Technological Innovation and Intellectual Property

Mike Masnick at Techdirt takes issue (”Why Treating Patents As Property Is A Bad Idea”) with the argument that patents should be evaluated as a property system, an argument that Mike Meurer and I make in our book, Patent Failure. Of course, Mike and I do not argue that this is the only way the patent system should be evaluated, but we think it is important to look in detail at the way the institutions of the patents system actually work. All too often, these details are glossed over and it is assumed that they work as well as, say, the property institutions for land.

Unfortunately, Mike Masnick confuses our call to evaluate the functioning of patent institutions by comparison to other property institutions with some of the more general rhetoric about “patents as property.”

There is little doubt that “property” has long been a great rhetorical confection. Property is, after all, “theft” (Proudhon) and also the source of “economic freedom” (Friedman). Some people argue that “patents are property” and by this they mean that patents should have very strong and very rapid enforcement. As Masnick points out, Mark Lemley used this viewpoint as a straw man in a recent paper. Lemley describes a “real property system” as one where patents with uncertain validity or uncertain boundaries (so you can’t tell upfront that they are infringed or not) are strongly enforced.

Clearly, this is a bad idea and it is hardly what Mike Meurer and I are talking about. In our view, patents with uncertain validity or uncertain boundaries are not at all like tangible property and strong enforcement of such rights is not justified.

Unfortunately, there is a tendency to reduce property to a single dimension: “strength.” But real property systems, as opposed to rhetorical confections, involve complex institutions and there is value in understanding how they can and should work.

There has been a debate among legal scholars about whether patents were seen by the framers of the US Constitution as “property” or, as Thomas Jefferson charged, a monopoly “privilege.” For instance, Adam Mossoff has argued that the case law of the early nineteenth century shows that judges treated patents as an expansive property right.

But one thing is clear and is often forgotten: the early patent system lacked basic institutional features necessary for an effective property system. For example, it was very difficult to find out what had already been patented, aside from actually infringing a patent and then receiving a complaint from the patent owner. That is, the basic “notice” function of property was largely missing.

In 1845, Rufus Porter, an itinerant mural painter and sometime inventor from western Maine, began Scientific American as a publication that summarized new inventions. In 1846, he sold it to Munn and Company, the largest patent agent, and they began systematic reporting on new patents. Prior to the 1840s, occasional Annual Reports from the Patent Office would list granted patents, but little detail on claims and no drawings were available to the public without visiting the Patent Office in Washington (or corresponding with a patent agent, also time-consuming and imperfect). In 1843, the Annual Report included claims of the patents granted. In 1854, the Annual Report first included selected patent drawings. Only with the Act of 1870 (and the advance of lithographic printing) was the Patent Office required to provide copies to the public, including libraries. At that time the Official Gazette replaced the Annual Reports.

A similar pattern seems to have played out in Britain, where the first complete index of patents was published in the Abridgements of Specifications in 1853.

Thus, however much judges might have viewed patents as a form of property, it seems that the role of patents to function as an effective property system was significantly compromised during the first half of the nineteenth century.

A Time to Rethink

Patents as property was also front and center in the thoughts of one judge on the Court of Appeals for the Federal Circuit, the main appellate court for patent disputes in the US. Senior Judge S. Jay Plager, speaking at a symposium at George Mason University, called for a “rethinking” of several aspects of patent law by returning to its origins in property law.

According to the BNA, Plager “called for a renewed focus on setting recognizable patent ownership boundaries and on strengthening the notice function that patents are intended to serve. Such a reevaluation might require a reassessment of whether software and business methods are patentable subject matter, Plager said. It might lead to limiting a patent’s scope to what was known at the time of the application filing, and to an abandonment the doctrine of equivalents as a basis for patent infringement liability.”

In addition to rethinking claim construction,

Plager said he regretted the unintended consequences of the decisions in State Street Bank and AT&T. Those rulings led to a flood of applications for software and business method patents, he noted. If we “rethink the breadth of patentable subject matter,” he said, we should ask whether these categories should be excluded from patent protection.

This new thinking is certainly encouraging. Let’s see how it develops.

The idea that patents can be analyzed as a property system—both regarding its strengths and its weaknesses—seems to be gaining currency in influential circles.

Last week in the Wall Street Journal, L. Gordon Crovitz writes “…in the case of patents, poorly defined property rights for inventions are leading even the biggest companies to take desperate measures…” He goes on to highlight our argument that the patent system provides much stronger incentives for pharmaceuticals than for software and communications technologies because of the nature of the rights granted:

New drugs require great specificity to earn a patent, whereas patents are often granted to broad, thus vague, innovations in software, communications and other technologies. Ironically, the aggregate value of these technology patents is then wiped out through litigation costs.

Andreas Panagopoulos sent a brief note on a theoretical paper on startups and innovation. In this model, the startup’s patents add value to an incumbent’s patent portfolio when the incumbent acquires the startup. There is a trade-off between the incumbent’s patents deterring entry and the acquisition prospects increasing startup value. Andreas write:

In modern hi-tech industries where technology is complex and cumulative, a new innovation is likely to infringe on existing patents. Hence, an entrant firm is under potential threat of litigation from a competing incumbent firm that has accumulated a patent portfolio. It is not clear, therefore, how entrepreneurial activities may be sustained in the same technological terrains as those of powerful incumbent firms.

In a model where an incumbent faces a sequence of potential startups and the incumbent’s chance of winning an infringement lawsuit increases with the size of its patent portfolio, we demonstrate a positive dynamic impact on the startup innovation that is generated by an interplay of takeover deals (out-of-court settlements) and carefully selected levels of IP protection. The core insight behind this result stems from the observation that the benefit of a takeover for the incumbent goes beyond commercializing the new innovation. This is because the incumbent capitalizes on the enhanced bargaining position that the current takeover will bring about in all potential future deals by incorporating the current startup’s patented ideas to its own patent
portfolio, which allows it to better barricade its technological territory, increasing its chances of prevailing in future infringement lawsuits. Since this prospect of future surplus for the incumbent hinges on the current takeover, a part of the surplus accrues to the current startup, enlarging its bargaining share in the takeover deal. We show that this feedback effect of future prospects on the current deal can motivate the startups’ innovation activities that would not take place without it, and as a consequence, increase the social welfare.

We emphasize that for maximum effect the level of IP protection should be selected carefully at a moderate level. The aforementioned increase in the startup’s bargaining share, being proportional to the marginal benefits brought by the last patent added to the incumbent’s portfolio, would be too small to be effective if the IP protection is too weak. An excessive IP protection, on the other hand, would accumulate the incumbent’s bargaining power too quickly, killing off the innovation incentives for startups prematurely. We illustrate this point further by way of computer simulations.

Not sure how this plays out in a world where any player (e.g., troll) can acquire patents that can be used as bargaining tokens…

Patent trolls or sharks have been in the news recently. Verizon, Google, Cisco, HP and other companies have created a joint effort to buy up patents that trolls might otherwise use against them. It will be interesting to see whether this strategy will take bad patents off the market or whether it might, instead, simply increase demand, thus increasing the rewards to obtaining overly broad patents, encouraging even more disputes and litigation.

Also, the June issue of the Harvard Business Review has a nice piece on patent sharks by Joachim Henkel and Markus Reitzig. They point out that the strategy of amassing large “portfolios” of patents does not work against trolls,since the trolls have no business that can be threatened with a countersuit. Moreover, they suggest that this strategy may have contributed to the current problems large firms experience with trolls. Because they flooded the patent office with thousands of applications for patents on trivial inventions, these large firms might well have contributed to the decline in patent standards that has allowed patent sharks to flourish.

Tim Lee has an interesting post on a paper by Gerard Magliocca that compares patent sharks of the 19th century to modern day trolls. Lee writes,

The best patents—pharmaceutical patents, say—apply to a well-defined industry. Pharmaceutical companies need to monitor pharmaceutical patents in order to determine what they’re allowed to do. In contrast, every business on Earth uses software and “business methods.” Therefore, every business on Earth is a potential target. That means it’s much easier for trolls to find potential victims. It also means that the targets—many of whom don’t think of themselves as being in the software industry or the “business method industry”—will be ill-equipped to respond to the lawsuit.

Precisely the same observation applies to 19th century patent sharks. Because most people in the 19th century were farmers, patents on farm tools were likely to be infringed by millions of individual farmers who lacked the expertise to evaluate the patent and the resources to hire lawyers to defend themselves.

[This is the second post in a series on the new book, Patent Failure, by James Bessen and Michael Meurer]

Do patents encourage economic growth, stimulate R&D investment, or deliver wealth to innovators? In our previous post we reviewed the empirical research in economics and we could not find consistently positive evidence about the performance of patents.

In this post we narrow our focus. We ask whether the modern American patent system encourages innovation by large (publicly traded) American firms. We answer this question with empirical research that is presented in chapters 5 and 6 of our book Patent Failure. We find that the patent system discourages investment in innovation by the average publicly traded American firm. Although the patent system provides positive incentives in some industries like pharmaceuticals, it provides negative incentives in most industries. Further, the performance has deteriorated over time.

Measuring benefits
Our conclusion is based on separate estimates of the benefits and costs of patents to innovative firms. We use two different techniques to estimate the value of patents to their owners. The first technique examines the decision to pay patent maintenance fees. The size of the fee sets a lower bound on the expected value of the patent at each payment date. A large fraction of patents lapse each time maintenance fees are due. Using well-known econometric tools, we use payment information on a large set of patents to calculate patent value.

The second technique relies on the stock market valuation of publicly traded firms. Firm share value is determined by investor expectations about future firm profits. Expected future profits depend on the assets owned by a firm; both physical assets and intangible assets including patents. We use standard econometric tools to apportion share value to the different assets owned by a firm. Thus, we can calculate the value of a firm’s patent portfolio, and from that, the value of the average patent.

These two rather different techniques produce estimates that roughly correspond. We calculate a mean worldwide patent value of $370,000 for publicly traded American firms (This number is presented in 1992 dollars; updating for inflation yields $512,800 in 2007 dollars.) Like other researchers, we find that patent values vary tremendously depending on the industry. The average value of patents held by large pharmaceutical firms is easily an order of magnitude larger than the average value of patents held by firms in other industries. Also, the distribution of patent value is skewed so that the median patent value is nearly an order of magnitude smaller than the mean.

Costs
Innovative firms are rewarded with patents and enjoy the expected value of patent ownership. But patents also impose expected costs on innovators as defendants in litigation. When an innovator commercializes a new technology there is a risk that a patent owner will assert a patent against the innovator. Innovators sometimes respond to this risk by licensing patents in advance that might be asserted against them, or by designing a product that steers clear of any possible patent assertion. For most innovators these strategies are often not profitable (and often not even feasible). In our next post, we provide the reasons and evidence that patent notice often fails badly and makes ex ante licensing or patent avoidance unlikely in most industries. Assuming we are right, then typical innovators face an unavoidable risk of having to defend against patent lawsuits. This is the largest cost that patents impose on innovators.

We measure this cost by gauging the stock market reaction to the filing of a patent lawsuit against an alleged infringer. We study lawsuits filed against publicly traded American firms from 1984-1999 and we find that the median defendant faces a total litigation cost of $2.9 million (1992 dollars), and a mean litigation cost of $28.7 million (1992 dollars). (Updating for inflation to 2007, the median is about $4 million and the mean is $39.8 million.) Some of this cost is borne by pirates or other non-innovating firms, but we will argue in our next post that most of this cost falls upon firms because they have commercialized innovative technology. Furthermore, in our book we explain that we made conservative assumptions and probably underestimated litigation cost. We conclude that in industries other than chemicals and pharmaceuticals, defense against American patent lawsuits amounts to 13% of R&D spending by defendant firms (19% in 1999). In contrast, our studies of patent value indicate that worldwide patent value amounts to only 6% of R&D spending by these same firms. The result — patents impose a tax of at least 7% on R&D investments outside of the chemical and pharmaceutical industries.

The two figures below summarize total patent costs and benefits for publicly traded firms. The red line shows the annual aggregate costs to these firms of defending against patent litigation. The blue line shows an estimate of the incremental annual profit flow derived from all patents worldwide held by publicly traded American firms. The first figure shows that chemical and pharmaceutical firms earn far more from their patents than they lose to litigation.

But for other firms, the second figure tells a simple but dramatic story: during the 1980s, these firms might have, at best, broken even from patents, but in the mid-1990s litigation costs exploded. By almost any interpretation, the patent system could not be providing overall positive incentives for these firms by the end of the 1990s.

We conclude with three important notes. First, patents do provide profits for their owners, so it makes sense for firms to get them. But taking the effect of other firms’ patents into account, including the risk of litigation, the average public firm outside the chemical and pharmaceutical industries would be better off if patents did not exist. Second, our best evidence relates to the eighties and nineties, but the evidence we have for this decade suggests that the patent tax has grown with the continued growth of patent lawsuits. We find no offsetting evidence that patents have become substantially more valuable in this century. Third, we find that small publicly traded firms get small positive R&D incentives from patents. This is also very likely to be true for small, non-publicly traded firms and non-profit inventors. We explore the significance of small inventors in a separate chapter.