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.
