1. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-NoDerivs-NonCommercial Common Deed 1.0 Design of IP Three questions: (1) When is IP superior to other funding mechanisms? (2) How large should the rewards to innovation be? (3)How should the reward be structured? How large? –When ideas are scarce (no patent race) –When ideas are common knowledge (patent race) Structure: Mainly about length and breadth of the right.

2. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-NoDerivs-NonCommercial Common Deed 1.0 When “ideas are scarce”, what makes patents inefficient? DWL (review) mv p m dv software users vv Idea (v,c)

3. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-NoDerivs-NonCommercial Common Deed 1.0 If “ideas are common knowledge”, what makes patent races inefficient? (1) Inefficient delegation of effort Suppose (v1/r – c1) < (v2/r – c2) Do patent choose the best idea? Cannot just auction the right to develop it: Why not? c1 v1/r c2 v2/r Previously discussed various forms of sponsorship: contests (prototype auctions, tournaments) Auctions (Vickrey, prototype contests) Is there an IP solution? Research joint ventures? Gandal and Scotchmer 1993 (different model)

4. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-NoDerivs-NonCommercial Common Deed 1.0 Well studied standard model: E firm pays a fixed cost c upfront to enter the race. Each firm has an independent probability p of failure in each time period. One firm: Total probability of success is 1-p. Two firms: Total probability of success is 1-p 2. marginal contribution of 2 nd firm is S x (p-p 2 ) n firms: Total probability of success is 1-p n. marginal contribution of n th firm is S x (p n -p n+1 ) n firms: Total social value is S x P(n) - nc = S x (1-p n ) -nc What makes patent races inefficient? (2) Inefficient rate of investment

5. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-NoDerivs-NonCommercial Common Deed 1.0 (2) inefficient races 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? S x P(n) number of firms n free entry outcome if winner receives the whole social value nene n*n* optimal cn

6. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-NoDerivs-NonCommercial Common Deed 1.0 (2) inefficient races 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. S x P(n) number of firms n free entry outcome if winner receives  instead of S nene n*n* cn  x P(n) Tandon 1983

7. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-NoDerivs-NonCommercial Common Deed 1.0 (2) inefficient races: solution? Modify patent value. Difficult because of one-size-fits-all Private contracting: research joint venture? Should this be legal? S x P(n) number of firms n free entry outcome if winner receives  instead of S nene n*n* cn  x P(n) Tandon 1983

8. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-NoDerivs-NonCommercial Common Deed 1.0 What makes patent races inefficient? (3) Inefficient Sharing of technical knowledge The winner with knowledge sharing The winner with data hoarding time

9. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-NoDerivs-NonCommercial Common Deed 1.0 (3) Inefficient Sharing of knowledge At least three types of knowledge a)State of progress: How much progress has the rival made? Should the firm that is behind drop out? Should the firm that is ahead announce that it is ahead? (how is this represented in the diagram in the previous slide?) (Scotchmer and Green 1990) b)Technical knowledge: What does the rival know, that can speed it to completion? (How is this represented in the diagram in the previous slide?) Bhattacharya et al, Brocas, D’Aspremont et al Reinganum 1983; modify for shared technical knowledge c)Efficient delegation: Which firm is more efficient, and how can the inefficient firms be induced to stay out? (Gandal and Scotchmer 1993) d)Prospects for success (correlated information; Minehart & Sc)

10. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-NoDerivs-NonCommercial Common Deed 1.0 Size versus Structure of the reward Distinguish between the size of the reward, however it is given, and the structure 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.

11. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-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 (later lecture)

12. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-NoDerivs-NonCommercial Common Deed 1.0 Breadth & Horizontal Competition A higher price increases demand of substitute goods. ) 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 chapter 4, Innovation and Incentives

13. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-NoDerivs-NonCommercial Common Deed 1.0 Breadth & Cost of Entry (Gallini, Maurer & Scotchmer) Entry lowers the market price, eventually the competitive price, 0. n*(T,K) = equilibrium number of entrants=5: (1/n) T p(n) x(p(n)) = K Patent Policy: (T,K) T=length of protection K = cost of entry pmpm p n*(T,K)

14. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-NoDerivs-NonCommercial Common Deed 1.0 Use 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 ~~ ~ ~

15. © Suzanne Scotchmer Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0 Attribution-NoDerivs-NonCommercial Common Deed 1.0 Optimal patent design often depends on what is assumed about licensing. In the Gallini paper, the social tradeoff is between duplicated costs and a lower price for consumers. Gallini concludes that patent life should be short, but broad, to avoid duplication. The tradeoff vanishes if the patent holder can license. How can the patent holder profit by licensing? What is the best structure of rights when a patent holder will license to increase profit?