22Standing on the Shoulders of Giants

American Economic Association Standing on the Shoulders of Giants: Cumulative Research and the Patent Law Author(s): Suzanne Scotchmer Source: The Journal of Economic Perspectives, Vol. 5, No. 1 (Winter, 1991), pp. 29-41 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/1942700 Accessed: 05/10/2008 21:33 Your use of the JSTOR archive indicates your acceptance of JSTOR's Terms and Conditions of Use, available at http://www.jstor.org/page/info/about/policies/terms.jsp. JSTOR's Terms and Conditions of Use provides, in part, that unless you have obtained prior permission, you may not download an entire issue of a journal or multiple copies of articles, and you may use content in the JSTOR archive only for your personal, non-commercial use. Please contact the publisher regarding any further use of this work. Publisher contact information may be obtained at http://www.jstor.org/action/showPublisher?publisherCode=aea. Each copy of any part of a JSTOR transmission must contain the same copyright notice that appears on the screen or printed page of such transmission. JSTOR is a not-for-profit organization founded in 1995 to build trusted digital archives for scholarship. We work with the scholarly community to preserve their work and the materials they rely upon, and to build a common research platform that promotes the discovery and use of these resources. For more information about JSTOR, please contact support@jstor.org. American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The Journal of Economic Perspectives. http://www.jstor.org Journal of Economic Perspectives- Volume 5, Number I-Winter 1991 -Pages 29-41 Standing on the Shoulders of Giants: Cumulative Research and the Patent Law Suzanne Scotchmer S ir Isaac Newton himself acknowledged, "If I have seen far, it is by standing on the shoulders of giants." Most innovators stand on the shoulders of giants, and never more so than in the current evolution of high technologies, where almost all technical progress builds on a foundation provided by earlier innovators. For example, most molecular biologists use the basic technique for inserting genes into bacteria that was pioneered by Herbert Boyer and Stanley Cohen in the early 1970s, and many use a technique for causing bacteria to express human proteins that was pioneered at Genentech. In pharmaceuticals, many drugs like insulin, antibiotics, and anti-clotting drugs have been progressively improved as later innovators bettered previous tech- nologies. Computer text editors are similar to one another, as are computer spreadsheets, in large part because innovators have inspired each other. An early example of cumulative research was Eli Whitney's cotton gin, which was quickly modified and improved by other innovators who seriously curtailed his profit. ' IEli Whitney was very generous in disclosing details of his gin to other innovators, even beyond what was required by patent law. Other innovators patented improvements, but after much litigation the new patents were held to infringe Whitney's underlying patent. Whitney and his partner did not recover sufficient damage awards to compensate them for their litigation and the time that it took to enforce the patent. For an extensive discussion, see Jeanette Mirsky and Allan Nevins, The World of Eli Whitney (Macmillan Co, 1952). Klemperer (1990) also discusses the cotton gin. * Suzanne Scotchmer is Professor of Public Policy, University of California, Berkeley, California. 30 Journal of Economic Perspectives Most economics literature on patenting and patent races has looked at innovations in isolation, without focusing on the externalities or spillovers that early innovators confer on later innovators. But the cumulative nature of research poses problems for the optimal design of patent law that are not addressed by that perspective. The challenge is to reward early innovators fully for the technological foundation they provide to later innovators, but to reward later innovators adequately for their improvements and new products as well. This paper investigates the use of patent protection and cooperative agree- ments among firms to protect incentives for cumulative research. The Available Tools The breadth of patent protection is a key consideration in the incentives to innovate. Patent applicants protect themselves against competition from deriva- tive products by claiming broad protection. Patent law would provide no protection at all if it did not protect against trivial changes, like color or size. The allowable breadth of claims is determined by patent examiners and the judiciary. If broad protection is granted, then a derivative or second generation product will likely infringe the prior patent, so a license on the original patent is required to market it. If patent protection is narrow, then many derivative products and applications can be patented and marketed without infringement.2 We might be tempted to conclude that broad protection encourages firms to find fundamental technologies but discourages them from seeking out second- generation applications and derivative products. However, these two conclu- sions may be inconsistent, since proper incentives to find fundamental technologies may require that the first patent holder earn profit from the second generation products that follow. There will be no such profit if no second-generation products follow. Patent protection would be an unnecessary policy tool if the government had the same information about the costs and benefits of individual research projects as firms have. In that case, the government could simply select the research projects that would be socially efficient and commission research from the lowest cost firms. However, the government will generally have less infor- mation than firms,3 and I will therefore assume that the length and breadth of patent protection and other aspects of the government's policy toward R&D cannot depend on firms' private information about their expected costs.4 2U.S. patent protection is broader than that in most other countries, particularly Japan, partly due to the "doctrine of equivalents," which can broaden protection beyond the claims in the patent according to similarity of function. 3Wright (1983) discusses the private information of firms as the main justification for patent protection, rather than using prizes or contracts as incentive instruments. 4A policy of reimbursing costs to the successful innovator would not be adequate, since a project that was a "good bet" at the beginning might nevertheless fail. Suzanne Scotchmer 31 Given that the length and breadth of patent protection cannot depend on the expected costs of an R&D project, the only way to ensure that firms undertake every research project that is efficient is to let the firms collect as revenue all the social value they create. Otherwise, some projects that are socially desirable will not be undertaken. If an innovation is a reduction in the cost of producing a good, then the social value is the saved costs. If the innovation is an improvement to a product, the social value is the difference in consumers' willingnesses to pay for the improved and unimproved products. When research firms collect all the social value as profit, households still benefit, but in their capacity as shareholders rather than as consumers. But there are at least two problems with allowing research firms to collect all the social surplus as profit (or as much as possible). First, strong patent protection leads to socially inefficient monopoly pricing. Second, firms in a patent race may overinvest in research if the patent is worth more than the (minimum) cost of achieving it (Loury, 1979). This problem is related to the problem of the commons: An increase in one firm's rate of investment transfers some probability of becoming the patentholder from other firms to itself. Because of this transfer, all firms might overinvest.5 These points are well- recognized in the R&D literature. When an initial innovation facilitates later ones, as is the case with basic research, another issue arises. Part of the first innovation's social value is the boost it gives to later innovators, which can take at least three forms. If the second generation could not be developed without the first, then the social value of the first innovation includes the incremental social surplus provided by second generation products. If the first innovation merely reduces the cost of achieving the second innovation, then the cost reduction is part of the social surplus provided by the first innovation. And if the first innovation accelerates development of the second, but at the same cost, then its social value includes the value of getting the second innovation sooner. Because of these externalities provided to later innovators, developing the first innovation may be efficient even if its expected cost exceeds its value as a stand-alone product. First innovators will have correct incentives to invest only if they receive some of the social surplus provided by second generation products. But at the same time, enough profit must be left for the second innovators so that they will invest if investing is efficient. This essay asks how close patent incentives can come to accomplishing that goal. A premise in much of what follows is that firms other than the first innovator should participate in development of second generation products. Since the first innovator might not have expertise in all applications, more second generation products are likely to arise if more researchers have incen- 5But Gandal and Scotchmer (1989) show that prior agreements among firms that would otherwise race can overcome the incentive for overinvestment, even if their research costs are private information. When such prior agreements are allowed, the firms will invest at the efficient rates if and only if the private value of the patent is equal to the social value. 32 Journal of Economic Perspectives tive to consider them. In this view, contrary to the premise of much of the patent race literature, creativity is largely serendipitous. Not every R&D firm sees the same opportunities for new products. However, outside research firms can integrate with initial patentholders in at least two ways: the firms can form cooperative ventures to research and develop new products, and they can form licensing agreements after products have been developed and patents have been awarded. I will call these two types of contracts prior agreements and licenses, respectively. Prior agreements permit firms to share the costs, as well as the proceeds, of research.6 Licenses are negotiated after research costs are sunk and patents have been awarded. Both types of agreements can increase profit by improving efficiency and possibly by reducing product market competition. Although many authors have discussed cooperation in research, they have not focussed, as I will, on how the breadth of patent protection and cooperation among research firms work together in protecting incentives to innovate. In this view of how incentives to innovate are protected, a key role of patent protection is that it sets bargaining positions for the prior agreements and licenses that will form, and therefore determines the division of profit in these contracts. Patent Protection and Licensing A system of property rights that might seem natural would be to protect the first innovator so broadly that licensing is required from all second genera- tion innovators who use the initial technology, whether in research or in production. But such broad protection can lead to deficient incentives to develop second generation products. When the licensing agreement is negoti- ated after a patent has been granted, research costs have already been sunk. The bargaining surplus to be split between the first and second innovators at that time is the incremental market value of the second product, not net of research costs. A second innovator who cannot market the next generation product without a license has a very weak bargaining position. If the second innovator does not get all the surplus being bargained over, he will earn only a fraction of the new product's market value and presumably only a fraction of its social value, and this fraction may be less than the cost of developing it. Hence the incentive for an outside firm to develop second generation products can be too weak.7 Under such broad patent protection, the incentive for the first innovator to develop a second generation product will be stronger than for an 6Prior cooperation in research has been treated leniently by antitrust law and the authorities. For example, the National Cooperative Research Act (1984) established that joint ventures are not per se illegal, but will be treated according to a "rule of reason." The Act also reduced damages in civil suits from treble to single, provided the firms follow the proper notification procedure. Perspectives on this act are discussed in the symposium on "Collaboration, Innovation and Antitrust" in the Summer 1990 issue of this journal. 7See Green and Scotchmer (1990) for an elaboration of this idea. Standing on the Shoulders of Giants 33 outside firm (provided the first innovator has expertise to develop the new product, and thinks of it), since the first innovator will earn the entire incre- mental profit. As well as offering deficient incentives for second innovators, broad patent protection might inefficiently inflate incentives for the first innovation. In licensing agreements, the first innovator will earn a share of the market value of each infringing later product. If the first innovation reduces the cost of achieving later innovations, but is not the only possible vehicle to achieve them, the first innovator's share should not exceed the cost reduction. If it does, the first innovator will be overrewarded. In what follows I explore two solutions to these defective incentives. The remainder of this section investigates what happens if the first innovator's patent protection is narrowed so that a different enough second generation product does not infringe and thus can be marketed without a license from the first innovator. In the following section, I investigate prior agreements in which second innovators can "sell" their ideas to the first innovator or integrate with the first innovator. Neither solution is perfect, as we shall see. The inadequacies of narrowing patent protection are most easily exposed if we first suppose that first and second generation products do not compete in the market, although second generation products build on the first generation technology; for example, many new pharmaceuticals that are therapies for different illnesses all build on a few basic techniques of bio-engineering. Second innovators cannot have excessive incentive to invest, since they cannot earn more than consumers' willingness to pay in the markets they serve. Licensing from the first innovator would transfer away some of the second innovators' revenue and hence reduce their incentive to invest. To provide efficient incentives to the second innovator, society should protect the first innovation so narrowly that a new product never infringes and therefore second innovators never have to license. But such a scheme does not sufficiently reward the first innovator, since the first innovator does not profit from the cost reduction conferred on the second innovators. The first innovator's incentive to invest becomes still weaker under narrow patent protection if the second generation product is a substitute for the first. Competition between the two patentholders would erode their joint profit, transferring some of the social surplus of the combined innovations to con- sumers. As an example, suppose that the second generation product is a superior version of a drug, and that the two patent-holders compete on price. Then the second generation product will survive in the market and its price will equal the difference in consumers' willingness to pay for the two drugs plus the marginal cost of producing the drug. In this outcome, the second innovator earns as profit exactly the incremental social value of the newer drug, while the first innovator's profit falls to zero. Such profit erosion could be mitigated if the antitrust authorities permitted collusive licensing among patentholders who would otherwise compete. For 34 Journal of Economic Perspectives example, licensing with per-unit royalties can lead to collusive outcomes, since the royalty raises the licensees' private production cost and therefore keeps the equilibrium price high.8 In ordinary antitrust law, collusion through licensing would violate the spirit of the Sherman Act and subsequent legislation. But where incentives to innovate are at stake and where later technology builds on an earlier technology, such collusion allows the first innovator to profit from the externality conferred on later innovators. Of course, firms would be tempted to exploit any leniency by the antitrust authorities in contexts where incentives to innovate are not at stake. This problem should not be minimized. There is something quite general economists can say about the combined effects of patent law with licensing: No such policy can achieve fully efficient incentives, even if society permits collusive licensing between patent holders who would otherwise compete and the firms jointly collect all the social surplus as profit. This is essentially because of "double marginalization." To give the second innovator an incentive to invest whenever social benefits exceed R&D costs, the second innovator must earn the entire social surplus of his innova- tion. But to compensate the first innovator for the externality or spillover she provides, she too must earn part of this surplus. It is impossible to give the surplus to both parties.9 When both first and second generation products are developed, the divi- sion of profit between the two innovators depends on the breadth of patent protection. To see this, assume that there is a random component to the outcome of a research project, so that when a research firm invests in a second generation product, it does not know whether its product will infringe the prior patent. The breadth of the prior patent determines the probability that the second generation product will infringe. If the second product turns out to infringe, the second innovator must license and this will force him to share the profit of the improvement with the first innovator. The second innovator is in a better position if its product turns out not to infringe, since the second innovator can profitably compete with the prior patentholder in the market. Thus, if breadth of the first patent could be interpreted to depend on the expected costs and benefits of a second generation product, we could ensure that the second innovator's expected profit would be zero. If not, some second generation products will be stymied even though they would contribute posi- tively to joint profit and to social welfare, and the second innovators who invest will typically make positive profit. To summarize, the "natural" system of property rights-requiring every later innovator to license any underlying technology-will on average give deficient incentives for outside firms to develop second generation products. 81f royalties are permitted, then licensing is similar to permitting the initial patent-holder to buy up the patents on later products that use the in