Patents as Property, Part 3

[Tim Lee]

In my first two posts, I described how a property system is supposed to work and compared it to the actual performance of the patent system. I concluded that the patent system seems to work reasonable well as property for the pharmaceutical industry, while it fails miserably for other technologies.

So what went wrong? Patent law is a mind-numbingly esoteric subject, and one I'm still learning about myself, so I'm not going to try to attempt a definitive answer in a blog post, but let me make a few general observations.

I largely agree with Bessen and Meurer's description of the general problem: the patent system does an inadequate job of providing notice of patent boundaries. Real property has a variety of mechanisms—fences, no trespassing signs, regular property lines, records on file with the county—that make it easy for someone to figure out when he might be trespassing and with whom he needs to negotiate. Patent law has few, if any, comparable mechanisms. If a smart inventor gets an idea for a new (non-chemical) product and wants to find out whether it's already covered by patents, there's no practical way for him to do that. For any given product, there will be thousands of patents that are potentially relevant—one estimate says that the typical e-commerce site would need to check more than 11,000 patents, for example—and a patent lawyer will charge several hundred dollars per patent to do the necessary checks. Even if an aspiring entrepreneur managed to raise the several million dollars it would take to clear all the patents related to a new product, that wouldn't give him any real assurances because the opinion of any given patent lawyer isn't legally binding. The patent lawyer might tell the inventor that a given patent doesn't infringe, only to get sued and discover that the judge or jury disagrees with the patent lawyer. And of course even an exhaustive clearance effort wouldn't catch submarine patents (which don't surface until after the entrepreneur has started selling his product) or patents in other fields that are interpreted so broadly as to cover inventions far afield from the original patented invention.

A good example of this latter case is Patent 4,528,643, "System for reproducing information in material objects at a point of sale." The invention described by this patent is nominally a mall kiosk that can sell on-demand tapes of music stored at a remote location. "Point of sale" is retail jargon for computerized cash register, and almost everyone assumed that's what the patent covered. However, the owner of the patent, E-Data, began asserting the patent against e-commerce sites that didn't have "point of sale locations" in the conventional sense, and the court bought this broader interpretation. Suddenly, a patent for a mall kiosk became a monopoly over a broad swath of e-commerce technologies. Prior to the court cases regarding the patent, most patent lawyers would have told a potential e-commerce developer that the patent didn't apply to them. But they would have been wrong, and the developer could have faced millions of dollars in royalties.

As a result, in many high-tech fields, especially software, it's taken for granted that any non-trivial product infringes numerous patents, and that finding all the relevant patents is effectively impossible. So startups' standard strategy is to build their product without worrying about what patents they might be infringing, and hope to grow fast enough that they'll be able to hire good patent lawyers when the inevitable patent lawsuits arrive. Once the startups have some free capital, they begin a process of patent stockpiling, attempting to amass enough patents that they'll have some leverage against adversaries in patent litigation. Companies that fail to do this—that spend all their resources on engineers rather than patent lawyers—wind up in the unfortunate situation of Vonage. Vonage, the Internet telephony pioneer, was sued by Verizon, a far less innovative company by almost any measure, because Verizon had spent resources amassing patents while Vonage had focused on actually developing useful products. Vonage ultimately had to pay Verizon $120 million in damages. No one disputes that Vonage developed its technology independently, but independent invention isn't a defense to claims of patent infringement.

Bessen and Meurer's notice theory also explains the relatively better record of chemical patents. Chemical formulas provide a reasonably objective way to distinguish different inventions. Chemical and pharmaceutical patents can be indexed by molecular formula, and it's then reasonably easy to conduct a search to see if a particular chemical has been patented. There's no comparable way of describing inventions in most other fields, so the boundaries tend to be a lot less clear.

So what should be done? There are three broad reforms that I think could make a difference. First, the courts need to be much stricter about allowing patents on abstract concepts. Patents should cover a specific physical device, not a broad category of functionality. Where patent claims are broad or vague, they should either be given the narrowest possible interpretation, or they should be declared invalid altogether.

Second, the patent office should institute reforms to better define the boundaries of patents, and the courts should defer more to these determinations. Currently, the US Court of Appeals for the Federal Circuit, which oversees patent appeals, has a tendency to re-interpret the scope of patent claims without regard for the interpretations given by the lower courts and the Patent Office. Patent examiners should carefully record, in detail, what a patent covers, and then courts should defer to these descriptions. Bessen and Meurer also recommend that the Patent Office offer a service, for a few hundred dollars, of providing opinion letters on whether a given patent infringes a given invention. Unlike an ordinary legal opinion, a Patent Office letter would be giving weight in any future litigation. This seems like a good idea.

Finally, the Federal Circuit should end its unfortunate experiment with patents on software. Supreme Court precedents disallowed patents on software until the 1990s, and the software industry was plenty innovative. A series of decisions by the Federal Circuit eviscerated the rule against patents on software. Bessen and Meurer's statistics indicate that software patents have the lowest value and the highest litigation rates, and I don't think it's a coincidence that the surge in patent litigation corresponded with the legalization of software patents (although those certainly weren't the only bad decisions the Federal Circuit made in the 1990s). The Supreme Court has yet to rule on the Federal Circuit's de facto legalization of patents and software, and in my view they ought to reverse it at the first opportunity.

To return to the original theme of this series, I hope it's clear why I'm uncomfortable with the analogy between patents and traditional property rights. Outside the pharmaceutical industry—and especially in the software industry—the patent system is more like a rent-seeking operation for the benefit of the patent bar than it is a functioning system of property rights. It's possible that the reforms I suggest above (and others Bessen and Meurer propose in their book) could improve things sufficiently that patents will work as property. But until that happens, I think it's a category error to regard patents as a type of property right.

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.

Patents as Property, Part 1

[Tim Lee]

The phrase "intellectual property" to describe the patent and copyright systems has become so commonplace that few people give it a second thought. Superficially, the copyright and patent systems are structured like traditional property systems, and this has become the dominant way we think about these legal regimes.

But determining whether a legal regime is a well-behaved property system is an empirical question, not merely a matter of semantics or tradition. For example, I'm sure that New York cabbies consider their taxi medalions to be their property—and valuable property at that—but few economists would characterize the creation of such a scheme as "strengthening property rights." Effective property rights systems have two important characteristics. First, they enhance certainty and promote efficiency by establishing clear boundaries to contested resources. Real property, for example, has a system of surveying and claim recording that allows any interested person to determine who owns each plot of land and what its precise boundaries are. Second, property rights create positive incentives for productive activities by rewarding people who produce new assets or enhance existing ones.

The first consideration cannot be an argument for treating patents as property because ideas are non-rivalrous. Once an idea has been created, it can be used freely by anyone. Hence, the analogy between patents and traditional property rights rests entirely on that second characteristic: that patents, like real property, creates incentives for productive behavior by giving inventors exclusive rights over the use of their inventions. Indeed, patents can be considered an effective property system only to the extent that it performs this function. If the existence of the patent system, on average, makes invention a more profitable activity than it would be otherwise, then it makes sense to consider patents a kind of property right. If, in contrast, the patent system creates no net incentives for innovative activity, or worse if it creates a net disincentive, then the usual incentive-based arguments for property rights simply don't apply to the patent system.

And indeed, the second characteristic (positive incentives for innovation) depends crucially on the first (clear and predictable boundaries). As we learned from Hernando de Soto, "property" systems without clear boundaries and predictable rules are an impediment, not an aid, to economic growth. A system in which boundary lines are unclear—if, say, a given plot of land is claimed by a dozen surrounding residents with no clear process for determining who is the rightful owner—the resulting uncertainty and the costs of litigation will swamp the positive incentive effects of the legal regime.

That insight is the starting point for Patent Failure, an important new book by James Bessen and Michael J. Meurer. A well-functioning patent system should look like this graph, lifted from page 139 of their book:

This shows how the patent system affects the chemical and pharmaceutical industries. The dashed line at the top shows the profits from all chemical and pharmaceutical patents, while the solid line on the bottom shows the costs to alleged infringers of patent disputes—some of which, we should remember, are innocent. As we would hope, the top line is significantly above the bottom line. The net incentive for innovation created by the patent system is the different between these lines—the profits to patent holders minus the costs to alleged infringers from patent lawsuits. While the uptick in litigation in the late 1990s is worrisome, the patent system seems to be working the way it's supposed to in these industries. The positive incentive effects of patents appear to be significantly larger than the deadweight costs of patent litigation.

In my next post, I'll show you what the graph looks like for the rest of the patent system, and discuss the implications of this for patent policy.

The egg came first

[Conor Friedersdorf]

Literally.

People are always using the chicken/egg question as shorthand for situations where it's impossible to determine what actually came first.

But if you believe in evolution, it's clear that once upon a time there were two animals that we wouldn't quite consider chickens, that those not-quite-chickens mated, that an egg was laid, and that out of that fertilized egg hatched the first animal that meets whatever our definition of chicken is.

In other words, the egg came first.

Not soft on Microsoft

I suppose everyone is fascinated by whatever aspect of the Microsoft/EU antitrust case validate their political ideas. For many people, it is the triumph of the state against the big, bad corporation; for others, it is an unwarranted intrusion into free markets. Here are the aspects that interest me, though:

1. Antitrust lags the market in a way that threatens to make it meaningless. Just as the IBM antitrust case was quickly made irrelevant by the shift of market power from hardware to software, the EU has come in to force open a market that no longer seems either so important, or so thoroughly dominated by Microsoft. Now Apple and Google are the rising threats, and undoubtedly, in a decade they too will be under fire from some firm you've probably never heard of. In the future, we may see antitrust rulings coming just in time for the bankruptcy sale.



2. The EU regulatory commission seems notably more hostile to American companies than to locals. If EU antitrust authorities come to be seen as having a mandate to force European products on unwilling consumers, they will do a great deal of damage to both European markets, and world trade.



3. Many of the EU's supporters on this are hoping that the union will become a defacto super-regulator, which can use its market size to force changes on international companies. Henry Farrell writes:

   It is possible for companies such as Microsoft to sell different products in the EU and the US. But it is very expensive to have to do this, as well as often being politically awkward (when consumers would like what is on offer in another jurisdiction but can’t get it), and always organizationally highly inconvenient. The result is that companies are likely to make their products comply with EU rules across markets, except when the costs to so doing are very high indeed. This means that the European Commission is effectively becoming a regulator that substantially affects what is or isn’t sold in US markets too. The US administration has taken a hands-off (some might say supine) approach to preventing monopoly abuses in technology markets – the Commission is now in an excellent position to start to fill this regulatory vacuum. This should make for some interesting politics – while the US administration is likely to deplore this ruling, I don’t know that there is very much that it can actually do about it (especially given the continued controversy over its decision to roll over for Microsoft after the Bush administration came into office). It seems to me that the Commission has chosen its case very well, with respect to cementing its power over European information technology markets and increasing its international influence very substantially too. This should make for very interesting international politics.

   Certainly, there was a substantial forum-shopping aspect to this case; technology companies that couldn't compete in the US ran to friendlier European regulatory agencies with their complaints. There is no logical reason that competitive frictions between Real Networks, Sun Microsystems, or Novell, and Microsoft, should have been adjudicated in Europe.

   But Henry's optimism assumes that the effect of the regulatory breakup is to make consumers (rather than producers) better off. This seems a rather dubious assumption considering that it's major achievement so far has been forcing Microsoft to sell its software with fewer features at the same price as the fuller-featured product. Had the commission gone farther, and forced the company simply to entirely unbundle Windows Media Player, the result would have been to advantage Real, but deprive consumers of something they had been getting for free.

   Perhaps Microsoft will harmonize its versions. Or perhaps it will sell a dumbed down European version at the same price as the full-featured US product, while loudly announcing that they are doing so in response to EU antitrust regulations. Perhaps consumers will still get mad at Microsoft, instead of the commission. But I wouldn't count on it. This sort of political consideration will considerably constrain the commission's power. It will even do so for "invisible" changes, such as the efforts to get Microsoft to disclose its server hooks. Microsoft might just decide to keep Europe one version behind America, which would not bolster already weakening support for central EU regulation.

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Harder than it looks

It's rather common to hear those in favor of price controls on prescription drugs argue that the government does all the real research anyway, and the pharmas just steal it and slap their name on the resulting pill; or that the cost of R&D is wildly overblown.

As a counterexample to these two claims, I (well, Derek Lowe, really) give you: Renin inhibitors.

I notice that the first marketed renin inhibitor seems to be doing fairly well. That's an interesting phrase, "first marketed renin inhibitor". . .

This is a good example of what drug discovery can be like. Renin is a fine drug target – it’s been known for a long time as a key component of blood pressure regulation, and that’s a condition affecting a huge market whose treatment provides a real medical benefit. What more do you want?

OK, let’s make it even more attractive. It’s not that hard to set up a renin assay, and the protein is well-studied. The counterscreens and secondary assays are not a problem; hypertension is fairly well understood. And if you screen for renin inhibitors, you generally find chemical matter to start off with, too. Protease inhibitors vary quite a bit in their drug-likeness, but they’re certainly not impossible on the face of them.

But even after all this, I would not like to be asked to count how many renin inhibitors have been reported over the years, never to be seen again. The first reports I can find go back to the early 1980s. Given the lead time for these things, I can safely assume that these compounds were being made around the time I went the my high school Junior Prom (theme: “Saturday Night Fever”, natch – it was 1978, after all). And here we are in 2007, and the first one has finally made it to market. It wasn't easy, either - the compound was left for dead years ago, and was only kept going by some ex-Novartis people who started their own company and licensed the compound back to Novartis when it finally made it through the rough spots.

So, what’s the problem? Many compounds have been done in by poor behavior in living models (distribution, absorption, and so on). Getting oral bioavailability in this area has been a lot harder than anyone thought, and even the current drug is no great winner in that category. Projects start and stop, difficulties occur, and the years go by. And other mechanisms for going after hypertension have, of course, come to market, starting with the ACE inhibitors (which come from roughly the same disco era as the first run of renin compounds). They took the gigantic market that an early-1980s renin inhibitor would have had, but even so, I don’t think a year has gone by since that someone in the industry hasn’t been working on one. (There's still room to think that a renin compound would have a better profile than the existing drugs, though). And here we are: 2007. A sobering thought, that is.

Lock-in

Apparently it has taken all of two months for people to figure out how to unlock the iPhone. I find it hard to imagine that this will make a dent in Cingular's profits--the majority of people aren't going to mess around with soldering guns and cards. On the other hand, I imagine people said the same thing about that crazy Napster network.