38E00100 Economics and Management of Intellectual Property Part IV “Breadth and Duration of Intellectual Property and Their Optimal Design” Tuomas Takalo,

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) QmQm PmPm Market for proprietary information goods MC a a=Q max CSp PSp DWL

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= a 2 /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.  ∞  T  1/r

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 = a 2 /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

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= a 2 /2- 3 a 2 /8= a 2 /8

P Q P(Q)=a-Q QpQp PpPp Market for proprietary information goods MC a a=Q max CSp pp DWL

We see a virtue of IP: The discounted social value of innovation = a 2 /2r The inventor with an idea knows to get  T a 2 /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.

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 T  C/  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 T  C/  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/  a 2  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?