38CO2000 Economics of Intellectual Property Rights (IPRs) Spring 2006: Lecture 4 Practical issues: - The book: There should be one copy of the book at the department of TMP (4th floor) to be available for student copying (Is this legal?) - Essays. If you go for the scientific paper option, note that the technical level of scientific papers vary a lot. Choose a level that suits to you. - The articles in the Journal of Economic Perspectives are non- technical and excellent. -The articles in the American Economic Review Papers and Proceedings are relatively non-technical, relatively excellent and extremely short. - The book by Jaffe and Lerner is non-technical and excellent, and short for a book. You can choose a chapter from there (or from Scotchmer’s book) - Articles in law and management journals are often non-technical (not in all such journals!). The same applies to Research Policy

RECAP from the last time 1)To get a patent one needs to apply for it and the P.O. needs to examine the application. The patent will be granted if the application/invention satisfies novelty, non-obviousness, usefulness and disclosure requirements -Disclosure function of the patent system -Problem of deteriorating patent quality (in the US) 2) Patents provide relatively strong intellectual property right, in particular because of the absence of independent-invention defense, breadth of the protection and inventive step 3)Breadth vs. inventive step - Breadth governed by “doctrine of equivalents”. Determines whether infringement occurs (infringement with respect to claims) -Inventive step governed by novelty and non-obviousness. Determines patentability  There can be inventions that are unpatentable and non-infringing and inventions that are patentable and infringing (blocking patents)

Optimal design of patent life T=discounted patent life Cost of innovation C If C is invested, probability of making an invention =  When the patent is in force, a profit flow  p Eg with a zero MC and a linear inverse demand P=a-Q,  p =a 2 /4 If imitation/entry costless,  c =0 Innovator’s (ex post) profit from the patented innovation The innovator’s expected profit =  P(T). II.1. Optimal Design of Patents (when competition is horizontal)

The innovator invests only if  P(T)  C So P(T) is a measure of the incentive to innovate  T must be at least C/  p Social return flow on innovation When the patent is in force Wp=  p +CSp After the patent expires Wc=CSc In general, Wp<Wc, i.e., Wc-Wp=DWL E.g., with MC=0 and P=a-Q we have DWL=a 2 /2-3a 2 /8=a2/8

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

Note: A virtue of IP The full discounted social value of innovation = a 2 /2r The inventor with an idea knows to get  Ta 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 patent life, i.e, the full social value minus DWL over the patent life so the patent is like a tax on users The effect of patent life 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 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 Solution: Since S’<0, choose T as small as possible subject to the firm’s incentive constraint  T*=C/   p Heuristics: -Optimal patent life 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

Examples concerning the duration of IPRs explicitly: 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) On-going debate on 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!

Notes: 1)Requires that society commits to T*. Ex post 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 2)One size does not fit all. Certainly, if T is the same for all inventions and industries, there are inventions where the incentive constraint is not satisfied (T 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*)

3) The patent system can yield overinvestment in innovation. -Suppose there is free entry to the market for invention -Suppose all firms can make the invention with probability  by investing C but only one of the successful inventors gets the patent -How many firms will enter? -The probability that an inventor gets the patent is given by [1-(1-  ) n ]/n Explain… -Denote the probability by  (n)/n - the inventors expected profit is given by Note:  (n)/n and hence expected profit is decreasing in n. Proof… -Then entry will occur until

-From the welfare point of view it is only relevant that the invention is made at least by one inventor -The probability of at least one success is given by [1-(1-  ) n ], ie by  (n) -  (n) is increasing in n -Social value of nth entrant is S(T)[  (n)-  (n-1)]-C -Socially optimal number of entrants is S(T)[  (n)-  (n-1)]>C> S(T)[  (n+1)-  (n)] - This number can be larger or smaller than the number of entrants determined by market equilibrium E.g., assume  =1. Social value of the second innovator = 0. However, if there will be at least two inventors and the costs are unnecessarily duplicated.

The Economic Effects of Patent Breadth Recall that legally breadth is governed by the “doctrine of equivalents” and claims infringement must be established with respect to claims breadth is endogenous in the sense that 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 Economically the breadth measures how difficult it is to bring a non- infringing substitute in the market Determines the pricing power of the patent holder over the patent life Product space and technology space

Product space: How “similar” a competing product must be to infringe patent, reminds “doctrine of equivalents” Example: Breadth affects the demand of the patented good. E.g., demand with a broad patent: P b =b-Q with a narrow patent: P n =n-Q where b>n.

P Q P b (Q)=b-Q QbQb PbPb Effect of Breadth in Product Space A decrease in patent breadth b nn DWL P n (Q)=n-Q n PnPn QnQn bb

Technology space: How costly it is to find a non-infringing substitute for the patented technology, i.e., to “invent around” the patent. Example: Two firms, an innovator and an imitator the imitator can copy the innovator’s product with cost K(b) where b is patent breadth and K’>0. For brevity K=b. if the innovator is alone at the market, she earns  p if the imitator enters, both firms earn  d <  p if b   d, no entry Generalization: IPRs and market structure consider free entry with cost b  market will consist of n firms defined by  n >b>  n+1 Note: Definition close to piracy/copying  more appropriate for copyright?

P Q P(Q)=a-Q QpQp PpPp Effect of Breadth in Technology Space: Market when the patent is broad and there is no entry a pp

P Q P(Q)=a-Q QnQn PnPn a PS n =nπ n Effect of Breadth in Technology Space: Market when the patent is narrow and there is n-1 entrants πnπn

Example 1. Product Space IBM’s patent on ‘smooth end of auction in the internet’, US patent 6,665,649 it ‘claims’ a computer program that determines the end time of an auction according to D=-dln(1-r/m) where d is the posted expected duration of the auction, and r<m is a pseudo random number picked by the program from an exponential distribution what a about a competitor enters and introduces a similar auction where r is picked from a uniform distribution? breadth determined in the infringement court cases - a very narrow patent would allow the competitor enter - a very broad patent would prevent anyone using random-ending auctions (in the internet)

Example 2. Technology space: Amazon’s ‘one-click shopping’ patent, US patent ‘claims’ a computer program allowing customers enter their credit card number and address only once, avoiding to re-enter that on follow-up visits to the Amazon site Barnes & Noble entered with a similar but not identical technology  Amazon took B&N to the court  Amazon got a preliminary injunction forcing B&N to use ‘two-click shopping’ system in during the X-mas period  B&N did not want to wait to the end of the court case and bought a license a broad patent allows no Internet retailer to use similar ‘one-click shopping’ method, a narrow patent allows rivals enter if they use different software program to obtain the ‘one-click’ property

Generic Economic Effects of Patent Breadth let b denote patent breadth, b  [0,1] let  (b) the profit flow after the successful innovation as a function of patent breadth (when the patent is in force) assume  ’>0,  (1) =  p and  (0) =  c =0 similarly, welfare flow as a function of the patent breadth W(b), over the duration of the patent: W’<0, W(1)=W p, W(0)=W c

The firm’s profits on an existing innovation as a function of the patent life & breadth, P(T, b): Ex post social welfare as a function of patent life and breadth, S(T, b): i.e, full social value minus DWL as before. Now DWL is a function of patent breadth DWL(b) Note If b S(T,1), where P(T,1) and S(T,1) are as in the analysis of optimal life i.e. the tradeoff between ex ante and ex post inefficiencies.