Are Patents Creative or Destructive? Tom Nicholas Working Paper 14-036 November 12, 2013 Copyright © 2013 by Tom Nicholas Working papers are in draft form. This working paper is distributed for purposes of comment and discussion only. It may not be reproduced without permission of the copyright holder. Copies of working papers are available from the author. Are Patents Creative or Destructive? Tom Nicholas* Harvard Business School November, 2013 Abstract Current debate over patent aggregation has led to renewed interest in the long standing question concerning whether patents are a creative or a destructive influence on the process of technological development. In this paper I examine the basic patent tradeoff between incentives and monopoly distortions in light of recent contributions to the literature. I outline where patents can function effectively, where they can be damaging and where additional complementary mechanisms to spur innovation may be appropriate. Keywords: Patents, innovation, incentives * William J. Abernathy Professor of Business Administration, Harvard Business School. I thank the Division of Research and Faculty Development for funding. ARE PATENTS CREATIVE OR DESTRUCTIVE? * TOM NICHOLAS Patent aggregation is not a new phenomenon—the practice of acquiring patents in order to profit from their sale or from licensing fees has a long history going back to the middle of the nineteenth century when trade in invention in the United States first began.1 But recent high profile instances in which intellectual property (IP) has been acquired, in particular by non- practicing entities such as the patent aggregator Intellectual Ventures (which holds a worldwide portfolio of approximately 30,000–60,000 patents)2, has led to renewed debate about the most appropriate incentives for promoting innovation. Patent law is based on the idea that a temporary monopoly is a necessary reward for innovative effort and that short run deadweight loss is tolerable in return for incentives to invent. Patent aggregators may curb incentives to invent by rent-seeking from creative inventors.3 According to this view, they distort the patent system and undermine the IP marketplace. While legitimate patent transactions and disputes over IP should be encouraged, Robert Merges has argued, for example, that “the legal system must shut down markets when the things being exchanged have no social value.”4 Yet, while patent aggregators have been criticized for exploiting genuine inventors, a more favorable interpretation of their activities is that they are intermediaries bridging the gap between * William J. Abernathy Professor of Business Administration, Harvard Business School. I thank the Division of Research and Faculty Development for funding. 1 Naomi R. Lamoreaux, Kenneth L. Sokoloff & Dhanoos Sutthiphisal, Patent Alchemy: The Market for Technology in U.S. History, 87 BUS. HIST. REV. (Spring 2013). 2 Tom Ewing & Robin Feldman, The Giants Among Us, 1 STAN. TECH. L. REV. 1 (Jan. 9, 2012), http://stlr.stanford.edu/pdf/feldman-giants-among-us.pdf. 3 It seems reasonable to assume that the largest negative effect would be on incentives to invent at the product development stage of the R&D process but because of feedback loops between product development and upstream fundamental research it is also possible that patent litigation in this area curbs incentives more generally. 4 Robert P. Merges, The Trouble with Trolls: Innovation, Rent-Seeking, and Patent Law Reform, 24 BERKELEY TECH. L.J. 1583 (2009), http://www.btlj.org/data/articles/24_4/1583_Merges.pdf. 2 inventors and firms in the market for innovation. A vibrant market for ideas leads to expectations of payoffs.5 These payoffs, in turn, provide incentives for new research and development, which promotes technological advance. The upshot of the debate is that arguments can be constructed that go both ways. Patent aggregators either undermine the very foundations of IP, or they are a necessary prerequisite for innovation markets to develop and efficiently function. Firms such as Intellectual Ventures justify acquiring and enforcing large portfolios of patents on the basis of the argument that patents encourage technological development. But this assertion itself has been contentious in research on the economics of innovation for decades. In 1951 Edith Penrose famously conjectured that “[i]f national patent laws did not exist, it would be difficult to make a conclusive case for introducing them; but the fact that they do exist shifts the burden of proof and it is equally difficult to make a really conclusive case for abolishing them.”6 More than half a century later the debate is ongoing. Michele Boldrin and David Levine put forward the case for abandoning the patent system altogether.7 Robert Merges, on the other hand, staunchly defends the very fundamentals of IP.8 Adam Jaffe and Josh Lerner, while noting the importance of IP, highlight the defects of the U.S. patent system, such as the granting of frivolous patents and the unnecessary proliferation of patent litigation.9 Whether patents are a creative or a destructive influence on innovation is fundamentally important in light of the fact that most countries currently have patent laws and the significance attached to IP rights in policy discussions. If the patent aggregators are right that patents promote 5 ASHISH ARORA, ANDREA FOSFURI & ALFONSO GAMBARDELLA, MARKETS FOR TECHNOLOGY: THE ECONOMICS OF INNOVATION AND CORPORATE STRATEGY 8 (2001). 6 EDITH T. PENROSE, THE ECONOMICS OF THE INTERNATIONAL PATENT SYSTEM 40 (1951). 7 MICHELE BOLDRIN & DAVID K. LEVINE, AGAINST INTELLECTUAL MONOPOLY (2008). 8 ROBERT P. MERGES, JUSTIFYING INTELLECTUAL PROPERTY (2011). 9 ADAM B. JAFFE & JOSH LERNER, INNOVATION AND ITS DISCONTENTS: HOW OUR BROKEN PATENT SYSTEM IS ENDANGERING INNOVATION AND PROGRESS, AND WHAT TO DO ABOUT IT (2006). 3 technological discovery, then basic statistics on patents suggest innovation is flourishing. Notably, around 1 million patents are granted each year globally.10 In the United States alone more than 8 million patents have been granted since the 1836 Patent Act set the foundation for modern patent law.11 More recently, the Patent Law of the People’s Republic of China went into force in 1984 and patenting has proliferated ever since. In 2011 China surpassed the total number of patents granted in a year in the United States.12 All the statistics indicate that patents represent a key component of the IP framework around the world. To the extent that there is still considerable debate and disagreement about the usefulness of patents as a mechanism for spurring technological development, in this paper I survey recent contributions to the literature. The main objective is to determine whether the argument frequently put forward by patent aggregators—that patents encourage innovation—has any basis. Although IP covers patents, copyright and other mechanisms, given the sheer size of the scholarly literature, I confine most of the analysis to contributions that focus on patents. I. PATENTS AND INCENTIVES TO INVENT From the very beginning, patents in the United States were subject to debate about tradeoffs. Patents were first introduced in 1790 when Thomas Jefferson became the first patent commissioner and examiner. Initially Jefferson strongly opposed the idea of extending a monopoly to an inventor on the basis that only those who could afford it would be able to benefit from the invention. His belief that new knowledge was a public good meant that he refrained 10 WIPO statistics database. Last updated: November 2012 http://ipstatsdb.wipo.org/ipstatv2/ipstats/patentsSearch 11 U.S. Patent & Trademark Off., Table of Issue Years and Patent Numbers, for Selected Document Types Issued Since 1836, http://www.uspto.gov/web/offices/ac/ido/oeip/taf/issuyear.htm 12 WIPO, supra note 9. 4 from patenting his own discoveries, such as the innovative agricultural machinery he developed for working his Virginia plantation. Jefferson’s opposition to patents derived from his utilitarian belief in the process of science and invention and from the freedoms advocated by the new Constitution. Later, after appreciating the virtue of patents as an incentive mechanism, Jefferson became more predisposed to the use of patent protection for inventions under the assumption that “ingenuity should receive a liberal encouragement.”13 After revising the rules concerning the validity of patents and examination requirements, the United States adopted a system in 1836, the basic hallmarks of which can still be observed today. Under modern patent legislation patents serve two functions: first, to promote innovation by permitting inventors to appropriate returns from their research and development efforts; and second, to diffuse the knowledge that results from new discoveries by requiring the inventor to publicize the technical ideas as a patent in sufficient detail to allow a skilled person to reproduce the invention. At one level the justification for IP is a deep-rooted philosophical one. Most prominently, Robert Merges makes a compelling argument for the existence of IP as a device to reward creativity and inventiveness. While much of Mergers’ discussion focuses on IP broadly defined, the rationale for patents follows from the same intellectual foundations. Patents reward inventive effort and when subjected to appropriate limits can achieve socially efficient outcomes. The well-known writings of liberal philosophers including John Locke, Immanuel Kant, and John Rawls