Patents are necessary for innovation – critiques are misguided

The U.S. patent system issued its first patent on July 31, 1790, which was signed by President George Washington.1 Samuel Hopkins obtained that patent for a process of making potash, an ingredient used in fertilizer.2 The over 6 million patents issued since then have supported the market development of steamships, automobiles, electric power, electric appliances, aviation, aerospace, telecommunications, mobile communications, computers, the Internet, biotechnology, and nanotechnology. Despite these significant achievements, the U.S. patent system is facing a perfect storm of criticism from academics, politicians, judges, journalists, and industry groups, with calls for abolishing or heavily regulating patents. In this article, I suggest that the anti-patent storm in part reflects a basic misunderstanding of the purpose of the patent system. A better understanding of the contributions of patents may help calm the anti-patent storm and avoid disrupting the highly successful U.S. system of invention and innovation.

I argue in this article that patents “promote the progress of science and useful arts,” because they provide the foundation of the market for inventions.3 I develop a comprehensive economic framework for the study of patents that extends work I have done on market microstructure, the theory of the firm, invention, and innovation.4 Applying this framework, I demonstrate that patents support the market for inventions in several important ways: (1) by increasing transaction efficiencies and stimulating competition, (2) by establishing what I term “the market for innovative control” that provides incentives for efficient investment, and (3) by promoting the financing of invention and innovation.5 I show that the market foundation role of patents has important implications for antitrust and public policy toward intellectual property (IP).

Yet, for many academics, the patent system is a “failure,”6 in a “crisis,”7 and a “major wound” that should be abolished.8 The press tends to agree: “Abusive and frivolous lawsuits brought by holders of patents are costing the American economy billions of dollars.”9 Antitrust policy makers seeking “a proper balance between exclusivity and competition” argue that “[i]nvalid or overbroad patents disrupt that balance by discouraging follow-on innovation, preventing competition, and raising prices through unnecessary licensing and litigation.”10 The Supreme Court in a series of opinions has ruled claims for a wide range of subject matters as patent-ineligible.11 Commentators have noted the “hostility to patents” by the Executive Branch.12 Congress is in the midst of extensive bipartisan patent reform efforts.13 According to industry lobbyists, such as the Electronic Frontier Foundation, “[w]e happen to be at a special point in time when every branch of government is itching for patent reform.”14

I demonstrate that, contrary to these assertions, patents create economic benefits, because the market for inventions generates efficient incentives for invention and innovation. This is important because the market for inventions is vast. The market for inventions includes disembodied inventions in the form of licensing, cross licensing, assignments, and contractual research and development (R&D). The market for inventions also includes technologies embodied in goods and services, production processes, transaction techniques, and firms themselves.15 The market for inventions further includes financing of invention and innovation through entrepreneurial and corporate finance.

First, I show that key features of the patent system—exclusion, transferability, disclosure, certification, standardization, and divisibility—increase transaction efficiencies and stimulate competition in the market for inventions. These properties of patents reduce transaction costs associated with transferring, licensing, cross-licensing, combining, implementing, and developing inventions. Patents give owners rights to exclude others from making, using, or selling their inventions.16 Patents help convert inventions into transferable assets, so that inventors and adopters can transact more efficiently in the market for inventions. Patents promote disclosure of inventions, which reduces costs of search and bargaining in the market for inventions. Patents provide certification of technologies, which decreases information asymmetry in the market for inventions. Patents provide standardization in IP, which reduces the costs of contracting in the market for inventions. Finally, patents allow greater divisibility of technology, which promotes modularity and increases gains from trade in the market for inventions. Patents thus generate economic benefits that are based on more efficient transactions and greater competition in the market for inventions.

Second, I introduce the concept of the market for innovative control. Patent owners not only obtain residual returns from their inventions, but also have residual rights to choose how their inventions are made, used, and sold.17 The market for innovative control helps determine the value of inventions, selects the best inventions, and allocates inventions to the highest-value users. The market for inventions is a market for innovative control because patent owners have rights to develop inventions, apply inventions to produce innovations, and invest in complementary assets. The market for inventions provides incentives for the efficient organization of firms and industries in terms of the extent of vertical integration of R&D and manufacturing.

Third, I emphasize that patents facilitate the financial separation of inventions from their inventors, helping inventors obtain financing.18 By serving as intangible real assets, patents are useful for contracts that finance invention, as indicated by the use of licensing or transfer options for companies funding university research. Entrepreneurs report that patents can be important in securing financing for startups and establishment of firms.19 Patents also are important for corporate finance and appear as intangible real assets in the balance sheets of corporations. Patents affect the value of corporations in two main ways.20 Patents that are “assets in place” affect the firm's earnings either through licensing royalties or through own-use of the technology as a productive input. Patents that offer “growth opportunities” affect the firm's expected value because they indicate the potential to invest in innovation based on the firm's IP or to invest in invention of related technology. Financial contracts and the capital structure of firms help provide incentives for invention and innovation.

Patents are forward-looking—they perform most of their economic functions in the market for inventions after they are granted. The market foundation role of patents stands in stark contrast to the common view that patents provide “rewards” for inventors. The “rewards” view tends to be backward-looking; according to this view patents complete most of their economic functions at the time they are granted. The “rewards” view of patents is highly misleading for public policy because it does not accurately describe public and private institutions. Contrary to the “rewards” view, markets, not government agencies, determine what rewards inventors and innovators receive and market participants provide those rewards. The “rewards” view considers patents as sources of residual returns for IP owners without considering that ownership provides the basis for innovative control. Based on the “rewards” view, some researchers recommend weakening patents through antitrust, limits on litigation, compulsory licensing, government ownership, price controls, taxes, and subsidies.21 These regulatory approaches would stifle or eliminate the economic benefits that result from the market for inventions.

The market foundation role of patents offers insights into public policy toward IP. With patent protections for IP, the market for inventions determines the market value of inventions and the returns to invention, innovation, and complementary inventions. IP policy should maintain the property rights system because of its benefits for competition and transaction efficiencies. This implies maintaining the key features of the patent system: exclusion, transferability, disclosure, certification, standardization, and divisibility. In addition, to support the market for innovative control and the financing of invention and innovation, patents should have sufficient scope to provide IP protections for development of inventions and innovations. Weakening patent rights would reduce transaction efficiencies and competition, distort incentives and guidance in the market for innovative control, and reduce incentives to finance invention, commercialization, and innovation. Public policy makers should not attempt to determine rewards for inventors, because governments lack the vast amounts of information dispersed in the market place, as Friedrich Hayek understood.22