Patents internalize positive externalities, solving free riders and maintaining incentives to invent.

The function of internalizing externalities is not foreign to patents; in fact, internalizing positive externalities is their reason for being. The classic justification for patents posits that the technical information at the heart of technology is a public good. This means that the information is both nonrival (one's consumption of the information does not diminish its availability) and nonexcludable (in the absence of legal protections, it is difficult to prevent others from accessing it).119 As a public good, technical information is subject to undersupply in a fully competitive economy; noninnovating firms could simply copy the inventions of others, thus undermining incentives to invent. Patents allow inventors to exclude free riders, thus mitigating the public goods problem and maintaining incentives to invent.

Put differently, patents internalize positive innovation externalities. Assume that it costs Merck $2.6 billion to develop a new FDA-approved drug and bring it to market.12o In the absence of patents, competing drug companies could simply copy Merck's drug for free. In this scenario, Merck's significant R&D expenditures would generate tremendous positive externalities for its competitors (as well as patients and society at large).121 While positive externalities seem like a good thing, they can depress incentives to invent if the inventor does not capture a meaningful share of the benefits produced. If nearly the entire value of Merck's invention "spills over" to others (including competitors) as positive externalities, Merck would have little incentive to invest in R&D. Patents provide Merck and other inventors with a right to exclude others from practicing an invention for twenty years. As such, they allow inventors to internalize a significant share of the positive externalities of their inventions, thus shoring up incentives to invent.