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April 15, 2005

Patent Economics: Part 3 - The Inventor's Dilemma

Given that substitution inherently limits the monopoly power of patents (as explained in part 2 of this series), here we consider how patents provide economic benefit to a patent owner and society. Consider the counterfactual case of invention in a society that does not offer a patent grant. An inventor without access to patent protection faces the inventor's dilemma.

An inventor develops a marketable idea with significant commercial potential. What next?

As with most such ideas, a sizable capital investment would be required to productize the idea, and then manufacture, market, and sell the resultant products. If the inventor lacked the necessary capital to commercialize the invention, the challenge would be find a buyer or investor for the invention. Here the dilemma arises.

Without patent protection, an invention can only be protected by treating the invention as a trade secret; that is, not revealing sufficient details such that the invention could be replicated, and thus the inventor inspiring her own competition. But an investor or buyer would not be willing to risk capital without knowing sufficient details to gain confidence in the commercialization prospects of the invention. The level of information necessary to attract investment is the same level for giving the invention away. Without legal protection, there is no incentive to invest in an idea which, once exposed, may be readily copied.

The inventor's dilemma is readily solved by a patent, which gives the inventor freedom to disclose without unleashing the threat of creating self-competition.

The inventor's dilemma arises because of the intrinsic nature of information as a public good. By contrast, private goods necessarily have limited ownership and exclusive consumption.

Public goods, however, are both nonrival (the supply is inexhaustible), and nonexclusive. A good is nonrival if one person's consumption (usage and enjoyment) of it does not lessen its consumption by others. In microeconomic terms, the marginal cost of providing the good to an additional consumer is zero. A good is nonexclusive if people cannot be prevented from consuming it. Information, including jokes, are definitely public goods: it's impossible to stop word-of-mouth. Police protection is generally considered a public good, at least by those who consider it good.

The nature of public goods, namely non-rivalry and non-exclusivity, results in a lower level of production than would otherwise occur if the good could somehow be privatized. Indeed, public goods define what is called the free-rider problem. Why pay for something you can get for free?

The major economic justification for the existence of government is to provide public goods which individual consumers would otherwise easily shirk paying their fair share for. Environmental protection, for example, would be under-funded if not for government. Of course, as some would contend with environmental protection, a public good can be underfunded even with government.

Governments can correct for the underproduction of public goods in several ways, depending upon the type of good. As with national defense, the government may provide it, paying for it through tax revenues. Government may subsidize private production, such as the U.S. government-sponsored human breeding program, in the form of child tax credits. Regulation, such as for environment protection, is another method to correct for what otherwise would be a market failure.

A government may attempt to create a market for a public good by establishing new forms of property rights related to an otherwise public good. For environmental protection, one such measure is tradable pollution permits, coupled with penalties for polluting without a permit. Patents are another form of such intervention to create a property right from what otherwise would be a public good.

Patent protection creates a barrier to market entry. How else could an inventor recoup the costs of invention without the patent's right to exclude?

Without patents, both an inventor and competitors compete to sell a good at a competitive price based on manufacturing costs. Only the inventor pays for the cost of inventing, while competitors pay a lower cost for reverse engineering - that is, copying the invention. An inability to recoup the cost of invention discourages it.

Invention defines technological progress. Economic well-being would suffer greatly without it. The history of the world up to the 18th century is an economic landscape of stagnant or fitful technological progress, because the incentives and prerequisites for profiting from invention were lacking. The book "The Birth of Plenty," by William J. Bernstein, is recommended reading to those interested in this subject.

A common argument used against the worthiness of software and business method patents is that the cost of invention is low: namely, the inventor's brain-wattage. This argument is seldom put forth by creative types, who know from experience that invention is 1% inspiration and 99% perspiration; the perspiration including the education and experience necessary to take a creative step of invention. This argument is also seldom put forth by patent holders, who know the level of effort required to obtain patent protection.

Developing successful software production and business processing methods requires education, experience, methodical observation & thought, and attention to detail while retaining "the big picture." Knowing enough to frame production and process methods into software is nontrivial. There is particular irony that software developers denigrate the skills of their better peers by suggesting that none are sufficiently innovative to deserve the same protection that toy makers rightly receive.

Next - exploring and assessing the incentives that patent protection provides.

Part 1 - Monopoly
Part 2 - Substitution
Part 3 - The Inventor's Dilemma
Part 4 - Incentives
Part 5 - Theories
Part 6 - Perspectives

Posted by Patent Hawk at April 15, 2005 11:47 AM | The Patent System


Your argument makes complete sense. You have obviously spent a great deal of time studying this and have done a good job of explaining the importance of strong patents and their role in protecting inventors' ideas. I think that strong patents are necessary to encourage patent enforcement and minimize patent infringement so that the inventor can be assured that they will get paid for their ideas in the end.

Posted by: Ray Subs at May 18, 2009 11:53 AM