The Ideas Anticommons

Reforming patents to work for, not against, innovation

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Previously, I explored some of the merits and drawbacks of patenting/intellectual property as a mechanism to incentivize innovation. When comparing patents with prizes, I arrived at the conclusion that patents, while highly imperfect, cannot be completely abolished and replaced with awards. That said, there is certainly room for improvement to the existing IP system. Here we look at some proposals for how we might rethink intellectual property and sharpen the blade of innovation for the 21st century.

To reiterate, economic theory holds that the free market will naturally underinvest in science and innovation. Our global “problem-solving machine” will undersupply new ideas because it’s cheaper and less risky to copy than it is to innovate. Furthermore, basic research, which has no clear return on investment, is largely neglected. This is all because ideas are non-rivalrous. My use of an idea doesn’t prevent anyone else from also using it. Thus, to give an idea marketable value, we must enclose it behind a metaphorical “fence.” In essence, we create artificial scarcity through what we call “intellectual property.”

I won’t rehash the many problems with patents, but I do want to emphasize that the current IP system is of questionable utility and can prevent the efficient use of ideas. Patents can give rise to what we previously explored as the “Tragedy of the Anticommons.” As you might recall, the Tragedy of the Commons occurs when shared “ownership” results in underinvestment and overuse of a resource. Its evil sister, on the other hand, where ownership is too “absolute” and divided, results in the underuse of a resource, in this case, an underuse of ideas. A patent dispute between the Wright Brothers and Glen Curtis, for example, stymied aircraft technology in the US until the government intervened at the outset of World War 1.

Some have made the case that we could abandon IP entirely. Indeed, during World War 1, under the 1917 Trading with the Enemy Act, US authorities confiscated all German-owned US patents and made them available for compulsory licensing. Counter to prevailing theory, the compulsory licensing scheme was associated with a ~20 percent increase in invention by affected German and American firms. That said, the scheme was a one-off event; should compulsory licensing have remained law, innovation likely would have been depressed.

In his book, Launching the Innovation Renaissance, Alexander Tabarrok also questions the utility of patents, writing that humans have been breeding and registering new types of roses for thousands of years. It was only after the 1930 Plant Patent Act that breeders gained the ability to patent breeds. Therefore, the theory holds, that after 1930 we should find a surge in new patented rose breeds. But we don’t; over 80 percent of new breeds created thereafter were unpatented.

Roses are not unique in this regard, indeed, most ideas of all shapes and varieties are not patent-protected, and innovation marches along just fine, if not better, without them. There are, however, areas where patents do appear to stimulate innovation. One such area is pharmaceuticals where it may cost over a billion dollars to develop a new drug, while just a few cents to produce each pill. Here, patents have an outsized impact because of the high initial capital investment and low marginal cost of production (and replication). The Orphan Drug Act, for example, gave sponsors of drugs for rare diseases seven years of market exclusivity. The act led to a boom in the development of new lifesaving drugs for very uncommon diseases.

Tabarrok concludes that the disconnect between theory and practice lies in the fact that, over time, we have become much more liberal in what allow to be patented. In times past, a tangible product had to be successfully demonstrated before a patent could be granted. Today, on the other hand, an intangible idea alone will suffice, and these ideas can be frustratingly broad. He points to the infamous “E-data” patent that was granted in 1983, which covered everything from downloading photos, music, and other files. Creators were forced to pay royalties to E-Data for what was essentially a vague idea, not a technology. In his words, “Edison famously said, "Genius is one percent inspiration, ninety-nine percent perspiration." A patent system should reward the 99 percent perspiration, not the 1 percent inspiration.”

Tabarrok recommends splitting patents into terms of varying lengths based on the level of “sunk costs.” An idea or innovation that has low costs could easily apply for, and be granted, a short-term patent. However, long-term patents would be subject to higher scrutiny, requiring evidence to show that the innovator expended a great sum of resources to develop the idea. Taking a page from Tabarrok, I envision a two-tier patent system with 2-year and 20-year patents available to inventors. The 2-year patent would be essentially an extension of a “first mover” advantage in the marketplace, granted for the 1% inspiration. The 20-year patent, on the other hand, would require evidence of sunk costs to reward the other 99 percent.

Arguably, this solves many of the problems plaguing the current patent regime by shortening the duration of most patents issued. It does not, however, solve the deadweight loss and allocative efficiency challenges for long-term patents. Remember, I previously argued that there is a “spectrum” of optimal property rights. Common ownership results in high allocative efficiency (anyone can use the property) but low investment incentives. When ownership rights are too strong, however, investment incentives are high but allocative efficiency is low, so the property is not used in the most efficient ways. At both extremes, the result is not optimal. That is, the best property is not commonly owned or privately owned, but rather a hybrid of both. Especially for IP, property that is intangible, we can use this continuum to our advantage.

Patents as Probabilities

Ian Ayres and Paul Klemperer propose a radical rethink of IP along these lines: Probabilistic Patents. They argue that an efficient patent policy should provide “constrained” market power as opposed to an absolute one. That is, the government should allow a limited amount of patent infringement that balances returns to inventors with social costs. One means of achieving “constrained” market power is to combine uncertainty with delay of IP enforcement.

Probabilistic determination means that some “infringers” will make the calculation that the risk of violating a patent is worth the potential profit. A few “infringers” will enter the marketplace and curtail the monopoly power of the patent holder. Only a limited number of players would step in because the market would naturally reach a point where the risk of “infringement” would outweigh the potential for profit. Thus, competition would be limited and would not wipe out the patentholder’s profits or their incentive to innovate. Ayres and Klemperer illustrate how a small amount of uncertainty reduces deadweight loss (the aforementioned social costs of patents) by much more than it reduces the patentees’ expected profit. For example, they calculate that if the probability of enforcement is cut to 95%, the market price of the patent is cut by 10% and the social deadweight loss is reduced by over 18%.

Would this not reduce the incentive to innovate? It certainly does by a small amount but we can compensate for this by lengthening the term of the patent. For example, reducing the probability of enforcement to 90 percent would require lengthening the patent term by just 3.4 percent to achieve the same profits for the patent holder, while still reducing the social cost of the patent by roughly 30 percent. In short, consumers of IP benefit from oligopolistic pricing for a longer period than they do under monopoly pricing for a shorter one. A similar outcome could be achieved through a Duopoly Auction. In that system, a patent would confer not only the right to an idea but also a mandate to auction it off to a second owner. The inventor would still receive profit from its own sales alongside a hefty lump sum payment at the patent auction. Consumers would benefit from access to lower-cost duopoly-priced ideas rather than monopoly-priced ones.

A Continuum of Excludability

We don’t need to roll the dice on patent enforcement, however, if we know its value. Much of the difficulty in valuing ideas stems from a natural variation in the degree of excludability. Amy Kapczynski & Talha Syed discussed this “continuum of excludability” in the Yale Law Journal. In their paper, they note that 30,000 people die every year in ICUs from infections resulting from central-line catheters. The IP system, of course, would reward a company handsomely for developing a new antibiotic that saves these lives. But the solution doesn't need to be a new drug. In fact, the New England Journal of Medicine developed a life-saving innovation that cuts these infections by two-thirds: a simple checklist of standard hygienic and communication practices that can be performed at any ICU at virtually no cost. A patent system would protect and reward the creation of a new drug, but it would struggle to reward the developer of this checklist.

Both inventions have similar social value, but one has greater market value. The reason for this is the degree of excludability. Even if one could patent the checklist, it would be impossible to monitor the activity of every ICU to ensure that royalties were paid when the system was used. A drug, on the other hand, is highly excludable; the legal system can prevent copies from being produced and sold on the market. Thus, when we discuss the market value of a patent or idea, that value is derived from the social value moderated by the fraction of that value that is excludable in the marketplace. Much of the research on IP tends to focus on pharmaceuticals because they are easily excludable. But this does a disservice to other ideas that are less tangible but otherwise have equal or higher social value. Putting this all into a crude formula, the market value (V) is the social value (S) moderated by the fraction of social value that is excludable (C).

V=C(S)

Patent Buyout Auctions

The most popular method for divining a patent’s value was proposed by Michael Kremer in 1997: patent buyout auctions. In his proposal, an auction is used to determine the value of a patent, whereupon the government buys and open sources it. This concept has some historical precedent. Daguerreotype photography, invented in 1837, was the first means of taking photographs. The government of France recognized the importance of this new technology, purchased the patent, and placed it into the public domain. Free to use, the technology rapidly spread across Europe, and within months, the process of taking photographs was translated into dozens of languages. Chemists all across Europe quickly improved upon the technology, likely faster than they would have had it not been in the public domain.

Kremer’s proposal works like this: When a patent is filed, it would automatically go into a public auction. The auction would be a Sealed Bid Second Price Auction (SBSPA). In an SBSPA, bids are submitted in written form without knowing the other bids in the auction. The highest bid wins, but only pays the second highest bidder’s price. Unlike traditional first-price auctions where bidders are trying to guess what other parties are offering, the SBSPA incentivizes participants to bid the true value only. The government would also submit a bid, but the government’s bid would take the private value of the patent, determined by the auction, and add a multiplier.

Why? New ideas create positive externalities that cannot be fully captured privately. Kremer suggests a multiplier of 2x that would roughly account for the positive externalities that the private sector cannot capture. By default, the government’s bid would win the auction. The patent holder could elect to sell or retain the patent. If sold, it would be placed into the public domain for the benefit of humankind. The beauty of patent buyouts is that inventors will be rewarded for their work, while society gets to immediately enjoy the fruits of new ideas.

In my view, the problem with Kremer’s system is that it’s vulnerable to manipulation. Since the government is buying the vast majority of patents at a significant markup, there is an immense risk that bidders and inventors will collude, driving up patent valuations and forcing the government into paying excessive prices. Kremer recognizes this and suggests that the government step aside on random auctions, creating risk for colluders. With that said, even with safeguards, it is too easy for three CEOs to meet on a golf course and arrange a “patent pumping” scheme that would net billions in profit, even if they occasionally would take losses. Additionally, I do not think this system would be affordable as it would require trillions of dollars in government spending every year.

Enter Harberger

Kremer’s overarching goal is to determine the value of an idea so we can eliminate the “holdout problem” and improve the allocative efficiency of IP. We don’t need buyouts and auctions to do this, however. Once we understand that monopoly protection is a pure creation of the sovereign state, it may be optimal to reframe patents as partially publicly owned. The owner has the right to profit from his idea but must pay a portion to the sovereign authority that made this possible. A small annual tax, almost a kind of “lease” from the state, can transform patents from monopoly into partially publicly owned property. As in Kremer’s system, the challenge lies in accurately assessing the value of the IP. That’s where Harberger taxes come in. To determine the value of an idea we turn to the IP owners themselves. They self-assess the value, and the government charges an annual tax (between 2-7 percent) on that valuation.

Naturally, IP owners will want to assess the value low to reduce their tax burden. This is why, under a Harberger system, anyone can buy IP at the self-assessed value at any time. For example, a patent holder might want to value their idea at $10 billion to prevent anyone from buying it. But with a 2.5 percent annual tax, they would have to pay $250 million a year to keep their monopoly rights. Instead, they will rationally choose a realistic $100 million valuation, incurring a reasonable $250 thousand annual levy that is worth paying for patent protection. The combined constraints of a buyout price and recurring tax force a broadly honest valuation upon self-assessment.

Like probabilistic patents, a small tax here has a big impact. Indeed, studies illustrate that a tax of just 2.5% percent on property would significantly improve social welfare by balancing the allocative and investment efficiency of property. Under this regime, IP can be purchased at a fair value without the “holdout problem.” At the same time, the tax is not too high to completely deter investment and innovation. Crucially, this recurring tax would also discourage rent-seeking behavior, including patent-trolling, by imposing a cost on unproductively squatting on patents.

A New IP Paradigm

For all of its flaws, Kremer’s auction system illustrates that if one can value an idea, we have a basis upon which to either open source it or make it liquid and tradeable. Here, I propose a framework that does what we need it to do at an affordable cost while also eliminating the incentives for manipulation. Remember, my aforementioned two-tier patent system would result in fewer long-term patents. Only the most coveted IP would likely receive 20-year protection and this IP is my focus. Once the long-term patent is granted, its value will be determined either by auction or self-assessment. Either way, the moment that the IP is valued, it is open for purchase by the government or the private sector.

Harberger taxation slightly weakens the monopoly power of IP owners and provides other parties the opportunity to make more productive use of that IP. A small tax would incentivize IP owners to more readily license their ideas at a lower cost. One might imagine that private players could also band together into associations that would purchase IP that was beneficial for its members. For example, airlines might partner with aircraft manufacturers to purchase a new patent for a fuel-saving jet engine turbine blade. By spreading the cost across multiple firms, all parties benefit financially from a relatively small investment. IP owners have the right to refuse the sale, however, every bid they refuse becomes the baseline of a new Harberger levy. The higher the valuation, the higher the levy will become. IP owners can avoid paying the Harberger tax at any time; all they need to do is open-source the patent for all to use.

To eliminate manipulation concerns, I diverge from Kremer in a few ways. First, because we are using Harberger taxation to inject liquidity into the IP market, we no longer need the government to buy and open-source everything. The state may purchase IP it deems worthy of the public domain, but this is optional. Furthermore, I question if the government must pay markups to an inventor as Kremer advocated. As discussed in Stanford Lawyers magazine, we do not permit the full internalization of social benefits in any other property realm, thus it is disingenuous to place such a demand on IP. If I plant flowers on my lawn, existing property law does not permit me to hunt down every passerby and charge them for the beautification that I provided. The market need not provide a perfect capture of social benefits for inventors, only enough to cover the fixed and marginal costs of producing IP.

Taming the Anticommons

With no mandatory government buyouts or markups, my system is cheap to implement and immune from manipulation. In fact, with the revenue from the Harberger tax, it would likely pay for itself. To the extent that the tax may dull inventors’ profits, we can borrow from Ayres and Klemperer and extend the length of the typical patent term. Because IP would be subject to taxation, it would not be rational for “orphaned” works to exist; most would immediately be released into the public domain. Similarly, the recurring tax on IP would discourage patent trolls as they would now face losses. Additionally, my system would greatly reduce the cost of IP litigation. In infringement cases, courts’ roles would be limited only to adjudicating whether or not an infringement took place. They would be freed from the arbitrary task of determining the damages suffered, as this number would be publicly available.

When we combine the above with a proper tax design that doesn’t depress investment alongside enhanced government grants, we can spur greater investment into the inputs of idea creation. Moreover, through prizes and improved IP law, we can also raise the effectiveness of the outputs. Together, this ‘push and pull’ will encourage the market to produce more ideas by better aligning the social benefits of innovation with private incentives. When further leveraging the multiplier effect of the triple helix, we can greatly accelerate the diffusion of new ideas and technology into society for human betterment.

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