Government intervention is key to spur R&D in sectors in which companies do not see as economically worthy.

[Reto M & Pedro Henrique D, 7-19-23, GRUR International Journal of European and International IP Law, “Potential and Limits of Patent Law to Address Climate Change”, , accessed: 7-9-24, AngH]

The first type of market failure has its origin in the lack of appropriate individual demand in the respective market. An example of this would be medicines for treating rare diseases or diseases that only occur in regions where the financial means to buy such pharmaceuticals are lacking.15 Since the global demand is small under such circumstances, the pharmaceutical industry has no incentive – or at least no monetary incentive – to invest in R&D related to appropriate pharmaceutical solutions in these fields.

The same type of market failure may also occur in relation to sustainable innovations to the extent that they do not even emerge, although it would be possible. For as long as the majority of consumers prefer cheaper but less sustainable products, it cannot be assumed that there is sufficient demand for sustainable but more expensive products. As a result, there are no (monetary) incentives for the companies responsible for harming the environment to invest in such technologies.

One may of course argue that this situation is not a market failure at all. The fact that a social need – whose fulfillment is politically desired – is not met by the market ultimately means that the market is indeed responding to the actual demand reflected in the price.16 However, scholarship – including economics – also uses the term ‘market failure’ to refer to a mismatch between an assumed social need – which does not necessarily reflect the demand of the majority of individual market players – and the actual supply.17 For instance, some authors consider the general lack of demand that hampered market growth after the Great Depression of 1929 as a ‘market failure’,18 the correction of which was the subject of Keynesian policies. The aforementioned example of rare diseases19 follows the same path.

In any event, it can hardly be denied that the circumstances at issue here give rise to a negative externality – i.e. costs incurred by a third party as a result of the conduct of other parties.20 The classic example of negative externality is pollution.21 It causes a social cost that, without adequate regulation, is not reflected in the market price of the product generated. Similarly, the consequences of climate change and all the social costs related to it are not adequately reflected in the price of non-sustainable products, which tend to be in greater demand than sustainable products. In view of this, and also to structure the legal analysis in a clear manner, in this article the lack or insufficiency of demand for sustainable products is considered to be a market failure.

In such a situation – and that is the crucial point in this first type of market failure – the mere possibility of receiving a patent for a sustainable invention remains ineffective. After all, no one invents something in order to merely obtain a patent, but ultimately – unless idealistic reasons are in the foreground – in order to recoup investments and eventually obtain the envisaged worthwhile profit.

Thus, it follows that in the case of this first type of market failure there is also no point in adjusting the controls of patent law – for instance to speed up examination or to lower fees. To counteract the fact that the market does not call for what should ideally be demanded, taking into account value-related or similar reasons, measures outside of patent law are required. This will be discussed further in this article.22

2. The second type of market failure

The second type of market failure is characterized by the fact that a demand for innovative products does indeed exist in the market. Nevertheless, private actors may be deterred from making investments due to the fear of not being able to recoup the cost or achieve adequate profits.

This risk is particularly pressing if the right holder's first-mover advantage23 is not expected to be sufficient for these purposes because free riders are able to launch cheaper imitation products on the market without their own substantial investment.24 This puts pressure on the market price, with the risk that the costs of R&D for the technology in question can no longer be recovered. As a result, the innovator may bear the cost. If an innovator anticipates this risk, it will not invest in the first place. Consequently, an innovation that is – in principle – possible will not occur.

One of patent law’s core functions is to counteract this second type of market failure by granting the innovator market exclusivity for a limited period of time. It is nevertheless overly simplistic to say that patent law as such provides incentives for innovation in this case. Rather, the incentives continue to come from the market. Subject to sufficient market demand, patents may ensure adequate returns from selling products incorporating the patented invention. Patents provide market exclusivity, allowing the determination of a price that takes into account the investments made.

3. The third type of market failure

The third type of market failure occurs when innovations that would in principle be possible are impeded. This can occur for various reasons. One reason of particular interest for this analysis, which deals with the role of IP rights with regard to sustainable innovations, is the existence of third-party rights, above all patents. In fact, patents can be used not only to prevent imitators (thereby avoiding the second type of market failure), they also have the potential to drive competitors out of an innovation market. It is well known that patents in the IT sector have often been used as strategic weapons.25 Further examples of anticompetitive patent-related strategies can be found in the health and pharmaceutical sector.26

Such practices have the effect of turning the intended function of patent law into its opposite. Legal protection no longer serves to support innovative behavior, but rather obstructs dynamic competition and, consequently, further innovation. In other words, patent law develops dysfunctional effects.

This insight is not new, but it is questionable whether the consequences have been sufficiently considered so far. Adjustments in patent law may be necessary to avoid overprotection that could impair its functional use. Of course, this also applies in the field of sustainable technologies, where the consequences of this third type of market failure can be particularly serious, which is why it is all the more important to explore the possibilities for optimizing patent law.

III. Options to avoid market failure related to sustainable technologies

Appropriate measures – including those related to patents – for correcting market failure vary depending on the type of such failure. This section concentrates on regulatory options for the correction of market failure that may affect sustainable innovation. Some of these options deserve more attention at the academic level. Further fundamental research (including interdisciplinary research) may not only verify the economic justifications and viability of such options, but may also make concrete recommendations for the appropriate regulatory design.

1. Avoiding the first type of market failure (insufficiency of market demand)

The demand for sustainable products may be insufficient due to their higher prices compared to less sustainable ones, so that the latter continue to be consumed. Thus, there will be no, or not enough, market incentives to innovate in the area of sustainable technologies to achieve the environmental objectives determined by policymakers.

In these cases, a lack of incentives can to some extent be substituted and innovation be stimulated by state intervention. The granting of patents is similarly an intervention by the state because it eliminates free (in this case, imitation) competition. Nevertheless, as noted above,27 patent law is not suitable to counteract this first type of market failure.

Instead, some reflections on other forms of state intervention and their impact on innovation are worthwhile. In principle, there are two avenues for state intervention.