38CO2000
Economics of Intellectual Property Rights (IPRs)
Practical issues:
Spring 2006: Lecture 4
- The book: There should be one copy of the book at the department of
TMP (4th floor) to be available for student copying (Is this legal?)
- Essays. If you go for the scientific paper option, note that the technical
level of scientific papers vary a lot. Choose a level that suits to you.
- The articles in the Journal of Economic Perspectives are nontechnical and excellent.
-The articles in the American Economic Review Papers and
Proceedings are relatively non-technical, relatively excellent and
extremely short.
- The book by Jaffe and Lerner is non-technical and excellent, and
short for a book. You can choose a chapter from there (or from
Scotchmer’s book)
- Articles in law and management journals are often non-technical
(not in all such journals!). The same applies to Research Policy
RECAP from the last time
1) To get a patent one needs to apply for it and the P.O. needs to examine
the application. The patent will be granted if the application/invention
satisfies novelty, non-obviousness, usefulness and disclosure requirements
- Disclosure function of the patent system
- Problem of deteriorating patent quality (in the US)
2) Patents provide relatively strong intellectual property right, in particular
because of the absence of independent-invention defense, breadth of the
protection and inventive step
3) Breadth vs. inventive step
- Breadth governed by “doctrine of equivalents”. Determines whether
infringement occurs (infringement with respect to claims)
- Inventive step governed by novelty and non-obviousness. Determines
patentability
 There can be inventions that are unpatentable and non-infringing and
inventions that are patentable and infringing (blocking patents)
II.1. Optimal Design of Patents
(when competition is horizontal)
Optimal design of patent life
 r

1

e
1
T   e rt dt 

t
0
r


1

r
t 1

•
T=discounted patent life
•
Cost of innovation C
•
If C is invested, probability of making an invention = 
•
When the patent is in force, a profit flow p
•
Eg with a zero MC and a linear inverse demand P=a-Q, p=a2/4
•
If imitation/entry costless, c=0
•
Innovator’s (ex post) profit from the patented innovation

P(T )   ert p dt  T p
0
•
The innovator’s expected profit =  P(T).
The innovator invests only if  P(T)C
•
•
So P(T) is a measure of the incentive to innovate
 T must be at least C/p
•
Social return flow on innovation
•
When the patent is in force Wp=p+CSp
•
After the patent expires Wc=CSc
•
In general, Wp<Wc, i.e., Wc-Wp=DWL
•
E.g., with MC=0 and P=a-Q we have DWL=a2/2-3a2/8=a2/8
Market for proprietary information goods
a
P
P(Q)=a-Q
CSp
Pp
p
DWL
Q
Qp
MC
a=Qmax
•
Note: A virtue of IP
•
The full discounted social value of innovation = a2/2r
•
The inventor with an idea knows to get Ta2/4, i.e. the investments
will be made in relation to social value
•
The more valuable is the invention to society, the more is the
inventor willing to put resources in innovation
•
Ex post social welfare as a function of the patent life,

S (T )   e rtW p dt  
0



c
1
W


e rtW c dt  TW p    T W c 
 T W c W p
r
r

i.e, the full social value minus DWL over the patent life
•
so the patent is like a tax on users
•
The effect of patent life on ex post social welfare: dS/dT=-DWL<0.
•
Seek the optimal patent life T*
•
Assume that the government can commit to T*
 a two-stage principal-agent game where the policy- makers choose
first T* and then the firm chooses whether to invest
 better to proceed backwards (look for a subgame perfect
equilibrium)

•
The firm’s problem has been solved:
- Invest if TC/p, do not invest otherwise
•
In this kind of a principal-agent problem this rule is often called the
agent’s incentive constraint (IC)
•
The first stage: the policy-makers choose T to maximize S(T)-C
subject to the firm’s optimal decision/incentive constraint
•
Solution: Since S’<0, choose T as small as possible subject to the firm’s
incentive constraint

T*=C/p
•
Heuristics:
Optimal patent life optimally balances the ex ante and ex post
problems in the creation of knowledge.
-
It minimizes the ex post DWL but provides enough protection to
justify the investment
Examples concerning the duration of IPRs explicitly:
•
The US ‘Mickey Mouse’ Copyright Act of 1998
• Under the former law, Mickey would have been free stuff 2003
(Pluto 05, Goofy 07, Donald Duck 09) because he appeared first
time in the 1928 cartoon “Steamboat Willie”.
• Huge lobby by Walt Disney and others  the US copyright law was
extended to the level of EU (an extension of 20 years)
•
The US patent term extension of 1995  the US patent duration was
extended to the level of EU (an extension from 17 to 20 years)
•
On-going debate on the harmonization of patent term extensions
• in pharmaceutical industry marketing and sales of new drugs are
delayed due to regulatory reviews required for commercialization
 patentees unable to exploit full term  US, Japan, Europe allow for
patent extensions
• extensions (ex post) bad news for consumers and generic drug
industry but stimulate the innovation of new drugs
• e.g., the US Patent Term Restoriation Act of 1984 explicitly designed
to balance the opposing interests!
Notes:
1)
Requires that society commits to T*. Ex post government has an
incentive to cheat and put T=0: this is optimal ex post. However, if this
were possible, the inventor would realize it, and would not invest.
- e.g. Apple ITunes vs France
2)
One size does not fit all. Certainly, if T is the same for all inventions and
industries, there are inventions where the incentive constraint is not
satisfied (T<C/p) or where the incentive constraint is slack (TC/p>0) and hence DWL is higher than necessary.

Optimal rule suggests that T should be invention specific. With linear
inverse demand P=a-Q, the optimal rule is given by T*=4C/a2

The larger is C or the smaller is  or a, the longer should be optimal
patent life (T*)
3) The patent system can yield overinvestment in innovation.
-
-
Suppose there is free entry to the market for invention
-
Suppose all firms can make the invention with probability  by
investing C but only one of the successful inventors gets the patent
-
How many firms will enter?
The probability that an inventor gets the patent is given by [1-(1-)n]/n
Explain…
-
Denote the probability by (n)/n
the inventors expected profit is given by
 n 
n
P(T ) 
 n T p
n
Note: (n)/n and hence expected profit is decreasing in n. Proof…
 n  1P(T )
 n P(T )

C

Then entry will occur until
n 1
n
-
From the welfare point of view it is only relevant that the invention is
made at least by one inventor
-
The probability of at least one success is given by [1-(1-)n], ie by (n)
-
(n) is increasing in n
-
Social value of nth entrant is S(T)[(n)-(n-1)]-C
-
Socially optimal number of entrants is
S(T)[(n)-(n-1)]>C> S(T)[(n+1)-(n)]
- This number can be larger or smaller than the number of entrants
determined by market equilibrium
E.g., assume =1. Social value of the second innovator = 0. However, if
P(T ) / 2  T p / 2  C
there will be at least two inventors and the costs are unnecessarily
duplicated.
The Economic Effects of Patent Breadth
Recall that legally
•
breadth is governed by the “doctrine of equivalents” and claims
•
infringement must be established with respect to claims
•
breadth is endogenous in the sense that the applicant and the PO
determine the range of applications covered by claims
- the applicant claims as much as she can
- the PO checks out what claims allowable
•
Economically the breadth measures how difficult it is to bring a noninfringing substitute in the market
•
Determines the pricing power of the patent holder over the patent
life
•
Product space and technology space
Product space: How “similar” a competing product must be to infringe
patent, reminds “doctrine of equivalents”
Example: Breadth affects the demand of the patented good. E.g., demand
•
with a broad patent: Pb=b-Q
•
with a narrow patent: Pn=n-Q
where b>n.
b
Effect of Breadth in Product Space
A decrease in patent breadth
Pb(Q)=b-Q
P
n
P
(Q)=n-Q
n
Pb
P
b
n
n
DWL
Qn
Qb
Q
Technology space: How costly it is to find a non-infringing substitute for
the patented technology, i.e., to “invent around” the patent.
Example: Two firms, an innovator and an imitator
•
the imitator can copy the innovator’s product with cost K(b)
where b is patent breadth and K’>0. For brevity K=b.
•
if the innovator is alone at the market, she earns p
•
if the imitator enters, both firms earn d< p
•
if b < d, there is entry, if if b> d, no entry
Generalization: IPRs and market structure
•
consider free entry with cost b  market will consist of n firms
defined by
n>b>n+1
Note: Definition close to piracy/copying  more appropriate for
copyright?
a
Effect of Breadth in Technology Space:
Market when the patent is broad and there is no entry
P
P(Q)=a-Q
Pp
p
Q
Qp
Effect of Breadth in Technology Space:
Market when the patent is narrow and
there is n-1 entrants
a
P
P(Q)=a-Q
Pn
PSn=nπn
π
n
Q
Qn
Example 1. Product Space
IBM’s patent on ‘smooth end of auction in the internet’, US patent 6,665,649
•
it ‘claims’ a computer program that determines the end time of an
auction according to D=-dln(1-r/m) where d is the posted expected
duration of the auction, and r<m is a pseudo random number picked by
the program from an exponential distribution
•
what a about a competitor enters and introduces a similar auction
where r is picked from a uniform distribution?
•
breadth determined in the infringement court cases
- a very narrow patent would allow the competitor enter
- a very broad patent would prevent anyone using random-ending
auctions (in the internet)
Example 2. Technology space:
Amazon’s ‘one-click shopping’ patent, US patent 5960511
• ‘claims’ a computer program allowing customers enter their credit
card number and address only once, avoiding to re-enter that on
follow-up visits to the Amazon site
•
Barnes & Noble entered with a similar but not identical technology
 Amazon took B&N to the court  Amazon got a preliminary
injunction forcing B&N to use ‘two-click shopping’ system in during
the X-mas period  B&N did not want to wait to the end of the
court case and bought a license
•
a broad patent allows no Internet retailer to use similar ‘one-click
shopping’ method, a narrow patent allows rivals enter if they use
different software program to obtain the ‘one-click’ property
Generic Economic Effects of Patent Breadth
•
let b denote patent breadth, b[0,1]
•
let (b) the profit flow after the successful innovation as a function of
patent breadth (when the patent is in force)
•
assume ’>0, (1) = p and (0) = c =0
•
similarly, welfare flow as a function of the patent breadth W(b), over
the duration of the patent: W’<0, W(1)=Wp, W(0)=Wc
•
The firm’s profits on an existing innovation as a function of the patent
life & breadth, P(T, b):
 r

1

e
 rt
e
0  bdt   b r

•

  T b

Ex post social welfare as a function of patent life and breadth, S(T, b):


0
e rtW b dt  




c
W
e rtW 0dt 
 T W c  W b 
r
i.e, full social value minus DWL as before. Now DWL is a function of
patent breadth DWL(b)
Note
• If b<1, P(T, b)<P(T,1) and S(T,b)>S(T,1),
where P(T,1) and S(T,1) are as in the analysis of optimal life
i.e. the tradeoff between ex ante and ex post inefficiencies.