Patent Theory versus Patent Law, by Alexander Tabarrok

Alexander Tabarrok, of the Marginal Revolution and George Mason University, writes this paper, Patent Theory versus Patent Law about, you guessed it, how patent theory compares to patent law as it is practiced. Refer to this blog post on how to get the PDF.

Abstract

The abstract, verbatim:

According to the economic theory of patents, patents are needed so that pioneer firm have time to recoup their sunk costs of research and development. The key element in the economic theory is that pioneer firms have large, hard to recoup, sunk costs. Yet patents are not awarded on the basis of a firm’s sunk costs. Patent law, in fact, ignores costs. The disconnect between patent law and patent theory suggests either that modifying patent law so that it better fits with patent theory would reduce the costs and inefficiencies associated with current patent practice or that the standard economic theory of patents is wrong.

Introduction

Alexander first explains the economic theory briefly and then puts forth the shape of his argument:

Although the economic theory is well accepted, I argue that it does not fit well with the actual patent system. A patent system designed around the idea of recouping sunk costs would look quite different than the current system. In particular, as I will explain below, the current system ties returns to innovation to the benefits of a patented idea, i.e., as the value of the idea increases monopoly profits increase. Yet the economic theory of patents implies that returns should be tied to the sunk costs of researching and developing the patented idea.

The poor fit between the economic theory of patents and the actual patent system suggests two alternative hypotheses. Either the theory is correct and the patent system is poorly designed, or the patent system is well designed but not for the purposes of recouping sunk costs. Which of the two hypotheses one prefers depends in part upon one’s priors about therelativeefficiency of theory versus practice. My primary approach is to assume that the economic theory is correct. Thus, I argue for reforms that would bring the patent system more into accordance with the economic theory.

Theory

This section explains the theory of patents and briefly mentions that the current patent system is not connected to the economic theory because it ignores the costs that innovates face that imitators do not. Those are sunk costs that the economic theory is concerned with.

An interesting observation of this section is that when a product’s value is high, it should not be protected as much as a product whose value is low. This is because since the sunk costs are not related to the benefits, they are repaid easier.

Practice: Examples of Patented Products with Low Innovation to Imitation Costs

Amazon’s “one-click purchasing” is a patent that was granted for something with little to no R&D costs. Another is the discovery of a medical procedure, which by definitions means there were not R&D costs.

Edison famously said that “Genius is one percent inspiration, ninetynine percent perspiration.”8 A patent system should reward the ninetynine percent perspiration, not the one percent inspiration. In inventing the lightbulb, for example, Edison laboriously experimented with some 3000 possible materials for the filament, before hitting upon carbonized cotton thread (Shulman 1999). If Edison were to patent the lightbulb today he would not need to go to such lengths. Instead, Edison could patent the use of an “electrical resistor for the production of electro-magnetic radiation,” a patent that would have covered oven elements as well as lightbulbs.9

Proposal

The key thing that needs to be done is that the sunk costs of an patented product must be integrated into patent policy, somehow. Alexander proposes multiple ways of doing this:

  • Changing what products can be patented, preferably by looking at standard innovation/imitation cost ratios in the industry.
  • Changing the probability that a patent is granted (or enforced.)
  • Changing the length of the patent.
  • Changing the breadth of the patent.

An interesting suggestion is to register innovations but not award patents, instead you wait twenty years and estimate how much the innovation was worth and award that with interest. This solves the problem of not being able to estimate correctly the benefits of the innovation before hand.

The “realistic” proposal that does not strive for complete perfection is to allow firms to apply for patents of varying lengths, and as the length increases the scrutiny of the patent office. But, Alexander tries to point out many changes that may not require legislation and would instead modify the discretion of patent examiners and infringement judges.

Objections and Implementation

“Perhaps the strongest objection against a patent system that takes into account sunk costs is that measuring sunk costs is difficult (Scotchmer 1988).21 If the sunk costs are born by the patent applicant then this problem does not seem overly difficult.”

And ever the economist:

In order to improve the current system it is not necessary to estimate sunk costs precisely so long as they can be estimated well enough to reasonably assign patent duration to a limited number of categories. If sunk costs justify a patent of 20 years, for example, it’s unimportant whether they are two, three or four times greater than necessary. The thrust of this proposal is to make marginal changes in the current patent system rather than to replace that system with something entirely new.

(Note: There’s a typo in note 23, “The higher sunk costs are” not “The higher are sunk costs”–I think.)

There is Little to Lose from Patent Reform

If it were clearly true that on net the patent system increased economic growth and technological advancement then on precautionary grounds alone there would be a good case against reform. But the consensus from many studies of innovation is that most innovations would occur without patents.

Alexander then discusses the proof of this that has been studied and documented by others. He also cites in the footnotes someone, Cohen et al. (2000), who found that “much patenting is simply generated by the patent system itself as firms patent in order to protect themselves from the patenting of other firms.”

But, Tabarrok recommends merely weak patents in cases where there are not useful, because they are useful in some instances. He is not completely against patents for any ideological reason.

Other Theories of Patents

In this section he addresses the concern that perhaps the economic theory of patents is wrong and that either another theory is necessary, whether it is another defined one (e.g. the disclosure theory) or a theory implicit in the current patent system.

Conclusion

Another brief summary like the abstract.

And here, I will leave myself a note to compare this paper with François-René Rideau‘s discussion of patents in Patents Are An Economic Absurdity, when I get a change to read it.

Could Gambling Save Science?: Encouraging an Honest Consensus, by Robin Hanson

Robin Hanson writes in Could Gambling Save Science?: Encouraging an Honest Consensus about an interesting way of getting scientists to “put their money where their mouth is” with ideas.

The pace of scientific progress may be hindered by the tendency of our academic institutions to reward being popular, rather than being right. A market-based alternative, where scientists more formally “stake their reputation”, is presented here. It offers clear incentives to be careful and honest while contributing to a visible, self-consistent consensus on controversial (or routine) scientific questions. In addition, it allows funders to choose questions to be researched without choosing people or methods. The bulk of this paper is spent examining potential problems with the proposed approach. After this examination, the idea still seems plausible and worth further study.

Hanson describes problems in the scientific community that are rooted in the causes of the scientific revolution. Essentially the problem is between outsiders and insiders, the insiders who have a stake in the status quo and don’t want to be proved wrong.

Most controversial issues of four centuries ago seem long settled by now, and continued research may well settle most of the today’s controversies. Academia can claim some credit for this, and academic institutions have continued to evolve in response to perceived problems, formalizing publication in journals, credit in citations, and evaluation in anonymous peer review.

Yet little has really changed. Academia is still largely a medieval guild, with a few powerful elites, many slave-like apprentices, and members who hold a monopoly on the research patronage of princes and the teaching of their sons. [...]

Peer review is just another popularity contest, inducing familiar political games; savvy players criticize outsiders, praise insiders, follow the fashions insiders indicate, and avoid subjects between or outside the familiar subjects. [...]

Publication quantity is often the major measure of success. This encourages redundant publication of “smallest publishable units” by many co-authors. The need to have one’s research appear original gives too little incentive to see if it has already been done elsewhere, as is often the case, and neglects efforts to integrate previous research.

Perhaps the core problem is that academics are rewarded mainly for telling a good story, rather than for being right.

So what is the resolution? The author describes:

Imagine a betting pool or market on most disputed science questions, with the going odds available to the popular media, and treated socially as the current academic consensus. Imagine that academics are expected to “put up or shut up” and accompany claims with at least token bets, and that statistics are collected on how well people do. Imagine that funding agencies subsidize pools on questions of interest to them, and that research labs pay for much of their research with winnings from previous pools. And imagine that anyone could play, either to take a stand on an important issue, or to insure against technological risk.

This would be an “idea futures” market, which I offer as an alternative to existing academic social institutions. Somewhat like a corn futures market, where one can bet on the future price of corn, here one bets on the future settlement of a present scientific controversy. This is admittedly an unusual suggestion. But consider what might happen.

After discussing many example scenarios, the author resolves problems related to the proposal. Included are the illegality of gambling in many situations and the zero-sum nature of gambling.

Being monetarily zero sum does not make betting useless. Betting markets allow traders to reduce risk, and create informative prices. In liquid markets most of the trading, liquidity, and price rationalization comes from speculators, for whom the market is basically a betting game. Buying any particular stock in the stock market, for example, is basically a bet in a zero-sum game when compared to investing in the standard “market” combination of all assets in the same tax and risk category. (While, if the prices are irrational, such bets may help the economy as a whole, this “externality” also benefits people not betting on that question.)

In fact, a standard way to analyze financial portfolios is to break them into contingent assets, each of which has value in only one possible world [ShW]. A “complete” market, where one can bet on anything, is best, allowing investors to minimize risk and maximize expected return [La].

Science bets would not only allow corporations to more easily insure against technological risk, but they would create prices embodying the sort of valuable information that governments now fund research to obtain. When the betting stakes are invested in stocks, the money is hopefully being put into productive use by those companies. Therefore, ignoring transaction costs and judging fees, the average rate of return of contingent assets split from stocks would be the same as the return on those stocks.

Networks, Law, and the Paradox of Cooperation, by Bryan Caplan and Edward Stringham

Bryan Caplan and Edward Stringham expand in Networks, Law, and the Paradox of Cooperation (PDF) on Caplan’s critique of the thesis by Tyler Cowen and Dan Sutter that the anarcho-capitalist ideal of private defense firms is impossible due to the structure that industry would form.

Cowen and Sutter (1999) argue that libertarian doubts about the viability of collusion are inconsistent. How, they ask, can free-market economists be simultaneously optimistic about the private production of public goods, but skeptical about collusion? Collusion is, after all, a public good vis-a-vis competing firms. Cowen and Sutter’s challenge may be dubbed the Paradox of Cooperation: Laissez-faire can cope with either the monopoly or the public good problem, but not both.1 Libertarians who dismiss concerns about collusion are at best over-confident.

Cowen (1992) goes further by claiming that in so-called network industries, libertarians are not just over-confident, but wrong: Laissez-faire leads to monopoly, not competition. Although his network industry argument poses a challenge for more moderate libertarians too, Cowen primarily employs it to expose the fundamental weakness of the radical anarcho-capitalist position (Rothbard 1978, Friedman 1989): An excellent example of a network industry is the very free market in defense services that anarcho-capitalists favor. In consequence, anarcho-capitalists are sorely mistaken about the consequences of their ideas if tried.

The paper very much follows the structure of the previously mentioned critique, but is expanded with references and detail.

The authors bring up the issue of cooperations that are “self-enforcing”:

Cowen here conflates two radically different sorts of business cooperation under the generic heading of “collusion.” Standardizing products is essentially a coordination game, fixing prices a prisoners’ dilemma. As long as consumers want a uniform product, adhering to industry standards is self-enforcing. As long as consumers prefer to pay less rather than more, price-fixing is not. Ability to reach the cooperative outcome in the former in no way “implies” ability to reach it in the latter.5

The authors also mentions an important point about how to measure the success, or failure, of a collaboration and identify that is possible to have partial success in such endeavours:

First consider the effectiveness of partial participation. Voluntary collaboration never yields unanimity. But howinjurious is the shortfall? This hinges on the elasticity of outsiders’ behavior. Suppose that 50% of all firms in an industry join a cartel to restrict production. They will be unable to raise prices much because outsiders’ supply curves will typically be elastic. Firms that refuse to join the cartel increase their output to exploit the situation. Indeed, if outsiders’ supply is perfectly elastic, strict unanimity is crucial; any departure from 100% participation renders the cartel impotent. In contrast, if 50% of all people who benefit from clean air decide to “do their part” by buying low-pollution cars, they can make a significant dent in the problem. As long as the outsiders already pollute to the selfishly optimal point, an improvement in the level of air quality has no effect on their marginal incentive to pollute. Half of the drivers pollute less; half pollute the same; air quality improves. Of course, neither the cartel nor the clean air movement fully solves its public good problem. The point is that voluntary pollution abatement is a partial success, whereas the voluntary cartel is a full failure.

Outline of a Critique of Tyler Cowen’s “Law as a Public Good”, by Bryan Caplan

In July 1993, Bryan Caplan wrote Outline of a Critique of Tyler Cowen’s “Law as a Public Good”, in August 2004, Jay McCarthy read it.

The summary provides a good picture of what the issue is:

Many critics of free-market anarchism have argued that collusion rather than competition would prevail, making anarchism no more attractive than government. However, up to now very little attempt has been made to justify this claim. On its face, the idea that defense services are a natural monopoly is highly implausible, as David Friedman points out in his _Machinery of Freedom_.

It is for this reason that Tyler Cowen’s recent critique of anarchism is a major contribution to the debate. For in his “Law as a Public Good: the Economics of Anarchy,” Cowen puts forward a powerful reason to buttress the view that collusion would prevail. There are certain industries, which we may call network industries, that have a peculiar feature: competing firms must also cooperate (to some extent) with their supposed competitors in order to be in business in the first place. Normally, competitors have no reason to trade with each other — why should one supermarket have any dealings with another? But this is not always the case: in industries like credit cards, banking, and franchises, competing firms must also cooperate. [...]

Well, so what? Why does it matter that in certain industries, competitors must also cooperate to a limited extent? The answer is that this industry structure can make collusion work. [...]

What does all this have to do with the viability of free-market anarchism? Cowen’s answer is that the defense industry is a network industry. Just like the industries discussed earlier, defense firms must cooperate with their competitors (to a limited extent) in order to do their job. In the event of a dispute, competitors must agree to arbitrate with their rivals in order to preserve peace. (Moreover, all of the advocartes of anarchism have forcefully argued that any sensible businessman would do precisely that.) But the very possibility of peaceful cooperation between competitors indicates that we have a network industry on our hands; and such a network, immune to the usual checks against collusion, is likely to suppress competition in the mutual interests of the members. In particular, since the defense industry, taken as a whole, has a near-monopoly on force, the entire society would be in danger should the various firms in the industry succeed in colluding. The united defense industry could do whatever it wanted. Anarchy would be transformed in a state of the worst sort.

Caplan’s critique makes us of a few points:

  • Competing Networks
  • Private Supply of Public Goods for Self-Interested and Altruistic Purposes (This contained some insightful nuggets.)
  • Varying Degrees of Network, due to:
    • Degree of Linkage Amongst Members
    • Lumpiness of Transactions
    • Service-Oriented or Member-Oriented Networks
    • Origin of Network: Designed or Evolved?
    • Independence from the Network
    • Propensity to Use Collusive Power

He then deconstructs a possible defense industry and tries to ascertain if it would be a powerful, collusive network industry. The resolution is “No.” And it centers on the: local nature of crimes, general independence of criminals, its relation to common law, and the diverse variants of defense a firm may pursue (some that exist today.)

Finally, Caplan makes an interesting observation and briefly describes his version of anarchy. I found the observation to be very insightful:

As I suggested in conversation with Cowen, people seem to behave “altruistically” (“ideologically” might be a more neutral word) in one sphere of life but not the rest. In their role as private individuals, people give huge amounts of money to charity. But very few businessmen run their businesses like charities, even if they are charitable people. (Even there, though, most people wouldn’t murder for a living, even if the pay were good.) Perhaps this is a way to solve Cowen’s paradox, that if private supply of public goods works, then collusion works, and if collusion doesn’t work, then private supply of public goods doesn’t work either. If people are (somewhat) ideological qua private individuals, but profit-maximizing qua businesspeople, then both good results (non-collusion and private supply of public goods) can spring from the same group of people.

Another related observation: While in their business roles people are probably less charitable than in their private roles, most businesspeople still feel somewhat constrained by morality. Most wouldn’t murder or steal to increase profits. In a way, the business role tends to relax some, but not all, of the moral constraints that they feel as individuals. (Not that this is a bad thing — I agree with Milton Friedman that managers should be charitable with their own money, not their stockholders’.) Compare this to the governmental role: this seems to relax almost all of the moral constraints that people feel. It is a truism that the gentlest people will kill for their governments; but how many would kill for their employers? So perhaps this is another reason (and not just a deus ex machina) to think that ideological constraints on abuse of power would work better in an anarchist society.

The Market for Martyrs, by Laurence R. Iannaccone

Laurence R. Iannaccone describes The Market for Martyrs in this interesting PDF from George Mason University.

It looks at religious violence and militant groups from an economic perspective–there are “terrorist firms” supplying some good to an demanding consumer base:

Injury-oriented sacrifice can be modeled as a market phenomenon grounded in exchanges between a relatively small supply of people willing to sacrifice themselves and a relatively large number of “demanders” who benefit from the sacrificers’ acts. Contrary to popular perception, it is on account of limited demand rather than limited supply that markets for “martyrs” so rarely flourish. Suicidal attacks almost never profit the groups best equipped to recruit, train, and direct the potential martyrs.

He touches on the many interesting costs and difficult risks of running of a terrorism business:

In contrast to legitimate businesses, terrorist firms face the threat of capture, imprisonment, or execution. This does much more than merely raise costs; it forces the firm to adopt internal structures that are larger, more complex, and more vertically integrated than would otherwise be efficient. The terrorist firm incurs high “transaction costs” when working with other firms or the general market. To avoid detection, the firm must conduct its market transactions through complex, covert, and costly channels. This is, of course, especially true when seeking specialized inputs such as explosive devices or military hardware. Subcontracting is similarly costly insofar as it raises the risk of detection through covert surveillance, intercepted communications, betrayal, or capture of the subcontractor. Vertical integration minimizes these external costs, but does so at the cost of larger and more costly internal forms of organization, including division of the firm into many different sub-units. The proliferation of subunits is especially pronounced for terrorist and revolutionary organizations, which face such grave risks from defection or discovery, that they typically divide themselves into numerous small cells (which also help to reduce free-riding).

I found this quote to be intriguing as well, if only for its delicate skirting around saying what needs to be said:

Who pays? Even if all other problems can be solved, the terrorist firm may have no effective way to “sell” its product. Although no one cares to call suicide attacks a “public good,” the consequences are public in the sense of being non-excludable and nonrival. Hence even if many people attach great value to the attacks, each individual person will have no incentive to pay for the product either before or after the fact. Standard economics solutions are largely out of the question, because they require collective action that virtually guarantees detection by authorities.

And finally, something that seems incredibly important:

Lost in most studies of religious militancy is a crucial fact: religious extremism almost never leads to violence. Thousands of “sects” and “cults” flourish in every region of the world and every religious tradition. Their deviant beliefs and behavior cover every conceivable aspect of life and many demand astonishing levels of commitment and obedience. Yet very few turn to crime, fewer still embrace violence, and virtually none encourage murder or suicide. Inevitably, the exceptions receive tremendous attention in the news, research literature, and popular consciousness; but this is precisely because they are so exceptional. To put the numbers in perspective, consider that the United States in home to several thousand religious organizations (Melton 1991; Melton 1986) but in the past two generations only two religious leaders have ordered killings: Jim Jones of the People’s Temple and David Koresh of the Branch Davidians. 30 And only two groups have embraced suicide: the People’s Temple and Heaven’s Gate. The remaining 99.9% of religious groups (who probably account for 99.99% of actual members) are guilty of doing nothing even remotely similar. 31 Keeping this fact in mind is exceedingly difficult, when books on fundamentalism routinely carry titles like Terror in the Mind of God (Juergensmeyer 2001) or The Battle for God (Armstrong 2001).

Patent Theory versus Patent Law, by Alexander Tabarrok

Alexander Tabarrok, of the Marginal Revolution and George Mason University, writes this paper, Patent Theory versus Patent Law about, you guessed it, how patent theory compares to patent law as it is practiced. Refer to this blog post on how to get the PDF.

Abstract

The abstract, verbatim:

According to the economic theory of patents, patents are needed so that pioneer firm have time to recoup their sunk costs of research and development. The key element in the economic theory is that pioneer firms have large, hard to recoup, sunk costs. Yet patents are not awarded on the basis of a firm’s sunk costs. Patent law, in fact, ignores costs. The disconnect between patent law and patent theory suggests either that modifying patent law so that it better fits with patent theory would reduce the costs and inefficiencies associated with current patent practice or that the standard economic theory of patents is wrong.

Introduction

Alexander first explains the economic theory briefly and then puts forth the shape of his argument:

Although the economic theory is well accepted, I argue that it does not fit well with the actual patent system. A patent system designed around the idea of recouping sunk costs would look quite different than the current system. In particular, as I will explain below, the current system ties returns to innovation to the benefits of a patented idea, i.e., as the value of the idea increases monopoly profits increase. Yet the economic theory of patents implies that returns should be tied to the sunk costs of researching and developing the patented idea.

The poor fit between the economic theory of patents and the actual patent system suggests two alternative hypotheses. Either the theory is correct and the patent system is poorly designed, or the patent system is well designed but not for the purposes of recouping sunk costs. Which of the two hypotheses one prefers depends in part upon one’s priors about therelativeefficiency of theory versus practice. My primary approach is to assume that the economic theory is correct. Thus, I argue for reforms that would bring the patent system more into accordance with the economic theory.

Theory

This section explains the theory of patents and briefly mentions that the current patent system is not connected to the economic theory because it ignores the costs that innovates face that imitators do not. Those are sunk costs that the economic theory is concerned with.

An interesting observation of this section is that when a product’s value is high, it should not be protected as much as a product whose value is low. This is because since the sunk costs are not related to the benefits, they are repaid easier.

Practice: Examples of Patented Products with Low Innovation to Imitation Costs

Amazon’s “one-click purchasing” is a patent that was granted for something with little to no R&D costs. Another is the discovery of a medical procedure, which by definitions means there were not R&D costs.

Edison famously said that “Genius is one percent inspiration, ninetynine percent perspiration.”8 A patent system should reward the ninetynine percent perspiration, not the one percent inspiration. In inventing the lightbulb, for example, Edison laboriously experimented with some 3000 possible materials for the filament, before hitting upon carbonized cotton thread (Shulman 1999). If Edison were to patent the lightbulb today he would not need to go to such lengths. Instead, Edison could patent the use of an “electrical resistor for the production of electro-magnetic radiation,” a patent that would have covered oven elements as well as lightbulbs.9

Proposal

The key thing that needs to be done is that the sunk costs of an patented product must be integrated into patent policy, somehow. Alexander proposes multiple ways of doing this:

  • Changing what products can be patented, preferably by looking at standard innovation/imitation cost ratios in the industry.
  • Changing the probability that a patent is granted (or enforced.)
  • Changing the length of the patent.
  • Changing the breadth of the patent.

An interesting suggestion is to register innovations but not award patents, instead you wait twenty years and estimate how much the innovation was worth and award that with interest. This solves the problem of not being able to estimate correctly the benefits of the innovation before hand.

The “realistic” proposal that does not strive for complete perfection is to allow firms to apply for patents of varying lengths, and as the length increases the scrutiny of the patent office. But, Alexander tries to point out many changes that may not require legislation and would instead modify the discretion of patent examiners and infringement judges.

Objections and Implementation

“Perhaps the strongest objection against a patent system that takes into account sunk costs is that measuring sunk costs is difficult (Scotchmer 1988).21 If the sunk costs are born by the patent applicant then this problem does not seem overly difficult.”

And ever the economist:

In order to improve the current system it is not necessary to estimate sunk costs precisely so long as they can be estimated well enough to reasonably assign patent duration to a limited number of categories. If sunk costs justify a patent of 20 years, for example, it’s unimportant whether they are two, three or four times greater than necessary. The thrust of this proposal is to make marginal changes in the current patent system rather than to replace that system with something entirely new.

(Note: There’s a typo in note 23, “The higher sunk costs are” not “The higher are sunk costs”–I think.)

There is Little to Lose from Patent Reform

If it were clearly true that on net the patent system increased economic growth and technological advancement then on precautionary grounds alone there would be a good case against reform. But the consensus from many studies of innovation is that most innovations would occur without patents.

Alexander then discusses the proof of this that has been studied and documented by others. He also cites in the footnotes someone, Cohen et al. (2000), who found that “much patenting is simply generated by the patent system itself as firms patent in order to protect themselves from the patenting of other firms.”

But, Tabarrok recommends merely weak patents in cases where there are not useful, because they are useful in some instances. He is not completely against patents for any ideological reason.

Other Theories of Patents

In this section he addresses the concern that perhaps the economic theory of patents is wrong and that either another theory is necessary, whether it is another defined one (e.g. the disclosure theory) or a theory implicit in the current patent system.

Conclusion

Another brief summary like the abstract.

And here, I will leave myself a note to compare this paper with François-René Rideau‘s discussion of patents in Patents Are An Economic Absurdity, when I get a change to read it.