Back in the 70s and 80s, you could study the economics of invention as if it were static. X is out there and we want to invent it, so how can we incentivize people to do the R&D? The famous tradeoff in patenting is found in the literature: if I give a patent, I generate a deadweight loss triangle from monopoly (plus the “inefficiency rectangle” if you like your firm dynamics with an evolutionary flavor), but if I don’t give a patent, no one has any reason to invest in the fixed cost of R&D. The second part of that argument weakens a bit if firms can keep their invention from being copied for a short while while they extract rents – it takes time to reverse engineer – but the basic tradeoff is still there. (What about the tradeoff between secrecy and disclosure, you may be wondering; my reading of the literature is that the requirement that patents disclose how to make an invention is essentially a meaningless restriction, since firms can choose to rely on trade secrets and since, even when they patent, firms can be obtuse enough in describing certain technical aspects of the invention that it may not be possible for competitors to imitate.)
Recent work on patents, though, takes a much more dynamic attitude toward invention: “If I have seen farther, it is because I have stood…” and all that. When invention is cumulative, the relevant tradeoffs are much more subtle. For instance, if you need A to make B, and both A and B have fixed costs, then who should get the patent to B? The firm who did the R&D work on A that made it possible? The firm that actually invented B? Bessen and Maskin follow this line of reasoning to a surprising conclusion: in some industries, not only do patents decrease social welfare, but they aren’t even in the interest of any of the firms in that industry! I also like this paper as well because it’s nice evidence that (at least some) economists could care less about credentials: James Bessen is a lecturer at a law school with no formal graduate degree of any kind, while Eric Maskin is a Nobel prize-winning economic theorist at Princeton’s Institute for Advanced Study. This paper actually needs them both. Bessen has done a lot of really interesting work on innovation policy, while the result I’ll show shortly relies on some non-obvious game-theoretic reasoning about imperfect information, an area right in Maskin’s wheelhouse.
The basic model is simple. There are two firms, who can either do research for free or at cost c. If one firm does research, the next invention in a sequential line is invented with probability p. If both firms do research, the next invention is found with probability q, where p<q<2p. Each invention in the line has identical value v, drawn from a known distribution, where v represents the incremental value of each new invention. After an invention is made, any firm can imitate; after innovation, any firm can imitate costlessly, in which case each firm gets payoff sv, where s<1/2 is a "share" of the full value v. Patents make imitation impossible. The social planner, of course, would have firms always do research when it is free, and have either one or both of the firms work if they have a cost of research. The choice of zero, one or two firms working when research is not free depends on a cutoff rule on the value of each invention.
Sequential invention makes firms more likely to innovate in the absence of patents than static innovation. The reason is simple: though I am still upset that an imitator may take some of the revenue from an invention I invest in, I also know that if I don’t make that invention, the next product in the sequential line will never be possible. So I need less value from the present invention to make R&D worthwhile. And patenting can make us worse off. The problem is asymmetric information: I don’t know whether the other firm is a high cost or a low cost of R&D firm. When I invent product 1 in a line, the model assumes my patent can keep you from inventing and selling product 2. Of course, I can offer you a license. If I think you have cost 0 R&D, I will set the license equal to exactly the surplus you expect to gain from inventing the next product in a sequence. Then we’ll both work on the next product, and no matter what, I will reap all the surplus. But it may be costly for you to do R&D. In order to get you to do work on the next product, then, I would offer you a licensing fee that just lets you cover the cost of your R&D, but otherwise gives me all the surplus. It turns out that in a range of values, the firm that invents product 1 would rather just get the higher licensing fee always from the zero cost guys, meaning that it never licenses to the high cost guys, even when product values are high enough that social welfare would want to have both firms working on research, and where both firms would indeed do research if there were no patents. Ex-ante, meaning before firms have any patents yet, the firms may well prefer the world without patents to the world with patents for this reason (though, of course, once they have a patent, the firm can only be made worse off by losing it).
One final result, relevant to software and other industries: if the value of inventions is large, and if s is close to one-half (meaning that imitation is not “too” dissipating), then in both the patent and no patent case, firms are better off having a competitor who may imitate/become a licensee. Having a competitor means, basically, the industry is able to invent more quickly. Even when Lotus and Microsoft keep ripping each other off, the fact that they are both inventing new features expands the size of the market, and makes both better off than in the monopolistic world where only one firm did all the R&D.
File these results under “patents can sometimes harm” and “someone tell the law & econ guys that informational frictions matter”.
http://www.sss.ias.edu/files/papers/econpaper25.pdf (2006 Working Paper. The final version is in RAND 2009. If you have access, read the RAND and not the working papers – this paper floated around for a decade or so before publication, and some early versions have a number of mathematical mistakes.)
A Fine Theorem 
Nice post for a very important paper. As it often happens in economics, moving from a static to a dynamic world changes what we thought we knew; and, in this case, it highlights that much is wrong with the patent system.
Much work has been done in law schools, and I think there is room for economics to rethink some of its beliefs here – e.g. check out if interested Heller’s work on ‘anticommons’ – negative externalities when exclusion rights overlap, here: http://www.sciencemag.org/content/280/5364/698.full
Or one could go all the way to the anti-patent camp and read the work of Boldrin and Levine ‘Against Intellectual Monopoly’ [full text under creative commons here: http://www.dklevine.com/general/intellectual/against.htm%5D
Thanks for sharing!
Absolutely the anticommons literature is interesting – if you search this site, you’ll find quite a few posts about that literature, as well as alternatives to patents more generally.
That’s a great paper, but too complicated for the world to process for a while. The insights are absolutely true though in my experience in the tech field. You can tell if a VC gets it by their attitude toward having competitors. A startup in a field with no competitors at all is probably in the wrong field.
Unfortunately the current fad is towards extractive businesses. Even businesses that are not conceptually extractive get judged on how well they extract profit from things under their control, as if everything was an oil well or a mine.