38CO2000 Economics of Intellectual Property Rights (IPRs) Spring 2006: Lecture 2

1. 38CO2000Economics of Intellectual Property Rights (IPRs) Spring 2006: Lecture 2 • Practical issues: • The course lasts until 3.5. • One lecture will be reduced against the lecture on 8.11, which is included in the course. The date will be announced later. • The exam is 9.5., 9-13. Needs a registration via weboodi.

2. Recapitulating from the last time: • 1) The importance of the IPRs has dramatically increased over the past 30 years • We now know that technological progress is a major reason for economic growth and that IPRs are a major incentive mechanism that affects technological progress • Creation of the market for technology • Technological change • Legal changes • Success and failures of corporations • 2) There is a wide array of various IPRs

4. 3) Knowledge is a public good. Non-rival and to various extent non-excludable. • - There is a fundamental tradeoff between the creation of the incentive to innovate and using innovations once made • Ex ante, before investments in knowledge production, there is an appropriability problem. • Ex post, once knowledge exists, it does not wear out and there is no point to restricts its use • Intellectual property makes knowledge (more) excludable and hence creates the incentive to innovate ex ante but restricts its use ex post. • Appropriability follows from the nature of knowledge and institutions that support innovation. • This fundamental tradeoff is underlying the most debate concerning IPRs!

5. An example • suppose it costs 1000.000€ to develop a new product • MC of production = 50€ • 100.000 buyers • the producer-innovator needs to get at least 60€ per product [(100.000*50+1000.000)/100.000] to make the innovative effort profitable • suppose at least one other firm with an identical production technology enters in the industry • suppose that there is no IPRs and the innovation is easy to copy, i.e., imitation/duplication cost  0€ • in the competitive equilibrium the price will be 50€ • both firms make zero profits • no incentive to make the innovation in the first place! • This the essence of the appropriability problem (Arrow, 62)

6. Approbriability problem and the rise of IPRs • Because of the approbriability problem, there is a market failure in the market for innovation (creating new knowledge). • As usually, the source of market failure is that there is too little • capitalism, i.e. property rights on knowledge are not well defined • A straightforward solution: define property rights on knowledge, i.e., make products of knowledge excludable •  intellectual property rights is a relatively old economic institution • e.g. chefs in Sybaris 700-500 BC • It is a puzzle whether IP is an old economic institution or a new. Is the notion of IP is inherent to humans? • rather capitalistic and democratic institution • the rise of IPRs inherent to the rise of capitalism • e.g. formal patent law introduced 1474 in Venice

7. Another side of the coin: the ex post problem • Once knowledge is created it is waste to restrict its use • widespread notion that knowledge should be a publicly accessible good • tensions trough history after major technological breakthrough, e.g., the antipatent movement of the end of 1800 century, compare with the free software movement • There is nothing new in the current situation • Let us develop the concepts used over this course and look the ex post problem in more detail • It is also a major defect of IP compared with other institutions to support innovation

8. Competitive market for “tangible” goods Pmax=a Demand P(Q)=a-Q “willingness-to-pay” P (price) CS=W MC P* Q* Q (quantity) or # of consumers

9. In a competitive market for tangible (excludable, rival) goods • Producer surplus / profits (PS) = (P*-MC)Q*=0 • Consumer surplus (CS) = (a-P*)Q*/2= Q*2/2 • Social Welfare (W)= PS+CS=CS=(a-P*)Q*/2= Q*2/2 • With integrals… • Competitive markets are efficient since • The good goes to the ones who value it most • Price equals the opportunity cost of resources required to prodice the good (P=MC) • i.e., the “indivisible hand” works • Proofs…

10. Market for non-proprietary information good • competitive • MC of production/duplication  0 Pmax=a P P(Q) CSc=Wc MC P*=0 Q*=Qmax=a as P(Q)=a-Q Q

11. In a market for non-proprietary information good (non-excludable, non-rival) • PSc (little c stands for competitive given MC=0) = (P*-MC)Q*=0 • CSc = (a-P*)Q*/2=a2/2 • Wc = PSc+CSc=CSc=a2/2 • A competitive market for non-proprietary information good is efficient like any other competitive market • the ex post market!

12. Market for proprietary information goods a P P(Q) CSp Pm PSp DWL MC Qm a=Qmax Q

13. In a market for a proprietary information good (excludable, non-rival) • PSp (little p stands for proprietary) = (Pm-MC)Qm= PmQm>0=PSc • CSp = (a-Pm)Qm/2=(Qm)2/2 < a2/2 = CSc • Wp= PSp+CSp=PmQm+(a-Pm)Qm/2= (a+Pm)Qm/2= <Wc • Wc-Wp=DWL (Dead-weight loss due to proprietary pricing) • A market for a proprietary information good is inefficient due to market power of the producer • Recall: The problem ex ante i.e., the approbriability problem. There is no incentive to innovate unless PS>0. E.g., if the cost of innovation is 0<K<PSp, the information good is created under the proprietary system but not in the competitive system

14. In sum: there is a fundamental tradeoff between the creation of the incentive to innovate and spreading of innovations. • If no IPRs or weak IPRs, there is little innovation • If strong IPRs, there is price of innovations is too high and their use is restricted

15. Welfare Strength of IPRs

16. The current strong IPR/ “Intellectual Capitalism” era is rather young, about 30 years • The question of our time: Does knowledge economy need to be capitalistic, i.e. do we need IPRs? • - Cf. manifests, debate in popular press, free software movements, Boldrin-Levine, Bessen-Hunt etc • In essence, would the incentive to innovate be sufficiently high or even higher without IPRs? • Does not go well in the traditional left-right political division • E.g, the Finnish MEPs that voted against the software patent directive last summer include Satu Hassi, Pia-Noora Kauppi, Eija-Riitta Korhola, Riitta Myller, Alexander Stubb… • BUT as said there is nothing new in the current situation

17. An example: the adoption of patent law in Switzerland • many rejections in the popular vote in the 19th century • finally approved by the lobby from watch industry • restricted to mechanical innovations because the Swiss chemical industry wanted to imitate Germans!

18. Note: there are other institutions to foster creation of knowledge than IP • Public production • Public procurement (contests) • Subsidies • Prizes • - IP is not an ideal incentive mechanism. Nor are the others • The other mechanisms are better in solving the ex post problem but IP is better in solving the ex ante problem • Firms/innovators have better knowledge what should be invented or what is feasible to invent than the government • IP typically restricts the use of innovations (but only the users pay).

19. Is it optimal to combine the mechanisms, e.g., why publicly funded innovations are also protected by IPs? • Is IP the best system? • Is it possible to design the other systems better so that we can get rid off IPs? Come up with a new mechanism? • Is it possible to design IP better? • - Designing IP so that it does not restrict use while providing the incentive to innovate • - Another major reason for the patent institution is disclosure i.e. spreading of innovations • If IP is the best, are there too many or too few forms of IPRs? • Do we need more sui generis IPRs (industry or even innovation specific IPRs)?

20. Overview • Intro • Patent (and other IP) Policy • II.1 Static context • II.2 Cumulative context • Management of Patents (and other IPs) • III. 1. Patenting vs secrecy • III. 2. Licensing • IV. Competition Policy and IPRs • V. Innovation and IPRs in Financial Services Sector • Other…