1. 38E00100 Economics and Management of Intellectual Property Lecture 5 “Breadth and Duration of Intellectual Property and Their Optimal Design” continues and “Intellectual Property and Cumulative Innovation” begins Tuomas Takalo, 29.1.2007 www.takalo.net

2. Part I. Basic IP Law (Välimäki, 2h) Part II. Use of IPRs (Välimäki, 2h) Part III. Basic Economics of IP (Takalo, 2h) Part IV. Breadth and Duration of IP and Their Optimal Design (Takalo, 3h) Part V. Intellectual Property and Cumulative Innovation (Takalo, 4h) NEXT TIME: A Guest Lecture + Part V cont. Outline of Lectures

3. Recapping Part IV 1) Optimal duration of IP minimizes ex post DWL but provides enough protection to justify the investment  T*=C/  p 2) 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. - The same logic applies to many policy debates related to IPs even if they do not invoke the duration of IPRs explicitly - e.g. Apple iTunes

4. The Economic Effects of Breadth of an IP legally breadth is governed by the “doctrine of equivalents” and claims in (case of patents) economically breadth measures how difficult it is to bring a non-infringing substitute in the market - Determines the pricing power of the IP holder over the duration of the IP - Product space (shift in demand) and technology space (the costs of inventing around)

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

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

7. Technology space: How costly it is to find a non-infringing substitute for the proprietary technology. E.g., to “invent around” a patent to “independently-innovate” around a copyright

8. Example: Two firms, an innovator and an imitator the imitator can copy the innovator’s product with cost K(b), where b is the breadth of IP and K’>0. For brevity, let 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

9. Generalization: IPRs and market structure –The more there are rivals in the market, the lower is the profit of a single firm, i.e.,  (1)>  (2)>… >  (n-1)>  (n)>  (n+1) - e.g., Cournot/quantity competition –Free entry with cost b  market will consist of n firms defined by  (n)>b>  (n+1).  the profit of the IP holder is at most b

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

11. P Q P(Q)=a-Q QnQn PnPn a PS n =nπ n Effect of Breadth in Technology Space: Market when the IPR is narrow and there is n-1 entrants πp =πnπp =πn

12. 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 if a competitor enters and introduces a similar auction where r is picked from a uniform distribution? - a very narrow patent would allow the competitor enter - a very broad patent would prevent anyone using random-ending auctions (in the internet)

13. Example 2. (Technology space?: Amazon’s ‘one-click shopping’ patent, US patent 5960511 ‘claims’ a computer program allowing customers enter their credit card number and address only once, avoiding to re-enter that on follow-up visits Barnes & Noble entered with a similar 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

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

15. Ex post profits as a function of duration & breadth, P(T, b): Ex post social welfare S(T, b): i.e, full social value minus DWL as before. Now DWL is a function of breadth DWL(b) For b S(T,1)=S(T,1)

16.  Generic effects of breadth:   P(T,b)/  b=T  ’>0 and  S(T,b)/  b=-TDWL’=TW’<0  the tradeoff between ex ante and ex post inefficiencies! i.e., increasing breadth reduces ex post competition in the market, increasing both the incentive to innovate and DWL

17. Seek optimal breadth-duration mix Stage 1) The policy-maker chooses policy (T, b) Stage 2) The firm invest in R&D (  ) Proceed backwards, look for a SPE Stage 2) The firm chooses C so as to maximize  P(T,b)-C  the firm invests only if P(T,b)  C/ 

18. Stage 1) The optimal policy (T*, b*) maximizes the ex ante social welfare:  S(T,b)- C subject to the firm’s incentive constraint By the same logic as before, the optimal policy satisfies P(T*,b*)=C/    (b*)T*=C/  Differentiating the optimal rule with respect to T* and b* yields: Duration and breadth are policy substitutes

19. Problem: two substitute variables – what is their optimal mix? Consider two policies Policy 1: narrow but long IP (b1, T1) (~copyright) Policy 2: broad but short IP (b2, T2) ( ~patent) such that T1>T2, b1<b2 and  (b1)T1=  (b2)T2=C/  Which policy is better?

20. Answer: choose the one with higher ex post social welfare S(T, b) The problem is to choose T and b so as to minimize TDWL(b) s.t.  (b)T=C/  The effect of T is linear both on the incentive to innovate and DWL  We can focus on the effects of b, and use T to compensate

21.  the choice of optimal policy mix boils down to a ratio test: Choose breadth to minimize DWL(b)/  (b)  if DWL(b1)/  (b1) < DWL(b2)/  (b2), copyright (narrow but long) is better  if DWL(b1)/  (b1) <DWL(b2)/  (b2), patent (broad but short) is better The benefit of IP is that it provides the incentive to innovate The cost of IP is dead-weight loss Higher ratio means that the cost of creating the required incentive to innovate is higher

22. Suzanne Scotchmer 09/14/2004. Subject to Creative Commons NC-SA License -with linear demand, which policy is better, ~ or *? p x(p)x(p) p p*p* x(p*)x(p*) p ~ ~

23. Notes: 1)Both DWL and incentive to innovate crucially hinge on b and the shape of the demand. e.g. with very convex demand broad but short is optimal 2) we have a prediction in which industries one should apply patents and in which industries one should apply copyrights  We have a prediction concerning the welfare impacts of the expansion of patentable subject matter

24. IP durations and breadth duration patent trade secret copyright breadth

25. Part I. Basic IP Law (Välimäki, 2h) Part II. Use of IPRs (Välimäki, 2h) Part III. Basic Economics of IP (Takalo, 2h) Part IV. Breadth and Duration of IP and Their Optimal Design (Takalo, 3h) Part V. Intellectual Property and Cumulative Innovation (Takalo, 4h) NEXT TIME: A Guest Lecture + Part V cont. Outline of Lectures

26. Exam 60 points, Essay 40 points Exam 5.3. What is a good deadline for the essay? I will have time to correct exams + read essays only starting from April, 2  I suggest the deadline for the essay to be Sun, April, 1, midnight. missing deadline  reduction of 2 points/day i.e. if I receive your essay 3rd April, the max you can get is 36 points Exam+Essay

27. Part IV: Stand-alone innovations: innovations isolated events with no bearing on future innovations In practice, innovation builds on the existing knowledge and previous innovations, “standing on the shoulders of Giants” e.g., Windows-95 had e-mail, Windows-98 e-mail + internet explorer, Windows-XP e-mail + internet explorer + media player, Windows Vista e-mail + internet explorer + media player+ search engine... Part V. IP and Cumulative Innovation

28. The basic trade-off between the creation of incentives and the use of innovation (ex post) hangs around, but –it will be modified with cumulative innovation –social value of an innovation includes the incremental value of future discoveries the innovation enables –private value depends on the inventor’s ability to appropriate the value of future discoveries  the “basic” tradeoff of the cumulative innovation: how to secure the incentives to innovate the first innovation without stifling the incentives to create future discoveries?

29. Cumulative innovation can consist of –improvements on the existing products –creation of basic technologies (e.g., research tools) and their (commercial) applications –cost reductions for producing earlier products

30. Bath breaking innovation Basic innovation Improvement 1 Improvement 2 Improvement 3

31. Basic innovation 2 Improvement Basic innovation 1 Basic innovation 3 Problem of fragmentation

32. ImprovementState of the art Quality q0 Quality Ladder Quality q1  =q1-q0 Quality

33. Problems: –the later innovations may render the previous ones obsolete –the ‘first’ and ‘second’ innovations can be made by different firms  how to split the cake?  what about if the second one infringes the IP of the first innovator? A new concept: forward protection measuring how well an innovation is protected against future ones.

34. For the sake of concreteness, let us focus on patents Forward protection of patents pools Inventive step = non-obviousness + novelty determining patentability (Leading) breadth determining whether there is an infringement or not

35. Novelty: invention not used nor published previously Non-obviousness: invention not obvious to someone with ordinary skills in the technology  Inventive step: a minimum amount that an invention must advance technological progress to be patentable Benchmark: prior art (Leading) breadth determines how different another product or technology must be to escape infringement Determines a minimum difference between inventions

36. Tempting to think that breadth and inventive step are equivalent: if an invention is patentable, it cannot infringe if an invention infringes, it is not patentable But this is wrong. An invention can be unpatentable, infringing patentable, non-infringing patentable, infringing (blocking patents) unpatentable, non-infringing

37. non-infringing unpatentable infringing unpatentable A narrow patent, large inventive step Breadth Inventive step patentable, non-infringing

38. infringing patentable infringing unpatentable A broad patent, small inventive step Inventive step Breadth patentable, non-infringing

39. related concepts: patent strength = probability that both the patent validity and the infringement holds in the court Patents (IPRs) are probabilistic property rights patent quality affects, among other things, how clearly forward protection is defined, patent validity

40. On patent quality There is a widespread concern of deteriorating patent quality in the US Examination quality Fail to meet novelty requirement Reasons for the development Expansion of patent subject matter Increase in the number of patent applications The incentives of the PO examiners Harder to search prior art in new areas

41. Covered subject matter: - Traditionally patents were granted on machines, industrial process etc recently expanded on, in particular in the US in software, biotechnology, mathematical algorithms, business methods, plants, animals, cell lines, genes etc  Boundaries of the patent system under the heated debate. - There are moral objections to patenting. We concentrate on economics. - In the EU, the law explicitly states (cf. Suomen patenttilaki 1 § 2) that one cannot patent - scientific theories and mathematical methods - artistic creations - presentations of knowledge - plans, rules, methods and computer software for any commercial or other intelligent activity -Rules on patenting of plants and animals complicated. Be it as it may, there are thousands of patents on software in the EU

42. Modified from Graham et al. 2002 EPO SystemUSP System Invention First to fileFirst to invent 1 year (US only) Patent Application Publication 18 mos Secrecy Disclosure 2-3 years Secrecy Rejected Opposition 9 mos Disclosure 20 years Litigation Patent Issues Renewal Fees Patent Issues Renewal Fees Re-examination Re-issue Litigation Rejected