10-Apr-06 Copyright: Tuomas Takalo. Can be used s.t. Creative Commons By-Nc-Sa License 38CO2000 Economics of Intellectual Property Rights (IPRs) Spring

10-Apr-06Copyright: Tuomas Takalo. Can be used s.t. Creative Commons By-Nc-Sa License

38CO2000Economics of Intellectual Property Rights (IPRs)

Spring 2006: Lecture 9

Practical issues:

• Homepage: www.elisanet.fi/takalo

• The exam is 9th, May. Let us fix the required material for the exam after Eastern

• Next time: the first guest lecture by lawyer Heidi Merikalla, Borenius & Kemppinen, which is a, if not the, leading business law service company in Finland. www.borenius.com

• Recall: at least one exam question taken from the guest lectures

http://www.elisanet.fi/takalo

http://www.borenius.com/


• Essays: Unless some one opposes, the deadline is 16th, May, midnight. I will reduce 3 points per day from missing the deadline until I submit the results to the HSE staff. After that I will reject all the essays. (40 points is the max)

• Please send your essay as an email attachment to [email protected], with some appropriate title. E.g, “Essay for the TMP course”

• Or send it by surface post to: Tuomas Takalo,

Bank of Finland, Monetary Policy and Research Department, P.O.BOX 160, 00101 Helsinki.

mailto:[email protected]


Recap:

1) Basic corporate IP strategy: patenting vs. secrecy

• In surveys, IP is the least efficient appropriability strategy. E.g., secrecy typically more efficient

• Firms typically patent their inventions only if they cannot keep them secret• E.g., Nokia (Tekniika ja talous 2.4.1998)

• Nonetheless, the rise of IPs and patents spectacular

There seems to be an arms’ race going on

Patenting can be a dominant strategy (Nash) equilibrium even if it provides a “weak” protection.


0

2

2

0

Secrecy Patents

Secrecy

Patents

Firm 2

Firm 1

The Arms’ Race:Payoff Matrix


Recap:

• Note: The arms’ race requires that firms can and do come up with similar innovations frequently• Increasingly, this seems to be the reality. Why?

• If independent invention is more frequent, it should have implications on IP management and policy• Recall: independent invention is a defense for

infringement in all forms of IPs except for patents• Cf. Kultti-Takalo-Toikka, 2006, AER papers&proceedings

2) Open Source is a novel licensing model

• Leveraging it in for profit business is challenging – for economic theory if not for anything else!


I. Intro

II. Patent (and other IP) PolicyII.1 Horizontal competitionII.2 Cumulative competition

III. Management of Patents (and other IPs)III. 1. Licensing & cumulative innovationIII. 2. Basic Corporate IP strategy: Patenting vs. secrecy III.3. Licensing via open source

IV. Competition Policy and IPRs

V. Innovation and IPRs in Financial Services Sector

Other…? Economics of copyright & IPs in network industries

Overview


• 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. -

IV. Competition Policy and IPRs


• Competition laws guard consumer surplus by promoting competition- competition not competitors, as inefficient firms will be

wiped out by competition

• As discussed, IPRs create the incentive to innovate by enforcing temporary market power over innovations• i.e. the IPRs reduce consumer surplus in horizontal

competition Recall the 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 (IPR laws)- ex post: information is public good, no reason to restrict its use

because it does not wear out (competition laws)

• The tension has been there and the balance has shifted: E.g. loosely speaking one can say that in the US supremacy of antitrust laws prevailed around 1930-1980 and supremacy of IPR laws around 1890-1920; 1980-present

• The tension has shown up over the past 20 years when IPs and their management has 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

competition laws have become more tolerant

• Yet, the tension is here, cf. Microsoft in US and Europe, MasterCard-Visa


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

Competition laws should focus on the competition for the market not within the market


• Monopolies can stimulate innovation (Schumpeter):

• 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- dd m2d

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: Prohibition of agreements that restrict competition

• Article 82: Abuse of dominant position


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

- Article 82 typically is not a concern for small firms if they leverage on IPs.

- 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


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

e.g., the EU “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 EU “IPRs are not immune from competition law intervention”


In sum

- Competition laws seem to be up-to date

- Modern (official) view:

- There is no inherent tension between the IP and competition laws (cf. the EU 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, this is a bit too “trendy” to my taste – how can there be a problem of seeking a balance without a tension?

- So, while it would be more appropriate to refer to a proper balance, I will speak about a tension for brevity.


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

• Recall: R&D and IPRs can be substitute competitive strategies

• Monopolies can be bad for innovation (Arrow):

• Consider a monopoly and a competitive industry.

• The monopoly earns m before innovation and m + after it the incentive to innovate m + - m =

• In the competitive industry 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”


3) Competitive industry can generate too much innovation from welfare point of view:

• Consider n firms trying to innovate

• 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 Case

• 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 problems with antitrust authorities started in the mid 90s but the case started in 1998 is the best documented

• Centers around Internet Explorer

• A later but parallel case in Europe that centers around Media Player


• In the mid 90s Netscape was the main Internet browser but Microsoft already had the dominant market share in the OS market

• Key: Indirect network effects that make a demand of a product depend on the number of complementary products

• Netscape in itself was not a threat but Netscape combined with Java language had the potential of making Windows redundant

• Java is a middleware between software applications and an OS

• Netscape was a distribution road to Java, if Java had become standard, there would have been explosion of applications independent of the underlying operating system

• Indirect network effects create a chicken-and-egg problem:

• An operating system cannot become popular unless it has a lot of available software applications written for it

• Application programmers do not want to write to an operating system unless it is popular


• 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

Microsft’s business strategies that raised antitrust concern

1) Exclusive dealing

• Restricts access by rivals to some resource to weaken their ability to compete


• Microsoft make agreements with computer manufacturers so that Internet Explorer icon could not be removed nor a rival browser icon made more prominent

• judged anticompetitive, because Microsoft allowed manufacturers to modify the Windows desktops in other respects

• Microsoft offered Internet content providers a preferential placement in Explorer if the content providers would promote Explorer as their browser of choice

• not judged anticompetitive because increased content providers’ incentives to innovate complementary products with Microsoft

2) Predatory behavior

• Microsoft 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

• Microsoft developed a dialect of the Java language for Windows (so called “polluted Java”)

• Government: Microsoft tried to disperse Java so as to prevent it becoming a standard

• Microsoft: wanted to optimize Java to get efficiency gains

judged to be anticompetitive: predatory behaviour because of unnecessary short-run losses and other reasons


3) Tying and bundling

• Integration of Explorer with Windows: Microsoft refused to offer Windows without Explorer

• Government: Predatory because MC of installing Explorer zero whereas installing Netscape positive.

• Microsoft: Explorer a standard product improvement

judged not to be anticompetitive?


Did Microsoft harm consumers?

• Probably not in the short run:

• The Java dialect, free Explorer, integration of Explorer with Windows benefited consumers directly

• The actions forced Netscape prices to zero, too

• However, they kept prices of Windows high

• Probably yes in the long run:

• Reduced the scope for platform competition

• Java did not became a standard

• Explorer now in the dominant position

• However, contracts with content providers should have enhanced efficiency


Microsoft vs. European Commission

• Many similarities with the US case:

• Microsoft has bundled Media Player with Windows in a similar manner as Explorer

• Commission: by leveraging Windows into other markets, notably the media player market, Microsoft slows down innovation in the IT sector

• Microsoft should offer Windows without Media Player

• Microsoft: Media Player is a product improvement


• Differences:

• Rival media players such as RealNetworks posses hardly a threat to Windows in a similar manner as Netscape/Java did

• However, they make it hard for Microsoft leverage Windows outside the desktop PC into mobile and home entertainment markets

competition for the markets

• Commission wants Microsoft to share technical information to allow other companies’ server systems to work better with Windows driven PCs

• Microsoft uses IPR laws as a defense more extensively than in the past: information sharing and other remedies proposed by Commission will violate its IPRs and are in conflict with IPR laws


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

• The 1995 US Guidelines and the 2004 EU regulation try to incorporate IP issues in competition law

• 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

Documents

10-Apr-06 Copyright: Tuomas Takalo. Can be used s.t. Creative Commons By-Nc-Sa License 38CO2000 Economics of Intellectual Property Rights (IPRs) Spring