State of Innovation

Patents and Innovation Economics

Rent Seeking and Patents

Patents are often analyzed as monopolies or rent seeking.  Patents are clearly not a monopoly.  A monopoly give the exclusive right to sell a product or service.  A patent does not give the holder this right.[1] For more information see The Myth that Patents are Monopoly.

The concept of economic rent is a more useful concept than monopoly for analyzing patent law. In the typical patent case production will either remain the same or increase compared to the pre-patent situation.  As a result of the invention, protected by the patent, the inventor has a cost advantage that allows him to make more money–economic rent–than his competitors.  In that sense there is no restriction of production and hence no monopoly.[2]

Economic rent is defined in Wikipedia as “excess returns” above “normal levels” and they are associated with a lack of competition in markets.[3] What is meant by “normal levels” of return?   Is it the same return that a person could make by putting their money in the bank?  Or is the same return a person could make by investing in the stock market?  Or is the same return that a person could make by investing in non-inventive manufacturing or service business?  The concept of “excess returns” suffers from the same flaws as all socialist concepts of fairness – who decides?  The concept of “excess returns” only makes any sense statistically.  We are not talking about the returns from a specific patented invention, but the average return from inventing versus other economic investments.  In addition, it only makes sense to compare the return on patented inventions to investments in private manufacturing or private service businesses.  Let’s assume that the people who suggest that patents are rent seeking mean, patent holders are on average (statistically) receiving a higher return (excess return) compared to other similar private investments.  For simplicity I will assume a private manufacturing business.  Based on these assumptions, would the fact that investors in patent inventions (hereinafter inventors) receive a higher return than other manufacturing business be bad for the economy or bad for consumers?  Let’s be clear that most commentators who state that patent holders are rent seekers, believe this would be damning evidence against patents.

There are several possible scenarios that meet the assumptions above: 1) inventors receive normal returns on manufacturing their invention, 2) inventors receive normal returns both on their manufacturing costs and their cost of inventing, 3) inventors receive normal returns both on their manufacturing costs and the risk adjusted costs of inventing and marketing a new invention, and 4) inventors receive excess returns both on their manufacturing costs and the risk adjusted costs of inventing and marketing a new invention.

My post Invention – A Financial Analysis , created the following mathematical model for the cost of inventing.

Ci(n) = (Inv + Mi)/P + NRE + PC*n + OH*n   (New Product based on invention)

Cmt(n) = NRE + PC*n + OH*n  (Me-too product)

Where Ci is the cost of creating a product for the owner of the invention, Inv is the cost of creating the invention, P is probability of that the invention will succeed in the market, Mi is the incremental marketing and sales cost of introducing a new invention, n is the number of products that have been produced, NRE is the nonrecurring engineering cost of setting up production, PC is the production cost of the making n products and OH is the cost of overhead for producing n products, Cmt is the cost of creating a me-too product. I will use this mathematical model to analyze the four scenarios discussed above.

Scenario 1 – Inventors Receive Normal Returns On Manufacturing Their Invention

In the above equation this means that the inventor can receive no compensation for cost of invention (Inv), the cost of marketing a new invention (Mi), or for the probability of success (P).  This means that the inventor will never be able to justify the cost of inventing (Inv, Mi, p), since it is a sunk cost that will always cause the inventor’s return to be less than they would receive by investing in other manufacturing businesses.  Why undertake the cost, risk, and hassle of inventing when you can obtain better returns by investing in any random manufacturing industry.  If this is patent critics’ idea of rent seeking, then they will essentially kill off all but accidental inventing and inventions that can be kept a trade secret.  It will also kill off all venture capital.

Scenario 2 – Inventors Receive Normal Returns on Both Their Manufacturing Costs And Their Cost Of Inventing

In this scenario inventors are allowed to receive normal returns on their inventing costs (Inv) and their manufacturing costs (NRE, PC, OH).  However, this does not compensate them for costs of marketing the invention (Mi) or their probability of success (P).  While this makes inventing slightly more favorable, it still does not justify investing in inventing instead of any random manufacturing industry.  If this is patent critics’ idea of rent seeking, then they will essentially kill off all but accidental inventing and inventions that can be kept a trade secret.  It will also kill off all venture capital.

Scenario 3 – Inventors Receive Normal Returns Both On Their Manufacturing Costs And The Risk Adjusted Costs Of Inventing And Marketing A New Invention

Now this scenario sounds fair.  Inventors (statistically) are compensated for all their true costs and risks.  Inventors are in exactly the same position as investors in any other (manufacturing) business.  In addition, inventors have the random chance of hitting the jackpot.  This supposedly fair mined solution to the problem of rent seeking by patent holders ignores the return received by the beneficiaries of the invention (hereinafter society).  Is this a fair solution if society receives an “excess return” when they buy (use) the invention?  Let’s look at a real world example to illustrate this point.  Because of the cotton gin, US cotton exports change from less than 500,000 pounds in 1793 to 93 million pounds by 1810.[4] A single cotton gin could generate up to 55 pounds[5] of cleaned cotton daily a 25 fold improvement over previous methods.[6] So Eli Whitney would receive a 10% or so return on his invention, while society (cotton farmers – owners of the cotton gin) would receive a 2500% return.  Why is it fair for Eli Whitney to receive a “normal return” of say 10% on his efforts while the purchasers of his cotton gin receive a 2500% return on their investment?  Who is the real rent seeker in this situation?

Is the Eli Whitney case an outlier case?  Real world purchasers in a B to B situation will only purchase an inventive product if they will receive more than an “normal return.”  If an invention only provides a “normal return” to the purchaser, then they will have a wide variety of known devices that will provide them average return.  There is no reason to select an inventive product that is going to require the purchaser to learn a new product and possibly alter their existing processes when they can get the same return from existing choices.  Similarly, no rational investor is going to invest in an invention if they can obtain the same return by investing in a number of other known projects.  This shows that in the real world both the inventor and the purchaser have to receive excess returns for an invention to be successful.

We know that neither the inventor nor the purchaser of the invention is expecting a normal return.  An invention will only be successful if both the buyers and the inventor receive an above normal return on their investment.  The inventor and the buyer are both rent seeking according to standard economic theory, which shows that the concept of “rent seeking” is seriously flawed.  I propose that real rent seeking is when one party to a transaction obtains above normal returns and while the other party obtains below normal returns.

It is clear that the real rent seekers are not patent holders but a society that wants to obtain the benefits of new technologies without paying the creators of these new technologies.

Scenario 4 – Inventors Receive Excess Returns Both on Their Manufacturing Costs and the Risk Adjusted Costs of Inventing and Marketing a New Invention

This is the only scenario under which inventing can be encouraged.  As explained above, both the inventor and the purchasers must receive above normal returns in order for the invention to successful in a free market economy.   This is the very definition of how economic progress occurs.  Economic progress (real increases in per capita GDP or per capita income) only occur because of increases in our level of technology.  Our patent system has to provide excess returns above normal levels for inventors if we want our economy and standard of living to increase.


[1] 35 USC 154 [2] Dam, Kenneth W., THE ECONOMIC UNDERPINNINGS OF PATENT LAW, JOHN M. OLIN LAW & ECONOMICS WORKING PAPER NO. 19 (2D SERIES), http://www.law.uchicago.edu/files/files/19.Dam_.Patent.pdf, p.4. [3] Wikipedia, Opportunity Costs, http://en.wikipedia.org/wiki/Opportunity_cost, 8/24/10. [4] Wikipedia, Eli Whitney, Jr., http://en.wikipedia.org/wiki/Eli_Whitney,_Jr., 8/24/10. [5] Wikipedia, Eli Whitney, Jr., http://en.wikipedia.org/wiki/Eli_Whitney,_Jr., 8/24/10. [6] Gordon, John Steele, An Empire of Wealth: The Epic History of American Economic Power, Harper Perennial, New York, 2004, p. 84.

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August 26, 2010 - Posted by | -Economics, Innovation, Patents | , , , ,

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