Economics and Intellectual
Property
Economic Theory of Property
Physical property rights grant
exclusive use of a
resource to its owner, together with the legal
authority and backing for excluding others from
using the resource
Property rights are granted to individuals by
society
Granting these rights provides social benefits but
also imposes social costs
Economic Theory of Property
 Benefits
 Property
rights reduce transactions costs in determining how a
resource will be used
 Example:
Enclosure of common grazing pasture
> Prior to enclosure, commons were over-grazed, leading to reduced
productivity in raising of cattle
> Transactions costs incurred to reduce over-grazing would require
villagers to coordinate grazing activities, even though individual
incentives would encourage the opposite
> Assignment of ownership to the commons permits the necessary
coordination, whether for grazing or other more productive uses of the
land
Economic Theory of Property
 Property
rights also confer a dynamic benefit by providing
incentives for the owner of a long-lived productive resource to
undertake costly investments without facing the risk that
others might appropriate the benefits of the investment
 In
our example of the commons, enclosure of the land and assignment
of ownership rights might lead the owner to decide that the land was
better used in crop production rather than grazing.
 The decision to plant, however, will be contingent on the owner’s
confidence in the fact that he alone will be permitted to harvest the
crop
Economic Theory of Property
 Costs
 Transactions
 These
cost in transfer of ownership
can be small, as, for example, when you sell a car or house,
but they can also be large
 Example: A factory is given the right to dump waste products into a
river at some point in time, by a grant of ownership
 At a later point in time, the river becomes more valuable to society for
recreational activities
 Even though it would benefit society to transfer ownership of the river
from the factory to boaters, no single individual will have enough
incentive to pay the cost buying the river back from the factory
 In this case, it would be better not to assign a property right to the river
 Rather, use a liability law to control how much waste can be dumped
Economic Theory of Property
 Rent-seeking
behavior
 Because
a property right is essentially a grant of monopoly control
over a resource, there will be incentives for individuals to pursue
ownership rights in ways that may be socially wasteful since the
monopoly rights obtained allow the individual to earn monopoly rents
 Example: Suppose a sunken ship has been abandoned, but would be
worth $1M if salvaged.
> Suppose salvage cost is $100K
> Absent property rights to the ship, there are incentives for many
different salvage companies to attempt to salvage it, even though only
one will eventually succeed.
Economic Theory of Property
 Example,
continued: Suppose instead that the ship’s
original owners retained their property right in the sunken
ship
> They could then salvage the ship by auctioning off the right to
salvage to the lowest bidder among the salvage companies,
while retaining the right to the remaining value of the raised ship
> If the market for salvage services is competitive, this will result in
an efficient transaction
 Property
law includes a doctrine (the so-called committed
searcher doctrine) which effectively assigns property rights
to the first person to identify and actively assert control
over abandoned property
Economic Theory of Property
 A third
cost associated with the granting of property rights is
the cost of protecting the right
Cost of police protection
 Courts
 Private efforts to exclude unallowed access
 In some instances, these costs may exceed the benefit of excluding nonpaying use.

> Example: The owner of a mall which provides free parking has implicitly decided
that the benefit of being able to charge for parking is less than the cost this would
impose of potential lost sales by shopkeepers in the mall
Application to Intellectual
Property
The same
cost-benefit analysis we applied to
physical property can be applied to the realm of
ideas
We call ideas which are granted protection
intellectual property
Consider the benefits and costs we identified for
physical property as they would apply to ideas
Application to Intellectual
Property
 Benefits
 The
analog of the physical commons in the realm of ideas is the intellectual
public domain (or simply the public domain when it is understood that we
are talking about ideas)
 Ideas in the public domain can be freely used by anyone
 Unlike the physical commons, there is no possibility of overuse of the
intellectual public domain, since ideas are both intangible, and non-rival

Ideas in the public domain are public goods, since one person’s use of an
idea doesn’t preclude others from using the same idea, and, absent
intellectual property protections provided by the government, it is impossible
to exclude people from using the idea
Application to Intellectual
Property
 The
dynamic benefit of allowing proprietization of ideas via
intellectual property rights is important however
 Consider
a new production innovation that results from a firm’s R&D
expenditures
 If the idea behind the innovation leaks out, rival firms can adopt the
innovation and produce at the same marginal cost as the original firm,
but without having incurred the costs of R&D that led to the innovation
 Since this puts the original innovator at a competitive disadvantage, it
follows that if the firm cannot either keep the innovative idea secret, or
obtain intellectual property protection for the idea that allows it to
recover its investment costs, it won’t undertake the R&D.
 Schumpeterian competition
 Boldrin and Levine’s critique: the fixed cost of innovation is a
sunk cost and so shouldn’t hinder competition as long as the
innovator can earn sufficient rents to cover the cost
Application to Intellectual
Property
Costs
 Transfer
costs exist with intellectual property as with
physical property
> The transactions costs associated with transfer of intellectual
property (or the determination of illegal use of intellectual
property) can be substantial because of the problem of
identifying which particular idea is actually protected
> In patent law, for example, the novelty requirement can be
difficult to ascertain, generating substantial costs to the PTO and
to the CAFC in litigating claims against patent validity
Application to Intellectual
Property
 As
with physical property, there are rent-seeking costs associated with
the granting of intellectual property rights
> One particularly important form of rent-seeking behavior associated with
the monopoly use rights conferred by patents is the so-called “patent
race,” which we will examine in detail shortly
 The
costs of protecting intellectual property can be quite large and
hence are a key consideration in forming intellectual property policy
> Consider a production innovation which the innovating firm is able to
keep secret and hence exploit for its own benefit
> From a social perspective, it would be more beneficial if the innovation
were adopted by the whole industry, rather than just by a single
innovative firm
> This cost is the basis for the requirement of disclosure in patent law
Application to Intellectual
Property
 The
importance of the costs of protecting intellectual
property are also magnified significantly if the underlying
fixed cost of innovation is large, while the marginal cost of
using the innovative idea is small or zero
> Again, absent the ability to exclude non-payers from using an
innovative idea, firms won’t incur the fixed cost of innovating
unless they can simultaneously protect the innovation
> When fixed costs are large, firms may end up investing
substantial resources in protecting trade secrets or otherwise
discouraging imitators
Application to Intellectual
Property
The
cost-benefit tradeoff
 The
costs associated with granting intellectual property
rights dictate that if the laws governing the granting of
these rights are meant to promote economic efficiency, the
should contain provisions which minimize the associated
costs
 These provisions will typically not have counterparts in the
laws governing physical property rights
Application to Intellectual
Property
 Examples:
> The non-obviousness requirement for obtaining a patent ensures that
no one will be able to enjoy monopoly status and earn monopoly rents
by obtaining a property right for an innovation which is easily discovered
and applied
» From a social perspective, obvious innovations are not costly to
make and so need not be incentivized
» No counterpart to this requirement in physical property law
> The fact that patents are valid for only a limited duration serves to limit
rent-seeking behavior by putting a ceiling on the expected present
value of the patent
» Limited duration also helps control the growth in transactions
costs for licensing the use of an innovation if it is widely adopted
Application to Intellectual
Property
For
intellectual property, the high social costs of
granting these property rights raise important
questions about whether these rights are costjustified at all
 Add-on
nature of intellectual property rights
 Innovators enjoy fundamental physical property rights that
protect both the act of creation and its products
> A writer’s laptop is protected from theft and laws against fraud
> Trade secrets and no-compete clauses in employment contracts
allow firms to protect innovations without granting explicit
property rights
Application to Intellectual
Property
 With
these protections alone, we would expect to see
much if not all of the innovative activities currently
observed since
> some activity is undertaken without the expectation of financial
gain (internal reports, personal correspondence, unpublished
works of art or scholarship)
> other activities are financed other than through sale on
commercial markets (in-house innovations in manufacture of a
firm’s product, innovations in management activities)
> still other activities are low enough in cost that costs can be
recouped before competitors innovate (so-called incremental
innovation)
Application to Intellectual
Property
 On
the other side, when society creates expansive intellectual
property rights, it creates monopolies which will price the results of
innovation above their marginal cost, thus generating an allocative
inefficiency
> This inefficiency can be particularly extreme if most of the cost of the
innovation is fixed, while the marginal cost of using the innovation is
very low, since the monopoly owner of the protected innovation will
price the use of the innovation in order to recoup the fixed costs of R&D
in as short a time as possible
> As we will see in the next module, monopolies also have a lower
incentive to innovate further, so that the grant of the property right can
reduce the pace of innovation
 Hence,
the trade-off of social benefit and cost for intellectual property
is considerable
 Society needs to be careful not to make intellectual property rights
overly expansive
Application to Intellectual
Property
Models
We
turn next to developing some models that explore
the efficiency issues and cost-benefit trade-off
associated with intellectual property protection
 Patent
Races
 Welfare Properties of Patent Protection
 Optimal Patent and Copyright Protection