20 Dec 2004  Research & Ideas

The U.S. Patent Game: How to Change It

Innovators and society are paying too high a price in the current patent system, says a new book by Adam B. Jaffe and Harvard Business School’s Josh Lerner. A book excerpt and Q&A with Lerner.

 

When lawyers fare better than inventors and entrepreneurs where U.S. patents are concerned, you know injustice is being done. The current system makes patents easier to acquire, sure, but renders them less prestigious as well, and less likely to attract valuable financing. In addition, older firms that are feeling threatened have learned how to bully younger upstarts by wielding licenses and patent law like a weapon. It certainly doesn't encourage the spirit of innovation, does it?

However, it isn't just the inventors and fledgling businesses that suffer. The economy as a whole does too, in ways that are often invisible.

A provocative new book by economists Adam B. Jaffe and Josh Lerner describes what's wrong, but shines a light on ways to fix the system, too. Their book, Innovation and Its Discontents: How Our Broken Patent System is Endangering Innovation and Progress, was published in November 2004 by Princeton University Press. Jaffe is professor of economics and dean of Arts and Sciences at Brandeis University. Lerner is the Jacob H. Schiff Professor of Investment Banking at Harvard Business School.

In Innovation and Its Discontents, Jaffe and Lerner say the patent system is the product of three elements that are required to interact: technology, people, and government. The interaction, which they describe in detail, "ultimately affects us all, and so should concern us all," they write.

In the following interview for HBS Working Knowledge, Lerner explains what's wrong and how to fix it.

Ann Cullen: How did you come to write this book with Adam B. Jaffe? What sparked your interest in this research?

Josh Lerner: Adam and I have done research, together and separately, over the past decade on issues related to patent policy. While this work explored a variety of interesting issues, the limited circulation of the periodicals in which the works appeared and the necessarily technical nature of the articles meant their impact was limited. Meanwhile, in many settings—from panel discussions to consulting projects to congressional hearings—we were hearing about the increasing severity of the patent system's problems, and the negative effects that they were having on firms.

While these issues had been widely recognized by practitioners, and had been the subject of weighty, footnote-laden reports by such bodies as the Federal Trade Commission and the National Academy of Sciences, there had been little popular attention to this issue. (The only trade books on the topic seemed to either be "war stories" about memorable patent disputes or exhortations to executives to get rich by exploiting the patent system's weaknesses!) These circumstances led us to decide to write this book. We sought to write a volume that would be readily accessible for business and government practitioners, and which conveyed clearly the system's problems and some steps to solving them.

Q: What are the current barriers to fixing the patent system? What reforms to this system do you suggest?

A: Why is reform of the patent system so hard? An extensive body of work, often described as "political economy," provides an answer to this question, at least at a broad-brush level. These writings have emphasized the danger of "capture" of government programs. [Editor's note: In a nutshell, regulatory capture refers to the tendency of regulators to favor, in effect, the interest of the industry they are supposed to be regulating rather than the public interest.] Any program that assigns subsidies or assigns property rights is prone to the distortions that may result as interest groups or politicians seek to direct the public programs in a manner that benefits them.

While the most dramatic effects are seen in the U.S., this is a global problem.

The patent system has many features that make the problem of capture likely. The most important of these relate to the complexity of these laws. The set of lawyers who understand these issues is unlikely to be large. While probably few are inclined to intentionally perpetuate an inefficient system, the substantial gains that they enjoy from the current system's complexity—e.g., lengthy and lucrative assignments—is likely to have a subtle effect on many practitioners' reactions to proposals for radical change.

Moreover, the negative effects of bad patent policy are very diffuse, and very difficult to see and understand. Consumers are unlikely to get excited about the extent to which subtle shifts in abstract judicial doctrine will affect the amount they pay for new products. Even CEOs are not apt to give these arcane issues the same kind of attention as something like tax policy, which affects a corporation's bottom line in a direct and transparent way.

Q: How have the changes in the patent process you document affected entrepreneurial finance?

A: Young, innovative firms are hurt in two ways by a poorly-operating patent system. First, as patents become easier to get, their value for the truly innovative firms—such as those backed by venture capitalists—decreases. Just as excellent students no longer can stand out if "grade inflation" at a college leads to almost all students getting A's, so too, innovative companies find it increasingly difficult to get the visibility and recognition they deserve if the patent system does not work efficiently.

Second, young firms are frequently targets of patent litigation. In many cases, an established firm, frequently one whose competitive position and innovative activity are declining, realizes it has a valuable stockpile of issued patents. This firm then approaches rivals, demanding that they take out licenses to its patents. In many cases, they will target smaller and young firms who do not have extensive financial resources to engage in protracted patent litigation. The small, young firms are often forced to capitulate.

Q: Given the changes you document to the U.S. patent process, do you think that if the current system is not fixed, more innovation will move overseas?

A: While the most dramatic effects are seen in the U.S., this is a global problem. As Dominique Guellec, the chief economist at the European Patent Office in Munich, observes, "patent offices are under incredible pressure" worldwide. Many offices have had to grapple with an influx of patents, and many nations are strengthening patents—often in response to pressure by American politicians. So this is not a uniquely American problem.

Nonetheless, to the extent that the problems are most severe in the U.S., I agree that this will tend to depress the share of the U.S. in innovation.

Q: Your book talks about the "pauperization of the patent system." Can you elaborate on what you mean by this?

A: Beginning in the early 1990s, Congress converted the United States Patent and Trademark Office from an agency funded by tax revenues, which collected nominal fees for patent applications, into one funded by the fees it collects. Indeed, the patent office has become a profit center for the government, collecting more in application fees than it costs to run the agency! In some years, as much as $200 million, or about 15 percent of total revenues, have been diverted from the patent office to the U.S. Treasury.

This change has had important consequences. Increasingly, the patent office views itself as an organization whose mission is to serve patent applicants. And, of course, what applicants want is for their applications to be granted! Furthermore, the new orientation creates strong incentives for the patent office to process applications as quickly as possible, and at the lowest possible cost. As a result, there has been a widely perceived decline in the rigor with which patent applications are reviewed. This, in turn, encourages more people to apply for dubious patents.

Cumulative and Overlapping Innovation

by Adam B. Jaffe and Josh Lerner

Imagine that you have purchased one of those new MouseStomper mousetraps and put it to work in your kitchen. It does much better than any mousetrap you have used before, but, once in a while, the culprit still manages to escape with the pâté. You want to know why, so you spend weeks hiding in your broom closet, where you can watch the MouseStomper at work without scaring away the mice. After a while you figure out an improvement in the MouseStomper that makes it even more effective.

We do not particularly want to encourage people to spend large amounts of time in their broom closets, but we do generally want to encourage improvements in existing technologies. And, just as the case with "original" inventions, inventing and developing improvements is time-consuming and costly. So we need to have good incentives.

Obviously, the firm that is making and selling a given technology has an incentive to improve it. But in many cases, they may not be the ones in the best position to make such improvements. As in the broom closet example, it is often customers who have good ideas about product improvements. More generally, one of MouseStomper's competitors might not just imitate the new technology; they might actually figure out a way to do it even better. So how do we create broad incentives for people to invest in improvements?

The obvious answer is to grant patents on improvements, and such patents are indeed allowed, if the improvement embodies some idea that was not covered by the patent on the underlying technology. This seems fair. But in practice it is tricky to implement. To make the patent on the original invention useful, its owner must be given some latitude to modify the invention and still have it be covered by the original patent. But if such latitude is too wide, then many improvements are likely to fall under the original patent. So there is a tradeoff: granting broad patent protection gives the maximum incentive for "original" inventions, but it may actually discourage improvements.

A classic example of the tradeoff between rewarding pioneering inventions and allowing improvements is the Edison electric light bulb. Edison was granted the basic patent on incandescent lighting in 1880. For the next dozen years or so, there was much dispute about the validity and breadth of this patent. Many companies offered competing products. A number of these contained important improvements in the design of the filament and the bulb itself, and the cost of the bulb trended steadily downward. Then, in 1891, Edison General Electric Company won an infringement suit against its competitor, United States Electric Lighting,17 and subsequently won injunctions against a number of competitors. The flow of improvements then slowed, until the expiration of the patent allowed competitors to re-enter and resume their efforts to improve Edison's design.18 Now, surely Edison's invention was about as novel as they get. And Edison and his assistants put a lot of time and money into testing different materials until they succeeded with the carbon filament, justifying a patent to allow significant profits to be earned on the invention. But acknowledging the legitimacy of Edison's patent and his efforts to enforce it is not inconsistent with recognizing that the monopoly thereby created temporarily inhibited the subsequent improvement of the invention and the development of the industry more broadly.

In principle, subsequent inventors with good ideas about improving an important invention ought to be able to negotiate an agreement with the owner of the original patent that allows the improvement to be implemented. This could be done by granting the improver a license to use the original patent, or by selling or licensing the improvement back to the holder of the original invention. After all, if the improvement is really a good one, both the original inventor and the improver have an incentive to see it implemented. In practice, however, such agreements often are difficult to work out. After the Wright brothers patented their basic design for an aircraft stabilization and steering system, there were many others who wanted to work on a wide variety of different ideas for aircraft. But the Wright brothers refused to license anyone, and engaged in protracted litigation with a number of designers.19 With the entry of the United States into World War I, the U.S. government in fact pushed the major aircraft manufacturers, including the Wrights' firm, to license their patents as a package, in order to ensure the rapid manufacture of planes and the development of new designs. The rapid development of numerous different aircraft concepts in the years after the establishment of this "patent pool" suggests that the pioneering patent—combined with the unwillingness or inability of the inventors to cooperate with their technological followers—temporarily retarded the development of technology.

Thus, there is an inherent tension between providing strong patent rights to encourage breakthrough innovations, and the inhibition that those strong protections may create for the development of subsequent improvements.20 A related problem is created by the reality that firms are often working more or less in parallel on related research. Multiple firms may each apply for patents on what are, in effect, different versions of the same idea or set of ideas. In principle, what should happen is that each should be entitled to a patent only on those aspects (if any) of their creation that are unique and truly new. In practice, this is very hard to do. What is likely is that each will be granted a patent that describes its invention in a way that leaves considerable ambiguity as to whether or not the inventions of the other firms are or are not covered. As a result, all may suffer uncertainty about what products they can or cannot legally sell. In the face of potentially overlapping patent grants, the risks associated with bringing new products to market are augmented rather than reduced, because expensive litigation with uncertain outcomes is added to other worries.21 Thus, the patent system in such cases may well inhibit rather than encourage innovation.

Sometimes parallel development leads to a situation where the problem is not so much uncertainty about patent rights, but patent rights that interfere with each other. In the early history of radio, the British inventor Marconi was granted a basic patent on radio transmission, and also acquired another patent on the two-element vacuum tube, or diode. (Some of us are old enough to remember when radios and TVs had "tubes.") The diode was a crucial and fundamental invention, but it was improved upon by the three-element tube or "triode" invented by Lee De Forest. AT&T held the patent on the triode. The courts ruled that the triode was an improvement on the diode, and as such AT&T and De Forest could not use the triode without a license to the diode patent controlled by Marconi. Marconi refused to grant such a license, but of course he could not, himself, make triodes without a license from AT&T, which was not granted. As a result, the triode, which was widely seen as a major improvement, was simply not used for some time.22 So again we see a situation where patent rights retard the improvement of technology, and do so despite the incentive faced by the parties to use license agreements to solve the problem. Apparently, inventors are a stubborn lot.

So it is hard to get it right
In summary, much is at stake in creating institutions that create incentives for innovation. Because of the inherent riskiness of the innovation process, patents are crucial in many cases to provide enough protection that investors are willing to put up the money to develop new technology. But patents are blunt instruments. Because of the complexity of the evolution of technology, the monopoly that they create will sometimes retard rather than encourage competition. This means that, in the best of worlds, a patent system is a compromise among competing objectives.

Excerpted with permission from Innovation and Its Discontents: How Our Broken Patent System is Endangering Innovation and Progress, by Adam B. Jaffe and Josh Lerner.

Copyright (c) 2004 by Princeton University Press.

Footnotes:

17. Edison Elec. Light Co. v. United States Elec. Lighting Co., 47 F. 454 (C.C.S.D.N.Y. 1891).

18. See Arthur Bright, The Electric-Lamp Industry: Technological Change and Economic Development from 1800 to 1947, New York: Macmillan, 1949.

19. See Wright Co. v. Herring-Curtiss Co; 204 F. 597, 614 (W.D.N.Y. 1913), as well as the discussion in George Bittlingmayer, "Property Rights, Progress, and the Aircraft Patent Agreement," Journal of Law and Economics, 31 (1988), 227-248.

20. These issues have been explored in a series of papers by Suzanne Scotchmer and her coauthors. For an overview, see Suzanne Scotchmer, "Standing on the Shoulders of Giants: Cumulative Research and the Patent Law," Journal of Economic Perspectives, 5 (1991), 29-41.

21. For a comprehensive examination of patent litigation trends, see Jean O. Lanjouw and Mark Schankermann, "Enforcing Intellectual Property Rights," STICERD, LSE Economics of Industry Group Discussion Paper: EI/30, 2001.

22. See Federal Trade Commission, Report of the U.S. Federal Trade Commission on the Radio Industry in Response to House Resolution 548, Washington, D.C.: Government Printing Office, 1924.

About the authors

Ann Cullen is a business information librarian at Baker Library, Harvard Business School, with a specialty in finance.

Adam B. Jaffe is Professor of Economics and Dean of Arts and Sciences at Brandeis University. He is the author, with Manuel Trajtenberg, of Patents, Citations, and Innovations: A Window on the Knowledge Economy.

Josh Lerner is the Jacob H. Schiff Professor of Investment Banking at Harvard Business School. He is the author, with HBS Professor Paul A. Gompers, of The Money of Invention.