The economics of patents
Merit course – 2005
Motivation: to see “how patents work” and
how economic theory can help to design
them
the role of patents
patent length
Other patent dimensions

IBM vs Apple
Winners & losers?
1000
45
40
Microsoft
35 100
30
25
Intel
10
20 Compaq
15 Apple
10 1
5 IBM
0
0
1981
1983
1985
1987
1989
1991
1993
1995
1997
1985 1987 1989 1991 1993 1995 1997
Bron: Harvard Business School Apple case studies 1992 & 1998 Bron: Worldscope database

Technology Spillovers and incentives
The problem that spillovers create is an
incentive problem
This may be solved by the award of a patent:
the legal monopoly to be the only user of an
invention
Monopolies make an economist alert!
Technology spillovers are not totally bad: they
are a source of welfare
– Example: the history of the personal computer

The role of patents
The three Ps:
– Patronage (e.g., universities)
– Procurement (e.g., defense or public sector
research institutes)
– Patents
Patents and spillovers: publication of
patented inventions

Designing patents
Can we design a patent that strikes the
balance between incentive and welfare
generation?
Patent length, breadth, width and height

Patents and spillovers – How can
patents leave spillovers?
Patentable and non-patentable parts of
knowledge
Standing on the shoulders of giants
Rent spillovers

Nordhaus model of patent length
Minor and drastic innovations

Nordhaus model of patent length
Longer patents create a longer profit stream
for the inventor, but at a decreasing rate
(profits far away in the future are worth less)

Nordhaus model of patent length
Maximum profit for a monopolist
minor
(A Bc) (c c),
qx
A
Value of the consumer surplus
S cd.
B
0

Nordhaus model of patent length
Invention possibilities function
cc
R,
c
T
NPV of net profits
minor
V e d R.
0
T T
1e
V c R (A Bc)e d R c R (A Bc) R.
0
T
V 1e
(1 )
cR (A Bc) 10
R
Optimal R&D
1
T
1e
expenditures
1
R c(A Bc) .
T T
1e 1e
1
V c c(A Bc) (A Bc)
Resulting NPV of
1
profits
T
1e 1
c(A Bc) .

Nordhaus model of patent length
NPV of profits for varying patent duration

Nordhaus model of patent length
Longer patents create less consumer welfare
(they leave a shorter period for consumers to
benefit from all the advantages of the patent)

Nordhaus model of patent length
Total welfare resulting
T
e
WV e d V .
from innovation
T
q x(c)
A 1
Consumer surplus after
B(c c)2,
cd
B 2
patent runs out
q x(c)
2
Part of total welfare due
T T T
e 12 1e e
2 1
Bc c(A Bc)
2
to increased consumer
T T
1e e
1
c (A Bc) c(A Bc) .
surplus

Nordhaus model of patent length
Consumer surplus (NPV) as a function of
patent duration

Nordhaus model of patent length
Total welfare as a function of patent duration
Higher demand elasticity decreases optimal patent life, higher
technological opportunities leads to shorter optimal patent life

Patent breadth
Systems nature of knowledge: spillovers are
often in the form of relevant implications by
outsiders
In the spirit of the Nordhaus model: be careful
not to prevent too many spillovers from
locking out
Modeling patent breadth: Horizontal product
differentiation

Van Dijk / Klemperer model of patent
breadth – Horizontal differentiation
vp d if the consumer buys
U
0 otherwise
b p The indifferent
vp |w 0| v |w b| w .
2 2
consumer

Van Dijk / Klemperer model of patent
breadth
1
pb p
Profit function
.
2 2
1
b ( 1)p b
0 p ,
Find optimal price
p 2 2 1
1
Substitute into indifferent
b b b
w , pw .
2( 1) 2( 1)
consumer
b
Consumer welfare loss “right”
b2 ( 2)2
(b )d .
1
1)2
8(
w
w
b 2 (4 )
Consumer welfare loss “left”
(p )d .
2
8 ( 1)
0
1
b2 ( 2)2 b 2 (4 ) b b
.
Total welfare loss
1 2
2( 1) 1
1)2 8 ( 1)2
8(

Van Dijk / Klemperer model of patent
breadth
1 1
2)2
b( b b (4 ) b
1 2
1.
4( 1) 1 4( 1) 1
Broad patents are bad,
because they sacrifice a lot of
consumer surplus for little
profits (incentives)
Narrow patents are bad,
because they sacrifice a lot of
consumer surplus for little
profits (incentives)
Patent breadth is a tool to vary the ratio of welfare loss to
incentive (=profit). Policy: pick the best ratio and adjust
patent length

Patent breadth
‘Gold mining’ of patents
– Genetic technology
– The importance of applicability of patents
A trend towards broader patents (pro-patent
era in the US)
Software protection: copyright (narrow) vs
broad patents: EU parliament debate

Prudence in patent breadth
Systems nature of knowledge: one invention
depends on another one
A prudent rule is to leave an important part of
the relevant implications to outsiders (do not
award broad patents on all imaginable
applications of a discovery)
Genetic research is an important
contemporary example

The last aspect of patent protection:
Inventive step
Every patent must have a minimum degree of
novelty and must not be obvious to “someone
skilled in the art”
– But check some of the patents in patent databases
on the web
– Would you consider the “one click to buy” system
at Amazon.com “not obvious to someone skilled in
the art”?

Van Dijk model of patent height -
Vertical differentiation (quality)
v m f p if the consumer buys
U
0 otherwise
p2 p1
Indifferent consumer
m f1 p 1 m f2 p2 m ,
f2 f1
p2 p1 p2 p1
x1 , x2 1 .
Demand functions
f2 f1 f2 f1
p2 p1 p2 p1
Profit functions
p1 , p2 p2 .
1 2
f2 f1 f2 f1
p2 2p1 1
1
0 p1 p,
22
p1 f2 f1
p1 2p2
Optimal prices yield a game
1
2
1 0 p2 (p f f ).,
2121
p2 f2 f1
(Nash equilibrium)
f2 f1 f2 f 1
p1 , p2 2 .
3 3

Van Dijk model of patent height

Van Dijk model of patent height
Innovation possibilities function
f 2.
R(f )
f2 f1 f2 f1
2 2
Net profit functions
V1 f1 , V2 4 f2 ,
9 9
V1 1
2 f1 0 f1 0,
f1 9
Optimal inventive
V2 4 2
2 f2 0 f2 .
step
f2 9 9
When h 2/9 patent height does not become restrictive
When h>4/9 the imitator decides not to enter the market
When 2/9 < h < 4/9 the first-best choice of the imitating firm
is ruled out

Strategic patents
Patents are intended as legal protection from
imitation
The Yale survey: only one third of innovations
is protected by a patent
Why not the other two thirds?
novelty requirements
secrecy better alternative
afraid of inventing around
Can patents serve a different function than
just protection?

Patent strategies – Granstrand

Strategic patents
Costs of litigation are an important aspect of
strategic patenting
Strategic patenting puts more emphasis on
the non-competitive aspects of patents, and
hence on the inefficiencies rather than the
welfare-creating effects