Chapter 23: Patents and Patent Policy1 Patents and Patent Policy

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Transcript of Chapter 23: Patents and Patent Policy1 Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Patents and Patent Policy

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*IntroductionInformation is a public goodNon-rivalry in consumptionIf Eli Lilly tells Merck how to make Prozac the information does not leave Lilly Marginal cost of sharing info, e.g., the Prozac formula, is zero Allocationally efficient price = marginal cost = 0Non-excludability of people who dont pay for informationEasy to copy or reverse engineer productsTrade secrets are hard to keepEffective price is zeroIf price of information is zero, no incentive to produce information or develop new productsno dynamic efficiencyPatent Policy must balance the demands of allocational and dynamic efficiency

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Optimal Patent LengthPatents may be used to protect innovators and make the economy more dynamically efficient Temporarily create monopoly power (bad)Encourage creation of new products (good)Two central questions of patent policyHow long should patent lastHow wide a range of substitutes should patent span?Optimal Patent LengthNo simple answer such as 14, 17 or 21 yearsNordhaus (1969) classic model illustrates key factors in determining optimal patent length

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Optimal Patent Length (cont.)Competitive industry with constant cost cFirm can conduct R&D of intensity x at cost r(x) that rises with xSuccessful R&D lowers cost to c x $/unit = pQuantitycQ0Cc-xQTCABDemand

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Optimal Patent Length (cont.)Assume that patent lasts for T years. During life of patent, innovator earns monopoly profit area A When patent expires in T years, consumers gain surplus A plus area B (formerly static deadweight loss)Trick is to choose length T that gives A to producers for a long enough time to encourage high R&D intensity x and therefore cost savings c x, incentives to producers but that does not delay the realization of B for too long a timeIncentive to producersSize of A research intensity x Present value of A for T year is V(x,T) Cost of research activity is r(x)Net gain of R&D if patent lasts T years is: V(x,T) r(x)Firms will choose x that maximizes this gain x*(T)

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Optimal Patent Length (cont.)Patent Office understands that for any value of T, firms will optimally choose x(T) research intensityWhen patent expires in T years, areas A and B are realized as consumer surplus forever. The present value of this surplus that starts in T years is CS(x,T).Patent policy goal is to maximize net total surplus recognizing that its choice of T determines the amount of R&D intensity x*(T). That is, patent policy aims to maximize:V[x*(T) ,T] r[x(T)] + CS[x*(T)]This is a single equation in T and so standard maximization techniques apply

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Optimal Patent Length (cont.)Insights of the Nordhaus model1. Optimal patent length is positive but finiteIf T = 0, firms will not do any R&DAs T gets largerFirms do more R&D but effect diminishes because the cost of more research intensity r(x) rises & because extra profit in last years of a patent is discounted severely As T gets larger, society has to wait longer to gain the welfare triangle B. At some point, this cost of dominates the increment to x. T is finite.

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Optimal Patent Length (cont.)Insights of the Nordhaus model (cont.)point, this cost of dominates the increment to x. T is finite.2. Optimal patent length is shorter the more elastic is demandThe more elastic demand is, the greater the static welfare loss B3. Optimal patent length is shorter the lower the cost of R&D, r(x)Profit increases linearly with the size of the cost reduction but the welfare loss increases quadratically.As the equilibrium cost reduction rises, so does the loss from keeping T large

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Patent Length and BreadthOptimal patent length may depend on how broad patent protection isIf patents are broad, length should probably be limited because have broad and long patents would confer too much monopoly powerBroad patent protection has the advantage that it prevents minor alterations on the original invention [Klemperer (1990)]Long patents may actually discourage innovation [Gallini (1992)]. With short patents, rivals can afford to wait until patent expiresIf patents are long, rivals cannot wait but will try to invent around the patent. The anticipation of this copycat activity may depress innovationDenicolo (1996) argues that optimal patent length and breadth depends on market conditionsThe more competitive an industry the more long, narrow patents are desirableUnfortunately, while the Denicolo argument may be rational, it is hard to implement a policy that doesnt treat all firms the same.

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Patent RacesTechnological break-throughs have a winner-take-all featurewhoever discovers Prozac or invents a new good wins the patent and associated monopoly power whether they were first by a year or first by a weekThis winner-take-all feature makes R&D efforts a bit like a raceall that matters is finishing first What are the implications of patent races?Example:Assume two firms, BMI and ECNDeveloping a new product for which Demand is P = 100 2Q.Product will be produced at constant marginal cost c = 50Development requires a lab and probability of successful development is 0.8Cost of lab is K

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Patent Races (cont.)Qualitatively, there are three possible outcomes:Neither firm invests in a labOne firm invests in a lab and the other doesntBoth firms invest in a labIf no firm invests, each gets 0Suppose only one firm invests in a lab: if successful, it will be a monopolist and earn an operating profit of $312.50Since the probability of success is 0.8, the expected profit conditional upon spending K on the lab is 0.8*$312.50 K = $250 KThis expected outcome is illustrated by the two off-diagonal elements in the payoff matrix below

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Patent Races (cont.)Suppose both firms invest in a lab. From BMIs perspective there are three possible outcomesIt is not successful and so earns 0 operating profit. This happens with probability 0.2It is successful and ECN is not. In this case, it will be a monopolist and earn an operating profit of $312.50. This happens with probability, 0.8*0.2 = 0.16. The expected operating profit is therefore $50.Both BMI and ECN are successful. In this case they each earn duopoly operating profits of $138.89. This happens with probability, 0.8*0.8 = 0.64. So the expected operating profit is $88.89.Taking all three outcomes together, the expected profit net of lab costs when both invest in a lab is $138.89 KThis is shown in the lower right diagonal of the payoff matrix below

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Patent Races (cont.)The Pay-Off MatrixBMIECNNo R&D LabNo R&D LabR&D LabR&D Lab (0, 0)(0,$250 K)($250 K, 0)($138.89-K, $138.89-K)If K $250, then no firm will invest in a lab. Even a monopolist cannot expect to cover lab costs this high.If $0.138.89 K < $250, then the Nash Equilibrium is for one firm to invest in a lab. If both invested, at least one would want to change its decision. The issue here is which firm will do the investment .If K < $138.89, the Nash Equilibrium is for both firms to invest in a lab

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Patent Races (cont.)Patent races raise the possibility that R&D investment can either be excessive or insufficientThe possibility that it can be excessive is illustrated by the outcome in which both firms invest. When both invest, we either get no development (prob = 0.04); a monopoly (prob = 0.32) or a duopoly (0.64)The expected operating profit in total is then: 0.32*$312.50 + 0.64*$277.56 = $277.64. The expected consumer surplus is: 0.32*156.25 + 0.64*277.78 = $227.28. So, the total expected surplus net of lab costs when both invest is:$277.64+227.28 2K $505 2K. The expected surplus with just one lab is 0.8($312.50 + $156.25) K = $375 K. Two labs are excessive if $375 K > $505 2K, I.e., if K > $130

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Patent Races (cont.)The reason that R&D can be excessive is wasteful duplication. Each firm thinks only about its own potential gain and not about the fact that if both are successful (which is fairly likely given that the probability of a successful lab is 0.8) they will hurt each others profitHowever, there can also be too little investment.This is because firms do not consider the increased consumer surplus that successful development of a new product will generate

    Chapter 23: Patents and Patent Policy

  • Chapter 23: Patents and Patent Policy*Sleeping PatentsMost firms have many patents including some that they never use. Similarly, many film studios buy the rights to books and plays but never produce them. Instead, these patents and copyrights are left dormant or sleeping. Why?The answer is that it is worth more to the in