The Patent Lottery:

1. The Patent Lottery: Exploiting Behavioral Economics for the Common Good Shahil Patel & Rani IEOR 190G 5/9/2009

2. Section 1: Summary

3. Overview • Legal studies research paper written by Dennis D. Crouch • Main Idea: “The benefits of using intellectual property as an innovation incentive must be balanced with concerns of holdup costs and potential monopoly harms. The lottery effect provides a tool that may help weaken the connection between these otherwise linked pros and cons.”

4. What is a “Lottery Effect”? • Objective of “State Lottery” is to collect funds from people for public spending / social benefit • Statistics show that investors are sensitive to the size of the jackpot but insensitive to the probability of winning • Thus, State Lottery increases its “house rake” by marginally increasing the size of the jackpot • “Lottery Effect”: people are overly-optimistic and ignore the odds of success

5. Behavioral Economics • Author’s arguments are founded in behavioral economics • Branch that applies scientific research on social, cognitive and emotional factors to better understand economic decisions • Inventors treated in this paper as investors • Example – Availability heuristic • News reports of an event’s occurrence increases a person’s prediction of the frequency of the event • Reports of successful innovation may increase the perception of large payout, and neglect of low odds of future success

6. Expected Utility Theory • You have two options: • Take $3,000 now with 100% certainty • Or, you have an 80% chance at getting $4,000 vs. 20$ chance at $0 • Expected payout of second option is higher, yet most people choose the first • Investors are assumed to be risk-averse • Then why are inventors not averse to taking such large risks by filing patents?

7. Patent Lottery Effect • Future payout, or “jackpot size” is the primary motivation behind innovation • Inventors will over-estimate the payout of their inventions, but disregard their low probability of success • Same may hold true for “sets” of patents (i.e. patent portfolios) • Important distinction: inventors are insensitive to probability of success, but this probability MUST remain greater than zero

8. Application: Patent Law Policy • To increase social benefits, policymakers must adjust patent rights by using policy levers • Length of patent term • Level of nonobviousness required for patentability • Type of relief available against infringers • Goal is to maximize the upside (promote innovation) and minimize downside (monopolistic business activities, excessive litigation etc…) • Certain levers may increase an incentive to innovate with only a small increase In monopoly harm, while others may decrease monopoly harm with only small decrease on innovative activity

9. Case Study I • 2006 Supreme Court case: eBay, Inc. v. MercExchange, L.L.C • eBay is the infringer • MercExchange is not practicing its patent, but still demands injunction • Court decisions go back and forth • Ultimately, case is settled but court reduces the probability of injunction • According to author, this is decision follows the lottery effect model • Monopolistic rents minimized, while impact on private investor is small

10. Case Study II • 2007 Supreme Court case: KSR International Co. v. Teleflex, Inc. • Court expanded the number of patents that could be invalidated as obvious • According to author, the decision reduced the probability of obtaining a successful patent in the invalidated domain to zero • Decision also left ultimate potential payout unchanged • This violates the lottery model

11. Comparison • eBay case reflected positive application of the lottery model • Payout is the primary driver – by reducing this, court minimized social rents • Probability of success is decreased, but this has minimal impact on innovation • KSR reflected a negative application by Supreme Court • Payout is left unchanged – no effect on social rents • Probability of success is decreased to zero – this has huge negative impact on innovation

12. Section 2: Project overview

13. Main Objectives • Review this paper from analytical perspective • Evaluate claims made by author • Closely examine the patent lottery effects model • Is the theory adequately supported by the provided model?

14. Initial Reaction • Provides an interesting new perspective on inventor investment behavior through a creative application of behavioral economics • Adequately explains analogy of lottery effects • However, fails to make strong connection between lottery effects model and applications to patent law policy • Also, many ideas are either too simplistic or inadequately supported

15. Section 2: Critical Analysis

16. Criticism I • Is INVENTOR behavior actually similar to INVESTOR behavior? • Expected (Value of State Lottery) = Function of ($1 tkt price, jackpot payout, probability) • Expected (Value of Innovation using Patent Lottery) = Function of (price, payout, probability) • House rake clearly defined with state lottery, but not with patent lottery • Difficult to find EXPECTED VALUE using patent lottery because none of these variables are known

17. Criticism II • Small inventors have high affinity for risk-taking, while “boldest technological innovations” happen outside of corporate culture • Thus, patent lottery effects only apply to small inventors • Further, this only helps us to understand “most valuable patents” • Is this a good enough sample of the population?

18. Criticism III • Patent lottery effect is only a partial answer • Does not take into account extrinsic motivations • Desire to be first to market • Shareholder value (i.e. impress VCs & other investors) • Insurance against future competition • Only briefly mentions these aspects • No substantial data

19. Criticism IV • Author claims that the balance of the variety of positive and negative social impacts "finance" the patent system and hence serve as "house rake" of patent lottery. • It is not clear exactly how one would calculate this house rake, or increase it.

20. Criticism V • Model i=J*P is too simplistic • It only has incentive I • Only two levers are large payout J and the probability P • Author mentions both jackpot volatility and risk as aspects of patent lottery, but these measures are not accounted for in model • Hard to deduce how to maximize positive innovative activity, & minimize negative rents • There is no mention of how his model can be "tweaked” for a specific scenario.

21. Criticism VI • Patent lottery construct is not the only way to treat the adjustment of patent law policy • Author does not address these constructs, or specifically explain why his model is superior

22. Criticism VII • Paper cannot answer the following question: • "Would you be willing to invest time and/or money in developing a new innovation that had only a small chance of reaping huge rewards, if you knew that the expected and most likely return would be less than your original investment?" • This is what every inventor wants to know.

23. Criticism VIII • KSRvs. Teleflex case is a weak example • Author states that court decision to expand invalidation of patents discourages innovation • This implies that court should not constrain innovation, even if it is unnecessary and unobvious • Also, the author does not address the minimization of rents associated with elimination of future litigation regarding the invalidated patents

24. Areas for Further Research • Empirical results are needed to support the claim that this model can be applied • Also assumptions for the model should be stated • For example, are there factors that would minimize litigation using this formula? • This research could be an inter-disciplinary effort so that the modeling approach is more thorough