A Model of OptimalA Model of OptimalSoftware Patent Policy Software Patent Policy

DesignDesign

Professor Matt ThatcherProfessor Matt Thatcher

2

Trade Secret LawsTrade Secret Laws Uniform Trade Secrets Act (UTSA)Uniform Trade Secrets Act (UTSA)

gives right to companies to keep certain gives right to companies to keep certain information secret (to maintain competitive edge)information secret (to maintain competitive edge)

covers formulas, patterns, programs, devices, covers formulas, patterns, programs, devices, methods, processesmethods, processes

Must have the following characteristics:Must have the following characteristics: be novelbe novel represent economic benefit to firmrepresent economic benefit to firm involved some cost and effort to developinvolved some cost and effort to develop is generally unknown to the publicis generally unknown to the public company must show effort to keep the company must show effort to keep the

information secretinformation secret

3

Trade Secret LawsTrade Secret Laws (cont.) (cont.)

Problems:Problems: Software often must be put into the public Software often must be put into the public

realm, making it difficult to keep secret (and realm, making it difficult to keep secret (and generally unknown to the public)generally unknown to the public)

does not protect from independent discoverydoes not protect from independent discovery Economic Espionage Act (1996)Economic Espionage Act (1996)

penalties: up to $10 million and 15 years penalties: up to $10 million and 15 years prison for theft of trade secretsprison for theft of trade secrets

IP lost in industrial espionage IP lost in industrial espionage > $300 > $300 bill / year bill / year

4

Trade Secret LawsTrade Secret Laws (cont.) (cont.)

How do you show you are keeping How do you show you are keeping information secret?information secret? identify all information to be protectedidentify all information to be protected label it label it confidentialconfidential educate employees of importance of trade secretseducate employees of importance of trade secrets make only accessible to limited # of people on a make only accessible to limited # of people on a

need-to-know basisneed-to-know basis develop develop non-disclosurenon-disclosure agreements agreements develop develop non-competenon-compete clauses clauses

Compuserv v. IBM (2005)Compuserv v. IBM (2005) technology protectionstechnology protections

firewalls, encryption, secure databases, etc.firewalls, encryption, secure databases, etc.

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Why Do Firms Patent Why Do Firms Patent Software?Software?

Number of Software Patents Issued Per Year [Bessen and Hunt (2004)]

0

5000

10000

15000

20000

25000

Year

Nu

mb

er o

f P

aten

ts I

ssu

ed /

yea

r

1982 2002

6

Patent Height (h)

Patent Width (w =

h - )

Basic Product (s = 0)

Allowable Imitation ()

Patent Height: Protection from improvements

Patent Width: Protection from imitation

Patent Length: Duration of protection

Improvement to the Basic Product

7

Patent LawsPatent Laws Requires that innovation under review must Requires that innovation under review must

be:be: new, useful, and non-obvious to a person of new, useful, and non-obvious to a person of

ordinary skill in the relevant fieldordinary skill in the relevant field Once awarded, a patent provides patent-Once awarded, a patent provides patent-

holder:holder: scope of protection from imitation for 20 years scope of protection from imitation for 20 years protects functions/behaviors of the program protects functions/behaviors of the program protects from independent discoveryprotects from independent discovery

Cannot patent Cannot patent abstract ideas, laws of nature, scientific abstract ideas, laws of nature, scientific

principlesprinciples

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Patent LawsPatent Laws (cont.) (cont.)

U.S. Patent and Trademark Office (USPTO)U.S. Patent and Trademark Office (USPTO) patent examiners (~3000) search for patent examiners (~3000) search for prior artprior art

existing body of knowledge that is available to a existing body of knowledge that is available to a person of ordinary skill in the artperson of ordinary skill in the art

what is the problem with this in the software arena?what is the problem with this in the software arena? determine originality and noveltydetermine originality and novelty ~ 25 month application process~ 25 month application process details about patented innovations are placed details about patented innovations are placed

in the public domainin the public domain No limit to monetary penaltyNo limit to monetary penalty

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Debating Patent Policy DesignDebating Patent Policy Design

Why reform the U.S. patent system?Why reform the U.S. patent system? Samuelson (2004)Samuelson (2004)

What is wrong with software patent What is wrong with software patent quality?quality? patent height is too low!patent height is too low! patent width is too wide!patent width is too wide! patent length is too long!patent length is too long!

Economic perspectiveEconomic perspective National Academies(2004)National Academies(2004) Federal Trade Commission(2003)Federal Trade Commission(2003)

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Research QuestionsResearch Questions

What is the What is the targettarget of feasible patent policy of feasible patent policy designs?designs?

Which policy designs in the targetWhich policy designs in the target are good/bad for society? are good/bad for society? are good/bad for consumers?are good/bad for consumers?

Which policy design is socially optimal?Which policy design is socially optimal? How do changes to an established policy design How do changes to an established policy design

affect social welfare? That is, what happens if affect social welfare? That is, what happens if the authoritythe authority increases height? increases height? narrows width? narrows width? shortens length?shortens length?

Should software products be patentable at all?Should software products be patentable at all?

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Model of Duopoly CompetitionModel of Duopoly Competition(R&D Race / Product Improvements / Price)(R&D Race / Product Improvements / Price)

Pre-gamePre-game posit a basic, well-known software productposit a basic, well-known software product

where quality of basic product is normalized to where quality of basic product is normalized to zerozero

Free Market Competition (No Patent Model)Free Market Competition (No Patent Model) Stage 1Stage 1: two firms compete in R&D to develop a novel : two firms compete in R&D to develop a novel

ideaidea Stage 2Stage 2: the innovator (: the innovator (nn) transforms a novel idea ) transforms a novel idea

into an improvement (into an improvement (ssnn > 0) to the basic product at > 0) to the basic product at substantial fixed cost, C(substantial fixed cost, C(ssnn)=k)=kssnn

22 /2 /2 Stage 3Stage 3: the imitator (: the imitator (mm) observes the innovator’s ) observes the innovator’s

product improvement and decides to what extent it product improvement and decides to what extent it will imitate at zero fixed cost, will imitate at zero fixed cost, ssmm [0, [0,ssnn]]

Stage 4Stage 4: the firms simultaneously set prices and offer : the firms simultaneously set prices and offer products, where MC(products, where MC(ssnn) = MC() = MC(ssmm) = 0) = 0

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Individual’s utility function: Individual’s utility function:

Individuals’ purchase decisions:Individuals’ purchase decisions:

Solving for product demands:Solving for product demands:

Vertically Differentiated Vertically Differentiated Demands Demands

(Stage 4)(Stage 4)

1,0~ where psU ii

m

mimmi

mn

mnimminni

s

pps

ss

pppsps

0

m

m

mn

mnm

mn

mnn s

p

ss

ppQ

ss

ppQ

and 1

13

npns ms mp mnmnsspp

nnsp

Graphical Representation of Graphical Representation of Demand Demand

(Stage 4)(Stage 4)

np

ns

ms

mp

mn

mn

ss

pp

m

m

s

p1 0

14

nRnpns ms mp mnmnsspp

nnsp

Graphical Representation of Graphical Representation of DemandDemand

(Stage 4)(Stage 4)

np

ns

ms

mp

mn

mn

ss

pp

n

n

s

p1 0

mRnR

CS

CS

DWL

DWL

15

Solving for Prices Solving for Prices (Stage 4)(Stage 4)

mn

nmnm

mn

nmnn

mn

mnmmnm

mn

mnnmnn

mnm

nmmn

m

m

mn

mnmn

n

n

mnm

n

m

m

mnn

n

mmmnnn

ss

sssQ

ss

sssQ

ss

sssssp

ss

sssssp

sss

psps

pss

ppss

p

sss

s

pssp

QpCQp

4),( and

4

2),(

4

)(),( and

4

)(2),(

02

and 02

02

and 02

and

2

2

2

2

n

Firms’ profit functions: Firms’ profit functions:

Profit functions (given quality levels) are concave Profit functions (given quality levels) are concave in prices:in prices:

First Order Conditions (F.O.C.s):First Order Conditions (F.O.C.s):

Solving the F.O.C.s gives:Solving the F.O.C.s gives:

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Performance Measures Performance Measures (Stage 4)(Stage 4)

242

212

,,,,

)4(2

)54(,

4, and

24

4,

2

2

22

2

2

2

2

2

2

n

mn

mmnnn

mnmnmmnnmn

mn

nmnmn

mn

mnmnmnm

n

mn

mnnmnn

ks

ss

sssss

ssssssss

ss

sssss

ss

ssssss

ks

ss

sssss

Firms’ profit functions (after substitution): Firms’ profit functions (after substitution):

Consumer surplus function:Consumer surplus function:

Social welfare function:Social welfare function:

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Solving for Imitator QualitySolving for Imitator Quality(Stage 3)(Stage 3)

7

4

0)4(

)74(

0)4(

)87(2

4,

3

2

4

2

2

2

2

nnm

mn

mnn

m

m

mn

nmn

m

m

mn

mnmnmnm

sss

ss

sss

s

ss

sss

s

ss

ssssss

Imitator profit function: Imitator profit function:

Profit function is concave in quality:Profit function is concave in quality:

F.O.C.:F.O.C.:

Solving the F.O.C. gives the imitator’s Solving the F.O.C. gives the imitator’s best best response function:response function:

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Solving for Innovator QualitySolving for Innovator Quality(Stage 2)(Stage 2)

kss

kss

kss

kss

kkpp

kkss

kss

ks

mnmn

mnmmnn

mnmn

nn

n

n

n

4608

259),( and

4608

196),(

4608

14),( and

4608

49),(

)96

1,

192

7(),( and )

12

1,

48

7(),(

048

7

0 2

2

Innovator’s profit function is concave in quality: Innovator’s profit function is concave in quality:

F.O.C.:F.O.C.:

Solving the F.O.C. gives the Solving the F.O.C. gives the free market outcome free market outcome (MO) values:(MO) values:

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The Patent ModelThe Patent Model

Patent policy is set before the game Patent policy is set before the game begins: begins: patent height (h)patent height (h) patent imitation level (patent imitation level ()) patent length (t)patent length (t)

where 0 < where 0 < < h and t < h and t [0,1] [0,1] Which policies give the innovator profit Which policies give the innovator profit

incentive to seek a patent?incentive to seek a patent?

hshthtth

ssth

mnnPOn

mnnPOn

,1,,, where

,,,

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ConclusionsConclusions

The POR is the The POR is the targettarget of feasible patent policy of feasible patent policy designsdesigns

Impact of changes to established policy design on Impact of changes to established policy design on social welfare social welfare patent length patent length social welfare social welfare

but contracts the POR and eliminates good policy but contracts the POR and eliminates good policy optionsoptions

patent width patent width social welfare social welfare patent height patent height social welfare if patent is long and high social welfare if patent is long and high

Optimal patent policy designOptimal patent policy design max length and set height/width to intermediate levels max length and set height/width to intermediate levels if length is short if length is short set the highest, widest policy in the POR set the highest, widest policy in the POR reduces R&D incentives to discover a novel ideareduces R&D incentives to discover a novel idea

Is policy too low, too wide, and too long?Is policy too low, too wide, and too long? it depends!!!!it depends!!!! many factors may prevent the policymaker from identifying many factors may prevent the policymaker from identifying

the POR or hitting a goodthe POR or hitting a good

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Questions?Questions?