Intellectual Property Rights, Competition
Policy and Innovation: Is There a Problem?
P.A. Geroski*
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Cite as: PA Geroski, "Intellectual Property Rights, Competition
Policy and Innovation: Is There a Problem?", (2005) 2:4 SCRIPT-ed
422 @: http://www.law.ed.ac.uk/ahrc/script-ed/vol2-4/geroski.asp
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© P.A. Geroski 2005. |
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1. Introduction
Most of us share the presumption that when markets work well, they ought to be left undisturbed to get on with it. When, however, markets do not work well - when a “market failure” of some type or other occurs - then there is scope for policy intervention. The case for intervening is not, of course, a complete no-brainer: intervention in the face of market failure only makes sense when it is likely to produce a more satisfactory outcome than would be produced were the market to be left on its own.
Innovation - or, more broadly, the production of knowledge - is a classic example of an activity that is likely to involve a market failure. Knowledge has all the properties of a “public good”: that is, goods which are non-rival in use and non-excludable (whether they are produced in the private or in the public sector does not matter in this context). “Non-rival in use” means that one individual can consume the good in question without any fear of restricting the consumption of the same good by another person. Put more simply, with public goods, there is no possibility of congestion arising to interfere with the consumption of the good or service by particular individuals . “Non-excludability” means that it is difficult or impossible to prevent someone who has not paid for the good from consuming it. With non-excludability, free riding by users of knowledge becomes a real possibility. Not only does this make it hard for an innovator to sell his/her increment of knowledge (and thereby cover his/her costs), but it also may make it hard to ascertain just how valuable it really is to consumers.
The production of knowledge has a further property that helps to cause market failure, namely that while it is costly to produce, it is typically costless to reproduce. That is, all the costs of producing knowledge are fixed (and they are usually sunk as well). This creates two problems: first, knowledge creators must be sure that there is a market sufficiently large to cover their fixed costs if they are to make the investment in generating new knowledge; and second, the fact that reproduction costs are zero means that prices could, and probably should, fall to zero. This, in turn, makes it hard to guarantee that fixed costs will be covered.
These problems are widely understood and a number of solutions to them exist. There is widespread agreement that one way forward is to create a set of property rights which exist for a limited period of time that will enable an innovator to recoup the costs of the investment s/he has made in generating the new knowledge. This property right effectively gives the innovator a monopoly in the use of the knowledge s/he has created, enabling him/her to control its subsequent use (or, at least, control the terms on which others can use it). The question that I want to address in this brief paper is a simple one: is this the best policy that one might use to stimulate innovation?
There is
no doubt that intellectual property rights do preserve incentives to
innovate, but that is not my question. What lies beneath the question
are two further questions: does the system of intellectual property
rights that is commonly used have undesirable side effects? And are
there other, possibly more effective, ways to stimulate innovation?
My answer to both of these questions is a qualified yes. In
particular, I think that one undesirable side effect of intellectual
property rights systems is that they sometimes inhibit innovation. A
second is that they provide incentives which are unrelated to the
input made by innovators, which means that they may well distort
incentives to innovate. Finally, I think that competition policy has
an important role to play in stimulating innovative activity, and one
that might both complement and even substitute for the type of
protection offered by intellectual property rights.
2. Intellectual property rights and innovation
My first set of observations centre on the question of whether the system of intellectual property rights which is commonly used in most advanced countries has undesirable side effects. There is no doubt that a policy of granting relatively unrestricted monopoly rights to particular agents can have undesirable side effects in markets built up around the use of the innovation. This is most obviously the case with patent licences that grant exclusive rights, or limit the geographical application of rights, in ways that restrict competition in the market for the product produced using the patent. However, there is a second set of possible side effects that I want to focus on here, namely those that subvert the whole purpose of the policy, namely stimulating innovation.
Innovation is the process by which knowledge advances. The progress of learning is marked by the production of new ideas, the wider diffusion of existing ideas and the embodiment of ideas in new artefacts such as new goods and services. One important feature of the production of new knowledge is that knowledge builds on itself: new ideas are suggested by old ideas, and they often combine several old ideas in a new and quite different package. It follows that the process of innovation is likely to be more effective and more efficient if today’s innovators are allowed free access to the results of yesterday’s innovations. The difficulty is that the intellectual property rights granted to protect yesterday’s innovation sometimes allow that innovator to control today’s innovation. When that happens, intellectual property rights can impede the rate of innovation. It seems to me that there are two specific areas where there might well be a concern that patents, in particular, inhibit innovation.
The first is essentially the problem of the “anti-commons”. Every innovator draws from a large and deep well of public knowledge, and no one is restricted in the access to, or the use they can make of, information in the common domain in which that public knowledge resides. Further, since information is essentially a public good – as stated above, meaning that it is non-rival and non-exclusive in use – there is never likely to be a problem of congestion in the public domain; hence, there can be no real justification for restricting or regulating access to it. It follows that anything which restricts access to the public domain, or restricts the size of that domain itself, is likely to reduce innovation. More generally, licences which give the licensee rights to the innovation produced by the licensor, unduly broad patents and patent claims which cover, or lay claim to, knowledge not produced by the patent holder, are all examples of practices which might pervert the purpose for which intellectual property rights were developed.
The second problem arises with complex innovations. When a new innovation draws on several different areas of technology, then the innovator will need to undertake a series of bilateral negotiations with existing intellectual property rights holders if his/her innovation is to see the light of day. This, in turn, means that any individual antecedent patent holder has the ability to hold up the new innovation, possibly using this bargaining power to extract most of the returns that it promises to produce for its creator. These “patent thickets”, as they are sometimes called, basically inflate the transactions costs of developing a new innovation, and are, therefore, likely to inhibit the rate of development of new ideas or the good and services that come from them.
One of the
dilemmas that patent thickets create are that clearing the ground for
new innovations may well – if such clearing was anticipated by
the original innovators - dull the incentive of those who developed
the original innovations on which all the rest depends. This is, in
some ways, much the same dilemma that broad patents give: the broader
the patent, the greater is the incentive to innovate to get that
patent; however, the broader the patent, the more difficult it is to
develop spin-off innovations that are tangential to the original
innovation. In both cases, strong incentives are given to develop new
innovations, but these incentives can inhibit the further development
of those initial new innovations. If you like, patent thickets and
broad patents encourage more innovations today, at the possible
expense of more innovations tomorrow. Just how costly a policy this
is depends of course on just how much of a tomorrow there really is.
3. The design of intellectual property rights
My second observation is that even when patents and other forms of intellectual property rights do not actually inhibit innovation, they may distort incentives in various ways that might reduce the value of the innovations which they stimulate. To understand how this might happen, it is necessary to step back and think a little about the design of intellectual property rights systems.
When a competition economist first encounters the intellectual property rights regime that is common in most countries, their first reaction is likely to be bafflement. Competition economists are used to the idea that investments - particularly when they involve a substantial amount of sunk costs - might need to be protected in certain circumstances, and that firms ought to be able to recover their costs and earn a reasonable return on such investments. Indeed, this is, or ought to be, as true in the case of intellectual property as it is true of the construction of huge power stations, telecommunications networks and sewer systems. An inventor or innovator needs to be sure that s/he will be properly rewarded for his/her efforts, and, if s/he is not, then his/her incentive to innovate is bound to be diminished.
This kind of issue typically comes up in the context of public utilities where some element of natural monopoly is present. The existence of natural monopoly means that the problem for regulators is to ensure that regulated companies make enough return on their investment, but are not allowed to use such investments to extract monopoly returns from consumers. Much the same should apply to intellectual property rights, and for much the same reasons: they should be strong enough to insure that innovators gets a fair return for their efforts, but not so strong that innovators are able to extract unreasonably high returns from consumers.
What is really puzzling about the intellectual property rights system is the way that it goes about preserving such incentives. For competition economists, the natural first step is to sum up all the investments made, allow for a bit of risk and compute a rate of return that the innovator ought to be allowed to earn on that investment. But, intellectual property rights regimes typically grant inventors monopoly rights for a fixed period of time regardless of their costs, or, for that matter, of the social value of their innovation. Further, these intellectual property rights place very few restrictions on the kinds of licensing provisions that inventors can impose on those who wish to take advantage of their work, allowing them, in principle, to earn phenomenal returns in some circumstances.
Now, one might feel that the traditional design of intellectual property rights has the virtues of simplicity, meaning that the comparatively low costs of running the regime more than outweighs its limitations. It is certainly true that the one size fits all regime reduces the amount of regulation which has to occur; and that giving inventors 20 years protection regardless of what they invent is undoubtedly a lot simpler than computing a reasonable rate of return for each innovation that is patented. However, simplicity has a price. In particular, one must ask just what kind of incentives to innovate does this kind of fixed time limit system produce?
There are
probably two slightly perverse incentives that are worth noting.
First, this kind of rights regime steers inventors towards those
types of innovations or inventions that intellectual property rights
can actually protect - it is clearly more profitable to invent things
that are patentable than things which are not. Further, because the
upside can be unlimited, it arguably steers too many resources into
such innovations. If innovators are able to extract whatever they can
from users, successful innovations can generate revenues that vastly
exceed their costs. Second, and harking back to a point made earlier,
there is little need or incentive for innovators to channel those
gains into producing further innovation. The rights given to
intellectual property rights holders protect the investments that
they have already made, and there is no requirement that these
returns are invested into further innovative activity (although that
said it is not wholly obvious that there should be). Hence, the time
limited regime incentivises first time innovation, possibly at the
cost of follow on innovation.
4. Competition policy and innovation
My third and final set of observations centre around the question of whether there are other, possibly more effective, ways to stimulate innovation. In fact, it is well known that there are a number of alternative routes to this end, and the relative merits of most of them have been widely debated. It has long been understood that procurement practices (such as those which underlie user led innovation processes) can be a major driver of innovation. Similarly, the use of Research &Development subsidies, and more general public spending on research, will clearly stimulate innovation, as may business support policies directed at entrepreneurial high tech firms. In what follows I want to focus on yet a further alternative, namely the use of competition policy to stimulate innovation.
It has long been believed that competition and innovation are not compatible; that truly competitive markets (at least in the textbook sense of “perfect competition”) are incapable of sustaining innovative activities by firms. Usually associated with the work of Joseph Schumpeter, the argument is, in essence, that in the absence of some monopoly power, firms will be unwilling to invest in innovation. The argument continues that the presence of some monopoly will ensure that prices are above variable costs, and, hence, that fixed costs can be paid off. Further, it is argued that the existence of some excess profits gives firms the option of funding innovation out of retained profits, something that might be easier to do than borrowing from uninformed, risk averse, investors. Such firms may also have the capabilities to innovate, having been able to finance the development of skills and capabilities that they would otherwise lack. Finally, it is argued that some degree of monopoly power may make it somewhat easier to market the new idea, or the good or service which embodies it; that is, a monopolist is likely to be able to appropriate more of the returns of his/her innovation than would a firm in a very competitive market.
The big problem with these arguments is that they do not address incentives. There is very little doubt that monopolists have the ability to innovate - they are likely to have the cash flow, market position, skills and even scale of activities to undertake research and development, and bring new products to market. Whether they actually will do so is another question entirely. Most firms who have a well established market position have accomplished this on the back of particular innovations and the development of specialised expertise. They have made deep investments in serving their market in a certain way - investing in procurement systems, customer relationships and large scale manufacturing - and they have shaped their organization to match what they are doing. Innovative activity is, however, disruptive, and anything that disrupts a profitable activity not always welcome.
It is worth trying to make this point more precisely by distinguishing two types of innovation: what are called “sustaining innovations” and “disruptive innovations”. Sustaining innovations offer consumers more of the same basic proposition, and they draw on - and deepen - the existing skills sets of firms. New personal computers that offer more computing speed, or more memory, are examples, as are cars that drive faster, or more economically, than existing cars. Disruptive innovations, on the other hand, offer consumers quite a different proposition, and they often demand the development of new skills and expertise by firms. They are sometimes called “competence destroying innovations” (with sustaining innovations sometimes being called “competence enhancing”).
The point is really simple. A well established firm with some degree of market power is much more likely to prefer to introduce sustaining innovations than disruptive innovations. Sustaining innovations build on, and develop, what it is already good at; they will help to protect its existing business against the challenge of slower, less adept, rivals. Disruptive innovations, on the other hand, offer lower net returns for established firms than they offer for new players. For an established firm, the gain to introducing a disruptive innovation is the gross profits from doing so, less the loss of profits from activities that the innovation displaces. For new firms or outsiders, there is no existing activity to displace with accompanying loss. It has, therefore, a larger incentive to introduce a disruptive innovation.
There is a further point worth considering. The Schumpeterian arguments that I have just been discussing all suggest that it is monopoly ex ante which matters for innovation: it is firms who already have some market power that the Schumpeterian argument identifies as likely innovators. It follows that there may be a real conflict between competition policy and encouragement of innovation: if this Schumpeterian argument is correct, then any attempt to attack existing positions of market power is likely to retard innovation.
Intellectual
property rights, on the other hand, are concerned to create monopoly
ex poste -- that is, after the innovation has been made - in
order to stimulate innovation. It is the promise of monopoly -- not
its actual fact -- that stimulates innovation in this line of
thinking. Any attack on existing monopoly positions will, in this
view, not affect innovation, since what matters is the expectation of
having a monopoly (at least temporally) on the use of the innovation
after it is made. This is perfectly compatible with having a good
deal of competition in the market before the innovation is developed.
5. Conclusions
I started this paper with a question - is the system of intellectual property rights, with which we are all familiar, the best way to stimulate innovation? The gist of what I have had to say is that the answer is “maybe”. In a sense, this is not a surprising conclusion: it is just too hard to be sure what the best policy is in almost every setting in which this question comes up. At a more sensible level, however, “maybe” is an answer pregnant with possibilities. Most of these arise from two different types of observations: first, that intellectual property rights systems can inhibit innovation, or at least distort it in particular directions; and second, that competition and innovation are not inimical.
For me, as a competition policy practitioner, the argument that competition stimulates innovation is an important one, for it suggests that competition policy is not necessarily in conflict with the use of intellectual property rights to stimulate innovation. At a practical level, this argument seems to me to have two implications. First, it seems clear that one ought to regard restrictive licensing practices as just what they are: namely, restrictive practices. In this, as in many other areas of anti-trust, the rule of reason ought to apply. That is, such practices should be evaluated in the context of the benefits which they might – or might not – bring to consumers, in both the short and also the long run. Second, anything that substantially lessens, or adversely affects, competition in a particular market is, or should at least potentially be regarded as, a threat to innovation. And, finally, the need to stimulate innovation is the one thing that both competition policy and intellectual property rights have in common.
* Chairman UK Competition Commission. The views are not necessarily even my own final settled views on the subject. They are offered to stimulate debate, and they are certainly not the official view (or, for that matter, the unofficial view) of the Competition Commission, or any of the members or staff associated with it. The usual disclaimer applies.