Free-riders, efficiency and social optimality

December 9, 2006 at 11:50 am · Filed under Innovation, Patents

Technology is applied knowledge. Knowledge is a pure public good because it is completely non-rivalrous (my consumption does not reduce your consumption).

Pure public goods suffer from the free-rider problem. The good should be provided to the level where the marginal cost equals the marginal social benefit. But the marginal private
benefit is less that the marginal social benefit and so private provision tends to under-supply.

Patents solve this by allowing the owner to appropriate the social benefit. The licence fees or monopoly market position enable the owner to internalise the social benefit by converting it to private benefit. Therefore the marginal private benefit can be equated to the marginal social benefit, meaning that an efficient level of knowledge production can be achieved.

The efficient level defined here is a Pareto-efficient outcome. At this level of output, it is not possible to increase the welfare of one member of society without decreasing the welfare of at least one other.

But Pareto-efficient outcomes are seldom socially optimal. Market conditions do not necessarily lead to the socially preferred outcome – poverty, inequality, etc can be pareto-efficient outcomes of a market allocation of resources.

In the case of patents, the Pareto-efficient outcome is achieved by allocating the entire market surplus to the patent owner. Therefore, although we can buy high quality DVD players for less than $100, almost the entire economic profit is being appropriated by a few companies that make hundreds of millions of dollars in revenue from their licences, and some of which do not manufacture anything.

A solution to the inequality and social non-optimality may be redistribution via taxation. The patent system attempts to provide this by applying patent maintenance fees, but they are set at derisory levels that are only sufficient to cover the costs of running the patent office. How much redistribtion can take place when maintenance fees are set at several thousand dollars for a patent with a market value of hundreds of millions?

So how about a licence revenue tax policy? Coupled with a monopoly profit tax. The funds could be used to reallocate surplus to areas of technology that are under-developed (for good market reasons) such as research into malaria or other diseases affecting poor countries; or low-carbon energy technologies, etc. A tax policy such as this can achieve better social optimality without producing an inefficient outcome, as is shown by the second theorum of welfare economics.

There are, as usual, practical difficulties. What company will correctly disclose the value of its patent portfolio if it is going to be taxed on that value? And what are the transaction costs of administrating such a valuation and collection policy?

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First mover advantage

August 24, 2006 at 10:13 pm · Filed under Innovation

Daniel Scocco on Innovation Zen has an interesting article on First Mover Advantage.

Why is this interesting for the economics of technology?

First let us note that first mover advantage is not something that emerges from classical economic theory of competitive markets. In competitive market theory, new firms will enter the market and take market share until there are a large number of firms with roughly equal market share. First mover advantage is a result of market failure, due to product or production characteristics.

Daniel describes three main causes of first mover advantage in a market.
1. Industrial age environment – in an age of slow change, the first move has a time advantage.
2. Natural Monopolies – some markets can only support one supplier (motorways, electricity supply, …)
3. Bias towards winners.

I would add at least two more:
4. Economies of scale.
5. Network externalities.

Economies of scale exist in many new industries.  If a firm faces decreasing average costs, then they can increase profits and decrease prices by increasing output.  Once the first firm is established, others cannot enter the market unless they are able to at least match the scale of output of the incumbent firm.

Network externalities occur when a firms product generates derivatives or dependent products from other firms.  The best-known example of this is the Windows operating system which established itself as a defacto “standard” on which many other products now depend.

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Economic basis of the patent system

August 24, 2006 at 10:11 pm · Filed under Patents

Why do we have a patent system?

A patent is a policy mechanism to correct the economic problem of positive externalities. An externalitiy occurs when one party’s actions create costs or benefits for another party, without those costs or benefits being transmitted by market prices.

The classic example of a negative externality is pollution – the cost of pollution is borne by society as a whole but the cost is not included in the market price of goods manufactured by polluting industries. The consequence is that the price of the goods is too low (doesn’t reflect the true social cost), too much of the goods are produced, and too much pollution is produced.

Solutions to negative externalities include taxing producers so that private costs better represent social costs (Pigouvian tax), creating markets for tradeable rights (e.g. carbon emissions) and creating property rights. In the case of property rights, the Coase theorm says that it doesn’t matter who owns the property rights, the poluters and the people affected will bargain and trade until the efficient level of production and pollution are reached.

Returning to patents, private innovation has positive externalities. If I invent a new drug that improves concentration, then anyone can copy that drug and benefit from it. The private benefits are significantly less – some studies indicate that the social benefits of innovation are 1.5 to 12 times the private benefits.

What is wrong with this? There are private costs involved in innovating and the amount of innovation will be determined in the innovation market by producers (inventors) equating their private marginal costs with the private marginal benefits, which then determines the profit-maximising output level where marginal cost = marginal benefit. Since there are positive externalities, a socially inefficient level of innovation will occur.

Governments attempt to solve the problem by creating property rights for innovation – patents. The theory is very simple: if private innovators can capture more of the social benefits of their innovation and convert them to private benefits, then more innovation will occur and efficiency of the innovation market will be improved.

Now that the theory has been outlined, there are several important questions that need to be answered:

1. Innovation is an uncertain activity, unlike producing steel. Do inventors really determine their level of innovation be equating their marginal costs with their marginal benefits if the marginal benefits are unknown?

2. The patent system transfers some of the total social benefit to the inventor. But we should be interested in marginal benefits, not total benefits. The private and social benefit functions are different and it may be that the marginal cost equals the marginal social benefit at levels that are above, equal to or less than the marginal private benefit. i.e. without intervention, the market may already produce an efficient level of innovation, or too much or too little.

Although you might not recoginise it in these terms, this is the argument of the open source movement.

3. The patent system creates monopoly property rights. Monopoly also results in inefficient levels of production – so one inefficiency is replaced with another. Balancing the two “wrongs” to create an increase in social benefits may be difficult.

4. The patent system releases technical information into the global public domain which may otherwise be kept secret. This information can be used, often without infringing the patent, and so it is a simple social gain.

I will attempt to explore these issues in future articles.

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