Economic issues raised by patents

Viewed from the angle of innovation policy, patents aim to foster innovation in the private sector
by allowing inventors to profit from their inventions. The positive effect of patents on innovation as incentive mechanisms has been traditionally contrasted with their negative effect on competition and technology diffusion. Patents have long been considered to represent a trade-off between incentives to innovate on one hand, and competition in the market and diffusion of technology on the other.

However, recent evolutions in science and technology and patent policy and progress in the economic analysis of patents have nuanced this view: patents can hamper innovation under certain conditions and encourage diffusion under others. The impact of patents on innovation and economic performance is complex, and fine tuning of patent design is crucial if they are to become an effective policy instrument.

Empirical evidence tends to support the effectiveness of patents in encouraging innovation,
subject to some cross-industry variation. In a series of surveys conducted in the United States, Europe and Japan in the mid-1980s and 1990s, respondent companies reported patents as being extremely important in protecting their competitive advantage in a few industries, notably biotechnology, drugs, chemicals and, to a certain extent, machinery and computers. Companies in other industries reported that patents play a secondary, if not negligible, role as a means of protection for their inventions, as they tend to rely more on alternative means such as secrecy, market lead, advance on the learning curve, technological complexity and control of complementary assets (Levin, Klevorick, Nelson and Winter, 1987; Cohen, Nelson and Walsh, 2000).

However, patent protection may also hamper further innovation, especially when it limits access
to essential knowledge, as may be the case in emerging technological areas when innovation has a
marked cumulative character and patents protect foundational inventions. In this context, too broad a protection on basic inventions can discourage follow-on inventors if the holder of a patent for an essential technology refuses access to others under reasonable conditions. This concern has often been raised for new technologies, most recently for genetic inventions (Bar-Shalom and Cook-Deegan, 2002; Nuffield Council on Bioethics, 2002; OECD, 2003a) and software (Bessen and Maskin, 2000; Bessen and Hunt, 2003).

In addition, as has long been recognised, the main drawback of patents is their negative effect on
diffusion and competition. As patents are an exclusive right that creates a temporary monopoly, the patent holder can set a market price higher than the competitive price and limit the total volume of sales. This negative impact on competition could be magnified as patent holders try to strengthen their position in negotiations with other firms, in an attempt to block access by competitors to a key technology, or inversely, to avoid being blocked by them (Shapiro, 2002). Such strategic patenting seems to have developed over the past 15 years, notably in the electronics industry (Hall and Ziedonis, 2001).

Nevertheless, patents can also have a positive impact on competition when they enhance market
entry and firm creation. Not only is there evidence of small companies being able to assert their right in front of larger ones thanks to their patent portfolio, but patents may also be a decisive condition for entrepreneurs to obtain funds from venture capitalists (Gans, Hsu and Stern, 2002). Moreover, patents may enhance technology diffusion. Patenting means disclosing inventions which might otherwise be kept secret. Industrial surveys show that the reluctance of firms to patent their inventions is primarily due to the fear of providing information to competitors. This has been confirmed in the OECD/BIAC survey on the use and perception of patents in the business community, sent to firms in OECD countries in 2003 and in which respondents indicated their intensive use of patents as a source of information (Box 2; Sheehan, Guellec and Martinez, 2003). Patents also facilitate transactions in markets for technology: they can be bought and sold as property titles or, more frequently, be subject to licensing agreements which allow the licensee to use the patented invention in return for payment of a fee or royalty (Arora, Fosfuri and Gambardella, 2001; Vonortas, 2003). Finally, enhancing technology diffusion has been the goal put forward by governments to encourage universities to patent their inventions, with the objective of licensing them to businesses that will further develop and commercialise them (OECD, 2003b).

In summary, the traditional view of patents as a compromise between incentives to innovate and barriers to technology diffusion, if not incorrect, presents a rather partial picture, as patents can either encourage or deter innovation and diffusion, depending on certain conditions. In fact, the effect of patents on innovation and diffusion depends on particular features of the patent regime. Patent subject matter, patenting requirements and patent breadth are three basic tools for policy makers involved in the design of patent regimes that could be used to enhance both innovation and diffusion (Encaoua, Guellec and Martinez, 2003):
• Patent subject matter is the domain of knowledge that can be patented, if the patenting criteria
of novelty, non-obviousness and usefulness are also met. For instance, scientific discoveries
and abstract ideas are generally excluded. Its definition must be based on a careful
examination of when it is efficient for society to offer patent protection in addition to other
legal or market-based means of protection.


• Patenting requirement is the height of the inventive step required for a patent application to be
granted. It is understood as the extent of the contribution made by an invention to the state of
the art in a particular technology field. The higher that contribution, the more selective the
process, thus the lower the number of patents granted. The lower it is, the larger the likelihood
of finding many inventions with no significant social value. Conversely, too high a requirement
would discourage innovations which, while not being radical, are still necessary for
technological breakthrough to translate into actual products and processes.

• The breadth of a patent is the extent of protection granted to patent holders against imitators
and follow-on inventors. Not only do patentees obtain exclusive rights on their own invention
but also on other inventions which are deemed “functionally equivalent”, and to a certain
extent on improvements of their inventions. Patents that are too broad allow their holders to
“pre-empt the future”, while patents that are too narrow discourage research that feeds into
follow-on inventions. Other policy or legal aspects have an impact on the patent system, including the amount of damages attributed by courts in case of infringement, the conditions for exemptions for research use, etc. Taken together, these aspects determine the strength of patents. Overall, excessively weak and narrow patents might deter business investment in R&D, as it becomes too easy for an imitator to undercut the inventor’s market price. Weak and narrow patents may also encourage secrecy at the expense of publicity, and harm markets for technology, hence hindering diffusion of technology. Conversely, excessively strong and broad patents may open the door to undesired strategic behaviour by patent holders, who may use their titles to appropriate revenue from existing inventions marketed by other companies. For instance, a broad patent on a basic invention with no substitutes may be equivalent to having an exclusive right of exploitation over an essential facility, allowing its holder to bar follow-on inventors who would be willing to invest in R&D to create socially useful applications.
By carefully balancing these multiple instruments, policy makers can design patent regimes that are favourable to both innovation and diffusion.

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