Perm do both – it reduces looting and expropriation

I propose an alternative that does not introduce a risk of either patentee confiscation or government looting. In my proposal, the innovator receives both a patent and a prize. Under this scheme, the patentee receives the patent profit and a prize that approximates the consumer surplus. The amount of the prize would be limited, as in the Kremer proposal, to some fixed percentage (or multiple) of patentee profit. Thus, the patentee receives the patent profit multiplied by a markup factor M2, where ideally

For example, if the demand schedule is linear, the ratio of the residual consumer surplus to the monopoly profit is ½. Thus, the patentee would be given a prize equal to 50 percent of profit. In this system, the patentee cannot have his profits confiscated because he has the usual patent; the patentee can only do better than under the current system. Since there is no auction of the patent, and the government does not propose to take patents and put them into the public domain, there is absolutely no risk of confiscation.

This stands in contrast to the Shavell and Ypersele plan. Under their plan, it seems at first glance that the patentee can only do better than under the current system. However, because the government takes patents and puts them into the public domain, there is a substantial risk that the patentee will suffer confiscation. Recall, the way confiscation can occur under the Shavell and Ypersele plan is that government approaches the patentee with a confiscatory prize offer, and the patentee comes under political pressure to accept the government’s offer.

Consider the problem of looting. In setting the prize amount, there is obviously a risk that an agent could arrange for the government to be looted by setting the prize well above the amount of consumer surplus. There are several reasons this risk is minimal or nonexistent under the patent-plus-prize scheme.

First, like the Kremer proposal, the amount of the prize is limited to a fixed percentage of patentee profit. In the proposed scheme here, the percentage is designed to measure the amount of consumer surplus from the patent. In the case of linear demand, the percentage is exactly 50 percent. However, more sophisticated methods of determining the precise percentage can be used.

Second, the approximation of consumer surplus is a conservative measure of the additional social value, beyond profit, created by the patent. There are additional components of social value not captured by this approach. For example, after the patent expires, society gets the entire surplus – the increment being the so-called deadweight loss – and this is clearly attributable to the innovation. Second, during the life of the patent, rivals attempt to introduce competing products to eat into the patentee’s profits and create substitutes. This process of creating substitutes reduces the market power of the patentee and therefore increases the surplus going to consumers. Third, the patent has spillover benefits to other firms (follow-on innovators) who attempt to build on the innovations revealed by the patent. The consumer surplus approximation, in the form of a prize, fails to incorporate these additional sources of social value. Because it fails to do so, it is quite unlikely to result in a transfer to the patentee that exceeds the additional social value, beyond the profit, created by the patent.

Under the patent-plus-prize scheme, there would be no effort to capture the unattained surplus (ASX in Figure 1) in the prize portion. Note that I do not refer to this as deadweight loss in this scenario. The reason is that the relevant choice is between the patent, with its accompanying monopoly price, and no production at all. The patent does not fall into the public domain, except upon expiration, under the patent-plus-prize scheme. Hence, the option of production and selling at marginal cost during the term of the patent does not exist. No deadweight loss arises.

For this reason (that is, because there is no deadweight loss), the patent-plus-prize scheme does a better job of aligning private and social incentives to innovate than the optional prize schemes that assign patents to the public domain upon award of the prize. Under the patent-plus-prize scheme, the innovator captures the social value of the innovation, or nearly so. The major portions of social surplus that are not captured in the patent-plus-prize scheme are the spillover benefits (e.g., to follow-on innovators) and the post-expiration social surplus. The spillover benefits are not central to the other prize schemes, and in any event those benefits can be incorporated easily into the markup as suggested by Kremer. The post-expiration surplus is not incorporated into the prize estimation in the optional prize schemes as well. One could attempt to incorporate the post-expiration surplus, but it would be difficult to estimate with any reasonable degree of accuracy. A great deal changes in the market during the course of a twenty year patent term.