, generic & functional elements.

Broadly defined to include words, phrases, images, forms, shapes, colors

Novelty; Priority

Nominal originality requirement First use (incl. constructive use)

Scope Limited to protected work, but extended by derivative right; limited by fair use

Limited to product class, but extended under confusion rationales; limited by fair use

Remedy Injunctive relief; lost profits or statutory damages

Injunctive relief; disgorgement of D’s profits and damages to P.

Barbie v. Bratz: The Departing Employee Problem

The “Bratz” case• 2000: Bryant is employed by Mattel pursuant to contract, which provides:

“I agree to communicate to the Company as promptly and fully as practicable all inventions conceived or reduced to practice by me . . . at any time during my employment by the Company. I hereby assign to the Company . . . all my right, title and interest in such inventions . . . .”

• 2000: In his spare time, Bryant develops idea for Bratz dolls and pitches it (with a rough sketch) to MGA. MGA offers him a consulting agreement and he resigns from Mattel.

• 2001-04: Bratz line of products achieves great success, capturing 40% of Barbie/Bratz market and reaching $1B in annual revenues for MGA.

• 2004: Mattel sues Bryant and MGA for breach of contract, TS infringement and copyright infringement.

The $1B Clause

“I [Employee] agree to communicate to the Company as promptly and fully as practicable all inventions conceived or reduced to practice by me . . . at any time during my employment by the Company. I hereby assign to the Company . . . all my right, title and interest in such inventions . . . .”

Original Bratz + DerivativesOriginal Sketch 2015 Products

The Problem of the Pitch• The “information paradox” (Arrow 1962)

• Possible solutions:– NDAs?– Idea contracts?

• Does this work? See: http://www.apple.com/legal/intellectual-property/policies/ideas.html

– Patents, copyright– Know-how + Reputation

The Make/Buy Problem

• Making money in tech requires invention plus commercialization. Which typically costs more?

• Firms constantly face “make/buy” decisions in the commercialization process. This is standard market specialization.

• In IP-intensive markets, firms implement those make/buy decisions through a combination of IP rights plus licensing agreements.

Supply Chain Structures in IP Markets

B1 B1

B1

C1 (user)

B2

R&D

Production

Distribution

Market

(i) (ii) (iii)

B1

B2

Supply Chain Functions/Structures

= license-based delivery of IP asset

= direct delivery of IP asset

B3

Source: Barnett (2017a)



(i) (ii) (iii)

R&D

B1

B1

B1



Production

B2

B2

Distribution

B1

B3

Market

C1 (user)

Semiconductor Supply Chain Models OEM/Intermediate User

• In-house • Some use of foundries

3rd-party contractors

Incumbent (Integrated) Model Fabless (Disintegrated) Model

• In-house • Some IP in-licensed

In-house

Chip Design

Prototyping

Fabrication

Assembly, Testing

Sales, Distribution, Support

• In-house • Some IP in-licensed • Some use of design

services firms

Contract with foundry


In-house

Function

Source: Barnett (2011)

The Patent Thicket Problem

• Thousands of patents can apply to one smartphone model. Those are held by many different companies.

• Yet the market basically seems to work well.

• How is this possible?

The Patent Pool SolutionX Corp.

Z Corp.

Licensees (OEMs)

POOL

Y Corp.

AdministratorTransaction fee

Patent rights

Royalty fees

Patent Holders/Licensors

End-Users

PC$

The “Patent Plumbing” Behind Smartphones, Bluetooth, YouTube, DVD Players (and more)


Part II: Economics of IP – The Conventional Approach

Basic Framework• Agent: Profit maximizing inventor or creator.

• Problem: Innovation is incompatible with perfect competition. Pricing at marginal cost does not enable recovery of fixed R&D costs.

• Solution: IP “monopoly” generates time-limited premium to support and incentivize innovation.

• New Problem: Any positive pricing of a “nonrivalrous” intangible asset is inefficient.

Perfectly Competitive Market (Uniform Pricing)

Price

0 Quantity

Demand

Marginal cost

100

$5

Consumer Surplus

$15

Non-Competitive Market (Uniform Pricing)

Price

0 Quantity

Deadweightloss

Demand

Consumersurplus

Qm= 60

Marginal costPc = $5

$15

Pm = $10

Profit (Producer Surplus)

Qc=100

Pricing Options:P*Q=R$5*100 = $500$10*60 = $600$15*0 = $0

The Incentives-Access Tradeoff• Incentives-access tradeoff: Conventional IPR policy is based on a tradeoff

between static inefficiency (resulting in higher access costs) and dynamic efficiency (resulting in more innovation).

• Policy objective: Assuming perfect information, IPRs are calibrated to create smallest necessary “wedge” between zero marginal and positive fixed costs. This maximizes efficiency gains, net of “deadweight losses” and transaction costs borne by intermediate and end-users of IP-protected assets.

• Application: The incentives-access tradeoff can explain why IP rights often have more substantial limitations in time or “space” as compared to property rights in land or tangible assets. Exs.:– Time-limited duration of copyrights and patents– Debates over scope of the “derivative right” in copyright– “Fair use” defense to copyright infringement

References: Posner (2005); Landes and Posner (2003); Machlup (1958)

IP Agnosticism• Much of conventional economic analysis of IP is agnostic about the net

welfare effects of formal IP rights (e.g., Machlup 1958). By contrast, economic analysis almost always concludes that real property rights have net positive welfare effects.

• This school of thought emphasizes the deadweight losses inherent to monopoly pricing and, in general, any positive pricing of a “nonrivalrous” IP asset. In this framework, “zero IP” is treated as the default option and IPRs should be introduced and extended with caution.

• Caveat: Many if not most “IP agnostics” recognize that the value of IP rights in pharmaceuticals is well-established empirically. Factors:– Massive absolute R&D, testing and marketing costs– Large difference between “invention” and imitation costs– Long time lag between product conception and market release

• The rest of IP: ???????????

Prelude to Part III: Rethinking the Conventional Approach

The Automotive Patent Roadblock• Conventional view: Aggressive patent infringement

litigation by Selden against Ford (1903-1911) inhibited early development of automobiles.

• Some inconvenient facts: – Automotive production grew significantly during the litigation.– Ford’s production grew significantly during this period.– Automotive innovation advanced substantially. Most notably,

Ford released the Model T in 1908.

• Following conclusion of the litigation, the industry formed a patent pool, which lasted until 1957. Cross-licensing norms persisted thereafter.

0

50000

100000

150000

200000

250000

300000

350000

400000

1903 1904 1905 1906 1907 1908 1909 1910 1911 1912

Motor Vehicles Manufactured

$0

$5,000,000

$10,000,000

$15,000,000

$20,000,000

$25,000,000

$30,000,000

$35,000,000

$40,000,000

$45,000,000

1904 1905 1906 1907 1908 1909 1910 1911 1912

Revenues

Profits

Dividends Paid

U.S. Motor Vehicle Production (1903-12) Ford Motor Co. (1904-1912)

1903: Selden patent assignee sues Ford; 1908: Release of Ford Model T; 1909: Selden patent upheld; 1911: Ford ultimately prevails (non-infringing). Source: Barnett 2016 (citing Seltzer 1928).

The Patent “Explosion”

0

100

200

300

400

500

600

700

800

900

1000

1860 1870 1880 1890 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010

Domestic utility patent grants per million US residents Domestic utility patent applications per million US residents

1982: Fed. Cir. estab.

Sources: USPTO, U.S. Census Bureau

Some Inconvenient Facts• Since establishment of the Federal Circuit in 1982 and an increase in the

strength of patent protection, there has been no decline in national U.S. R&D intensity. Holds constant at approx. 2.5% through 2006, after which it has jumped to approx. 2.75%.

• In patent-intensive IT markets, output is up, innovation is constant, and quality-adjusted prices are down (Galetovic, Haber & Levine (2015)). In the patent-intensive smartphone market, sales increased approx. 900% from 2006-2012 and market concentration among device manufacturers has declined substantially (Mallinson 2016).

• None of this is determinative. But it raises doubts about the conventional wisdom concerning the “deadweight losses” and other social costs of strong IP, even outside the pharmaceutical industry.

Part III: Economics of IP – New Approaches

Limitations of the Conventional Approach• Unrealistically assumes market power and zero enforcement costs in all

cases. This inflates the social costs of IP.

• Provides a rationale for innovation incentive mechanisms (e.g., prizes, grants), rather than patents or copyrights specifically.

• Mostly ignores the pricing and allocative function of IPRs, akin to property rights in land and tangible assets.

• Focuses on the “zero-sum” exclusionary function of IP in the litigation context. Mostly ignores “positive-sum” financing, licensing, and commercialization activities in real-world technology and content markets.

• Often ignores the market’s ability to contract around IP-related transactional roadblocks (Merges 1996).

New Framework• Multiple agents: Profit-maximizing inventors and

commercializing entities on “path to market”.

• Revised assumptions: limited market power; positive enforcement costs.

• Problem I: fixed-cost recovery (as in conventional approach)• Problem II: Information paradox (Arrow 1962). No reliable

contractual solution.

• Solutions: IP + non-IP instruments, incl. scale and vertical integration (Teece 1986). Ease of access to non-IP instruments may differ across firm types (Barnett 2011).


B1 B1

B1

C1 (user)

B2

R&D

Production

Distribution

Market

(i) (ii) (iii)

B1

B2




B3



(i) (ii) (iii)

R&D

B1

B1

B1



Production

B2

B2

Distribution

B1

B3

Market

C1 (user)

Advantages of the New Approach

• Recognizes that IPRs do not typically confer market power. Recognizes positive enforcement costs.

• Addresses commercialization and licensing activities, so covers both litigation and transactional contexts.

• Recognizes that IPRs can reduce transaction costs and, for certain firms, lower entry barriers.

• Recognizes pricing function of the IP system. This provides an economic account of the IP system specifically.

IP and the Theory of the Firm

• Firm boundaries reflect efficient allocation of tasks between the market (by contract) and the firm, as a function of relative transaction costs (Coase 1937, Williamson 1985).

• IP-rich relationships involve a special transaction cost given the difficulty of contracting over informational assets.

• If patent system reduces costs of contracting over information, it enables markets to develop efficient transactional structures. In particular, it supports the formation of specialized R&D firms without downstream capacities (Arora & Merges (2004); Barnett (2011, 2016); Kieff (2005, 2006)).

Example 1: Biopharma Supply Chain

Market Release

Additional R&D

Marketing; Distribution

Contract: Large pharmaceutical firm

Supply Functions/Inputs Supply Structures

Production

UNIVERSITY

Late-stage clinical Testing

IP transfer

START-UP

Pre-clinical testing Early-stage clinical testing

Financing Contract: venture capitalist

Example 2: Semiconductor Supply Chains OEM/Intermediate User

• In-house • Some use of foundries


Incumbent (Integrated) Model Fabless (Disintegrated) Model

• In-house • Some IP in-licensed

In-house

Chip Design

Prototyping

Fabrication

Assembly, Testing

Sales, Distribution, Support

• In-house • Some IP in-licensed • Some use of design

services firms

Contract with foundry


In-house

Function


Example 3: IP and Foreign Direct Investment

Technology Transfer to a Foreign Jurisdiction

Technology Holder

No transfer Firm: Internal transfer to local wholly-owned subsidiary or affiliate.

Contract: External transfer by contract to local partner.

0 Expropriation risk

Foreign jurisdiction

Home jurisdiction

IP strength0

International Semiconductor Supply Chain

Source: Barnett (2017b)

References• Arora, Ashish and Robert Merges. Specialized supply firms, property rights and firm

boundaries. 13 Industrial & Corporate Change 451 (2004).• Arrow, Kenneth. Economic welfare and the allocation of resources for invention, in The Rate

and Direction of Inventive Activity (1962).• Barnett, Jonathan. Why is Everyone Afraid of IP Licensing? 30 Harv. J. L. & Tech. 123 (2017a)• Barnett, Jonathan. Patent Tigers: The New Geography of Global Innovation. Criterion J. on

Innovation (2017b). • Barnett, Jonathan. Three Quasi-Fallacies in the Conventional Understanding of Intellectual

Property. 12 J. L. Econ. & Policy 1 (2016).• Barnett, Jonathan. The Anti-Commons Revisited. 29 Harv. J. L. & Tech. 127 (2015).• Barnett, Jonathan. Intellectual Property as a Law of Organization. 84 S. Cal. L. Rev. 785

(2011).• Coase, R.H. The Nature of the Firm. 4 Economica 386-405 (1937).• Galetovic, Alex, Stephen Haber and Ross Levine. An Empirical Examination of Patent Holdup.

11 Journal of Competition Law & Econ. 549-578 (2015).• F. Scott Kieff. IP Transactions: On the Theory and Practice of Commercializing Innovation. 42

Houston Law Review 727 (2005). • Kieff, F. Scott. Coordination, Property and Intellectual Property: An Unconventional Approach

to Anticompetitive Effects and Downstream Access, 56 Emory Law Journal 327 (2006).

References (cont.)• Landes, William and Richard Posner. The Economic Structure of Intellectual Property Law

(2003).• Machlup, Fritz. An economic review of the patent system (1958).• Mallinson, Keith. Don’t Fix What Isn’t Broken: The Extraordinary Record of Innovation and

Success in the Cellular Industry Under Existing Licensing Practices, 23 George Mason Law Review 967-1006 (2016).

• Merges, Robert P. Contracting Into Liability Rules: Intellectual Property Rights and Collective Rights Organizations, 84 California Law Review 1293-1393 (1996).

• Richard A. Posner. Intellectual Property: The Law and Economics Approach, 19 Journal of Economic Perspectives 57-73 (2005).

• Teece, David. Profiting from technological innovation: Implications for integration, collaboration, licensing and public policy. 15 Research Policy 285-352 (1986).

• Williamson, Oliver. The Economic Institutions of Capitalism (1985).

The Economics of Intellectual Property: TheoryAgendaPart I: Everything About IP (Almost)IP UniverseCommon Characteristics of IP RightsOverview of Trade Secrets and PatentsPatents v. Trade SecretOverview of Copyright and TMBarbie v. Bratz: The Departing Employee ProblemThe “Bratz” caseThe $1B ClauseOriginal Bratz + DerivativesThe Problem of the PitchThe Make/Buy ProblemSlide Number 15Semiconductor Supply Chain ModelsThe Patent Thicket ProblemThe Patent Pool SolutionSlide Number 19The “Patent Plumbing” Behind Smartphones, Bluetooth, YouTube, DVD Players (and more)Part II: Economics of IP – The Conventional ApproachBasic FrameworkPerfectly Competitive Market (Uniform Pricing) Non-Competitive Market (Uniform Pricing)The Incentives-Access TradeoffIP AgnosticismPrelude to Part III: Rethinking the Conventional ApproachThe Automotive Patent RoadblockSlide Number 29The Patent “Explosion”Some Inconvenient FactsPart III: Economics of IP – New ApproachesLimitations of the Conventional ApproachNew FrameworkSlide Number 35Advantages of the New ApproachIP and the Theory of the FirmExample 1: Biopharma Supply ChainExample 2: Semiconductor Supply ChainsExample 3: IP and Foreign Direct Investment International Semiconductor Supply ChainReferencesReferences (cont.)

Documents

The Economics of Intellectual Property: Theory...(with a rough sketch) to MGA. MGA offers him a consulting agreement and he resigns from Mattel. • 2001-04: Bratzline of products