1. © Suzanne Scotchmer 09/14/2004 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 Design of IP: Outline 09/14-16/04 What should determine the size of a reward for innovating? –When ideas are scarce –When ideas are common knowledge (patent races) In intellectual property, what determines the reward, and how should the reward be structured?

2. © Suzanne Scotchmer 09/14/2004 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 The optimal size of the reward (e.g., patent life) Two arguments. Nordhaus (scarce ideas) and race (# of firms) Nordhaus: Implicitly focuses on single inventors with scarce ideas. Tradeoff is between “too little innovation” and “too much deadweight loss.” The amount of innovation can always be increased by increasing the patent value, but it increases deadweight loss on every inframarginal innovation. Race: Arises where ideas are not scarce. The problem is to avoid over-entry or under-rewards

3. © Suzanne Scotchmer 09/14/2004 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 Optimal reward when Ideas are Scarce Higher reward (patent life T) increases deadweight loss.  (v a,, c a ) value,v  (v b,, c b ) cost,c space of ideas (v,c) v  T’ vTvT

4. © Suzanne Scotchmer 09/14/2004 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 Optimal reward when ideas are common knowledge High reward may lead to a race –Problem with Races: Duplication of effort? –Problem with Races: Pursue the right ideas? (the problem of aggregating information) Is a race beneficial for society? –May duplicate costs (bad) –May increase the probability of success or the time of discovery (good). –We cannot know which of these possibilities is more important without knowing how innovation works: need the right model of the creative environment.

5. © Suzanne Scotchmer 09/14/2004 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 A race model with independent successes and failures. If successes and failures are independent, “duplication” is not well defined. Suppose (for simplicity) that each firm pays a fixed cost c upfront to enter the race. Suppose each firm has an independent probability of success in each time period. It may take several time periods to receive the innovation. The innovation will be sooner if there are more firms, but the cost is also higher.

6. © Suzanne Scotchmer 09/14/2004 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 Races continued P(n)=probability at least one firm succeeds S= social welfare in case of success What does the diagram look like, and how many entrants will there be if the private reward is less than S? Should the private reward be less than S? P(n)S number of firms n free entry outcome if winner receives the whole social value nene n*n* optimal cn

7. © Suzanne Scotchmer 09/14/2004 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 Races continued Modify diagram to account for the fact that the winner receives less than the whole social value. Reduces number of entrants, possibly to the efficient number. P(n)S number of firms n free entry outcome if winner receives  instead of S nene n*n* cn P(n) 

8. © Suzanne Scotchmer 09/14/2004 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 A second model, with unambiguous duplication. Suppose firms have different “ideas” to fill the same niche. Suppose (v 1 /r – c 1 ) < (v 2 /r – c 2 ) How do we make sure that the best idea is chosen? Patents and simple prizes fail, as we have seen. Cannot just auction the right to develop it: Why not? c 1 v 1 /r c 2 v 2 /r Vickrey auction works, but only if value can be observed. Prototype contest: Leads to duplicated cost and possibly not the best Patents and Prizes do not work very well! (Why?)

9. © Suzanne Scotchmer 09/14/2004 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 Policy Levers to set the value of an IP reward So far we have mainly been discussing the optimal size of the reward, however it is given. But the reward can also be structured in different ways. Length T Breadth: A second policy lever for determining the size of a reward. Broader IP rights can be shorter, because they are more profitable in each period. –Oncomouse. What about an oncowalrus? –Amazon’s one-click patent.

10. © Suzanne Scotchmer 09/14/2004 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 Breadth: Three Definitions Breadth excludes horizontal substitutes –Define breadth on the product side Breadth defines cost of entry –Define breadth on the technology side Breadth excludes vertical substitutes –Defined for sequential innovation

11. © Suzanne Scotchmer 09/14/2004 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 Breadth & Horizontal Competition ) ˆ,( 211 ppx ) ~,( 211 ppx 2 ˆ p mcp  2 ~ 1 ~ p 1 ˆ p ) ˆ,( 122 ppx  ˆ  ~ substitute market ) ~,( 122 ppx 1 1  ˆ 2

12. © Suzanne Scotchmer 09/14/2004 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 Breadth & Cost of Entry n*(T,K) = equilibrium number of entrants: (1/n) T p(n) x(p(n)) = K IP Policy: (T,K) K = cost of entry

13. © Suzanne Scotchmer 09/14/2004 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 The ratio test: Should breadth cause price to be lower, and the IP right to last longer? The consumer cost of raising money through monopoly pricing is deadweight loss. Goal: Maximize ratio of profit to deadweight loss. p x(p)x(p) p*p* x(p*)x(p*) p p x(p)x(p) p*p* x(p*)x(p*) p ~~ ~ ~