Patents as Property, Part 2

[Tim Lee]

In my last post, I suggested that effective property systems have two important chracteristics: clear boundaries and positive incentives for productive activity. I showed a graph from Bessen and Meurer's Patent Failure suggesting that patents on chemical and pharmaceutical products appear to be behaving as a well-designed property system ought to. Now, the bad news. Here's the same graph for the rest of the patent system:



Again, the dashed line is total profits attributed to patents, while the solid line is the cost of patent litigation to potential infringers. As you can see, the situation is very different in non-chemical industries: in the late 1990s, the costs of litigation from non-chemical patents were several times as large as the profits those patents generated for their owners.

These statistics, if accurate, are quite extraordinary. If real property worked this way, we'd see $4000/month in litigation costs arising out of trespassing allegations for every $1000/month rental property. Needless to say, there wouldn't be much real estate development in such a legal environment.

The obvious response is that we shouldn't be overly concerned with "trespassers" (alleged patent infringers) because they shouldn't have trespassed in the first place. But this is where the point about unclear boundaries come in. What we're seeing here is not that some companies are deliberately infringing on other companies' patents as an alternative to investing in R&D. Rather, the problem is that there are now so many patents on the books, many of them quite broad, that it is effectively impossible to develop almost any kind of technology without infringing numerous patents. Even worse, because the boundaries of patents are so fuzzy, it's generally not even possible to predict which patents will apply to which technologies. Even an innovator who earnestly tried to avoid infringing, by licensing or inventing around all the relevant patents, is likely to run afoul of a patent his lawyers didn't find, or to face litigation over a patent his lawyer thought didn't cover that invention. What this means is that the patent holders and the alleged infringers are largely the same companies. Microsoft, for example, holds close to 9000 patents, yet it faces dozens of patent lawsuits every year from smaller companies.

How seriously should we take Bessen and Meurer's numbers? Their book just came out so I have yet to see serious criticism of their findings. And I don't know this area well enough to have a strong opinion about how seriously we should take their specific methodology. But to my non-statistician's eye, they appear to have done their homework. On the profit side, they survey a lot of different estimates of patent values and tend to accept the highest reasonable estimates, giving the patent system the benefit of the doubt. On the cost side, their results may be more open to challenge. It's important to note that the litigation costs they estimate are not limited to direct expenses like attorney's fees and expert witnesses. Rather, recognizing that litigation imposes significant costs beyond attorney's fees, they attempted to estimate costs by observing changes in stock price in response to the announcement of lawsuits. If the efficient market hypothesis is correct, this should give a reasonable estimate of the total costs of patent lawsuits to defendants. However, the error bars are likely to be large, so the numbers should be taken with a few grains of salt.

Another important caveat is that their methodology is focused on publicly-traded companies. Their methodology doesn't work for non-public firms or individuals because they don't have stock prices that can be used as a basis for calculations. And indeed, it's likely that things are less grim for smaller inventors because they tend not to get sued as often. However, it's important to keep in mind that the bulk of research and development is done by publicly traded companies, and large companies tend to hold the most valuable patents. So even if the patent system works better for smaller companies than larger ones, the net effect of non-chemical patents is still likely to be negative.

A final point to keep in mind here is that the bar Bessen and Meurer are setting for the patent system here is incredibly low. In a well-functioning property system, litigation shouldn't simply be lower than associated profits, it should be a small fraction of profits. We can see this in the rates for title insurance, which costs a fraction of a percent of the value of the house. Likewise, movie studios typically obtain errors and omissions insurance to cover themselves in case someone discovers that they've inadvertently used copyrighted material without getting the necessary permissions. In contrast, it's virtually impossible to get insurance that will cover inadvertent patent infringement, because there's no reliable way to verify that the necessary patent rights have been obtained the way insurance companies do with copyrights and real property.

So even if Bessen and Meurer's litigation cost estimates were off by an order of magnitude—if litigation consumed a half of patent profits, rather than four times their value—that would still be strong evidence that the patent system was in desperate need of reform. (As reader Rolf Andreassen points out, even the pharmaceutical graph I showed in the previous post wasn't stellar—litigation costs were eating up about a quarter of patent profits at the end of the period, and they were rising rapidly) A well-designed property system is one in which the costs are not just lower than the profits, but are a small fraction of them. Unless there are really massive flaws in their numbers, which seems unlikely, the patent system needs an overhaul.

In my final installment I'll talk about how things got so bad, and discuss some possible reforms.