Question

How do government–imposed barriers such as patents impact consumers and suppliers in these markets

Answer 1

Patents are perhaps the most important legal instruments for protecting intellectual property rights. A patent confers to an inventor the sole right to exclude others from economically exploiting the innovation for a limited time (20 years from the date of filing). To be patentable, an innovation must be novel in the sense of not constituting part of the prior art or more generally of not being already in the public domain. A patentable innovation also must involve an inventive step, meaning that it must be non-obvious to a person with ordinary skills in the particular field of application. The innovation also must be useful to be patentable; that is, it must permit the solution of a particular problem in at least one application. A major element of a patent application is disclosure: the invention must be described in sufficient detail to enable those skilled in the particular field to practice it. The patent application also lays out specific claims as to the scope of the patent itself. The traditional statutory scope of patents—encompassing machines, Industrial processes, composition of matter, and articles of manufacture—excluded important kinds of scientific discoveries such as laws of nature, natural phenomena, and abstract ideas. But recent developments in the use of patents for computer software, information technology, and biotechnology innovations are challenging a reductive interpretation of such exclusions.

Benefits and Costs of Patents

From an economic perspective, the crucial features of patents are that (1) they deal with new knowledge, as embodied in an innovative product or process, and (2) they confer (limited) monopoly rights to the inventor. New knowledge that makes possible the production of new products and/or processes obviously carries considerable economic value, but it has features that make it problematic for the market system to handle prop- erly (Arrow 1962). Specifically, knowledge is a quintessential public good. Pure public goods have two basic attributes. First, they are non-rival in consumption, meaning that a person’s use of a public good does not affect the amount of it that is available for others. Second, they are non-excludable, meaning that it is not possible to prevent individuals from enjoying the public good once it is available. An example of a pure public good is national defense. It is clear that, absent intellectual property rights, most discoveries and inventions would exhibit public good attributes.

The problems that a competitive system has with public goods are readily apparent.An inventor may bear all the cost of an innovation, but everyone benefits (possibly to varying degrees) from a discovery, and thus everyone has an incentive to free ride on the innovative efforts of others. The inherent externalities associated with this class of public goods generate a market failure: a competitive market system may be expected to provide an inefficiently low level of innovations. Intellectual property rights in general, and patents in particular, address this problem by attacking the non-appropriability of knowledge that lies at the heart of this market failure. Specifically, by endowing innovators. With property rights on their discoveries, patents are a legal means of affecting the excludability attributes of otherwise pure public good.The main economic benefits and costs of the patent system are intimately related to the nature of the market failure that it addresses, and to the second-best character of the solution that it provides.

Patents Can Promote New Discoveries

By endowing discoverers with property rights over the fruits of their efforts, patents affect the incentive to innovate and are likely to increase the flow of innovations. This increase is presumably desirable, given that otherwise the market system may provide too little new knowledge. But by giving the patentee exclusive rights on the exploitation of a unique economic good that is still non-rival in consumption, a patent creates a monopoly situation that adversely affects the efficient use of new knowledge.

Patents Can Help the Dissemination of Knowledge

An additional benefit of patents is related to the disclosure requirement. In most countries, patents are disclosed 18 months after the filing date or earlier. The importance of this feature is predicated on the fact that, absent patents, inventors can rely on trade secrets to protect their discoveries. By providing an incentive for disclosure, patents are held to contribute to a desirable dissemination of scientific and technical information, allowing other inventors to avoid duplicating existing discoveries and making it easier to develop further innovations that build on the known state of the arts. It is useful to note that the disclosure argument offers an economic role for patents, even for inventions that have already taken place, and as such it is quite distinct from the incentive role of patents due to the increased appropriability of R&D output.

Patents Can Avoid Wasteful Innovation Efforts

As the arguments on the disclosure property of patents suggest, an important and beneficial effect of new knowledge is that it makes possible further innovations and discoveries. Discoveries from basic research are often of this sort, at times opening up entire new fields of research. It can be argued that patenting of such seminal inventions can have useful social payoffs. It relies on the notion that broad, early property rights on key inventions allow an orderly pursuit of follow-up innovations and reduce wasteful innovation races. An analogy can be made to the practice of granting mineral claims on land where no discovery has yet been made, to avoid a wasteful mining of the prospect. Whereas patents in such cases can clearly have positive efficiency effects, it is also easy to see that broad, early patents can adversely affect further research, especially when the original discovery has applicability in many uses. If the original inventor does not have a comparative research advantage or interest in pursuing some research directions, and licensing of the patented innovation to third parties is problem- atic (perhaps because of excessive transaction costs), patenting can have adverse effects on the flow of further innovations.

Patents Can Help Technology Transfer and Commercialization

Whereas the difficulty of licensing may reduce the desirability of exceedingly broad property rights, patents can actually play a critical role in licensing and, more generally, in the dissemination of new knowledge. Specifically, to put a value on information a would-be purchaser needs to have the information, but at that point, if the seller does not have property rights on the information, the would-be buyer has no more incentive to pay for it. Patents, therefore, can play a crucial role in reducing transaction costs of licensing innovation and, more generally, in technology transfer.

A related but distinct role for patents as instruments of technology transfer has been articulated to rationalize the Patent and Trademark Laws Amendments of 1980, com- monly known as the Bayh-Dole Act. The main elements of this reform were to allow universities and other entities to patent, retain title to, and commercialize federally funded inventions; and, to allow federal agencies to grant exclusive licensing for their inventions. Based on the view that the main role of patents is to provide incentives for innovation that would not occur otherwise, it would be difficult to make an economic case for public institutions patenting discoveries that already have been publicly funded and accom- plished. Likewise, the role of patents in transferring information would be irrelevant in this case, because public research institutions have little use for trade secrets, and because it is difficult to improve on the dissemination of information achieved by simply publish- ing a discovery. But the presumption here is that many discoveries produced by publicly funded R&D, and in the public domain, may not be used in technological developments because, without an exclusive license backed up by patent rights, firms would not be interested in expensive development work required to transform an invention into a new product. But more generally, when it is difficult to assert property rights on development work, a patent on underlying innovations obviously may aid development and commercialization of new technologies.

Length and Scope of Patent Protection

As illustrated in the foregoing, the patent system entails a fundamental trade-off— inventors are given a monopoly position (which entails inefficiencies) in order to provide them with incentives to innovate (which carries economic benefits).³ In other words, the dynamic efficiency of encouraging invention leads to static inefficiency created by a monopolistic situation. Given that, a natural question to ask is, what is the optimal degree of patent protection? The degree of market power provided by a patent essentially depends on three elements: the length (duration) of the patent, the breadth of the patent, and the height of the patent.

Duration of the Monopoly Power

The length of the patent determines the duration of monopoly power that a patentee can expect and thus affects the static inefficiency as well as the incentive role of patents. The benefit to the innovator increases with the length of the patent. But from society’s point of view, too short a patent may dissuade research, whereas a patent that is too long may give excessive rent to the owner and may block further improvement.

The Scope of a Patent

Whereas the length of the patent protection characterizes the duration of the monopoly power, the scope of a patent bears on the intensity of the induced monopoly power (Merges and Nelson 1990). The breadth of a patent defines the range of products that are encompassed by the claims of the patent and therefore protects the patent holder against potential imitators. In general, the less specific the claims of the patent are, the broader the patent. The height of a patent, on the other hand, confers protection against improvements or applications that are easy or trivial. The value of a patent to a firm depends on how effective its protection is in these two dimensions (breadth and height), in addition to being related monotonically to the patent length.

Unlike its maximum length, which is fixed by law, patent breadth is, to a certain extent, endogenous. Patent breadth depends on the claims put forth by the patentee and also is a feature over which the patent office has some discretion . Clearly, a reduction in the breadth of patents would induce more competition (e.g., imitation), which benefits consumers. But too narrow a patent reduces the incentive to innovate. What is the optimal breadth for patents? Economic analysis suggests two kinds of results in this setting. Narrow and long patents can be found to be optimal because broad patents are costly for society in that they give excessive monopoly power to the patent holder (Gilbert and Shapiro 1990). Central to this conclusion is that the flow of payoff from holding a patent has a negative impact on the social surplus. Thus, a minimum level of flow of payoff (breadth), with duration adjusted accordingly, would be socially optimal. In Klemperer’s (1990) more general model, both narrow and long, or broad and short, patents can be optimal, depending on the structure of demand. Broad and short patents can also be optimal when they discourage imitation and thus enhance the incentive to innovate. Specifically, imitation is discouraged when it is too costly (broad patent) and when imitators do not have enough time to enter the market (short patent).

Cumulative Innovations

The importance of patent height is most apparent for the case of sequential innova- tions. Such innovations are particularly relevant when the innovation is a research tool, used mainly in the R&D process for further innovations.

Patents, Market Structure, and the Incentive for R&D

The research activity of innovators undoubtedly is influenced by the patent system, as well as by the industry structure. To gain some insights into the interaction of patents and industry structure, we explore how innovators invest in R&D. Note first that the discovery of an innovation affects the structure of the market. This is easy to understand if we consider a process innovation that allows reducing production costs: firms can compete in the pre-innovation and, if a patent is granted, the holder will be a monopolist in the post- innovation market. Competition can also take place at the R&D level. This competition is very much affected by the patent system, which has the feature of a winner- takes-all contest. To analyze the effects that this may have on R&D, recall that the pre- sumption is that, absent patents, economic agents do not have sufficient incentives to invest in R&D activities and, consequently, not enough innovation activity would take place. The term of comparison here is usually the socially optimal level of R&D activities, which one can define (at least conceptually) taking into account the overall expected benefits brought about by an innovation, as well as the costs of R&D projects. This first-best solution typically cannot be achieved by a decentralized market system, for lack of incentives and coordination mechanisms (the market failure predicament), and it cannot be achieved by a centralized government either, for lack of information and implementation mechanisms. Given these benchmarks, the patent system is likely to increase private investments towards the first-best (socially optimal) level of R&D.

To isolate the pure incentive to innovate (that is, without any competition at the innovation stage), it is necessary to note that the value of an innovation to an inventor depends on the nature of the innovation but also on the market structure that applies at the production stage (Arrow 1962). Monopoly and competition provide useful polar cases. It turns out that, the incentive to innovate is lower in a monopolistic market than in a competitive market. This is due to the replacement effect: a monopolist has less to gain from a given innovation (say, a cost-reducing innovation) because one monopolies- tic situation replaces another monopolistic situation. But even under competitive production conditions the incentive to innovate is less than what is socially optimal. This latter case is actually depicted in Figure 1, which can be interpreted as representing a market where competitive producers with unit cost c must pay a royalty to the inventor. What is missing from the foregoing analysis is the possibility of entry in the innova- tion industry; typically it is possible (and likely) for more than one firm to pursue the same research result. The resulting “patent race” tends to dissipate the expected rent from patenting and to increase aggregate R&D investment (in a fashion akin to the “common pool” problem of competitive fishing in an open access fishery).

Consider now the dimension of time and suppose that the date of discovery of the invention is a decreasing function with the investment in research (Dasgupta and Stiglitz 1980), and assume that the investment is completely paid at date zero. The pre-innovation situation is competitive, and only the firm that first makes the innovation will be granted a patent (monopolistic post-innovation situation). This situation is similar to an auction in which at date zero the patent will be granted to the firm that proposes to innovate first. In this setting, only one firm will invest exactly the amount that it will gain from innovating. The deterministic nature of the relationship between the date of discovery and the invest- ment makes it easy to find that the investment undertaken by a monopolist is smaller than the investment undertaken by competitive firms. Furthermore, the monopolist invests less than that which is socially optimal. This is due to the negative externality of the invest- ment of an innovator on her rivals, which none of the firms internalize.

Beyond Patents

The main justification for patents is to foster innovation in a market economy, but the patent system is not the only method for encouraging innovation. Copyrights and trademarks, of course, are additional instruments for intellectual property right protection that typically apply in contexts where patents do not. Trade secrets, on the other hand, can apply to patentable innovations and can provide effective protection against another party’s discovery by inappropriate means (although a trade secret offers no protection against independent discovery or reverse engineering). More generally, alternatives to patents include rewards or prizes, procurement con- tracts, and public production of new knowledge. With the reward system, the government specifies a fixed sum of money for a well-defined research goal and then awards thisprize to the first firm to achieve the desired result. Asymmetric information between researchers and the government can make it difficult to implement the reward mechanism (Wright 1983). Specifically, to be effective, the government must know about the feasi- bility of various research projects as well as be able to assess the demand for various potential innovations. But firms are likely to be better informed than the government on such matters, and a decentralized solution such as the patent system may be superior. With the procurement system, the government picks the firms that will be involved in the research project and specifies the terms of the project (such as expected research output and compensation terms) in a binding contract (Laffont and Tirole 1993). Unlike the prize system, this method can eliminate unwanted duplication of research efforts. But again, for this system to be efficient, the government must be quite knowledgeable about the costs and benefits of research ventures.⁷ More generally, innovations can be stimu- lated by the government’s direct involvement in the production of new knowledge.

Conclusion

The patent system has emerged as the central institution for asserting intellectual property rights in many crucial fields of science and technology. From an economic point of view, patents offer a second-best solution to the market failure arising from the public- good nature of knowledge. As such, the patent system contributes to solving a problem but comes with shortcomings of its own, mostly because it creates market power posi- tions that can adversely affect the economic performance of the system. In fact, for most of the nineteenth century, the patent system was under considerable criticism by the same economics profession that now provides the most valuable insights for its defense. This change is due to the increased appreciation for the critical role that innovations play in stimulating economic growth.