38E00100Economics and Management of Intellectual Property

Lecture 8

“Competition Policy and Intellectual Property”Tuomas Takalo, 7.2.www.takalo.net

Scotchmer, Chapter 6

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

Outline of Core Lectures

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

• Ex ante license would nonetheless typically be beneficial for society

• Yet, various problems make it typically infeasible in practice

• Asymmetric information about the licensee’s 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”

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

Basic innovation 2

Application

Basic innovation 1

Basic innovation 3

Problem of fragmentation

• 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. -

Part VI. Competition Policy and IP

• 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

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

• 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

• 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

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

cpu

pu

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cpu

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Act Do not act

Act

Do not act

Consumer 2

Consumer 1

Consumers’ problem

• 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

But...

• Government’s incentive to cheat ex post tends to make IPRs weaker

• In more dynamic context strong IPRs are not necessarily bad for consumers

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, paper&pulp or auction houses…

• Competition laws too static as they do not recognize the Schumpeterian competition in innovative industries

- “creative destruction” where today’s monopolies are bankrupt tomorrow unless they do not innovate

the competition for the market vs. competition within the market

• 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 monopoly’s incentive to innovate: m- d

• The entrant’s incentive to innovate: d

m - d d m 2d

The monopoly’s incentive to stay a monopoly larger than the entrant’s incentive to become a duopolist!

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

• 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

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

In the EU:

- Article 81(3) give a block exemption to agreements that promote technological progress

- e.g. R&D 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

- 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

- Both the US and EU Guidelines & Regulation take the view that IP is not intrinsically anticompetitive

e.g., the EC: “IPRs promote dynamic competition…”…”there 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”

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

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?

• 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 + >

In the competitive industry the incentive to become a monopoly larger than the monopoly’s incentive to replace himself, “the best of all monopoly profits is a quiet life”

Incentives to innovate

Degree of CompetitionInverse strength of IP

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 I<WmnI 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

4) 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

• Network effects: a consumer’s 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.

• 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)

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

• 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

• Government’s 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: Microsoft’s 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

• 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

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

• 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

• TTBE includes a black list of prohibited agreement clauses. e.g.,

• Price fixing, limitation production/sales, division of markets/customer, limiting licensee’s ability to use own technology and engage in R&D

• Probably the most tedious competition policy problems deal with standardization and IP policies of standard-setting organizations

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 can’t use the market power

• Political economy aspects tend to support strong IPRs, the Government’s 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

• 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

• 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