1. 13 Intellectual Property 1 Aaron Schiff ECON 204 2009 Reading: Cabral p.303-306, Deak p.96-99

2. Introduction In this topic we will study intellectual property, which is the legal institutions that protect information goods like inventions, algorithms, software, music and movies. Objectives of this lecture: Understand the basic characteristics of information goods and the economic implications, different types of intellectual property, and the basic economics tradeoffs associated with intellectual property.

3. Information Goods An “information good” refers to both information itself, and a good that retains information. –Example of pure information: Google’s PageRank algorithm. –Example of a good that retains information: A music CD. Information itself has no physical mass or boundary. Goods like books, CDs, records, DVDs, tapes store information. –It is not the pages of paper and covers that makes a book valuable. –People buy the information stored in them

4. Information Goods Regular goods are rival: –Have physical mass and boundaries. –Multiple people cannot physically own them simultaneously. –Deteriorates with use. –Examples: cars, houses, clothes Information is non-rival: –Multiple people can use them at one time. –Information does not deteriorate with use –Examples: technology for building a plane, music.

5. Information Goods Once an information good has been created, it is also difficult to exclude people from using it. Information goods therefore have the basic characteristics of public goods. –Non-rival and non-excludable. Information goods also typically have large fixed costs of production and low marginal costs of reproduction.

6. Information Goods Once an information good has been created, social efficiency requires that it be available to anyone who is willing to pay the marginal cost of reproduction. –In most cases this would mean a very low or zero price. Example: Once a computer programme has been written, it is socially best to let anyone who wishes to use it for free. –It will not deteriorate through use. The only cost is cost of duplicating it (copying on CD, sending over internet).

7. Information Goods Non-excludability also makes it impossible to have any market power over an information good. –Can’t restrict who can and cannot use the information. Thus the market for reproduction of information goods will be highly competitive and the price of a copy will get driven down to marginal cost. Example: Market for books in the U.S. in 1800s.

8. Should Information be Free? Condition for social efficiency is: “marginal cost” = “marginal benefit” What is cost of producing information ? –In the short run (once the information has been obtianed), the only cost is cost of duplication. There is no implicit cost from deterioration due to use. –In the short run, it is efficient to provide information for only the cost of duplication. In the long run, the cost of producing information itself (not duplication) needs to be considered.

9. Should Information be Free? Cost of producing new information can be very high. –Finding best methods for building planes takes significant resources = high cost. –Recording a new song requires resources. –Composition of a new song requires resources. –Writing a new book requires resources. These are fixed costs that do not vary with the usage of the information good. In the long run calculation, these costs need to be taken into account. If these costs are not compensated, no one will incur the cost of producing information.

10. Intellectual Property (IP) Without any protection, creators of information goods will not be able to make any profit from reproduction to cover the fixed costs of production. –Very weak incentives to produce information goods in the first place. IP is a legal institution that attempts to solve this problem by granting legal monopolies over the reproduction of an information good. IP establishes property rights on ideas and information –Right to exclude others from using it. –Makes it possible to sell, rent and transfer ownership.

11. Intellectual Property (IP) IP grants market power to creators of information goods, and gives them the ability to charge P > MC for reproduction. –Profits from reproduction can then cover fixed costs of production. –People who buy a copy at P > MC are incurring the part of long run cost of information production. There are four basic types of IP: patents, copyright, trademarks and trade secrets. –We will focus on patents and copyright.

12. Patents A patent on an invention gives its owner the right to sue for infringement if anyone tries to make, use, sell, offer to sell, import or offer to import the invention. –Gives the right to exclude others from using an invention. Patents are specific to a country. Patents are very powerful – even if you unknowingly duplicate someone’s invention, they can still sue you for infringing their patent. Patents cover non-trivial ideas or technologies. –Must be useful, novel and not obvious.

13. Patents To get a patent, you have to submit a detailed application to a national patent office. –The application is examined to make sure it meets the criteria for patentability. –Patent applications are published so that anyone see the details. –Patents are valid for 20 years from the date of application. If granted, it is up to the patent owner to monitor for infringement and sue if necessary.

14. Copyright Copyright generally gives the owner the exclusive right to reproduce the copyrighted work, to prepare derivative works, to distribute copies of the copyrighted work, to perform the copyrighted work publicly, or to display the copyrighted work publicly. Copyright only protects the form of expression of an idea, rather than the idea or subject matter itself. –Copyright prevents people from making exact copies of your novel, but not from writing a novel with a similar type of story.

15. Copyright Unlike patents, copyright is granted automatically. Copyright lasts for 70 years after the death of the author. “Fair use” of limited excerpts for comment, criticism, research, parody etc is permitted. As with patents, the copyright owner must monitor for infringement and sue if necessary.

16. IP and the Internet Almost all information goods can be digitised. The Internet makes copying and distribution of digital information very easy and very cheap. –This provides an economic benefit because it reduces the cost of information reproduction. –But it also makes piracy easier and undermines the basic principles of intellectual property. Internet businesses also depend on IP as sources of profits. –Patents on business methods and algorithms. –Patents and copyrights on software.

17. IP and the Internet Google’s PageRank patent (6,285,999):

18. IP and the Internet Amazon’s “1-click shopping” patent (5,960,411):

19. The Basic IP Welfare Tradeoff Given that an information good has been produced, the socially optimal price is of reproduction is P = MC. But this generates zero profits from reproduction that won’t cover the fixed costs of production. IP rights give the ability to set the reproduction price at P > MC. This results in short-run welfare losses, but long- run welfare gains.

20. The Basic IP Welfare Tradeoff Illustration: Q P Demand Reproduction MC MR = Welfare loss from IP – fixed cost of production = Welfare gain from IP

21. Example 1 Suppose the demand for a new song is Q = 100 – P. Marginal cost of reproducing the song is zero. Fixed cost of producing the song is $1,000. Questions: –Calculate the monopoly price of reproduction and number of copies of the song sold. –Calculate the welfare loss of the monopoly created by IP. –Calculate the welfare benefit of production of the song followed by monopoly reproduction. –Calculate the net welfare benefit of granting the IP right.