The Economics of Patents Lecture 3dec.ec.unipg.it/~fabrizio.pompei/Lecture3.pdf · The Economics of Patents Lecture 3 Fabrizio Pompei Department of Economics University of Perugia

The Economics of PatentsLecture 3

Fabrizio Pompei

Department of EconomicsUniversity of Perugia

Economics of Innovation (2016/2017)(II Semester, 2017)

Pompei Patents Academic Year 2016/2017 1 / 29

Contents of the Lecture*

1 A Brief Sketch of the Patent Right

2 Economic Interpretation of the Patent Process

3 Optimal Patent Design: Length and Breadth ofProtection

4 Questions for lecture 3

*References:

1 Property Rights and Invention, Rockett K. (2008), sections: I; II; III; V up topage 20


A Brief Sketch of the Patent Right

What is a patent?

A patent refers to a temporary property right on an invention...right but not a guarantee to exclude others from making, using orselling the patented propertythe patent holder generally has no obligation or necessarily even the right topractice the innovationfor example, if inventor A is granted a patent, where the exercise of thatpatent would infringe the patent rights of inventor B, inventor A has noautomatic authorisation to exercise her patent

In exchange for these exclusionary rights, the patent holder mustpublicly disclose the invention as part of a publicly available patentdocument

While there are some differences in how it is interpreted betweenEurope and the US, the disclosure should be viewed as broadly helpfulto third parties wishing to understand the nature of the innovationWhile the embodiment of the innovation is protected by the patent, theunderlying idea is not



What is a patent? (II)

The features of the innovation must be described in a set of claims,which define the metes and bounds of the patent

Patentable subject includes a process or product, a composition of matter(such as a chemical composition) or machine, or a new and usefulimprovement on any of these

Patentable subject matter in the US has broadened over the past thirty yearsto include the products of genetic manipulation, software and businessmethods

Patentable subject matter in the US remains relatively broad compared toother countries, despite extensions that have occurred elsewhere

Patentable subject matter tends more towards technicality and industrialapplicability in Europe than in the US

These differences have been cited as resulting in the slower movement inEurope towards allowing patents in areas such as business methods, geneticmaterial and surgical methods



What is a patent? (III)

In most patent systems, a patentable innovation must represent asignificant innovative step

Once granted, a patent may be exercised, traded (sold or ’rented’ via alicensing contract, or otherwise transferred) or abandoned, like other formsof property

Patent protection lasts a statutory maximum of 20 years from the date offiling

Statutory protection need not last this long, however, as periodic renewalpayments often are required to maintain the right up to its statutorymaximum term

Only about 8% of all patents go to full term in Europe, as due tomaintenance and other legal costs a European patent valid in all memberstates could cost ten times more than a US patent for a 20 year term

Extension of the patent term beyond 20 years is clearly much more difficult,and can only be attempted by indirect strategies



Basic Patent Systems in the US and EuropeanUnion

In the US patents are set forth in Article 1, Section 8 of the United StatesConstitution where Congress is granted the power To Promote the Progress ofScience and Useful Arts by securing for limited Times to Authors and Inventors theexclusive Right to their respective Writings and Discoveries

US Patent and Trademark Office (USPTO) has the main role to judge thepatentability of an invention

Congress has further enacted various patent laws, among them the alignmentunder the TRIPs (Trade Related Aspects of Intellectual Property) agreements

The harmonization with TRIPs and other key treaties also holds for other countriessuch as EU (for example, Paris Convention, which specifies that a first patentfiling date in any member state can serve as the patent application date for anysubsequent member state filing; the European Patent Convention, whichestablishes the European Patent Office as a means of coordinating patent grantswithin Europe and the Patent Cooperation Treaty, which establishes a uniformprocedure for filing patent applications in the member states)



Basic Patent Systems in the US and EuropeanUnion (II)

In Europe, patents may issue from either the patent office of individual countriesor from the European Patent Office (EPO), or both.In fact, a common practice is to file at the EPO only after having filed at thepatent office of a specific European country or the US

The administrative body responsible for implementing patent grants, such as theUSPTO or the EPO, reviews patent applications to determine if the candidateinvention satisfies the minimum standards for patentability: novelty andnonobviousness being the most salient characteristics

Patents are only as strong as their enforcement:Enforcement is handled privately in the US through the court system. Forexample, if a patent-holder detects infringement within the jurisdiction of thepatent, the patent-holder can sue the violator in court

The European approach relies much more on an oppositions system to weed out’bad’ patent grants (for example, third parties may submit opinions during thepatent examination on whether a patent grant should be made and to a greaterextent during a centralised post-grant oppositions procedure)


Economic Interpretation of the Patent Process

The foundations of the economics of patents:The Arrow Model

From an economic perspective, the crucial features of patents are that theydeal with new knowledge, as embodied in an innovative product orprocess, and they confer (limited) monopoly rights to the inventor.

New knowledge that makes possible the production of new products and/orprocesses obviously carries considerable economic value, but it has featuresthat make it problematic for the market system to handle properly (Arrow1962).

According to Arrow, knowledge is a quintessential public good

Public goods are non-rival in consumption, meaning that a person’suse of a public good does not affect the amount of it that is availablefor others.

Public goods are non-excludable, meaning that it is not possible toprevent individuals from enjoying the public good once it is available



The foundations of the economics of patents:The Arrow Model (II)

The problems that a competitive system has with public goods are readilyapparent.

An inventor may bear all the cost of an innovation, but everyone benefits(possibly to varying degrees) from a discovery, and thus everyone has anincentive to free ride on the innovative efforts of others.

The inherent externalities associated with this class of public goodsgenerate a market failure:

a competitive market system may be expected to provide aninefficiently low level of innovations.

Intellectual property rights in general, and patents in particular, address thisproblem by attacking the non-appropriability of knowledge that lies at theheart of this market failure.

Specifically, by endowing innovators with property rights on their discoveries,patents are a legal means of affecting the excludability attributes of anotherwise pure public good



The Arrow Model

The main economic benefits and costs of the patent system are intimatelyrelated to the nature of the market failure that it addresses, and to thesecond-best character of the solution that it provides.Actually, in its article ’Economic Welfare and the Allocation of Resources forInvention’, published in 1962, Arrow proposes an alternative solution:’for optimal allocation to invention it would be necessary for the governmentor some other agency not governed by profit-and-loss criteria to financeresearch and invention.This outcome is well represented in the following simplified version of the Arrow’smodel that, in turn is based on the following assumptions:

1 Knowledge underlying innovation is a public good2 Innovation is a cost reducing and radical process innovation3 Given a patent system, only one firm wins the race to innovate and

apply for a patent4 Indivisibilities and uncertainty characterize the production process5 There is a technological incentive (TI) to innovate:

TI = πpost−innovation − πpre−innovation (1)Pompei Patents Academic Year 2016/2017 10 / 29


The Arrow ModelLet us suppose there is a monopoly situationThis monopolistic firm decides to innovate according to TI , that is the positivedifference between the post innovation profit (rectangle P ′mehc ′ ) and thepre-innovation profit (rectangle Pmbgc)Remember that by introducing a radical process innovation the monopolistic firmnot only sets the post innovation price (P ′m) lower than the previous one (Pm),but P ′m is also lower than the previous constant marginal cost (c)

Xm

Pm

cP’m

c’

a

b

d

h

eg

TI monopolistic firm: P’m e h c’ – Pm b g c

f

X’mXc X’c



The Arrow Model (II)Now, it is the turn of a perfect competition marketMany competitive firms, but only one can win the race and gets the patentNow, TI is the positive difference between the post innovation profit (rectangleP ′mehc ′ ) and zero, the TI of competitive firm is larger than TI ofmonopolistic firm. This because no profits were accruing to the competitive firmsbefore introducing innovationAfter introducing innovation the competitive firm becomes a monopolistic firm

Xm

Pc = cP’m

c’

a

b

d

h

eg

TI competitive firm: before innovation Pc =c

Therefore, TI = P’m e h c’ – 0

f

X’mXc X’cPompei Patents Academic Year 2016/2017 12 / 29


The Arrow Model (III)Technological Incentive of the Social PlannerIf the government supports innovation a competitive market is guaranteed,competitive firms sell goods at lower prices, no monopoly emerges and the socialwelfare increasesThe biggest TI is the social planner’s one

Xm

Pm

Pc = cP’m

P’c=c’

a

b

d

h

eg

TI of the Social Planner:

c’ f a – c d a

f

X’mXc X’c

TI of the social planner is the trapezoid

c’ f d c

A social planner maximises the social welfare



The Arrow Model (IV)

The Arrow model triggers an animated debate concerning the socialefficiency of a patent system

By endowing discoverers with property rights over the fruits of their efforts,patents affect the incentive to innovate and are likely to increase the flow ofinnovations.

This increase is presumably desirable, given that otherwise the marketsystem may provide too little new knowledge.

But by giving the patentee exclusive rights on the exploitation of a uniqueeconomic good that is still non-rival in consumption, a patent creates amonopoly situation that adversely affects the efficient use of new knowledge.

For that reason the policy maker has to define an optimal design ofthe patent system

First of all, the policy maker objective function could be influenced byspecific goals concerning a country’s economic development and containedin constitutional laws

This is the case, as we already anticipated, for the United States



The objective Function of PolicymakersWe will now use the US system to outline issues in the interpretation of thepatent processBy and large, these basic features are shared with non-US patent systems, sothe focus on the US is for expositional convenienceSo, let’s take Article 1, Section 8 of the US Constitution, that is quiteexplicit that the objective of the intellectual property rights system is theprogress of Science and the Useful ArtsThe interpretation one takes is important to the conclusions one reachesabout the optimality of any intellectual property protection systemIf one were to take Article 1 at its word, one might wish to use the rate ofinnovation or, less directly, the rate of research and development spending:the more the betterSome scholars compare the optimal design of patents when the objectiveis to maximise the rate of innovation to the optimal design when theobjective is to maximise discounted consumers’ surplusA system that aims to maximise consumers’ surplus places more valueon frequent innovation than a system that maximises the rate ofinnovation, since intermediate steps generate surplus gains for eachquality step that enters consumption



The objective Function of Policymakers (II)

There is a question of when the value is realised for society or for theinventor compared to when the patent right is awarded

If the patent right is awarded early, before much of the expenditure todevelop the innovation has been incurred, then the exclusionary rightensures that the patent holder can reap the entire reward to itsexpenditure before that expenditure is incurred

If the right is granted late, and many firms may compete for that right,then the potential patent holder only faces an expected benefit at thetime of its research investment

The difference between these two scenarios can affect the incentives toinvest, as the patent holder is in a race for the right to the fruits of itsinvestment in the latter case but is not in the former case



The objective Function of Policymakers (III)

The social and private value of a patent need not flow directly from thetechnology that is patented, but may be largely derivative

Value may flow primarily from the innovations a patented advance inspires,the so called follow-on innovationsor from companion innovations that are used together to create a valuableproduct, complementary innovations

In both these cases, a single patent in isolation may have no private value atall

Therefore we can have pure research tools: innovations that havetechnical value but no monetary value in isolation

In such cases, a main function of the patent right is to facilitate thetransfer of value via licensing contracts from the follow-on innovationsor the complementary innovations back to the holder of a ’key’ patent



The Reward Theory of Patents of Nordhaus(1969)

The Reward Theory states that by generating potential monopoly power (and thus patent monopoly rents) exclusivity provides remuneration forsuccessful innovatorsIf the cost to generating an innovation is privately borne, then theanticipation of such private compensation is a necessary ’reward’ toinduce innovation in a market setting with profit-maximising agentsIf exclusive rights were not available to the innovator, and if the underlyingknowledge is a pure public good, any party could use this information toduplicate the invention and compete with the patent-holder to provide it topurchasersHence, the patent system promotes innovation that would otherwisebe underprovided by the market due to a positive informationalexternalityConsider first the classic case where a single inventor has exclusive rights tosupply an invention that is deemed useful. This inventor is, then, amonopolist over some demand curve.



The Reward Theory of Patents of Nordhaus(1969) (II)

If the inventor sets a single price, as a monopolist, it can earn profits labelledπ in the figure.



The Reward Theory of Patents of Nordhaus(1969) (III)

π is the private ’reward’ for the inventive effort.

Of course, these monopoly profits come hand in hand with consumer’ssurplus, s, but also a deadweight loss, d , created by the monopoly pricing.

Hence, there is a social cost to ensuring the reward to innovation.

The private value captured by the inventor is less than the social valuecreated by the innovation: only by awarding the entire social surplus, thetriangle W = (π + s + d), could firms’ incentives be brought in line withsociety’s.

The incentive to generate scientific progress, while positive, is socially toolow in such a system, creating a dynamic welfare loss.


Optimal Patent Design: Length and Breadth of Protection

Single Innovation Models: Optimal Length

We will take into account very simple models in which only aninnovation is patented

Again, Nordhaus (1969) set the stage for this work by suggesting that thelength of patent protection should balance off two forces:1) first, for an innovation that will potentially yield benefits to society

forever, the length of protection should be long (potentially infinite).2) Since protection is based on exclusive ownership, however, this

creates a potential deadweight loss due to monopoly pricing

Suppose that the innovation generates a notional maximum discountedsocial value W̄ that could be earned if it were available for free immediatelybut a deadweight loss, d , is incurred during each period of protection

Let the flow profits for each period of protection be π for the innovator.Profits fall to a baseline level of zero after protection expires.



Single Innovation Models: Optimal Length(II)

Suppose also that there are T periods of patent protection (for example, Tyears)

This patent protection allows entrepreneur to gain a profit π, but also raisesa penalty for social value, that equals the deadweight loss d

Now, let’s define the discounted rate X(T)we use to calculate discountedvalues for profits (π) and deadweight loss d

X (T ) = 1−e−rT

r

Therefore, if a patent protection applies for the innovation the netdiscounted benefits to society will beW̄ − dX (T )where dX (T ) is the discounted value of deadweight losses accumulated overthe years T of duration of the patent protection.

The expression W̄ − dX (T ) is decreasing in T



Single Innovation Models: Optimal Length(III)

W̄ − dX (T )

We can either think of maximising this expression with respect to T orminimising dX (T ) with respect to T ...

...subject to the constraint that the discounted benefits generated frominnovation, X (T )π, meet a value, c , required to induce innovation.

Noting that X (T )π is increasing in T , the solution to this problem isthe minimum T that allows the constraint to be met.

Formally, society’s problem is to maximise total discounted social welfarefrom innovating (or minimise the total discounted social costs), wherewelfare in each period decreases with the price premium over marginal costand the patent expires at time T . If we take π to reflect the price costmargin, we have the following social planner’s problem:

MaxW̄ − [X (T )d(π)]subject to the constraint that c ≤ X (T )π



Single Innovation Models: Optimal Length(IV)

Let’s take again the expression reported above:

MaxW̄ − [X (T )d(π)] (2)

subject to the constraint that c ≤ X (T )π

what’s matter now is that in this maximisation program thesocial planner has two different tools to maximise social welfareby implementing patenting rules:

1) The statutory length T

2) The price-cost margin (or profit π) that is an argument ofthe deadweight loss function d(π)



Single Innovation Models: Optimal Length(VI)

MaxW̄ − [X (T )d(π)] (3)

subject to the constraint that c ≤ X (T )π

For example, the social planner can restrict the statutory length Tbut, at the same time, allowing the price-cost margin (π), andtherefore the monopoly power, to be large

In contrast, the social planner can reduce the price-cost margin (π) byregulating the monopoly prices of the innovator. This reduces thedeadweight loss (d(π). At the same time the social planner set thestatutory length T higher.

Therefore a sort of trade-off between the ’statutory length’ andthe ’price-cost margin’ emerges



Single Innovation Models: Patent Breadth

Gilbert and Shapiro (1990) extend this model by allowing the patentbreadth

They associate to the ’patent breadth’ the possibility to protect bymeans of new collateral patents (incremental improvements) theoriginal design

It means that broader claims could be approved by the patent office,resulting in a larger ’exclusion zone’ around an innovation in productspace

This could translate into higher monopoly profits if close substitutesare not permissible.

According to Gilbert and Shapiro (1990) narrow and long patents canbe found to be optimal because broad patents are costly for society inthat they give excessive monopoly power to the patent holder



Single Innovation Models: Patent Breadth(II)

Nancy Gallini (1992) noted instead that patent breadth could be animportant lever to limit excessive social welfare losses

For example, often the lengthening of patent lifetime is not only associatedto discounted flow of monopolistic profits...

... but also to increasing imitation possibilities perceived by competitors thattry to practice the inventing around

Therefore, inventing around a patent involves bypassing the definition of theprotected invention

In other words, the policy maker must take into account that the increasedreward earned by patent holders makes entry more attractive.

Specifically, for a given cost of imitation, lengthening the period of patentprotection now makes imitation more attractive.

The entry costs incurred are, of course, also social costs.

Hence, the social planner’s problem is to create a reward that compensatesinnovators, minimises deadweight loss, and minimises duplicative spending.



Single Innovation Models: PatentBreadth(III)

By setting a larger breadth, that is a larger ’exclusion zone’ around theoriginal patent...

...imitation is just discouraged, there is no resource cost to imitation for anygiven level of industry profits

If both the length of protection and the breadth of protection are policylevers of the government, then the best policy is to set breadth , the directinstrument to control imitation, large enough to discourage all imitation...

... and the length to generate the desired reward for innovation.

This is an argument for patents that are optimally broad and short.


Questions for lecture 3

MULTIPLE CHOICE QUESTIONS FOR LECTURE 3

1. The enforcement of patents in the European Union is based on: a) Handled privately through the court system b) Assessing the scope of patent rights; c)

Handled by civil courts; d) Opposition system.

2. What kind of problems a patent right solves: a) Low labour productivity efficiency; b) Market failure due to informational asymmetries in innovation; c) Market failure because knowledge supporting innovation is a private good; d) Market failure because knowledge supporting innovation is a public good

3) Max W −[X(T)d(π)]subject to the constraint that c ≤ X (T )π, means a) Maximizes the inventor’s profits subject to constraint of social costs; b) Maximizes the social welfare and minimizes the inventor’s profits; c) Maximizes the social welfare subject to constraint of adequate incentive for inventors; d) Maximizes the social welfare subject to constraint of adequate incentive for consumers. 4) Broadening the patent protection is convenient: a) When there are too few rivals; b) In case of perfect competition; c) to improve the inventing

around and limiting social welfare losses; d) to limit the inventing around and reducing social welfare losses.


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The Economics of Patents Lecture 3dec.ec.unipg.it/~fabrizio.pompei/Lecture3.pdf · The Economics of Patents Lecture 3 Fabrizio Pompei Department of Economics University of Perugia