Carl Shapiro, in addition to being a bigshot in the academic study of invention, is also a member of Obama’s Council of Economic Advisers. I’m not sure how much of a role he had in advising on the Leahy-Smith patent reform act that was passed last year, but many of the reforms seem to come directly from this NBER Working Paper, so I imagine his role was a big one.
Most academic economists working on IP-related issues think, for a variety of reasons, that IP is currently far stronger than the optimal level. Indeed, many would prefer a world with no patents and copyrights at all to the current system. But let’s take the simplest possible reform: if the social benefit granted by a patent exceeds the social value created by the invention, we ought limit the strength of the patent. You might wonder, how is it even possible for the patentholder to gain more than the social value of his invention? A standard monopolist with a patent still creates consumer surplus and some deadweight loss – that is, social value not captured by the inventor – unless the monopolist is perfectly price discriminating. Shapiro, drawing on a number of earlier papers, gives three nice examples where return to the patentholder exceeds social value. Unless otherwise noted, we assume there is zero deadweight loss created by the patent; if there is deadweight loss, the reason for weakening the patent is even stronger.
First, we know from Loury (1979) and Tandon (1983) that if a patent gives the first firm to invent the full social value of his invention, there will be too much effort expended trying to win that prize; when each firm is deciding whether to expend more effort on R&D, they do not take into account that their increased effort lowers the probability of winning for the other firm. Tandon shows that this “patent race” effect is particularly strong for inventions that are relatively cheap to produce, such as those that are close to obvious. One way to fix this problem somewhat is to allow a second firm who independently invents at roughly the same time as the first firm to invent to sell the product without needing a license. That is, if a product is easy to invent, and two firms expend a lot of effort on it in an attempt to win the patent race, the second firm’s effort is not a total social waste since it may lead to a second independent invention, turning the eventual monopoly (with high deadweight loss) into a duopoly (with lower deadweight loss). Many economists and legal scholars have proposed allowing an independent inventor exception, but Congress has thus far shown no interest in taking up this idea. This is perhaps no surprise: Congress refused to pass the Public Domain Enhancement Act a few years back, an IP-related law that is as big a free lunch as you will ever see.
Second, probabilistic patents are often not challenged. Imagine a patent that, if challenged in court, has a 30% chance of being upheld as valid; many such weak patents exist. Assume that is totally free to challenge the patent, meaning there are no legal or transaction costs. Shapiro shows the following example, drawing on a paper of his with Joseph Farrell. Let a patent with probability .3 of being upheld when challenged be licensed to an oligopolistic downstream industry. The patent adds $10 of value to the products of all downstream inventors, so if the license royalty is greater than $3, the patentholder is earning more than the expected value of his patent. Imagine a royalty of $6. If I challenge the patent in court and my rival does not, then when I win the challenge, I and my rival in the downstream product market are both able to use the invention without paying any license fee, hence our costs are the same, and hence winning the challenge does not earn me any more profits due to competition with my rival. If I lose the challenge, then my rival pays a royalty of only $6, whereas I will have to pay $10 for each unit where I infringe, and hence I will be at a disadvantage in the downstream market. Therefore, neither firm will challenge the patent in equilibrium, and the inventor will earn more than his true social contribution.
Third, hold-up, particularly in the form of the “patent ambush,” can lead to excess returns. Imagine I can sell my product with noninfringing design A at a price of 100 dollars, or with infringing design B, for which I will need to license a previous invention, at a price of 120 dollars. The patent thus increases the value of my product by $20. If I Nash bargain with the inventor, we will split the gains from using his invention in my product, and therefore I will pay $10 to use the invention, and earn $110 per unit by producing design B. This intuition is very different if I first make investments, then learn about the patent. Imagine A and B both require 40 dollars of fixed cost per unit, each, to design. If I don’t know about the patent, I will design product B, and plan to earn 80 dollars per unit. The patentholder will then come to me and tell me I need a license or he will sue for infringement. Once the fixed cost of B is sunk, the surplus from obtaining a license is 20+40=60 dollars, since not obtaining a license means I will need to produce A, which costs another 40 dollars and sells for 20 dollars than design B. So a Nash bargaining outcome is that I pay 30 dollars for the license and produce B. That is, the patentholder can use holdup to extract extra rents after I have made specific investments.
One way to fix the last two problems is to allow informal post-grant challenges to patents, perhaps by third parties. This makes weak patents in important industries less likely to cause hold-up after specific investment, and also limits the ability of third parties to take advantage of the reluctance of licensees to challenge once license terms have been established. The new patent reform does vastly increase the scope for post-grant review.
What’s too bad about the 2011 patent reform is that the types of examples provided by Shapiro above are only the most clean-cut, overwhelmingly obvious ways to improve the efficiency of the patent system. They don’t even pretend to approach what would be necessary for an optimal IP regime. Aside from a handful of congressmen, (Zoe Lofgren and Ron Wyden on the democratic side, or Jason Chaffetz on the Republican side, among them) Congress is filled with IP maximalists. For the sake of social welfare, it’s too bad.