Technological Innovation and Intellectual Property

[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.

Note: This is the first in a series of four posts about empirical research on the performance of the patent system based on the new book by James Bessen and Michael Meurer, Patent Failure, published by Princeton University Press [book web page]. This first post reviews the sizable body of empirical research analyzing the impact of patents on R&D investment and economic growth. The other posts will present new empirical research featured in the book. The theme across all four posts is that patents often fail to perform effectively as property rights.

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Economists cherish property rights that provide strong incentives for investment and trade, and that thereby contribute to economic growth. Potentially, patent rights could accomplish these three goals, and surely they sometimes do. Apparently though, it is hard to set up and maintain a patent system that works as property.The rise of new market economies and strengthening of property rights around the globe in the last two decades provides economists with “natural experiments” that help us evaluate whether and how much property rights contribute to investment and growth. The empirical results are impressive. Countries that expanded the role of markets and strengthened property rights have prospered from these choices. Economic historians find the same results hold going back to the Industrial Revolution.

Comparable studies of patent systems are discouraging. The evidence certainly is consistent with the notion that patents encourage American pharmaceutical R&D. But otherwise, it is hard to find evidence suggesting patents are a major factor spurring R&D investment, that patents contribute to economic growth, or even that the patent system is a source of great wealth to important inventors and innovators (outside of a few industries like pharmaceuticals).

Economic history. Douglass North casually links patents and property rights and attributes a significant role to patents in the British Industrial Revolution. But many other economic historians are skeptical. Relatively few English inventors of key technologies prior to the mid-nineteenth century seemed to benefit from patents. Christine MacLeod finds that about nine out of ten English patents arose in industries that saw little innovation, and that patenting was at best loosely related to technological innovation. And Petra Moser, using information on inventions exhibited at the 1851 Crystal Palace Worlds Fair, finds that only 11% of British inventions were patented.

Patents played a more significant role in the nineteenth century U.S. economy. Zorina Khan speaks of a “democratization of invention” in America. Individual mechanics and farmers obtained patents in large numbers and an active market for patents developed that lasted until the end of the century.

Institutional differences probably explain much of the disparity between the countries. British patents were not examined, but American patent examination started in 1836. Patent enforcement was costly and uncertain in England while in the U.S. patent fees were quite low, and a cadre of patent agents and lawyers supported a sector of professional inventors.

Cross-country studies. Park and Ginarte conducted a cross-national analysis of economic growth that included measures of general property rights and a measure of the strength of a country’s patent rights. They find that general property rights have a positive and statistically significant effect on economic growth but the patent index has a negative coefficient that is not statistically different from zero. However, they do find limited evidence that patent rights are correlated with a country’s R&D spending at least in wealthier countries.

Beware though, correlation is not causation. Patents might cause R&D investment and growth, or it might be, instead, that successful technology companies or other groups, such as the patent bar, have lobbied for patent protection. In this latter case, economic success promotes the expansion of the patent system, not the other way around. In a separate paper the same authors look at the factors that determine a country’s patent index. They find, in fact, that lagged R&D (R&D from five years earlier) is positively correlated with subsequent intellectual property rights strength. This suggests that there is, indeed, a significant reverse causality.

“Natural experiments.” Several researchers have analyzed changes in patent law. Sakakibara and Branstetter look at the effect of a 1988 law that strengthened patents in Japan. They found no evidence of an increase in either R&D spending or innovative output which could be plausibly attributed to the patent reform. Bessen and Hunt look at the effect of changes in the US treatment of inventions that involve software. They found that the number of software patents grew dramatically. However, firms in the software industry acquired relatively few patents; instead, most were obtained by firms in electronics and computer industries known for stockpiling large arsenals of patents to use as bargaining chips. Moreover, the firms that acquired relatively more software patents tended to actually reduce their level of R&D spending relative to sales.

A massive study by Josh Lerner looks at 177 changes that strengthened patent law in a panel of 60 countries over 150 years. Lerner is not able to directly measure the effect of these changes on innovation. Instead, he measures their effect on patenting within the country making the change and also the effect on patenting by domestic inventors at Great Britain’s Patent Office. He finds that overall foreign inventors increased their patenting in countries that strengthened their patent laws. However, domestic inventors actually patented at a lower rate after the change, both within their country and at the British Patent Office. Why the decline in English patents? Probably because there was less invention after patents were strengthened.

Exclusionary Power of Patents. Not surprisingly, the bright spot for patent performance is the pharmaceutical industry. Grabowski and Vernon shows that patents deliver value to drug pioneers by supporting high drug prices. They find that prices drop to 37% of their original level two years after the entry of generic manufacturers. The higher prices that pharmaceutical firms charge while they are still on patent allow them to earn above-normal profits, and more than recover their development investments.

But the pharmaceutical industry is not typical. Survey respondents told Mansfield (1981) et al. that patents increased imitation costs only 7% at the median for electronics and machinery inventions; the figure was 30% for pharmaceutical inventions.

Surveys also find that in most industries (pharmaceuticals are the exception!) R&D managers report that lead time, goodwill, trade secrecy and other means of appropriation are more effective than patents in obtaining returns on their R&D investments (Levin et al. 1987, Cohen et al. 2000). For this reason, it is not surprising that survey research also finds that most inventions are not patented (Arundel and Kabla 1998, Cohen et al. 2000). On average, large European firms applied for patents on only 36% of product innovations and 25% of process innovations. Again, pharmaceutical firms are outliers—they applied for patents on 79% of pharmaceutical products.

Conclusion. Why don’t patents reliably encourage R&D and growth? Probably because it is hard to sustain patent laws and institutions that make patents work like property. Patents applied to small molecule drugs do seem to work like property; they deliver wealth to drug pioneers and encourage R&D. For most other technologies it’s hard to find evidence that patents work as property. Similarly, over time and across countries and industries, patents sometimes deliver wealth and encourage R&D, but there’s no evidence that this is generally true. Future posts will identify the reasons that patents fail to perform like property.

–Mike Meurer and Jim Bessen