Economics of Information and Communication Technology

Transcription

1 Economics of Information and Communication Technology Alessio Moro, University of Cagliari October 26, 2017

2 Sequential innovation ICT products are extremely complex. Technological progress allows to integrate in a single product a large number of previous innvoations. Examples: mobile phone, MPEG data format. The basic version of MPEG is covered by a series of patents belonging to more than 20 companies and institutions (from Columbia University to LG and Phillips). In ICT industries most of follow-on inventions build on previous innovations. Sequence of incremental steps of innovation.

3 Sequential innovation Important consequences on market efficiency. Initial innovation highly desirable: the contribute to social welfare directly and indirectly. Cumulativeness also implies that follow-on inventors need to negotiate licencing agreements. We focus on the role of patents for the innovation process. Patents are used to appropriate the returns on R&D. However, they can also be used strategically. We present a formal analysis of the optimal patent policy in the case of sequential innovation.

4 A tour at the patent office A patent grants its holder a temporary monopoly position on the exploitation of an invention. Thus, right to prevent use, commercialization or importing the patented product ( negative right ). Particularly relevant in ICT industries: veto power on any technology that needs the patented product as a component to be produced. Need to sign patents agreements with the different patent holders.

5 How to obtain a patent? File an application at patent and trademark office (PTO). Application contains the description and the claims. Description: details how the invention works and must allow reproducibility by an expert. Claims: define the scope of the protection granted (patent breadth, which is the extent of the protection granted).

6 How to obtain a patent? The PTO checks that the invention satisfies the requirements for patentability: 1 Subject-matter eligibility: discoveries, scientific theories and mathematical methods cannot be patented. 2 Novelty: invention is novel if it represents an advance over existing knowledge (need to make a prior-art search). 3 Non-obviousness: meets an inventive step standard which requires the innovation not to be a mere extension of previous work. 4 Industrial applicability: susceptible of use in some kind of industry.

7 What if patent infringed? Once patent is granted, the invention is protected for 20 years from the date of the application. If the inventor believe the patent is infringed she can go to court to restrain the third party from continuing. Court can decide on infringment or that no patent was violated. The court can also overrule the PTO decision and invalidate the patent if it does not meet the patentability requirements.

8 The role of patents During the lengt of the patent the holder has a monopoly position and so can collect profits from her R&D activity. The traditional view suggests that the existence of patents increases social welfare as it induces firms to invest in R&D. Patents also favor the diffusion of information regarding the innovation. This information can be used to create follow-on products. Patents can be easily transferred to other firms or individuals. Without patents it is complicated to sell innovations. The inventor does not want to disclose details. The buyer does not buy without details. Thus patents favour the market for ideas.

9 The role of patents During the lengt of the patent the holder has a monopoly position and so can collect profits from her R&D activity. The traditional view suggests that the existence of patents increases social welfare as it induces firms to invest in R&D. Patents also favor the diffusion of information regarding the innovation. This information can be used to create follow-on products. Patents can be easily transferred to other firms or individuals. Without patents it is complicated to sell innovations. The inventor does not want to disclose details. The buyer does not buy without details. Thus patents favour the market for ideas.

10 The role of patents Patents enhance a more efficient division of labor. Firms specialize in research projects and then sell the innovation to manufacturers (fabless firms). Signaling purpose. With information asymmetry, patents portfolios can be used as collateral to receive credit from banks.

11 Other appropriability mechanisms Survey questionnaire administered to 1,478 R&D labs in U.S. manufacturing. Managers do not consider patents as the most effective mechanism in order to profit from their innovation. Question: report the percentage of product innovations for which each appropriability mechanism has been effective in protecting the firm s competitive advantage Secrecy Patents Oth. Legal Lead Time Co. Serv. Co. Prod Patents are the last but one mechanism to protect the innovation.

12 The strategic role of patents 700, , , , , , , ,000 90, Dramatic increase in patent applications since the 80s. ICT patents represented 5% of the total in the early 80s. This number increases to 20% in the late 90s. Why such a large increase if patents are not the most effective mean to appropriate returns of the innovation?

13 The strategic role of patents Technological complexity implies that often firms do not have proprietary control over components. They need to negotiate licensing agreements. A large patents portfolio increases barganing power in negotiations. Often cross-licensing agreements to guarantee reciprocal access.

14 The strategic role of patents Also stock up patents for aggressive or defensive motives. A large portfolio represents an insurance against rival firms taking legal action for patent infringment. Or it can be used to foreclose competitors or to hamper rival firms.

15 Which consequences? Quality of granted patents dropped. A concern is that a strenghtening of patent protection combined with lower quality of patents decreases the incentive to innovate. With a larger number of patents the probability of infringing one with a new innovation is high.

16 Standing on the shoulders of giants The innovation process is highly cumulative. Innovation in ICT proceeds in incremental steps: inventors improve technologies developed by others. The cumulativness of innovation and the complexity of modern technologies make it difficult to design industrial policies to stimulate R&D. This is because different generations of investors may have conflicting interests. A strengthening of the patent policy benefits early inventors and impairs later innovators.

17 Standing on the shoulders of giants In the case of isolated innovation patent protection stimulates R&D (positive effect) and creates monopoly power (negative effect). The optimal patent policy needs to balance the two effects. With cumulative innovation two additional effects: 1 Social benefit of innovation is stand-alone value + contribution to future innovations (positive externality); 2 Hold-up problem: patent protection on initial innovations might undermine R&D incentives of follow-on innovations.

18 Patent policy with isolated innovation A firm needs to decide whether to invest or not in a research project. By investing an amount c in R&D the firm obtains an innovation valued v (social value of the innovation in perfect competition). The invention is isolated, that is, not based on previous innovations, nor it is a basis for future innovations. After the innovation is created, it is commercialized for a period of time normalized to T = 1. The firm has a marginal cost function of commercialization and faces a known demand function.

19 Patent policy with isolated innovation p C Two phases of the life cycle of the product. In the first phase there is patent protection, in the second there is not. In the second phase other firms copy the product and the equilibrium is p = A and q = q c (perfect competition). Social welfare is maximized and this is the value of v (triangle ABC). p m.... F A E B MC. q m MR. q c D q Figure Lecture 6.3: 6: profits Cumulative and social innovation welfare in dynamic isolated industries innovation

20 Patent policy with isolated innovation In the first phase there is patent protection. The monopolist charges p m and sells q m. The innovator s profits are the area AEFp m, social welfare is AEFC and deadweight loss is EBF. p C.... F p m A E B MC. q m MR. q c D q Figure 6.3: profits and social welfare isolated innovation

21 Patent policy with isolated innovation The profits of the monopolist can be seen as a fraction x [0, 1] of the overall value of the innovation v. Thus vx corresponds to the area AEFp m. Simlarly the deadweight loss can be seen as a fraction d [0, 1] of v. Thus vd corresponds to the area EBF. p C.... F p m A E B MC. q m MR. q c D q Figure 6.3: profits and social welfare isolated innovation

22 Optimal patent policy with isolated innovation We determine the social welfare associated with the innovation protected by a patent lenght T [0, 1]. Between T and 1 the patent has expired and social welfare is v. Between 0 and 1 the patent is valid and social welfare is v vd. As the innovator bears the cost c we have that total welfare from the innovation is T (v vd) + (1 T )v c = v(1 dt ) c, The innovator obtains profits vxt c. Result: In the case of isolated innovation, the socially optimal patent lenght equals T = c/vx, the value of T such that vxt c = 0.

23 Patent policy with cumulative innovation There are two firms, A and B, each one deciding whether to undertake or not a research project. The two firms choose sequentially. If A invests B has the opportunity to undertake its project. Otherwise B cannot do anything. Projects are identified by {v i, c i } with i = A, B. Innovation i is patentable and the product based on the innovation has life cycle normalized to 1. Products are commercialized in different markets (i.e. firms A and B do not compete with each other).

24 Patent policy with cumulative innovation We define patent breadth the extent to which a patent covers the field to which it pertains. We denote breadth by β and interpret it as the probability of the second innovation infringing the patent protecting the first innovation. In case of infringment firm B needs to sign an agreement with A in order to sell its product. In case no agreement is reached the case is brought to court. The court sets a fee equal to half the revenues of B. As in the case of isolated innovation revenues are v i xt for i = A, B.

25 Patent policy with cumulative innovation The social value of the second innovation is determined in the same way as the first innovation. Two phases depending on whether the patent is valid or expired. Social value is T (v B v b d) + (1 T )v b c B = v B (1 dt ) c B. For the first innovation the social value is now v A (1 dt ) c A + v B (1 dt ) c B. }{{}}{{} stand alone value externality

26 Timing of the game t=1. A decides whether or not realise the research project {v A, c A }. If the project is developed the innovation is patented. t=2. If firm A realises the invention, B decides whether or not realise the research project {v B, c B }. Firm B knows whether its invention violates A patent. Before investing c B firm B negotiates a fee L(T ). Once it has developed its invention firm B patents it. Negotiations on the fee are in perfect information about the projects. If parties do not reach an agreement the court imposes a payment L(T ) = v B xt /2 to firm B. We want to determine the socially optimal patent policy in terms of patent lenght T and breadth β.

27 Patent policy under symmetric information Need to determine the socially optimal T and β. Use backward induction and see what happens after the innovation by A has been developed. Result 2: Firm B invests in R&D if and only if the returns on the innovation are larger than or equal to the cost of the research project: v B xt c B ; in case of patent infringment B pays to A a licensing fee: L(T ) = { vb xt c B 2 if c B v B xt < 2c B v B xt 2 if v B xt 2c B It is straightforward to see that without patent infringment firm B undertakes the project if v B xt c B. Result 2 suggests that even if there is patent infringment the condition v B xt c B is sufficient to undertake the project.

28 Patent policy under symmetric information Result 2 rests on the assumption that as long as the profits of the innovation cover the cost, both firms have an incentive for the innovation to be produced. Also, if the innovation is profitable enough, firm A can avoid any agreement with firm B, and the latter still undertakes the project. Corollary 1: Licensing negotiations are efficient and there is no risk of holding up the follow-on innovation. B does not invest c B B invests in R&D vbxt cb L(T ) = 2 2c B B invests in R&D L(T ) = vbxt 2 v B xt Figure 6.4: firm B s decision

29 Patent policy under symmetric information B s decision to innovate depends on T but not on β. Patent breadth β only affects the probability that A makes profit out of B s invention, and so expected profits. Corollary 2: Patent breadth does not affect the decision to develop the future innovation. Thus any value of β is socially optimal. T plays the same role as in the case of isolated innovation. Thus optimal patent lenght is again T B = c B /v B x.

30 First innovator s decision Overall profits of the first innovator are: v A xt }{{} + βl(t ) + (1 β)0 }{{} c A direct profits expected licensing profits Profits are increasing in both T and β. We need to consider two cases: I) the first innovation generates small direct profits (v a is small); II) the first innovation generates large direct profits (v a large).

31 Case I) v a is small A has little stand alone value in generating profits (v A x T B < c A ) The firm undertakes the project only if benefits from the licensing fee, βl(t ), are substantial. As the fee depends on both T and β, which instrument is best to manipulate to maximize social welfare? β affects the expected revenues of firm A, but not the deadweight loss nor the realization of B s innovation. Optimal to set β = 1 to maximize to stimulate the realization of A s project. T induces the standard trade-off, so it has to be set at the minimum value for firm A to perform the innovation.

32 Case I) v a is small Two possible subcases: a) direct profits are very small; b) direct profits are small; A s innovation generates small direct profits. A s innovation generates large direct profits β = 1 T = T > T B β = 1 T = T B ca L(T B ) c A any β T = T B v A xt B Figure 6.5: socially optimal patent policy In case a) profits induced by the optimal patent lenght to induce B to innovate, T B, are too small to induce A to innovate, v A x T B + βl( T B ) c A < 0. Need to set T > T B such that v A x T + βl( T ) c A 0.

33 Case I) v a is small A s innovation generates small direct profits. A s innovation generates large direct profits β = 1 T = T > T B β = 1 T = T B ca L(T B ) c A any β T = T B v A xt B Figure 6.5: socially optimal patent policy In case b) the first innovation is profitable for β = 1 andt = T B. Thus T B is socially optimal. With a smaller T firm B does not perform the innovation. With a larger T social welfare declines. Observation 3: When the first innovation generates small direct profits the patent policy needs to be designed in order to guarantee large licensing profits.

34 Case II) v a is large A s innovation generates small direct profits. A s innovation generates large direct profits β = 1 T = T > T B β = 1 T = T B ca L(T B ) c A any β T = T B v A xt B Figure 6.5: socially optimal patent policy In this case the first innovation generates substantial direct profits v A x T B c A 0. If T T B both firms invest regardless of the patent breadth β. The optimal policy is T = T B and β can take any value as it affects only expected profits of A (but it is not crucial to perform the project).

35 Isolated vs cumulative innovation Which is the optimal patent lenght in the case there is only one firm with the possibility of performing the two innovations? The socially optimal patent length is larger when innovations are performed by two different firms rather than by a single innovator. In the last case, optimal patent policy is such that v A xt c A + v B xt c B = 0. With two firms only a fraction of v B xt c B is enjoyed by firm A. Thus, T that makes the above equation zero may not be enough to make to make A s project profitable.

36 Information asymmetry and hold-up The previous results suggest that patents should be broad to compensate the early innovator for the externality she generates. A large β does not imply a deadweight loss and does not hold on future innovations. With asymmetric information licencing negotiations might be more problematic: patent holder and the innovator have different expectations on the value of the product. We extend the previous model to account for asymmetric information between the patent holder and the innovator.

37 Information asymmetry and hold-up The R&D cost of the firm, c i, with i = A, B, is uniformely distributed between [0, 1]. Firm i privetely observes the realization of c i before undertaking the project. The realization of c A and c B is independent for the two firms (A cannot infer anything about c B after observing c A and vice versa). With the patent valid up to T the innovator appropriates all social benefits of the innovation, v i, making profits Tv i (so x = 1 and d = 0). We assume that T = 1 to maximize the probability that A innovates (any T inducing the investment in R&D is optimal), and focus on the role of β. In case of infringment A makes a take-it-or-leave-it offer and if B rejects it the court sets a fee of v B /2.

38 Negotiations and the hold-up problem Assume that A makes the take-it-or-leave it offer sv B, with s (0, 1). It must be that sv B v B /2, otherwise B rejects the offer and goes to court. So the first innovator is forced to propose s 1/2. Assume that v B = 1. A knows that B accepts only if (1 s)v B c B. Thus: 1 the proposal is accepted with probability (1 s)v B (the probability that c B (1 s)v B ); B pays sv B to A. 2 the proposal is rejected with probability 1 (1 s)v B (the probability that c B > (1 s)v B. A obtains no revenues from B.

39 Negotiations and the hold-up problem Expected profits of A from the licencing fee are (1 s)sv 2 B + s0 which are maximized for s = 1/2. The proposal by A corresponds to the payment imposed by the court in case of disagreement. Furthermore, licencing negotiations do not eliminate the hold-up problem. Result 4. With asymmetric information about R&D costs, licensing negotiations are inefficient. If the patent owned by A is violated and c B (v B /2, 1], the follow-on innovation is held-up: even if socially deisrable, firm B does not develop the innovation. Corollary 3. With asymmetric information about the R&D cost, patent breadth affects firm s B decision of developing the research project. An increase in β makes the hold-up probelm more likely to occurr.

40 Optimal patent breadth Firm A makes its project when v A }{{} direct profits ( ) 2 vb + β + (1 β)0 c A 0. 2 }{{} expected licensing profits On one hand, β increases the likelihood of the first innovation. On the other it decreases the likelihood of the second innovation. To find the optimal patent we consider a policy maker with imperfect information. The policy maker knows the probability distribution of c A and c B but not their realizations.

41 Optimal patent breadth The welfare function is W (β) = I(II + III + IV ), ( where I = pr v A c A + β ( v ) ) B2 2 0, [ II = v A E c A v A c A + β ( v ) ] B2 2 0, III = βpr ( c B v B 2 ) ( vb E [ c B c B v B 2 ]), IV = (1 β) (v B E [c B ]). I is the probability of A developing its own research project. II represents social welfare derived from the realization of the first innovation. III and IV represent social benefits associated with the realization of the second innovation with and without patent infringment.

42 Optimal patent breadth It can be proved that optimal patent leght is β W = { 1 va if v A 1 0 if v A > 1 The optimal patent is decreasing in the amount of direct profits of A. If v A is small need to increase β to induce A to innovate. If v A is large the innovation takes place regardless of β. Thus it is optimal to set a small β, which reduces the hold-up problem (probability that B innovates increases). Thus, with cumulative innovation, when licensing negotiations are inefficient, it does not necessarily follow that stronger patent protection leads to larger R&D investments.