Incentives are the only path to solvency.

Over the past several years the U.S. Supreme Court has slowly, but consistently, eroded what is considered patent-eligible, most recently with decisions on software[1] and gene[2] patents. In essence, the universe of patentable innovations has been diminished. And with it, the country’s economic potential.

Innovation is a powerful economic force and driver of both development and prosperity. Yet the Supreme Court’s recent decisions undermine the incentives to innovate in areas critical to future U.S. economic growth. Reducing the patent-eligible landscape in this way essentially eliminates any future U.S. contribution in these areas. Fundamentally it is an issue of incentives and their power to shape behavior.

Incentives are essential to innovation due to the expense of research and development activities, and the public-goods nature of the resulting knowledge. As described by Belleflamme (2006), intellectual property (IP) generating activities suffer from three generic sources of market failure: externalities, indivisibilities and uncertainty.[3] The externalities arise from the public-goods nature of information, which makes imitation is easier than invention. Information and knowledge are public good in the sense that they are non-rival in consumption[4] and non-excludable[5]. In addition, intellectual property markets are characterized by indivisibility since knowledge and information are inherently discrete. Finally, knowledge creation involves tremendous uncertainty and risk.

Innovators face appropriability problems due to these three market failures. That is, investors are unable to fully capture the returns on their investment and the social benefits usually exceed the private benefits. Empirical studies suggest that investors capture at most half of the returns on their investments.[6] As a result, many potentially beneficial investments in innovative pursuits are foregone because the private returns available are inadequate to warrant investment. In essence, the market provides insufficient incentives for innovation and knowledge and information are underprovided. In answer to this, intellectual property rights solve the under provision problem and provide innovators with the needed incentives to invest.

For all these reasons, we know that innovations must be incentivized. Historically, societies have incentivized and rewarded research in a variety of ways, including patents, prizes, and direct government funding and grants. The primary mechanisms utilized today are patents and government grants. As Suzanne Scotchmer (2006) wrote, “All forms of funding are implicitly incentive schemes, since they set the direction of research and encourage people to do it. Some funding is given ex ante, such as grants, whereas other funding is given ex post, such as patents and prizes. . . The only fundamentally new incentive scheme of the past 400 years is intellectual property. Whereas wealthy benefactors and governments can indulge in basic science and curiosity-driven research, a research agenda driven by patents is hostage to the market and to consumer sovereignty. The consumers who are sovereign are those with resources.”[7]

The patent system serves two primary functions: it provides an incentive for research and development and promotes the diffusion of ideas and information. As described by Clancy and Moschini (2013), the incentive potential of patents stems from their private value which is a function of their length, scope and breadth. “The length of the patent is codified by law (twenty years from filing the application), although the effective economic life of the patent can be considerably shorter, and influences how long competitors can be excluded from a particular market. The scope of a patent is more subtle and concerns the breadth of its applications, which relates to the range of products or processes that can be excluded by a patent’s right (by the so-called doctrine of equivalents, a product might be found to infringe on a patented product even if it is not an exact replica). Unlike length, the breadth of a patent cannot be explicitly codified, and it is left to be determined by the patent’s claims, as approved by the patent examiners and ultimately adjudicated by the courts.”[8]

Empirical evidence from economic studies confirms that patents provide the incentives that promote innovation and the impact is particularly pronounced in some sectors. Incentives matter. This claim is bolstered by tens of thousands of empirical economic studies, and not one that convincingly refutes it.

In a study of 60 countries over the period 1960-1990, Park and Ginarte (1997) find that the strength of intellectual property rights was positively associated with research and development (R&D) investments.[9],[10] Hall (2007) and Hall and Marhoff (2012) confirm the value of patents as important incentives for R&D in several sectors, including pharmaceuticals, biotechnology and medical instruments.[11],[12] In the context of product innovations, a recent study by Duguet and Lelarge (2012) concludes that “overall, patents do increase the private incentives to innovate, but through a specific, unbalanced, channel. Indeed, at the firm level, the direct incentive effect of patents is restricted to the firms’ R&D effort, which affects significatively their product innovations.”[13] The importance of patents to incentivizing innovation stems, in part, from their reliance on market forces, arguably moreso than any other incentive mechanism. Patents leave all technical, developmental, and economic deicisions in the hands of innovators and consumers. They work due to the wisdom of Adam Smith’s so-called invisible hand.

Steven Landsburg summed it up succinctly, “Most of economics can be summarized in four words: ‘People respond to incentives.’ The rest is commentary.”[14]

In the context of patentability, consider the importance of the 1980 Supreme Court decision in Diamond v. Chakrabarty, 447 U.S. 303, 206 USPQ 193 (1980), and the consequences. While the United Kingdom was once the world leader in biotechnology, this changed drastically with the 1980 decision in which the Court “held that microorganisms produced by genetic engineering are not excluded from patent protection by 35 U.S.C. 101.”[15] The importance of this decision to the emergence of the U.S. biotechnology industry cannot be overestimated. In the words of Biotechnology Industry Organization (BIO) President and CEO Jim Greenwood, “By finding that subject matter derived from nature is eligible for patenting if it is modified by man into something new, useful and unobvious, the Court provided assurance to biotech companies and their investors that emerging technologies are protected by the patent system even if they could not have been foreseen when the system was created 200 years earlier.”[16] The result has been transformative for the biotechnology industry. Now dynamic and flourishing, the industry enhances and extends human life through innovations in medicine, agricultural crop productivity, and renewable fuel. These benefits span the globe, incentivized by effective patent protection.