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Copyright (c) 2003 Janet Hope, Research School of Social Sciences, Australian National University, Canberra, ACT 0200. Verbatim copying and distribution of this site is permitted in any medium, provided this notice is preserved.

Economics

An information economics perspective

Cumulative innovation and the optimal design of intellectual property rights

Introduction

This section examines the issue of scientific exchange in the light of economic theories of intellectual property. Interestingly, some recent economic thinking about the intellectual property system, and patents in particular, has strong parallels with Hilgartner's data stream perspective developed in the sociological literature, but in order to present this thinking in context it is necessary first to consider more traditional economic theories about the appropriate scope of intellectual property laws.

Notes

[101a] Loughlan provides a modern perspective on moral justifications for intellectual property rights: "there is no widespread social and economic acceptance of a general proposition that persons ought to be legally entitled to regain the full value of their labour. What do you think capitalism is about?" ([Loughlan, 1998 #18], page 15.)

Traditional economic justifications for intellectual property laws

The literature dealing with economic justifications for intellectual property protection is enormous. Fortunately, an paper by Nelson and Mazzoleni provides a convenient entry point. They identify four economic theories purporting to explain how patent protection promotes technological innovation. These are the "invention-inducement theory", the "disclosure theory", the "development and commercialisation theory" and the "prospect development theory". [102]

The invention-inducement, disclosure and development and commercialisation theories all treat patent protection as a response to potential market failure resulting from the "free rider" problem. A free rider is someone who imitates and thereby gets the benefit of an invention without having made the investment of time, effort, skill or money required to actually invent it. Assuming that inventions are easier to copy than to make, a rational actor would not choose to invest the resources necessary to make a new invention or to develop and commercialise an existing invention -- or at any rate would not choose to disclose a new invention -- without some means of protecting that investment. The invention-inducement theory, the disclosure theory and the development and commercialisation theory each postulate that by conferring on the patentee or his or her assignees the exclusive right to commercially exploit an invention for a limited time, patent rights create a needed economic incentive to engage in the relevant phase of the innovation process.

According to these theories, the social benefit of promoting innovative activity through exclusive patent rights comes at a social cost. In effect, a patent is a limited monopoly: an opportunity to create a legally enforced market structure in which the patent holder can charge more for his or her product than would be possible in a competitive market.[103] Because monopoly rights impose a cost on the community by way of increased prices and reduced output, patent laws should be designed to grant patents only for inventions which would not otherwise have been made, or which would not otherwise have been made available to the community through disclosure or development and commercialisation. This leads to a fundamental problem with incentive arguments in favour of patent rights. To justify patent protection in any given context -- for example, for research tools in biotechnology -- it is necessary to demonstrate first, that some extra incentive to engage in innovative activity is needed; second, if it is needed, that the patent incentive is likely to be effective; and finally, that there is no better way to achieve the desired result. [104] But this is difficult, perhaps impossible, to do. [103a] Patent ownership is not the only way to obtain an economic return from new inventions: for example, innovators may enjoy a pioneer advantage even in the absence of patent protection. As sociological studies of science show, economic incentives are not the only kinds of incentives which motivate innovation.[105] And while empirical evidence suggests that overall levels of innovation do respond to economic stimuli, governments have at their disposal a range of economic instruments for stimulating innovation other than patents, including the provision of research funding or venture capital, tax concessions, procurement policy, export development grants, tariffs and bounties. [106] With respect to the disclosure theory, it has been argued that patents may not in fact create an incentive to disclose inventions that would otherwise be kept secret, because patent protection is most attractive relative to trade secrecy for those very inventions which could not easily be kept secret for long. [107] Given this complexity, it is not surprising that empirical assessments of the incentive function of patent protection have been inconclusive.

Nelson and Mazzoleni's fourth theory, the prospect development theory, differs from the older incentive theories just discussed in that it treats the patent system not merely as a device to enable the capture of returns on investment in innovation, but also as a system for efficiently allocating resources to the development of existing inventions. Introduced by Edmund W. Kitch in 1977, the prospect development theory postulates that granting broad patents on early stage inventions allows patent holders to coordinate subsequent research and development within the area of the patent claim (the "prospect"). If the patent holder has an exclusive right to exploit the new technological prospect, later arrivals will be unable to derive economic benefit from developing the prospect unless they negotiate directly with the patent holder to obtain licences to the underlying technology. Thus the patent holder becomes a link among all those working to develop the prospect, preventing wasteful duplication of effort and facilitating the transfer of information. [108]

In Kitch's view, the prospect function of the patent system enhances its public welfare effect. However, the prospect development theory as a justification for patent rights has a twist in its tail when applied to research tools in biotechnology. As Nelson and Mazzoleni point out, the assumption that development of technological prospects is most efficient when it is centrally coordinated by the patent holder is inconsistent with the scientific ideal of individualism and independence in research, which is based on the belief that coordination or central planning of research impedes scientific progress by weakening the initiative of researchers and substituting the judgment of the co-ordinator for that of the individuals who are actually immersed in the details of the research. [109] Sociologists of science have argued that the most efficient possible organisation of scientific research involves independent initiatives by competing scientists working with knowledge of each other's achievements. [110] Even where imperfect knowledge leads to duplication of effort, such duplication may be valuable: for example, multiple overlapping research efforts may improve the impact and accessibility of new research claims or help establish their validity, while different researchers may make different mistakes, interpret results differently or perceive different implications of the same results, thereby achieving greater overall understanding. [111],[112]

Assuming both Kitch and the sociologists of science are correct -- assuming that patents do function as a claim system for new technological prospects, but that innovation in relation to research tools in biotechnology proceeds most efficiently by way of independent initiatives on the part of many different researchers -- it follows that granting broad patents on early stage inventions in biotechnology may actually threaten innovation by forcing subsequent researchers to enter into potentially costly license negotiations with the patent holder. The unattractive alternative would be for later arrivals to give up hope of deriving economic reward from working on the prospect, provided of course that the work did not have to be abandoned altogether for fear of infringing the patent. The higher the transaction costs associated with obtaining a license from the patent holder, the greater the likelihood that a prospect will not be efficiently developed. Thus, the implications of the prospect development theory for patent protection of research tools turn on whether the transaction costs of patent licensing are assumed to be high or low.

Notes

[102] [Nelson, 1997 #48] The second and third of these theories were encountered earlier under the heading "...". Nelson and Mazzoleni give a brief outline of each theory as follows ([Nelson, 1997 #48], page 1): "Invention-inducement theory: The anticipation of receiving patents provides motivation for useful invention. Disclosure theory: Patents facilitate wide knowledge about and use of inventions by inducing inventors to disclose their inventions when otherwise they would rely on secrecy. Development and commercialisation theory: Patents induce the investment needed to develop and commercialise inventions. Prospect development theory: patents enable the orderly exploration of broad prospects for derivative inventions."

[103] [Loughlan, 1998 #18], page 93

[103a] Methods for empirical studies have included examination of historical records of industrial development for countries with and without patent systems; qualitative research to determine the impact of patent incentives on research and development decisions in firms; and measurement of the difference between private and social rates of return to investments in research and development. ([Eisenberg, 1989 #58], pages 1031-1033.)

[104] David Vaver expresses the point neatly: "[I]f the allocation of [intellectual] property rights is simply a means to an end, namely, to make the fruits of creativity and research available to users, then one must ask if the means is the most effective way to that end. If the rights restrict availability and use more than they increase it, they are unjustifiable; if the converse, one must ask if there are better means of increasing availability and use, either by modifying the rights or by finding alternative means." David Vaver, "Some Agnostic Observations on Intellectual Property" (1991) 6 Intellectual Property Journal (Canada) 125 at 126-8).

[105] Also note in this connection the comments of Burger CJ delivering the judgment of the court in Diamond v Chakrabarty (1980) 447 US 303 at 317-318: "It is argued that this Court should weigh... potential hazards in considering whether respondent's invention is patentable subject matter.... We disagree. The grant or denial of patents on microorganisms is not likely to put an end to genetic research or to its attendant risks. The large amount of research that has already occurred when no researcher had sure knowledge that patent protection would be available suggests that legislative or judicial fiat as to patentability will not deter the scientific mind from probing into the unknown any more than Canute could command the tides."

[In relation to other incentives, also consider the freeware debate... maybe do a big comparison chapter later on, when considering policy options?]

[106] [Eisenberg, 1989 #58], page 1031, footnote 59; Industrial Property Advisory Committee, Patents, Innovation and Competition in Australia, A Report to the Minister for Science and Technology, Canberra,1984, page 15. The authors go on to observe that "[s]uch measures may be less important than the broader dimensions of national economic policy which, by affecting taxation, exchange rates, interest rates, employment, and demand, set the climate for investment in innovation."

[107] Long-term secrecy is not always feasible in relation to a new invention, for example because marketing the invention as a product provides an opportunity for reverse engineering. In that case, there is no need to provide an incentive to disclose the invention -- it will be disclosed anyway. But where long term secrecy is feasible, the inventor may have little to gain from patent protection, which may not last as long as a well-kept trade secret, and which may be difficult to enforce if infringers are also able to keep their use of the invention secret. See [Eisenberg, 1989 #58], pages 1028-1029.

[108] Edmund W. Kitch, "The Nature and Function of the Patent System" (1977) 20 Journal of Law and Economics 265-290 (concerning the facilitating of information transfer, see especially pages 276 and 278-9).

[108a] For a comprehensive overview of the patent system before the 1960s, see generally Fritz Machlup, An Economic Review of the Patent System, Study No. 15 of the Subcomm. on Patents, Trademarks and Copyrights of the Senate Comm. on the Judiciary, 85th Cong., 2d Sess. (1958)

[108b] Kenneth J. Arrow, "Economic Welfare and the Allocation of Resources to Invention", in Richard R. Nelson, ed., The Rate and Direction of Inventive Activities, Princeton University Press, Princeton, 1962.

[108c] Edmund W. Kitch, "The Nature and Function of the Patent System" (1977) 20 Journal of Law and Economics 265, page 277-278.

[109] [Nelson, 1997 #48], page 6; [Eisenberg, 1989 #58], page 1060.

[110] [Eisenberg, 1989 #58], page 1061, citing Michael Polanyi, "The Republic of Science: Its Political and Economic Theory" (1962) 1 Minerva 54.

[111] [Eisenberg, 1989 #58], page 1063-1065, citing works by Robert K. Merton and Warren O. Hagstrom.

[112] According to Kitch, the patent system cannot perform a prospect function in the context of basic scientific research because it is impossible to fashion a meaningful property right around a mere discovery or explanation of scientific phenomena. However, he does believe that basic research faces the same problems of coordination among researchers as are found in applied research, and suggests that the prospect function performed by the patent system in relation to applied research may be performed in relation to basic research by peer review procedures for research grant applications (Edmund W. Kitch, "The Nature and Function of the Patent System" (1977) 20 Journal of Law and Economics 265 at pages 288-289).

Newer ideas

Unlike sociological theories, traditional economic theories of intellectual property have tended to support strong intellectual property rights. Yet more recent economic theories which take into account the economic characteristics of information suggest a different conclusion. The picture of the innovative process which emerges from recent economic theory bears a striking resemblance to that painted by recent research in the sociology of science. Both emphasise the importance of information flow for ongoing innovation and the existence of uncertainties and obstacles (transaction costs) associated with the exchange of scientific information.

The importance of taking transaction costs seriously is highlighted by further economic research which deals explicitly with the optimal design of intellectual property rights in contexts where innovation is cumulative. The main message of this literature is that the design of intellectual property laws must take into account the ease or difficulty with which IP rights are traded after they have been granted by the state. In particular, granting strong property rights to initial innovators may be appropriate if later inventors can easily negotiate access to the initial innovations in order to build on them. However, if post-grant transactions are blocked in some way, granting strong initial property rights may stifle follow-on research.

An information economics perspective

Kitch's acknowledgement of the information function of patents reflects an important shift in economic thinking about patents since the 1960s. Until that time, economic discussion had centred around the role of patents in facilitating product markets by allowing owners of goods to sell the goods separately from the associated intellectual property.[108a] However, in 1962 Kenneth Arrow observed that patents and other intellectual property rights also facilitate markets in information. [108b] In the commercial world, the integration of valuable information from a range of sources requires firms to bargain for the transfer of that information. But in the absence of patents, such bargaining runs into difficulties. If the owner of information discloses it to a prospective buyer, the buyer has obtained the information for free. On the other hand, if the owner does not disclose the information, the buyer will be unable to judge its value and will therefore be unwilling to pay the asked price. A patent allows the owner of the information to disclose it to prospective buyers without losing its value; at the same time, the parties may reach an agreement about the transfer of related information not directly covered by the patent, for example information about how to apply the technology efficiently ("know-how"). (Although Kitch did not refer directly to Arrow's paper, his article describes the information aspects of patents in essentially these terms. [108c]) Arrow's observation switched the focus of economic discussion from product to information markets and eventually triggered further insights into the relationship between information flow and the patent system, including insights about the significance of transaction costs.

In his 1996 book "Understanding Novelty: Information, Technological Change, and the Patent System", Thomas Mandeville builds on Arrow's work on information markets to develop a new economic theory of the patent system. Mandeville observes that although conventional economic theories of the patent system do not give clear policy guidance as to the appropriate scope of patent protection, they do seem to suggest that a strong patent system is desirable for the reasons touched on above: strong property rights enable firms to control their technology and appropriate returns from it, thus providing incentives for the allocation of resources to innovative activity. [113] He proposes an alternative, "information" perspective on innovation which points to a more complex but basically contrary view of appropriate patent scope.

According to Mandeville, conventional economic theories of the patent system share two underlying assumptions. The first is that technological information is easy to copy, resulting in a lack of incentive to invest in innovation. The second is that the market is, or should be, the primary mechanism for the exchange of technological information among firms. Together these assumptions give rise to the perception that patents are necessary in order to overcome "market failure due to inappropriability". But, says Mandeville, an information perspective on innovation suggests neither assumption is correct for more than a very small proportion of technological information.

To construct his information perspective, Mandeville begins by outlining the characteristics which distinguish information from material goods with respect to production and dissemination within the economy. For example, information is inexhaustible; it is accumulative, in that it grows with use and its social value is enhanced through dissemination; it has some of the characteristics of capital, in that the acquisition of information usually represents an irreversible investment; information is indivisible; the cost of producing it is independent of the scale on which it is used; and most importantly for Mandeville's arguments, the greater part of the cost of transferring information is the cost incurred by the recipient in absorbing the information and allocating scarce resources to its use. [114]

The second essential element of Mandeville's information perspective is his continuum model of technological information. [115] Defining technology as "information applied to doing things", he observes that some of this information is codified into machines, blueprints, technical and trade journal articles, and patent specifications, but that much of it exists in less codified form. For Mandeville, codification represents formalised learning -- that is, learning arranged, organised into a pattern and ultimately embodied in a tangible object. Predictability is an important element of codification: a technique is not codified unless it consistently yields the same output. Thus, highly codified or tangible information appears only after substantial prior learning has taken place. At the other extreme, uncodified information consists of undeveloped ideas and unarticulated know-how; uncodified information is "pure", intangible information. Mandeville's model is a continuum because there are degrees of codification: for example, information contained in patent specifications will generally be less codified than that embodied in a prototype machine, which in turn is less codified than the information embodied in a mass produced machine. In the process of innovation, codified information evolves out of uncodified information.

Mandeville argues that although most of the real world probably lies somewhere in between the two extremes of highly uncodified and highly codified information, the bulk of economic phenomena associated with innovation occurs toward the "uncodified" end of the continuum. [115a] Further, in any given field at a particular time, the proportion of technology which remains uncodified is determined both by the degree of complexity inherent in the technology and by its newness. Generally, says Mandeville, the older or more mature the technology, the more it has been codified. A new industry based on a new technology is in a fluid situation where most relevant technological information has yet to be codified. [116] Compared with other industries, the biotechnology industry certainly fits this description, and many research tools in biotechnology are likely to be relatively uncodified.

Having developed his continuum model, Mandeville points out that the degree of codification of technological information affects the ease, speed and mode of its diffusion, transfer or imitation. [117] For example, while highly codified information can be communicated without the need for personal interaction, uncodified information is best communicated in person, through practice and "learning by doing". Because transfer costs are higher the less codified the information, the conventional assumption about ease of copying holds only for the highly codified end of the information spectrum; for uncodified technology, information and user costs inhibit imitation. Similarly, high transaction costs associated with the transfer of uncodified information affect the efficiency of the market as a means of coordinating its production and distribution. Mandeville illustrates this point by reference to the case of technology licensing, observing that several well-established difficulties faced by the market in this context are exacerbated in relation to highly uncodified information. [118] He argues that because the market does not work well as a facilitator of information exchange with respect to uncodified information, various nonmarket mechanisms have arisen to fill the gap. These include information transfer via hierarchies within firms, personal communication networks and personal mobility, open publication, collaboration between technology supplying firms and between technology users and suppliers, and the use of consultants. [119]

Thus, Mandeville's argument is that conventional theories of the patent system exaggerate both the problem of inappropriability and the role of the market in the innovative process. If most technological information is not easy to copy -- that is, if free riding is not after all such an attractive option -- and if the costs of acquiring and transmitting most technological information are much higher via the market mechanism than via a range of other existing mechanisms, then it follows that there is no need for a strong patent system to shore up a failing technology market. However, Mandeville goes further, arguing that strengthening property rights on technological information may be not just unnecessary, but actually counter-productive to overall technological advance.

According to Mandeville, an information perspective on innovation highlights the cumulative and collective nature of the process. This is in contrast to the conventional view, which emphasises the role of the individual innovating firm. [120] Innovation is cumulative in the sense that the existing stock of technology is a crucial input in the production of new technology, and collective in that it relies on the interaction of many participants. Because innovation is cumulative, it depends on information flow between present and future innovators; because it is collective, it depends on information flow among current participants, including rivals. From this viewpoint, even unauthorised copying among competing firms is beneficial to overall technological innovation because it is part of a process of transfer and learning.[120a]

Patents, however, have the effect of blocking other firms from freely adopting, imitating or improving on the patented idea without the consent of the patentee. Although patents may (as Kitch theorised) encourage the diffusion of ideas by giving patent holders an incentive to sell the patented product or licence the patented technology, this occurs via the market mechanism; Mandeville argues that while patents can aid the market exchange of highly codified, tangible technology, they tend to discourage the flow of uncodified information via nonmarket mechanisms (absent the patentee's consent, that is exactly what they are intended to do). [121] Further, the argument that the blocking effects of patents can be overcome through licensing and other contractual arrangements is not convincing with respect to uncodified technology -- that is, most technology: even if the patent holder is willing to license the technology to all comers, license agreements between arms-length agents in the marketplace are a much slower and more costly form of information transfer than nonmarket mechanisms -- and the more uncodified the technology, the higher the transaction costs. [122] While conventional theory supposes that the restrictive effects of patents can be justified if they ultimately encourage the production of new information, such a trade-off makes no sense in the realm of uncodified information because there is no clear distinction between production and use: stifling the flow of information automatically stifles its production. [123]

In a mature industry where much of the relevant technology has already been codified, Mandeville suggests that patents may not do much harm. But in new, highly innovative industries, a greater proportion of technology remains uncodified and nonmarket mechanisms are crucial to the information exchange necessary for cumulative technological advance. [124] If Mandeville is correct, strong patent protection in the field of biotechnology may be particularly harmful, impeding the necessary flow of information and deterring the formation of clusters of firms working to develop new technologies. [125]

Two points may be made in relation to Mandeville's theory. First, as Mandeville acknowledges, the incompatibility of property rights with pure, intangible information has always been recognised in patent law: patent doctrine excludes theories and abstract ideas from protection. [126] However, recent developments in patent law -- emanating in particular from the US Federal Circuit -- have expanded the boundaries of patentability such that the patent system now comes close to allowing capture of the value of information itself. [127] In a recent article dealing with the patentability of DNA sequences of unknown function, Rebecca Eisenberg warns against applying "bricks and mortar" rules to information goods; Mandeville's position, that property rights are inconsistent with the economic characteristics of uncodified information, supports Eisenberg's conclusion that there are sound policy reasons to be wary of expanding property rights in intangible information. [127a]

The second point is that Mandeville's vision of clusters of competing firms working on related problems within the same field, exchanging information relatively freely via a range of mechanisms and placing little emphasis on formal property rights and marketplace transactions, is strongly reminiscent of the conditions described by sociologists of science as optimal for the progress of scientific research. Mandeville is aware of this: he observes that informal personal communication, networking and incentives for individuals to communicate and signal the possession of new information seem as important in the realm of uncodified technology as they are conventionally acknowledged to be in the realm of science. [128] Thus it appears that recent sociological and economic theories about the effects of property rights on information flow and the overall pace of technological advance overlap substantially, at least with respect to leading-edge technology exemplified by many biotechnology research tools. [129] The parallels between Mandeville's and Hilgartner's models of technological innovation are especially striking: for example, both postulate that the ease and mode of information transfer depends on where the particular information lies along different kinds of continuum (uncodified to codified, novel or scarce to widely available, untested to reliable); both treat the process of innovation as a continuous cycle driven by complex interactions among many participants, present and future.

Notes

[108a] For a comprehensive overview of the patent system before the 1960s, see generally Fritz Machlup, An Economic Review of the Patent System, Study No. 15 of the Subcomm. on Patents, Trademarks and Copyrights of the Senate Comm. on the Judiciary, 85th Cong., 2d Sess. (1958)

[108b] Kenneth J. Arrow, "Economic Welfare and the Allocation of Resources to Invention", in Richard R. Nelson, ed., The Rate and Direction of Inventive Activities, Princeton University Press, Princeton, 1962.

[108c] Edmund W. Kitch, "The Nature and Function of the Patent System" (1977) 20 Journal of Law and Economics 265, page 277-278.

[109] [Nelson, 1997 #48], page 6; [Eisenberg, 1989 #58], page 1060.

[110] [Eisenberg, 1989 #58], page 1061, citing Michael Polanyi, "The Republic of Science: Its Political and Economic Theory" (1962) 1 Minerva 54.

[111] [Eisenberg, 1989 #58], page 1063-1065, citing works by Robert K. Merton and Warren O. Hagstrom.

[112] According to Kitch, the patent system cannot perform a prospect function in the context of basic scientific research because it is impossible to fashion a meaningful property right around a mere discovery or explanation of scientific phenomena. However, he does believe that basic research faces the same problems of coordination among researchers as are found in applied research, and suggests that the prospect function performed by the patent system in relation to applied research may be performed in relation to basic research by peer review procedures for research grant applications (Edmund W. Kitch, "The Nature and Function of the Patent System" (1977) 20 Journal of Law and Economics 265 at pages 288-289).

[113] [Mandeville, 1996 #248], page 9

[114] [Mandeville, 1996 #248], pages 57-66

[115] This model is elaborated in chapter 4, "Developing an information-theoretic perspective on innovation", [Mandeville, 1996 #248].

[115a] [Mandeville, 1996 #248], page 52-54

[116] [Mandeville, 1996 #248], page 50-51

[117] [Mandeville, 1996 #248], page 57

[118] [Mandeville, 1996 #248], chapter 5, "Information flow mechanisms in the technological change process".

[119][Mandeville, 1996 #248], page 75

[120] [Mandeville, 1996 #248], page 9

[120a] [Mandeville, 1996 #248], page 93

[121] [Mandeville, 1996 #248], page 98

[122] [Mandeville, 1996 #248], page 99

[123][Mandeville, 1996 #248], page 96

[124] [Mandeville, 1996 #248], page 50-51

[125] The relevance to the biotechnology industry of Mandeville's arguments against strong patent protection is demonstrated by the work of Walter W. Powell. Writing from a sociological perspective, Powell has argued that in fields where knowledge is developing rapidly and the sources of knowledge are widely dispersed, the locus of innovation is found in interorganisational networks. In a recent article, he emphasises the importance of relational contracting among participants in the biotechnology industry: because the underlying science and technology is so diverse, not even the largest players can build a sufficiently strong research base to cover all areas of technical innovation, and similarly, it is not easy to assemble the full range of skills required to get new products to market beneath one roof. To compensate for this lack of internal capability, participants in the field have turned to joint ventures, research partnerships, strategic alliances, minority equity investments and licensing arrangements. Powell regards information flow as being so important in the field of biotechnology that he describes the biotechnology industry as not so much an industry in the traditional sense, as a "conduit" for a wide range of surrounding sectors to access fundamental new technologies. See generally [Powell, 2001 #298].

[126] [Mandeville, 1996 #248], page 103

[127] [Eisenberg, 2000 #221], pages 791-792.

[127a] [Mandeville, 1996 #248], page 103; [Eisenberg, 2000 #221], page 796.

[128] [Mandeville, 1996 #248], page 105.

[129] This is not to say that the policy implications are always clear. Sociologists Cambrosio and Keating argue that private ownership of specific research tools may actually promote their transfer from local to extended networks within the scientific community ([Cambrosio, 1998 #192], page 176, and see footnote... above; Mandeville would describe this as part of the process of codification), while Merges ([Merges, 2001 #291]) argues that property rights can promote the formation of economic institutions, such as patent pools, which then act as channels for the informal exchange of valuable information (see below in text).

Cumulative innovation and the optimal design of intellectual property rights

Other economic theorists building on Arrow's insights about the relationship between property rights and information transaction costs have also focused on the cumulative nature of innovation. Robert Merges notes the emergence in the early 1990s of a strand of economics literature attempting to describe how intellectual property rights affect bargaining between pioneer inventors and follow-on improvers in contexts where research activity is directed toward the development of improvements or applications of a previous invention. [130] This "cumulative" or "sequential" innovation literature is part of a broader economics literature on optimal design of intellectual property rights sparked by William D. Nordhaus' 1969 observation that patent length represents a trade-off between encouraging innovation and avoiding the deadweight loss associated with monopoly profits.[131] The optimal design literature considers how refinements in the length, breadth and standard of intellectual property protection might impact on its effectiveness as an incentive mechanism. [132]

When economists began to think about how the cumulative nature of innovation affects optimal patent design, they immediately saw a problem of incentive. An invention which facilitates future innovations may be assumed to be of greater social value than one which is only useful in itself. However, in such a case it is difficult to turn social value into private value, because the incremental value of future innovations is not automatically reflected in the price of the initial invention. Unless social value can be converted into private value, so the argument goes, early innovators will have inadequate incentive to invest.[133] This problem is especially likely to arise in the case of research tools, because a large proportion of their social value resides in the innovations they facilitate. [134] A solution is to give early innovators some claim on profits arising from subsequent innovations, but this creates a new problem by reducing incentives for follow-on innovators. [135]

From this starting point, much of the literature on cumulative innovation has focused on how intellectual property rules determine the division of profits among sequential innovators, with the aim of finding those "settings" under which profits are divided so as to respect the costs of early and later innovators and thus provide adequate incentives at every stage of the innovation process. [136] Unfortunately (though perhaps not surprisingly), increased attention to the problem of patent design in the context of cumulative innovation has not resulted in any clear guidance as to whether or how intellectual property rules should be altered in order to encourage innovation. In an article reviewing ten years' worth of literature on cumulative innovation, Nancy Gallini and Suzanne Scotchmer cautiously extract a case for broad and short patents, arguing that broad patents can serve the public interest by preventing duplication of research and development costs, facilitating the development of second generation products and protecting early innovators who lay the foundations for later development; these arguments are consistent with Kitch's prospect development model of patent function. [137] On the other hand, John H. Barton believes that the current balance of incentives is probably too much in favour of initial innovators and concludes that the best response to the recognition that innovation is cumulative is not to find ways to strengthen the control of the initial innovator, but rather to find ways to strengthen incentives and opportunities for follow-on innovators. [138]

One lesson which does emerge clearly from the cumulative innovation literature is that private contracting among rights holders can dramatically affect the optimal design of patents. The benefits of broad patents identified by Gallini and Scotchmer depend on the ability of right holders to contract around conflicts in rights: with contracting, patent holders can profit from improvements instead of being threatened by them, and will therefore ensure that they arise even if they infringe the patent; but without contracting, there is a danger that broad patents will inhibit future innovators from making improvements. In other words, whether property rights are helpful or counterproductive in encouraging innovation depends on the ease with which innovators can enter into agreements for rearranging and exercising those rights.[139] This issue of transaction costs is taken up below

Notes

[130] [Merges, 2001 #291], p125; [Merges, 2000 #253], p.... (Can't find photocopy to get page number.) Early papers include [Merges, 1990 #293] and [Scotchmer, 1991 #294].

[131] Nordhaus, W., "Invention, Growth, and Welfare: A Theoretical Treatment of Technological Change", MIT Press, Cambridge, Mass., 1969

[132] For a review of the optimal design literature, see [Gallini, 2002 #239]. (Downloaded on 13 June 2001 as a working paper dated May 6 2001 from Suzanne Scotchmer's internet homepage, http://socrates.berkeley.edu/~Scotch/ip.html. No page numbers; coversheet describes the paper as forthcoming in two publications:

Innovation Policy and the Economy, vol. 2, Adam Jaffe, Joshua Lerner and Scott Stern, eds, MIT Press 2002

Legal Orderings and Economic Institutions, F. Cafaggi, A. Nicita and U. Pagano, eds., Routledge Studies in Political Economy....)

[133] S. Scotchmer, Cumulative Innovation in Theory and Practice, Goldman School of Public Policy Working Paper 240, University of California (Berkeley), February 1999, p1. ( [Scotchmer, 1999 #307], downloaded on 12 December 2001 from Suzanne Scotchmer's internet homepage, http://socrates.berkeley.edu/~Scotch/ip.html.)

[134] [Gallini, 2002 #239], under heading IV: Optimal Design: The Case of Cumulative Innovation".

[135] See [Barton, 1997 #306], text accompanying notes 12 to 25. (No page numbers in my copy, downloaded from LexSee...)

[136] [Gallini, 2002 #239], under heading "IV: Optimal Design: The Case of Cumulative Innovation". In this connection, Barton observes that early basic research is more likely than follow-on research to have been publicly funded through research grants or other schemes which may provide adequate incentives even in the absence of intellectual property protection: [Barton, 1997 #306], text accompanying note 19.

[137] [Gallini, 2002 #239], under heading "IV: Optimal Design: The Case of Cumulative Innovation".

[138] [Barton, 2000 #265], p1934.; [Barton, 1997 #306], text accompanying note 25.

[139] [Gallini, 2002 #239], under heading "IV: Optimal Design: The Case of Cumulative Innovation".

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