Economics and Intellectual Property

Economic Theory of Property  Physical property rights grant exclusive use of a resource to its owner, together with the legal authority and backing for excluding others from using the resource  Property rights are granted to individuals by society  Granting these rights provides social benefits but also imposes social costs

Economic Theory of Property  Benefits  Property rights reduce transactions costs in determining how a resource will be used  Example: Enclosure of common grazing pasture >Prior to enclosure, commons were over-grazed, leading to reduced productivity in raising of cattle >Transactions costs incurred to reduce over-grazing would require villagers to coordinate grazing activities, even though individual incentives would encourage the opposite >Assignment of ownership to the commons permits the necessary coordination, whether for grazing or other more productive uses of the land

Economic Theory of Property  Property rights also confer a dynamic benefit by providing incentives for the owner of a long-lived productive resource to undertake costly investments without facing the risk that others might appropriate the benefits of the investment  In our example of the commons, enclosure of the land and assignment of ownership rights might lead the owner to decide that the land was better used in crop production rather than grazing.  The decision to plant, however, will be contingent on the owner’s confidence in the fact that he alone will be permitted to harvest the crop

Economic Theory of Property  Costs  Transactions cost in transfer of ownership  These can be small, as, for example, when you sell a car or house, but they can also be large  Example: A factory is given the right to dump waste products into a river at some point in time, by a grant of ownership  At a later point in time, the river becomes more valuable to society for recreational activities  Even though it would benefit society to transfer ownership of the river from the factory to boaters, no single individual will have enough incentive to pay the cost buying the river back from the factory  In this case, it would be better not to assign a property right to the river  Rather, use a liability law to control how much waste can be dumped

Economic Theory of Property  Rent-seeking behavior  Because a property right is essentially a grant of monopoly control over a resource, there will be incentives for individuals to pursue ownership rights in ways that may be socially wasteful since the monopoly rights obtained allow the individual to earn monopoly rents  Example: Suppose a sunken ship has been abandoned, but would be worth $1M if salvaged. >Suppose salvage cost is $100K >Absent property rights to the ship, there are incentives for many different salvage companies to attempt to salvage it, even though only one will eventually succeed.

Economic Theory of Property  Example, continued: Suppose instead that the ship’s original owners retained their property right in the sunken ship >They could then salvage the ship by auctioning off the right to salvage to the lowest bidder among the salvage companies, while retaining the right to the remaining value of the raised ship >If the market for salvage services is competitive, this will result in an efficient transaction  Property law includes a doctrine (the so-called committed searcher doctrine) which effectively assigns property rights to the first person to identify and actively assert control over abandoned property

Economic Theory of Property  A third cost associated with the granting of property rights is the cost of protecting the right  Cost of police protection  Courts  Private efforts to exclude unallowed access  In some instances, these costs may exceed the benefit of excluding non- paying use. >Example: The owner of a mall which provides free parking has implicitly decided that the benefit of being able to charge for parking is less than the cost this would impose of potential lost sales by shopkeepers in the mall

Application to Intellectual Property  The same cost-benefit analysis we applied to physical property can be applied to the realm of ideas  We call ideas which are granted protection intellectual property  Consider the benefits and costs we identified for physical property as they would apply to ideas

Application to Intellectual Property  Benefits  The analog of the physical commons in the realm of ideas is the intellectual public domain (or simply the public domain when it is understood that we are talking about ideas)  Ideas in the public domain can be freely used by anyone  Unlike the physical commons, there is no possibility of overuse of the intellectual public domain, since ideas are both intangible, and non-rival  Ideas in the public domain are public goods, since one person’s use of an idea doesn’t preclude others from using the same idea, and, absent intellectual property protections provided by the government, it is impossible to exclude people from using the idea

Application to Intellectual Property  The dynamic benefit of allowing proprietization of ideas via intellectual property rights is important however  Consider a new production innovation that results from a firm’s R&D expenditures  If the idea behind the innovation leaks out, rival firms can adopt the innovation and produce at the same marginal cost as the original firm, but without having incurred the costs of R&D that led to the innovation  Since this puts the original innovator at a competitive disadvantage, it follows that if the firm cannot either keep the innovative idea secret, or obtain intellectual property protection for the idea that allows it to recover its investment costs, it won’t undertake the R&D.  Schumpeterian competition  Boldrin and Levine’s critique: the fixed cost of innovation is a sunk cost and so shouldn’t hinder competition as long as the innovator can earn sufficient rents to cover the cost

Application to Intellectual Property  Costs  Transfer costs exist with intellectual property as with physical property >The transactions costs associated with transfer of intellectual property (or the determination of illegal use of intellectual property) can be substantial because of the problem of identifying which particular idea is actually protected >In patent law, for example, the novelty requirement can be difficult to ascertain, generating substantial costs to the PTO and to the CAFC in litigating claims against patent validity

Application to Intellectual Property  As with physical property, there are rent-seeking costs associated with the granting of intellectual property rights >One particularly important form of rent-seeking behavior associated with the monopoly use rights conferred by patents is the so-called “patent race,” which we will examine in detail shortly  The costs of protecting intellectual property can be quite large and hence are a key consideration in forming intellectual property policy >Consider a production innovation which the innovating firm is able to keep secret and hence exploit for its own benefit >From a social perspective, it would be more beneficial if the innovation were adopted by the whole industry, rather than just by a single innovative firm >This cost is the basis for the requirement of disclosure in patent law

Application to Intellectual Property  The importance of the costs of protecting intellectual property are also magnified significantly if the underlying fixed cost of innovation is large, while the marginal cost of using the innovative idea is small or zero >Again, absent the ability to exclude non-payers from using an innovative idea, firms won’t incur the fixed cost of innovating unless they can simultaneously protect the innovation >When fixed costs are large, firms may end up investing substantial resources in protecting trade secrets or otherwise discouraging imitators

Application to Intellectual Property  The cost-benefit tradeoff  The costs associated with granting intellectual property rights dictate that if the laws governing the granting of these rights are meant to promote economic efficiency, the should contain provisions which minimize the associated costs  These provisions will typically not have counterparts in the laws governing physical property rights

Application to Intellectual Property  Examples: >The non-obviousness requirement for obtaining a patent ensures that no one will be able to enjoy monopoly status and earn monopoly rents by obtaining a property right for an innovation which is easily discovered and applied »From a social perspective, obvious innovations are not costly to make and so need not be incentivized »No counterpart to this requirement in physical property law >The fact that patents are valid for only a limited duration serves to limit rent-seeking behavior by putting a ceiling on the expected present value of the patent »Limited duration also helps control the growth in transactions costs for licensing the use of an innovation if it is widely adopted

Application to Intellectual Property  For intellectual property, the high social costs of granting these property rights raise important questions about whether these rights are cost- justified at all  Add-on nature of intellectual property rights  Innovators enjoy fundamental physical property rights that protect both the act of creation and its products >A writer’s laptop is protected from theft and laws against fraud >Trade secrets and no-compete clauses in employment contracts allow firms to protect innovations without granting explicit property rights

Application to Intellectual Property  With these protections alone, we would expect to see much if not all of the innovative activities currently observed since >some activity is undertaken without the expectation of financial gain (internal reports, personal correspondence, unpublished works of art or scholarship) >other activities are financed other than through sale on commercial markets (in-house innovations in manufacture of a firm’s product, innovations in management activities) >still other activities are low enough in cost that costs can be recouped before competitors innovate (so-called incremental innovation)

Application to Intellectual Property  On the other side, when society creates expansive intellectual property rights, it creates monopolies which will price the results of innovation above their marginal cost, thus generating an allocative inefficiency >This inefficiency can be particularly extreme if most of the cost of the innovation is fixed, while the marginal cost of using the innovation is very low, since the monopoly owner of the protected innovation will price the use of the innovation in order to recoup the fixed costs of R&D in as short a time as possible >As we will see in the next module, monopolies also have a lower incentive to innovate further, so that the grant of the property right can reduce the pace of innovation  Hence, the trade-off of social benefit and cost for intellectual property is considerable  Society needs to be careful not to make intellectual property rights overly expansive

Application to Intellectual Property  Models  We turn next to developing some models that explore the efficiency issues and cost-benefit trade-off associated with intellectual property protection  Patent Races  Welfare Properties of Patent Protection  Optimal Patent and Copyright Protection