38E00100Economics and Management of Intellectual Property

Part IV

“Breadth and Duration of Intellectual Property and Their Optimal Design”

Tuomas Takalo, 24.1.2007 www.takalo.net

Week 1. Välimäki

1. Basic IP Law; 2. Use of IPRs

Week 2. Takalo

3. Basic Economics of IP and Innovation

4. Breadth and Duration of IP and Their Optimal Design

Week 3. Takalo + Guest Lecture

5. Optimal Design cont + IP Policy and Management: Cumulative Innovation

6. Cumulative Innovation cont + Guest Lecture

Outline of Lectures

1) Knowledge is a public good. Non-rival and to various extent non-excludable

There is a fundamental tradeoff between the creation of the incentive to innovate and using innovations once made

• Ex ante, before investments in knowledge production, there is an appropriability problem

• Ex post, once knowledge exists, it does not wear out and there is no point to restricts its use

• Intellectual property makes knowledge (more) excludable and hence stimulates the incentive to innovate ex ante but restricts its use ex post

Recapping Part III

calls for a balance:

inventors/creators users/public

inverted U-shape relation between strength of IP and welfare

• This fundamental tradeoff/need for a balance/inverted U-shape is underlying the most debate concerning IPRs!

cf. Gowers’ Review/ Economist’s article 9 of Dec

2) IP is not the only mechanism to encourage innovation.

- the other include prizes, public production and procurement, and subsidies.

- IP is roughly speaking worse in solving the ex post problem but better in solving the ex ante problem

- Its virtues: decentralization, only users’ pay, creates correlation of private and social value of innovation

-Its defects: restriction of use (DWL(+hold-up)), allocation of R&D effort

P

Q

P(Q)

Qm

Pm

Market for proprietary information goods

MC

a

a=Qmax

CSp

PSpDWL

• DWL could be reduced or even eliminated, if the IP holder would be able to discriminate on price

• Some form of price discrimination is possible even with information goods (see Shapiro and Varian)

Is it possible to design IP better?

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

A Digression on Methodology

(Cf. “Arm-chair economist” by Landsburg or “Hidden order” by Friedman or Economics crime novels by Marsall&Jevons):

• TMP/IO-economics uses models not because they are realistic but because they offer a consistent way to understand firms’ & policy-makers’ behavior

• Models are like maps

– One-to-one map pretty useless in orienteering

– The real-world aspects left out depends on the purpose of the map

• Models build on assumptions:

– Some of them are plainly false but the literate truth of assumptions is never a prerequisite for scientific inquiry

– Assumptions are tested not by their literal truth but by the quality of their implications

• Good models and their predictions often generalize

• How to model innovation process?

Production function vs. ideas model

Breadth and Duration of IP and Their Optimal Design

(Scothmer, Chapters 3-4)

Production function

W = the social (gross) value of innovation

E.g.,with zero MC and a linear inverse demand P=a-Q, W=a2/2

= success probability of making an innovation

Cost of innovation C(). C’>0, C’’<0

• Net welfare from innovation S()=W-C()

• Society should choose the level of R&D to maximize S()

• I.e., innovation is just matter of investing resources.

• If W were known ex ante, why not just to post a prize equal to it?

• Or produce publicly?

Ideas model:

• Ideas are generated first and then decision to invest in developing an idea is made

• W is not known at least prior to some one thinking the idea.

• Ideas are scarce in the sense that an idea also identifies an economic need (W).

• In the ideas model the IP system has its virtues:

- potential inventors are the one who come up with ideas

- they and not some government agency decide whether to invest in the idea or not

- if the idea turns out to be valuable for market/society, IP system guarantees that the inventors get rewarded

• Ideas view applies in particular to the patent system as it o perates as the level of ideas/inventions

• Copyright in traditional context: the choice is about a career rather than which idea to pursue

Critique of ideas approach:

- Where do ideas come from?

- Would pouring more money to the production of ideas yield more ideas? Back in the production function model

• In what follows we for brevity use production function approach

- Keep in mind that presumption is that ideas, or their values (W) are non-observable or at least non-verifiable by an outside party (government agency)

• Focus on the basic trade-off between ex ante and ex post considerations

• Generic view on IP in case of stand-alone inventions/creative works

- Copyright- Patents (e.g. in pharmaceutical industry)- Trade secret

• Many insights apply more widely

• But leaves important issues out (as we will see next week)

Policy levers: duration and breadth

Duration: rather clear-cut, measures the time-period the IP is in force

• after IP no longer in force, information (invention, works etc) in public domain

• Patent: 20 years (from application, conditional renewal fees)

• Copyright: often authors’ life + 70 years (works for hire, 95 yrs after publication or 120 yrs from creation)

• Trade secret: forever (until becomes public)

• Statutory life usually differs from economic life

• E.g.• secret leaks out

• patented invention becomes obsolete renewal fees are not paid

•less than 10% patents are kept force full period

“patents as real options”

• Invalidity: Typically a firm that is sued for infringement claims that the patent is invalid

• copyrighted material becomes obsolete

Breadth of protection

• An elusive concept

• Not a legal concept but essential in practice and economics

• A loose definition: determines how different a competing product must be to avoid infringement/violation

• Breadth vs. inventive step (patents, EU) / non-obviousness (patents, US)

• Breadth vs. novelty (patens) / originality (copyright)

• Breadth vs. subject matter

Patent breadth• exclusive right to use invention commercially

• if a patent were restricted to the original invention exactly, protection would be trivial to circumvent (invent around)

• independent invention is not a defense!

• Doctrine of equivalents: “patent covers any product that does the same work substantially the same way to obtain the same result”

• E.g., if you patent a bottle that is closed by a screw cork the invention covers a bottle closed by an oak cork

• E.g., change of color not sufficient to escape infringement

• Infringement must be established with respect to patent claims

• Patent protects what is claimed for

• Claims chosen by the applicant and checked by the PO (patent examiners)

• All claims should be related to one invention

Writing claims carefully/strategically very important

• Patent breadth is endogenous

- 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

• Constrained by disclosure: Patents granted for inventions that are disclosed in the patent application that will be put in the public domain

can facilitate imitation/inventing around the patent

failure to disclose can imply invalidity

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

Copyright breadth

• protects exact expression, against direct copying

- ideas vs. expressions

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

• constrained by independent invention

Trade secret breadth

• protects commercially valuable information, against misappropriation

- theft, bribery, unauthorized disclosure

• constrained by independent invention, accidental disclosure

• departure of personnel?

• contracting a crucial determinant

IP durations and breadth

duration

patent

trade secret

copyright

breadth

Notes:

• Breadth affects economic duration

• Breadth is endogenous (claim writing, DRM, IP management, contracting etc)

• Ultimately determined in the court

• Even patents do not necessary leverage a strong market power (not to mention a monopoly) on output market

• Breadth is nonetheless limited and patents can be invented-around

• Patents and protected innovations are usually inputs,

• Substitute inputs/patents are available

• New products need increasingly many inputs

fragmentation of IPRs (cf. Rahnasto 03)

Designing Optimal Duration of an IPR

• Assume an IP is so broad that it is not possible to make an non-infringing substitute

• If innovation is successful, an IPR is awarded for years

• T=discounted duration of the IPR

• Clearly dT/d>0 so we can focus on T.

∞ T1/r

01 1

11

tt

rrt

rr

edteT

• Consider an inventor with an idea

• Cost of innovation C

• If C is invested, probability of making an invention =

• When the IPR is in force, a profit flow p

• Eg with a zero MC and a linear inverse demand P=a-Q, p=a2/4

• When the IPR expires, entry by rivals drive the profits down to c[0, p]

• If imitation/entry costless, c=0

• Innovator’s ex post profits as a function of the discounted IPR duration, P(T):

• Assume c=0 P(T)= T p

• The effect of IPR duration on the ex post profits:dP/dT=p >0, i.e. the longer duration boosts incentives

to innovate

The innovator invests only if P(T)C

The innovator invests only if T> C/p

So T must be at least C/p

)()(0

cpc

crtprt Tr

dtedteTP

• Social return flow on innovation

• When the IPR is in force Wp=p+CSp

• After the IPR expires Wc=c+CSc=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

P

Q

P(Q)=a-Q

Qp

Pp

Market for proprietary information goods

MC

a

a=Qmax

CSp

p

DWL

• We see a virtue of IP:

• The 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 duration of an IPR:

i.e, the full social value minus DWL over the duration

• so the IPR is like a tax on users

• The effect of the IPR duration on ex post social welfare: dS/dT=-DWL<0.

pcc

crtprt WWTr

WdtWedtWeTS

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 second stage

• The firm’s problem has been solved:- Invest if TC/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 TC/p

• Solution: Since S’<0, choose T as small as possible subject to the firm’s incentive constraint

T*=C/p

- Optimal duration of an IPR 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

Notes:

1) Requires commitment to the optimal policy T* . Ex post the 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 (and other countries)

2) One size does not fit all.

• If T is the same for all inventions, there are

• inventions where the incentive constraint is not satisfied (T<C/p)

• or where the incentive constraint is slack (T- C/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*)

Recent debates on the duration of IPRs

• 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)

• 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!

• Debate on the harmonization of copyright term (cf. Gowers’ review)

• Should copyright for sound and performance recordings be extended from 50 to 95 years?