the economics of innovation - uzh · the economics of innovation ... discounted time from present...

The Economics of Innovation

Prof. Dr. Ulrich Kaiser

Department of Business Administration

University of Zurich

Spring semester 2013

University of ZurichDepartment of Business AdministrationProf. Dr. Ulrich Kaiser

The Economics of InnovationSpring semester 2013

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4. On the optimal design of patentsp g p

Some slides adopted from Suzanne Scotchmer

Contents May Be Used Pursuant to Attribution‐Noncommercial‐No Derivative Works 1.0 Generic http://creativecommons.org/licenses/by‐nd‐nc/1.0/



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4. On the optimal design of patentsp g pDesign of IPTwo questions:

How large should the rewards to innovation be?

How should the reward be structured? How large?

When ideas are scarce (no patent race)

When ideas are common knowledge (patent race)

Structure: Mainly about length and breadth of the right

(cc) Suzanne Scotchmer



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4. On the optimal design of patentsp g pIP virtued l d k ( d )IP decentralizes decision making (as opposed to prizes)

(cc) Ulrich Kaiser



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4. On the optimal design of patentsp g pIP trade‐off:

ff ( l h f l d l )Static efficiency (monopoly rights; sometimes wasteful duplication)

Dynamic efficiency (incentives for innovation)

(cc) Ulrich Kaiser



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4. On the optimal design of patentsp g pSize of the reward (e.g., patent life T)

Two arguments:Nordhaus (scarce ideas) Race (# of firms)

Nordhaus: implicitly focuses on single inventors with scarce ideas; tradeoff is between “too little innovation” and “too much deadweight loss”; amount ofbetween too little innovation and too much deadweight loss ; amount of innovation can always be increased by increasing patent value, but it increases deadweight loss on every inframarginal innovation

Race: arises where ideas are not scarce; the problem is to avoid over‐entry or under‐rewards




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4. On the optimal design of patentsp g pPatent races

Can accelerate progress

Can lead to wasteful duplication

Not necessarily efficient investment decisions

But do not select the firms with best ideas

Firms can get locked in and invest just because the other investsFirms can get locked in and invest just because the other invests




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4. On the optimal design of patentsp g pIllustration

T: discounted time from present until expiration of IP right at time τ, satisfies

1τ

0""

;)1(

11

∞

+≅= ∑∫ =

− τ

tftidir

dteTt t

o

rt

)(/10""0""

∞===∞==

τττ

stocorrespondrTtoTfromrunstimediscountedtofromrunstimeordinary

(cc) Ulrich Kaiser



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4. On the optimal design of patentsp g pIllustration

Id i ( )Idea: pair (v,c)

v: per period consumer surplus with competitive supply

c: developing cost

If social value v lasts forever, discounted social value is v/rIf invention is marketed, pr period profit is πv (π fraction, π<1)

Proprietory profit available for a patent that lasts for discounted length T: πvT

Associated deadweight loss lv per period or Tlv in total for patent life

(cc) Ulrich Kaiser

Associated deadweight loss lv per period or Tlv in total for patent life



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4. On the optimal design of patentsp g pOptimal reward when Ideas are ScarceHigher reward (patent life T) larger deadweight lossHigher reward (patent life T) larger deadweight loss

cost, c

space of ideas (v,c)

vπT’ 'TT <

• (vb,,cb)

vπT’

vπT

TT <

• (va,,ca)

value, v

(cc) Suzanne Scotchmer(This diagram is illustrative; know the idea, not the diagram.)

,



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4. On the optimal design of patentsp g pOptimal reward when Ideas are ScarceHigher reward (patent life T)Higher reward (patent life T)

larger deadweight loss

more innovation (becomes more profitable)

i l l i l i h h i (if i i i d )social value is larger with shorter protection (if innovation is made)

No uncertainty so far!

(cc) Ulrich Kaiser



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High reward may lead to race; racing can be inefficient:Optimal reward when ideas are common knowledgeHigh reward may lead to race; racing can be inefficient:

Duplication of effortPursuit of wrong ideas (the problem of aggregating information)

I b fi i l f i t ?Is a race beneficial for society? May duplicate costs (bad)May increase the probability of success or the time of discovery (good)

We cannot know whether a patent race is good or bad without knowing how innovation works; we need the right model of the creative environment




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If successes and failures are independent “duplication” is not well definedRacesIf successes and failures are independent, duplication is not well definedSuppose (for simplicity) that each firm pays a fixed cost c upfront to enter the

raceS h fi h i d d t b bilit f f il i h tiSuppose each firm has an independent probability p of failure in each time

periodIt may take several time periods to receive the innovation; the innovation will

be sooner if there are more firms, but the cost is also higher




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Suppose successes and failures are independentRaces: probability of success and number of entrantsSuppose successes and failures are independentp is the probability of a failure. Hence 1‐p is the probability of success

O fi t t l b bilit f i P(1) 1One firm: total probability of success is P(1)=1‐pTwo firms: total probability of success is P(2)=1‐p2Marginal contribution (P(1)‐P(2)) of 2nd firm is S*(p‐p2), where S denotes the

social welfaren firms: total probability of success is 1‐pn = P(n)marginal contribution of nth firm is S*(pn‐pn+1)n firms: Total social value is S * P(n) ‐ nc = S * (1‐pn) ‐nc Patents: govern number of attempts




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P(n)=probability at least one firm succeedsRaces continuedP(n)=probability at least one firm succeedsS= social welfare in case of successWhat does the diagram look like, and how many entrants will there be if the private

reward is less than S?reward is less than S?

Should the private reward be less than S?S x P(n)

f t t if icn free entry outcome if winner receives the whole social value

optimal

cn

(cc) Suzanne Scotchmernumber of firms nnen*

optimal



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Modify diagram to account for the fact that the winner receives less than the wholeRaces continuedModify diagram to account for the fact that the winner receives less than the whole

social value.Reduces number of entrants, possibly to the efficient number.

Tandon 1983S x P(n)

cn Tandon 1983

free entry outcome if winner

Π x P(n)

free entry outcome if winner receives Π instead of S


number of firms nnen*



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So far: optimal size of the rewardSize versus structure of the rewardSo far: optimal size of the reward

But reward can also be structured in different ways:

Length TBreadth:

A second policy lever for determining the size of a rewardBroader IP rights can be shorter, because they are more profitable in

each periodOncomouse; what about an oncowalrus?Amazon’s one‐click patent




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Breadth excludes horizontal substitutes; define breadth on the product sideBreadth: three DefinitionsBreadth excludes horizontal substitutes; define breadth on the product side

Breadth defines cost of entry: define breadth on the technology side (also k th t f i ti d)known as the costs of inventing around)

Breadth excludes vertical substitutes: defined for sequential innovation (later lecture)




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Two effects:BreadthTwo effects:

Additional income through licensing

Stronger protection of invention

Gallini: breath determines cost of inventing around




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4. On the optimal design of patentsp g pBreadth & horizontal competition

)ˆ,( 211 ppx )ˆ,( 211 ppx

2p̂2p̂1p̂1p̂ )ˆ,( 122 ppx )ˆ,( 122 ppx

Π̂Π̂ Π̂Π̂

1~p1~p

ΠΠ

Π~Π~)~,( 122 ppx )~,( 122 ppx

1

1 ΠΠ2

)~,( 211 ppx )~,( 211 ppx

mcp =2~ mcp =2~

ΠΠ1

(cc) Suzanne ScotchmerA higher price increases demand of substitute goods.



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4. On the optimal design of patentsp g pBreadth & horizontal competitionD d f t t d d d b tit t i i l tiDemand for patented good and substitutes is inelastic:

Broad, short patent monopoly pricing similar to lump‐sum tax which avoid distortion

Patent goods and substitutes are no substitutes at all but potential infringer serves different users demand curves and profits coincide, same deadweight loss; if ratio of deadweight loss to profits is smaller, broad, short patent best (reduces deadweight loss)

(cc) Ulrich Kaiser



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4. On the optimal design of patentsp g pBreadth & cost of entry

Patent Policy: (T,K)T=length of protectionK = cost of entry (Breadth)

p(1)One firm

p(¥ )=0

p(n*(T,K ))

x(p)Many firms

n*(T,K) = equilibrium number of entrants:(1/n) T p(n) x(p(n)) = K (see exercises)

(cc) Suzanne ScotchmerEntry lowers the market price, eventually the competitive price, 0



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4. On the optimal design of patentsp g pRatio test: should breadth cause price to be lower, and the IP right to last longer?right to last longer?The consumer cost of raising money through monopoly pricing is deadweight loss (yellow)

l ( / ) f f d d h lGoal: Maximize ratio (π/DWL) of profit to deadweight loss

p p

p* p*

p

p

p

p

~~


x(p)x(p*) x(p)x(p*)~ ~



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