Law

Intellectual Property
Economics of Intellectual Property: Innovation
and Creativity- Policy Linkages

Development Team
Role Name Affiliation

Principal Investigator Professor (Dr.) Ranbir Singh Vice Chancellor, National

Law University, Delhi
Paper Coordinator Mr. Yogesh Pai Assistant Professor of
Law, National Law
University, Delhi
Content Writer (CW) Swaraj Paul Barooah Founder: KNOW-GAP
and Coordinator SPICY
IP
Content Reviewer (CR) Mr. Pratyush Kumar National Law University,
Delhi
 Module Detail
Subject name Law

Paper name Intellectual Property

Module name/ Title Patents- Compulsory Licensing /other uses without

authorization
Module Id Law/IP/# 04

Pre- requisites Basics of law and economics, concepts of IP law, need for IP law,
theories of IP law
Objectives To get a fundamental understanding about economic aspects of
innovation and creativity and how intellectual property as a
dominant mode of knowledge production performs its role,
along with relevant limitations.
Key words Intellectual property economics, law and economics, innovation
policy, private property, incentive theory

2
 Structure of Module

Topic
Sub Topic
Introduction

1. Economic Analysis

2. Incentive theory

3. Private property rights determining patterns of

productivity

4. Racing & non-coordination issues

Summary

Self Check Exercises

Introduction

The intellectual property regime currently serves as the most prominent cog of modern
society’s innovation mechanisms. With the knowledge economy ever expanding,
appropriation rights over information plays an increasingly vital role to economic growth and
development, as well as modes of cultural production and dissemination. With the rise of the
law and economics movement, 1 the economic analysis of intellectual property has created
much debate. While first wave of scholars focused exclusively on IP rights as drivers of
economic activity, the second wave scholarship evolved to place IP norms within a larger
economic context, so as to better understand the ‘rate and direction’ of cultural change and
technological growth, by accounting for the broader range of socio-economic norms within
which the IP paradigm finds itself.2 Given this broader context, the second wave has also
employed many different methodologies to study issues of the economics of IP rights.

The economic analysis of law can be defined as “an application of economic methodology to
explain and evaluate the formation, structure, process and impact of law and legal
institutions”.3 This includes positive analysis (current regime and its consequences) as well as

1
See generally, Richard Posner, Intellectual Property: The Law and Economics Approach, 19(2)
(2005), J ECON PERSPECT, 57.
2
For more on the major differences between first wave scholarship and second wave scholarship, see
ROBERT MERGES, ECONOMICS OF INTELLECTUAL PROPERTY LAW, 2014, forthcoming in Parisi (ed),
Oxford Handbook of Law and Economics.
3
Eli Salzberger, The Law and Economics Analysis of Intellectual Property: Paradigmatic Shift from
Incentives to traditional property, (2010), available at http://ssrn.com/abstract=1574994.

3
normative analysis (prescription of desirable consequences). As this chapter focuses on the
role of IP in innovation and its policy linkages, it will mainly focus on the normative analysis.

Learning Outcome:
 Will be able to understand the need for study of economics of IPRs
 Will be able to understand the nature of inquiry in economic analysis of
intellectual property
 Will be able to understand the relevance and methods of applying economic
analysis to IP
 Will be able to understand the nature of economic distinction between IP as a
public good and other properties (land and chattels) as private goods.
 Will be able to examine the incentive theory of IP
 To understand the patterns of productivity in economic analysis of IP
 To understand the limitation and critiques of dominant economic analysis of IP

1. Economic analysis

The four major justifications of intellectual property rights include the natural rights/lockean
theory, the personhood/kantean theory, the social welfare/democratic theory, and the
utilitarian theory. Of these, the economic analysis of the law primarily concerns itself with the
most widely accepted of the four – the utilitarian theory of intellectual property.

The utilitarian theory justifies intellectual property rights as mechanisms that can be used to
maximize social utility or social welfare. While easily comprehensible as broad principles,
converting this into practice requires two levels of questioning. Firstly, the question of how to
achieve this utilitarian ideal of ‘greatest good for greatest number’, or maximum social
welfare. And secondly, how this method, whatever it is, can be applied to intellectual property
law.

As the first question relates to the general law and economics approach, it will not be dealt
with in detail here. Essentially, there are two methods commonly used to maximize social
welfare – (i) the Kaldor Hicks criterion4: a measure of economic efficiency which focuses on
maximizing welfare by preferring outcomes where the party gaining from the shift from one
scenario to the other, could (either practically or even just theoretically) compensate the party
being made worse off, and after such compensation, still be better off; or (ii) wealth
maximization5: a method of achieving welfare maximization by focusing on the proxy of
wealth as a measure of social welfare. Thus a wealth maximization system is one which
prefers outcomes that maximize welfare as measured by consumers’ ability and willingness to

4
Nicholas Kaldor, Welfare Propositions in Economics and Interpersonal Comparisons of Utility,
ECONOMIC JOURNAL 69 (1939), 549-52.
5
RICHARD POSNER, ECONOMIC ANALYSIS OF LAW (3d ed), 1986, pp. 11-15.

4
pay. While these two approaches have individual nuances as well as separate critiques, some
scholars have strongly contended that in any case, the Kaldor-Hicks criterion as a method of
maximizing social welfare, in practice, starts tending towards wealth maximization.6

The second question of how to translate this ‘maximum social welfare’ into precise
administrable terms has led to broadly three different approaches.7
Firstly, the incentive theory, that states that social welfare can be maximized by ensuring that
the efficiency gains made by incentivizing innovation through allowing exclusionary rights
(IPRs), are greater than the deadweight losses and other costs incurred by allowing artificial
restrictions on the use of information goods.
Secondly, that ‘property’ rights are the most optimal method of determining patterns of
productivity that will most likely enhance consumer welfare.
And thirdly, that intellectual property rights can be used to reduce duplicative or
uncoordinated research and innovation activity.

Points to Remember

The utilitarian theory justifies intellectual property rights as mechanisms that can be used to
maximize social utility or social welfare. While easily comprehensible as broad principles,
converting this into practice requires two levels of questioning. Firstly, the question of how to
achieve this utilitarian ideal of ‘greatest good for greatest number’, or maximum social welfare.
And secondly, how this method, whatever it is, can be applied to intellectual property law.

2. Incentive theory

The ‘incentive’ theory states that in order to incentivize social welfare through a faster rate of
creation of information goods, exclusionary rights over such information goods are required.
Simultaneously though, social welfare is negatively affected by larger deadweight losses and
administrative costs associated with monopoly-induced prices for information goods that
would’ve or could’ve been created even in the absence of the enhanced incentive. As such,
analysis through the ‘incentive theory’ lens focuses on balancing these tradeoffs against each
other.

6
DOUGLAS A. KYSAR, REGULATING FROM NOWHERE, (2010), 104.
7
For a more detailed discussion on this, see William Fisher, Theories of Intellectual Property, in NEW
ESSAYS IN THE LEGAL AND POLITICAL THEORY OF PROPERTY (Stephen R. Munzer ed.,
2001).

5
To better understand how these tradeoffs work, we must look into the nature of the goods. In
economic terms, information goods are known as ‘public goods’8 due to their non-rivalrous
and non-excludable nature.

i. A completely ‘rivalrous’ good is one, which once used, cannot be used again. A completely
non-rivalrous good, in contrast, is never extinguished regardless of how many times it is used.
For example, an apple, once ‘used’ or consumed, can no longer be consumed. On the other
hand, information can be used an infinite number of times without any loss to the
information. I.e., regardless of the amount of consumption of the good, the marginal cost of
providing it to another consumer is zero.

ii. An ‘excludable’ good is one, which at any given point in time, whose use can be restricted
only to a certain number, or certain set of people. In contrast, a non-excludable good is one
which does not and cannot restrict the number of parties who can use it. For example, light
from a lighthouse provides directions to any and all ships that pass by. It is restricted to only
by the extent to which the distance that light can travel and hence it is nearly completely non-
excludable good. Similarly, public parks and roads are mostly non-excludable, unless there is
an entry fee or a toll tax.

Goods are said to be “public goods” when they are both non-rivalous as well as non-
excludable. Many intangible goods, such as ideas, information or knowledge are both ‘non-
rivalrous’ as well as ‘non-excludable’ and thus are public goods. There is no loss in quality or
quantity when information is used or transferred. This means information is most efficiently
used when it is freely and widely consumed.

However, as Kenneth Arrow pointed out in 19629: as public goods such as information or
knowledge are easily reproducible, there is little incentive for the creation of new
information. Once the information is created, the ease with which it can be reproduced or
reverse engineered, proportionately reduces the ability of the creator to recuperate any
investments that she may have made in the creation of such information, thus reducing
incentives to create or innovate. However, when a (limited) ‘right to exclude’ others from
reproducing that information (in the form of a patent or copyright for example), the creator or
innovator is able to appropriate benefits during the exclusion period, by monetizing the
creation through sales or licensing. This exclusion right therefore acts as an incentive which
increases the rate of innovation.

However, as information goods are public goods, there is an inefficiency created by the grant
of this exclusion right. This initial inefficiency that is created by reducing the spread of
information is called a ‘static inefficiency’. As the ability to exclude competitors from the
market allows creators to charge a price above the marginal cost, there is a certain amount of
consumption that will be priced out from using that information at the new cost even though
they may have used it at the marginal cost. This loss is referred to as a ‘deadweight loss’.
Similarly, there are also other costs that arise, such as transaction costs, administration costs
and enforcement costs.10

8
For a detailed discussion on “Public Goods”, see Paul Samuelson, The Pure Theory of Public
Expenditure, The Review of Economics and Statistics, Vol. 36, No. 4. (Nov. 1954), pp. 387-389.
9
Kenneth J. Arrow, Economic Welfare and the Allocation of Resources for Invention, in THE RATE
AND DIRECTION OF INVENTIVE ACTIVITY: ECONOMIC AND SOCIAL FACTORS 609, 623
(Richard Nelson ed., 1962).
10
SUZANNE SCOTCHMER, INNOVATION AND INCENTIVES 36 (2004).

6
This static inefficiency acts as an incentive to increase the overall rate of innovation, thus the
static inefficiency is seen as necessary for ‘dynamic efficiency’. There is a careful tradeoff
involved here as a balanced IP regime ensures that the losses from static inefficiencies are not
greater than gains from dynamic efficiency. Thus, analysis through this lens generally
involves focusing on increasing or decreasing IPR durations, or even breadths, so that the
gains from the innovation incentivized, are higher than the losses from restricting the ability
of such information to flow freely. For example, though often difficult to implement in
practice, ‘price discrimination’ is seen as one method of reducing static inefficiencies.11

A major hurdle with the incentive theory, is that it does not account for non-monetary
incentivies in determining IP policy. Several non-monetary incentives exist, such as prestige
incentives, scientific curiousity, lead-time advantages, etc. In several fields (such as academic
publishing, art, software), it can be argued that these incentives alone may be sufficient to
generate innovative activity. While in some other fields (such as pharmaceuticals), they may
play little to no role, and hence monetary incentives may be crucial. Therefore aside from
requiring empirical evidence with which to make such decisions, policy makers also need to
shift away from the harmonization trend, so as to account for these differences across
different sectors of technology as well as to account for the differing technological capacities
present in different countries or regions.

3. Private property rights determining patterns of productivity

Though the above discussion has focused on ‘exclusion’ rights or property rights over
information goods, there are also other incentive mechanisms which enhance the rate of
innovation over information goods. These include prize mechanisms, 12 government
procurement13 as well as ‘commons’ based models14. Each of these models provide incentives
that overcome the free-rider problem without incurring the ‘static inefficiency’ losses that the
IP regime uses.
In Prize systems, a government or a philanthropic organization offers a financial reward to
anyone who creates a certain invention. Usually the prize is announced prior to the invention
though there are also instances of it being announced after the invention has come to light as
well. Prize systems are slowly generating renewed interest in information economics today,
even as criticisms of the patent system increase.15 Most ‘basic research’ takes place under
grants from the government or philanthropic funds, where, rather than proprietary rules,

11
‘Price discrimination’ is the making available of a product at prices closer to the willingness or
ability of a consumer to pay such price. Perfect price discrimination would allow every consumer to
tailor the price to her ability to pay – however this is not possible to discover in real life. A more
realistic example is national price discrimination, where a product could be sold at $100 in a rich
country, whereas the same product could be made available at $15 in a poor country.
12
See Joseph Stiglitz, Give Prizes not Patents, NEW SCIENTIST 21 (Sept. 16, 2006) available at
http://keionline.org/misc-docs/giveprizesnotpatents.pdf.
13
See Steve P. Calandrillo, Economic Analysis of Property Rights in Information: Justifications and
Problems of Exclusive Rights, Incentives to Generate Information, and the Alternative of a
Government-Run Reward System, 9 FORDHAM INTELL. PROP. MEDIA & ENT. L.J. 301 (1998).
14
JAMES BOYLE, THE PUBLIC DOMAIN: ENCLOSING THE COMMONS OF THE MIND
(2008).
15
Though see Michael Kremer & Heidi Williams, Incentivizing Innovation: Adding to the Tool Kit, 10
INNOVATION POL’Y & ECON. 1 (2010).

7
results are shared under norms of open scientific exchange.16 Similarly, the ‘commons’ based
approach to creation can be characterized as production that is based on collaborative
approaches rather than proprietary approaches. An example can be seen in the example of
Wikipedia, wherein anyone interested can make or edit an entry which is then peer-reviewed
by other volunteers. Another prominent example is the Open Source movement, which has
been particularly successful in the field of software.

The question now arises as to why the IP system is preferred over any of these other systems.
Harold Demsetz answered this question in 1968, by discussing efficiency gains that arise
through market signals.17 He pointed out that a decentralized system, such as the IP system,
could direct innovative resources towards maximizing social welfare, as consumer demand
would determine successes and failures in the market. By extension, goods that met the most
social value would be indicated through market signals. In contrast, for example, in a prize
system, the prize setters would be tasked with determining where or how their prize fund
could maximize social utility; and the cost of generating such information is extremely high.
Market signals thereby efficiently provide direction as to where inventive resources are to be
allocated, as they don’t rely on an entity to generate this information, but rather on market
signals expressed by the public. Demsetz suggested that these efficiency gains in collecting
information regarding where innovative resources should be allocated, automatically made an
IP system more efficient than other types of innovation systems, despite deadweight losses
that may occur with an IP system.

Points to Remember

Although discussion has focused on ‘exclusion’ rights or property rights over information goods,
there are also other incentive mechanisms which enhance the rate of innovation over information
goods. These include prize mechanisms, government procurement as well as ‘commons’ based
models. Each of these models provide incentives that overcome the free-rider problem without
incurring the ‘static inefficiency’ losses that the IP regime uses.

This premise has taken a central role in the much of the subsequent economic analysis of
intellectual property law – as analysis has predominantly focused on tradeoffs ‘internal’ to IP,
rather than focusing on IP as one of the methods of innovation. For example, many of the
questions which courts and academics concern themselves with include patentability, breadth
of a patent, standards of novelty and non-obviousness, patent enforcement, etc. There are also

16
See, e.g., J.H. Reichman & Paul F. Uhlir, A Contractually Reconstructed Research Commons for
Scientific Data in a Highly Protectionist Intellectual Property Environment, 66 LAW & CONTEMP.
PROBS. 315, 331–32 (2003).
17
Harold Demsetz, Information and Efficiency: Another Viewpoint, 12 J.L. & ECON. 1, 14 (1969).

8
questions of ‘restrictions’ or ‘limitations’ to IPRs which are often debated in terms of
transaction costs, such as preventing the abuse of patent rights, or ‘flexibilities’ such as
compulsory licenses, fair use in copyrights, etc, as the transaction costs involved in the
ordinary execution of such exchanges would be too high to allow the information goods to
reach the hands of the people who are able and willing to pay for them.

However, in this context, it is useful to articulate the differences between ‘physical’ property
rights and ‘intangible’ or ‘intellectual’ property rights, as mistaken conflation of the two as
essentially similar ‘property’ rights, can lead to harmful policy.

In the case of ‘physical’ goods, property rights are often seen as the best method of ensuring
physical objects or land is best made use of – as private ownership is understood to
incentivize owners to make the better use of that property than if it were in the commons, and
thus a good solution to the ‘tragedy of the commons’. On the other hand, as the economics of
information makes clear, ‘property’ rights over intangible property are given despite the most
efficient use of that information or knowledge being when it is available to the public.
Therefore it does not necessarily flow that owners of IPRs will make ‘best use’ of their
information goods. Neglecting this distinction undermines the importance of the public goods
nature of information, and therefore also undermines the importance of the public domain. If
this tradeoff isn’t properly calibrated, there is the danger of allowing deadweight losses to
overshadow any dynamic efficiency based gains. The paradox therefore remains: that if
intellectual property is made stronger than required, signals on the market will be clearer as to
what types of activity are most desired. However, granting overly strong intellectual property
rights would lead to over-investment in certain market-centric type of products and less so in
products related to public goods, such as education, primary research, health of the poor,
etc.18

4. Racing & non-coordination issues

This final category looks to reduce economic wastage that can occur in the inventive process
through IPRs and has broadly led to a re-examination of IPRs as one of at least three methods
of innovation, rather than as the sole determinant of innovative activity. Although questions
internal to the IP regime are still the ones most predominantly discussed in the IP-innovation
framework, it is worth noting that there is a small but growing dissent to the premise that IP is
a more efficient than other innovation systems. Notably, Brian Wright, in a more nuanced
piece, 19 demonstrated that of the three major institutional approaches to innovation, (IP,
government contracts and prizes), there may be no real efficiency gains to separate any one as
being a more efficient option than the other, as each may have advantages and disadvantages
that are not present in the other.20

Wright points out that due to ‘racing’,21 (when multiple firms separately expend resources
working towards the same goal), IP systems and Prize systems could result in duplicative

18
Fisher, supra note 7.
19
Brian D. Wright, The Economics of Invention Incentives: Patents, Prizes, and Research Contracts,
73 AM. ECON. REV. 691, 691, 697–98, 701 (1983).
20
See generally, Amy Kapczynski, The Cost of Price: Why and How to get beyond Intellectual
Property Internalism,59 UCLA L. REV. 970 (2012).
21
‘Racing’ refers to the investment of allocative resources by multiple parties towards a goal that is
achievable only by a limited, usually one, entity. As the different parties are competing with each other
for the same ‘incentive’, they keep secret from each other, information as to research that they are

9
wasteful investment, as only one entity will eventually secure the incentive at the end. With
regard to racing, government contracts may be more efficient as they limit the number of
entrants thus reducing potential costs of duplicative research.

The other side of this coin is that IP systems and Prize systems both allow entrants to self-
select whether they are suited for the innovative activity. Such entrants are better placed to
make use of private information to decide whether they are well suited to competitively
investing inventive resources towards this incentive goal. If they cannot competitively invest
their resources towards this goal, (such inadequacy may be possible with the government
contracts system), then there are various other types of inefficiencies that can arise, as the
financial incentive is awarded, or promised up front and not based on the result. For example,
this could lead to delays, or low quality work.

At the same time, government contracts and prize systems face a significant problem. The
fund allocator must determine the value of an innovation as well as amongst which innovators
the fund must be spread over. Should the amount be too small, it won’t attract enough
entrants. Should the amount be too large, it will be wasteful. If too much of the amount is
given to the first innovator, there will be very little incentive to improve upon the product. If
the amount is spread amongst too many follow-on participants, then there won’t be sufficient
incentive for the primary innovation. However, recent work on prize systems have tinkered
with models which do not require the amount to be decided prior to the innovation – but
rather, after the innovation occurs. These methods could include through the pegging of prize
allocation based on sales, on perceived value, etc.22

Thus, with activity in the information economics space being imported into the economic
analysis of IP, there is a slow resurgence of looking at IP as a means to innovation, rather than
a goal in itself – placing it in context of several external factors which affect how normative
policy could be affected.

Summary
To recap, the economic analysis of intellectual property law is concerned with the utilitarian
justification for intellectual property – which states that it is for the greatest good for the
greatest number of people. Whether we use the wealth maximization technique, or the
Kaldor-Hicks criterion, there are three separate methods of applying utilitarian principles to
intellectual property law and policy. These are, (i) the incentive method, which seeks to
balance incentives for creativity and innovation, with simultaneous efficiency losses, such
that an optimal rate of innovation is achieved; (ii) ensuring that producers can adequately
determine what consumers want, based on market signals; and (iii) the minimize rent
dissipation.

As is clear, each of the above approaches require separate policy considerations as they come
with their own separate benefits and critiques. Thus, even though the utilitarian justification
of intellectual property continues to remain the most dominant one, its usage in policy
discourse is severely curtailed by the lack of a coherent underlying or unifying theory for
these different approaches.

undertaking – leading to all the parties duplicating efforts. Racing is primarily a problem in patent law
rather than other forms of IPR.
22
Michael Abramowicz, Perfecting Patent Prizes, 56 VAND. L. REV. 115 (2003).

10
From the above discussion though, there are three broad points that can be drawn across all
three of the above approaches:

i) It is not clear that higher levels of intellectual property will generate a higher level of
innovation.
ii) Intellectual property regimes interface differently with different sectors of technology and
optimally need to be configured accordingly. This means that countries of different socio-
economic statuses should approach intellectual property policy in ways appropriate to their
domestic capabilities and realities.
iii) Intellectual property policy is not sealed off from other countervailing considerations but
rather should be considered as a part of larger economic and social issues.

As is evident, applying any of the lessons learnt from the study of the economic analysis of
intellectual property law to specific policy questions require technology sector specific
empirical data as well as larger economical trends, within which to place (or remove) the
particular IPR policy lever in question, in order to determine how it can best be applied to
maximize social welfare.

Self-check Exercises

 What are the are two methods commonly used to maximize social welfare?

 How does the utilitarian theory justify intellectual property rights as mechanisms that can be
used to maximize social utility or social welfare.
 Explain the incentive theory as applied to incentives for innovation

 Is it clear that higher levels of intellectual property will generate a higher level of innovation?
 Is intellectual property sector specific

11