38E00100Economics and Management of Intellectual Property

Lecture 5

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

and “Intellectual Property and Cumulative Innovation”

begins Tuomas Takalo, 29.1.2007

www.takalo.net

Part I. Basic IP Law (Välimäki, 2h) Part II. Use of IPRs (Välimäki, 2h)

Part III. Basic Economics of IP (Takalo, 2h)

Part IV. Breadth and Duration of IP and Their Optimal Design (Takalo, 3h)

Part V. Intellectual Property and Cumulative Innovation (Takalo, 4h)

NEXT TIME: A Guest Lecture + Part V cont.

Outline of Lectures

Recapping Part IV 1) Optimal duration of IP minimizes ex post DWL but provides enough protection to justify the investment

T*=C/p

2) 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.

- The same logic applies to many policy debates related to IPs even if they do not invoke the duration of IPRs explicitly

- e.g. Apple iTunes

The Economic Effects of Breadth of an IP

• legally breadth is governed by the “doctrine of equivalents” and claims in (case of patents)

• economically breadth measures how difficult it is to bring a non-infringing substitute in the market

- Determines the pricing power of the IP holder over the duration of the IP

- Product space (shift in demand) and technology space (the costs of inventing around)

Product space: How “similar” a competing product must be to infringe the IP, reminds “doctrine of equivalents” in the case of patents

Example: Breadth affects the demand of the proprietary good. E.g., demand

• with a broad IP: Pb=b-Q

• with a narrow IP: Pn=n-Q

where b>n.

P

Q

Pb(Q)=b-Q

Qb

Pb

Effect of Breadth in Product SpaceA decrease in breadth

b

n DWL

Pn(Q)=n-Qn

Pn

Qn

b

Technology space: How costly it is to find a non-infringing substitute for the proprietary technology. E.g.,

• to “invent around” a patent

• to “independently-innovate” around a copyright

Example: Two firms, an innovator and an imitator

• the imitator can copy the innovator’s product with cost K(b), where b is the breadth of IP and K’>0.

• For brevity, let 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 b> d, no entry

Generalization: IPRs and market structure

– The more there are rivals in the market, the lower is the profit of a single firm, i.e., (1)> (2)>… >(n-1)> (n)> (n+1)

- e.g., Cournot/quantity competition

– Free entry with cost b market will consist of n firms defined by (n)>b>(n+1).

the profit of the IP holder is at most b

P

Q

P(Q)=a-Q

Qp

Pp

Effect of Breadth in Technology Space:Market when the IPR is broad and there is no entry

a

p

P

Q

P(Q)=a-Q

Qn

Pn

a

PSn=nπn

Effect of Breadth in Technology Space:Market when the IPR is narrow and there is n-1 entrants

πp =πn

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 if a competitor enters and introduces a similar auction where r is picked from a uniform distribution?

- 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

• Barnes & Noble entered with a similar 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 Effects of Breadth

• let b denote patent breadth, b[0,1]

(b) = the profit flow as a function of breadth (when the IP is in force)

• assume ’>0, (1) = p and (0) = c =0

• W(b) = welfare flow as a function of breadth over the duration of the IP

• W’<0, W(1)=Wp, W(0)=Wc

• Ex post profits as a function of duration & breadth, P(T, b):

• Ex post social welfare S(T, b):

i.e, full social value minus DWL as before. Now DWL is a function of breadth DWL(b)

• For b<1, P(T, b)<P(T,1)=P(T) and S(T,b)>S(T,1)=S(T,1)

bTr

ebdtbe

rrt

10

bWWTr

WdtWedtbWe c

crtrt

00

Generic effects of breadth:

• P(T,b)/b=T’>0 and S(T,b)/b=-TDWL’=TW’<0

the tradeoff between ex ante and ex post inefficiencies!

i.e., increasing breadth reduces ex post competition in the market, increasing both the incentive to innovate and DWL

• Seek optimal breadth-duration mix

• Stage 1) The policy-maker chooses policy (T, b)

• Stage 2) The firm invest in R&D ()

• Proceed backwards, look for a SPE Stage 2) The firm chooses C so as to maximize

P(T,b)-C

the firm invests only if P(T,b)C/

Stage 1) The optimal policy (T*, b*) maximizes the ex ante social welfare: S(T,b)- C subject to the firm’s incentive constraint

• By the same logic as before, the optimal policy satisfies

P(T*,b*)=C/ (b*)T*=C/

• Differentiating the optimal rule with respect to T* and b* yields:

• Duration and breadth are policy substitutes

0'

*

*

db

dT

• Problem: two substitute variables – what is their optimal mix?

• Consider two policies • Policy 1: narrow but long IP (b1, T1) (~copyright)• Policy 2: broad but short IP (b2, T2) (~patent)

such that T1>T2, b1<b2 and (b1)T1=(b2)T2=C/

• Which policy is better?

Answer: choose the one with higher ex post social welfare S(T, b)

• The problem is to choose T and b so as to

minimize TDWL(b) s.t. (b)T=C/

• The effect of T is linear both on the incentive to innovate and DWL

We can focus on the effects of b, and use T to compensate

the choice of optimal policy mix boils down to a ratio test:

• Choose breadth to minimize DWL(b)/(b)

if DWL(b1)/(b1) < DWL(b2)/(b2), copyright (narrow but long) is better

if DWL(b1)/ (b1)<DWL(b2)/ (b2), patent (broad but short) is better

• The benefit of IP is that it provides the incentive to innovate

• The cost of IP is dead-weight loss

• Higher ratio means that the cost of creating the required incentive to innovate is higher

Suzanne Scotchmer 09/14/2004. Subject to Creative Commons NC-SA License

- with linear demand, which policy is better, ~ or *?

p

x(p)

p

p*

x(p*)

p

~

~

Notes:

1) Both DWL and incentive to innovate crucially hinge on b and the shape of the demand. e.g. with very convex demand broad but short is optimal

2) we have a prediction in which industries one should apply patents and in which industries one should apply copyrights

We have a prediction concerning the welfare impacts of the expansion of patentable subject matter

IP durations and breadth

duration

patent

trade secret

copyright

breadth

Part I. Basic IP Law (Välimäki, 2h) Part II. Use of IPRs (Välimäki, 2h)

Part III. Basic Economics of IP (Takalo, 2h)

Part IV. Breadth and Duration of IP and Their Optimal Design (Takalo, 3h)

Part V. Intellectual Property and Cumulative Innovation (Takalo, 4h)

NEXT TIME: A Guest Lecture + Part V cont.

Outline of Lectures

Exam 60 points, Essay 40 points

Exam 5.3.

What is a good deadline for the essay? I will have time to correct exams + read essays only

starting from April, 2

I suggest the deadline for the essay to be Sun, April, 1, midnight.

• missing deadline reduction of 2 points/day

i.e. if I receive your essay 3rd April, the max you can get is 36 points

Exam+Essay

• Part IV: Stand-alone innovations: innovations isolated events with no bearing on future innovations

• In practice, innovation builds on the existing knowledge and previous innovations, “standing on the shoulders of Giants”

e.g., Windows-95 had e-mail,Windows-98 e-mail + internet explorer, Windows-XP e-mail + internet explorer + media player,

Windows Vista e-mail + internet explorer + media player+ search engine...

Part V. IP and Cumulative Innovation

• The basic trade-off between the creation of incentives and the use of innovation (ex post) hangs around, but

– it will be modified

• with cumulative innovation – social value of an innovation includes the

incremental value of future discoveries the innovation enables

– private value depends on the inventor’s ability to appropriate the value of future discoveries

the “basic” tradeoff of the cumulative innovation: how to secure the incentives to innovate the first innovation without stifling the incentives to create future discoveries?

• Cumulative innovation can consist of

– improvements on the existing products

– creation of basic technologies (e.g., research tools) and their (commercial) applications

– cost reductions for producing earlier products

Bath breaking innovation

Basic innovation

Improvement 1

Improvement 2

Improvement 3

Basic innovation 2

Improvement

Basic innovation 1

Basic innovation 3

Problem of fragmentation

Improvement State of the art

Quality q0

Quality Ladder

Quality q1

=q1-q0

Quality

• Problems:– the later innovations may render the previous

ones obsolete

– the ‘first’ and ‘second’ innovations can be made by different firms

how to split the cake?

what about if the second one infringes the IP of the first innovator?

• A new concept: forward protection measuring how well an innovation is protected against future ones.

• For the sake of concreteness, let us focus on patents

• Forward protection of patents pools

• Inventive step = non-obviousness + novelty determining patentability

• (Leading) breadth determining whether there is an infringement or not

• Novelty: invention not used nor published previously • Non-obviousness: invention not obvious to someone

with ordinary skills in the technology

Inventive step: a minimum amount that an invention must advance technological progress to be patentable

• Benchmark: prior art

• (Leading) breadth determines how different another product or technology must be to escape infringement

• Determines a minimum difference between inventions

• Tempting to think that breadth and inventive step are equivalent:

• if an invention is patentable, it cannot infringe

• if an invention infringes, it is not patentable

• But this is wrong. An invention can be

• unpatentable, infringing

• patentable, non-infringing

• patentable, infringing (blocking patents)

• unpatentable, non-infringing

non-infringing

unpatentable

infringing

unpatentable

A narrow patent, large inventive step

Breadth Inventive step

patentable, non-infringing

infringing

patentable

infringing

unpatentable

A broad patent, small inventive step

Inventive step Breadth

patentable, non-infringing

• related concepts:

• patent strength = probability that both the patent validity and the infringement holds in the court

• Patents (IPRs) are probabilistic property rights

• patent quality affects, among other things, how clearly forward protection is defined,

• patent validity

On patent quality

• There is a widespread concern of deteriorating patent quality in the US

• Examination quality

• Fail to meet novelty requirement

• Reasons for the development• Expansion of patent subject matter

• Increase in the number of patent applications

• The incentives of the PO examiners

• Harder to search prior art in new areas

Covered subject matter:

- Traditionally patents were granted on machines, industrial process etcrecently expanded on, in particular in the US in software,

biotechnology, mathematical algorithms, business methods, plants, animals, cell lines, genes etc

Boundaries of the patent system under the heated debate.- There are moral objections to patenting. We concentrate on

economics.

- In the EU, the law explicitly states (cf. Suomen patenttilaki 1 § 2) that one cannot patent- scientific theories and mathematical methods- artistic creations- presentations of knowledge- plans, rules, methods and computer software for any commercial or other intelligent activity

- Rules on patenting of plants and animals complicated.

Be it as it may, there are thousands of patents on software in the EU

Modified from Graham et al. 2002

EPO System USP System Invention

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

Patent Issues

RenewalFees

PatentIssues

RenewalFees

Re-examination

Re-issue

Litigation

Rejected