Lecture Notes 14: R&D and Patents
Some Basic Economics of R&D
Most economists agree that research and development (R&D) is the basic lifeblood of capitalist economies. Indeed, it is basic macroeconomics that technological innovations are the only source of permanent growth in standard of living. The fact that standard of living has grown more in the 200 years or so since the industrial revolution than in the previous 100,000 years of human existence is almost entirely attributable, at its core, to technological innovation. Research and development raises productivity.
Firms undertake large investments in R&D, although the amount varies considerably by industry. Recent estimates for US firms are that the software industry spends about 14% of its revenues on R&D. Healthcare and electronics are also big spenders on R&D, both coming in at about 10% of revenues. The World Bank estimates that the US economy as a whole invests a little less than 3% of its GDP on R&D. This is a fairly typical number for industrialized economies, although South Korea and Israel come in above 4% of GDP.
Governments provide significant incentives for R&D, either directly or implicitly through the tax system. For example, in the US, firms can write off R&D expenditures from their taxes. And the government spends over $100 billion directly on R&D, either in government agencies or via universities and private firms.
There are good reasons for government support. The basic problem is a positive externality. New innovations provide benefits for the firm that finances the innovations. But the flow of new ideas produces benefits for other firms, and of course for consumers as well. As a result, the social
benefit produced by R&D spending is much higher than the private benefit by the firm that undertakes the expenditure. It is then simple economics that spending on R&D will be at lower than the optimal level โ the firm pays the costs of its R&D expenditures privately, but many of the benefits are public.
To be more specific, we can think of information generated by R&D as a public good. It is nonrival
โข Outright copying or โreverse engineeringโ is often not that difficult. Software is a good example, where reverse engineering is almost routine.1 Same thing with pharmaceuticals. Chemicals are easy to synthesize once the formula is known.
โข Trade secrets are hard to keep. Information can leak.
โข Even if the information is protected by a patent, many patents are difficult to enforce and many new inventions are essentially โinventing aroundโ an existing patent.
There is strong evidence of these information spillovers. Imitators typically bear about 40% lower costs than the original developers bore. Indeed, estimates are that firms are able to duplicate new innovations about 98% of the time. And in 70% of cases reviewed, 6 or more firms were able to produce an imitation. The time to successful imitation in manufacturing industries is typically only a year or two.
If you put all of this together, it is clear that there are substantial positive spillovers from firm expenditures on R&D. Many of the benefits created by R&D are external to the firm that undertakes the investment, so innovation will be at less than the socially optimal level.
Market Structure and Incentives to Innovate
Consider a firm that can invest in an innovation that will reduce its marginal cost of production. And suppose for the moment that the firm is able to protect its innovation and that it alone will benefit from the new technology.
The social benefit created by the new innovation includes the new profit and the new consumer surplus that results from reduced marginal costs. Of course, weโre back to a familiar argument โ the firm keeps only the profit, and so it may not pay for the firm to invest in new innovations even if it is socially efficient to do so. In other words, the Profit + CS may be large enough to cover the cost of the innovation, but the firm undertaking the cost captures only the profit.
A standard result in these models is that incentives to innovate are higher in competitive markets than for monopolies. The basic reason is that the monopoly already earns an economic profit, whereas the competitive firm is stuck at zero profit prior to the new innovation.2
1 In fact, a judge ruled in 1992 that reverse engineering of software is perfectly legal and a fair use of the software. 2 This is called the replacement effect โ the new innovation just replaces some of the already-existing profit. Another
To summarize, a monopoly has less incentive for R&D than a firm in a competitive market, but both have less than the socially optimal incentive for R&D.
And this is the most generous case โ we have assumed that the firm is able to protect its innovation. If the innovation can spill over to other firms, then the private incentives for R&D are even lower.
Protection of Intellectual Property
We have argued that firms on their own do not have an incentive to engage in the efficient level of R&D because of the spillover problem โ many of the benefits spill over to other firms. In the most extreme case, if a firm invents a new product and the market immediately becomes competitive, then the firm investing in the invention would get no profits from the invention and thus would have no incentive to undertake the R&D spending in the first place.
In an attempt to limit spillovers and to encourage R&D, most capitalist economies provide substantial protections for intellectual property.
Patents
Patents provide an inventor with exclusive rights to a โnew and useful product, process, substance or design.โ In the US, there are over 600,000 patent applications every year, about half filed by Americans and about half filed by foreigners. A bit fewer than half of these are typically approved. The US has had patent protection since 1790, and millions of patents have been approved since then. Corporations patent more than individuals do.
US patents typically give 20 years of protection, although that may be extended, e.g. in cases where the company has a long approval period and would not be able to actually enjoy 20 years of exclusive sales rights.
There are a number of requirements to file a patent.
โข The invention must be useful.
โข The invention must be novel.
โข The invention must be nonobvious. For example, you cannot patent a slight modification that is known to everyone in an industry.
โข The invention must be publicly disclosed.
โข The inventor must provide a working model, if available.
Copyrights
While patents cover function and purpose, copyrights cover artistic expression. Specifically, a
copyright gives creators exclusive production, publication and sales rights to artistic, dramatic, literary or musical works.
For an individual who copyrights his own work, copyright protection extends for the life of the author plus an additional 70 years. Works copyrighted by businesses are protected for 95 years.
Trademarks
Trademarks are words, symbols or other marks used to distinguish a good or service provided by one firm from that provided by other firms. Unlike patents and copyrights, trademarks do not expire after a fixed term. Trademarks can be lost if a word develops into a generic descriptor for a product rather than a particular brand. โAspirinโ, โescalatorโ, โtrampolineโ and โyo-yoโ all started out as brand names.
Optimal Patent Length
The basic problem of patent policy is a simple tradeoff. Patent protection creates temporary monopoly power, which is bad for society because it leads to monopoly markups and deadweight loss. On the other hand, protection of intellectual property increases incentives for firm R&D by letting them keep a larger portion of the benefits that their expenditures generate. Patent policy must therefore balance between providing incentives to innovate and generating benefits to society from free market competition (price reductions).
We will first address the question of optimal patent length. The workhorse model was developed by Norduaus (1969). The big idea is that the patent must be long enough to generate sufficient profits to encourage the innovation, but no longer. A patent that lasts any longer than this simply adds deadweight loss from the monopoly markup.
Suppose that firms choose their levels of R&D, which we call ๐ฅ๐ฅ. A firm that engages in R&D enjoys patent protection for ๐๐ years, after which the patent expires and it no longer earns profits from the innovation. The present value of the profit stream from the R&D is given by ฮ (๐ฅ๐ฅ, ๐๐). The cost of the R&D is ๐๐(๐ฅ๐ฅ). The firm will choose its R&D spending ๐ฅ๐ฅ to maximize net present value:
ฮ (๐ฅ๐ฅ, ๐๐) โ ๐๐(๐ฅ๐ฅ)
So how should the government choose the patent length ๐๐? The government cares about firm profits but it also cares about consumer surplus. And the longer the patent life ๐๐, the longer consumers will have to wait to enjoy lower prices, and the lower consumer surplus will be. The present value of the stream of consumer surplus for society is given by ๐ถ๐ถ๐ถ๐ถ(๐ฅ๐ฅ, ๐๐). Thus, the governmentโs objective in setting patent policy is to choose ๐๐ that maximizes social welfare, which includes both firm profits and consumer surplus.
Social Welfare = ฮ (๐ฅ๐ฅโ, ๐๐) โ ๐๐(๐ฅ๐ฅโ) + ๐ถ๐ถ๐ถ๐ถ(๐ฅ๐ฅโ, ๐๐)
In doing this calculation, the key thing to take into account is the โbackwards inductionโ. The government has to figure out how much research ๐ฅ๐ฅโ(๐๐) the firm will find optimal, depending on the patent length ๐๐ that it sets. The government should take this as given and find the optimal patent length accordingly.
In any case, you can see the tradeoff. A longer patent length means that the firm engages in more research, but it also means a longer delay in realizing the consumer surplus from lower prices and the elimination of the monopoly markup.
There are a few insights from the Nordhaus model.
1. The optimal patent length is positive, but finite โ If there were no patent protection at all (๐๐ = 0), the firm would get no benefits from R&D spending and would not engage in any. As ๐๐ gets larger, firms engage in more R&D, but itโs also more costly, and the extra profit at the end is discounted quite heavily โ so the benefit to society from increasing ๐๐ is diminishing the longer and longer we extend the patent. On the other hand, society gains from shortening ๐๐ because of the increased consumer surplus. At some point, the benefit of additional years of patent protection (more research) are not sufficient to outweigh the loss in consumer surplus. This is why the optimal choice of ๐๐ is finite.
2. The optimal patent length is shorter when demand is more elastic โ When demand is elastic, there is a large reduction in sales and consequently a large deadweight loss from the monopoly markup generated by the patent. Thus, the benefits are higher from ending the patent more quickly.
3. The optimal patent length is shorter when R&D is more costly โ When R&D is more costly, the net benefits to society from incentivizing it fall.
Optimal Patent Breadth
The previous section covers the tradeoffs in setting patent length โ that is, how long patent protection should last. A related question concerns the breadth of patent protection โ that is, how broadly should innovations be defined? Should firms be allowed to pursue legal action against any rival that even comes close to its patent? Or should patents be very narrow, allowing rival firms to legally develop variations on the patented innovation? Again, there are tradeoffs and a number of important considerations.
Note that the question is intimately related to patent length. If patent protection is very narrow, then patent length may be practically irrelevant. Close imitations may erode monopoly profit before the patent actually expires.
The seminal research in this area is by Gilbert and Shapiro (1990), who argue that patents should be long but narrow. If the patent is very broad but expires quickly, then there is likely to be a big โjumpโ in the price as soon as the patent expires. Generally, society works better with smoother transitions. Gilbert and Shapiroโs idea is to have a narrow patent that rival firms gradually innovate around, leading to a smooth reduction in price as imitation gradually seeps through. The expiration of the patent itself wonโt have a sharp impact.
By contrast, Klemperer (1990) argues for patents that are short but broad. His basic idea is that consumers wonโt be forced to repeatedly bear โswitching costsโ in moving to lower-priced alternatives as imitations gradually seep out. If the patent is all-inclusive but short, consumers will just wait for the patent to expire. Gallini (1992) adds that this scheme avoids wasteful firm expenditures on imitation. Since the patent is broad, rival firms can just wait a few years for the patent to expire instead of spending money trying to reverse engineer and imitate.
In any case, the basic tradeoff here is really the same. Broad patents create high prices, deadweight losses and allocative inefficiency. But we still need to ensure somehow that firms are able to capture enough profit to provide incentives to develop the innovation in the first place.
Some Policy Alternatives
No Protection for Intellectual Property
Another problem is that lack of legal protections for intellectual property are likely to reduce investment in R&D, which again is the primary growth engine in market economies. We have some evidence on this. In 1989, 40 countries did not grant patents for pharmaceutical drugs. India did not grant patents for pharmaceuticals until 2003, when a settlement with the World Trade Organization required them to start doing so. Evidence appears to show that the loss to consumers and domestic firms (imitators) far exceeds the increased profits for Western companies. However, this is static analysis and does not consider the long-term impacts of discouraging research. On this front, the long-term estimate is that โ for each $1 gained by consumers in the form of lower prices from lack of patent protection, consumers lose $3 from foregone research and product development that is not undertaken because of the lack of protection for intellectual property.
Government-funded Research
One option here is outright payments. In Japan, nearly half of R&D expenditures are directly funded by the government; estimates for the US hover around 30% of R&D spending. The US also maintains heavy subsidies for R&D indirectly, through the tax system. For example, there is a 20% tax credit for R&D expenditures.
Simple economics would suggest that this is the solution to the whole problem โ If private R&D expenditures are suboptimal because of the positive externality effect created by R&D, then the government can subsidize private R&D spending to incentivize it, just like they do with other activities that generate large positive spillovers for society (e.g. vaccines and education). Furthermore, by doing it this way, the government could incentivize research while avoiding the deadweight loss from monopoly markups built into the patent system. Nevertheless, there are two serious problems in this context.
1. Incentive problems โ If the government subsidizes R&D spending, then firms might not be as careful in using the money for wisely and for projects that are likely to generate results. As we said earlier in the course, lots of failures are typically required to reach a successful project. But if the government subsidizes both successes and failures, firms might be less cautious about avoiding failures.
2. Information problems โ The government probably is not in a good position to measure the true costs and benefits of research, so figuring out the optimal subsidy level is a problem in practice.
Prizes
own private costs and expected benefits from searching. The problem is that, from the perspective of society, the additional probability of discovery from adding another firm is not worth the additional cost of having more searching firms. The additional probability of a discovery from adding a new firm might be very small, but the new firm engages in the research for the chance that it can get there first and win the prize.
Joint Ventures
One solution to the spillover problem might be to allow firms to engage in joint research, whereby they share R&D costs and all of them benefit from successful projects. A closely-related option is a patent pool, whereby participating firms agree to cross-license patents to each other.
One policy problem is that such cooperation can potentially run afoul of antitrust laws. The government might suspect that, if the firms are cooperating on product development, they are also likely to coordinate on pricing and production. Congress has tried to relax rules on this recently, in order to support more joint research ventures. Patent pools are also common. The original DVD technology was disseminated via a legally-approved patent pool.
Another observation to make is that, even though joint ventures can eliminate the externality / spillover problem to some extent, they do not eliminate it completely. While joint ventures solve the problem of outside firms benefitting from private R&D expenditures, the joint project still does not feel the full social benefit of its R&D projects, because some of these benefits accrue to consumers in the form of consumer surplus. We are back to a familiar argument โ firms, even acting jointly, only capture the producer surplus that results from new innovations. But this is not the full social value of the innovations, because the full social value also includes the consumer surplus. Thus, even if firms can prevent spillover to other firms, they still have an incentive to engage in less than the efficient level of R&D.
Finally, although joint ventures can reduce spillover to other firms, they canโt eliminate it completely. This is particularly true in settings where firms not involved in the venture can themselves imitate the innovations produced by the joint venture.
Licensing
What if we allow a patent holder to transfer his exclusive selling rights to someone else? This arrangement is called licensing, for which the patent holder normally earns a royalty.
inventions can be disseminated to society. In addition to being able to manufacture more efficiently, a licensee may have access to markets that a patent-holder would not (e.g. an overseas market).
One important point is that there can be a difference between minor innovations with small reductions in costs and major innovations that reduce costs by a large amount. In a Cournot Oligopoly, a firm that develops a technology that reduces costs by a modest amount is better off licensing the technology to its rivals (and charging the maximum royalty the firms are willing to pay) than it is by hording the innovation for itself. On the other hand, if the innovation is โdrasticโ and reduces cost by a sufficient amount that it could drive rivals completely out of business, then the firm is better off not licensing the new technology and instead operating as a monopoly.
What form should the royalty take? If the patent-holder charges per-unit price to the licensee, then the patent-holder faces a double marginalization problem. The licensee would manufacture less than the optimal number of products. A better solution is a two-part tariff. The patent-holder should charge little or nothing for each per-unit use of the license, and then charge a fixed fee for the right to hold the license. The patent-holder can theoretically appropriate all of the surplus generated by his patent using this scheme.
Which is the best option?
Should we prefer government solutions or market-based solutions? If the government has full information, then government-financed research is the most efficient solution to the problem. By providing subsidies or by directly funding research, the government can correct for the spillover problem and can incentivize the efficient level of research. This is theoretically superior to the patent system as a way to correct for spillovers because it can incentivize the proper level of R&D without requiring a period of markups and monopoly deadweight loss, as a patent does.
The problem is that inventors are likely to have more information than government officials about new technologies and about the costs and benefits of innovations. Recognizing that the government has limited information, patents may lead to better outcomes, even taking into account the deadweight loss that they generate.
Patent Races
Consider a model where two firms are engaging in continuous R&D to produce some new innovation, but only the firm that succeeds first will be able to patent the product and collect any royalties on it. This is called a patent race. What can we say about the level of research spending in such a setting, relative to the socially optimal level? It turns out that anything is possible.
โข If the cost of R&D is too high, then firms might not bother to engage in the search at all. Even if the innovation would produce benefits that exceed costs, searching firms only have a chance of getting any benefits from it. These expected benefits might not be sufficient to outweigh the cost for the firm to engage in the research. In this case, patent races produce less than the efficient level of R&D. And, again, the firm is only factoring in its own profits from R&D, not the consumer surplus.
โข If the cost of R&D is lower, then firms might engage in too much research relative to the optimal level. The basic problem is wasteful duplication. Each firm thinks only about its own potential gain from winning the race, not about the fact that a โwinโ will reduce the other firmโs profit. This boils down to a prisonersโ dilemma, and both firms end up engaging in vigorous and costly search to be the winner.
Conclusions
For some final perspective on this issue, economists are not in agreement about the whole concept of patents. There are a group of economists who argue that patents are not all that important for incentivizing innovation. Levin, et al. argue that, in order, the following are the most important ways for firms to protect their returns from a new process or innovation:
1. Lead time (moving first) 2. Learning-by-doing
3. Good sales and service to lock in customers 4. Secrecy
5. Patents
To close with some brief comments about policy, patent cases are the only cases in the federal system that are handled by a dedicated court that is specialized in patent issues. In the 1980โs, this court developed a strong pro-patent legal framework. In light of these enhanced protections of patent rights, the pace of patent applications picked up rapidly.
2006 case almost forced Blackberry to shut down because a firm claimed that they had patented the idea of pushing emails to a mobile device in 1990. The firm (NTP) never produced a single product or applied for any licensing, but nevertheless was able to protect their patent in court. Many economists worry that cases like this create excessive risks for entrepreneurs. Other economists warn that weakening intellectual property protections can reduce the incentives for innovation.
Exercises
Problem 1
Consider a market where the demand is given by ๐๐ = 240 โ ๐๐. The marginal cost of production is initially $120 per unit. There is a new innovation that can reduce marginal cost to $60.
a. Consider a monopoly. What are profits before the innovation? What are profits after the innovation? How much is the monopoly willing to pay for the innovation?
b. Now suppose that the market is a Cournot oligopoly and that only one of the firms has an opportunity to develop the new innovation. What are the firmโs profits before the innovation, when both firms have the same costs? What are the firmโs profits after the innovation, when one firm benefits from the reduced cost? How much is the Cournot duopolist willing to pay for the innovation?
c. Now suppose that the market is a Bertrand oligopoly, and that only one of the firms has an opportunity to develop the new innovation. What are the firmโs profits before the innovation, when both firms have the same costs? What are the firmโs profits after the innovation, when one firm benefits from the reduced cost? How much is the Bertrand duopolist willing to pay for the innovation?3
d. Suppose now that the innovation takes some time to develop and that the cost reduction occurs several years down the road from the research expenditure. In general, how does an increase in the interest rate impact the incentives to innovate?
Problem 2
Consider a Cournot oligopoly with two firms. Market demand is ๐๐ = 120 โ ๐๐. The marginal cost for both firms is currently $60.
a. Find the equilibrium outputs and the profits of each firm.
b. Now suppose that one firm can reduce its marginal cost to $30. If it keeps the innovation to itself, what will be the equilibrium output and profits?
c. Suppose that the innovating firm licenses the technology to its rival for a cost ๐๐ per unit manufactured. What is the rivalโs output, as a function of ๐๐? What is the innovatorโs profit, as a function of ๐๐? What value of ๐๐ maximizes the innovatorโs profit, and how much profit does the innovator earn?
d. Suppose instead that the innovating firm licenses the innovation to its rival for a fixed licensing fee ๐ฟ๐ฟ (and no royalty). What is the maximum fee it can charge? How much profit does the innovator earn?
e. Do consumers prefer the royalty or the licensing fee?
