38E00100 Economics and Management of Intellectual Property Lecture 8

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38E00100Economics and Management of Intellectual
PropertyLecture 8 Competition Policy and
Intellectual PropertyTuomas Takalo,
7.2.www.takalo.netScotchmer, Chapter 6
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Outline of Core Lectures
Part I. Basic IP Law Part II. Use of IPRs Part
III. Basic Economics of IP Part IV. Breadth and
Duration of IP and Their Optimal Design Part V.
Cumulative Innovation and IP Part VI.
Competition Policy and IP Cases, Basic IP
Corporate Strategy, Industry studies, 2 Guest
Lectures
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• Recapping the last lecture
• The basic tradeoff of IP in cumulative
  innovation ensuring that the first innovation is
  made may put the later ones in jeopardy and vice
  versa.
• If ex ante licensing is infeasible, the second
  innovators fears hold-up and has lower incentive
  to invest
• If it is feasible, the second innovation will be
  made but the first innovator now fears hold-up
  and has lower incentive to invest

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• Ex ante license would nonetheless typically be
  beneficial for society
• Yet, various problems make it typically
  infeasible in practice
• Asymmetric information about the licensees costs
• Fragmentation
• Ex ante is not always beneficial for licensors
• Hiding and waiting until the later inventors are
  successful in commercialization gives hold-up
  power
• ? The rise of patent trolls

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• 4) Fragmentation problem, anticommons
• - suppose three essential patent/IP holders
• - it costs c to make the application, profits
  P.
• The ex ante cake P-c.
• - The inventor of the application negotiates with
  each holder separately
• - Assume equal bargaining power.
• The inventor of the application should pay
  (P-c)/2 to each IP holder ? impossible!
• ? The IP holders should form a (patent) pool,
  collude or merge ? antirust problems

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Problem of fragmentation
Basic innovation 1
Application
Basic innovation 2
Basic innovation 3
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Part VI. Competition Policy and IP

• The need for competition policy
• People of the same trade seldom meet together,
  even for merriment and diversion, but the
  conversation ends in a conspiracy against the
  public, or in some contrivance to raise prices.
  It is impossible indeed to prevent such meetings,
  by any law which either could be executed, or
  would be consistent with liberty and justice. But
  though the law cannot hinder people of the same
  trade from sometimes assembling together, it
  ought to do nothing to facilitate such
  assemblies much less to render them necessary
• - Adam Smith. Wealth of Nations 1.10.82. -

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• Competition laws guard consumer surplus by
  promoting competition
• competition not competitors, as inefficient firms
  will be wiped out by competition
• IP creates the incentive to innovate by enforcing
  temporary market power over innovations
• ? IP needs to reduce at least temporarily
  competition ? DWL
• There seems to be almost by definition a tension
  between antitrust/competition and IP laws
• IPRs convey market power, antitrust constrains it

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• Notes
• - market/monopoly power is used in my
  lectures as an economic concept A firm has
  market power if it can price above its MC.
• - legal concept is different
• market power itself is not necessarily a
  violation of competition laws but its abuse
  certainly is

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• The tension is caused by the fundamental
  trade-off between ex ante and ex post
  considerations
• ex ante need to stimulate innovation (IP laws)
• ex post information is public good, no reason to
  restrict its use, because it does not wear out
  (competition laws)
• The tension is not new but the balance has
  shifted E.g. in the US supremacy of antitrust
  laws around 1930-1980, supremacy of IPR laws
  around 1890-1920 1980-present
• The tension has shown up over the past 25 years
  when IP and its management have become the core
  competitive assets of firms
• leveraging IPRs is key to success but can violate
  competition laws

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• The innovation has become the core competitive
  asset of nations, too
• Alain Greenspan 27.2.2004 conceptualization (of
  GDP) is irreversibly increasing the emphasis on
  the protection of IPRs
• competition laws have become more tolerant
• Yet, the tension is here, cf. Microsoft in US and
  Europe, MasterCard-Visa

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• Political economy of IP and competition policy
• Competition (consumer) laws and authorities are
  needed to protect consumers because consumers are
  a dispersed group
• consumers face a public good production problem
  in protection of their interest
• difficult to coordinate joint action to protect
  the interests of consumers as a whole

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Consumers problem
Consumer 2
Act
Do not act


Act
Consumer 1
Do not act
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• Lobbying often based on the static/ex post
  situation
• In the static context strong IPRs are good for
  producers/innovators and bad for consumers
• - Countries that produce/innovate lobby for
  strong IPRs and countries that consume/imitate
  lobby for weaker IPRs
• IPRs tend to be strong because
• a) producer side is typically more concentrated
  than consumer side ? easier to organize lobby
• b) countries that produce/are technologically
  advanced have more political power

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• But...
• Governments incentive to cheat ex post tends to
  make IPRs weaker
• In more dynamic context strong IPRs are not
  necessarily bad for consumers

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• Is there a problem and what might it be?
• 1) Are competition laws outdated?
• If innovation is key to prosperity and innovative
  industries ubiquitous
• ? Competition laws should be restricted to
  traditional industries such as asphalt,
  paperpulp or auction houses
• Competition laws too static as they do not
  recognize the Schumpeterian competition in
  innovative industries
• creative destruction where todays monopolies
  are bankrupt tomorrow unless they do not innovate
• the competition for the market vs. competition
  within the market

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• Monopolies can stimulate innovation (Schumpeter)
  The case of nondrastic innovation
• Consider a monopoly and a potential entrant. The
  entrant can enter if it innovates first, the
  monopoly can deter the entry by innovating first
• The monopoly earns ?m
• If the entrant enters, both firms earn duopoly
  profits ?d
• The monopolys incentive to innovate ?m- ?d
• The entrants incentive to innovate ?d
• ?m - ?d ? ?d ? ?m ? 2?d
• The monopolys incentive to stay a monopoly
  larger than the entrants incentive to become a
  duopolist!

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• The actual competition laws
• - In the US competition policy governed by the
  Sherman Act of 1890 and the Clayton Act of 1914.
  Concerned with horizontal competition.
• - In the EU competition policy governed by the
  Articles 81 and 82 of the EC Treaty (as well as
  the Articles 87-89 concerning the state aid) from
  1957 (the Rome Treaty) and 1992 (the Maastricht
  Treaty)
• Article 81(1) Prohibition of agreements/decisions
  /practices that restrict competition
• Provision contrary to 81(1) automatically void ?
  cannot be enforced

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• Article 82 Abuse of dominant position
• Any abuse ...of a dominant position within the
  common market....shall be prohibited...insofar as
  it may affect trade between Member States
• e.g.
• imposing unfair purchase/selling prices
• limiting production to the prejudice of consumers

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• Looks bad but
• In the US
• implementation based on case law where the
  enforcers are ultimately the courts
• ? this offers flexibility
• the Department of Justice and the Federal Trade
  Commission can act in behalf of consumers and
  bring the cases to the courts
• These agencies notify firms on the actions that
  may cause competition policy concerns
• In 1995 they issued Antitrust Guidelines for
  Licensing Intellectual Property

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• In the EU
• Article 81(3) give a block exemption to
  agreements that promote technological progress
• e.g. RD cooperation, technology transfers (TTBE)
• The European Commission issues regulations and
  guidelines on how to apply the Treaty
• Regulation (EC No.772/2004) on the Application of
  Article 81(3) to Technology Transfer Agreements
  associated Guidelines

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• Existence of IP not such indication of
  dominance/abuse of it
• Article 82 typically is not a concern for small
  firms if they leverage on IPs
• But IP one of the factors enabling the abuse of
  dominant position. E.g.
• preventing competitors from entering the market
• preventing the use of necessary production
  factors

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• Both the US and EU Guidelines Regulation take
  the view that IP is not intrinsically
  anticompetitive
• e.g., the EC IPRs promote dynamic
  competitionthere is no inherent conflict
  between IPRs and Community competition rules
• Both, nonetheless, impose a number of market
  share and other restrictions
• e.g., the EC IPRs are not immune from
  competition law intervention

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• Summing up suggestion 1) Are competition laws
  outdated...
• Competition laws seem to be up-to date
• Modern (official) view
• There is no inherent tension between the IP and
  competition laws (cf. the EC opinion above).
• Both promote welfare of consumers IP law
  fosters competition for markets and competition
  law competition within markets
• The problem is to seek a proper balance between
  the two bodies of law
• However, how can there be a problem of seeking a
  balance if there is no tension in the first place

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• 2) Does the tension arise because firms leverage
  IPRs more aggressively and more sophisticated
  manner?
• Innovation a costly way to deter entry.
• IPRs facilitate tying, bundling, predatory and
  exclusive behavior that aim at preserving market
  power, and do not necessarily stimulate
  innovation
• are IP and innovation substitute competitive
  strategies?

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• Monopolies can be bad for innovation (Arrow) the
  case of drastic innovation
• Consider a monopoly and a competitive industry.
• The monopoly earns ?m in pre innovation market
  and ?m ?? in post innovation market
• ? the incentive to innovate ?m ?? - ?m ??
• Competitive firms earn 0 before innovation but
  the innovator earns ?m ?? after the innovation
• The incentive to innovate ?m ?? gt ??
• ? In the competitive industry the incentive to
  become a monopoly larger than the monopolys
  incentive to replace himself, the best of all
  monopoly profits is a quiet life

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Incentives to innovate
Degree of Competition Inverse strength of IP
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• 3) Competitive industry can generate too much
  innovation from welfare point of view
• Consider n firms trying to innovate in a winner
  takes all patent race
• The cost of innovation I, welfare from innovation
  Wm.
• It may be the case that IltWm?nI and certainly,
  Wm-I? Wm-nI
• Too much innovation can be bad as the costs of
  innovation should be taken into account!
• - Not a politically correct observation

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• Network effects vs. predatory behavior
• Predatory pricing
• In an initial stage a firm charges unprofitable
  price to foreclose rivals from the market and
  then can charge a high prices that compensates
  the losses of the first stage
• More generally, predatory behavior
• A firm incurs short-run losses so as to eliminate
  competition and gain larger profits in the
  long-run

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• Network effects a consumers utility from a
  product depends on the number of other users of
  the product.
• Direct network effects the utility depends
  directly on the number of other users.
• E.g., e-mail a camera phone.
• Indirect network effects the utility depends on
  a feature of a product. The quality of the
  feature depends on the number of other users.
• E.g., The utility from an OS depends the number
  of software applications written on the OS. The
  number of applications depends on the number of
  users.

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• Network effects create a chicken-and-egg problem
• Nobody is willing to buy a product unless it is
  popular
• The product cannot be popular unless many are
  willing to buy
• ? With network effects, a business strategy that
  prices products below marginal costs can be vital
  for the success of the products even without any
  need to deter entry
• Very difficult to isolate anticompetitive
  conducts from competitive business strategies in
  network industries
• Applies more generally hard to distinguish
  predatory pricing from competitive pricing (e.g.
  Finnair vs. Flying Finn/Blue 1)

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• An Illustration the Microsoft vs. US
• U.S. Government (Department of Justice) asserted
  that Microsoft engaged in anticompetitive conduct
  to maintain its operating system monopoly to the
  detriment of consumers
• Microsoft asserted that the company has benefited
  and benefits consumers by supplying high quality,
  innovative products
• According to the government, antitrust action
  against Microsoft would stimulate competition and
  innovation in the software industry
• According to Microsoft, the action would reduce
  competition and innovation in the software
  industry

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• Microsoft hired Richard Schmalensee, (an MIT
  econ. prof. of IO), as their chief adviser for
  trials
• Schmalensee the competition in the software
  market was not between operating systems but
  between platforms on which the software
  programmers could write on
• ? Windows was facing significant actual and
  potential competition from other operating
  systems such as Linux, OS/2, Mac OS, Sun Solaris
  but also Java, Lotus notes and other middleware
• Moreover, significant potential competition from
  future platforms (E.g. Nokia)
• ? vigorous competition for the markets

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• Governments chief economists was Daniel
  Rubinfeld (a UC Berkeley econ. prof of law and
  economics and public economics) and they hired
  Franklin Fisher (an MIT econ. prof of IO) as
  their chief adviser
• Rubinfeld Fisher Microsofts prices were in
  the long-run monopoly level even taking into
  account of potential competition
• Because of network effects, Microsoft had
  substantial market power
• Mircrosoft used market power so as to increase
  entry barriers and exclude Netscape Java, not
  stimulate competition
• Microsoft engaged in predatory behavior offered
  Explorer free and even paid Apple to use it

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• On surface a valid business model in the network
  industry giving Explorer free makes Windows more
  attractive
• However, the argument should apply equally for
  distributing Netscape
• judged to be anticompetitive

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• Licensing of IP and competition policy
• One can sell IP, like any other property, via
  negotiation, auction, and posted price/fixed fee.
  
• All IPs can and do get licensed, even trade
  secrets (e.g., Coca-cola)
• In theory, auction is usually the best way to
  sell an object. In practice, however, other ways
  are more popular. The same applies to IP.
• A popular method output royalty with or without
  a fixed
• Licensee pays according to what he sells, e.g.,
  of final price per unit sold or x euros per unit
  sold

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• A license can include a variety clauses.
• It can be exclusive only to one or restricted
  number of licensees
• non-exclusive the licensor reserves the right to
  license the technology to any number of firms he
  wants
• exclusive license via auction in theory the best
  method
• Some licensing clauses/restrictions can cause
  antitrust problems (despite TTBE in the EU)
• E.g., exclusive dealing requires that the
  licensee only
• resorts the licensor as sole supplier

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• TTBE includes a black list of prohibited
  agreement clauses. e.g.,
• Price fixing, limitation production/sales,
  division of markets/customer, limiting licensees
  ability to use own technology and engage in RD
• Probably the most tedious competition policy
  problems deal with standardization and IP
  policies of standard-setting organizations

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• Summary
• The tension between IPR and competition laws make
  antitrust issues in innovative industries
  complicated
• If IPR laws work, firms have market power, if
  competition laws work, firms cant use the market
  power
• Political economy aspects tend to support strong
  IPRs, the Governments incentive to cheat ex post
  weak IPRs
• Licensing of IP a major source of competition
  policy problems
• ? The 1995 US Guidelines and the 2004 EU
  regulation try to incorporate IP issues in
  competition policy

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• Nonetheless, the tension will remain
• on the one hand, the competition in the network
  industries so complicated that it will be very
  difficult to make precise antitrust assessments
• on the other hand, the potential welfare effects
  so large that one cannot ignore the tension
• ? cautious approach wise

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• but if an action is taken it should be effective
• Remedies should stop a firm engaged in
  anticompetitive conduct from continuing to do so
  and should deter others from doing so
• Microsoft has been found guilty in
  anticompetitive conduct many times over the past
  10 years but
• Will MSN be integrated in Microsoft Vista?
• 29.3. 2006 the Commission warns Microsoft a about
  antitrust concerns if Vista is prepacked with a
  search engine