Patent Failure

Do patents help promote innovation?

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The marketplace is like a boxing ring where ideas compete with one another; it is a great place for ideas to test their mettle and see which can be crowned a true “innovation.” A boxing ring, however, is not well-suited to creating new ideas. It is easier for a bystander sitting in the crowd to observe and copy the winner, minimizing their own risk and expense while maximizing their return. Mimicry of the successful, one of humanity’s defining characteristics, it seems, can backfire. Patents and intellectual property law are intended to tilt the balance back in the innovator’s favor by giving the innovator a temporary monopoly on an idea, but do they actually work? Or do they, in fact, harm innovators more than they help?

Patent Origins

Originally, the concept of the patent was not intended to promote innovation at all but arose from a dispute between the King and the Parliament of England. The main purpose of the Statute of Monopolies, enacted in 1624, was to prohibit the King from raising revenue by selling monopoly privileges to supporters. Years later, the newly founded United States improved upon the English system, simplifying the process and explicitly designing patent law to encourage innovation. The US Patent Law, first enacted in 1793, also became the basis for similar laws adopted in Germany in 1877, Japan in 1888, and ultimately much of the world.

In a competitive market, innovation carries significant expense and risk. Developing a new lifesaving drug, for example, can easily cost over $1 billion and risk commercial viability. With such stakes, a rational person would bide their time, wait for someone else to incur that cost and risk, and then copy the final successful product. Having avoided the cost of development, the copcat can undercut the original inventor. Absent the protection that patents confer, innovators have an incentive to keep their ideas secret for as long as possible, hoping to recoup their investment from first-mover advantage alone. This is suboptimal for two reasons. First, little innovation will occur if everyone waits for someone else to do it. Second, those who do take on the cost of innovating will jealously guard their IP from competitors, preventing the diffusion of new ideas.

Patents try to solve this. A patent is a temporary government-sanctioned monopoly on an idea that provides an inventor the right to exclude others from using that idea. After the patent term expires (usually after 20 years), the idea is placed into the public domain for anyone to use and improve upon. The intent is to allow the inventor to capture the positive externalities of their work, to temporarily profit from their idea. Patents attempt to strike a balance between the social costs of idea monopolies and the incentive to produce those ideas in the first place.

Interestingly, for all the respect that a “patent” or “intellectual property” confers in modern social discourse, there is remarkably little research to suggest that patents work as intended. Indeed, there is reason to think that the patent system may do more to inhibit innovation than promote it. There are three main avenues of patent failure:

1) In most cases, patents barely work as intended. They enable inventors to recoup only a small fraction of the social value of their ideas. But in rare cases when they do work, they create deadweight loss, driving up the price of goods and services.

We might see patents as the inverse of the land value tax. Whereas with LVT, we acknowledge land scarcity and tax the rents away, with intellectual property, we seek to create artificial scarcity where there is none (ideas are nonrival) and allow for the (temporary) extraction of rents. The patent system, however, does this poorly even on a good day. Even with the monopoly pricing that patents would theoretically confer, most innovators can only capture a small fraction of the social benefits of their ideas. This means that, in many instances, it isn’t worth the time and effort to patent at all. More on this in a moment.

In some industries, however, patents seem to work well, arguably too well. This is particularly true in the pharmaceutical industry, where monopoly pricing of chemical compounds creates immense social costs known as “deadweight loss." Patent pricing of AZT, for example, a drug used to treat AIDS, prices many out of treatment. Many lives could be saved by abolishing the patent and allowing others to produce the drug at a marginal cost, but doing so may prevent the creation of new life-saving drugs in the future.

2) Patents block follow-on innovation and encourage other parties to “patent around” ideas, which is seen as duplicative and wasteful.

While the law considers patents a form of property, this is, as I said earlier, an artificial construct. Unlike tangible property, such as real estate, ideas are non-rival. My use of an idea does not prevent your use of it, and vice versa. This makes defining the limits or boundaries of “intellectual property” very difficult. While we can define the boundaries of a parcel of land with extreme precision, the borders around ideas are inherently fuzzy. This innate ambiguity opens the door to patent trolling and inadvertent violations of IP.

There is a famous patent case that exemplifies both wasteful “patenting around” and the blockage of innovation: Kodak’s foray into instant photography in the 1970s. Kodak, seeking to compete with “instant” photography rival Polaroid, spent large sums of money, hiring a small army of chemists and patent lawyers who worked diligently to develop an instant photography process that didn’t infringe on Polaroid’s patents. Indeed, they developed a process that, they argued, worked “backward” from Polaroids. Nonetheless, Polaroid sued Kodak for patent infringement, and the legal battle that ensued forced Kodak to settle with a $900 million payment to Polaroid.

The fiasco forced Kodak to exit the instant photography space entirely. This famous case illustrates that the fuzzy nature of patents makes it difficult to avoid accusations of infringement, even when one works diligently to avoid it. Here, millions of dollars were thrown away trying to “patent around” another party, only for a court to fail to discern the boundaries between two distinct chemical processes. In many cases, the existence of patents makes innovation more risky and potentially more wasteful than it otherwise would have been.

3) Patents encourage excessive litigation by “trolls” who exploit their ambiguity and the high cost of litigation to extract money from the innovators themselves.

Arguably, the scope of what is patentable has grown too broad over time, opening the system to systemic abuse. For example, there are patents for a peanut-butter-and-jelly sandwich design (Patent 6,004,596) and a technique for combing hair to hide a bald spot (Patent 4,022,227). Part of the reason for the deterioration of the patent system is the rise of software patenting since the 1990s. Software patents are inherently abstract; thus, it is much harder to define where the boundaries of ownership begin and end. This inherent fuzziness leads to infringement, often only perceived. There are so many patents, and the cost of conducting patent searches is so high, that many firms don’t conduct them at all. Anyone selling a product online could conceivably be violating thousands of patents; it’s difficult to know for certain.

Sometimes, this ambiguity is deliberately engineered and leveraged through so-called “submarine patents.” While patents themselves are public, many patent-holders slow-walk the application process, delaying the submission of key “boundary” information and wording their patents as vaguely as possible. They keep a low profile, only reemerging once an innovator takes a product using a similar idea to market, then they pounce and sue them for infringement. Many innovators, having already sunk money into the commercial product, must choose between a protracted and expensive court battle or a costly settlement.

Since the late 1990s, litigation of this kind has contributed to the deterioration of the United States patent system. Indeed, in their book, Patent Failure, James Bessen and Michael Muerer found that outside of the chemical/pharmaceutical industry, the litigation risks that patents invite outstripped the benefits of patent protection entirely.

Did they ever work?

While most acknowledge the issues facing the modern patent system, it’s also unclear whether patents played much of a role in promoting innovation historically. Richard Arkwright, for example, made a fortune off a broadly worded patent on spinning technology, despite it being challenged and invalidated. Edmund Cartwright, on the other hand, patented the “power loom,” but made no money from his idea. Even worse, John Kay invented an improved weaving machine but was nearly financially ruined by the ensuing patent litigation. Patents don’t reliably reward innovators. Indeed, many of the most significant innovations to steam engines in that era came from “collective invention,” where innovations were shared and built upon, as opposed to being patent-protected. Today, open-source software is shared and collectively improved in much the same way.

Studies have found no definitive link between patent quantity and innovation. One study examining the expansion of patent scope in Japan after a 1988 reform found no evidence of any attributable increase in R&D spending or innovative output. Another study, by Bessen and Hunt, found that while the US’s promotion of software patents promoted a huge increase in industry patenting, most were simply “stockpiled,” not in the spirit of innovation, but as bargaining chips in defense of anticipated litigation. Paradoxically, firms that acquired the most patents reduced their R&D spending relative to product sales, indicating that innovation may have slowed due to patent wars.

The notable exception here, again, to widespread patent failure is the chemistry/drug industry, where patent boundaries are much easier to define and the costs of imitation are much lower. Drug developers, for example, spend exorbitantly to develop new, life-saving drugs; much of that expense is devoted to clinical trials that generic drug manufacturers don’t need to conduct. In the US today, this appears to be the only industry where we can safely argue that the existence of patent law truly encourages innovation.

In sum, as a form of intellectual property, patents are a novel idea with a noble cause. There is little reason to believe, however, that they ever worked very well and, outside a few select sectors, that they serve their intended purpose of promoting innovation. Reform of the intellectual property system is desperately needed; that much is certain. Yet, alternatives to patenting remain elusive. Many have suggested that cash prizes could replace the patent system. In another essay, I discuss why prizes are not the panacea that proponents claim they will be.

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