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«Do patents slow down technological progress? Real options in research, patenting, and market introduction Tuomas Takalo, Vesa Kanniainen* Department ...»

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International Journal of Industrial Organization

18 (2000) 1105–1127

www.elsevier.com / locate / econbase

Do patents slow down technological progress? Real

options in research, patenting, and market introduction

Tuomas Takalo, Vesa Kanniainen*

Department of Economics, University of Helsinki, P.O. Box 54, FIN-00014 Helsinki, Finland

Received 30 September 1997; received in revised form 31 July 1998; accepted 31 October 1998


This paper challenges the widely held view in the industrial organization literature that patents always speed up technological progress. We introduce a model of an innovating firm with uncertain property right to its innovation. The impact of a commitment to an R&D project is to create future options for patenting and market introduction. Each decision undertaken will change the conditions in which the innovator operates. It is shown that an increase in patent protection reduces the elasticity of the option value of the program with respect to the value of the project, raising the threshold value of market introduction and enhancing the ability of the innovator to wait. Thus, while the effect of patent is to raise the rents on and thereby the potential amount of innovations, it also tends to slow down market introduction. © 2000 Elsevier Science B.V. All rights reserved.

Keywords: Patents; Real options; Sequential investments JEL classification: D92; L10; O31

1. Introduction It is common wisdom in the theory of innovation that patents promote technical progress. Our paper challenges this view. We introduce the argument that by * Corresponding author. Tel.: 1358-9-1918875; fax: 1358-9-1918877.

E-mail address: Vesa.Kanniainen@Helsinki.fi (V. Kanniainen).

0167-7187 / 00 / $ – see front matter © 2000 Elsevier Science B.V. All rights reserved.

PII: S0167-7187( 98 )00049-6 T. Takalo, V. Kanniainen / Int. J. Ind. Organ. 18 (2000) 1105 –1127 1106 reducing the losses from the rival’s entry, patents also enhance the ability to wait for commercialization and may actually lead to delaying market introduction of new innovation. The reason for such a result is that with patenting the innovator will be less concerned about competitive introductions. Without patenting, an innovation has properties of a public good. We regard the patent as a contract between the innovator and society. By patenting, the patent holder discloses information about its innovation to competitors. Information disclosure has social value in reducing duplication. In exchange, society chooses the scope for protection. Even if lead time may show up as an appealing instrument against competitors, such a hedge basically creates an option value for delaying before commercialization. This phenomenon has not been left unnoticed; van Leuven (1996) says: ‘‘In cases where the applicant is not sure about the concrete use of the innovation he may decide to keep his options open for the future and may ask for patent protection.’’ It has indeed been observed in practice that especially in new markets firms acquire patents and to be able to wait and find out how the uncertain market demand will evolve 1. This observation points to interpretation of patents as options to commercialize. An informal discussion on this point can be found in Pitkethley (1997).

Such a result will be shown in the following model. First, we regard the investment projects as sequential; each decision undertaken creates a sequence of future options 2. Second, each decision is viewed as altering the economic conditions, e.g. the market structure, in which the innovator is operating. From the perspective of the real world, it is well-known that there are inactive or ‘sleeping’ patents though such a phenomenon is not very efficiently documented 3. Firms acquire patents to slow down the progress of potential rivals by forcing the rivals 1 The authors have consulted Mr Ilkka Rahnasto, a legal counsel for Intellectual Property Rights Management of Nokia Group. He indicated that patents are often left temporarily unused when they arise as distinct from the normal activity of a company, or in other cases when there is considerable uncertainty about future technology or market. Market uncertainty can sometimes be a source of temporary disuse even in actual development projects.

2 The approach of sequential real options has a wide range of applications in other economic or other social contexts. As an example, one can think of dating, leading to an option to propose marriage later which again leads to further options.


There is, however, anecdotal evidence. Areeda and Kaplow (1988) discuss the nonuse of patents:

‘‘One significant way of exercising a patent is to suppress it—that is, neither to use nor to license it.’’ They refer to the information in Machlup, An Economic Review of the Patent System 12 (Study No. 15 of the Subcommittee on Patents, Trademarks, and Copyrights of the Senate Committee, 1958) who reports that ‘‘It has been estimated that between 80 and 90% of all patents may be in this category.’’ Furthermore, the Economic Council of Canada (1971) reports that ‘‘only 15 per cent of the patents granted in the three years covered by the survey have been worked in this country, while 48 per cent have been worked in other countries.’’ The report also refers to a US study (by F.M. Scherer) which had found that on average only 54 per cent of patent-holders (covered in a 1956 survey) did in fact put their patent to commercial use. Moreover, the HBS case study (HBS, 1986) points to the practice of the XEROX Corporation of leaving some of its patents unused. Cf. also Footnote 1.

T. Takalo, V. Kanniainen / Int. J. Ind. Organ. 18 (2000) 1105 –1127 1107 to develop differentiated products. Our approach, however, emphasizes the intrinsic nature of an inactive patent as an option. Some patents will remain in force for some time only and are then left unrenewed. The option to commercialize may not turn out to be economically viable or technological progress elsewhere in the industry may have reduced the value of such an option. For example, Lanjouw (1998) finds that over half of computer patents, whether commercialized or not, are worthless within ten years of their application date. Our model provides a formalization of an incentive to hold inactive patents for some time though with the ultimate aim of commercialization of the new product 4.

The fascinating study by Long (1991) shows that the historical evolution of the patent institution goes back at least to 13th century Europe. The practice of granting a privilege to an innovator was well-established in the 15th century Venice culminating in ‘the first law of patents’ of 1474. The study of patents by economists came much later, though one should not overlook the fact that Adam Smith’s The Wealth of Nations (Smith, 1976) includes remarks on patents. The normative justification for patents in the economic literature, introduced by Machlup (1968) and Nordhaus (1969), emphasized the future welfare gains from new innovations in wiping out the short-run welfare losses resulting from the allocative efficiency loss from monopoly power. Subsequent economic theory has provided further insight into the complex mechanisms associated with the patent institution. Having explored the issue of optimal patent length in his seminal work in 1969, Nordhaus (1972) was also the first to provide an analytical framework to study the impact of patent width. Even though a few examples employing imperfect patent protection existed, e.g. Kamien and Schwarz (1972), his important observation that patent width is significant in preserving incentives to innovate remained forgotten for almost 20 years.

It is possible that it was the 200th anniversary of US patent law, designed to achieve the constitutional objective of promoting the inventive process, that inspired several simultaneous attempts to extend the theory of patents at the beginning of this decade. To mention some of the contributions, Waterson (1990) presents a description of how the coverage of a product patent actually affects market behavior. Klemperer (1990) clarifies the definition of patent breadth in a model of horizontal product differentiation. By assuming that the profits of the innovator are a concave function of the patent width, Gilbert and Shapiro (1990) show that the optimal patent policy prefers narrow but infinitely long patents.

Matutes et al. (1996) elaborate the issue of the optimal length and scope of patent 4 An opposite motive cannot be ruled out either. There are products which might have the chance of becoming a standard. This is the case if a sufficiently large market share is captured. In such a case, the innovator might prefer to be imitated by other firms and therefore it might find it attractive to refrain from applying for a patent. Our model focuses on products which are not expected to become product standards.

T. Takalo, V. Kanniainen / Int. J. Ind. Organ. 18 (2000) 1105 –1127 1108 protection further. They verify the informal argument by Scotchmer (1991) that patent scope is a key consideration in incentives to innovate. Indeed, the main conclusion in their paper is that width of patent protection should be used to induce early introduction of new innovations.

The importance of patent width follows from the fact that acceptance of the patent requires the revelation of information. In Matutes et al. (1996), imitation is possible through either the information included in the patent file or reverseengineering the products introduced into the market. It is intrinsic to the patent institution that the competitors will have access to information about the innovation. Only exceptionally can patent width be ‘absolute’. Instead, imitation remains an option for the competitors in the form of more costly ‘inventing around’. Below, we emphasize that the incentives of the innovator are determined by patent width and effective patent length, instead of the statutory patent duration.

Indeed, as the empirical evidence reported by Levin et al. (1987) suggests, the choice between obtaining a patent and maintaining secrecy may be influenced by the extent to which the disclosures made in the patent document facilitate the imitation. Patents do increase imitation costs, as the query by Mansfield et al.

(1981) in addition to Levin et al. (1987) indicates, but they cannot prevent imitation. Gallini (1992) provides an extensive welfare analysis of the patent system in which patent breath increases imitation costs. The fact that patenting involves sunk costs in terms of various agent fees 5 led Pakes (1986) to treat patenting in a novel way as an optimal renewal problem: an inventor faces the problem of whether to pay the annual renewal fee or not 6.

Besides there being fixed patenting costs, the timing of the patent application is a matter of optimization. There may be a potential trade-off between submitting and hence revealing information early and making imitation more costly, and submitting later thereby increasing the possibility of rival introduction but without 5 Patenting is costly, especially within an international context, including, for instance, filing fees, agent fees and translation fees, for discussion see Eaton and Kortum (1994). In the UK, a patent lasts for a maximum of 20 years, during which time annual registration fees must be paid to keep it in force.

In 1998, the fee for obtaining a patent stood at a modest £205. The annual renewal fees are based on a sliding scale beginning at £55 in the fifth year of the patent and increasing to £450 for the 20th and final year. The USA, where patents also last for 20 years since 1995 (earlier 17 years), has a complicated fee structure based on a $790 basic filing fee and a $1320 issue fee. It recently also adopted an increasing annual fee to maintain the patent: after 3.5 years $1050, after 7.5 years $2100 and after 11.5 years $3160. If only for simplicity, we lump all patent costs into one variable, P, through discounting the future costs to the date when the patent is approved.

6 By paying the fee, the patent holder receives the returns from the patented innovation for the next year and the option to maintain the patent over the coming years. As a result, Pakes (1986) was able to estimate the option values of the patent by employing patent renewal data from three European countries.

T. Takalo, V. Kanniainen / Int. J. Ind. Organ. 18 (2000) 1105 –1127 1109 any helpful knowledge spillovers 7. A patent gives the innovator time to process information on the trends in market conditions and exogenous uncertainties associated with the demand so as to make ultimately the right decision on the introduction of the new product. Depending on the subsequent expected economic value of the patented idea, the innovator may keep the option of bringing the product onto the market alive for some time. Specifically, knowing that patent protection reduces the losses from the rival’s entry, the innovator might choose to wait longer. Were this the case, patents would actually slow down technological progress. The current paper formalizes this intuition 8.

We have chosen to model innovation valuation in terms of a continuous-time stochastic process given that innovations are inherently subject to technological uncertainty and given that the expectations of future demand are subject to continuous revisions in light of market changes. Such methods have been widely used in the theory of investment under uncertainty since McDonald and Siegel (1986). The problem of sequential investment decisions under uncertainty has been earlier studied by Dixit and Pindyck (1994). The current paper builds on their methodology with the qualification that commitment of a sunk cost of initiating a research program and the subsequent patenting decision changes the nature of the stochastic process faced by the innovator. This leads to separation over time of optimal timing of commitment to various sunk costs.

Our paper is structured as follows. After presenting the model in Section 2 we begin from the last problem, that is, in Section 3 and Section 4, we deal with the optimal introduction of the new innovation onto the market. Section 5 and Section 6 are devoted to analyzing patent application and launching the research project, respectively. Section 7 concludes the paper with some remarks on testable hypotheses.

2. A model of sequential innovation Consider a person who has an


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