38CO2000 Economics of Intellectual Property Rights (IPRs) Spring 2006: Lecture 6
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38CO2000Economics of Intellectual Property Rights (IPRs)
Spring 2006: Lecture 6Practical issues: • Homepage: www.elisanet.fi/takalo
• I try to fix the schedule and the reading-list for the latter part of the course by the next lecture
•Essays:
• Surf in the net to find good papers but be careful.
1) Open source: Lerner & Tirole, JIE-02, JEP-05, Lakhani & Von Hippel ResPol-03, Evans&Wolf Harvard Business Review -05 , Maurer&Scotchmer-05 etc….
2) Biotech/biomedicine IP: Heller&Eisenberg, Science (1998), the book by Arora, Fosfuri and Gambardella (2001) etc. Scotchmer and some references therein. Hermans-Kulvik, chapter 4 (2006). Etc This lecture.
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Suzanne Scotchmer 09/14/2004. Subject to Creative Commons NC-SA License
Recap Horizontal competition: • The consumer cost of raising money through monopoly pricing is DWL
• Should breadth cause price to be lower, and the IP right to last longer?
• The ratio test: the optimal patent policy maximizes the ratio of ex post profit to ex post social welfare
p
x(p)
p*
x(p*)
p
p
x(p)
p*
x(p*)
p
~ ~
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2) Part II.2 Cumulative innovation and IPs
- cost reductions for producing earlier products
- improvements on the existing products (quality ladder)
- creation of basic technologies (e.g., research tools) and their (commercial) applications
- E.g. research or GPTs in biotechnology
-The commercialization effort of drugs very costly
-There has been a division of labor to firms that do research on basic technologies and firms that commercialize them
Note: Some such as Scotchmer make a distinction between basic innovations vs applications (bath breaking innovations) and research tools vs. applications (problem of fragmentation)
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Bath breaking innovation
Basic innovation
Application 1
Application 2
Application 3
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Basic innovation 2Application
Basic innovation 1
Basic innovation 3
Problem of fragmentation
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Improvement State of the art
Quality q1
Quality Ladder
Quality q2
=q2-q1
Quality
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Quality ladder:
Consumer utility: U(qi)=qi
• Buy the improvement if U(q2)-p2U(q1)-p1, buy the state of the art otherwise
q2-p2 q1-p1 p2-p1≤q2-q1= the price margin at most
• Assume unit mass of consumers ( one consumer) and Bertrand (price) competition: What are (Nash) equilibrium prices and profits?
• Suppose the firm with q1 charges some p1 the firm with q2 charges - where →0 the profit of firm 2 p2 and the profit of firm 1 = 0 firm 1 wants to undercut to p1-2 the profit of firm 1 p1 and the profit of firm 2 = 0 firm 2 wants to undercut to -2...….and so on until p1=0 and p2= .
- This is a unique Bertrand-Nash equilibrium where the profits of firm 2 = and the profits of firm 1 = 0.
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- the “basic” trade-off of the cumulative innovation: how to render social value private to secure the incentives to innovate the first innovation without stifling the incentives to create future discoveries
- IP tries to solve the problem via forward protection: how well the first innovator is protected against future improvements
- Inventive step: patentability of future innovations
- (leading) breadth: whether future innovations infringe- Weak protection: nothing infringes- Strong protection: everything infringes
- Patent quality: the validity of the patent on the first innovation
- Patent strength: the probability that a patent on first innovation is both valid and the improvement infringes
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• IPs improve the functioning of markets for technology– They determine the terms of the use, e.g., bargaining
position in licensing negotiations
• Problems caused by IPRs• Used to block others, fragmentation, hold-up problems
• Is stronger IP good for R&D incentives?
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The effects of patents on cumulative innovation: the case of basic technology and its application
• basic research with little commercial value can be essential for creating the scope for commercial applications
• Assume deterministic innovation of basic technology and its commercial application
• the costs of creating the basic technology cB > 0
• the market value of the technology in itself is zero
• if the technology is made, it can be protected by a patent
• a firm other than the patent holder has an idea of how to make a commercial application of the basic technology
• the cost of making commercial application is cA > 0
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• the private value of the application is P(T)=T whereT is the (discounted) patent life, P’ > 0
• the social value of the application is S(T)=W/r-TDWLS’<0
the social value of the basic technology is at least S(T)-cA
• in general the first innovator has too little incentives to invest- payoff zero, you have to pay cB>0
• The problem of cumulativeness: how to transfer surplus from the second innovator to the first innovator?
• if the application infringes the patent covering the basic technology, the second innovator forced to acquire a license
• if no infringement, no way to transfer the profits!
• If no transfers of profit, no investment in the first innovation no investment in the second innovation IP creates the market for technology
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• Assume potential infringement• Can the firms be certain about infringement ?
• Consider licensing negotiations between the patent holder (the first innovator) and the innovator/producer of the commercial application (the second innovator)
• Are negotiations made before or after the application is made? Which is more realistic? Why?
• Consider first ex post licensing, i.e., negotiations occur only after the application is ready for production (cA has been sunk)
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• the available cake is P(T), the first and second innovator should find a way to divide it
• b = the share of the first innovator
• 1-b = the share of the second
• b reflects the bargaining power of the first innovator
• if no good reasons to assume otherwise, set b=1/2 (Nash-bargaining solution, solution for Rubinstein alternating offer bargaining)
the payoff of first innovator B =bP(T) - cB
the payoff second innovator: A=(1-b)P(T) – cA
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• In practice b affected by patent quality and patent strength
• assume the first innovator has full bargaining power but the patent is of imperfect quality
• b = strength of forward protection = probability that both the patent validity and the infringement holds in the court
B =bP(T) – cB & A =(1-b)P(T) – cA as before
Note: this abstracts from costs of litigation. These costs are huge in practice. • 1-3 million USD• 50.000-500.000 EUR
why infringement disputes ever reach courts?
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1st Inventor: Invest?
(0,0) 2nd Innovator: Invest?
(-cB,0) Buy a licence?
Produce and take to the court? (bP-cB ,(1-b)P-cA)
Yes
(-cB ,-cA) (bP-cB ,(1-b)P-cA)Yes
No
No Yes
No Yes
No
An extensive form of the investment game (a game tree)
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• The basic tradeoff of the cumulative innovation:
• increasing b increases the incentive to create the basic technology but decreases the incentive to create the application
• it is possible that there is no incentive to make the commercial application even if P(T)>cA , there is no incentive to make the basic technology!
• increasing T could be a solution: both B and A are increasing in T • If T max {cB/b, cA/(1-b)) then both innovations are
made
• But the basic tradeoff of the horizontal competition appears (recall S(T), S’<0)
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• This is a manifestation of a hold-up problem: the second innovator realizes that she will be held-up in the negotiations over the license
• the problem emerges from contract incompleteness and relation-specific investment• these concepts underlie the modern theory of a firm (cf.
Williamson, Hart)
Contract incompleteness:
• impossible to write a verifiable contract on the investment to develop the application because of transaction costs • it can be hard to identify the second innovator ex ante• the investment is likely to be complicated and hard to
measure
Relation-specific investment makes the investment irreversible (little value outside the relationship)• when the cake is divided, the investment is sunk• unless the second innovator gets a license, nobody willing
to buy the firm/technology
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• Consider next ex ante licensing: negotiations over the license can be conducted before the commercial application is made (cA is not sunk)
There is no hold-up problem!
• the first innovator has an incentive to secure that the commercialization is made, i.e., that (1-b)P(T) – cA0
the first innovator requires at most bmax1- cA/ P(T) even if b>bmax
the commercialization will be made, if it is profitable, even if the first innovator has full bargaining power & perfect forward protection!
the available cake is P(T)-cA
• the payoff of first innovator: (P(T)-cA) - cB
• the payoff second innovator: (1-)(P(T) – cA)
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• forward protection (b) increases only in so far b<bmax , i.e., (b), ’>0 if b[0, bmax]
forward protection cannot be used to secure the incentive to make the basic technology if (bmax)(P(T)-cA) cB
• the patent term works, i.e., set TTminsuch that (P(Tmin)-cA) –cB=0 Tmin=(cA+cB/) /
• but the basic trade-off of the static model looms…
Notes1) Optimal patent life solves P(T*) - cA - cB = 0
T*=(cA+cB)/ • a longer patent life would unnecessarily prolong monopoly
distortions• a shorter patent life would not create incentives to innovate
2) T*<Tmin
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3) if the innovators collude or if innovation is concentrated in the same firm, the patent term can be set at the optimal level
• The profit of a merged firm: P(T)-cA-cB
T =(cA+cB)/ guarantees the incentive to innovate
competition policy in “Schumpeterian” industries is complicated issue!
• More generally, when hold-up problems are severe, vertical integration works a reason why we have firms (cf. Holmström and Milgrom, JEP-98, Hart-95)
4) IP reduces the hold-up fear of the first innovator, because the infringement forces licensing, creating the market for technology
• Suppose that there is no infringement. • The first innovator fears the hold-up (after she has invested and
created the basic technology, no body is willing to pay for it) and does not invest,
• Collusion or vertical integration would be the only way to induce the investment in the basic technology
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5) With ex ante licensing, the second innovation will be made if in so far P(T)>cA. the hold up problem concerning the first innovation can remain even with IP the key problem is to compensate early innovators how to increase their bargaining power?
6) The hold-up problem also remains concerning the second innovation if ex ante licensing is not feasible
• Why ex ante licensing can be infeasible?
management of IP when innovation is cumulative
• If ex ante licensing is not feasible, hold-up problem could be solved e.g, via reputation, long relationships, strategic alliances, reciprocity, hostages…
management of IP when innovation is cumulative
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The effects of patents on cumulative innovation: the case of improvements (quality ladder)
• Suppose the first innovation has commercial value in itself and the application is an improvement . The quality of the first innovation is q1 and the quality of the application is q2
• assume unit mass of consumers with a unit demand (buyers buy only if qp) & Bertrand competition if both products in the market, both the price and the
profits on the application equal 1=q2-q1. As to the first innovation, both of them are zero if the first innovation is in the market alone, its price and
profits are q1
• Add a third innovator with quality q3
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Second innovator
First innovator
q1
Quality Ladder with 3 Products
q2
1=q2-q1
Quality
q3
Third innovator
2=q3-q2
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• Consider the second innovator: If all inventions infringe, she is both a licensee of the first innovation and a licensor of her own innovation for the innovator of the third innovation
• It is well possible that stronger patens increase the gains as a licensor less than losses as a licensee 2<1
stronger patents are not necessarily good for incentives to innovate
• complementary innovation (Bessen&Maskin, Hunt)