1

Weak IP rights and innovation

Vincenzo Denicol and Luigi Alberto Franzoni
1

2

University of Bologna, Italy
December 2009
Introduction
The law provides various forms of legal protection for innovations, depending on the subject
matter (manufactured items, artistic works, design, etc.) and degree of novelty. Patents are
usually regarded as a strong form of protection, since they provide an exclusive right on the
innovative technological knowledge. Copyrights and trade secrets, by contrast, are regarded
as weak forms of protection, since they prohibit direct copying, but not independent
duplication.
The recent literature on the optimal breadth of IP rights has underscored the positive
role of such independent duplicators in increasing the degree of product market competition,
and hence in reducing the social costs of IP protection.
3
This literature, while recognizing the
risks of permitting outright copying of innovations, argues that parallel development and
independent discovery should not be discouraged, since the benefits they induce on the
competition side may outweigh their adverse effects on innovation. In this perspective, the
optimal form of IP protection appears to be that provided by copyrights and trade secrecy,
which do not prevent independent developers to practice the innovation.
Building on the original insight of La Manna et al. (1989), Maurer and Scotchmer
(2002), Shapiro (2006), Kultti and Takalo, (2008), and Henry (2009), among others, have
argued that patent protection should be weakened so as to allow second independent
inventors to practice the innovations they obtain by parallel development. More specifically,
they argue that independent inventors should be granted a defense to patent infringement

1
Correspondence to: Department of Economics, Piazza Scaravilli 2, 40126 Bologna, Italy.
2
We are grateful to Scott Stern, Samson Vermont, Richard Wilder, the seminar audience at GMU (Conference
on Law and Economics of Innovation), and editor Geoffry Manne for helpful comments.
3
See, among others, La Manna et al. (1989), Farrell (1995), Leibovitz (2002), Kultti, Toikka, Takalo (2006),
Shapiro (2006) and (2007), Bessen and Maskin (2008), Henry (2009).
2

(independent inventor defense). This proposal has spurred an interesting debate, which has
mostly focused on the practical problems posed by its implementation.
4

Even if the focus of this stream of literature centers on the rights of the patent holders
against second inventors, its insights have a more general bearing. They suggest that
exclusive rights are an inefficient system of rewarding innovation when multiple parties are
likely to discover the same innovation more or less at the same time. If this is so, then the
analysis can be applied also to the case where duplication is forced by the policy maker, e.g.
by compulsory licensing or by mandatory disclosure of secret technological knowledge and
know-how. And there are many other instances in which IPRs and competition law may
collide, and courts have to decide whether to favour ex-ante innovation or ex-post
competition.
5

The stance taken by antitrust authorities and the courts on these issues varies over time and
across countries. In the US, there seems to be a general consensus - reinforced by Trinko
(540 U.S. 398, 2004) - that competition rules should not trump IP law.
6
In Europe, anti-trust
authorities and the courts follow a different approach, which tends to set a closer boundary to
IPRs. According to the European approach, a refusal to license an IPR by a dominant
undertaking constitutes an abuse if certain "exceptional" conditions hold, outlined by the
European Court of Justice in the Magill case. Encouraged by its success in the Microsoft
case, the European Commission seems to support a "balancing of interests" approach, where
the positive effect of more intense competition should be weighted on a case by case basis
against the adverse impacts on innovation (DG Competition 2008).
From a Law and Economics viewpoint, when an innovator is forced to license its innovative
technological knowledge, the protection afforded to him or her degrades from a property rule
to a liability rule in the sense of Calabresi and Melamed (1972). The owner of the innovative
knowledge, that is to say, is not entitled to enjoin other parties from it, but has to content
himself with compensation (a license fee) decided by the court. However, in this context the
traditional comparison between property rule and liability rule needs to be extended to
account for their effects on the incentives to innovate.
7


4
See Blair and Cotter (2001), Vermont (2006) and (2007), and Lemley (2007).
5
See, for instance, Hovenkamp et alt. (2008), and Vickers (2009) for an introduction.
6
See, for instance, the recent report by the U.S. Dept. of Justice and Fed. Trade Commission (2007).

7
See, for instance, Lemley and Weiser (2007) and reference therein.
3

In what follows, we will develop an analytical framework that is simple and tractable and yet
helps bring to the fore some effects omitted in the previous literature. Building on our previous
work (Denicol and Franzoni, 2009), we will compare strong and weak IP rights using
Kaplow-like ratio tests, which relate the social costs (in terms of deadweight losses) and
benefits (in terms of incentives to innovate) of alternative forms of protection. We investigate
firms incentives in an innovation race where two or more firms that target the same
innovation race to discover first, and show how the standard Kaplow test should be corrected
so as to account for the adverse effect on the incentives to innovate of the consolation prize
netted under non-exclusive rights by the loser. We conclude that the policy prescriptions
obtained by the previous literature need to be qualified.
The Ratio test
The optimal design of IP rights inevitably rests on the resolution to the fundamental trade-off
between the need to reward the innovator and the need to diffuse the innovation. This trade-
off involves many dimensions, the best explored of which is the duration of the exclusive
right.
8
More recent contributions have explored also the issue of the optimal breadth of the
exclusive right with respect to producers of similar products (see, for instance, Gilbert and
Shapiro 1990, Klemperer 1990, and Denicol 1996), follow-on innovators (see for instance
Scotchmer 2004 and Bessen and Maskin 2009), and prior (secret) users (see for instance
Denicol and Franzoni 2004 and Shapiro 2006).
Another important issue, which is the focus of this paper, concerns the right of the IP
holder to exclude imitators and duplicators. Here, the law follows two basic models,
associated with patent and trade secrets protection, respectively. Patent protection provides a
fully exclusive right to the patent holder, who can enjoin all others from the use and
commercialization of the innovation, independently of how they have obtained it.
9
Under trade
secrets protection, by contrast, the inventor is protected against copying, but not against
independent discovery, or duplication through reverse engineering.
10
Other forms of IP
protection lie somewhere in between these two extremes, and borrow elements from each of

8
Starting from the pioneering work of Nordhaus (1969).
9
In this sense, patent infringement resembles a strict liability offence. However, the analogy is not perfect, since
the determination of damages depends on whether the violator was put on notice or not (see Blair and Cotter
2001).
10
The law and economics of reverse engineering is discussed by Samuelson and Scotchmer (2002).
4

them. Copyright law, for instance, allows for parallel development but tends to put restrictions
on reverse engineering (circumvention of digital locks).
For simplicity, we focus on the comparison between patents and trade secrets
protection in a very simple setting. We start in this section by presenting a basic ratio test. In
the subsequent sections, we introduce several extensions and analyze how the appropriate
ratio test changes accordingly.
Let us consider the case where one firm (Firm 1) discovers an innovation and another
firm (Firm 2) duplicates it. Duplication by firm 2, either through independent discovery or
reverse engineering which are taken to be equivalent for the time being introduces some
degree of competition in the market: prices go down, and a larger share of consumers is
served. Thus, let us assume that the price of the new product decreases from its monopoly
price p
M
to a duopoly price p
D
, with p
D
< p
M
(see Figures 1 and 2).


Figure 1. Patent protection. Figure 2. Trade secrets protection.

Under patent protection (Figure 1), discovery spans a temporary monopoly followed by
perfect competition at the end of the patent term. During the patent life, of expected duration
, the innovator earns monopoly profits
m
while society bears the deadweight loss
m
(the
shaded area).
To make some progress, the literature has concentrated on the problem of the efficient
provision of the incentives to innovate. In other words, it has proceeded by taking the desired
level of remuneration of the innovator as given, and asking which form of protection yields the
5

target remuneration at the least social cost (see Gilbert and Shapiro 1990).
11
Thus, the
comparison focuses on the social loss entailed by the target level of the innovators profit in
the different regimes.
Initially, under both regimes there is a temporary monopoly, which entails the same
costs and benefits. The comparison between the two regimes therefore hinges on the second
period. In the strong regime there is monopoly until the patent expires. In the weak regime, by
contrast, there is duopoly until the secret leaks out. For simplicity, we rule out leakage, so in
our model secrecy lasts forever.
12

Let us focus on the comparison between the two regimes from the time when the
innovation is duplicated. Let h be the present discounted value of a perpetual constant
annuity, and let e be the present discounted value of a constant annuity over the patent
lifetime E ; obviously e h. Then, in order for the innovators expected discounted profit to be
the same under the two regimes, we must have: e
m
= h
d
, that is

e = h
d
/
m
..

The social cost of patents is measured by the deadweight loss
m
. Under trade
secrecy, social costs comprise both duopoly deadweight loss
m
and duplication costs d
u
,
which are sunk to reproduce an innovation already available. Hence, trade secrets protection
entails a lower social cost than patents if

<

.

Using the definition of e, trade secrets protection is preferable if

<

,

11
In Denicol and Franzoni (2009) we show that this method tallies with two apparently different policy
problems: the assessment of a marginal policy variation on the assumption that the benchmark regime is
optimally calibrated (as in Shapiro 2006), and the comparison of different regimes on the assumption that the
policy maker is able to calibrate the incentives to innovate by different means (e.g. patent duration, ease of
duplication).
12
Trade secrecy may terminate also for other reasons, e.g. because the technology becomes obsolete.
However, accounting for leakage and other similar effects does not modify the qualitative results of the analysis.

6


that is

<

.

Note that the ratio =

(=) represents the share of discounted duopoly profits that Firm 2

invest in the duplication process, and hence are wasted from the social viewpoint. Then,
trade secrets are preferable if the following ratio test is met:
13

+ <

.

The deadweight loss to individual profit ratio under duopoly depends on the intensity of
competition. Generally speaking, the tougher is competition, the lower are the prices, and
hence the lower is the deadweight loss to profit ratio (see Figure 2).
14
In the case of
homogenous goods and linear demand, for instance, the deadweight loss to profits ratio
under duopoly is the same as that under monopoly if firms compete la Cournot (where each
firm behaves like a monopolist on the residual demand). The duopoly ratio is lower than the
monopoly ratio if competition results in lower prices than under Cournot competition.
15
The
share of duopoly profits dissipated, instead, depends on the ease of duplication and on the
nature of duplication costs.
16
Hard to duplicate innovations entail larger costs.
17



13
Although the basic ratio test follows the same logic as the original test developed by Kaplow (1984), there are
important differences between our basic test and Kaplows, which are discussed in details in Denicol and
Franzoni (2009). On the use of Kaplow tests in IP, see Scotchmer (2004), ch. 4.
14
The implications for optimal taxation of deadweight loss increasing exponentially with prices have first been
explored by Ramsey (1927).
15
Product differentiation tends tilt the balance in favor of weak IP rights. Here, however, several factors come
into play, since differentiation affects both the social cost of monopoly (depriving consumers of product variety)
and the social cost of duopoly (since differentiation attenuates competition). See Denicol and Franzoni (2009).
If duopoly is asymmetric, because of a cost advantage of the innovator, then duopoly also entails production
inefficiency, and the balance is tilted against weak IP rights.
16
More generally, this share would also depend on the number of firms able to duplicate the innovation. See
Gallini (1992) and Denicol and Franzoni (2008).
17
Clearly, also the expenditure of the first inventor to fence off his technological knowledge would count as
social waste.

7

The main insight that we get from this analysis is that weak protection (trade secrets) is
likely to be preferable if the competition brought about by duplication is intense and
duplication costs are low (as a share of expected duopoly profits). By contrast, strong
protection is likely to be preferable when competition ensuing from duplication is weak and
the duplicative process is costly.
IP law and antitrust
Under certain circumstances, the right to exclude provided by patents and other IP rights may
run against antitrust law. Take for example the case of a firm holding monopolistic power that
refuses to license its proprietary know-how to a rival. In Europe, such a practice may fall
under the scrutiny of anti-trust agencies, which will try and ascertain if the firm is engaging in
an anti-competitive exclusionary conduct. In certain circumstances as when the proprietary
knowledge is regarded as an essential facility - the refusal to license may be deemed illegal,
and the owner of the innovative technology may be forced to share it with its rivals. In this
case, the protection afforded to the innovator is degraded to a liability rule, where the
compensation for the taking is decided by the court.
The basic ratio test developed in the previous section can be used to provide a first cut
analysis of this issue. Consider the case of a patent holder who is subject to mandatory
licensing. The patent holder loses her right to exclusive use, and rivals are allowed to
compete with the first inventor. While under trade secrecy rivals can access innovators
original knowledge by sinking duplication costs, under mandatory licensing they can do it by
paying the compensation decided by the court. In the latter case, no resources are devoted to
the wasteful duplication of an existing technology. However, the innovators profit goes down,
with a negative effect on the incentives to innovate. Again the policy maker has to trade off
lower incentives to innovate with more intense competition in the product market.

Let us consider, as before, the case where the policy maker intends to provide a pre-
specified reward to the innovator and decides which type of protection to grant.
18
The case of
weak patent protection now is taken to mean that the innovator is forced to disclose the

18
This problem might be directly relevant, for instance, in those cases where the policy maker intends to reduce
the reward to innovator and has to decide on whether to do it by either shortening the patent term or by reducing
the scope of protection.
8

innovation to the rival on payment of a compensation, the amount of which is decided by the
court and can range from nil to full duplication profits.
19
Since mandatory disclosure reduces
the innovators profit, the pre-specified reward can only be achieved if the weak patent has a
longer duration than the standard one. In other words, we make the analytically convenient
but rather unrealistic assumption that when a patent holder is forced to license its patent, the
duration of the patent is suitably extended.
Let w be the present discounted value of a constant annuity over the extended patent
lifetime, W,, and let e be the present discounted value of a constant annuity over the normal
patent lifetime, as before. Now we have e w.
The upper bound on the licensing fee to be paid by the duplicator is its expected profit e
d
. It
is convenient to express the mandatory licensing fee as a fraction of the duplicators
expected profits, with 0 1. Then, under a weak patent regime, the innovators expected
reward is w
d
(her own profits after duplication) plus w
d
(the licensing fee paid by the
duplicator), that is w
d
(1+).
For the innovators profit to be the same amount in both regimes, we must have: e
m

= w
d
(1+) , that is: e = w
d
(1+)/
m
.


Figure 3. Mandatory disclosure (=1/2).

Assuming, to fix ideas, that the patent holder is obliged to license his innovation as

19
The timing of the disclosure is immaterial for our purposes. In time period between invention and duplication,
monopoly prevails and the innovators profit and the deadweight loss are the same as under a standard patent.
9

soon as he discovers it, the total social waste under the weak patent system amounts to
duopoly deadweight loss
d
for the duration of the patent term. Now there are no duplication
costs, since competitors obtain the right to utilize the innovation by legal means, not by
duplication. Hence, weak patents entail a lower social cost than strong patents if

<

.

If e is set so as to provide the required reward to the innovator, we find that weak patents are
preferable if

<

(1 +)

,

that is

(1 +)
<

.

Under Cournot competition,
d
/
d
=
m
/
m
,. It follows immediately that the new ratio test is
surely passed if product market competition is more intense than under Cournot.
More generally, the ratio test is more likely to be passed (and hence the weak patent system
is more likely to be preferable) if the royalty rate is high, and if product market competition
(after disclosure) is intense. If is equal to one, i.e. if the innovator is able to appropriate the
full industry profits as in Maurer Scotchmer (2002) then weak patents are preferable for
any given any linear demand function. If instead is equal to nil, that is, if the innovation is
forcibly disclosed to rivals without compensation, then the ratio test becomes harder to pass
(if competition is more intense than under Cournot).

Overall, the simple application of the ratio test seems to suggest that a weakening of IP
rights is generally socially desirable. The virtues of ex-post competition seem to have a
greater weight than the adverse effects on the incentives to innovate. If, for some reasons,
the policy maker wants to reduce the incentive to innovate perhaps because innovators are
over-rewarded then a good way of doing so would be to enhance ex-post competition, for
10

instance by favoring competitors against the original inventors. We contend, however, that the
analysis developed in this section abstracts from a crucial factor, namely, the fact that
innovative activity is often rivalrous in nature. Accounting for this effect may change radically
the policy conclusions, as we shall see in the next section.
Rivalrous innovation
The ratio test developed in the previous section is based on the special case where one firm
serves the role of innovator and the other that of duplicator. In real life, the roles to be
played in the innovation game are open for competition, and firms race to gain technological
leadership. We now argue that the assumption of the previous section underestimates the
adverse effects of weak IP rights.
Look again at Figure 2. Here the profits netted by Firm 2 serve the purpose of
stimulating duplication, and thus, ultimately, a price reduction. They are not directly included
in the Ratio test, since the latter balances profits and deadweight loss from the perspective of
the innovator only. Yet, a closer analysis shows that the profits of the duplicator affect the
incentives to innovate in a deeper way. First, as already recognized, they stimulate
duplication. Secondly, and perhaps more important, they represent the reward to the loser of
the race. As such, they provide an incentive not to invest in the race. This effect has been
neglected so far, and it is the focus of this section.
When the innovation is the outcome of a race, firms will care both about the first prize
and the second prize. The second prize is in fact a consolation prize for the firm that fails to
invent first. As such, it affects incentives to innovate in a negative way: the larger is the
second prize, the less urgent is to discover the new technology. Differently put, while strong
IP rights make the race a winner-take-all contest, weak IP rights provide a reward to all firms.
All contestants win, although the first obtains more than the second.
To see how the division of the total prize affects the incentives to innovate, consider Figures 2
and 3. The total expected profits to the firms are represented by industry profits
1
d
+
2
d
for
the duration of the weak IP right. Incentives to innovate, however, are not proportional to the
sum of the prizes,
1
d
+
2
d
. They crucially depend on the difference between the first and
second prize, which is much higher under exclusive IP rights. The structure of the reward
scheme matters.
11

If the presence of a consolation prize reduces the incentives to innovate, the ratio test
developed in the previous section has to be modified, and the policy implications suitably
qualified. Under what circumstances does the second prize matter? And how can the ratio
test be adjusted so as to account for the consolation prize effect?
In Denicol and Franzoni (2009), we reformulate the ratio test for the patent / trade
secrecy choice. A similar solution can be applied to the mandatory licenses case. From the
point of view of a contestant, it is apparent that the importance of the second prize depends
on whether or not the rival is about to discover soon. If the rival is perceived as far away
from discovery, the contestant does not care about the presence of the second prize. It will
instead concentrate on the first prize and invest to get it earlier. Conversely, if the rival is
about to make the discovery, the contestant may very well settle for the second price and
reduce his own R&D investment.
In a symmetric innovation race, this means that the adverse effect of the consolation
prize is largest when R&D investment is large, and each firm is likely to make the discovery
soon. This is the case where the race is most rivalrous, in the sense that the main aim of
greater R&D investment is to preempt the other contestant. By preempting the rival, a firm is
able to switch from the second to the first prize. Hence, only the difference between the first
and second prize matters, not the aggregate value of the prizes.
20
For the sake of the ratio
test, in this case incentives to innovate are well proxied by the difference between the profit of
the winner and the loser of the race. Thus, the denominator of the ratio test becomes
1
d

(1+) -
2
d
(1-), that is, assuming symmetry,
d
[(1+) - (1-)] = 2
d
. Hence, the amended
ratio test reads as follows: mandatory disclosure is efficient if

:

<

.

When the innovation race is extremely rivalrous, as in the case considered here, the ratio test
is likely not to be passed if is small, as it is likely to be in reality,. For example, with
homogenous goods, linear demand, and Cournot competition, the test is not passed if < ,
that is, if the royalty paid to the innovator disgorges less than half of the duplicators profits.

20
This effect has been labeled competitive threat by the industrial organization literature. See Beath et alt.
(1989).
12


If the innovation race is moderately rivalrous, in the sense that firms invest both for bringing
the date of discovery forward and to preempt the rival who is likely to discover soon, but not
too early the adjusted ratio test depends on a parameter (0,1) that captures the degree
by which the profits to the duplicator delay innovation.
21
In this general set-up, the
denominator of the ratio test becomes
1
d
(1+)
2
d
(1-), that is, under symmetry,
d

[(1+) - (1-)] =
d
[1- + (1+)].

Mandatory disclosure becomes efficient only if

:

[1 + (1 +)]

<

.



If is close to zero, the ratio test is passed only if

(1 )
<

.

This is also a hard to pass condition, especially if is large (that is, if the innovation race is
tight and firms care about preempting the rival).

Overall, since the degree of rivalry of the innovation race depends on the amount of
resources invested by the firms, we can conclude that weak IP rights are not suitable for
highly innovative sectors, where firms make large R&D investments and technological
leadership is subject to intense competition.
Final remarks
Our analysis underscores the importance of timing for the optimal structure of the reward of
innovative effort. One desirable feature of the current patent system is that it rewards only the

21
See Denicol and Franzoni (2009) for the technical details.
13

first inventor: the winner takes all. Laggard contestants, late independent inventors, imitators,
and excluded competitors in principle get nothing.
22
This feature of the patent system makes
the innovation race extremely sharp, yielding very strong incentives to innovate with the least
amount of aggregate reward. Since monopolistic and duopolistic profits come at a cost, they
should be handed out in a parsimonious way, so as to get the highest incentives with the least
social cost. For this reason, weak IP rights which provide a consolation reward to late
comers may not represent an attractive alternative to the current system in industries
where R&D competition is intense. In these industries, using non exclusive rights as a mean
to decrease the reward to the innovator may be dominated by a policy of simply reducing
patent length.

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