Economic Analysis of Efficient Patents

1. Patents: property over inventions or ways of performing useful

processes
• The airplane, a method for making rubber, the email feature on a smartphone
Why Does IP Exist?

• Doesn’t exist in a state of nature. Government has to create IP rights.

• Better to start with the question: why do we have property?

• Three main reasons:
Why Do We Have Property?
1. Method for allocating resources to their highest-value user
Why Do We Have Property?
2. Method for avoiding the tragedy of the commons
Why Do We Have Property?
3. Method for incentivizing the discovery and creation of new property
Then How About Intellectual Property?
1. Make sure resources get to their highest-value user?
a) But IP is “non-rivalrous” (or “non-rival”)
b) You can use it, and I can use it at the same time. IP is not scarce.
2. Solve the tragedy of the commons?
a) Again, IP is non-rival. There is no tragedy of the commons.
3. Encourage the discovery and creation of new property?
a) This is the economic rationale for IP
b) We need IP to incentivize the creation of new inventions, books, movies,
etc.
IP and Free-Riding
• The problem that IP is trying to solve is free-riding
• Company A expends resources to invent something
• Company B copies the invention and sells the same thing, but without expending
the same resources to invent
IP and Free-Riding
• The problem is that if Company B doesn’t have to expend resources on
invention (research & development), it can undersell Company A
• Suppose it costs Company A $1 million to invent a pharmaceutical drug
• Each individual pill costs $1 to manufacture
• Company A expects to sell 1 million pills
• Company A will have to sell the pills at $2/pill to recoup its costs:
• ($1 million + $1/pill x 1 million pills)/1 million pills = $2/pill
• But if Company B can just copy Company A’s invention, it can sell the pills
for $1/pill
• That’s what it costs to manufacture each pill
IP and Free-Riding
• Another way of saying this:
• Each company has to sell at “average cost,” not “marginal cost”
• Marginal cost is what it costs to produce one more pill: $1 dollar
• Average cost is what it costs to produce each pill, if you include the initial R&D
costs
• For Company A, average cost = $2/pill because they spent $1 million on
R&D
• For Company B, average cost = marginal cost = $1/pill because
there is no initial R&D cost
IP and Free-Riding
• The result:
• Company A sells for $2/pill
• Company B sells for $1/pill
• What consumer would ever buy from Company A?
• That means that Company A will never recoup its initial research and
development costs
• If Company A is thinking ahead, that means it will never try to invent the drug in
the first place (because it will just lose money)
• As a result, the drug will never exist, and consumers will never benefit
from it
IP and Free-Riding
• IP solves this problem
• If Company A gets a patent on the drug, it can block Company B from selling it
• Company A can then charge a price that will allow it to recoup its costs without
fear of being undersold by Company B
IP as Public Good
• We can also think of this as a public good problem. Ideas and creative
works are public goods, like parks.
IP as Public Good
• A public good is:
• Non-rivalrous: we can all use it
• Non-excludable: I can’t stop you from using it
• Ideas and creative works are public goods
• We can all read Harry Potter or use iPhones at the same time
• Once the work or idea is posted somewhere, I can’t stop you from using it
• Society will tend to produce too few public goods
• If no one can capture the full value of the good, no one has the proper incentives
to produce it
IP as Public Good
• Basically a collective action problem
• Collectively, we’d all be better off if we had more public goods
• But no one of us has the incentives to produce them
• And it’s hard to coordinate
• I can’t write a contract with every other Harry Potter reader in the world
• Without the means to coordinate, the public good goes unproduced
IP as Public Good
• Two typical solutions to the public good problem:
1. Have government produce the good
a) It’s often the government that builds parks, roads, etc.
b) And sure enough, we see government doing a lot of R&D to produce inventions
c) But do you want to consume movies made by the government?
2. Propertize the public good
a) Give someone ownership of the park and let them charge admission
b) That is the solution we use here: IP is propertization of a public good
The Downside to IP
• All of this is the good news. IP creates incentives to produce more
inventions and creative works.
• Call this the “dynamic efficiency” rationale for IP
• But there is a very significant downside to IP as well
• Granting an IP right makes the right-holder a monopolist
• Only JK Rowling can sell copies of Harry Potter

• This allows the rights-holder to raise the price

• Remember: this is precisely the point of IP!
• But that will squeeze some consumers out of the market
A Competitive Firm Prices at Cost

Consumer
surplus

Price

Competitive
firm

Quantity
Monopolist Pricing
• Another way of saying the same thing:
• Monopolist sets marginal revenue = marginal cost
• Meaning: it doesn’t want to lose money by selling an additional unit (if marginal
revenue – marginal cost < 0)
• We could calculate marginal revenue in much the same way

• Bottom line: a monopolist is going to set a higher price than a firm in a

competitive market
Monopolist Sets a Higher Price

Monopolist

Price

Competitive
firm

Quantity
Higher Profits, But Deadweight Loss

Consumer surplus

Monopoly profits

Deadweight loss
Price

Competitive
firm

Quantity
Monopolist Pricing
• This higher price leads to producer surplus
• It also produces “deadweight loss”
• Deadweight loss is inefficiency caused when a transaction that would be
beneficial to both parties doesn’t occur
• There are people who want to buy the patented or copyrighted good for more
than its marginal cost
• Those would be efficient transactions because they would make both producer
and consumer better off
• But they won’t happen because the price of the good is too high
Higher Profits, But Deadweight Loss

Consumer surplus

Monopoly profits

Deadweight loss
Price

Competitive
firm

Quantity
Monopolist Pricing
• The amount of surplus that is lost is the deadweight loss
• If the monopoly price of the good is substantially higher than the
marginal cost, deadweight loss can be substantial
• This is a severe economic negative
• Called a “static inefficiency” – in equilibrium, people who want to buy a good
cannot purchase it
• This deadweight loss represents the main downside of IP
• In designing an IP system, must strike a balance between dynamic efficiency
(incentives to innovate and create) and static inefficiency (deadweight loss)
IP Design
• The existence of deadweight loss means that we don’t just want to give
IP rights for everything
• Every time someone acquires IP, there will be monopoly pricing and thus
deadweight loss
• We want to be judicious in where we award IP
• Theory: award IP rights only where necessary to incentivize innovation
• IP comes with a cost (deadweight loss)
• Make sure that the benefit (innovation) outweighs that cost
IP Design
• Theory: award IP rights only where necessary to incentivize innovation
• Remember, the original problem with IP was free-riding:
• Company A creates, then Company B free-rides off of that creation, takes the
idea, copies it, and undersells Company A
• The fact that Company B doesn’t have to expend resources in creating is what
causes the problem
• This allows Company B to undersell Company A
IP Design
• Because of this, we care about two separate costs:
1. The original cost of creating/inventing
a) The higher this cost, the greater the free-riding problem
b) But if creation is easy/cheap, we may not need IP
2. The cost of copying
a) The lower this cost, the greater the free-riding problem
b) But if copying is very costly, we may not need IP
IP Design
1. Only give patent rights for “novel” (new) inventions
a) If it’s not new, then it already exists and we don’t need to incentivize its
creation
2. Don’t give patent rights for “obvious” inventions
a) If it’s obvious, then it can’t have been hard to invent
b) Low cost of creation => smaller free-riding problem
3. Don’t give infinite patent rights or copyrights
a) As the duration of the IP right ↑, the incentives it creates ↑; but deadweight
loss ↑ as well
b) Make the IP last long enough to incentivize the inventor/creator
Demand for Crime
• Summing the number of crimes committed by each individual gives
the aggregate number of crimes in society.
• An increase in P will decrease the number of crimes.
• Corresponds to consumer’s demand curve sloping downwards.
• Demand curve for crime
The first Law of deterrence
• People commit less crime when the expected punishment increases.
• How much do crime rates respond to increases in expected
punishment.
• When supply of crime is elastic policy makers can reduce crime
significantly by moderate increases in expected punishment.
• When supply of crime is inelastic then other variables like
employment rates, drug addiction, quality of schooling become
important.
A supply and average revenue diagram for theft.
• The vertical axis shows dollars stolen per hour--the "wage" that
thieves receive.
• The supply curve S, like any other supply curve, shows how much
labor will be supplied at any wage--how the number of hours spent
stealing depends on the number of dollars per hour that can be stolen.
• The average revenue curve AR shows how the revenue from an hour
spent stealing varies with the amount of theft. As the number of
thieves stealing increases, the return per hour falls, so AR slopes
down, just like a demand curve.
Market Equilibrium
P S T.A = Total
amount stolen(A+B)
40

30
A (PS
20
Returns

10
B © D
(VL)
0 20 40 60 80
Q

Number of hours

32
• The total amount stolen per year is average revenue--the amount
stolen per hour--times the number of hours of theft per year. The area
shown as A+B.
• The thieves receive that as income, bear costs equal to C, and receive a
producer surplus equal to (PS).
• The victims lose the amount stolen and receive nothing. The net loss
L, the area under the supply curve, is equal to the loss to the victims
minus the gain to the thieves.
• Supply and revenue curves are one way of looking at the market for
theft and analyzing its costs.
• Another is as an example of the inefficiency of rent seeking. Both
thieves and victims are competing for possession of the same objects--
all of which, initially, belong to the victims.
• Expenditures by a thief either result in his getting the loot instead of
some other thief or in his getting the loot instead of its owner keeping
it.
• Defensive expenditures by the victims are also rent seeking--the
function of a burglar alarm is to make sure that the property remains in
the hands of its original owner.
• What we have really been doing is showing the advantage of a system
of secure property rights.
• If property rights are insecure, some individuals have an incentive to
spend resources trying to get property transferred to them, while some
have an incentive to spend resources keeping property from being
transferred away from them.
• That is true whether the transfer is done by private theft or government
taxation. Not earning taxable income or not buying taxed goods are
(costly) ways of defending yourself against taxation, just as installing
a burglar alarm is a (costly) way of protecting against theft.