© Suzanne Scotchmer 2007 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 Design of IP Two questions: (1) How large should the rewards to innovation be? (2)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.

© Suzanne Scotchmer 2007 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 Size of the reward (e.g., patent life) Two arguments. a) Nordhaus (scarce ideas) and b) race (# of firms) Nordhaus: Implicitly focuses on single inventors with scarce ideas. Tradeoff is between “too few innovations” and “too much deadweight loss.” The number of innovations 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

© Suzanne Scotchmer 2007 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 A higher reward (patent life T) increases deadweight loss. (This diagram is illustrative; know the idea, not the diagram.)  (v a,, c a ) value,v  (v b,, c b ) cost,c space of ideas (v,c) v  T’ vTvT

© Suzanne Scotchmer 2007 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 A high reward may lead to a profit-dissipating race. Racing can be inefficient. –Duplication of effort. –Pursuit of wrong ideas. 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 whether a patent race is good or bad without knowing how innovation works. We need the right model of the creative environment.

© Suzanne Scotchmer 2007 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 Races “Duplication” is not well defined. A simple patent race: Suppose the social value of discovery is S. Suppose each firm has an independent probability p of failure. Let P(n) be the probability that at least one of n firms succeeds. P(1) = (1-p), P(2) = (1-p 2 ), P(3) = (1-p 3 ), P(n) = (1-p n ) (increasing) The expected social value of the investment (ignoring costs) with one firm: S P(1) =S(1-p). with two firms: S P(2) =S(1-p 2 ). with three firms: S P(3) =S(1-p 3 ) with n firms: S P(n) =S(1-p n ) The marginal social value contributed by the first firm: S(1-p). the second firm: S(p-p 2 ). the third firm: S(p 2 -p 3 ) the n th firm: S(p n-1 -p n ) (becomes close to zero)

© Suzanne Scotchmer 2007 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 Races continued Now take account of costs. Suppose that the winner of the patent race gets the entire social value, S. Should the private reward be less than S? (Yes, why?) S P(n) S P(n) number of firms n free entry outcome if winner receives the whole social value nene n*n* optimal cn

© Suzanne Scotchmer 2007 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. 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

© Suzanne Scotchmer 2007 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 What have we learned here? There are two reasons that the reward should be less than the social value of the innovation: If the reward is given as a patent, the patent involves deadweight loss. We should be willing to forego some high-cost innovations in order to reduce DWL on innovations we will get in any case. Cost duplication. Giving the entire social value will lead to a profit-dissipating race, which also dissipates social value by wasting resources.

© Suzanne Scotchmer 2007 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 Size versus Structure of the 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. Two important policy levers for intellectual property: Length T Breadth: –Oncomouse. What about an oncowalrus? –Amazon’s one-click patent.

© Suzanne Scotchmer 2007 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 (later lecture)

© Suzanne Scotchmer 2007 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-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 good, x 2 ) ~,( 122 ppx 1 1  ˆ 2 proprietary good, x 1

© Suzanne Scotchmer 2007 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, K The number of entrants, n(K), depends on the cost of entry, K. If K decreases, the number of entrants n(K) increases. If K decreases, the price p(K) decreases. If K is 0 (free entry), “infinitely” many firms enter. The price becomes competitive, p=MC=0. Demand x(p ) Monopoly price P c =MC=0 P(n(K)) Price falls with the number of entrants, n price p

© Suzanne Scotchmer 2007 Contents May Be Used Pursuant to Creative Commons Attribution-NoDerivs-NonCommercial Common Deed 1.0Attribution-NoDerivs-NonCommercial Common Deed 1.0 We can use this apparatus to ask whether patents should be narrow or broad. The “breadth” is represented by K. High K means that entrants must “invent around” the patent. Keeping the patent life, T, fixed, what happens to the inventor’s incentives if the patent is narrower (K is smaller)? To phrase the question sensibly -- how should patents be structured – something should be kept fixed. Holding total profit fixed, should patents be long and narrow? Short and broad?

© Suzanne Scotchmer 2007 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 ~~ ~ ~