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Economics and Management of Intellectual PropertyHSE Spring 2008

Tuomas Takalo (www.takalo.net)

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1. Basics of IP Law (Välimäki)

2. Use of IPRs (Välimäki)

3. Basic Economics of IP

4. Designing Optimal IP Policy

5. Cumulative Innovation and IP

6. Microsoft Cases in the US and Europe (Välimäki)

7. Economic arguments used in legal cases (Välimäki)

8. Network Industries, Competition Policy, IP

9. Basic IP Management

10-11. Industry studies: IP in Financial Services etc

Outline of Core Lectures

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Economics and Management of Intellectual PropertyHSE, Spring 2008

Lecture 3

“Basic Economics of Intellectual Property”

Tuomas Takalo,www.takalo.net

Jan 21, 2008

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• IPRs (e.g., patents, copyrights, trade secrets) used be aboring issue in the backwater of corporations and society,

• But no longer

• “Era of Intellectual Capitalism”: IPRs are everywhere. E.g.almost daily in the FT

• Business, political, social and moral issue

“conceptualization (of GDP) is irreversibly increasing theemphasis on the protection of IPRs”

- Alain Greenspan -

Introduction

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Business issues:

• IP management crucial for success and failures ofcorporations

• IBM received 3622 US patents 2006, Canon 2427,Microsoft 1614, Nokia 810, Qualcomm 399...

• IP Business Models: Qualcomm, Apple iTunes,Intellectual Ventures

• IPs cause major changes in corporate strategy:Microsoft, Sun, HP, Nokia

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Political and social issues:

• Heated debate of pros and cons of IP system

• Software patent directive – one of the most lobbied andcontested directive proposal in the EU history

• New copyright law in Finland

• Industrialized v. developing countries

• Moral issues: patentability of genes, algorithms etc

• Many argue that the whole IP system should beabolished

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• Two major reasons for the development

1) Economic science

• Technological progress is the driver of economic growth(Solow’s works)

• Policy makers can affect technological progress(mainly) via IP policy

“If our objective is to maximize economic growth, arewe striking the right balance in our protection ofintellectual property rights?”

- Alan Greenspan -

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2) Technological progress itself: digitalization

• Knowledge as an economic commodity: market fortechnology

⇒ Specialization in knowledge production

• Intellectual property renders knowledge tradable commodity

• Technological changes that have undermined IP protection

2) ⇒ IP management crucial, changes in corporate strategy

1&2) ⇒ Legal and administrative changes that have strengthenedIP protection

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• Some legal changes:

• Due to a reinterpretation of the US patent law (theSupreme Court decision (Diamond v. Diehr, 1981),software patenting became possible.

• Due to a reinterpretation of the US patent law (anappellation court decision) State Street Bank and Trustv. Signature Financial Group business methods becamepatentable

• Note: European Patent Law prohibits patents on softwareand business methods

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• Intellectual property is about law and economics

• Emphasis is on the insights on IPRs offrered by the theoryof industrial organization

• I try to be correct on legal concepts but it is yourresponsibility to correct me whenever I will make an error

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Course based on

• Suzanne Scotchmer (2004) “Innovation and Incentives” MITPress

• Menell and Scotchmer’s survey (2005) in Handbook ofLaw&Ecs

• Adam Jaffe and Josh Lerner (2004) “Innovation and ItsDiscontents. How Our Broken Patent System is EndangeringInnovation and Progress, and What to Do About It?” PrincetonUniversity Press.

• The Economist, October 22, 2005. A Market for Ideas, A Surveyof Patents and Technology

• Kevin Rivette and David Kline (1999) “Rembrandts in the Attic:Unlocking the Hidden Value of Patents”. Harvard BusinessSchool Press

• Kultti-Takalo-Toikka (2006) American Economic Review

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Basic Law for Business and Economics

1. Intellectual property ≠ real (tangible) property

• there are similarities, though

2. Intellectual property legislation comprises of a variety laws

• Details complicated – basics simple

• US vs. Europe (rest of the world)

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Playing field of IPRsTrademarks

CopyrightsPatents

Contracts

Designprotection

Domain names

Tradesecrects

Marketing, selling andother authorizations

Utility models

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Some general legal characteristics of IPRs:

• Exclusive rights that can be used (to try) to forbid others

- Without right holder’s permission one cannotcommercially use the subject (or a very similar subject)protected by an IPR

• Limited duration

• Infringement can lead to injunction/prohibition &compensation

- Preliminary injunction

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Patent is the gold standard of the IPRs:

• Only under the patent system independent invention isnot a defense against infringement

- Unintentional infringement of other rights can bepunished

• Protection is fairly broad

• A substitute has to be “sufficiently different” not toinfringe

• Requires inventive step (novelty/non-obvious)

• An innovation has to be “significant”

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On the other hand, the patent system

• requires disclosure: patents granted for inventions thatare disclosed in the patent application, which will be inthe public domain

→ can facilitate imitation/inventing around the patent

• failure to disclose can imply invalidity

• constrained by user rights (experimental use, prior userrights (Europe), private use)

• duration is relatively short

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• requires formal and “tough” application process

- need to apply for a patent and then the PO (patentexaminers) decides whether the application is accepted(a patent granted) or not

• application process is costly and long

• allows patents on (significant) improvements

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Modified fromGraham et al.2002

EPO System USP SystemInvention

First to file First to invent

1 year(US only)

Patent Application Patent Application

Publication

18 mosSecrecy

Disclosure

2-3 years

Secrecy

Rejected

Opposition9 mos

Disclosure

20 yearsLitigation

PatentIssues

RenewalFees

PatentIssues

RenewalFees

Re-examinationRe-issue

Litigation

Rejected

18 mosSecrecy

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Intellectual property rights

Industrial Property Copyrights Trade secret(secrecy)

Patents and other forms ofprotection of inventions Identification marks

Overview of IPRs: Law

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Intellectual property rights

Protection of innovations(patents, copyrights etc)

Trade secret(secrecy)

Identification marks

Overview of IPRs: Economics

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Intellectual property protection on innovations

− Major economic function is to provide incentives to innovateand to (aesthetically) create

• Patents (on inventions)

• Copyright (on creative works)

• Database protection (EU)

• Design protection/patent (US)- appearance of a product

• Utility model (“Petty patent”) (lower novelty requirementstandard than in patents)

• Semiconductor chip design protection, plan-protection, etc

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Copyright

• protects exact expression, against direct copying

- ideas vs. expressions

• constrained by user rights (fair use, right to make privatecopies, citation, parody etc)

• constrained by independent invention

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Trade secrets provide an important economic alternative toprotect innovations

• protects commercially valuable information, againstmisappropriation

- theft, bribery, unauthorized disclosure

• constrained by independent invention, accidentaldisclosure

• departure of personnel?

• Affected by contract law, privacy etc

• E.g. in Finland: To what extent employers should have aright to monitor employees’ email communications

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Identification marks- Major economic function to protect integrity of the market

place rather than providing incentives

• Tradename- Every company has this IPR!

• Trademark- word, figure, sound…

• Domain names

• Protection for products after their place of origin (mämmi,champagne, feta, budweiser)

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Examples of identification mark issues

1) Gillette vs. LA Laboratories Ltd

• LA Laboratories’ blade packaging mentioned that "allParason Flexor and Gillette Sensor handles are compatiblewith this blade".

• Is this legal? Should it be legal from the economic pointof view?

2) Arsenal vs. Reed- Mr. Reed had been selling unauthorized Arsenal scarfswith an explicit statement that they are unofficial outsideHighbury stadium 31 years.

• Is this legal? Should it be legal from the economic pointof view?

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• The importance of identification marks should not beunderestimated, although not a focus of the course

• A way to protect a brand

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Basic Economics of IP

• Economic philosophy of IPs based on the notion of marketfailure

• Knowledge is a public good

• It is non-excludable and non-rival

• Like traffic light, national defense, clean air etc

• In other words, it does not wear out and it is hard toprevent others using it once available

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The non-excludability problem:

• Creation of knowledge requires effort & investments ofvarious degrees

• If no IPRs, a free-riding possibility emerges, diluting theincentive to innovate

⇒ too little innovation ⇒ too little growth (cf. endogenousgrowth models such as Romer-90)

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An example

• suppose it costs 1000.000€ to develop a new product

• MC of production = 50€

• 100.000 buyers

⇒ the innovator needs to get at least 60€ per product

[100.000*(60-50)-1000.000=0] to break-even

• suppose at least one other firm with an identical production

technology enters

• suppose that there is no IPRs and the innovation is easy to copy, i.e.,

imitation/duplication cost ≈ 0€

⇒ in the competitive equilibrium the price will be 50€⇒ both firms make zero profits

⇒ no incentive to make the innovation in the first place!

• This the essence of the appropriability problem (Arrow, 62)

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• There is a market failure in the markets for knowledge

• As usually, the source of market failure is that there is too littlecapitalism, i.e. property rights on knowledge are not well defined

• A straightforward solution: define property rights on knowledge

⇒ intellectual property rights are rather capitalistic institution

• the rise of IPRs inherent to the rise of capitalism- e.g. the first IP-like rights introduced in large scales in

medieval city-states (e.g. Venice)

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Another side of the coin: non-rivalry

• Once knowledge is created it is waste to restrict its use

⇒ widespread notion that knowledge should be a publiclyaccessible good

⇒ tensions trough history after major technologicalbreakthrough, e.g., the antipatent movement of the end of1800 century, compare with the free software movement

⇒ Fundamentally, there is nothing new in the currentsituation!

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• “Reward theory” of IPRs (non-exclusivity)i.e. “Monopoly rights” theory

- unprotected innovations are easy to imitate

- IPRs needed to provide the right (to try) to excludeothers

- the right to exclude is a source for market power

- market power boosts the incentive to innovate

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• “Contract theory” of IPRs (patents) (non-rivalry)

- in the absence of patent protection, innovations arekept in secret

- to induce disclosure & avoid unnecessary duplicationof innovation costs, a temporary “monopoly” right toinnovation

⇒ “patents as social contracts”: innovator discloses thedetails how to make the innovation and gets atemporary property right in return

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However, the other side of the coin:

- market power/ “monopoly right” reduces thecompetition in the post-innovation market (not good forconsumers)

⇒ The fundamental trade-off of the IP:

Ex ante, IPRs provide incentive to innovate

Ex post, they restrict the use of inventions

⇒ Need for a balance

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Welfare

Strength of IPRs

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• Let us develop the concepts used over this course and lookthe ex post problem in more detail

• It is also the major defect of IP compared with otherinstitutions of supporting innovation

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P (price)

Q (quantity) or # of consumers

Demand p(Q)=a-Q

“willingness-to-pay”Pmax=a

Size of themarket or

u(Qmax)

Qmax

u(Q)=(representative) consumer’s utility

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P (price)

Q (quantity) or # of consumers

MC

Demand p(Q)=a-Q

“willingness-to-pay”

Q*

P*

Competitive market for “tangible” goods

CS=W

Pmax=a

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In a competitive market for tangible (excludable, rival) goods

• Producer surplus / (ex post) profits (PS) = (P*-MC)Q*=0

• Consumer surplus (CS) = (a-P*)Q*/2= Q*2/2

• Social Welfare (W)= PS+CS=CS=(a-P*)Q*/2= Q*2/2

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Competitive markets are efficient since

• The good goes to the ones who value it most

• Price equals the opportunity cost of resources required toprodice the good (P*=MC)

i.e., the “indivisible hand” works

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P

Q

MC

P(Q)

Q*=Qmax=aas P(Q)=a-Q

P*=0

Market for non-proprietary information good-competitive- MC of production/duplication ≈ 0

CSc=Wc

Pmax=a

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In a market for non-proprietary information good (non-excludable, non-rival)

• P*=MC=0

PSc (little c stands for competitive) = (P*-MC)Q*=0

CSc = (a-P*)Q*/2=a2/2

Wc = PSc+CSc=CSc=a2/2

• A competitive market for non-proprietary information goodis efficient like any other competitive market

• the ex post market!

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P

Q

P(Q)

Qm

Pm

Market for proprietary information goods

MC

a

a=Qmax

CSp

PSpDWL

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In a market for a proprietary information good (excludable,non-rival)

PSp (little p stands for proprietary) = (Pm-MC)Qm= PmQm

Since the owner of the IP maximizes its profit:

Pm=a/2 → Qm=a/2 → PSp=a2/4 >0=PSc

CSp = (a-Pm)Qm/2=(Qm)2/2 = a2/8 < a2/2 = CSc

Wp= PSp+CSp=PmQm+(a-Pm)Qm/2= a2/4+a2/8 = 3a2/8< a2/2=Wc

Wc-Wp=a2/2-3a2/8=a2/8=DWL

DWL=Dead-weight loss due to proprietary pricing

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• A market for a proprietary information good is inefficientdue to market power of the IP owner

• DWL is the major defect of the IP as a technology policytool

• the larger the size of the market (a), the larger is the DWL

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Recall: The ex ante problem i.e., the appropriability problem

• There is no incentive to innovate unless PS>0

• E.g., if the cost of innovation is K, and 0<K<PSp, theinformation good is created under the proprietarysystem but not in the competitive system

• It can be 0<PSp<K<Wp

• If this is the case, a making IP stronger would be asolution

• It can also be that 0<PSp<Wp<K<Wc

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In sum:

• IP is need to make PSp>0

• But if PSp>0, also DWL>0

⇒ there is a fundamental tradeoff between the creation ofthe incentive to innovate and spreading of innovations.

• If no IPRs or weak IPRs, there is little innovation

• If strong IPRs, there is price of innovations is too high andtheir use is restricted

⇒ need for a balance

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• The current strong IP/ “Intellectual Capitalism” era israther young, about 30 years

• The question of our time: Does knowledge economyneed to be capitalistic, i.e. do we need IP?

• - Cf. manifests, debate in popular press, freesoftware movements, Boldrin-Levine, Bessen-Maskinetc

• In essence, would the incentive to innovate besufficiently high or even higher without IPs?

• Does not go well in the traditional left-right politicaldivision

BUT as said there is nothing new in the current situation

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Note: there are other institutions to foster creation ofknowledge than IP

• Public production

• Public procurement (contests)

• Subsidies

• Prizes

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• IP is not an ideal incentive mechanism. Nor are the others

- The other mechanisms are better in solving the ex postproblem but IP is better in solving the ex ante problem

- IP typically restricts the use of innovations (e.g. DWL)

- But only the users pay ⇒ all inventions funded by IPcreate Pareto-improvements

- DWL could be reduced or even eliminated, if the IPholder would be able to discriminate on price

- Some form of price discrimination is possibleeven with information goods

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- Another virtue: decentralization

- Firms/innovators have better knowledge what shouldbe invented or what is feasible to invent than thegovernment

- private value correlated with social value

- But another problem: research effort is not generallydelegated to the most efficient firms or the right numberof firms

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Open questions in technology policy

• Is it optimal to combine the mechanisms, e.g., why publiclyfunded innovations are also protected by IPs?

• Is IP the best system?

• Is it possible to design the other systems better so thatwe can get rid off IPs? Come up with a new mechanism?

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• Is it possible to design IP better?

- Designing IP so that it does not restrict use (minimizesDWL) while providing the incentive to innovate

- Another major reason for the patent institution isdisclosure i.e. spreading of innovations

• If IP is the best, are there too many or too few forms ofIPRs?

• Do we need more sui generis IPRs (industry or eveninnovation specific IPRs)?