Epip 2013

A. Panagopoulos & Park 2013 1
Patents v. Trade Secrets
In-Uck Park
Andreas Panagopoulos

Panagopoulos & Park 2013 2
Objective
• Are patents better than TS and in what
context?
• This is important because recent
theoretical evidence points to TS being
conducive to tech transfer; see Anton and
Yao 1993, and Henry and Ponce 2011
(both relying on a free riding threat).

We argue that
• patents have forward looking effects that
TS lack
• because they, can be used as bargaining
chips in future tech transferring
negotiations.
• when patent rights are fully transferred
they should merit a markup over TS.

In detail
• It is understood that patent portfolios
endow firms with the legal power needed
in gaining a better hand in out of court
settlement negotiations. In this respect, a
transfer of patent rights that increases the
size of a patent portfolio serves a dual
purpose.

Dual purpose
• A) It expands the firm’s tech-horizon,
• B) It increases its legal gravity when
bargaining an out of court settlement.
• This suggests that a patent does not only
convey monopoly profits on the technology
embodied in the patent (as TS do), it also
conveys pecuniary benefits that are related to
the ability of a patent to be used as a
bargaining chip for future licensing
negotiations (markup).Panagopoulos & Park 2013 5

Forms of tech transfer
• From all different forms of tech transfer,
such as licensing, the formation of a
patent pool, patent donations, the sale of
patents, or a firm takeover, only the last
two imply a full transfer of patent rights
that can merit such a markup.

Problem
• Easy to argue, hard to prove because this
argument implies that patents can capture
rents from future deals. Hence the
argument is recursive and if, at any point
in a series of tech transferring
agreements, a patent fails to capture
sufficient rents (as to stimulate a patent
generating innovation) the argument
collapses.

Startups
• We argue our case for a subset of all firms
(albeit a very important one) startups.
• This is because a) startup firms rely on
tech transfer and b) they lack the funds
and legal power to avoid being coerced
into a deal by an incumbent who holds a
patent portfolio and alleges infringement,
and c) a series of startup buyouts is now a
familiar occurrence (OI).

Asymmetries
• In strengthening our argument, we argue
our case in the most favorable scenario for
TS i.e. TS fully avoid disclosing the
technology at hand. Hence TS cannot
invite infringement proceedings, patents
can.
• i.e. two asymmetries: startups are different
than incumbents; TS avoid disclosure,
while patents don’t.

The model
• We analyze a model in which an
incumbent who owns a patent portfolio
negotiates (via Nash bargaining) a
takeover agreement with a sequence of
startups. With each takeover the patent
portfolio of the incumbent increases,
increasing i) her ability to threaten future
startups with infringement proceedings
and ii) her bargaining power in future
takeover negotiations.

Results:
• We find that as long as IP protection is
moderate patents can motivate R&D
efforts that would not have taken place
otherwise. If IP protection is balanced
startups should prefer TS

Why balanced?
• If IP protection is limited entrants abstain from
innovating; because their innovation is not
adequately protected from the incumbent.
• The same holds true if IP protection is very
strong.
• If IP protection is moderate, the incumbent’s
benefits of a takeover go beyond
commercializing the new innovation.

A static model
• Firm 1 is the dominant firm, and 2 is the startup.
• Firm 2 can do R&D at a cost C>0.
• The value of the innovation is V>0 if 2 commercialises it,
and if firm 1 does as well (Note: is not the
driving force behind our results)
• Innovation is sequential; potential infringement.
• If the case ends in court 2 loses with probability p.
• No litigation cost.
VV
*
VV
*

• The disagreement/threat points of the firm are the
respective expected surpluses from litigation.
2211
,
*
2121
*
2
*
1
21
max
:Hence
,
:asdefinedissetbargainingNashthe
gy,technolotheofvaluemaximumtheisSince
1and
dsds
VssssB
V
VpdpVd
Bss

• Stronger IP protection (a greater p) decreases the share
of 2 via weakening its bargaining position, reducing her
incentives to innovate.
• Note: this is also a licensing solution.
• A takeover/licensing is always preferable to litigation.
1,0/
2
11
)(
2
11
)(
*
*
2
*
1
VVr
V
rrp
ps
V
rrp
ps

For TS
Vdd 21
and0
2
2
*
2
*
1
VV
s
VV
s

For the static model
Since we have a one off Nash bargaining
negotiation and there are no future benefits for
patents: TS is better than patents because they
do not invite infringement allegations.

A sequential model
• With a positive level of IP protection the value of owning
the PATENTED innovation to firm 1 is V* plus the
increment in future bargaining share due to strengthening
its bargaining position via enlarging its portfolio.
• Therefore the surplus of firm 2 may be larger than in the
static model.
• To capture this we model probability p as a function of the
number of patents in the incumbent’s portfolio t (where t
also denotes time periods), and the level of IP protection
z.
∂p/∂z>0, ∂p/∂t>0, ∂²p/∂t²<0

• Patented innovation should stop when
• What matters here though is if innovation via
patents is possible when the cost of innovation
is at least equal to the innovator’s payoff when
the innovation is protected via a TS.
• To display our point C is at least equal to 2’s
maximum payoff from keeping the innovation
as a TS. Hence, after this point is reached a TS
prevails i.e. firms prefer the static solution.
• We label the last period a startup innovates and
patents as T.
Cts2

• Nonetheless, not all startups are created
as equal.
• Some have an R&D cost above C, some
not (skewed distribution).
• We assume that is the probability that
the R&D cost is zero, and (1- ) that it is
greater or equal to C.

Notation
• X(t): the value of the incumbent from deals
surrounding innovations not yet realised, at the
beginning of a period with portfolio t
• s1 and s2 the bargaining shares, from Nash
bargaining, of the two firms (incumbent and
entrant).
• discount rate
• If the case is litigated the incumbent wins with
probability p(z), where z denotes IP protection.

The model
• On the last date T that there is a patented
innovation:
• NOTE: the hat above a variable denotes t<=T
(1),)1()(ˆ)(ˆ
1
TXTsTX

• On the first date that there is no innovation by
a high cost firm:
(2),)1()()(1)( 1
tXtstXtX

)()1(
*
tXtXV
VtpdVtpd zz
)(1,)( 2
*
1
The total surplus that the innovation can generate
to the two firms is maximised when firm 1
commercialises it and adds it to its patent portfolio.
In this case the total surplus is:
The threat points are

The bargaining shares
• Which can be plugged into eq. (2) to get a difference
equation that describes X(1), X(2)….etc.
• Note: s1 & s2 are strictly greater than the static licensing
solution.
2
1
2
11
2
1
2
11
*
2
*
1
tXtX
V
rrtp
ts
tXtX
V
rrtp
ts
z
z

The difference equation
*
3
11
3
12
1 V
rrtp
tXtXtX z
Proposition: The above sequence {X(t)} is unique,
monotonically increases at a decreasing rate, i.e., X(t)-X(t-
1)>X(t+1)-X(t)>0 for all t>1, and converges to
*
12
11
V
rrp
X z
Proposition: in any equilibrium there exists T<∞ such that a
startup does not innovate and patent in any period t>T.

Before reaching T
)(ˆ)1(
*
tXtXV
VtpdVtpd zz
)(1,)( 2
*
1
The total surplus that the innovation can generate
to the two firms is maximised when firm 1
commercialises it and adds it to its patent portfolio.
In this case the total surplus is:
The threat points are
TsTs
tXtX
V
rrtp
ts
tXtX
V
rrtp
ts
z
z
22
*
2
*
1
ˆ
2
ˆ1
2
11
ˆ
2
ˆ1
2
11
ˆ

TsCTs
TsTs
22
22
ˆthatpossibleisit
ˆAs
We solve this problem through the use of
mixed strategies.
We show that there exists a unique value α∈(0,1-η),
for which an equilibrium solution is possible.

Theorem
• Up to T high cost startups prefer patents after
that startups are indifferent to patents or TS (TS
prevails).
• A similar argument is proved for low cost
startups.
• The argument does not collapse because:
• Patent length
• Patent donations

Simulation
We initially simulate for δ=.97 and η=.2 and then for δ=.99 and η=.8.
To provide an example (in line with the magnitudes of z we find):
when z=.007 a firm with a portfolio made up of 100 patents stands
a 50% chance of winning its case, and an increase of 1 patent raises
this by .34%.
We argue our case for V*=1, r=1, and C=1.0001.
An r=1 allows for results that are not driven by the disparity between V and V*,
Additionally, by choosing C>1 we ensure that:
a) innovation by high-cost startups may only be possible in a dynamic model
b) that IP protection is necessary for such innovation because
pz(t) is constant at 0 for all t if z=0, erasing any dynamic effect.
t
z
ztp 11)(

Converging s2

Inverse U
• To examine how z affects T, we find the values of T for
z's between .0001 and .01 in 20 steps of .0005.

Varying δ

Varying η

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