Intellectual property is an important issue for anyone thinking about technological progress. Some say it is essential to motivate invention, others say it slows it down, but it is doubtlessly the oldest and largest form of state support for innovative technology. The broad takeaways from traditional theory and research on this topic are neutral at best on whether patents actually increase innovation. Additionally, the theory of rent dissipation from public choice shifts the confidence interval on patent's effects much further to the left of zero. 

The basic theory of patents makes a lot of sense. The idea rests on the positive externalities stemming from the production of technology. These are difficult to quantify, but their existence is uncontroversial. Scientific ideas have impacts long after the death of their creator. Technologies are spread around the world and inspire many subsequent inventions. William Nordhaus estimated that less than 2% of the gains in human welfare from technological advances are actually captured by the inventor. These positive externalities imply underproduction of the most important input into civilizational progress, making innovations a prime target for subsidy. 

Intellectual property is a roundabout way of subsidizing the production of these positive externalities. Rather than directly subsidizing inventors, patents reward them with the monopoly profits they can garner from the exclusive right to use their idea. Adam Smith pointed out some advantages of this system over direct subsidy. Mainly that monopoly profits are automatically proportioned such that the most in-demand inventions get the most reward, avoiding some economic calculation problems with central planning. However, it also has some drawbacks. First and foremost that the quantity of the very inventions you want to promote is restricted. Statically, this is negative for welfare. Consumer surplus triangles are shrunk and deadweight loss is created by monopoly pricing. But over time, if the monopoly rights promote extra inventions, the sum of their smaller surpluses can exceed the competitive outcome. 

In addition to trading off static welfare losses for dynamic innovation gains, patents also siphon monopoly profits to inventors from future inventors. Most inventions are not unprecedented leaps in capability. Rather, they are tinkerings, combinations, and improvements on what is already known. But if what is already known is a protected monopoly, then improving on it or combining it with other knowledge is much more expensive, so we can expect less innovation from these sources. A characteristic example is the feud between George Selden and Henry Ford. George Selden built a single prototype of a internal combustion engine car and got a patent for it in 1895.

Instead of trying to produce this car, he simply sat back and collected rents from all of the other car manufacturers. He embroiled Henry Ford in an 8 year court battle which, after hundreds of thousands of 1900s dollars spent in legal fees and wasted time, Ford narrowly won. Even if patents incentivized George Selden to make his prototype, they slowed down Ford's mass production which was much more important for consumer welfare.

Although there may be some margins where these tradeoffs are beneficial, the curve with benefit on the y-axis and patent strength on the x-axis is undeniably 'n-shaped.'

Basic economic theory suggests that at least some level of IP subsidy could increase overall welfare, but empirical evidence consistently fails to confirm that IP increases innovation at all, let alone whether it increases enough to offset the deadweight loss of monopoly pricing. Branstetter (1999),  Lerner (2009) and Williams (2017) conclude that there is not enough evidence to claim that stronger patent laws even increase the number of patents filed for,  making it doubtful that patent laws have significant effects on the actual innovation that patent filings are only tenuously connected to. There is also evidence for the negative impacts of patents on follow on innovation through patent thickets and trolling.

One might still be reasonably convinced that patents are positive for innovation, at least on some margin. The basic logic of subsidizing a positive externality with monopoly profits is still strong, even if when attenuated by consumer welfare and follow on innovation tradeoffs. In my view, however, the following critique of monopoly profit welfare calculations from public choice is the death knell for patents. 

The logic of patents as subsidies for invention is based on this graph: 

Inventors get the pink square of monopoly profit, consumers get the white triangle above it, and the green triangle is lost to the world. But, as Gordon Tullock pointed out in the same graph in relation to protective tariffs, this static picture is incomplete because it does not consider the resources that were put into acquiring the right to these monopoly profits. 

Patents are not given or enforced for free. It takes tens of thousands of dollars and months of form filing to apply for a patent. Then, to enforce your patent, you'll have to go to court. Collectively, IP litigation costs are in the hundreds of billions of dollars. This paper estimates the costs of patent disputes from Non-Practicing Entities, i.e patent trolls or companies who hold patents for technologies that they don't actually produce. They find the direct legal fee and settlement cost at $29 billion dollars, with a wider measure of indirect costs including opportunity cost and wasted time at $80 billion. IBM keeps 370 patent lawyers on retainer, and companies routinely spend years battling out IP in court. All of this is paid for out of the pink square of monopoly profits that patents protect, leaving little left over to actually promote invention. The billions of dollars which go into lobbying groups like the Intellectual Property Owners Association and the American Intellectual Property Law Association dissipate the subsidy too. So do all of the favors and salaries fueling the revolving door between patent office employees and businesses. Since the monopoly rights from patents are rivalrous and zero sum, the sum of resources invested into this bidding for patents could easily exceed the total value of the monopoly profits in the first place, making the overall social effect negative.

Intellectual property has intuitive economic theory and a long history of implementation supporting it. But empirical research and a deeper dive into the theory reveal little evidence that they are helping innovation at all. This is not to say that the market allocation of investment in innovation is efficient. The positive externalities guarantee that it is not. But this market inefficiency is insufficient to justify a state intervention. The state intervention needs to actually improve the allocation, but patents do not. 

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The exclusivity rights conferred by intellectual property are exceptionally important in areas where the innovator's CAPEX requirements are high, but the cost to copycats is low -- like biopharma, energy, or even mining. The creation of a temporary monopoly engineers sufficient market value to make initial investment of high-risk capital on the order of hundreds of millions (if not billions) of dollars worthwhile and palatable (e.g. see https://dukespace.lib.duke.edu/dspace/bitstream/handle/10161/6707/Record5.pdf; https://digitalcommons.law.scu.edu/cgi/viewcontent.cgi?article=1019&context=facpubs ). 

The rules were never supposed to apply to extremely low CAPEX industries like software, however -- hence why "abstract ideas" were excluded from intellectual property law and are often negotiated and renegotiated in the courts as incumbent monopolies and patent trolls try to use regulatory capture to maintain their status.

I definitely agree that a bigger difference between original investment costs and copying costs makes patents more beneficial, but all of the criticisms I pointed out still apply. The Pharma industry spends billions on patent courts and lobbying. This has to be subtracted from the benefits that they provide, in addition to all the welfare losses from super expensive name-brand drugs.

What do you think about using prizes or direct subsidies for high CAPEX projects instead of IP?

In a more meta sense, I wonder if it is possible to have patents only for high CAPEX industries. It may be that the lobbying forces will inevitably push to expand the reach of patents, and one cannot separate the benefits of high CAPEX patents from the costs of low CAPEX ones.

There are a few issues to parse here --

  1. Patents are a necessary part of motivation to commercialize in high-CAPEX industries
  2. Pharma companies take advantage of regulatory capture and abuse the IP system to eke out longer exclusivity periods than are typically allowed by law (e.g. making negligible changes and repatenting a drug); this has been a net drain on innovation
  3. No cap, benchmark, or standard on biotech pricing has allowed companies to slowly ramp up pricing far beyond what is considered reasonable (e.g. the gradual ramp-up to a Million Dollar Pill)

Prizes and direct subsidies already exist for high-CAPEX projects and are also a crucial part of the system as it exists today. Almost all biopharma research starts out as state-funded work out of universities or NIH, until it reaches a point where it's ready for trials and gets spun out into a business. The trials themselves are then often further subsidized. There's a lot of work and money that has to go into making biotech viable just because of how little we understand about fundamental biology.

  1. Patents are much more useful in high-CAPEX industries, but I wouldn't call them necessary. There have been expensive capital investments without patent protection, even if they are not common.
  2. Agree here.
  3. 'Reasonable" does a lot of work here. Economists usually define reasonable as price = marginal cost and the whole goal here is to raise price high above that level. But the point is well taken that there is more consternation over pharma pricing than is justified.

This is sort of an orthogonal point but I think the reliance of pharma on patents is an example of the "break your leg and give you a crutch" strategy that the government often takes. A huge part of the CAPEX that goes into pharma development is going through FDA approval. So if that process is not going to change, patents are essential for further pharma development. But in some lassiez-faire counterfactuals I think we could get more pharma development even without IP protection. 

I think that prizes could replace the incentives of patents without most of the negative second order effects that I pointed out. Theoretically you could just match the monopoly profit with a subsidy, get the efficient quantity produced, and there are some mechanisms for dispersing the cash which avoid the rent dissipation.