38CO2000 Economics of Intellectual Property Rights (IPRs) Spring 2006: Lecture 6

1. 38CO2000Economics of Intellectual Property Rights (IPRs) Spring 2006: Lecture 6 • Practical 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.

2. 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 p p* p* ~ p ~ p ~ ~ x(p*) x(p) x(p*) x(p)

3. 2) Part II.2Cumulative 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)

4. Bath breaking innovation Application 1 Application 2 Basic innovation Application 3

5. Problem of fragmentation Basic innovation 1 Application Basic innovation 2 Basic innovation 3

6. Quality Ladder =q2-q1 Quality Quality q1 Quality q2 State of the art Improvement

7. Quality ladder: • Consumer utility: U(qi)=qi • Buy the improvement if U(q2)-p2U(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.

8. - 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

9. 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?

10. 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

11. 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-TDWL S’<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

12. 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 (cAhas been sunk)

13. 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

14. 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?

15. An extensive form of the investment game (a game tree) Yes No Yes No No

16. 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)

17. 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

18. Consider next ex ante licensing: negotiations over the license can be conducted before the commercial application is made (cAis 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) – cA0 • the first innovator requires at most bmax1- 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)

19. 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 TTminsuch that (P(Tmin)-cA) –cB=0  Tmin=(cA+cB/) / • but the basic trade-off of the static model looms… Notes 1) 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

20. 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

21. 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

22. 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 q1and the quality of the application is q2 • assume unit mass of consumers with a unit demand (buyers buy only if qp) & 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

23. Quality Ladder with 3 Products 1=q2-q1 2=q3-q2 Quality q1 q2 q3 First innovator Second innovator Third innovator

24. 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)