Research Handbook on the Economics of Intellectual Property Law: Vol 1: Theory and Vol 2: Analytical Methods 9781789903997, 1789903998

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Research Handbook on the Economics of Intellectual Property Law: Vol 1: Theory and Vol 2: Analytical Methods
 9781789903997, 1789903998

Table of contents :
Front Matter
Copyright
Contents
List of contributors
Part I: Intellectual Property as Property
1 Intellectual property as property
2 Anticommons, transaction costs, and patent aggregators
3 Governing intellectual property
Part II: IP and Incentives
4 Philosophical foundations of IP law: the law and economics paradigm
5 Intellectual property law and the promotion of welfare
6 Economic models of innovation: stand-alone and cumulative creativity
7 Economic analysis of network effects and intellectual property
8 Intellectual property and competition
9 Intellectual property and the economics of product differentiation
10 Price discrimination and intellectual property
11 When are IP rights necessary? Evidence from innovation in IP’s
12 Open innovation and ex ante licensing
13 Prize and reward alternatives to intellectual property
Part III: IP Costs
14 Tailoring intellectual property rights to reduce uniformity cost
15 Intellectual property enforcement costs
16 Economic analysis of intellectual property notice and disclosure
Part IV: IP and Institutions
17 Patent institutions: shifting interactions between legal actors
18 The economics of collective management
19 ‘The common law’ in the law and economics of intellectual property
20 In the shadow of the law: the role of custom in intellectual property
21 Infrastructure theory and IP
Part V: IP, Development, and International Trade
22 Creative development: copyright and emerging creative industries
23 Intellectual property and economic development: a guide for scholarly and policy research
24 Economic development and intellectual property rights: key analytical results from economics
Index
RESEARCH HANDBOOK ON THE ECONOMICS OF INTELLECTUAL PROPERTY LAW VOLUME 2
Copyright
Contents
List of contributors
Part I: Empirical Methods
1 Data sources on patents, copyrights, trademarks, and other intellectual property
Part II: Empirical Studies Relating to Patents
Section A Metrics
2 Patent citation data in social science research: overview and best practices
3 Patent value
Section B Patent Institutions and Litigation
4 Empirical scholarship on the prosecution process at the USPTO
5 The USPTO’s Patent Trial and Appeal Board
6 The Federal Circuit as an institution
7 Empirical studies of claim construction
8 Empirical studies of the International Trade Commission
9 Technical standards, standards-setting organizations, and intellectual property: a survey of the literature (with an emphasis on empirical approaches)
10 Empirical studies of patent pools
11 Empirical analyses related to university patenting
Part III: Patent Law Doctrines
12 Empirical studies in patentability
13 Patent duration
14 Infringement
15 Presumption of validity
16 Inequitable conduct and patent misuse
17 Remedies
Part IV: Technology-Specific Studies
18 Patent rights and innovation: evidence from the semiconductor industry
19 Patent trolls
20 Patents and innovation in economic history
21 The political economy of intellectual property reforms
Part V: Empirical Studies Relating to Copyright
22 Empirical studies of copyright litigation
23 Empirical studies of copyright registration
24 Copyright and technological change in music, movies, and books
25 Music copyright
26 Experiments in intellectual property
27 The effect of copyright law on access to works
Part VI: Empirical Studies of Trademark Law
28 Empirical studies of trademark law
Part VII: Empirical Methods in Trade Secret Research
29 Empirical methods in trade secret research
Part VIII: Knowledge Commons
30 Knowledge commons
Index

Citation preview

RESEARCH HANDBOOK ON THE ECONOMICS OF INTELLECTUAL PROPERTY LAW

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RESEARCH HANDBOOKS IN LAW AND ECONOMICS Series Editors: Richard A. Posner, Judge, United States Court of Appeals for the Seventh Circuit and Senior Lecturer, University of Chicago Law School, USA and Francesco Parisi, Oppenheimer Wolff and Donnelly Professor of Law, University of Minnesota, USA and Professor of Economics, University of Bologna, Italy Edited by highly distinguished scholars, the landmark reference works in this series offer advanced treatments of specific topics that reflect the state-of-the-art of research in law and economics, while also expanding the law and economics debate. Each volume’s accessible yet sophisticated contributions from top international researchers make it an indispensable resource for students and scholars alike.   Titles in this series include: Research Handbook on the Economics of Property Law Edited by Kenneth Ayotte and Henry E. Smith Research Handbook on the Economics of Family Law Edited by Lloyd R. Cohen and Joshua D. Wright Research Handbook on the Economics of Antitrust Law Edited by Einer R. Elhauge Research Handbook on the Economics of Corporate Law Edited by Brett McDonnell and Claire A. Hill Research Handbook on the Economics of European Union Law Edited by Thomas Eger and Hans-Bernd Schäfer Research Handbook on the Economics of Criminal Law Edited by Alon Harel and Keith N. Hylton Research Handbook on the Economics of Labor and Employment Law Edited by Michael L. Wachter and Cynthia L. Estlund Research Handbook on Austrian Law and Economics Edited by Todd J. Zywicki and Peter J. Boettke Research Handbook on Behavioral Law and Economics Edited by Joshua C. Teitelbaum and Kathryn Zeiler Research Handbook on the Economics of Intellectual Property Law Volume 1: Theory Edited by Ben Depoorter and Peter S. Menell Research Handbook on the Economics of Intellectual Property Law Volume 2: Analytical Methods Edited by Peter S. Menell and David L. Schwartz

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Research Handbook on the Economics of Intellectual Property Law Volume 1: Theory

Edited by

Ben Depoorter University of California, Hastings College of Law, USA and Ghent University, Belgium

Peter S. Menell University of California, Berkeley School of Law, USA

RESEARCH HANDBOOKS IN LAW AND ECONOMICS

Cheltenham, UK • Northampton, MA, USA

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© The Editors and Contributors Severally 2019 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA

A catalogue record for this book is available from the British Library Library of Congress Control Number: 2019945636 This book is available electronically in the Law subject collection DOI 10.4337/9781789903997

ISBN 978 1 84844 536 9 (2 volume set) ISBN 978 1 78990 399 7 (eBook)

06

Typeset by Servis Filmsetting Ltd, Stockport, Cheshire

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Contents List of contributorsvii PART I  INTELLECTUAL PROPERTY AS PROPERTY   1 Intellectual property as property Molly Shaffer Van Houweling

2

  2 Anticommons, transaction costs, and patent aggregators Rebecca S. Eisenberg

27

  3 Governing intellectual property Henry E. Smith

47

PART II  IP AND INCENTIVES   4 Philosophical foundations of IP law: the law and economics paradigm Robert P. Merges

72

  5 Intellectual property law and the promotion of welfare Christopher Buccafusco and Jonathan S. Masur

98

  6 Economic models of innovation: stand-alone and cumulative creativity Peter S. Menell and Suzanne Scotchmer

119

  7 Economic analysis of network effects and intellectual property Peter S. Menell

157

  8 Intellectual property and competition Herbert Hovenkamp

231

  9 Intellectual property and the economics of product differentiation Christopher S. Yoo

262

10 Price discrimination and intellectual property Michael J. Meurer and Ben Depoorter

281

11 When are IP rights necessary? Evidence from innovation in IP’s negative space Kal Raustiala and Christopher Jon Sprigman

309

12 Open innovation and ex ante licensing Michael J. Burstein

330

13 Prize and reward alternatives to intellectual property Michael Abramowicz

350

v

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vi  Research handbook on the economics of IP law volume 1 PART III  IP COSTS 14 Tailoring intellectual property rights to reduce uniformity cost Michael W. Carroll

377

15 Intellectual property enforcement costs Ben Depoorter

407

16 Economic analysis of intellectual property notice and disclosure Peter S. Menell

424

PART IV  IP AND INSTITUTIONS 17 Patent institutions: shifting interactions between legal actors Arti K. Rai

473

18 The economics of collective management Daniel Gervais

489

19 ‘The common law’ in the law and economics of intellectual property Shyamkrishna Balganesh

508

20 In the shadow of the law: the role of custom in intellectual property Jennifer E. Rothman

526

21 Infrastructure theory and IP Brett Frischmann

551

PART V  IP, DEVELOPMENT, AND INTERNATIONAL TRADE 22 Creative development: copyright and emerging creative industries Sean A. Pager

582

23 Intellectual property and economic development: a guide for scholarly and policy research Shubha Ghosh

636

24 Economic development and intellectual property rights: key analytical results from economics Keith E. Maskus

656

Index677

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Contributors Michael Abramowicz, Professor of Law, George Washington University, USA Shyamkrishna Balganesh, Professor of Law, University of Pennsylvania Law School, USA Christopher Buccafusco, Professor of Law and Director of the Intellectual Property and Information Law Program, Cardozo School of Law, Yeshiva University, New York, USA Michael J. Burstein, Professor of Law, Cardozo School of Law, Yeshiva University, New York, USA Michael W. Carroll, Professor of Law and Director of the Program on Information Justice and Intellectual Property, American University Washington College of Law, USA Ben Depoorter, Max Radin Chair and Distinguished Professor of Law, University of California, Hastings College of the Law and Affiliate Scholar, Stanford Law School, Center for Internet and Society, USA; CASLE, Ghent University, Belgium Rebecca S. Eisenberg, Robert and Barbara Luciano Professor of Law, Michigan Law, University of Michigan, USA Brett Frischmann, Charles Widger Endowed University Professor in Law, Business and Economics Charles Widger School of Law, Villanova University, Villanova, Philadelphia, USA Daniel Gervais, Milton R. Underwood Chair in Law and Director of the Vanderbilt Intellectual Property Program, Vanderbilt University Law School, USA Shubha Ghosh, Crandall Melvin Professor of Law and Director, Syracuse Intellectual Property Law Institute (SIPLI) and IP & Tech Commercialization Curricular Law Program, Syracuse University College of Law, USA Herbert Hovenkamp, James G. Dinan University Professor, Penn Law and the Wharton School, University of Pennsylvania, USA Keith E. Maskus, Arts and Sciences Professor of Distinction, Economics Department, University of Colorado, Boulder, USA Jonathan S. Masur, John P. Wilson Professor of Law and David and Celia Hilliard Research Scholar at the University of Chicago Law School, USA Peter S. Menell, Koret Professor of Law and Director of the Berkeley Center for Law and Technology, Berkeley School of Law, University of California, USA Robert P. Merges, Wilson Sonsini Goodrich and Rosati Professor of Law and Director of the Berkeley Center for Law and Technology, University of California, Berkeley, USA Michael J. Meurer, Abraham and Lillian Benton Scholar and Professor of Law, Boston University School of Law, USA vii

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viii  Research handbook on the economics of IP law volume 1 Sean A. Pager, Professor of Law and Associate Director of the Intellectual Property, Information and Communications Law Program, Michigan State University College of Law, USA Arti K. Rai, Elvin R. Latty Professor of Law, Duke Law School, Faculty Director of the Duke Law Center for Innovation Policy, and Duke Innovation and Entrepreneurship Initiative Research Fellow, USA Kal Raustiala, Professor and Director of the UCLA Ronald W. Burkle Center for International Relations, UCLA Law School, USA Jennifer E. Rothman, Professor of Law and Joseph Scott Fellow, Loyola Law School, Loyola Marymount University, Los Angeles, USA Suzanne Scotchmer, formerly Professor of Economics, Public Policy, and Law, University of California, Berkeley, USA, who died in 2014 Henry E. Smith, Fessenden Professor of Law and Director of the Project on the Foundations of Private Law, Harvard Law School, USA Christopher Jon Sprigman, Professor, New York University School of Law and Co-Director of the Engelberg Center on Innovation Law and Policy, USA Molly Shaffer Van Houweling, Harold C. Hohbach Distinguished Professor of Patent Law and Intellectual Property, Director of the Berkeley Center for Law and Technology, and Associate Dean for J.D. Curriculum and Teaching, University of California, Berkeley, USA Christopher S. Yoo, John H. Chestnut Professor of Law, Communication, and Computer and Information Science, University of Pennsylvania, USA

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PART I INTELLECTUAL PROPERTY AS PROPERTY

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1.  Intellectual property as property Molly Shaffer Van Houweling* 1

Contents I. Introduction II. ‘Property’ and IP III. Distinguishing Tangible and Intellectual Resources as Objects of Property A. Rivalry B. Excludability C. Costs IV. Three Cross-Cutting Themes A. Property and Possession 1. Possession, property origins, and the public domain 2. The challenges of non-possessory property B. Property and Information C. Property and Time V. Conclusion References

I. INTRODUCTION First-year law students learn early on that lawyers think of property not ‘as a relationship between a person (the owner) and a thing (that is owned)’ but rather as ‘relationships among people with respect to things’ (Dukeminier et al., 2014, p. 51, n. 33). This corrective appears perhaps to reorient legal thinking away from a layperson’s preoccupation with things and toward a more sophisticated focus on people and their legal relations (see Grey, 1980, for an extreme example of this view). But, in fact, what makes property law distinctive—in both its lay and expert formulations—is that the human relationships it governs (unlike the human relationships governed by the law of torts or contracts) are always mediated by things (see Smith, 2012). That these things carry legal implications with them

*  Harold C. Hohbach Distinguished Professor of Patent Law and Intellectual Property; Associate Dean, J.D. Curriculum and Teaching, University of California, Berkeley. Thanks to James Hicks for excellent research assistance. This chapter is licensed under the terms of the Creative Commons Attribution-NonCommercial 4.0 International (CC BY-NC 4.0) license, with attribution to Molly Shaffer Van Houweling as the author and to the original publication venue: Peter S. Menell and Ben Depoorter, eds. 2019. Research Handbook on the Economics of Intellectual Property Law. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. The terms of the CC BY-NC 4.0 license are available at https://creativecommons.org/licenses/by-nc/4.0/ (last accessed March 19, 2019).

2

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Intellectual property as property  3 yields the notion that property is in rem, not in personam. That these legal implications can affect anyone who encounters the thing means that they are good against the world. The things to which property rights attach are the locus of their owners’ rights to exclude. The alert law student will also note that the specific nature of a thing governed by property law can have consequences for the design of that law. The rules of acquisition by capture might sensibly differ depending on whether the thing at issue is a fox or a whale. The strength of the right to exclude might differ depending on whether the thing from which outsiders are excluded is a home or a shopping mall. The differences can be even more dramatic when the ‘thing’ at issue is not a tangible object at all, but rather an intangible work of authorship or invention. This chapter will explore how important aspects of property jurisprudence apply to the fields of law that have come to be known as ‘intellectual property’ or ‘IP’—focusing primarily on copyright and patent law.1 I aim to illustrate both the relevance of enduring property themes to these areas of law and the ways in which the nature of the intangible things governed by IP should force us to resist easy analogies to tangible property. I start by tackling the contentious question of whether IP should be considered property at all, in light of key differences between tangible resources and intellectual works. Finding the property frame a useful one despite these differences, I proceed by exploring three themes that have been important to the legal and economic analysis of tangible property, and that can usefully be brought to bear on IP: the role of possession in establishing and signaling property rights; the problem of information costs related to property rights; and, finally, the relationship between property rights and time. In each of these cases, careful attention to concepts that inform the design of sensible tangible property rules can help to inform scholarship and policymaking about IP rules as well.

II.  ‘PROPERTY’ AND IP The US Constitution authorizes Congress to ‘promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries’ (U.S. Const. art. I, § 8, cl. 8). This constitutional authorization for our federal copyright and patent laws is often referred to as the ‘Intellectual Property Clause’ (Walterscheild, 1994).2 Indeed, the term ‘intellectual property’ is now ubiquitous in discussions about patent, copyright, and related fields of law. But the term is controversial.3 Advocates of strong rights for authors and inventors often characterize copyrights and patents as property rights. They tend to use that characterization to argue that these rights should be stronger and more vigorously enforced (e.g. Epstein, 2010; Epstein, 2005; Mossoff, 2005; Easterbrook, 1990). Others reject the property characterization, emphasizing that 1   This chapter builds upon and incorporates some of my earlier work at the intersection of tangible and intangible property (Van Houweling, 2002, 2007, 2008, 2010, 2011, 2012a, 2012b, 2013, 2016a, 2016b, 2017). 2   On the history of the term ‘intellectual property,’ see Lemley (2005) and Hughes (2012). 3   For discussion of commentary critiquing and embracing the idea of IP as property, see generally Liivak and Peñalver (2013).

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4  Research handbook on the economics of IP law volume 1 copyrights and patents are, and should be, more limited than the rights of owners of tangible objects; and resisting the expansion of property-based arguments beyond copyright and patent to trademark and trade secret law (e.g. Lemley, 2005; Lemley, 1999; Lunney, 1999; Samuelson, 1989). Advocates and scholars in this group worry about the rhetorical force of property-based arguments, sensing that they tend to prompt facile thinking about absolute dominion (e.g. Lemley, 1997; Bessen and Meurer, 2008; Vaidhyanathan, 2001). A third group embraces the property paradigm but emphasizes that property rights are always contingent, contextual, and shaped by policy concerns about market failure and distributive justice. A nuanced view of property, according to these scholars, can enhance rather than distort conversations about rights in intangible things (e.g. Carrier, 2004; Chander, 2003; Cohen, 2014; Ghosh, 2007; Liivak and Peñalver, 2013; Menell, 2007b, 2011; Merges, 2011; Oliar and Stern, 2019). Scholars of tangible property have entered this conversation as well. They tend, like the third group of IP scholars, to offer a view of property that does not get carried away with notions of absolute dominion. Interestingly, some of them look to IP as a model from which tangible property law can borrow mechanisms for limiting property rights in tangible things (e.g. Dagan, 2012; Depoorter, 2011; Singer, 2014a; Singer, 2014b). My own view, from the perspective of a scholar working at the intersection of tangible and intangible property, is that the law of tangible property can be an important source of insights about both the benefits and costs of granting people rights to control the use of valuable resources, and about the various ways those rights and corresponding remedies can be structured (see Van Houweling 2002, 2007, 2008, 2010, 2011, 2012a, 2012b, 2013, 2016a, 2016b, 2017). This chapter highlights some of the many insights from tangible property law and doctrine that can helpfully be applied in the field that has come to be known as intellectual property. This application should of course be done with care. To properly apply lessons from tangible property law to IP requires assiduous attention to the special characteristics of the things—intangible creations and inventions—to which this body of property law applies, and to the specific environments in which IP rights are exercised.

III. DISTINGUISHING TANGIBLE AND INTELLECTUAL RESOURCES AS OBJECTS OF PROPERTY The most widely accepted rationale for property rights is that they promote efficient use of, and investment in, resources by internalizing the costs and benefits of that use and investment (Demsetz, 1967). This is a corollary of the tragedy of the commons, the notion that in the absence of property rights everyone with access to a resource will use it without regard to the full costs of that use while failing to make investments that would benefit other users (Hardin, 1968). This logic is most compelling when applied to resources that are scarce (thus making overuse problematic), that are difficult to produce and/or maintain (thus making underinvestment likely), and for which self-help cannot easily be deployed to avoid overuse and undercultivation (thus justifying the costs of establishing and enforcing property rights). On each of these dimensions, there are relevant differences between tangible resources and intellectual creations that should be kept firmly in mind when using a tangible property frame to guide understanding of IP.

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Intellectual property as property  5 A. Rivalry Start with scarcity and the specter of overuse. Tangible resources are generally rivalrous: if fully consumed by one person, they cannot be consumed by another. Their stocks are therefore subject to depletion if consumption is left unchecked. Intellectual resources, by contrast, tend to be nonrivalrous (see, e.g., Boyle, 2003). That is, their consumption by one person does not interfere with their consumption by others; it does not contribute to scarcity. This distinction leads many commentators to argue that IP rights are on shakier normative ground than tangible property rights, because they cannot be justified by the overuse aspect of the tragedy of the commons (e.g. Breyer, 1970; Carrier, 2004; Ghosh, 2007; Lemley, 2005; Menell, 2007a, 2011; Rose, 2003; Sterk, 1996) and because, as Henry Smith observes, ‘excluding others from information when they could use it at zero marginal cost seems wasteful’ (Smith, 2009b, p. 2084). This distinction and its normative implications should not be overstated, however (as noted by Nachbar, 2007). On the one hand, some intellectual resources can become less valuable when overused. Trademarks cannot achieve their function of reducing consumer confusion if they are used indiscriminately on different products from different producers. So too, the value of a celebrity endorsement could be undermined by indiscriminate association with many goods. These are intangible objects of IP protection the value of which could be diminished by overuse (see Landes and Posner 2003, pp. 485–7). Looking to the other side of the comparison, tangible resources are not always rivalrous as a practical matter. They can often be enjoyed simultaneously by multiple users who neither interfere with each other nor diminish the availability of the resource for future users (see Rose, 1986). Across resource types, nonrivalry undermines the logic of the tragedy of overuse. In the tangible realm as well as the intellectual realm, commons can produce comedy (to use Carol Rose’s (1986) term) instead of tragedy. As I will explain below, this helps to explain doctrinal rules that promote the growth of the unowned public domain. B. Excludability Property rights are often lauded as promoting investment in resources: they help investors secure rewards on their investments by excluding others from the benefits of those investments. It is often especially difficult for investors in intangible works to exclude other people. This characteristic is referred to as non-excludability, and is often offered as an especially powerful justification for IP. Note, however, that the starkness of the term non-excludability can be misleading (as noted by Parchomovsky and Siegelman, 2002). It is not as difficult to exclude people from enjoying the benefits of a work of creativity or invention as it is to exclude people from enjoying the benefits of a lighthouse, the classic nonexcludable public good. The author of a book could keep the book in her reading room, for example, to be read only by the people to whom she grants permission to enter.4 This rather ungainly type of

4   It was common during the Middle Ages for monasteries to charge fees for permission to copy manuscripts in their collections. Once a manuscript was copied, its owner lost control of

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6  Research handbook on the economics of IP law volume 1 exclusion has its drawbacks, of course. It limits the author’s ability to realize a return on her investment to the meager returns from her reading room invitees; and it limits the number of readers who can benefit from her work. The heart of the problem is not so much that intellectual works are nonexcludable. It is that exclusion is difficult to combine with wide dissemination, and therefore with extracting the full benefits of intellectual investments for both the author and the public (see generally Arrow, 1962). On the other side of the comparison, the classic lighthouse example reveals that the benefits of investing in tangible resources can also be nonexcludable. Both tangible and intellectual resources can present a public goods problem in which we worry that the market will not provide sufficient incentives to invest in a resource. In both cases, granting private property rights is a possible solution to the problem, albeit an imperfect one that entails its own costs and should be considered in light of alternatives (see generally Kapczynski, 2012). C. Costs There are also several distinctions between tangible and intellectual resources that are relevant to the costs of establishing and maintaining a property system (see generally Menell, 2011). One is the relative difficulty of delineating the boundaries that are important to the healthy functioning of a legal system premised on the right to exclude. Intellectual creations are notoriously difficult to define in ways that give clear notice that can help promote transactions and avoid inadvertent trespasses (Smith, 2009b). On this front, rights that attach to intellectual resources are similar to non-possessory rights that attach to tangible resources—think of servitudes and future interests. These rights can be similarly difficult to notice and comprehend in that they do not correspond to possession of a physical parcel or tangible object but rather interfere with the rights of people in possession (Van Houweling, 2008). The costs of property rights also include the distributive injustices perpetrated by the allocation of resources based on ability to pay (see generally, e.g., Ghosh, 2007; Van Houweling, 2005; Chander, 2003). Of course, neither property rights in tangible nor intellectual resources necessarily require or produce market-based allocation of those resources, at least as an initial matter. But free alienability is one hallmark of private property (albeit subject to important exceptions as noted by, e.g., Calabresi and Melamed (1972), Fennell (2009), and Radin (1987)). Thus property tends overwhelmingly to be distributed via the price mechanism. Here, tangible and intellectual property share the potential for tragic consequences when the market denies basic necessities to those unable to pay. But the tragedy is especially pronounced for nonrivalrous resources that could be distributed to everyone at little or no marginal cost (Kapczynski, 2012). Both tangible and intellectual property rights affect the distribution of physical resources, some of which are embedded with intellectual content (e.g. patented tools and medicine, books). IP rights are noteworthy in their potential to affect the distribution

the text embodied in it (Rose, 1995). This proto-copyright was valuable, however, in an age before mechanical reproduction, when an owner could charge a premium based on the superior quality of his manuscript compared to error-ridden copies (Van Houweling, 2010).

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Intellectual property as property  7 of inventive and creative opportunities as well, insofar as IP rights can limit cumulative invention and creativity by those who do not acquire permission to build upon what has come before. Once again, the distinction can be overstated. In the tangible realm, too, distribution of resources can dramatically impact opportunities for creativity, invention, and all other aspects of self-realization.

IV.  THREE CROSS-CUTTING THEMES Despite their differences, tangible and intellectual resources are both managed—in part—by legal institutions that can usefully be characterized as property regimes. The characteristics that make these regimes property—in rem rights that are good against the world and allow their owners to exclude others from valuable resources—pose some recurring questions and challenges that cut across the resource realms in which they operate. I proceed by exploring these questions and challenges as embedded in three themes: the role of possession in establishing and signaling property rights; the problem of information costs related to property rights; and, finally, the relationship between property rights and time. These themes have long been important to the legal and economic analysis of property law. All can usefully be brought to bear on IP as well, with the distinctions above kept carefully in mind. A.  Property and Possession 1.  Possession, property origins, and the public domain Possession operates as both a source and a signal of property rights in land and physical objects. The importance of possession has been traced back at least to Roman law and across legal traditions around the world (Fraley, 2011; Lueck, 1995); it has been explained as psychologically embedded (Barros, 2011; Friedman and Neary, 2009; Merrill and Smith, 2007) and even the product of evolution (Stake, 2004). Ambiguity about the meaning of possession is likely as old and widespread (Drassinower, 2006; Rose, 1985; Smith, 2003). Theorists have cited a number of different rationales in an effort to help explain the importance and meaning of possession as applied to particular property controversies.5 Some of these rationales are particularly helpful for understanding and perhaps improving the mechanisms by which authors and inventors seize ‘possession’ of the intangible subject matter of IP. One rationale for possession as an origin of property rights is that acquiring possession typically requires labor, which is both a moral justification for property rights from a Lockean labor-desert perspective and also worth incentivizing in order to promote the productive use of resources from a utilitarian perspective. A difficulty that often arises 5   The classic case of Pierson v. Post, 3 Cai. 175 (N.Y. 1805) is the most typical case study. The competing views offered by the majority, dissent, and innumerable commentators deploy arguments emphasizing labor, investment, notice, custom, and more, in an effort to explain what constitutes possession adequate to establish initial property rights in a wild fox (see, e.g., Rose, 1985; Epstein, 1979).

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8  Research handbook on the economics of IP law volume 1 in the tangible property context is that multiple people can claim that they labored in a deserving and socially productive way to reduce something to possession, but the rule of first possession aims to declare only one of them the winner. As Richard Epstein notes, ‘[s]ome labor goes unrequited when two pursue and one loses’ (1979, p. 1225). And yet, a rule that does its best to decide between two competing pursuers can be justified in the tangible property context by the benefits of individual ownership, and by the difficulty of fairly dividing the fruits of a joint pursuit. In his qualified defense of the first possession rule, Epstein contrasts the rule with what he sees as the only alternative, original common ownership coupled with a system of public control to ‘decide how the rights in question are to be packaged and divided amongst individuals’ (1979, p. 1239). In light of the challenges of establishing such a system and the potential for its abuse, Epstein argues that ‘[o]n balance the case tilts strongly for the first possession theories, whatever their infirmities’ (1979, p. 1238). How do these insights translate to IP? Here too, rules that award ownership on the basis of original acquisition would appear to reward and incentivize socially beneficial activity. But in the IP context there are special difficulties with identifying the ‘things’ subject to original acquisition and the acts that amount to possession. The intangible subject matter of copyright and patent protection is quite different from the parcels of land and wild animals that provide classic examples of the first possession rule in action. And yet there are clear analogs to first possession for purposes of acquiring rights in intellectual creations.6 Consider two examples: an original musical melody and a newfangled (i.e., novel and nonobvious) mousetrap. These are the types of creative and inventive works that copyright and patent law should incentivize. They required mental labor and were perhaps the result of costly failed experiments. At what point are these intangible creations ‘possessed’ in a way that should trigger a rule based on first possession? Arguably the mental labor that we want to reward and incentivize has already been expended by the time the author and inventor have captured the melody and mousetrap in their brains. But these are not the rules of first possession that IP law has adopted. In order to qualify for protection, the melody would have to be fixed in a tangible medium of expression (e.g. the notes written down or captured in a sound recording) (17 U.S.C. § 102). The mousetrap would have to be either actually or constructively ‘reduced to practice’ (e.g. Ariad Pharmaceuticals, Inc. v. Eli Lilly & Co., 598 F.3d 1336, 1352 (2010)). In some ways, these IP requirements are fully consistent with the rules and rationales of first possession that emerge from the tangible property context. These rules arguably require the type of possession that makes a resource available for a socially beneficial purpose. Merely giving chase to a fox—as laborious as that may be—does not result in ownership if the fox is still alive and hunting chickens. Similarly, a melody or mousetrap that exists merely in one individual’s head does not yet benefit society. In theory, copyright and patent both withhold their rewards until the intangible work is at least capable of being communicated to and used by other people. Where in practice they do not—for example, where patents are awarded based on constructive reduction to practice that does

6   On the connection between possession and intellectual property, see, e.g., Yen (1990); Drassinower (2006); Holbrook (2009, 2006, 2016); Oliar and Stern (2019); Smith (2007).

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Intellectual property as property  9 not in fact establish that the invention works—they are subject to critique (e.g. Lemley, 2016) that very much echoes arguments regarding the proper definition of possession of tangible property. In patent, something else is required in addition to reduction to practice. To establish patent rights, an inventor must file a timely patent application that discloses how to practice her invention (35 U.S.C. § 112). Patent’s disclosure requirements are consistent with a utilitarian rationale for first possession, under the theory that the public does not receive the full benefit of patentable inventions unless their details are adequately disclosed (Kewanee Oil Co. v. Bicron Corp., 416 U.S. 470 (1974)). By requiring that the inventor describe her invention in sufficient detail to establish that she has in fact captured it in her own mind, disclosure requirements also provide objective evidence that she has in fact done sufficient intellectual labor (not just abstract daydreaming) to merit reward and encouragement (Holbrook, 2006). Note, however, that not just any disclosure will do. Disclosure via a timely patent application is required. By contrast, disclosure via a printed publication, public use, or public sale does not establish patent rights. Just the opposite: these disclosures by the inventor deposit the invention into the public domain unless the inventor-discloser files a patent application within a year (35 U.S.C. § 102(a)–(b)). Does anything within the theory of first possession justify denying property rights to an inventor who has captured his invention by reducing it to practice and delivered its benefits to the public by disclosing it? Without more, the theory of possession as labor and productive use does not seem adequate to the task. Indeed, this IP example appears to confirm Epstein’s observation about the inadequacy of such theories: just as the unsuccessful chaser expended reward-worthy labor but was denied the fox, the patent-barred inventor expends reward-worthy ingenuity but is denied his IP. Both the tangible and IP examples suggest that the type of possession that triggers property rights must involve more than productive labor, which suggests that another rationale is at work. One candidate is notice: possession can provide clear notice of an owner’s claim. This idea is central to Carol Rose’s persuasive explanation in Possession as the Origin of Property, in which she observes that: [p]ossession as the basis of property ownership . . . seems to amount to something like yelling loudly enough to all who may be interested. The first to say, ‘This is mine,’ in a way that the public understands, gets the prize, and the law will help him keep it against someone else who says, ‘No, it is mine.’ (1985, p. 81)

For patentable inventions, merely disclosing an invention to the public via a public use, sale, or printed publication provides some notice—that is, notice regarding the nature of the invention and the inventor’s intellectual possession of it. As Holbrook (2006) notes: [D]emonstrating the possession of an intangible idea is difficult. One could describe an idea but not necessarily truly be in possession of it. For example, the idea of teleportation has existed in science fiction, such as in Star Trek, for some time. Simply having the idea of teleportation, however, does not mean that those authors are in possession of a teleportation device. Instead, the key aspect of possession is whether or not the author can actually make a functioning device. Thus, the best evidence of possession would be either the inventor physically creating the invention or, at least, providing a description that is clear enough to enable someone else to build it (2006, p. 146–7).

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10  Research handbook on the economics of IP law volume 1 Unless that description comes in the form of a patent application, however, it is insufficient to establish property rights in the invention. Why must an invention hunter, unlike a fox hunter, both demonstrate that she has grasped her prey and submit a bunch of paperwork to establish her claim to it?7 Here is an instance in which the distinct nature of the thing that is the subject matter of property has important consequences. Because of the nonrivalrous nature of an invention, the inventor’s possession of it does not prevent others from encountering it ‘in the wild.’ Another inventor might conceive of the same mousetrap idea; or he might encounter one of many coexisting physical embodiments of the invention. In either case, he may not recognize that the invention is the subject of patent rights unless there is some indication—either on the embodiment itself or in a centralized registry—that it has been claimed. For physical objects possession alone may be enough to communicate the signal that ‘this is mine!’ For intangible inventions that can be possessed by many people at the same time, something else is required. This is not to say that the functional equivalents of possession that we observe in the IP context—including both requirements that the IP owner has captured her intangible creation in a concrete way and has signaled her claim to others—are sufficient to serve possession’s purposes. The failure of patents to provide adequate notice to rival inventors is a notorious shortcoming of the contemporary patent system (see, e.g., Bessen and Meurer, 2008; Fromer, 2009; Long, 2004; Menell and Meurer, 2013). As for copyrights, the requirement that claims to works of authorship be communicated to the public via a centralized registry or marked embodiments has been abandoned (see, e.g., Ginsburg, 2010; Litman, 2016; Sprigman, 2004). Now fixation of an original work of authorship is all that is required, and works are eligible for the longest possible duration with no renewal paperwork (Samuelson, 2016). Even where the existence and ownership of a copyright is clear, its boundaries are subject to the vagaries of the idea/expression dichotomy, fair use, and other aspects of copyright scope and defenses (Fromer, 2009; Liu, 2016; Long, 2004; Menell, 2016). Works of authorship are even easier to claim than foxes, but copyright claims are much more difficult to observe. Many critics of contemporary copyright law lament this development and advocate for policy changes that would require (or at least more strongly incentivize) copyright notice and registration (e.g., Gibson, 2005; Landes and Posner, 2003; Samuelson et al., 2010; Samuelson, 2016; Sprigman, 2004). These calls are consistent with the notice-based rationales that property theorists have offered for possession as a trigger for tangible property rights; they also recognize that the unique characteristics of intangible property might require different mechanisms of notice provision. For the sake of argument, assume that these critics are right to argue that copyright (like patent) should require some form of ‘claiming’ that provides notice to the public in a way roughly equivalent to physical possession of tangible objects.8 What should the consequences of a failure to claim property be? In tangible property, the consequences 7   Note that paperwork is not irrelevant in the tangible property context, as Rose (1985) notes in her discussion of possession as notice. But recording of possession-based claims to tangible property is not generally required to establish them in the first instance, as discussed in Van Houweling (2013). 8   On the different claiming requirements of patent and copyright law, see generally Fromer (2009); Oliar and Stern (2019).

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Intellectual property as property  11 are typically that a rival claimant has an opportunity to become a property owner. Post failed to capture the fox, but the ‘saucy intruder’ Pierson succeeded.9 By contrast, in the copyright and patent contexts the analogs to first possession are not merely questions of who was first (or has anyone been first yet)—that is, who was first as between two ‘would-be’ owners, or when is the thing at issue still unpossessed and subject to capture and ownership by someone new? In the IP context, unlike in most tangible property contexts, it is possible for a failed or incomplete attempt at possession to make a work of authorship or invention forever unownable by anyone. Under US patent law, an invention that has been in public use for more than a year cannot thereafter be patented—by the inventor or anyone else (17 U.S.C. § 102). It has permanently entered the public domain. For the first two-plus centuries of US copyright law, a similar situation obtained: works that were published without proper notice entered the public domain and could not thereafter be captured for copyright purposes by their authors or anyone else (Samuelson, 2016; Sprigman, 2004). Can these IP doctrines be squared with first possession theory? Indeed they can, if we are attentive to the special qualities of intangible works. Consider Epstein’s defense of first possession: it relies on the assumption that it is desirable for tangible objects ultimately to be owned by someone. If the identity of that someone were not determined based on who was the first to possess an object, then the government would have to take over and figure out some more heavy-handed way to divvy things up. Why is this divvying necessary? Because of the tragedy of the commons, so the theory goes. Things without owners are unlikely to be carefully husbanded; they are instead likely to be overused. By contrast, once an intellectual work has been created, its nonrivalrous nature means it is not subject to dissipation.10 It therefore makes perfect sense that in the IP context the result of a failure adequately to possess something (and clearly signal that possession in a way that communicates an ownership claim) does not necessarily make that thing subject to ownership by one’s rivals, but might instead deliver it to the public domain. This explanation also helps to make sense of some of those tangible property contexts in which we do find a permanent public domain: they involve resources that are relatively nonrivalrous, where the risk of tragic overuse is low (Rose, 2003, p. 96). Note that not all forms of IP have the feature of falling inexorably into the public domain when inadequately claimed. For example, abandoned trademarks can be reclaimed by new owners who use them in commerce as source identifiers (which is the rights-triggering analog to possession in the trademark context). So too for potential trademarks that were unsuccessfully claimed by merchants who had not used them enough to qualify for protection. In these ways trademarks are treated like nearly captured foxes, where patents and copyrights are not. This too makes sense if we keep in mind key distinctions on the dimension of rivalrousness. Trademarks are unusual within the IP realm in the degree to which they are subject to congestion externalities—that is, they are subject to overuse. Although it is possible for many people to use the same trademark, if they do it is likely to lose its value as a trademark. Trademarks are effectively rivalrous

  See n. 5.   But see Landes and Posner (2003, p. 487), arguing that the value of a creative work might be depleted by overuse.  9 10

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12  Research handbook on the economics of IP law volume 1 resources. Their value can be maintained (and rebuilt) only if they are kept out of the public domain of indiscriminate use. In sum, looking to the role of possession in the law of tangible property helps to explain analogous mechanisms of rights acquisition in the realm of IP, and to diagnose their shortcomings. Perhaps more interesting, it also helps to explain a feature that is especially associated with (some forms of) IP: the permanent public domain. 2.  The challenges of non-possessory property Although possession is a touchstone for the acquisition and signaling of property rights, property and possession do not always go hand in hand. Consider the challenges posed for both tangible and IP regimes when property rights are held by non-possessors.11 These challenges arise in the tangible property context when, for example, the claims of current possessors are challenged by prior possessors—with the results often reflecting the enduring notion of ‘first in time, first in right,’ but sometimes prioritizing recent claims over stale ones (as with adverse possession, marketable title acts, and protection for bona fide purchasers). More striking, perhaps, are controversies over property rights held by people who may never have been in possession, but who nonetheless claim the right to control some aspect of a resource. Land servitudes are a classic example, and the anxiety and doctrinal complexity that has marked the body of law governing them (see French, 1982; Rose, 2011; Van Houweling, 2008) serve to reinforce the importance of possession as a touchstone of property reasoning. To see the relevance of these types of non-possessory property rights to IP, start with a classic passage from Justice Holmes’ 1908 concurrence in White-Smith Music Publishing Company v. Apollo Company, in which he considers that nature of copyright as a property right: The notion of property starts, I suppose, from confirmed possession of a tangible object and consists in the right to exclude others from interference with the more or less free doing with it as one wills. But in copyright property has reached a more abstract expression. The right to exclude is not directed to an object in possession or owned, but is in vacuo, so to speak. It restrains the spontaneity of men where but for it there would be nothing of any kind to hinder their doing as they saw fit. It is a prohibition of conduct remote from the persons or tangibles of the party having the right. It may be infringed a thousand miles from the owner and without his ever becoming aware of the wrong. It is a right which could not be recognized or endured for more than a limited time, and therefore, I may remark in passing, it is one which hardly can be conceived except as a product of statute, as the authorities now agree. (209 U.S. 1, 19 (1908) (Holmes, J., concurring))

In drawing the contrast between copyright and paradigmatic possessory property rights in tangible objects, Justice Holmes here emphasizes the non-possessory, ‘in vacuo’ nature of copyright and the way in which copyright owners can control strangers from afar, unconnected to any object possessed by the copyright owner. Copyright owners are thus unlike owners of possessory fee simple interests in land, whose rights to exclude generally impact the limited universe of people who come into contact with the physical boundaries of the owner’s parcel. 11   This section draws on my previous work on non-possessory property rights (Van Houweling, 2002, 2007, 2008, 2010, 2011, 2012a, 2013).

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Intellectual property as property  13 Justice Holmes alludes to another apparent copyright anomaly: although copyright owners are not necessarily possessors, the people whose spontaneity is restrained by copyright are typically in possession of tangible objects—books, sheet music, or other manifestations of the copyrighted work. As to these tangible objects, copyright operates not as an instrument of freedom from interference for the possessor but rather the opposite: an instrument of constraint operated by strangers (copyright owners) via remote control. Copyright thus strikes Justice Holmes as an odd sort of property right in that instead of liberating people to use their possessions it ‘restrains [their] spontaneity . . . where but for it there would be nothing of any kind to hinder their doing as they saw fit’ (White-Smith Music Publ’g Co. v. Apollo Co., 209 U.S. 1, 19 (1908)). Copyright owners’ power to control how remote strangers use objects in their possession is not as extraordinary as this passage suggests, however. Of course copyright shares this characteristic with patent and trademark. Beyond IP, copyrights are similar in this regard to a whole set of ‘remote control’ property interests that give their owners the right to control use of assets possessed by other people. Servitudes are the most prominent example.12 A servitude (which can take the form of an easement, real covenant, or equitable servitude) is a non-possessory property interest that gives its holder the right to use an asset (typically land) in specified ways, or to object to specified uses of it, or to insist on specified behavior connected to it. The asset is encumbered by the servitude, such that the servitude’s burdens ‘run with’ the asset, ‘pass[ing] automatically to successive owners or occupiers’ (American Law Institute, 2000, § 1.1). Unlike a mere contractual agreement to, say, refrain from operating a gas station in a residential neighborhood, a servitude is enforceable against successors in interest. Therefore, if you grant your neighbor an effective servitude she will be able to enforce the restriction against you and subsequent owners of your land. The benefit of a servitude typically runs to successors as well—from your neighbor to the next owner of her house. As Carol Rose puts it, ‘[t]he greatest overall advantage of servitudes is that they give stability to property arrangements over both time and space’ (Rose, 2011, p. 297). The stability that servitudes produce can be especially valuable for land use planning. Land is, of course, immobile and enduring. It is therefore often important for people who invest in land to be able to predict how surrounding land will be used far into the future, in order to make investments that will coordinate rather than conflict with adjacent activities. In recognition of these benefits, land servitudes and other varieties of remote control property rights have long been enforced by courts. Nonetheless, Justice Holmes’ contention that property rights with such features could only be the product of statute rings somewhat true. Judges have greeted most non-possessory property rights with suspicion and hemmed them in with doctrinal limitations. Servitudes came to be classified into the three major categories of easements, real covenants, and equitable servitudes, with each category subject to convoluted rules limiting formation, subject matter, and enforceability (French, 1982). As I describe in prior work, tracing the evolution of modern servitude law reveals several rationales for this type of hostility and the limiting doctrines that it produced.

12   Other examples include the future interests that accompany various types of defeasible estates. See generally Korngold (1988).

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14  Research handbook on the economics of IP law volume 1 I have organized these rationales into three broad categories: those related to notice and information costs; those related to dead hand control and other aspects of the ‘problem of the future’; and those related to harmful externalities (Van Houweling, 2008).13 Turning to IP, the basic anxiety and confusion associated with non-possessory property rights is perhaps unavoidable (unless we abandon IP for some alternative regime), because the structure of modern IP divorces ownership of physical objects embodying works of authorship and novel inventions from ownership of the corresponding copyrights and patents. This suggests that IP law should be acutely attentive to the problems that I associate with non-possessory property rights. Indeed, IP has developed an entire body of doctrine that attempts to mediate the tension between the rights of IP owners and the rights of owners of physical objects embodying IP. This is known as IP ‘exhaustion,’ and has emerged as one of the most contested areas of IP law in an era in which more and more objects of everyday life are burdened with non-possessory IP rights (see, e.g., Perzanowski and Schultz, 2016; Van Houweling, 2016a, 2016b).14 To better understand exhaustion and other limitations on remote control property rights, I turn in the next section to one of the key categories of concerns I associate with non-possessory property: notice and information costs. B.  Property and Information Information costs include the costs of conveying and comprehending information and also the costs imposed by failures to communicate. The monetary cost of a ‘no trespassing’ sign that effectively communicates the location of a land boundary is one type of property-related information cost, as is the mental energy that a passerby expends to read and understand that sign, and the aggravation that arises from inadvertent trespass after the sign falls down. Information costs overlap with transaction costs, a term typically used more generally (and seldom very precisely) to describe the information costs, negotiation costs, and enforcement costs related to voluntary exchanges.15 There are many ways in which the doctrines of property law have been shaped by concerns about information costs. Indeed, some scholars suggest that one of the most 13   Carol Rose offers a similar but not identical categorization, identifying the concerns as involving information or notice, renegotiability, and value (including third-party effects) (Rose, 2011). 14   The Supreme Court has addressed (and generally reaffirmed the importance of) IP exhaustion repeatedly in recent years. See Impression Products v. Lexmark, Inc., 137 S. Ct. 1523 (2017); Kirtsaeng v. John Wiley & Sons, 568 U.S. 519 (2013); Bowman v. Monsanto, 569 U.S. 278 (2013); Quanta Computer, Inc. v. LG Electronics, Inc., 553 U.S. 617 (2008); see also Omega S.A. v. Costco Wholesale Corp., 541 F.3d 982 (9th Cir. 2008), aff’d by an evenly divided Court, Costco Wholesale Corp. v. Omega S.A., 562 U.S. 40 (2010). 15   This characterization is an extreme simplification of the variety of ways in which the term ‘transaction costs’ has been used, as Lee Anne Fennell documents (2013). It maps—roughly—the categories emphasized by Coase (1960) and around which incomplete definitional consensus has formed. As Fennell observes, ‘[t]here is broad agreement that the costs people incur to get together, communicate with each other, and draw up and police contracts represent transaction costs. But the status of some other elements is contested’ (2013, p. 1484). Ellickson characterizes transaction costs within ‘three somewhat overlapping functional categories: (1) get-together costs, (2) decision and execution costs, and (3) information costs’ (1989, p. 615).

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Intellectual property as property  15 fundamental characteristics of property rights is their potential to impose undesirably high information costs, if not properly designed. From this perspective, property doctrine is and should be structured to mitigate information problems.16 The argument that information costs are of special concern in property law—­ compared, for example, to the law of contracts—is based in large part on the observation that property rights are ‘in rem,’ or ‘good against the world.’ That is, the obligations that arise from property rights (my obligation to avoid driving past a ‘no trespassing’ sign and onto the land beyond, for example) are not based upon any special ­relationship between owners and nonowners. These obligations bind complete strangers who encounter things to which property rights attach, regardless of whether they have agreed to be bound. As Thomas Merrill and Henry Smith, leading proponents of an information-costcentric theory of property, summarize: The in rem nature of such rights means all actors in the relevant community must recognize that they are subject to a duty to abstain from interfering with such rights insofar as they are held by any other member of the community. This generalized duty, in turn, creates an enormous information cost and collective action problem. The rights must be defined in such a way that their attributes can be easily understood by a huge number of persons of diverse experience and intellectual skills. The identity of the persons who hold such rights must be capable of communication by signals that can be immediately grasped and processed by an equally large multitude (2007, p. 1853).

Merrill and Smith use these observations about the in rem nature of property rights to generate a design principle: ‘the rights must be defined in such a way that their attributes can be easily understood’ (2007, p. 1853). Specifically, Merrill and Smith (2000) argue that property rights do and should conform to a limited, standardized set of easy-tounderstand forms—not ‘one size fits all,’ but a small menu that resists customization and idiosyncrasy in order to economize on information costs. Information costs do not always create problems worth solving through adjustments to legal doctrine, however. And even in circumstances in which they might, standardization of easy-to-understand property forms is only one mechanism through which to address those problems. But thinking about the special virtues of standardization and clarity where rights are good against the (vast, heterogenous) world is a good starting point for thinking about the relationship between information costs and rights regimes that govern both tangible and intangible resources. What if the nature of the resource at issue makes it extremely difficult to specify rights to it in a clear, standardized way? Thinking about this dynamic in relation to the nature of the resource helps us to think critically about the design of the law. IP scholars often contrast tangible and intangible property schemes on the basis of how much information is readily available about the identity of property owners and the nature of their rights. Typically, the comparison holds up tangible property—real property in particular—as the model of successful information provision. Physical signs can provide clues that a piece of land is owned by someone (often the person in possession). Customs 16   Note that not all information costs (or transaction costs more generally) constitute problems to be solved (Cooter, 1982, p. 28; Fennell, 2013, p. 1473).

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16  Research handbook on the economics of IP law volume 1 in the relevant neighborhood can shape how those signs are understood.17 Public records indicate exactly who that someone is and reveal details about the physical dimensions of the parcel, how its ownership has changed over time, and whether express encumbrances (liens, servitudes, and so on) complicate ownership.18 These sources of information help to prevent inadvertent trespass by those who wish to avoid invading private land; they facilitate consensual transactions for those who seek permission to use or buy it. IP rights, by contrast, do not so neatly correspond either to physical things in the world or to public records signifying ownership and identifying owners. Anxiety about the inadequacy of information regarding IP rights has increased in recent years due to statutory changes that have made the situation worse (e.g. the elimination of registration and notice as prerequisites for copyright protection) and to technological changes that have raised the stakes and thickened thickets of (often hidden) rights. In copyright, this anxiety is manifest in policy debates about the status of ‘orphan works’ whose owners cannot be identified and located (e.g. Chiang, 2016; Hansen, 2013; Loren, 2012; Urban, 2012; U.S. Copyright Office, 2006; U.S. Copyright Office, 2015). In patent, critics are alarmed when innovators’ investments are jeopardized by allegations that they have infringed unclear and thus difficult-to-avoid patent claims—especially in the realms of software and Internet business methods (Bessen and Meurer, 2008; Long, 2004; Menell and Meurer, 2013). In both the copyright and patent contexts, informational inadequacies can contribute to inadvertent infringement and then to surprising and costly disputes. Or fear of potential infringement—combined with the inability to identify, locate, and negotiate with relevant rights-holders—can chill productive endeavors (see Federal Trade Commission, 2011, p. 3; U.S. Copyright Office, 2006, p. 15). One approach to alleviating the information cost challenges that plague IP would be to try to replicate real property’s formal systems of centralized information provision. Copyright reformers, in particular, have called for statutory changes modeled on the centralized ownership information provided by land recording systems and the titleclearing function performed by marketable title acts (e.g. Lessig, 2010, p. 29). This could be accomplished, some argue, by ‘reformalizing copyright’ (e.g. Sprigman, 2004). The formal, centralized, and sometimes error-prone information mechanisms associated with land titles are not the only models offered by the law of tangible property, however. These structures coexist with other legal mechanisms—including rules about the form of property rights and the remedies triggered by their infringement—that are attentive to information costs concerns. As I have explained elsewhere (Van Houweling, 2013), this common law tradition features a wide variety of doctrinal tools. Even (or perhaps especially) if the formal, centralized informational structures of the land law are never fully replicated for intangible property, this set of tools may prove a valuable source of ideas for addressing contemporary IP challenges. For example, the touch and concern doctrine has traditionally constrained the subject matter of land servitudes in a way that helps to limit the information cost burden imposed by these potentially confusing non-possessory property rights. Like the other

  On custom in property and IP, see, e.g., Smith (2009a) and Rothman (2007, 2012).   For a helpful summary of formal information infrastructures in tangible property (with comparison to copyright), see van Gompel (2011, pp. 244–6). 17 18

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Intellectual property as property  17 ­ roperty-standardizing doctrines discussed by Merrill and Smith (2000), touch and concern p polices just how idiosyncratically the sticks in the bundle of property can be arranged. By limiting permissible servitudes to those that have a connection to the land they burden (and typically to a neighboring benefitted parcel) the doctrine helps to ensure that servitudes will be relatively easy to discover upon physical inspection, and that the owner of the beneficial interest will be relatively easy to identify and locate (Van Houweling, 2016a, 2016b). As I have argued elsewhere (Van Houweling 2008, 2011, 2013, 2016a, 2016b), IP exhaustion similarly helps to limit the information cost burden imposed by non-possessory IP rights. It generally allows owners of objects embodying copyrighted works and patented inventions to transfer those objects and to make normal consumer uses of them, consistent with reasonable expectations about what it means to own objects of personal property (see generally Perzanowski and Schultz, 2015, 2016). The upshot of this comparison is open to debate in light of developments in the law of servitudes, where the trend has been toward liberalization of doctrines like touch and concern in favor of enforcement of even idiosyncratic servitudes. Some observers take this to suggest that IP exhaustion should be similarly liberalized in favor of enforcement of idiosyncratic running restrictions on how IP-burdened objects may be used and transferred (see, e.g., Robinson (2004), but see Van Houweling (2008)). But on this point of comparison we should be careful to keep in mind key differences between tangible property and IP. The doctrinal liberalization in the law of land servitudes has happened in response to the establishment and improvement of recording systems that provide notice of even unusual servitudes. The logic of this doctrinal development might suggest, ironically, quite a different evolution in the law of IP, where digital age developments appear thus far to have exacerbated rather than alleviated information cost problems. In sum, the nature of property rights poses a recurring set of information cost challenges that are relevant to both tangible property and IP. Although difficult-to-define works of creativity and invention come with special information cost burdens, longstanding doctrines within tangible property law suggest useful tools that might be deployed to mitigate information cost concerns. Doctrines like intellectual property exhaustion, whose analogs and progenitors in the land law are being discarded, remain important for managing IP rights in an increasingly complex information environment. C.  Property and Time This section focuses on how IP compares to other types of property on the dimension of time—that is, how long the exclusive rights associated with copyrights and patents last compared with the exclusive rights associated with property rights in land and other tangible objects.19 One oft-cited distinction between copyright and patent law and the laws governing property in tangible things like land and chattels is evident on the face of the constitutional language limiting the duration of authors’ and inventors’ rights, which may only be secured ‘for limited Times’ (U.S. Const. art. I, § 8, cl. 8).20 To those skeptical of

  This section is derived in part from my previous work (Van Houweling, 2017).   For commentary emphasizing this distinction, see, e.g., Sterk (2005, pp. 446–59) and Bell and Parchomovsky (2002, p. 41). 19 20

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18  Research handbook on the economics of IP law volume 1 the notion of copyright and patent as forms of ‘property,’ this finite duration of authors’ and inventors’ rights is one of many ways in which those rights do not and should not operate like property. These skeptics point to the expansion in the duration of copyright as a way in which copyright is becoming more like tangible property and violating the spirit if not the letter of the constitutional limitation.21 Conversely, some of those who most fully embrace the concept of intellectual property argue that copyrights and patents should—like other forms of property—last forever.22 All of these scholars and advocates share a similar starting assumption: tangible property rights are potentially infinite in duration, while copyrights and patents are constitutionally required to be for ‘limited times.’ This characterization is ripe for refinement. While the duration of rights to land and other tangible objects may be theoretically infinite, a variety of limiting doctrines operate to terminate these rights when they threaten to prevent societally beneficial use of valuable resources. Long-lived property claims trigger fears about ‘dead hand control,’ a label that reflects underlying anxiety about special types of information and transaction costs that arise as owners move and proliferate and their claims become entangled over time, about threats to the autonomy of the living imposed by enforcing the preferences of prior generations, and about unfair distribution of resources caused by dynastic wealth accumulation. A variety of property doctrines are attentive to these fears. Indeed, the infamous Rule Against Perpetuities is arguably important as a topic of study for property students more for the powerful way that it illustrates the force of the concern with dead hand control than for its contemporary doctrinal significance. The law of adverse possession is similarly important in part for the way in which it illustrates problems caused by the assertion of stale claims. As for IP, despite express limits on the duration of copyrights and patents, the problems posed by stale, obsolete, and hopelessly entangled rights nonetheless loom large where technology is advancing so rapidly, where there is no natural limit on the proliferation of property claims, and where the public interest in access to the relevant resources often lasts far longer than the property owners’ interest in making available the rights-related information necessary to facilitate voluntary transactions. The issue of time is especially pressing in the copyright context. While the duration of copyright is theoretically limited, for many works it might as well be infinite. This is true, for example, for some so-called ‘orphan works’ whose owners cannot be located. These works may be underused during 21   For example, Lawrence Lessig laments that ‘though the founders never used that term, “intellectual property,” . . . to us, copyright and patents are clearly property rights, and clearly deserve all the absolute and permanent protection that ordinary property deserves’ (2001, p. 1068). Similarly, Simon Stern observes that ‘advocates of heightened copyright protection find it hard to resist the analogy with tangible property when challenging the limited duration of copyright’ (2012, p. 87). 22   Justin Hughes (2003, pp. 784–5) has documented such arguments:

  Motion Picture Association of America President Jack Valenti, for example, has stated publicly that copyrights should be permanent, like any other property right. He has been joined by at least one member of the U.S. Congress, Representative Mary Bono. Ms. Bono and Mr. Valenti carry on the legacy of many nineteenth-century U.S. authors who were advocates of perpetual copyright protection. There is some (many would say, superficial) appeal to their position: If one views a copyright as just another form of property, it makes sense to ask why it is treated differently than the enduring property rights in real estate, chattels, and financial instruments.

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Intellectual property as property  19 their long copyrights because permission to use them in ways subject to copyright cannot be obtained from unfindable owners (U.S. Copyright Office, 2006, p. 15). If such underuse includes a failure to properly preserve or duplicate existing copies of the works (fragile books or films, for example) then their use will also be effectively restricted even after the copyrights have expired.23 Thus the duration of copyright’s restrictions can be practically infinite, and yet tragically worthless in the long run to both lost copyright owners and society at large (Bibb, 2009, pp. 169–71). The problems associated with orphan works and other unintended consequences of ever-longer copyright terms are well-documented (e.g. Boyle, 2008; Chiang, 2016; Hansen, 2013; Loren, 2012; Urban, 2012; U.S. Copyright Office, 2006; U.S. Copyright Office, 2015). A wide variety of proposals has been offered to address them—including ex ante durational limits (Khanna, 2014), more comprehensive recording to help keep track of copyright owners (Landes and Posner, 2003), and time-sensitive application of doctrines like fair use (Hughes, 2003; Liu, 2002). But these proposals are often met with objections framed in terms of property rights, based on the assertion that tangible property rights are infinite and copyrights should be infinite as well (or at least as close to infinite as the Constitution’s ‘limited times’ language will bear) (Hughes, 2003, p. 784–5 (citing examples)). On closer inspection, it is clear that there are many ways that the duration of property rights in tangible things is in fact limited (Harding, 2009, pp. 292–3). This is especially common for those property rights that—like IP—allow their owners to exercise remote control over resources possessed by others. Return to the passage from White-Smith v. Apollo quoted above. Justice Holmes claims that because copyright is a non-possessory, ‘in vacuo,’ property right that exerts remote control over strangers, it ‘could not be recognized or endured for more than a limited time’ (White-Smith Music Publ’g Co. v. Apollo Co., 209 U.S. 1, 19 (1908)). His observation is also aptly applied to the other forms of ‘remote control’ property discussed above. On the one hand, servitudes and other non-possessory interests in tangible property (e.g. future interests accompanying defeasible fees) are designed to be durable, and thus to facilitate efficient long-term land use planning that would be difficult to accomplish through bilateral contractual measures alone. (Copyrights, too, are more durable than attempts to control copying of books by extracting express promises from each recipient of a copy.24) And yet, this durability can undermine efficiency when land use needs change and transaction costs make the restrictions difficult to renegotiate. Consider, for example, a residential use restriction imposed on a pocket of land hemmed in by noisy new highways. Because the likelihood of changed circumstances and of transactional difficulties increases with the passage of time, the durability of non-possessory property

23   For examples of these types of failures, see Reese (2012, pp. 292–7). Note that these are failures arguably attributable to living copyright owners. In a thought-provoking article, Eva Subotnik has therefore rejected the ‘dead hand’ as a way of conceptualizing the problems attributable to long (specifically, postmortem) copyright duration, identifying the problem as suboptimal stewardship by the living (2015, pp. 118–24). 24   Contemporary mass market ‘agreements’ imposed via click-wrap and other mechanisms that purport to attach to copies of intellectual works and thereby to establish privity of contract with whoever obtains possession of a copy are a different story (see Van Houweling, 2008).

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20  Research handbook on the economics of IP law volume 1 rights contributes to ambivalence about them.25 The specter of ‘dead hand control’ enforcing obsolete restrictions on living landowners and sacrificing socially beneficial use of resources thus explains much of the longstanding judicial hostility to enforcement of non-possessory property restrictions. Although no constitutional ‘limited times’ constraint applies to ‘non-intellectual’ property rights, judges and legislators have nonetheless imposed a collection of durational limitations on non-possessory property rights attached to land. Some of these limits (including some versions of the Rule Against Perpetuities) operate ab inicio to invalidate non-possessory property rights that purport to be perpetual or potentially perpetual. Some serve as durational limits that cause property rights to expire automatically after a certain period of time. Some allow property owners to save their rights from automatic expiration only by recording them periodically. Others operate ex post to extinguish property rights that have outlived their usefulness. There remain theoretically perpetual non-possessory property rights, but they are vulnerable to invalidation on a number of different grounds that are facially not about duration but appear to be influenced by concerns related to dead hand control. I will save consideration of the Rule Against Perpetuities and other limitations on future interests for another day (see Van Houweling, 2017) and focus here on durational limits on servitudes. A few states have enacted strict durational limits on servitudes, winning praise from some commentators (e.g. Rose, 1982, pp. 1413–16; Sweeney, 1995, p. 691; Winokur, 1989, p. 78). In Minnesota, for example, ‘covenants, conditions, or restrictions’ (with some exceptions) expire after 30 years. (Minn. Stat. Ann. § 500.20(2) (2002)). The relevant Massachusetts statute effectively forbids perpetual restrictions by imposing a 30-year default term on any restriction that does not specify its own duration (184 Mass. Gen. Laws 23). As the Supreme Judicial Court has explained, this provision ‘expressly precludes the imposition of perpetual restrictions on land’ and serves to ‘provide definitive endpoints to the term of such restrictions’ (Brear v. Fagan, 447 Mass. 68, 77 (2006)). Many states impose recording and renewal requirements instead of, or in conjunction with, durational limitations on servitudes. In many states, these requirements are imposed by marketable title acts that apply to various types of clouds on title. These statutory provisions generally declare that a landowner whose chain of title goes back for a specified period of time (typically from 20 to 40 years) has marketable title to that land free and clear of any contrary claims that have not been recorded (Van Houweling, 2017, pp. 68–9, n. 82 (citing examples)). Some states make all of this more explicit, with statutory provisions separate from their general marketable title acts that expressly provide for the automatic expiration of servitudes and/or future interests unless they are periodically recorded. For instance, the Iowa ‘stale use statute’ applies to both future interests and servitudes that restrict the use of land (Iowa Code Ann. § 614.24). The statute limits the duration of land restrictions to 21 years from initial recording unless a claim to extend them is recorded before the expiration of those 21 years. Similarly, in Massachusetts, restrictive servitudes with express durations of more than 30 years nonetheless automatically expire after 30 years 25

  Julia Mahoney (2002, 2004) is an especially vocal critic of this type of dead hand control.

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Intellectual property as property  21 unless they are recorded (with renewal recordation required every 20 years thereafter) (184 Mass. Gen. Laws 27).26 Ironically, the rise of marketable title acts and similar recording and renewal requirements during the second half of the twentieth century coincided with the elimination of the renewal requirement in US copyright law. Recognition of the unintended negative consequences of that shift have motivated calls to reinstitute some type of registration requirement as a prerequisite for long-lasting copyrights. For example, while serving as Register of Copyrights, Maria Pallante suggested that ‘a formal registration requirement near the end of term may be beneficial to the larger legal framework’ of copyright (Pallante, 2013, p. 1419). The details of her proposal mirror the operation of some of the state law recording schemes just described: Congress could shift the burden of the last twenty years of protection . . . from the user to the copyright owner, so that at least near the end of the term, the copyright owner would have to file with the Copyright Office as a condition of continued protection. Otherwise, the work would enter the public domain. (Pallante, 2013, p. 1419)

Pallante’s suggestion echoes other proposals to fix copyright by ‘reformalizing’ it, as discussed above. The examples from the tangible property realm suggest that formal requirements that help to justify and track long-lasting remote control rights would not only restore some advantages of historical copyright practice, but also unite copyright with the law that helps to discipline similar rights attached to land. And in the twenty-first century, technology might ease the process of complying with formal requirements, thus avoiding the traps and travails of the earlier era. In addition to ex ante durational limits that set a pre-determined expiration date for restrictive future interests and servitudes or impose an expiration date on those that have not been properly recorded, there are also both common law doctrines and state statutory provisions that operate ex post to terminate non-possessory use restrictions once they have outlived their usefulness. Underlying these ex post termination rules is the idea that circumstances may change in the years following imposition of a restriction in ways that render what was once a beneficial land use control into an unjustifiable hindrance that is nonetheless difficult to remove through voluntary negotiations. In the case of servitudes, the relevant doctrine transparently reflects this logic: restrictive servitudes can be terminated (or modified, or enforced only with damages as opposed to injunctions) due to ‘changed conditions.’ As the Ninth Circuit put it, ‘[t]he doctrine of changed conditions operates to prevent the perpetuation of inequitable and oppressive restrictions on land use and development that would merely harass or injure one party without benefiting the other’ (Cortese v. United States, 782 F.2d 845, 850–51 (9th Cir. 1986)). What would it mean to borrow the changed circumstances concept and apply it to copyright? The most straightforward way to incorporate this idea would be for judges applying the case-by-case analysis of the fair use doctrine to include in that inquiry a consideration of the age and continued importance of the copyright at issue. Several scholars have suggested this approach, tying it persuasively to fair use’s statutory factors 26   This is in addition to the Massachusetts provision discussed above, which imposes a 30-year limitation on any use restriction that does not specify its own duration.

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22  Research handbook on the economics of IP law volume 1 (Hughes, 2003; Liu, 2002). Here we see that this approach has a property law pedigree as well. In sum, courts and legislatures have deployed a range of techniques to limit the problems caused by long-lasting remote control property rights. These techniques include invalidation of some purportedly perpetual or long-lasting interests, mandatory term limits, periodic recording requirements, and ex post invalidation of obsolete restrictions. These are in addition to duration-related doctrines that apply to both possessory and remote control property interests (namely, adverse possession and statutes of limitation). Proposals for addressing problems caused by long-lived IP rights are met with objections often framed in terms of tangible property rights, with some vocal copyright and patent owners insisting that their property should not be uniquely burdened with durational limits, recording obligations, or doctrines that consider the possibility that their rights have outlived their usefulness. But looking carefully at the law of tangible property reveals that such burdens would be far from unique, especially when we examine the law’s treatment of non-possessory remote control property rights that are most analogous to IP. There is a long property tradition of looking ambivalently on remote control property— recognizing its potential to serve goals associated with long-term investment in valuable resources but guarding against its potential to unjustifiably constrain resource use long after those goals are accomplished or obsolete.

V. CONCLUSION Property rights are uniquely powerful and problematic because of the way they attach to, run with, and exclude people from things. The powers and the problems follow patterns, but also vary depending on the nature of the thing at issue. Keeping this variance in mind as we explore analogies between tangible property and IP allows us to use those analogies to distinguish and diagnose the novel and yet familiar challenges of contemporary IP. As explored in this chapter, attention to both the history of property possession and the special challenges of possession of IP helps to understand and diagnose the shortcomings of doctrines of IP acquisition and signaling. Looking at the special information cost challenges posed by rights that are good against the world helps us to understand how IP might harness more of the doctrinal tools that have traditionally helped mitigate these costs. And examining how the law governing non-possessory rights to tangible property is sensitive to how those rights can cause problems over time helps us to see how durational limits in IP are not confiscatory but rather consistent with property tradition. In sum, understanding IP as property can illuminate rather than obscure the special nature of rights in intellectual creations.

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26  Research handbook on the economics of IP law volume 1 Van Houweling, Molly Shaffer. 2011. ‘Touching and Concerning Copyright,’ 51 Santa Clara Law Review 1063–85. Van Houweling, Molly Shaffer. 2012a. ‘Technology and Tracing Costs: Lessons from Real Property,’ in Shyamkrishna Balganesh, ed., Intellectual Property and the Common Law. Cambridge, UK: Cambridge University Press. Van Houweling, Molly Shaffer. 2012b. ‘Atomism and Automation,’ 27 Berkeley Technology Law Journal 1417–501. Van Houweling, Molly Shaffer. 2013. ‘Land Recording and Copyright Reform,’ 28 Berkeley Technology Law Journal 1497–510. Van Houweling, Molly Shaffer. 2016a. ‘Exhaustion and Personal Property Servitudes,’ in Irene Calboli and Edward Lee, eds., Research Handbook on IP Exhaustion and Parallel Imports. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Van Houweling, Molly Shaffer. 2016b. ‘Exhaustion and the Limits of Remote-Control Property,’ 93 Denver Law Review 951–74. Van Houweling, Molly S. 2017. ‘Disciplining the Dead Hand of Copyright: Durational Limits on Remote Control Property,’ 30 Harvard Journal of Law & Technology 53–74. van Gompel, Stef. 2011. Formalities in Copyright Law. Alphen ann den Rijn, The Netherlands: Kluwer Law International. Walterscheild, Edward C. 1994. ‘To Promote the Progress of Science and Useful Arts: The Background and Origin of the Intellectual Property Clause of the United States Constitution,’ 2 Journal of Intellectual Property Law 1–56. Winokur, James L. 1989. ‘The Mixed Blessings of Promissory Servitudes: Toward Optimizing Economic Utility, Individual Liberty, and Personal Identity,’ 1989 Wisconsin Law Review 1–97. Yen, Alfred C. 1990. ‘Restoring the Natural Law: Copyright as Labor and Possession,’ 51 Ohio State Law Journal 517–59.

Legislative Materials U.S. Const. art. I, § 8, cl. 8. 17 U.S.C. § 102. 35 U.S.C. § 102(a)–(b), § 112. 184 Mass. Gen. Laws 23. 184 Mass. Gen. Laws 27. Iowa Code Ann. § 614.24. Minn. Stat. Ann. § 500.20(2).

Cases Ariad Pharmaceuticals, Inc. v. Eli Lilly & Co., 598 F.3d 1336 (2010). Bowman v. Monsanto, 569 U.S. 278 (2013). Brear v. Fagan, 447 Mass. 68 (2006). Cortese v. United States, 782 F.2d 845 (9th Cir. 1986). Costco Wholesale Corp. v. Omega S.A., 562 U.S. 40 (2010). Impression Products v. Lexmark, Inc., 137 S. Ct. 1523 (2017). Kewanee Oil Co. v. Bicron Corp., 416 U.S. 470 (1974). Kirtsaeng v. John Wiley & Sons, 568 U.S. 519 (2013). Omega S.A. v. Costco Wholesale Corp., 541 F.3d 982 (9th Cir. 2008). Pierson v. Post, 3 Cai. 175 (N.Y. 1805). Quanta Computer, Inc. v. LG Electronics, Inc., 553 U.S. 617 (2008). White-Smith Music Publishing Company v. Apollo Company, 209 U.S. 1 (1908).

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2.  Anticommons, transaction costs, and patent aggregators Rebecca S. Eisenberg*

27

Contents Theory of the Anticommons Empirical Studies A. Impact on Upstream Research B. Impact on Downstream Product Development III. The Rise of Patent Aggregators IV. Changes to Mitigate Anticommons Risks A. Limits on ‘Upstream’ Rights and Assertions B. Limits on Injunctions C. Lowering Information Costs D. Lowering the Costs of Patent Challenges References I. II.

I.  THEORY OF THE ANTICOMMONS An anticommons is a fragmented allocation of property rights in which resources are prone to underuse because it is too costly to assemble all the necessary permissions to put the resources to use (Heller, 1997; Heller and Eisenberg, 1998). The anticommons metaphor harkens back to the more familiar ‘tragedy of the commons’ (Hardin, 1968), in which resources made freely available in a commons (such as open fisheries and pastures) are prone to overuse because too many people hold privileges of use and nobody has a right to exclude anyone else. Privatization may solve a tragedy of the commons by giving a property owner a right to exclude others, thus providing the means and incentive to prevent wasteful overuse. But a poorly designed property regime that creates too many fragmented rights to exclude could lead to wasteful underuse in a tragedy of the anticommons. In a world of costless transactions, people could avoid both commons and anticommons tragedies by trading their rights (Fennell, 2004). But transaction costs, strategic holdouts, and information problems present a risk of persistent bargaining failures. The larger the number of rights holders and the more varied their entitlements, the more challenging it is to avoid waste through bargaining (Heller and Eisenberg, 1998; Eisenberg, 2001). Heller (1997) offered as an example empty storefronts in post-Soviet Moscow, alongside robust retail trade out of flimsy metal sidewalk kiosks. Heller attributed the

*  Robert and Barbara Luciano Professor of Law, Michigan Law, University of Michigan.

27

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28  Research handbook on the economics of IP law volume 1 underutilization of storefronts to fragmented allocation of the rights necessary to open up shop to a diverse group of owners (including private or quasi-private enterprises, workers’ collectives, privatization agencies, and local, regional, and federal governments) in the course of post-socialist privatization. Heller and Eisenberg (1998) extended the metaphor to fragmented ownership of intellectual property (IP) rights that an innovating firm must clear in order to develop a new product.1 They noted complaints about a proliferation of ‘upstream’ IP claims to biomedical research tools that serve as inputs to future ‘downstream’ product development following a shift in US government policy to promote the patenting of inventions made in the course of federally sponsored research (Eisenberg, 1996). Both illustrations happened to involve the creation of property rights following a transition from a more communal form of ownership (state ownership in the case of Soviet-era storefronts; free availability in the scientific commons in the case of research tools) to a new property rights regime. The creation of a new property regime, although not the only way that an anticommons might arise, may be especially fraught with possibilities for poor design of initial rights. Moreover, new property owners accustomed to a regime of communal ownership may initially lack the skills necessary to evaluate their rights and to transfer them at reasonable cost to users who could get more value out of them. These difficulties may eventually give way to successful bundling of rights through bargaining, perhaps with the assistance of intermediaries who figure out strategies for lowering transaction costs to realize potential gains from exchange (Merges, 1996; Heller and Eisenberg, 1998; Eisenberg, 2001). Bargaining may be costly, but not necessarily tragic (Barnett, 2015). At any given moment it can be difficult to tell the difference between transitory and enduring bargaining obstacles (Eisenberg, 2001). An anticommons may be more likely to persist if transaction costs are high, if heterogeneous rights are dispersed among diverse owners, and if information asymmetries and cognitive biases prevent agreement on relative values (Heller and Eisenberg, 1998). These conditions seem more likely with patent rights than with real property entitlements, because the patent system continuously creates new rights of indeterminate value for new claimants, with limited opportunity to establish consensus valuations of existing entitlements as new rights arise in the face of ongoing technological change. On the other hand, because patents are wasting assets that expire after 20 years and may lose value before that time as a result of technological obsolescence, owners may feel some urgency to enter into timely bargains before licensing options disappear (Epstein and Kuhlik, 2004). Subsequent commentators have sharpened and formalized the model of the tragedy of the anticommons and noted its similarities to a tragedy of the commons (Buchanan and Yoon, 2000; Fennell, 2004; Parisi et al., 2005; Schulz et al., 2003). Both tragedies could in theory be resolved through bargaining, and in both cases bargaining faces obstacles. These obstacles include the costs of identifying owners and users and determining the validity and infringement of rights, as well as the costs of evaluating heterogeneous rights and of bargaining over terms of exchange. In both contexts individual rights

1   Other commentators have used the term ‘patent thickets’ to describe numerous and overlapping patent rights that threaten to stifle rather than encourage innovation (Shapiro, 2001; Galasso and Shankerman, 2010). Both terms describe similar phenomena.

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Anticommons, transaction costs, and patent aggregators  29 holders bargaining independently are likely to charge more in the aggregate than would a single party who held the entire bundle of complementary rights because of the ‘double marginalization problem’: each individual rights holder will fail to internalize the full costs and benefits of its bargaining behavior on the overall price of the bundle (Parisi et al., 2005). In both contexts, there is a risk that an overall deal will be derailed by strategic behavior by one or more rights holders seeking to capture a larger share of the potential surplus (Fennell, 2004; David, 2011). Some experimental results support these intuitions (Depoorter and Vanneste, 2006; Stewart and Bjornstad, 2002; Parente and Winn, 2012). Other commentators maintain that market institutions can and do avoid anticommons tragedies (Barnett, 2015; Lichtman, 2006; Epstein and Kuhlik, 2004). Much of the anticommons literature focuses on the patent system, but some of it considers problems arising from fragmentation of ownership of copyright (Parisi and Sevcenko, 2001; Hunter, 2003; Loren, 2003; Depoorter, 2004; Van Houweling, 2010; McLeod and DiCola, 2011; Lee, 2016) and associated transaction costs (Depoorter and Parisi, 2002). US copyright law has mechanisms for avoiding an anticommons that have no counterpart in the US patent system, including statutory compulsory licensing provisions,2 well-established collective rights organizations (Gervais, 2015), and the fair use doctrine (Depoorter and Parisi, 2002).3 Nonetheless, recent controversies have highlighted salient examples of cultural innovations that have been significantly impeded by the complexity of licensing numerous copyrights. These include mass digitization of libraries of copyrighted works such as the Google Books project (Hofmann, 2013; Samuelson, 2011; U.S. Copyright Office, 2015), digital music sampling (McLeod and DiCola, 2011), and documentary film production (Aufderheide and Jaszi, 2004).

II.  EMPIRICAL STUDIES Much of the patent literature uses the term ‘anticommons’ loosely to lament various effects of patents that are only indirectly related to the problem of clearing numerous rights. For example, Murray and Stern (2007) characterize as ‘anticommons effects’ an observed relative decline in the rate of citations to scientific articles after the inventions they disclose are patented and thus removed from the public domain, even though each observation may involve the effects of only a single patent. An extensive literature purports to test the ‘anticommons’ by looking for negative effects of patents on the ‘upstream’ activities of biomedical research scientists, as distinguished from the more specific focus of Heller and Eisenberg (1998) on the impact of a proliferation of ‘upstream’ IP claims on ‘downstream’ product development. Despite these imprecisions in usage

2   17 U.S.C. §§ 115 (nondramatic musical compositions), 118 (public broadcasting), 111(c) (cable retransmission), 114(d)(2) (subscription digital audio transmission), 114(d)(1) (nonsubscription internet radio). Royalty rates are set by a Copyright Royalty Board established by statute (Copyright Royalty and Distribution Reform Act of 2004, Pub. L. No. 108-419, 118 Stat. 2341, codified at 17 U.S.C. §§ 801–805). For a history of the compulsory licensing provisions for nondramatic musical compositions and an explanation of their limitations see Peters (2004). 3   17 U.S.C. § 107. See also 17 U.S.C. § 110 (permitting unauthorized public performances under specific circumstances).

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30  Research handbook on the economics of IP law volume 1 and differences in focus, some of this literature illuminates the anticommons model in useful ways. A smaller literature focuses more directly on the impact of ‘patent thickets’ on product development in a variety of technological fields. But the search for empirical evidence of such an impact suffers from a lack of salience: it is challenging to measure or observe innovations that never happened. The following discussion considers separately studies of the impact of patents on upstream research and on downstream product development. Section III then considers growing concerns that in recent years have eclipsed debate about disaggregated ownership of fragmented patents: a distinct set of problems posed by the rise of patent aggregators. While patent aggregation seems like it would be an effective market solution to the bargaining challenge presented by fragmented ownership, it seems to have done more to reduce the costs of assertion by patent owners than to reduce the costs faced by technology users for clearing rights. The result on balance may be a greater risk of underuse as subsequent innovators need to incur more transaction costs to evaluate and clear rights that they might otherwise have ignored with little risk of assertion in the absence of aggregation. A.  Impact on Upstream Research The metaphor of the tragedy of the anticommons has had great resonance with science policy makers whose primary concern was not the impact of IP on future product development, but rather its impact on research science itself. This concern motivated a series of studies using surveys of research scientists from around the world, primarily in academia, to determine how much IP interferes with their work (Eisenberg, 2008). Although not directly relevant to the problem of the anticommons as pictured by Heller and Eisenberg (1998), these studies shed an interesting light on that problem. The most interesting finding of these studies was that academic scientists for the most part simply ignore any patents they might be infringing, and for the most part they get away with it (Walsh et al., 2003; Eisenberg, 2001; Nicol and Nielsen, 2003; Straus et al., 2004; American Ass’n for the Advancement of Science, 2007).4 An important exception to the obliviousness of academic scientists to patents was the impact of patented genes on clinical research using genetic tests in academic medical centers (Soini et al., 2008; Cho, 2003; Walsh et al., 2003). In telephone survey interviews with directors of laboratories performing genetic tests in the US, Cho (2003) found that 25 percent had stopped performing a genetic test and 53 percent had decided not to develop a new genetic test because of a patent or license. Of those respondents that had been contacted about potential infringement, 71 percent of those in commercial laboratories and 24 percent of those in universities reported that they had been prevented from performing a test (Cho, 2003). Patents on the BRCA1 and BRCA2 genes associated with susceptibility to breast cancer were a recurring source of complaints (Gold and Carbone, 2010), but not unique (Merz et al., 2002). Although relatively few academic scientists reported that patents constrained their

4   A rare but salient counterexample in which a university was held liable for patent infringement is the case of Madey v. Duke University, 307 F.3d 1351 (Fed. Cir. 2002), U.S. cert. denied sub nom. Duke University v. Madey, 539 U.S. 958 (2003).

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Anticommons, transaction costs, and patent aggregators  31 research activities outside of genetic testing, many scientists reported that their work was impeded by practical restrictions on access to proprietary materials and databases that they could not readily duplicate on their own (Cohen and Walsh, 2008; Walsh et al., 2003, 2007). The distinction between patent licenses and agreements for access to materials and databases is not entirely crisp. Mowery and Ziedonis (2007) found that materials transfer agreements were often associated with patented inventions. Some notoriously difficult negotiations have arisen over access to patented materials, such as genetically engineered mice (Murray, 2006). Academic agricultural biologists surveyed by Lei et al. (2009) associated an observed proliferation of materials transfer agreements with concerns about preserving IP protection. In a review of the literature, Herder (2012) noted that different authors have characterized quantitatively similar findings quite differently. For example, Walsh et al. (2007), finding that 1 in 9 researchers abandoned one research project every two years because of patents, concluded that worries about patent-related transaction costs are overstated, while Huang and Murray (2009), finding that genetic researchers forego about 1 in 10 research projects (or, more precisely, research publications) through the causal negative impact of a gene patent grant, concluded that there was reason to worry about the effects of gene patents on knowledge flows. Survey results also appear to be sensitive to the form of the questions. The agricultural biologists surveyed by Lei et al. (2009) gave broadly similar responses to the scientists surveyed by Cohen and Walsh (2008) and Walsh et al. (2007) on similar questions, but only Lei et al. asked respondents to evaluate the impact of intellectual property on their field, leading the agricultural biologists to ‘report that the IP protection of research tools is, on balance, having a negative impact on their research areas.’ Perhaps other respondents in the other surveys would have given similar responses to the same question. Other scholars have used less impressionistic data to gauge the impact of patents on subsequent research. Murray and Stern (2007) studied forward citations of patent-paper pairs involving papers published in the journal Nature Biotechnology between 1997 and 1999 and patents associated with the same work. They found that the grant of a patent was associated with a modest (10–20 percent) decline in future citations to the corresponding paper relative to expected citations for papers of similar quality that were not paired with a patent. Huang and Murray (2009) examined a larger data set of patent-paper pairs on gene discoveries from 1988–2006 and observed a relative decline in citations after patent issuance of about 5 percent, with the decline increasing with number of claims in the patent. Of particular relevance to the anticommons, the authors observed that the negative impact of patent grant was greater in the presence of patent thickets and when ownership of cited patents was fragmented (as suggested by prior art citations in the patent documents). It is difficult to reconcile the observations in citation studies of a relative decline in citations after patent issuance with the observations in the survey studies that scientists ignore patents (Herder, 2012; McManis and Yagi, 2014). Williams (2013) used a different empirical approach to test the impact of the IP strategy of the gene sequencing firm Celera, which relied on database access agreements as well as patents. Celera sequenced the human genome in a race with the publicly funded Human Genome Project (which required grantees to disclose their data in the publicly accessible GenBank database) and made the proprietary Celera database available only to paying subscribers during a period when the GenBank version was incomplete.

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32  Research handbook on the economics of IP law volume 1 Williams ­compared subsequent publications and diagnostic applications of genes that were first identified only in the commercial Celera database with subsequent research and diagnostic applications of genes that were first identified in the freely accessible GenBank database and found a reduction in subsequent research and product development associated with the Celera genes of 20–30 percent. Some observers have concluded from these studies that the effects predicted by the anticommons model are not borne out by the available data (Caulfield et al., 2006; McManis and Yagi, 2014). But the data are inadequate to support this conclusion because most of these studies merely investigated encounters of research scientists with IP rights without regard to the existence of conditions that would set the stage for anticommons effects. With the notable exception of Huang and Murray (2009), who found a greater decline in citations following patent issuance in the presence of patent thickets, these studies did not attempt to measure the existence of fragmented or overlapping IP rights held by different owners, nor did they ask about the impact of such rights on product development. Although not directly relevant to the impact of a proliferation of IP claims on commercial product development, these studies nonetheless shed an interesting light on transaction costs in the setting of negotiations over access to upstream research tools that could have implications in other settings that require users to negotiate with multiple rights holders. The studies provide considerable evidence of high transaction costs. Murray (2006) documented protracted negotiations for dealing with just one counterparty over a high-value research tool. Maurer (2006) recounts ultimately unsuccessful efforts of a community of academic biologists to overcome bargaining and information obstacles to pool their data on genetic mutations in a shared database with industry support. Williams (2013) found further evidence of significant transaction costs in negotiations between Celera and its database subscribers in the fact that the parties did not address patent licensing issues ex ante, before subscribers had invested in research that might be covered by Celera’s patents, but instead waited to negotiate licenses until after further inventions had been made, when Celera was in a stronger bargaining position. This contradicts the prediction of Green and Scotchmer (1995) that ex ante licenses will produce optimal incentives and will therefore be negotiated. Williams (2013) attributed the use of ex post licensing to transaction costs associated with scarcity of ideas, asymmetric information about development costs, and the risk that Celera would engage in competitive R&D based on unpatented information disclosed by prospective licensees in the course of negotiations. The observation that practical excludability had a greater impact on scientists than patents alone led Eisenberg (2008) to propose a refinement of the anticommons hypothesis to consider which side bears the burden of overcoming transaction costs. In the case of patents, rights holders must incur significant costs in order to identify infringers and assert their rights against them. The higher these costs, the more likely that transaction costs will protect users against detection and liability, particularly for low-value users like academic scientists whose activities pose little threat to the commercial interests of rights holders. In this context high transaction costs on rights holders mitigate the risk of underuse in an anticommons. On the other hand, for ‘practically excludable’ resources such as biological materials and databases, users themselves must incur transaction costs to find rights holders and negotiate for access, while rights holders may avoid search costs and wait for users to come to them. In this context high transaction costs work against users, aggravating the risk of underuse in an anticommons. (The effects may be

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Anticommons, transaction costs, and patent aggregators  33 quite different for high-value users such as commercial product developers, considered in the next section.) In other words, the presence of high transaction costs does not necessarily increase the risk of underuse in an anticommons. Depending on where the burden of overcoming transaction costs falls, high transaction costs could either aggravate or mitigate the risk of underuse. A corollary is that aggregation of rights could lead to both greater transaction costs and less use than disaggregated ownership if aggregators face lower assertion costs than disaggregated owners. This is because an aggregator might be expected to assert rights that users could otherwise safely ignore. This possibility is considered in Section III below. B.  Impact on Downstream Product Development There are reasons to predict that the risk of an anticommons could be either greater or lesser in the context of product development than it is in the context of scientific research. On one hand, rights holders that are willing to ignore the activities of academic researchers may be more likely to assert their rights when a product of commercial value is in sight. Moreover, commercial firms that hope to bring a product to market may be more concerned about potential infringement liability (and therefore less willing to ignore patents) than academic scientists. Rights that might go ignored and unasserted in the context of low-value research may therefore be more likely to require bargaining and clearance in the context of high-value product development, setting the stage for a possible anticommons. On the other hand, the higher values at stake in product development may provide greater motivation for the parties to reach bargains in order to avoid waste, making bargaining breakdowns less likely. Although the studies reviewed in the last section focused primarily on the impact of IP on the work of scientists rather than on product development, some of the studies included data from scientists in commercial firms and from institutional representatives other than research scientists. Walsh et al. (2003) included interviews with 12 lawyers, 3 scientists, and 9 business managers from the pharmaceutical industry; 7 lawyers, 4 scientists, and 7 business managers from the biotechnology industry; 7 outside lawyers; and 5 government and trade association personnel. Nicol and Nielsen (2003) included interviews of CEOs, IP personnel, and bench scientists from private industry and directors of research groups in diagnostic testing facilities, as well as outside patent attorneys, licensing consultants, and government and trade representatives. Although these small numbers raise questions about whether the data are generalizable, those studies that included commercial respondents and distinguished them from academic respondents found that commercial scientists were more likely to report difficulties in negotiating licenses and a need to alter their research plans because of patents (Walsh et al., 2003; Nicol and Nielsen, 2003; Hansen et al., 2007). Scientists responding to surveys may not be in as good a position to observe the impact of IP on product development as those people who are more directly involved in clearing rights and deciding which projects to develop. Interviews reported in the literature suggest that firms incur significant costs in culling through multiple patents to determine what licenses are necessary, and that these costs are greater in fields characterized by more extensive patenting (Eisenberg, 2008). For example, a lawyer for a pharmaceutical firm told Walsh et al. (2003) that lawyers in the small molecule division in his firm were responsible for eight

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34  Research handbook on the economics of IP law volume 1 projects each, while those in the biotechnology division of the same firms only handled about two projects each because of the greater complexity of the licensing issues that they had to manage in clearing rights for their projects. Respondents told Nicol and Nielsen (2003) that because of the increasing breadth of patent claims, it is now necessary to analyse more patents in detail in order to determine whether they must be licensed; however, at the end of this analysis, the number of patents that require licensing generally remains small. One Australian respondent estimated that a typical freedom to operate search might uncover anywhere from a dozen to 30 or 40 patents that are relevant, but that upon closer analysis ‘there may be only one or two or a few more that are blocking’ and that ‘[a]nything beyond three is probably too many’ (Nicol and Nielsen, 2003). Walsh et al. (2003), characterizing the reports of about 10 US industry respondents, said that an initial search would turn up hundreds of patents that they would have to consider, a number that was surely higher than in the past, but that after analysis the number that they would need to address would range from zero to a dozen. As Epstein and Kuhlik (2004) note, a proliferation of patents may represent competing alternative stepping stones to production rather than a blockade of overlapping rights. But a firm may need to incur significant information costs in order to figure that out. How many patents it takes to derail a project evidently depends not only on what the patents cover, but also on the stage at which they are identified. In both the US and Australia, respondents indicated that numerous patents would be more likely to deter a firm from pursuing a project at the outset than they would be to cause the same firm to abandon a project once it was already underway. A lawyer for a biotechnology firm told Walsh et al. (2003) that the firm assesses the patent landscape early on, and if it appears too formidable, ‘the project never gets off the ground,’ but that if patent issues arise later they are ‘not the show stopper that you would identify early on.’ Reviewing similar stories from Australian respondents, Nicol and Nielsen (2003) concluded ‘that it is possible that a number of potentially anticommons-affected projects do not come onto the radar, because such projects will have been abandoned well before any difficulty of negotiating with multiple parties is encountered.’ As noted in the last section, some studies have shown a negative effect of patents and licensing on the development and use of clinical genetic tests (Cho, 2003; Merz et al., 2002; Walsh et al., 2003; Soini et al., 2008), although it is not clear that the problems highlighted in these studies necessarily involve fragmented property rights and anticommons tragedies. Some genetic tests may be vulnerable to anticommons risks, such as DNA microarray products that simultaneously test for multiple genes or mutations covered by multiple patents (Barton, 2006). This is similar to the challenge of negotiating multiple copyright licenses for digital sampling of music (McLeod and DiCola, 2011). Industries may differ in their capacity to manage complex patent landscapes. Ziedonis (2004) studied patenting in the semiconductor industry, a capital-intensive industry with considerable patenting. Ziedonis used patent citation data from patents issued to 67 semiconductor firms between 1975 and 1996 to estimate the extent of fragmentation of ownership of technological inputs, and found that firms acquire patents more aggressively when fragmentation of ownership is more extensive. The difference was significantly more pronounced for more capital-intensive firms. Ziedonis explained that amassing a large patent portfolio could be a strategy for safeguarding capital investments while foregoing the costs and delays associated with ex ante contracting, by increasing the likelihood that the firm can threaten others with reciprocal lawsuits (Ziedonis, 2004).

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Anticommons, transaction costs, and patent aggregators  35 Barnett (2015) observes that although information and communications technology markets would appear to be fertile ground for an anticommons to arise, in that products require assembly of multiple components covered by patents with dispersed ownership, R&D spending and patenting have grown steadily, while consumer prices have declined. Barnett attributes the avoidance of anticommons effects to the capacity of markets to arrive at patent pooling and cross-licensing arrangements, and reviews the historical evidence of institutions that arose to aggregate patents on a variety of technologies that had generated patent thickets. Barnett also sees a pattern of limited pursuit and enforcement of patent rights within an industry as a kind of market response to overpropertization that limits anticommons risks (Barnett, 2009).

III.  THE RISE OF PATENT AGGREGATORS If fragmentation of rights creates obstacles to licensing and threatens to interfere with efficient use, an obvious potential solution is the aggregation of fragmented rights by one or more owners (Epstein and Kuhlik, 2004; Barnett, 2015). Aggregation reduces the number of entities that a product developer must bargain with and thereby reduces the number of potential holdouts, allowing patent owners and technology users to clear rights with a smaller number of transactions (Lemley and Melamed, 2013). Moreover, aggregating all the necessary rights in a single owner would solve the double marginalization problem because that owner would consider the full impact of royalty demands under multiple patents (assuming that aggregation reduced the number of owners to one). If transaction costs stand in the way of efficient use of patented inventions, one might expect entrepreneurs to figure out ways to reduce these costs in order to realize gains from licensing. Examples abound in the literature of patent pools, cross-licensing arrangements, and copyright collectives that have reduced the transaction costs associated with a proliferation of IP rights and facilitated the clearing of rights (Merges, 1996; Barnett, 2015). Patent aggregators have proliferated over the past 20 years under liberalized antitrust rules (Gilbert, 2004; Ewing and Feldman, 2012). But this phenomenon has not been uniformly welcomed as an efficient means of forestalling or correcting an anticommons. Many commentators have instead lamented the rise of patent aggregators as a new source of holdup against innovators rather than as an efficient mechanism for clearing rights (Ewing and Feldman, 2012; Bessen et al., 2011–12; Chien, 2009). Antitrust scholars have worried that patent pools may have anticompetitive effects if they bring into common ownership patents that cover substitutes that would otherwise compete in the market rather than complements that must be combined for use (Shapiro, 2001; Carrier, 2013). So far, patent aggregators have focused primarily on patents in the information and communications technology sectors (Hagiu and Yoffie, 2013). But Feldman and Price (2014) find that conditions are ripe for patent aggregators to play a larger role in the biotechnology and pharmaceutical sectors by acquiring patents currently held in university patent portfolios. Patent aggregators vary in their business models (Hagiu and Yoffie, 2013; Schwartz, 2014). Many firms that innovate and operate in technologically advanced fields accumulate large patent portfolios to preserve their own freedom to operate across a broader technological domain. Patent portfolios enhance their bargaining position in negotiations over

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36  Research handbook on the economics of IP law volume 1 patents held by other firms, and thus protect them from costly litigation (Parchomovsky and Wagner, 2005; Ziedonis, 2004). Critics have expressed more concerns about so-called non-practicing entities (NPEs) that make a business out of buying, selling, licensing, and asserting patent rights, sometimes on a very large scale, without practicing the underlying technology themselves (and therefore without exposing themselves to counter-assertion of patents held by other firms) (Bessen et al., 2011–12; Bessen and Meurer, 2014). But it is not clear in principle that patent portfolios held by NPEs are more pernicious than those held by operating companies (Lemley and Melamed, 2013). The distinction between NPEs and operating companies may be illusory, as NPEs may be acting on behalf of the operating companies that sell patents to them, obtain licenses from them, and invest in them (Ewing and Feldman, 2012; Lemley and Melamed, 2013). To the extent that patent aggregators lower the transaction costs of patent assertion, they may aggravate risks of underuse in fields characterized by extensive patenting. This is because transaction costs faced by those who assert patents (e.g., the costs of identifying infringers and pursuing them with demand letters and lawsuits) protect users by making assertions less likely, thus mitigating the risk of underuse (Eisenberg, 2008, 2011). Patent aggregators may be acquiring patents from owners that would otherwise be unlikely to assert their rights (McDonough, 2006), perhaps because they lack resources for litigation. Transfer of these rights to aggregators increases the liability risks faced by operating companies and shifts to technology users the burden of clearing rights that they might otherwise have safely ignored. Sale of these patents may increase the rewards to innovators by providing a market for their rights, but it also increases the risk of an anticommons. Indeed, Lemley and Melamed (2013) argue that the growth of a secondary market for patents has likely increased incentives for inventors to seek patents, thus contributing to an increase in the total number of patents. There are many reasons why patent aggregators may face lower assertion costs than the prior owners whose rights they acquire. They may have greater expertise in the strategic moves of patent assertion. At the same time, if they are NPEs they may feel undeterred by industry norms of forbearance from infringement litigation. Litigation costs may also be higher for operating firms that need to divert the attention of personnel who would ­otherwise be available for other more valuable tasks than for firms whose primary business is patent assertion. Aggregators may also enjoy economies of scale in patent assertion. If a user receives a demand letter asserting a single patent, it may be worth investing in a prior art search or opinion letter to determine whether the patent is valid or infringed, but if the demand letter comes from an aggregator with a large number of patents in its portfolio, the cost of such scrutiny could be prohibitive. Increasing portfolio size thus diminishes the likelihood that patent owners will face effective pushback for asserting low quality patents (Eisenberg, 2011) or patents that are not infringed.5 Put differently, in the absence of a robust secondary market for patents, fragmentation 5   Studies suggest that large non-practicing entities target defendants based on ability to pay cash settlements rather than likelihood of infringement of asserted patents. See, e.g., Risch (2012) at 484 (findings of infringement are rare in merits rulings in litigation by non-practicing entities, consistent with other studies); Cohen et al. (2015) at 17–24 (large non-practicing entities are more likely to target defendants that are flush with cash irrespective of infringement).

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Anticommons, transaction costs, and patent aggregators  37 of rights may leave many patents in the hands of owners that are unlikely to overcome the transaction costs of enforcing their rights. These patents may do little to promote innovation if they are never asserted or licensed, but they also are unlikely to lead to underuse of technology, because users can ignore them with little risk of liability. The rise of patent aggregators creates a market for these patents and consolidates them in the hands of owners that can enforce the rights at lower cost. This makes assertion more likely, which in turn increases the transaction costs and information costs facing users who can no longer assume that it is safe to ignore patents. As the number of patents that might be asserted against a user grows, the burden of identifying relevant patents and determining whether they are valid and infringed also grows. Aggregation may diminish the number of distinct owners of the rights that a user might be infringing, but if aggregation makes assertion more likely, it could nonetheless increase the transaction costs burden on users compared to the situation of fragmented ownership of the same rights. Moreover, new patents are constantly arising, and in the current market there are likely to be multiple aggregators asserting rights against the same operating firms. It is thus unlikely that aggregation will entirely relieve users of the risk of strategic holdouts and royalty-stacking. On the other hand, operating firms may be more likely than NPEs to use their patent rights for strategic purposes that result in excessive burdens on competitors (Lemley and Melamed, 2013). More generally, as large patent portfolios become more common and even necessary for operating technology companies, firms will continue to pursue larger numbers of patents, overwhelming the quality control mechanisms of the Patent and Trademark Office, disadvantaging small firms and new entrants, and adding to the information costs and transaction costs associated with innovation and the use of new technologies (Parchomovsky and Wagner, 2005). The growing size of patent portfolios owned by aggregators will also increase the cost of discerning whether included patents are complements or substitutes, calling into question the feasibility of using antitrust law to prevent the use of aggregation for improper anticompetitive purposes (Shapiro, 2001). If patent aggregation increases transaction costs rather than reducing them, it may prove more difficult for markets to figure out strategies to mitigate the inefficiencies arising from a proliferation of patent rights in a field. On the other hand, as Barnett (2015) and others have recounted, many innovative fields have flourished in the face of extensive patenting, including information and communications technology in the current era. Perhaps these fields would have seen even more innovation without having to face the transaction costs and strategic holdout problems arising from patent thickets. But the rate of actual technological progress suggests that these problems on balance have not been tragic in these fields.

IV.  CHANGES TO MITIGATE ANTICOMMONS RISKS The foregoing discussion suggests reasons to worry that the transaction costs of clearing numerous IP rights might pose an obstacle to socially valuable innovations in some circumstances. These costs arise not only from the burden of finding and bargaining with multiple rights holders who hold overlapping and fragmented rights, but also from the need to determine which rights are valid and infringed. The burden of determining ­validity

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38  Research handbook on the economics of IP law volume 1 and infringement is particularly significant for the patent system because the scope and validity of patent rights is often unclear (Bessen and Meurer, 2008). Aggregation of patent rights in the hands of a smaller number of owners may reduce the burden of finding and negotiating with multiple rights holders and reduce bargaining externalities that can lead to excessive royalty demands but it does not diminish the costs of determining the scope and validity of asserted rights. A number of changes have occurred since the publication of Heller and Eisenberg (1998) that have mitigated these risks. Some of these changes have come about through administrative and judicial restrictions on ‘upstream’ patents, some have been byproducts of legislative and judicial efforts to curtail the power of ‘patent trolls,’ and some have come from initiatives to improve patent quality. This section reviews some of these changes that may have forestalled anticommons risks. A.  Limits on ‘Upstream’ Rights and Assertions The picture of an anticommons as the result of fragmentation suggests poorly designed rights that are not properly scaled and have boundaries that do not correspond to likely uses. Heller and Eisenberg (1998) highlighted the example of expressed sequence tags, or gene fragments, that were unlikely to be useful as standalone products but would only be used in combinations that could be difficult to assemble in the presence of disaggregated ownership of rights. More generally, they worried that too many patents on ‘upstream’ research discoveries might impede ‘downstream’ product development. A number of initiatives sought to curtail a proliferation of patents in the specific context of genomic discoveries. The US National Institutes of Health (NIH), in cooperation with counterparts from around the world, undertook concerted efforts to ensure that genomic data generated in the course of the Human Genome Project would be made promptly and freely available in the public domain (Contreras, 2014). The US Patent and Trademark Office (PTO) further addressed the particular problem of patent applications on gene fragments at a time when many such patent applications were pending through implementing examiner training materials and guidelines that provided a framework for examiners to reject these applications (US Patent and Trademark Office, 2001). In an approach that was ultimately approved by the Court of Appeals for the Federal Circuit (Federal Circuit), the PTO expanded upon its interpretation of the ‘utility’ requirement for patentability so as to prevent allowance of patents on newly discovered gene fragments without disclosure of particular biological functions associated with those genes (In re Fisher, 421 F.3d 1365 (Fed. Cir. 2005)). Restrictions on the patenting of gene fragments was also the focus of a trilateral study by the European Patent Office, the Japan Patent Office, and the US PTO (Trilateral Study B3b, 2000). More generally, Heller and Eisenberg (1998) worried that too many ‘upstream’ patents procured by recipients of federal research funding following the Bayh-Dole Act of 1980 could paradoxically interfere with ‘downstream’ product development as a result of aggressive patent assertions. NIH promptly sought to discourage restrictive patenting and licensing practices on the part of its grantees through a variety of hortatory statements (Rai and Eisenberg, 2003; Department of Health and Human Services, 1999). Leaders in the university technology transfer community also sought to address this problem through dissemination of best practices to promote widespread availability of research

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Anticommons, transaction costs, and patent aggregators  39 results and to control aggressive assertions of ‘upstream’ patents that might interfere with downstream product development (California Institute of Technology et al., 2007). In addition to these efforts within the research community and the science agencies, the Federal Circuit invalidated a number of prominent university patents through its interpretations of patent law.6 In particular, the Federal Circuit fortified the statutory requirement that a patent application must include a ‘written description’ of the invention in a series of decisions invalidating broad university patents on basic research discoveries with claims that potentially dominated the products of drug companies (Mueller, 1998). More recently, the US Supreme Court has limited the availability of patents on fundamental research discoveries through robust enforcement of traditional exclusions from patentable subject matter for natural laws, natural products, and abstract ideas.7 The effect is to limit the power of upstream patents over downstream products, protecting product developing firms against patent assertions and limiting the number of upstream rights that they need to clear. B.  Limits on Injunctions A prominent worry in the anticommons literature is that individual patent holders will try to use their exclusionary rights to extract excessive shares of the potential gains from aggregation, creating a risk that valuable deals will not get done (Lemley and Shapiro, 2007). This concern has been diminished by the decision of the US Supreme Court in eBay v. MercExchange (2006), which made it more difficult for patent holders to obtain injunctions against infringers. Prior to that decision, the general rule in the Federal Circuit was that a prevailing patent holder was ordinarily entitled to a permanent injunction. After eBay, a patent holder seeking injunctive relief must demonstrate (1) that it has suffered an irreparable injury, (2) that money damages are inadequate to compensate for that injury, (3) that the balance of hardships indicates that the equitable remedy of an injunction is warranted, and (4) that the public interest would not be disserved by an injunction. In a concurring opinion, four justices noted in particular that a near-automatic injunctive remedy might give too much power to opportunistic patent holders to hold out for excessive settlement payments.8 6   See, e.g., Regents of the University of California v. Eli Lilly, 119 F.3d 1333 (Fed. Cir. 1997); University of Rochester v. G.D. Searle, 358 F.3d 916 (Fed. Cir. 2004); Ariad Pharmaceuticals v. Eli Lilly, 598 F.3d 1336 (Fed. Cir. 2010). 7   See, e.g., Mayo Collaborative Services v. Prometheus Laboratories, 566 U.S. 66 (2012); Ass’n for Molecular Pathology v. Myriad Genetics, 569 U.S. 576 (2013). 8   See eBay v. MercExchange (2006), 547 U.S. at 396–97:

  An industry has developed in which firms use patents not as a basis for producing and selling goods but, instead, primarily for obtaining licensing fees. . ..For these firms, an injunction, and the potentially serious sanctions arising from its violation, can be employed as a bargaining tool to charge exorbitant fees to companies that seek to buy licenses to practice the patents. [ ] When the patent invention is but a small component of the product the companies seek to produce and the threat of an injunction is employed simply for undue leverage in negotiations, legal damages may well be sufficient to compensate for the infringement and an injunction may not serve the public interest. (concurring opinion of Justice Kennedy, joined by Justice Stevens, Justice Souter, and Justice Breyer).

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40  Research handbook on the economics of IP law volume 1 This controversial decision arguably puts US patent law in violation of international agreements that set limits on compulsory licensing of patents (Cotropia, 2008; Dinwoodie and Dreyfuss, 2012). On the other hand, it diminishes the risks faced by unlicensed users by weakening the holdup power of patent owners. Product developing firms might therefore be more willing to invest in fields characterized by patent thickets without clearing all potentially infringed rights through ex ante licensing, if they figure that courts will give them a better deal in setting damages than patent holders would require to relinquish their injunctions. C.  Lowering Information Costs Another source of costs for subsequent innovators arising from a proliferation of patents is the sheer burden of figuring out what patent rights are relevant to a particular project (Bessen and Meurer, 2008). Although patents are public documents that typically disclose the identity of the inventor and initial assignee, it is costly to search for relevant patents, to analyse validity and infringement to determine which rights are necessary to clear, and to identify current owners (Eisenberg, 2011). These costs may be worth incurring if a firm is about to launch a lucrative new drug, but not if the values at stake are uncertain and speculative. Some of these costs could be lowered through law reform measures to make the scope of patent rights clearer and to maintain updated records of ownership and assignments. Although the US patent statute requires that patents include claim language ‘particularly pointing out and distinctly claiming the subject matter which the inventor or a joint inventor regards as the invention,’ (35 U.S.C. § 112), claim interpretation in the courts has become a highly indeterminate practice, leaving substantial uncertainty as to what a patent covers until the conclusion of appellate review (Saunders, 2007; Schwartz, 2008). The Federal Circuit left considerable room for ambiguity by minimizing the requirement for definiteness of claim language, holding that a patent claim was invalid for lack of definiteness only when its language was ‘not amenable to construction’ or ‘insolubly ambiguous’ (Exxon Research and Engineering Co. v. United States, 265 F.3d 1371, 1375 (2001)). Recent Supreme Court decisions reversed this approach, replacing the ‘insolubly ambiguous’ standard with a new rule that ‘a patent is invalid for indefiniteness if its claims, read in light of the specification delineating the patent, and the prosecution history, fail to inform, with reasonable certainty those skilled in the art about the scope of the invention’ (Nautilus v. Biosig Instruments, 134 S. Ct. 2120, 2124 (2014)). Shortly thereafter, the Supreme Court again reversed the Federal Circuit’s approach to claim interpretation, holding that the Federal Circuit must defer to factual determinations made by District Courts in the course of claim interpretation (such as determinations of the meaning of claim language to a person working in the field of the invention) (Teva Pharmaceuticals USA v. Sandoz, 135 S. Ct. 831 (2015)). Taken together, these two decisions promised to make claim interpretation more predictable and to provide greater certainty at an earlier stage in litigation without the need for appellate review, thus reducing the costs to innovators of determining whether they are infringing any patent rights. Initial observations suggest, however, that these decisions have had minimal impact on the claim interpretation practices of the Federal Circuit (Rantanen, 2015).

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Anticommons, transaction costs, and patent aggregators  41 On the other hand, the Federal Circuit has been more willing than the Supreme Court to reduce uncertainty about the scope of patent coverage through restrictions on the doctrine of equivalents. The doctrine of equivalents is an old infringement doctrine that predates modern patent claiming practice and allows infringement liability even when the defendant’s technology is not covered by the literal language of the patent claims if the differences are insubstantial (Warner-Jenkinson v. Hilton Davis Chemical, 520 U.S. 17 (1997)). The Federal Circuit has significantly curtailed the operation of the doctrine of equivalents over the years, making the coverage of patents correspond more closely to the claims (Allison and Lemley, 2007). But literal claim interpretation itself has remained a stubbornly indeterminate exercise, leaving considerable uncertainty about the technological scope of patents. Uncertainty about the coverage of patent claims is partly due to the inherent difficulty of defining new technologies in words. But it is also partly a result of strategic use of ambiguous language by patent applicants in order to retain flexibility in asserting their patents against future competitors who may use unforeseen technological variations. This flexibility comes at a considerable cost of uncertainty. The burden and risk for future innovators rise quickly as the number of patents that might be asserted against them increases. To the extent that courts make clear that they are unwilling to expand the effective reach of patents, whether through flexible interpretation of vague claim language or through liberal use of the doctrine of equivalents, future patent applicants may find it advantageous to do a better job of defining their inventions clearly in their claims. If this happens, users will be able to determine more easily just what a patent covers. Some reformers have also argued for legal changes that would increase publicly available information about patent ownership, assignments, and licenses (US Patent and Trademark Office, 2011). Although current law permits the parties to record a patent assignment and thereby cut off the interest of any subsequent bona fide purchaser (35 U.S.C. § 261), assignments are rarely recorded, leaving uncertainty about the current ownership of patents. Recording requirements are more common for interests in real property. As secondary markets for patents have grown with the rise of patent assertion entities, this gap in the public record has become more problematic. Future innovators who cannot determine who owns patents they may be infringing may be unable to clear rights ex ante, leaving them more vulnerable to holdup after they have incurred sunk costs  (Green and  Scotchmer, 1995). Federal recording requirements for patents would reduce the information costs facing potential infringers who want to clear rights (Glovsky, 2012). D.  Lowering the Costs of Patent Challenges The Leahy-Smith America Invents Act (2011) introduced new administrative procedures for challenging the validity of issued patents before an ­ administrative tribunal within the PTO.9 These proceedings are quicker and cheaper than

 9   These new proceedings include post-grant review during the first nine months after patent issuance, codified as amended at 35 U.S.C. §§ 321–9, inter partes review more than nine months

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42  Research handbook on the economics of IP law volume 1 litigation10 and have been surprisingly popular and effective as a means of invalidating patents (Carniaux and Sander, 2015). They offer a number of benefits for patent challengers relative to litigation, including an accelerated time frame for resolution (12 months from institution of the proceeding until final decision (35 U.S.C. §§ 316(a)(11), 326(a)(11)), rather than years for litigation), and a lower burden of proof (preponderance of the evidence (35 U.S.C. §§ 316(e), 326(e)), rather than the clear and convincing evidence required to establish invalidity at trial (Microsoft v. i4i Ltd, 131 S. Ct. 2238 (2011))). But even with these advantages, using these new proceedings can still cost hundreds of thousands of dollars per patent (American Intellectual Property Law Association, 2015). The goal of these new proceedings was to address the problem of patent quality, while the primary concern in the anticommons story is about excessive quantities of patents. But quantity and quality are related. As the quantity of patent applications has increased, PTO resource constraints make it more difficult for examiners to scrutinize each application with care, setting the stage for allowance of patents that closer scrutiny would reveal to be invalid. This may be tolerable if most patents are never asserted, and if users can, at reasonable cost, evaluate those patents that are asserted for validity and infringement before agreeing to pay royalties. But an opinion letter evaluating validity and infringement costs approximately $15,000 per patent (American Intellectual Property Law Association, 2015). As the quantity of asserted patents increases, it becomes unrealistic for users to provide an effective quality check at the point of assertion. If information costs are high enough, quantity in effect becomes a substitute for quality, giving patent aggregators the power to extract payments from risk-averse firms without regard to the merits of their patent infringement claims. The problems created by large numbers of patents are not limited to the costs of negotiating with multiple owners and are not resolved by aggregation of patents in the hands of a smaller number of owners. Quite the contrary, aggregation may increase the risk of underuse by facilitating assertion of patents that could otherwise be ignored. Some of these patents may be valid, and these rights should be licensed in order to provide a return to their owners, but others may be invalid or irrelevant to the activities of firms against which they are asserted. Large numbers of patents threaten to overwhelm the quality control mechanisms that allow patent owners, technology users, and antitrust authorities to separate the wheat from the chaff. Determinations of validity and infringement have remained stubbornly unpredictable, defying efforts to develop lower cost strategies for figuring out which rights need to be cleared.

after patent issuance, codified as amended at 35 U.S.C. §§ 311–19, and a transitional program in effect until 2020 utilizing post-grant review for covered business method patents (Leahy-Smith America Invents Act of 2011, Pub. L. No. 112-29, § 18(a), 125 Stat. 284). See U.S. Patent and Trademark Office (2012); Menell et al. (2015) at 14-29–14-33. 10   Recent estimates from the American Intellectual Property Law Association (2015) give a median cost of $350 million for pursuing post-grant proceedings through appeal, and a cost range for defending a patent infringement action of $500,000 to $375,000.

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Anticommons, transaction costs, and patent aggregators  43

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Anticommons, transaction costs, and patent aggregators  45 Maurer, Stephen M. 2006. ‘Inside the Anticommons: Academic Scientists’ Struggle to Build a Commercially Self-Supporting Human Mutations Database, 1999–2001,’ 35 Research Policy 839–53. McDonough, James F. III. 2006. ‘The Myth of the Patent Troll: An Alternative View of the Function of Patent Dealers in an Idea Economy,’ 56 Emory Law Journal 189–228. McLeod, Kembrew, and Peter DiCola. 2011. Creative License: The Law and Culture of Digital Sampling. Durham and London: Duke University Press. McManis, Charles R., and Brian Yagi. 2014. ‘The Bayh-Dole Act and the Anticommons Hypothesis: Round Three,’ 21 George Mason Law Review 1049–91. Menell, Peter, et al. 2015. Patent Case Management Judicial Guide. 3d ed. Clause 8 Publishing. Merges, Robert P. 1996. ‘Contracting into Liability Rules: Intellectual Property Rights and Collective Rights Organizations,’ 84 California Law Review 1293–393. Merz, Jon F., Antigone T. Kriss, Debra G.B. Leonard, and Mildred K. Cho. 2002. ‘Diagnostic Testing Fails the Test: The Pitfalls of Patents Are Illustrated by the Case of Haemochromatosis,’ 415 Nature 577–99. Mowery, David C., and Arvids A. Ziedonis. 2007. ‘Academic Patents and Materials Transfer Agreements: Substitutes or Complements?,’ 32 Journal of Technology Transfer 157–72. Mueller, Janice M. 1998. ‘The Evolving Application of the Written Description Requirement to Biotechnological Inventions,’ 13 Berkeley Technology Law Journal 615–52. Murray, Fiona. 2006. ‘The Oncomouse that Roared: Resistance and Accommodation to Patenting in Academic Science,’ retrieved on March 22, 2019, http://fmurray.scripts.mit.edu/docs/THE_ONCOMOUSE_THAT_ ROARED_FINAL.pdf. Murray, Fiona, and Scott Stern. 2007. ‘Do Formal Intellectual Property Rights Hinder the Free Flow of Scientific Knowledge? An Empirical Test of the Anti-Commons Hypothesis,’ 63 Journal of Economic Behavior and Organization 647–87. Nicol, Dianne, and Jane Nielsen. 2003. ‘Patents and Medical Biotechnology: An Empirical Analysis of Issues Facing the Australian Industry,’ retrieved on April 3, 2019, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2583508. Parchomovsky, Gideon, and R. Polk Wagner. 2005. ‘Patent Portfolios,’ 154 University of Pennsylvania Law Review 1–77. Parente, Michael, and Abel M. Winn. 2012. ‘Bargaining Behavior and the Tragedy of the Anticommons,’ 84 Journal of Economic Behavior & Organization 475–90. Parisi, Francesco, Norbert Schulz, and Ben Depoorter. 2005. ‘Duality in Property: Commons and Anticommons,’ 25 International Review of Law and Economics 578–91. Parisi, Francesco and Catherine Sevcenko. 2001–02. ‘Lessons from the Anticommons: The Economics of New York Times Co. v. Tasini,’ 90 Kentucky Law Journal 295–328. Peters, Marybeth. 2004. ‘Statement of Marybeth Peters the Register of Copyrights before the Subcommittee on Courts, the Internet and Intellectual Property of the House Committee on the Judiciary,’ 108th Congress, 2d Session, retrieved on Dec. 17, 2015, http://copyright.gov/docs/regstat031104.html. Rai, Arti K., and Rebecca S. Eisenberg. 2003. ‘Bayh-Dole Reform and the Progress of Biomedicine,’ 66 Law & Contemporary Problems 289–314. Rantanen, Jason. 2015. ‘Teva, Nautilus, and Change without Change,’ 18 Stanford Technology Law Review 375–93. Risch, Michael. 2012. ‘Patent Troll Myths,’ 42 Seton Hall Law Review 4267–99. Samuelson, Pamela. 2011. ‘The Google Book Settlement as Copyright Reform,’ 2011 Wisconsin Law Review 479–562. Saunders, Michael. 2007. ‘A Survey of Post-Phillips Claim Construction Cases,’ 22 Berkeley Technology Law Journal 215–40. Schulz, Norbert, Francesco Parisi, and Ben Depoorter. 2003. ‘Fragmentation of Property: Towards a General Model,’ 159 Journal of Institutional and Theoretical Economics 594–613. Schwartz, David L. 2008. ‘Practice Makes Perfect? An Empirical Study of Claim Construction Reversal Rates in Patent Cases,’ 107 Michigan Law Review 223–84. Schwartz, David L. 2014. ‘On Mass Patent Aggregators,’ 114 Columbia Law Review Sidebar 51–69. Shapiro, Carl. 2001. ‘Navigating the Patent Thicket: Cross Licenses, Patent Pools, and Standard Setting,’ in Adam Jaffe, Josh Lerner, and Scott Stern, eds., Innovation Policy and the Economy, vol. 1. Cambridge, MA: MIT Press. Soini, Sirpa, Segolene Ayme, and Gert Matthijs. 2008. ‘Patenting and Licensing in Genetic Testing: Ethical, Legal and Social Issues,’ 16 European Journal of Human Genetics S10–S50. Stewart, Steven, and David J. Bjornstad. 2002. ‘An Experimental Investigation of Predictions and Symmetries in the Tragedies of the Commons and Anticommons,’ Joint Institute for Energy and Environment Report No. JIEE 2002–07, retrieved on Apr. 3, 2019, http://isse.utk.edu/pdf/jieepubs/2002_07Experiment.pdf. Straus, Joseph, H. Holzapfel, and M. Lindenmeir. 2004. Genetic Inventions and Patent Law: An Empirical Survey of Selected German R&D Institutions. Munich: Verlag Medien Design. Trilateral Study B3b. 2000. Comparative Study on Biotechnology Patent Practices: Theme – Patentability of

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46  Research handbook on the economics of IP law volume 1 DNA Fragments, retrieved on Dec. 21, 2015, http://www.trilateral.net/projects/biotechnology/patentability. pdf. U.S. Copyright Office. 2015. Orphan Works and Mass Digitization, retrieved on Dec. 15, 2015, http://copyright. gov/orphan/reports/orphan-works2015.pdf. U.S. Patent and Trademark Office. 2001. Utility Examination Guidelines, 66 Federal Register 1092–9. U.S. Patent and Trademark Office. 2011. Request for Comments on Eliciting More Complete Patent Assignment Information, 76 Federal Register 72372–4. U.S. Patent and Trademark Office. 2012. Changes to Implement Inter Partes Review Proceedings, Post-Grant Review Proceedings, and Transitional Program for Covered Business Method Patents, 77 Federal Register 48680–731. Van Houweling, Molly Shaffer. 2010. ‘Author Autonomy and Atomism in Copyright Law,’ 96 Virginia Law Review 549–642. Vanneste, Sven, Alain Van Hiel, Francesco Parisi, and Ben Depoorter. 2006. ‘From “Tragedy” to “Disaster”: Welfare Effects of Commons and Anticommons Dilemmas,’ 26 International Review of Law and Economics 104–22. Walsh, John P., Ashish Arora, and Wesley M. Cohen. 2003. ‘Effects of Research Tool Patents and Licensing on Biomedical Innovation,’ in Wesley M. Cohen and Stephen A. Merrill, eds., Patents in the Knowledge-Based Economy. Washington: National Academies Press. Walsh, John P., Wesley M. Cohen, and Charlene Cho. 2007. ‘Where Excludability Matters: Material versus Intellectual Property in Academic Biomedical Research,’ 36 Research Policy 1184–203. Williams, Heidi L. 2013. ‘Intellectual Property Rights and Innovation: Evidence from the Human Genome,’ 121 Journal of Political Economy 1–27. Yeh, Brian T. 2015. ‘Copyright Licensing in Music Distribution, Reproduction, and Public Performance,’ Congressional Research Service, retrieved on Dec. 17, 2015, https://www.fas.org/sgp/crs/misc/RL33631.pdf. Ziedonis, Rosemarie H. 2004. ‘Don’t Fence Me In: Fragmented Markets for Technology and the Patent Acquisition Strategies of Firms,’ 50:6 Management Science 804–20.

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3.  Governing intellectual property Henry E. Smith* 1

Contents I. Property as Platform II. Fluid Property and the Need for Governance III. Governance of Intellectual Property A. Patent Versus Copyright B. Licensing C. Governance Through Equity D. Group Institutions IV. Conclusions References The ‘property’ in intellectual property has been nothing if not controversial. Stressing the property element in intellectual property is often assumed to amount to a call for overly strong protection for creators and inventors. Intellectual property skeptics believe that an overemphasis on property in this area results from rent-seeking, mistaken thinking, or misplaced metaphors from the world of tangible property. Information is different. Because information is nonrival, exclusion rights over it come at the cost of preventing harmless use. As long as they do not incur the costs of exclusion rights thought to be characteristic of property, other institutions already have a head start. An apparent counterpoint to property talk and property thinking is the notion of governance. Although ‘governance’ is a term with many meanings, several related notions stand out in potential contrast to exclusion rights. A commons is often governed by a group of user-participants, and accordingly Nobel laureate Elinor Ostrom’s (1990) landmark book exploring this institutional arrangement is titled Governing the Commons (see also Rose, 2011). What constitutes governance more generally covers a wide spectrum. We speak of corporate governance and governance in a public law setting. Closest to intellectual property, information-related activities can be governed through many types of institutions. These include public regulation and private contract. They even include customs and norms. Putting the idea of governance together with the inherent drawbacks of exclusive rights in property, and one might say that there is a presumption in favor of commons or the public domain, which then can be ‘governed’ in various ways.

*  Fessenden Professor of Law and Director of the Project on the Foundations of Private Law, Harvard Law School. Email: [email protected] I thank the participants at the Research Handbook Conference at the University of California, Berkeley, School of Law for helpful comments and Andrew Lewis for excellent research assistance. All errors are mine.

47

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48  Research handbook on the economics of IP law volume 1 This picture, while in many ways admirably broad, is still incomplete. Far from being at odds with property, governance is an important aspect of property itself. Exclusion and governance are typically mixed together in regular property (Smith, 2002). In order to understand what property does and does not offer in the area of information, we need to be clear on how these strategies work – and how they can work together. In this chapter, I will revisit the question of the governance of informational resources from the point of view of property and systems theory. Instead of being contradictory or mutually exclusive, property and governance overlap. The governance of uses is one end of a spectrum of strategies employed within property law. What sets intellectual property apart is the fluid nature of the resource. As in oil and gas, water, and radio spectrum, the separation of uses is more difficult and less desirable in general than in the case of land and tangible personal property. Indeed, property can be seen in part as a law of separation: it manages conflict and allows for specialization by separating things from their surroundings, classes of uses from each other, and various functions from each other (e.g. management and beneficial use) (Smith, 2017). Particularly prominent is the separation into modules associated with thinghood and the adoption of exclusion strategies for delineating rights. In the case of fluid resources, the problems with and difficulties of separation and exclusion lead the law to shift more readily to governance strategies than in the case of non-fluid property. This chapter will explore the structure of property and governance in intellectual property. Section I will set the stage by noting several notions of governance and the role they play in property theory. Regular property mixes exclusion and governance, and provides a modular structure for managing the interaction of actors with respect to things. Section II draws out the special challenges of fluid property, of which intellectual property is a prominent type, and will show how these special challenges call for complex forms of governance to facilitate use by multiple parties while containing opportunism. Governance is often required where multiple regimes overlap in fluid property, especially when common and private rights interact, in a semicommons. In Section III, I apply this framework to intellectual property. The role of governance in managing multiple use explains some differences between patent and copyright, patterns in intellectual property licensing, the role of equity in intellectual property, and the importance of collectiverights organizations.

I.  PROPERTY AS PLATFORM Property is such a controversial notion that contention even surrounds what property is. I will argue for the usefulness of a notion of property that takes the notion of separation as central. Characteristic of property law is the separation of clusters of resource-related activities for treatment in partial isolation of their context, in modular fashion. Most basic and prominent is the separation from legal things from their background context. This is far from the end of the story, though. Even in the definition of a legal thing, intellectual property is partially (but only partially) similar to tangible property (Madison, 2005; Smith, 2007a, 2012; Van Houweling, this volume). What property law requires is a legal ontology – a set of persons, activities, and things that are the units in which the law is framed. In a world of zero transaction

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Governing intellectual property  49 costs (Coase, 1960), we could imagine that the notion of thing would be far less important than it is in our world. For all possible activities of all people in society, the potential conflicts between and among them could be handled directly by contract – directly in the sense that the contracts would make reference to persons and activities without the need to define more abstract and formal notions like a thing. Proceeding in this fashion would likely be intractable (can intractability be overcome by contract in the zero transaction world?), and so in our world separating out clusters of activities into chunks – modules – through the definition of things is a massive shortcut (Lee and Smith, 2012). Thus, a person can be protected in a wide variety of activities with respect to a car from a wide variety of activities of others generally, by defining the rights and duties availing between the possessor (or owner) and everyone else through the car (Penner, 1997). Not literally through the car, but through a legal thing that closely corresponds to a car. Indeed, the legal ontology tracks everyday ontology closely in the case of personal property (although we need the law of accession to know, for example, that a calf goes to the owner of its mother) (Smith, 2015a).1 In the case of real property, more effort at legal delineation is required: physical boundary markers and surveys help define the legal thing we call a parcel. There is likely to be more error and more dispute here precisely because there is more delineation required to get from the world of actual things to legal things (Libecap and Lueck, 2011). Intangibles and intellectual property are, as is well known, even more difficult to delineate in legal terms (Fromer, 2009; Menell, 2011). Defining things is notoriously challenging in intellectual property, although, as we will see, these difficulties differ by area of intellectual property. Thus, copyright things (expressions) are quite ethereal, and copyright law defines rights more in terms of use than does patent law. In principle, an invention may be easier to define than an expression – and it serves as more of a shorthand over a wide range of uses (make, use, sell), but the delineation is quite problematic compared to personal and even real property (Bessen and Meurer, 2008; Menell and Meurer, 2013). The difficulty of delineating things in this area is closely related to the extended notion of ‘possession’ required for intangibles, which must key off notions of notice (copyright) and enablement and other disclosure (patent) (Van Houweling, this volume; Holbrook, 2006). And violations of rights do not announce themselves in the area of rights in intangibles, the way they do with rights over rival, tangible resources. Nevertheless, what thing-definition is doing here, however well or poorly, is to pick out sets of activities for bulk treatment. To see how indirect thing-definition can be in patent law, consider patents on tennis rackets. The tennis racket is an everyday object and not a very controversial item in most people’s ontology, even if there may be borderline cases (a squash racket used for a tennis game?). When it comes to incremental inventions relating to tennis rackets, the story is different. In Athletic Alternatives, Inc. v. Prince Mfg., Inc., 73 F.3d 1573 (Fed. Cir. 1996), a string system design company sued a racket manufacturer, alleging infringement of a patent on a splayed racket with a string pattern of offsetting attachment locations to the

1   In recent times there has been an upsurge in interest in how the law of accession intersects with intellectual property (Lee, 2011; Merrill, 2009, pp. 468–9; Newman, 2011; Smith, 2007a, pp. 1766–77).

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50  Research handbook on the economics of IP law volume 1 racket in which the offset distance ‘varies between’ a minimum and maximum distance. The allegedly infringing racket had two positions for string attachment that alternated, and the Federal Circuit upheld summary judgment of no infringement because on a narrow reading two positions do not ‘vary’ according to the specification. The case involved a complicated prosecution history and possibly ambiguity in the claim, and the court was perhaps penalizing ambiguity by adopting the narrower reading. The point in terms of delineation is that little of this tracks everyday understanding, and as a method of picking out various activities – by using the ‘invention’ as defined in part by this exercise in construction – it is very indirect and delicate indeed. As we will see, because thing-definition in intellectual property does not get as far as in regular property, governance plays a larger role relative to exclusion in intellectual property. In patent law, much of the definition has to occur ex post, where uses can be evaluated. Prominently and controversially, the doctrine of equivalents sometimes adds scope to prevent evasion of the literal boundaries, and in an earlier era the doctrine of equivalents played a larger role in cutting back on scope for potentially opportunistic patentees (Ellis, 1949, § 216). Alternatively, one might say that thing-definition itself is more a matter of governance in intellectual property (Collins, 2008). This is dramatically true of trademark. Is the mark a thing, and if so in what sense? We cannot really know what the thing is unless we know what others are doing in the ‘vicinity’ – what kinds of marks they are using for what kinds of business in what locations. Nonetheless, it is safe to say that governance is doing more work here than it would if it were possible to define a robust thing less tied to the context of use. By separating out clusters of activities, we can use a relatively easy-to-measure activity with respect to a thing as a proxy for harm that triggers the violation of a right over those activities. This is dramatically so in the case of exclusion strategies. Thus, crossing the boundary of Blackacre, damaging (or sometimes harmfully touching) an item of personal property, and making, using, or selling a patented invention, trigger violations in a way less costly to delineate, observe, and enforce than if one had to separately track the activities they stand in for. The exclusion strategy has the advantage of relative cheapness, and it allows the owner to become the residual claimant over those activities. Characteristically, property law begins with things and defines rough and ready exclusion strategies to protect their use value: torts like trespass and actions like replevin use relatively simple on/ off signals for violation of the holder’s right. But there is a big price. Because the activities that serve as a basis for finding violations of the right are just proxies for harm, the proxies will be over- and underinclusive with respect to the underlying activities we care about. This is true in the case of tangible property and even more true of intellectual property. The proxies are underinclusive in that many uses can be interfered with, without the triggering of the boundary crossing: not all nuisances involve boundary crossing by tangible objects – for example loud noises. The boundary-related proxies are overinclusive in the sense that not all intruders barred by the law of trespass would cause actual harm to the possessor’s uses (Ellickson, 1993). And more subtle coordination of uses, such as uniform door color, cannot be brought about by employing exclusion strategies. Here is where governance comes in. When a problem involving use conflicts becomes important enough, it makes sense to shift to the more costly but more refined governance strategies, which unlike exclusion strategies, do condition violation on proxies closely

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Governing intellectual property  51 tied to types of uses (Smith, 2004, 2007a). Rights to exclude are not absolute in regular property (Carrier, 2004). Exclusion gives way at some point to governance, and one form this can take is exceptions to the right to exclude (Merrill and Smith, 2010, pp. 74–84). The strategies fall along a spectrum; in a sense, exclusion is very crude governance and governance is fine-grained exclusion. Thus, nuisance, covenants, and zoning all zoom in on proper use. As we will see, when it comes to fluid property, the move from exclusion to governance happens not only more quickly, but in characteristic ways. The goal is to find the least bad proxies in light of both benefits and costs. In the case of regular property, many, including virtually all law-and-economics commentators, see property as serving the interest in the use of things. (This should be construed broadly to include preservation and existence value.) In the case of rival resources, uses conflict, and property serves in part to resolve those conflicts. If property employs an exclusion strategy, it is not because there is an inherent value to exclusion; exclusion is only justified if it is the most cost-effective method of resolving conflicts over uses. Exclusion as a strategy is indirect (Smith, 2009, 2011): we could imagine, in a zero transaction cost world, a law that directly resolved the conflict between any two activities. In our world, this would be prohibitively expensive, though. In addition, property in general and exclusion strategies in particular serve to protect owners’ investments and to provide a foundation for contract. The indirectness of the strategy is clear when we consider how these investments could be rewarded publicly or contracted over privately on a case-by-case basis. This more direct strategy would require an elaborate system of tracing the contribution of investment to consumer welfare, and, again proceeding this way would be prohibitively expensive most of the time. How does exclusion fit, if at all, into intellectual property? First, there is no allocation problem because the use of information itself is nonrival.2 Thus ‘conflicting uses’ cannot have the same meaning or role as it does in regular property. Nevertheless, how to pick proxies in order to protect investments and allow people to contract over their information-related activities does present a problem for which exclusion can in principle play some role, leaving open important empirical questions. Thus, in some areas of intellectual property, with patent law being the most prominent example, some theorists argue that commercialization is important in addition to or instead of the ‘reward’ that conventionally forms the rationale for intellectual property (Rich, 1942; Kieff, 2001; Sichelman, 2010). Exclusion has an asset-partitioning function in intellectual property (Heald, 2005). By employing proxies that give a residual claim over the return from a cluster of attributes of information, one can indirectly define rights to the return from rival inputs to commercialization, such as labor and materials that go into marketing. Moreover, this ability to appropriate the return from a cluster of attributes can be packaged and transferred, and it is likewise easier to transfer this bundle than a bundle of residual claims to articulated rival resources (which would otherwise require tracing through the commercialization 2   The nonrivalness of information counts in favor of certain alternatives to intellectual property, if the question is rewards for invention (Abramowicz, 2003; Duffy, 2004). Commercialization theory, as an alternative to reward theory, is a much more complex question, to which I return below. Nonrivalness of information also presents problems in getting people to reveal their values (Yoo, 2007).

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52  Research handbook on the economics of IP law volume 1 process) (Merges, 2005; Liivak, 2013). In general, exclusion promotes alienability in regular property law and contributes to the function of promoting transactions identified in the literature on patents. Exclusion’s indirectness is a double-edged sword. It is a relatively low-cost way to get at the commercialization activities we care about. It protects residual claims and allows contracting over them. When negotiations fail or a contract is breached, the baseline is there. The flipside – and major downside – is that the cruder this proxy is with respect to what is truly valuable, the greater is the distance between the exclusion strategy and a fully articulated system of governance or unfair competition and the greater is the waste in terms of foregone use that the intellectual property skeptics rightly point to as a cost of intellectual property in the first place. The question is what combination of exclusion and governance – and no protection – will be best. This is ultimately an empirical question, but simple institutional models can make a few predictions and allow for some rough guesses. To start with, aside from some very narrow detachable problems, it is difficult to serve commercialization using governance only. I will argue that the shift to governance happens more quickly in the case of copyright than in patent, but copyright still involves a thing – protected expression – and is, however tenuously, a property regime. Why is status as property important at all? Generally speaking, property law manages the complexity of private interactions over resources by employing the technique of modularity. In general, modular systems break down complex interactions in a way that provides for components called modules that contain intense interaction, and the modules are connected by interfaces that capture relatively sparser interactions (Baldwin and Clark, 2000; Langlois, 2002). Because the connections between modules are relatively sparse, work can take place within one or few modules without destabilizing and hard-to-foresee ripple effects. Indeed, modularity allows for ‘information hiding,’ in which module-internal information is not relevant to outside processes. In a car, much of the internal workings of the brake system are invisible to the windshield wiper and air conditioning systems. Modularization thus permits specialization. Much of the characteristic modularity of property law starts with the definition of legal things: defining a legal thing involves setting boundaries around clumps of interactions (modules) and defining the permitted interface between them (Smith, 2012; Sichelman and Smith, 2017). The kind of separation involved in modularity is typically partial: the system of interactions is not totally decomposable into freestanding non-interacting components; instead algorithms can be used to choose modularizations in which interaction is relatively intense within modules but relatively sparse across interfaces (Simon, 1981; Arora and Barak, 2009). As with modularity in general, managing complexity in this fashion allows for specialization. In property, recognizing the owner as being in charge (up to a point) of a legal thing permits the owner to specialize in investing in and becoming familiar with the asset. The separation involved in property is a separation into modules and extends to ‘entity property,’ which is based on asset definition and the separation of control from use (Merrill and Smith 2017, pp. 616–799). Such separation into functional modules facilitates specialization of management and various monitoring functions. Modularization in property is also vulnerable to strategic behavior when actors take regard only for what is internalized to them through modularization.

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Governing intellectual property  53 What is internalized is not just what is internal to the legal thing according to the exclusion regime; internalization also occurs though the governance regime at the interface. Thus, in real property, the legal things corresponding to Blackacre not only have boundaries protected by trespass and the like, but they also feature the rights and duties of nuisance law, duties of lateral support, any easements and covenants, zoning regulations, and so on. Without this interface of governance between legal things, owners would specialize, but myopically, engaging in a lot of overall welfare-reducing behavior. Employing legal things has to be compared with other methods of managing complexity, such as defining types of activity and using notions of foreseeability and proximate cause to resolve conflict, as in the law of torts. The question in intellectual property is not whether thing-definition is a good first cut or lends itself to delineation compared to regular property – it is definitely worse – but rather how these other more activityoriented methods of delineation for information would work. In the case of unfair competition, they perhaps work better. So the first question at the root of intellectual property is whether it is more advantageous to take a first cut at defining a thing and using an exclusion strategy, rather than doing nothing or directly governing in tort-like fashion. Likewise, in the question of whether intellectual property is property or regulation (Lemley, 2014; Mossoff, 2013), simply pointing to regulation does not answer that question: some regulation picks up where exclusion leaves off, and like exclusion keys off the things of a property regime. Other regulation is more free-floating and makes no special use of thing-based entitlements at all. This question of choice of strategy cannot be answered in isolation. Two factors are worth singling out. First, different things could form the platform for further property institutions. A thing could be defined narrowly or broadly, for example. Second, different thing-definitions could form a better platform for further governance than others. That is, ultimately, exclusion and governance work in tandem. Focusing in on particular uses to make exceptions or supplements to the exclusion regime can partially overcome the problems of under- and (especially) over-inclusion inherent in an exclusion regime. By the same token, governance can also make exclusion more effective when it targets strategic behavior designed to undermine the exclusionary regime. Examples include various equitable interventions and aspects of the law of nuisance (Kelly, 2011; Smith, 2015b). Thus, the institutional questions of exclusion and governance arise as a matter of total costs and benefits and at the margin (Coase, 1960). As in all institutional analysis, we must compare feasible alternatives. Because these institutions vary along many margins, we have to consider the total net benefit from any of them. However, when considering small changes, especially along one relatively isolated dimension, we can make predictions and recommendations along the one margin (Alston and Mueller, 2014; Smith, 2018). From a dynamic point of view, modular structures promote evolvability but only through a range. Thus, if the system is modularized a certain way, one of its great virtues is that one module can be tweaked or even replaced without causing havoc with the rest of the system (Simon, 1981; Baldwin and Clark, 2000). One can redesign the brakes on a car without worrying about the implications for fuel injection or air conditioning. Likewise, in the patent system, one could add a wider defense of research use to patent infringement or for satire in copyright or one could get rid of business method patents or extend patents to sports moves. All of these would be major changes in intellectual property, but because of the modular structure of entitlements and the legal doctrines, none of them would

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54  Research handbook on the economics of IP law volume 1 implicate every other corner of an area of intellectual property or intellectual property as a whole. While there is good reason to question whether courts and legislatures get it right when it comes to intellectual property, the modular structure facilitates change by making it more feasible without upsetting the entire apple cart. Modularity’s benefits in terms of facilitating change have their limits: major changes may not be achievable by local modular tweaks and instead may require remodularization. In general, modular systems under a wide variety of circumstances do evolve to achieve their goals more cost-effectively, but they can become trapped at a local maximum (Ethiraj and Levinthal, 2004). There may simply not be a path through the addition, subtraction, and modification of existing modules to climb a higher nearby ‘hill.’ For this, remodularization is required. Some major changes in property and intellectual property cannot come from the type of evolution facilitated through modularity. Instead, in the area of property, remodularizations, such as a redesign of the style of a property system, have been achieved on rare occasions by legislatures and autocrats. Examples include the Napoleonic Code and the 1925 legislation in England abolishing the machinery of the estate system and setting up national registration of land titles (Chang and Smith, 2012). These changes might be seen as out of equilibrium and are certainly harder to predict than are more ordinary changes. It is at the margin that predictions are most feasible. As usual, it is easier to measure a phenomenon and to make predictions about it when some things can be treated under the heading ‘all else equal.’ Under a variety of circumstances, there can be a Demsetzian evolution toward governance. The Demsetz Thesis holds that as potential externalities emerge with higher resource value, property rights will emerge to internalize them (Demsetz, 1967). Demsetz’s prime example was the emergence of property rights among the indigenous people of the Labrador Peninsula with the rise of the fur trade. As beavers became more valuable, family hunting territories emerged to prevent overhunting.3 Property rights can also emerge because the cost of internalizing externalities drops, as where the invention of barbed wire led to the fencing of open range in the American West (Anderson and Hill, 1975). By the same token, falling resource values and rising costs of delineation lead to an attenuation or abandonment of property rights (Anderson and Hill, 1975; Haddock and Kiesling, 2002). The emergence of ‘more property’ can, however, take the form of governance, and if the modular theory is correct, we should expect change to take place first at the interface of modules. One way for this to occur is to deal with interactions between modules not well handled by the exclusionary structure. Hence we get the law of nuisance, various exceptions to trespass, and the like. In intellectual property, the rise of particular problems can lead to exceptions to intellectual property, as with the doctrine of fair use, first in the courts and later through codification. I do not claim that any of these changes is optimal. What the theory does suggest is that, to the extent the process responds to efficiency, modular evolution will move locally in 3   Interestingly, the arrangement was more like a semicommons, because others still had the privilege to take a beaver for personal food consumption (as a sort of insurance against famine). The norm was to leave the pelt, but the access afforded by this own-consumption privilege was hard to police (Smith, 2000). And indeed the hunting territories were of such limited effectiveness that the Hudson Bay Company invested its own resources in conservation (McManus, 1972).

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Governing intellectual property  55 that direction. Thus, we can expect locally efficient in-group contracting over intellectual property rights (with the possibility of out-group externalities and collusion of the sort that is of concern in antitrust) (Ellickson, 1991). The locality of custom counsels caution in taking it up into the law of intellectual property (Rothman, 2013).

II.  FLUID PROPERTY AND THE NEED FOR GOVERNANCE What is special about intellectual property is that it manages a fluid resource. Other fluid resources include oil and gas, water, and radio spectrum, and, as we will see, the special costs and benefits of delineating rights in this family of resources lead to characteristic institutional solutions. Just as a legal thing is not the same as a physical thing, legal fluidity is like, but only like, physical fluidity. A fluid continually deforms under shearing stress, and fluids ‘flow’ in the familiar way, making individual parts of the fluid hard to track. In the physical domain, a fluid is more difficult to divide than is a solid. A legally fluid resource is one that is likewise difficult to separate into things – and hence to subject to exclusion strategies. The proxies one might use to delineate uses are leaky, in the sense that they do not stably pick out the class of uses we are interested in. This difficulty of separation of uses is related to the public good characteristics of these resources: they are hard to bound, but multiple use is very valuable. For fully nonrival resources, the value of the uses is additive, not mutually subtracting. Separating classes of uses or even things in the case of fluid resources is particularly difficult because of the potential for strategic behavior. Because of their nature, fluid resources are difficult to separate into things. This means that rights defined in terms of such things will be leaky. When separation works relatively well, we speak of regulating ‘access’: this is what exclusion strategies aim for. In constrast, neither narrow clusters of uses nor clusters that depend on less strict separation are suited to preventing actors from using the resource based on regulating access. These more-fingrained approaches to uses have the benefit of allowing for multiple use, but they leave the door open (as it were) to harmful uses under the guise of permitted uses (Ellickson, 1993; Smith, 2000). That is, the more directly rights and duties are defined in terms of narrower classes of uses and less categorically on the basis of exclusion from a thing, the more we have to police the specific use classes more closely, which is costly. Often this cost is worth incurring, and sometimes the strategic behavior is simply not worth curbing at all. The forms of governance for fluid property carry a signature that stems from the costs and benefits of delineating property in these resources (Smith, 2016). Because fluid resources make coordinating uses more important but more difficult in characteristic ways, we can make better predictions than simply that governance is relatively more important in intellectual property than in regular property. There is some truth to this simple generalization (Smith, 2007a), but it leaves a lot out of the picture. First, the shift to governance is nonetheless true of regular property, and the problems of strategic behavior in regular property are not wholly unrelated, if less severe than the ones that arise in intellectual property. One reason for the emphasis on governance in fluid property is that fluid property often requires hybrid regimes, mixing public, common, and private elements. Where two or

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56  Research handbook on the economics of IP law volume 1 more property systems apply to different aspects of the same resource, we have to worry about arbitrage-style behavior. Thus, in a semicommons, a resource is subject to common and private property and the two interact: actors’ behavior in the commons may be done with a view to private advantage, and use of private attributes can damage the commons (Smith, 2000). The prototypical example of a semicommons is the open-field system of early modern England (and other parts of Europe). There peasants had private rights to use land for grain-growing in long thin strips but would be required to throw these open as a common grazing area after harvests and during fallow periods. Ownership in the private period for grain-growing in bunches of scattered narrow strips has long been a puzzle, and one possible explanation is that this pattern made the strategic behavior in the commons more difficult. Individuals could not direct animals in a common herd to benefit their parcels with manure and damage others’ parcels with excessive trampling. The configuration in long thin scattered strips was quite inconvenient, but it made the boundaries effectively invisible during the commons periods (which they would not have been with compact contiguous parcels). This boundary configuration was a supplement to the governance rules (stinting) that are frequently found in successful common pool arrangements (Ostrom, 1990). Fluid property is particularly likely to be subject to hybrid regimes like the semicommons (Heverly, 2003; Yu, 2005; Loren, 2007; Smith, 2007a, 2007b; Frischmann, 2012; Barnett, 2010). The virtue of a semicommons is that it allows multiple access, and different institutions govern access on different scales, at different times, or with respect to different attributes. The problem is that multiple access precludes heavy reliance on boundaries to separate the uses. Thus, either we have to put up with use in one regime that is done with damaging regard to use in another regime, or we need governance strategies to constrain such behavior. In the case of water, both riparianism and (even) prior appropriation rely heavily on governance to deal with strategic behavior (Smith, 2007b; Freyfogle, 1989). Water is partially a public good: some uses are more consumptive than others, and it is hard to keep them separate. Thus, diversion for consumptive use is not the only purpose for water; it can be used for navigation, power generation, and so on, some of which have partial public goods features (Rose, 1990). In the case of water, these various uses and the rights that track them are highly intertwined. Prior appropriation is considered more parcelized or exclusionary than riparianism, and there is some truth in this (although riparianism is exclusionary in the sense that water rights are tied to the package of rights in riparian land). And yet consider the governance aspects of prior appropriation. In prior appropriation, what an appropriator for a beneficial use gets is a use right: it is measured by use and is lost by non-use. It also does not cover non-used water. Water that returns to the watercourse is appropriable by downstream appropriators. Even if the downstream appropriators are junior (later in time), a shift of use by the senior upstream appropriator or a transfer to a new user is not allowed to impact the junior appropriated rights to the return flow. This highly interlocking and evaluative scheme of governance allows for more intense appropriation of the water, at the cost of greater inconvenience for transfers and greater difficulty in shifting to new uses. If institutions respond to considerations of benefits and costs, we should expect governance where particular uses are especially important and conflicting, and where they are relatively easy to treat in separate fashion. First and most straightforwardly, if individual uses are particularly valuable, they are candidates for separate treatment. In the law of

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Governing intellectual property  57 nuisance, there is a shift from focusing trespass-style on obviously intrusive uses to reconciling conflicting uses, through rules of thumb or some kind of balancing (Smith, 2004). Easements and covenants pick out very specific sets of uses. And zoning often prescribes use, historically through separation into discrete areas, and now through land-use regulation or a form of contracting with developers. Although the institutional suppliers are very different, all of these devices are more fine-grained in terms of the uses they target than is the exclusionary regime of ad coelum and trespass.4 Again, a Demsetzian trend toward more property can take the form of more governance rather than more exclusion. In intellectual property, the nonrivalness of information and the cumulative benefits of the public domain lead to picking out uses directly. Thus, to take an extreme example, fair use is a highly complex free compulsory license for the public (Gordon, 1982; Leval, 1990). The uses involved are very valuable and make it worth incurring high delineation costs, especially in terms of governance. This governance can take the form of affirmative rights in the public to use information in certain ways, rather than undelineated privileges that would be more easily displaced. Off-the-rack law is not the only source of governance. Below we will return to the question of intellectual property licensing and collective-rights organizations. For simple models like that in Demsetz (1967) to hold, much has to be held constant. For one thing, the Demsetz account is a demand-side story: it treats the supply of property rights as a black box, and any difficulties in establishing rights are undifferentiated costs. The problematic dynamic of establishing property rights in groups or society as a whole is left unexplored. Others have brought supply considerations in (Libecap, 1989; Ostrom, 1990; Wyman, 2005). For fluid resources, a more fine-grained look at supply is required. Indeed, controversy has raged in intellectual property circles about whether licensing is likely and whether potential anticommons can be overcome (see below). Further, skepticism about intellectual property sometimes extends to suspicion of licensing itself: might licensing be used not to bargain over relaxing exclusion but rather to extend the owner’s control beyond the optimal point, or at least the one that Congress has decided upon (compare Burk and Cohen, 2001; Cohen, 2003 with Friedman, 1998)? Individual licensing and collective-rights organizations are thus central to whether intellectual property is a success or a failure. These are all governance regimes, but their costs and benefits are closely associated with their institutional sources. Nevertheless, the value of uses does not point unambiguously to more articulated governance. We need to compare the costs and benefits of separating out a narrow class of uses, versus affording owners broader exclusion rights, perhaps with defined exceptions. Exclusion rights are less good at solving use questions directly, but they economize on delineating uses in a fine-grained fashion. Exclusion rights also do not preclude governance by contract, individual, or group, and where contracting is lower (higher) cost, exclusion becomes more (less) attractive. Ultimately, to put it in economic, terms, the question is what combination of exclusion and governance, produced by which institution, is the most efficient.

4  The ad coelum principle is based on the maxim ‘cujus est solum, ejus est usque ad coelum et ad inferos,’ which translates as ‘one who owns the soil owns also to the sky and to the depths’), and provides that the boundaries of a parcel at least presumptively extend upwards and downwards, with adjustments – notably for airplane overflights (Merrill and Smith, 2017, pp. 10–16, 142–50).

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58  Research handbook on the economics of IP law volume 1

III.  GOVERNANCE OF INTELLECTUAL PROPERTY Because of its fluid nature, subjecting information to property rights is both controversial and challenging. As we will see, fluidity tends to require more extreme solutions than in the case of regular property. Depending on the type of use and the cost of contracting, we expect a greater role for the public domain, broader exclusion rights, or more detailed governance, or some combination of the three. What combination will actually occur is in large part an empirical question. Especially where multiple use is very important, hybrid rights regimes are valuable and require extra intervention to protect them from strategic behavior. In this section, I focus on several applications of this framework that highlight the importance of governance in intellectual property. First, the different costs and benefits of delineating classes of uses will help solve the puzzle of why patent and copyright are quite different, especially in that the former is – in a sense we can now define – more property-like than the latter. Second, the promise and perils of licensing in intellectual property and its crucial differences from regular property licenses will receive an explanation. Third, I will show how the system of rights in information is protected by equity as a second-order intervention where the law fails. Fourth and finally, as with fluid property regimes like water law, governance also is effected through collective-rights organizations. A.  Patent Versus Copyright Patent is overall more property-like than copyright. Theories of governance can help us explain why. All intellectual property, like property in general, is aimed at protecting uses. The activities that count as uses in the area of invention (patent) and expression (copyright) are different, and they vary in the ease with which they can be addressed. When it comes to inventions, the invention itself is nonrival, but the resources that go into creating and commercializing inventions are rival. (Although the uses of the information do not conflict, the uses of these other resources involved in commercialization would conflict.) The need to address these more remote rival input resources can push toward some form of property rights in information (Kitch, 1977, pp. 275–6), but this still leaves the question of what form these rights will take. The form of property in patent and copyright is very different: both are, like most property regimes, a mixture of exclusion and governance, but the emphasis is more toward exclusion in the case of patent and more toward governance for copyright (Smith, 2007a). The activities surrounding inventions – especially those involved in commercialization – are uncertain and interacting. Correspondingly, we have a large specialty of expert valuation in patent but less so in copyright. Indeed, now that in patent law there is a greater emphasis on damages relative to injunctions than there was ten years ago, the question of how to value the contribution of a patent to an overall product cannot be avoided (Lemley and Shapiro, 2007, 2013; Golden, 2010, pp. 582–6; Sidak, 2013; Sichelman, 2014), and the current state of the law is widely regarded as inadequate (Taylor, 2014). That a patent, especially in the hands of a ‘troll,’ might ex post be costly to avoid violating – factories have been built, standards have been set – and yet the patent contributes only in a small way to the value of a product (and could have been avoided at much lower costs ex ante than ex post) is the very problem that leads to a suspicion of injunctions in the first place. To date no clean solution for this valuation

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Governing intellectual property  59 problem has been found (Golden, 2010, p. 508). Again, this is characteristic of patent, and aside from works incorporating many copyrighted works, it is much less true of copyright. Correspondingly, the role of commercialization theory is much greater in patent than in copyright in the first place. Because the set of these invention-related activities is broad and uncertain, and many such activities must be coordinated, patent law bunches these uses together in a more exclusionary regime. Rights are based on a notional thing – the invention – and making, using, or selling the invention constitutes the violation (35 U.S.C. § 271). That is not to say that the violation is harmful itself. Rather, the system of rights based on this system of proxies – here the legal thing and violation defined in terms of any use of it – serves indirectly to protect the rival resources used in the creation and commercial development of the information. In copyright, by contrast, individual uses are not as hard to pick out. The basic entitlement in copyright is a list of use rights (17 U.S.C. §§ 106–106A) – very unlike property in general. In property, we can say that the essence of property is indefiniteness.5 The bundle of rights conceived as a list of use rights has come in for criticism for not capturing well how we actually delineate most property (for a variety of views see Symposium, 2011). But it does a reasonable job of capturing copyright. At the same time, defining a thing in copyright is not particularly easy (Long, 2004), and relative to focusing in on the activities we are interested in – in a governance regime – putting heavy emphasis on defining an expression as a thing does not make sense. Even some of the pathologies of copyright stem from this greater emphasis on governance. The story of copyright is a series of enactments for and against protection, lobbied for by interested parties at various points (Litman, 1987). One reason this is possible is that individual uses can be separated out and legislatively bargained over and delineated in legislation. Examples include the compulsory licenses set forth in the copyright act (see below). Also, if lobbying effort can coalesce upon a well-defined narrow set of uses, this helps in organizing the lobbying groups and in making their pitch. Within patent and copyright, the relative emphasis on exclusion and governance also tracks the predictions of information theory. In patent law, chemical invention is less problematic from a notice point of view than are patents in electronics or software (Bessen and Meurer, 2008; Menell and Meurer, 2013). Exclusion regimes depend on simple and stable proxies to define violations. Stating the invention in terms of a chemical formula and formulating violation in terms of any use of a substance describable with that formula is a prime example of an exclusion regime. Note that at the same time we allow such claims some indefiniteness and breadth on the dimension of function: if an inventor comes up with a new substance, the patent covers undisclosed and even heretofore unknown uses of that substance. In copyright, governance breaks down where we expect. Thus, the part of copyright that involves the most uncertain and interlocking set of activities is the area of derivative works. A new derivative work can incorporate many copyrighted works. Here valuation problems start looking more like they do in patent law. And when it comes to derivative

5   Austin (1873, p. 827) (‘[I]ndefiniteness is of the very essence of the right; and implies that the right . . . cannot be determined by exact and positive circumscription’).

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60  Research handbook on the economics of IP law volume 1 works, commercialization theory starts being cited as a rationale for protection. These notorious difficulties with derivative works stem partly from trying to solve with a governance regime the problems of multiple hard-to-foresee uses. Some well-known differences between patent and copyright line up along the exclusiongovernance spectrum. In patent law, independent invention is usually not a defense, which makes the proxy upon which violation is based much simpler, thus contributing to the exclusionary aspect of the regime. In copyright, independent creation is a defense, and it requires evaluation of access and similarity in order to tell whether a violation of the copyright has occurred. Likewise, the greater reliance on compulsory licenses in copyright is consistent with an emphasis on governance. In copyright, statutory provisions provide for compulsory licenses for secondary transmission by cable television (17 U.S.C. § 111(c)–(e)), production and distribution of phonorecords of musical works (§ 115), use by noncommercial broadcasters (§ 118), satellite retransmission (§ 119), and manufacturing and importing of digital audiotape devices (Audio Home Recording Act of 1992, Pub. L. No. 102-563, 106 Stat. 4237 (codified at 17 U.S.C. §§ 1001–10)). Delineating licenses requires specifying a class of covered uses, and compulsory licenses that are liability rules – one can use the copyright and pay a statutory fee – require measurement of uses in terms of value. That is relatively easier where the use is separable, and harder where it is uncertain and intertwined with other uses. By contrast, compulsory licenses were (at least until recently) rare in patent law despite some obvious immediate benefits.6 Finally, fair use is a complex governance regime, which we find only in copyright. Despite occasional calls for fair use in patent and regular property (O’Rourke, 2000; Depoorter, 2011), fair use is characteristic of copyright. Fair use requires a multifactor evaluation of the use in question: (1) the purpose and character of the use, including whether such use is of a commercial nature or is for nonprofit educational purposes; (2) the nature of the copyrighted work; (3) the amount and substantiality of the portion used in relation to the copyrighted work as a whole; and (4) the effect of the use upon the potential market for or value of the copyrighted work. (17 U.S.C. § 107)

Fair use in patent law would require measurement of uses in a way that has so far proved difficult. Although exclusion and governance can sometimes substitute at the margin, we have to consider multiple approaches to combining exclusion and governance. Thus the strength (and weakness) of patent law is its indirectness, which allows one to capture the return from commercializing information. Nothing requires that this be done in one regime. Extending the approach in the legislation on orphan drugs, Ted Sichelman (2010)

6   ‘[C]ompulsory licensing is a rarity in our patent system,’ and ‘compulsory licensing of patents has often been proposed but never enacted on a broad scale’ (Dawson Chem. Co. v. Rohm & Haas Co., 448 U.S. 176, 215 and n.21 (1980) (citations omitted)). A limited amount of compulsory licensing is allowed under TRIPS (Agreement on Trade-Related Aspects of Intellectual Property Rights, art. 8, 1994, 33 I.L.M. 81). One could see the decision in eBay v. MercExchange as a move toward compulsory licensing. I return to this question below.

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Governing intellectual property  61 proposes a regime for exclusive rights targeted just to commercialization. This is more fine-grained in two respects: it requires two regimes rather than one, and it requires an estimate of the incentive needed to commercialize. Whether to incur these costs – rather than to stick with a cruder regime that depends more on the indirect residual claim of the current patent – is an empirical question. It is not obvious whether and to what extent judges should be asked to calibrate intellectual property rights (Chiang, 2017). Brett Frischmann (2012, pp. 253–305) proposes that in light of a framework based on intellectual property as a semicommons, patent should look more like copyright. Again, the advisability of this turns on whether new conditions, for example in software, call for more governance to override the exclusion regime in patent law. B. Licensing Licensing illustrates the promise and limits of governance of intellectual property. Licenses pick out specific uses and allow for modification of the basic exclusion right, transaction costs permitting (Barnett, 2010, 2017; Feldman and Lemley, 2015). Compared with licenses in real property, intellectual property licenses are often more robust and are comparable in some ways to easements in land. Like licenses in regular property, intellectual property licenses allow for a regime that combines property and contract. Interestingly, also as in regular property, there is a lot of confusion about what exactly a license is. Because many licenses in real property and most licenses in intellectual property are created by contract, there is a natural tendency to equate licenses and contracts. This is not entirely accurate, and it can matter greatly in some contexts (Newman, 2013). Licenses are more property-related than the contracts that create them. Thus, if a copyright licensee exceeds the terms of its license, the copyright holder could seek the remedies available for a breach of copyright, including in many cases an injunction, even if the contract itself would not be eligible for enforcement by specific performance (Newman, 2013). Further, if the copyright holder transfers the copyright to another, it is subject to existing licenses. In real property this running with the asset would happen automatically with easements appurtenant and would happen for some covenants that pass certain tests. Covenants on personal property have always had an ambiguous status, especially when it comes to whether they run (Chafee, 1928, 1956; Robinson, 2004; Van Houweling, 2008). Licenses also raise issues particular to governance of information. Thus, one way of thinking about easements, covenants, and licenses, is as sticks in the bundle held by the owner and ready for distribution or retention. Some have objected that this is an unrealistic picture of these lesser interests (or non-interest permissions in the case of real property licenses) (Penner, 2013). Instead, the owner is exercising a power to create a new legal relation. In the case of an easement, the owner is creating a new in rem right, which in theory could be enforced against third parties. Licenses, in real property and in intellectual property, are not in rem, although through technological means they start looking that way. In the famous case of ProCD, Inc. v. Zeidenberg, 86 F.3d 1447 (7th Cir. 1996), Judge Easterbrook found that the copyright license was (or was like) a contract, and because it was in personam it could not be similar enough to the in rem copyright for purposes of preemption. Nevertheless, despite the heavy reliance in ProCD on the distinction between in rem and in personam rights,

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62  Research handbook on the economics of IP law volume 1 questions remain about how they differ in practice and how governance can become a means of achieving exclusion. One mode of governance is technological. The holder of information can ration access using Digital Rights Management. If this method is cheap and effective enough, does it become possible to achieve not just exclusion but in rem rights – good against everyone else – by means of mass producing more in personam governance relations? If one can bring it about through technological means that each individual using the information has to agree to the ‘owner’s’ terms, does this mean that the latter has achieved property? Does this upset the balance struck by copyright legislation? Consider fair use. If an author or publisher could restrict access to a book such that a reviewer could not read it, would that violate a right of the reviewer’s? It does, if we take seriously fair use as a robust affirmative regime governing use. Governance through licenses presents a problem of information costs for third parties. The more that licenses avail against third parties and the more they run with assets, the more impact they will have from an informational point of view. In the case of real property, even easements which are theoretically enforceable against third parties are constrained so that they do not present much more of an informational burden than the underlying fee in the land itself. An easement cannot easily govern behavior occurring off the land in question. (Negative easements are strictly rationed, in part for these reasons of open-endedness and potential lack of notice.) Thus, because of the nature of the resource (spatial) and reinforced by certain doctrines in the case of covenants (e.g. touch and concern), servitudes have few implications for third parties beyond the basic message sent by boundaries and trespass law. Licenses in real property are not enforceable against third parties and do not run, so they too present few third-party information costs. Further, real property servitudes and licenses do not present huge problems when parcels are split and combined. Because servitudes and licenses apply to a given area, they simply add up. If there is an easement over Parcel A in favor of Parcel B, and then Parcel A is merged with Parcel C, the easement is still located where it was. Nothing about the scope of the easement changes. The main problem is one of potential misuse. If O owns Parcel A with an easement over Parcel B and then acquires Parcel D next to A, the traditional rule mandated that O not use the easement to get to Parcel D. Such use would be misuse. This is clearly not easy to police, and proposals have been made to measure use by reasonableness, rather than location (Strang, 2008). Either way, as parcels are scaled up and down, there is not much in the way of confusion or contradiction. The situation is very different with intellectual property licenses. The special challenge of servitudes in fluid property-like intellectual property is well illustrated in Molly Van Houweling’s (2008) analysis of the ‘new servitudes’ in intellectual property. In addition to exacerbated problems of notice in intellectual property, she shows how licenses can conflict downstream. For example, the GPL Version 2, under which the original Linux kernel was created and licensed, and the Wikipedia GNU Free Documentation License require downstream users creating works incorporating the licensed material to make available the new work on the same terms as the input work. However, the terms requiring openness are detailed, and later versions of the license sometimes require conflicting actions. A downstream work thus may incorporate works with conflicting mandates. And like other fluid property, we want the governance rules to interlock tightly, but the problem then becomes dynamic change. Indeed, an involved and controversial process

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Governing intellectual property  63 was required to make it possible for the Wikimedia Foundation to relicense in order to overcome this problem (Elkin-Koren, 2011, pp. 340–41). In addition, as with other fluid property, the high cost of exclusion – based on a legal thing – leads to governance being built on a shakier foundation of exclusion. Indeed, as Van Houweling points out, we should worry when intellectual property servitudes exceed the entitlement baseline. Thus, while the Creative Commons license employs the (admittedly fuzzy) copyright baseline, Microsoft’s Vista EULA, by contrast, exceeded the scope of its copyright. Because this complicates the modularity of the legal rights, it comes at a cost not internalized to its creator. In a sense, intellectual property poses a special problem of standardization (numerus clausus, Merrill and Smith, 2000) that the ‘bubbles’ around parcels of land and items of personal property prevent in the case of regular property. First sale in copyright and exhaustion in patent respond in part to these problems of third-party information costs. If that is their role, it suggests that current doctrine may be too strong. In copyright, first sale doctrine allows the purchaser of a copyrighted work to resell it free from restrictions of the copyright holder. Similarly in patent law, the purchase of a patented article from the patentee ‘exhausts’ the patentee’s rights, and the owner of the good can resell it without restriction. These doctrines resonate with the traditional suspicion of servitudes on personal property (see above). As with servitudes on personal property, the problem is that these restrictions do not announce themselves and there is no registry to publicize them. Marking on the good itself is not standardized. However, as we have seen, intellectual property holders often try to accomplish through licensing what cannot be accomplished through property law, in effect substituting elaborate governance for exclusion or for the law’s version of governance. What if the intellectual property holder licenses the buyer but refuses to license those contracting with the buyer, especially if the good itself is not sold but manufactured under a license? Can the intellectual property owner go after the licensee’s customers? After some ambiguity, in Quanta Computer v. LG Electronics, Inc., 553 U.S. 617 (2008), the answer from the US Supreme Court is an undertheorized no. Moreover, like first sale, exhaustion is a mandatory rather than a default rule; it cannot be contracted around through licensing (Impression Products, Inc. v. Lexmark International, Inc., 137 S. Ct. 1523 (2017)). The institutional and informational approach can shed some light on the question of why we have first sale and exhaustion doctrines and how strong they should be. (Again, we are in the realm of empirical guesswork for now.) One possible position is the pre-Quanta Federal Circuit’s contractarianism, in which exhaustion would not apply to a method patent, leaving it open to a patent holder to license a firm but not the firm’s ­customers and to require them to acquire their own licenses. In reversing in Quanta, the US Supreme Court took the opposite approach, holding that exhaustion is a mandatory rule precluding restrictions of any kind further downstream from a licensee. Both positions are problematic. Full contractarianism does not reckon with the notice problems, especially to consumers, of licensing restrictions, and it foregoes the convenience of the anchor of a physical object as a locus of restriction-free use. The holding in Quanta, however, precludes more fine-grained multi-party governance regimes, which could be valuable in multiple stages of production among parties that are well aware of the need for a license. And there is no shortage of potential positions between these poles that could trade off notice costs and governance benefits. For example, Van Houweling (2008, pp. 932–9) argues for the

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64  Research handbook on the economics of IP law volume 1 distinction made in earlier Supreme Court cases between complex licensing that allows for restrictions on downstream commercial producing entities on the one hand and prohibits them for individual consumers (and perhaps bailees like repair shops) on the other. The former can be expected to be aware of the need for a license more than the latter, who have pre-existing expectations of being able to use the items of personal property they own. C.  Governance Through Equity Exclusion is sometimes vulnerable to opportunism, and to counter such opportunism, a characteristic governance regime comes into play: equity. Although not all such opportunism calls for equitable intervention, we generally have to worry about actors who are too aware of property law’s modular structures and can exploit misalignment of proxies and true value. Thus, in a fish catch limit, we need to address the potential strategic behavior of fishers who might kill and throw back small fish in order to ‘meet’ their quota with only more valuable larger fish. In intellectual property, strategic behavior is a major problem. In general, equity can be seen as a second-order intervention when problems like opportunism show the weakness in the regular law (Smith, 2015b). Equity in this sense is much like the civilian doctrine of abuse of right. Much of the problem of strategic behavior or opportunism in intellectual property surfaces in the area of remedies. And this problem of opportunism points to the usefulness of traditional equitable standards. Opportunism can take the form of unexpected and unfair use of leverage. The problem of excessive leverage is not unique to intellectual property, even though it may be more severe. The problem of coupling an injunction with exclusion is that the severity of the remedy can call forth opportunism, in which the right holder inflicts harm on a good faith violator out of all proportion to the injury or the blameworthiness of the violation. In real property, an injunction will not issue for a mere trespass, but repeated and continuous violations do presumptively lead to injunctions. If, however, the violation was in good faith and the injunction would inflict disproportionate hardship – that is, much more harm on the violator than it would benefit the movant – a court can withhold the injunction and just give damages (a general approach in equity, see Laycock, 2011). Bad faith violators still face injunctions. This scheme of shifting presumptions is designed to afford protection to rights, with a safety valve for certain good faith violations, which prevents excessive precaution on the one side and overenforcement on the other. The problem of so-called patent trolls exhibits a similar structure. Unfortunately, instead of applying the traditional equitable set of presumptions, modified perhaps to make good faith easier to find where patent notice is problematic, the US Supreme Court devised what it termed a ‘traditional’ equitable four-part test for injunctions in eBay Inc. v. MercExchange, L.L.C., 547 U.S. 388 (2006), which is actually based on the test for preliminary relief. Under this test, the movant must show: (1) that it has suffered an irreparable injury; (2) that remedies available at law, such as monetary damages, are inadequate to compensate for that injury; (3) that, considering the balance of hardships between the plaintiff and defendant, a remedy in equity is warranted; and (4) that the public interest would not be disserved by a permanent injunction. (547 U.S. at 391)

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Governing intellectual property  65 This test is problematic for many reasons. It makes no reference to good faith, which was one of the main methods of targeting in the traditional test. Moreover, ‘disproportionate hardship’ meant overwhelming disparity: it is a safety valve, not a balancing test seeking equipoise.7 The Federal Circuit may well have been wrong to apply a near-automatic presumption for injunctions, but the eBay test’s implicit agnosticism about violation and the lack of presumption for an injunction in cases of violation are not necessary as long as the (targeted) safety valve of disproportionate hardship is wide enough. Disproprtionate hardship is one possible tool to deal with holdup.8 Indeed there is an economic case to be made for the traditional disproportionate hardship defense in the area of patents (Schwartz, 1964, pp. 1045–6; Denicolò et al., 2008; Smith, 2009, pp. 2125–33). Disproportionate hardship is a proxy for opportunism, and is a targeted way to ‘reset’ the balance of leverage or achieve ‘proportionality’ between rights and leverage (cf. Merges, 2011, pp. 165–9). Moreover the (actually) traditional approach to injunctions took into account the potential for opportunism on both sides: make the safety valve too large, and opportunistic violators would use the possibility of undercompensation by a court as a weapon (Miller, 2007, p. 390). As with any liability rule, we have to worry that a violator will cherry-pick undervalued assets, and take advantage of the difficulty of proving damages – as would be the case with a patent that has not been licensed before. D.  Group Institutions As in other fluid property regimes, the need for governance often calls for collective-action organizations. In regular property, common property is located between private property and open access. Unlike open access, in common property a group manages the resource. Unlike with private property, this group is larger than the usual groups of co-owners (and the group does not create an artificial person to own the asset). Instead, the exclusion regime over the thing and group membership serve as a foundation for the group to build an often elaborate regime of governance. This is ‘governance’ in Ostrom’s (1990) sense and also ‘governance’ in the sense that these group-initiated regimes are couched in terms

7   Thus, interestingly, from a traditional equitable point of view all sides in eBay were off the mark. Disproportionate hardship did not mean asking which party would be would hurt more by an injunction, as the skeptics of injunctive relief argued (eBay, Inc. v. MercExchange, L.L.C., 2006 WL 1785363 (Appellate Brief) (U.S. Jun. 26, 2006); Brief Amici Curiae of 52 Intellectual Property Professors in Support of Petitioners (NO. 05-130), at 9). On the other hand, the Federal Circuit’s automatic injunction rule ignores the extent of the disproportionate hardship defense, as did its proponents in the Supreme Court, who ironically looked to building encroachments as an analogy for automatic injunctions. Epstein et al.’s amici brief analogized patent infringement to trespass and stated that ‘[t]he rule [for injunctions in building encroachment cases] is virtually automatic when the infringement is deliberate, and strict even when it is not’ (eBay, Inc. v. MercExchange, L.L.C., 2006 WL 639164 (Appellate Brief) (U.S. Mar. 10, 2006) Brief of Various Law & Economics Professors as Amici Curiae in Support of Respondent (NO. 05-130) (Richard A. Epstein, F. Scott Kieff & R. Polk Wagner); Epstein (2010, pp. 488–9)). However, Epstein had advocated disproportionate hardship as exception to a presumption for property rules in an earlier paper (1997, p. 2102). 8   Other possible tools include other equitable devices like estoppel (Smith, 2013), as well as denying injunctions in a more categorical fashion (Lee and Melamed, 2016).

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66  Research handbook on the economics of IP law volume 1 of use. After all, the members of the group have access; the question is how they will coordinate their use. The Ostrom framework is now being applied to problems of knowledge dissemination and use, of which intellectual property is only a part. (See the case studies in Frischmann et al., 2014.) Whether exclusion is needed as a platform for governance depends in part on how easy the knowledge problem is to modularize in the first place. Thus, in open source software, Wikipedia, and other realtively open, collaborative undertakings, the overall project can be broken down into small freestanding tasks (Benkler, 2002; Vetter, 2004). Where modularization needs to be imposed, there is more of a role for intellectual property or organizations (entity property). Governance can also be used by groups to overcome the drawbacks of exclusion. One potential problem with exclusion stems from the need in a larger project to use information subject to many rights. This could happen because a final product involves many patents. Where this occurs, it has been termed an anticommons: just as in a commons too many use rights lead toward overuse, in an anticommons too many exclusion rights promote underuse (Heller, 1998, 2008; Heller and Eisenberg, 1998). In addition to licensing, a large anticommons sometimes calls forth collective-rights organizations. Patent pools and copyright organizations are famous examples (Gervais, 2011). These organizations often overcome exclusion and achieve a shift from property rules to liability rules (Merges, 1996a), and indeed governance strategies, keyed as they are to uses, are often paired with liability rules. Once one is delineating a use, it often makes sense to value it rather than use a more on/off remedy like an injunction. Rights organizations are one reason anticommons problems have not loomed as large or persisted as long as many initially feared (Barnett, 2015; see also Eisenberg, this volume). Often these group institutions or sets of industry norms involve a semicommons. Information is often more common or public for some uses and more private for other uses. In a more diffuse context, scientists have (or at least had) a norm as described by Merges (1996b), in which scientists would be expected to share information and materials with other scientists but could demand payment from commercial actors. In a more organized setting, firms can form joint ventures in which intellectual assets are common for some purposes and private for others (Smith, 2000). In between are standard-setting organizations (SSOs), which separate out one function of property law, setting standards, and treat that as common while allowing members to control their intellectual property subject to FRAND obligations (to license on a ‘fair, reasonable, and non-discriminatory’ basis) (Lemley, 2002; Miller, 2007; Sidak, 2013; Smith, 2013; Contreras, 2017). Finally, we can consider the possibility of governance without exclusion. In regular property, this is closest to being true of what Carol Rose (1986) calls ‘inherently public’ property. Here no one – neither a private party nor a group nor the government – ­manages the resource. Instead, the unorganized public spontaneously, possibly through custom, uses the resource with high benefits of multiple use and a low enough level of conflict to make the shift to more organized management undesirable. For example, various doctrines of navigation and historic examples like maypoles illustrate inherently public property. The public domain of information is another example (Rose, 2003).

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IV. CONCLUSIONS Governance is not at odds with property; it is part of the overall institution of property. Because of their fluid nature, informational resources tend to involve a great emphasis on governance of uses in comparison to regular property. Exploring the problem of governance of property and the hybrid regimes we actually see has become a major avenue of work in regular property, and it is spreading to intellectual property. This focus is welcome because the problems of use are more difficult and more ethereal in this area.

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68  Research handbook on the economics of IP law volume 1 Epstein, Richard A. 1997. ‘A Clear View of The Cathedral: The Dominance of Property Rules,’ 106 Yale Law Journal 2091–120. Epstein, Richard A. 2010. ‘The Disintegration of Intellectual Property? A Classical Liberal Response to a Premature Obituary,’ 62 Stanford Law Review 455–521. Ethiraj, Sendil K., and Daniel Levinthal. 2004. ‘Modularity and Innovation in Complex Systems,’ 50 Management Science 159–73. Feldman, Robin, and Mark A. Lemley. 2015. ‘Do Patent Licensing Demands Mean Innovation?,’ 101 Iowa Law Review 137–89. Freyfogle, Eric T. 1989. ‘Context and Accommodation in Modern Property Law,’ 41 Stanford Law Review 1529–56. Friedman, David. 1998. ‘In Defense of Private Orderings: Comments on Julie Cohen’s “Copyright and the Jurisprudence of Self-Help,”’ 13 Berkeley Technology Law Journal 1151–72. Frischmann, Brett M. 2012. Infrastructure: The Value of Shared Resources. New York: Oxford University Press. Frischmann, Brett M., Michael J. Madison, and Katherine J. Strandburg. 2014. Governing Knowledge Commons. New York: Oxford University Press. Fromer, Jeanne C. 2009. ‘Claiming Intellectual Property,’ 76 University of Chicago Law Review 719–96. Gergen, Mark P., John M. Golden, and Henry E. Smith. 2012. ‘The Supreme Court’s Accidental Revolution? The Test for Permanent Injunctions,’ 112 Columbia Law Review 203–49. Gervais, Daniel. 2011. ‘The Landscape of Collective Management,’ 24 Columbia Journal of Law & the Arts 423–49. Golden, John M. 2010. ‘Principles for Patent Remedies,’ 88 Texas Law Review 505–92. Gordon, Wendy J. 1982. ‘Fair Use as Market Failure: A Structural and Economic Analysis of the Betamax Case and its Predecessors,’ 82 Columbia Law Review 1600–657. Haddock, David D., and Lynne Kiesling. 2002. ‘The Black Death and Property Rights,’ 31 Journal of Legal Studies S545–87. Heald, Paul J. 2005. ‘A Transaction Costs Theory of Patent Law,’ 66 Ohio State Law Journal 473–509. Heller, Michael. 1998. ‘The Tragedy of the Anticommons: Property in the Transition from Marx to Markets,’ 111 Harvard Law Review 621–88. Heller, Michael. 2008. The Gridlock Economy. New York: Basic Books. Heller, Michael, and Rebecca S. Eisenberg. 1998. ‘Can Patents Stifle Innovation? The Anticommons in Biomedical Research,’ 280 Science 698–701. Heverly, Robert A. 2003. ‘The Information Semicommons,’ 18 Berkeley Technology Law Journal 1127–89. Holbrook, Timothy R. 2006. ‘Possession in Patent Law,’ 59 SMU Law Review 123–76. Kelly, Daniel B. 2011. ‘Strategic Spillovers,’ 111 Columbia Law Review 1641–721. Kieff, F. Scott. 2001. ‘Property Rights and Property Rules for Commercializing Inventions,’ 85 Minnesota Law Review 697–754. Kitch, Edmund W. 1977. ‘The Nature and Function of the Patent System,’ 20 Journal of Law & Economics 265–90. Langlois, Richard N. 2002. ‘Modularity in Technology and Organization,’ 49 Journal of Economic Behavior & Organization 19–37. Laycock, Douglas. 2011. ‘The Neglected Defense of Undue Hardship (and the Doctrinal Train Wreck in Boomer v. Atlantic Cement),’ 4 Journal of Tort Law 1–35. Lee, Brian Angelo, and Henry E. Smith. 2012. ‘The Nature of Coasean Property,’ 59 International Review of Economics 145–55. Lee, Peter. 2011. ‘The Accession Insight and Pent Infringement Remedies,’ 110 Michigan Law Review 175–241. Lee, William F., and A. Douglas Melamed. 2016. ‘Breaking the Vicious Cycle of Patent Damages,’ 101 Cornell Law Review 385–466. Lemley, Mark A. 2002. ‘Intellectual Property Rights and Standard-Setting Organizations,’ 90 California Law Review 1889–980. Lemley, Mark A. 2014. ‘Taking the Regulatory Nature of IP Seriously,’ 92 Texas Law Review See Also 107–19, accessed February 26, 2019 at http://texaslawreview.org/wp-content/uploads/2015/08/Lemley-92-SeeAlso.pdf. Lemley, Mark A., and Carl Shapiro. 2007. ‘Patent Holdup and Royalty Stacking,’ 85 Texas Law Review 1991–2050. Lemley, Mark A., and Carl Shapiro. 2013. ‘A Simple Approach to Setting Reasonable Royalties for StandardEssential Patents,’ 28 Berkeley Technology Law Journal 1135–66. Leval, Pierre N. 1990. ‘Toward a Fair Use Standard,’ 103 Harvard Law Review 1105–36. Libecap, Gary D. 1989. Contracting for Property Rights. Cambridge: Cambridge University Press. Libecap. Gary D., and Dean Lueck. 2011. ‘The Demarcation of Land and the Role of Coordinating Property Institutions,’ 119 Journal of Political Economy 426–67. Liivak, Oskar. 2013. ‘Establishing an Island of Patent Sanity,’ 78 Brooklyn Law Review 1335–89. Litman, Jessica D. 1987. ‘Copyright, Compromise, and Legislative History,’ 72 Cornell Law Review 857–904. Long, Clarisa. 2004. ‘Information Costs in Patent and Copyright,’ 90 Virginia Law Review 465–550.

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Governing intellectual property  69 Loren, Lydia Pallas. 2007. ‘Building a Reliable Semicommons of Creative Works: Enforcement of Creative Commons Licenses and Limited Abandonment of Copyright,’ 14 George Mason Law Review 271–328. McManus, John C. 1972. ‘An Economic Analysis of Indian Behavior in the North American Fur Trade,’ 32 Journal of Economic History 36–53. Madison, Michael J. 2005. ‘Law as Design: Objects, Concepts, and Digital Things,’ 56 Case Western Reserve Law Review 381–478. Menell, Peter S. 2011. ‘Governance of Intellectual Resources and Disintegration of Intellectual Property in the Digital Age,’ 26 Berkeley Technology Law Journal 1523–59. Menell, Peter S., and Michael J. Meurer. 2013. ‘Notice Failure and Notice Externalities,’ 5 Journal of Legal Analysis 1–59. Merges, Robert P. 1996a. ‘Contracting into Liability Rules: Intellectual Property Rights and Collective Rights Organizations,’ California Law Review 1293–393. Merges, Robert P. 1996b. ‘Property Rights Theory and the Commons: The Case of Scientific Research,’ 13 (Summer) Social Philosophy and Policy 145–67. Merges, Robert P. 2005. ‘A Transactional View of Property Rights,’ 20 Berkeley Technology Law Journal 1477–520. Merges, Robert P. 2011. Justifying Intellectual Property. Cambridge, Mass: Harvard University Press. Merrill, Thomas W. 2009. ‘Accession and Original Ownership,’ 1 Journal of Legal Analysis 459–510. Merrill, Thomas W., and Henry E. Smith. 2000. ‘Optimal Standardization in the Law of Property: The Numerus Clausus Principle,’ 110 Yale Law Journal 1–70. Merrill, Thomas W., and Henry E. Smith. 2010. The Oxford Introductions to U.S. Law: Property. New York: Oxford University Press. Merrill, Thomas W., and Henry E. Smith. 2017. Property: Principles and Policies. New York: Foundation Press, 3rd ed. Miller, Joseph Scott. 2007. ‘Standard Setting, Patents, and Access Lock-In: RAND Licensing and the Theory of the Firm,’ 40 Indiana Law Review 351–96. Mossoff, Adam. 2013. ‘Introduction,’ in Adam Mossoff, ed., Intellectual Property and Property Rights. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Newman, Christopher M. 2011. ‘Transformation in Property and Copyright,’ 56 Villanova Law Review 251–325. Newman, Christopher M. 2013. ‘A License is Not a “Contract Not to Sue”: Disentangling Property and Contract in the Law of Copyright Licenses,’ 98 Iowa law Review 1101–62. O’Rourke, Maureen A. 2000. ‘Toward a Doctrine of Fair Use in Patent Law,’ 100 Columbia Law Review 1177–250. Ostrom, Elinor. 1990. Governing the Commons. Cambridge: Cambridge University Press. Penner, J.E. 1997. The Idea of Property in Law. Oxford: Clarendon Press. Penner, James. 2013. ‘On the Very Idea of Transmissible Rights,’ in James Penner and Henry E. Smith, eds., Philosophical Foundations of Property Law. Oxford: Oxford University Press. Rich, Giles S. 1942. ‘The Relation between Patent Practices and the Anti-Monopoly Laws,’ 24 Journal of the Patent Office Society 159–81. Robinson, Glen O. 2004. ‘Personal Property Servitudes,’ 71 University of Chicago Law Review 1449–523. Rose, Carol. 1986. ‘The Comedy of the Commons: Custom, Commerce, and Inherently Public Property,’ 53 University of Chicago Law Review 711–81. Rose, Carol M. 1990. ‘Energy and Efficiency in the Realignment of Common-Law Water Rights,’ 19 Journal of Legal Studies 261–96. Rose, Carol M. 2003. ‘Romans, Roads, and Romantic Creators: Traditions of Public Property in the Information Age,’ 66 (Winter/Spring) Law and Contemporary Problems 89–110. Rose, Carol M. 2011. ‘Ostrom and the Lawyers: The Impact of Governing the Commons on the American Legal Academy,’ 5 International Journal of the Commons 28–49, accessed on February 26, 2019 at https:// www.thecommonsjournal.org/articles/10.18352/ijc.254/. Rothman, Jennifer E. 2013. ‘Copyright, Custom and Lessons from the Common Law,’ in Shyamkrishna Balganesh, ed., Intellectual Property and the Common Law. Cambridge: Cambridge University Press. Schwartz, Herbert F. 1964. ‘Injunctive Relief in Patent Infringement Suits,’ 112 University of Pennsylvania Law Review 1025–48. Sichelman, Ted. 2010. ‘Commercializing Patents,’ 62 Stanford Law Review 341–412. Sichelman, Ted. 2014. ‘Purging Patent Law of “Private Law” Remedies,’ 92 Texas Law Review 516–71. Sichelman, Ted, and Henry E. Smith. 2017. ‘Modeling Legal Modularity,’ (draft), accessed on February 26, 2019 at https://extranet.sioe.org/uploads/sioe2017/sichelman_smith.pdf. Sidak, J. Gregory. 2013. ‘The Meaning of FRAND, Part I: Royalties,’ 9 Journal of Competition Law & Economics 931–1055. Simon, Herbert A. 1981. The Sciences of the Artificial. Cambridge, Mass.: MIT Press, 2nd ed. Smith, Henry E. 2000. ‘Semicommon Property Rights and Scattering in the Open Fields,’ 29 Journal of Legal Studies 131–69.

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70  Research handbook on the economics of IP law volume 1 Smith, Henry E. 2002. ‘Exclusion versus Governance: Two Strategies for Delineating Property Rights,’ 31 Journal of Legal Studies S453–87. Smith, Henry E. 2004. ‘Exclusion and Property Rules in the Law of Nuisance,’ 90 Virginia Law Review 965–1049. Smith, Henry E. 2007a. ‘Intellectual Property as Property: Delineating Entitlements in Information,’ 116 Yale Law Journal 1742–822. Smith, Henry E. 2007b. ‘Governing Water: The Semicommons of Fluid Property Rights,’ 50 Arizona Law Review 445–78. Smith, Henry E. 2009. ‘Institutions and Indirectness in Intellectual Property,’ 157 University of Pennsylvania Law Review 2083–133. Smith, Henry E. 2011. ‘Toward an Economic Theory of Property in Information,’ in Kenneth Ayotte and Henry E. Smith, eds., Research Handbook on the Economics of Property Law. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Smith, Henry E. 2012. ‘Property as the Law of Things,’ 125 Harvard Law Review 1691–726. Smith, Henry E. 2013. ‘Property as Platform: Coordinating Standards for Technological Innovation,’ 9 Journal of Competition Law and Economics 1057–89. Smith, Henry E. 2015a. ‘The Elements of Possession,’ in Yun-Chien Chang, ed., The Law and Economics of Possession. Cambridge: Cambridge University Press. Smith, Henry E. 2015b. ‘Equity as Second-Order Law: The Problem of Opportunism,’ (January 15, 2015), SSRN, accessed on February 26, 2019 at http://ssrn.com/abstract=2617413 or http://dx.doi.org/10.2139/ssrn.2617413. Smith, Henry E. 2016. ‘Semicommons in Fluid Resources,’ 20 Marquette Intellectual Property Law Review 195–212 (2015 Annual Helen Wilson Nies Lecture in Intellectual Property). Smith, Henry E. 2017. ‘The Economics of Property Law,’ in Francesco Parisi, eds., The Oxford Handbook of Law and Economics, Volume 2: Private and Commercial Law. Oxford: Oxford University Press, 148–77. Smith, Henry E. 2018. ‘Complexity and the Cathedral: Making Law and Economics more Calabresian,’ European Journal of Law and Economics (2018), accessed on February 26, 2019 at https://doi.org/10.1007/ s10657-018-9591-x. Strang, Lee J. 2008. ‘Damages as the Appropriate Remedy for “Abuse” of an Easement: Moving toward Consistency, Efficiency, and Fairness in Property Law,’ 15 George Mason Law Review 933–74. Symposium. 2011. ‘Property: A Bundle of Rights?,’ 8 Econ Journal Watch, accessed on February 26, 2019 at https://econjwatch.org/issues/volume-8-issue-3-september-2011. Taylor, David O. 2014. ‘Using Reasonable Royalties to Value Patented Technology,’ 49 Georgia Law Review 79–162. Van Houweling, Molly S. 2008. ‘The New Servitudes,’ 96 Georgetown Law Journal 885–950. Van Houweling, Molly S. This volume. ‘Intellectual Property as Property.’ Vetter, Greg R. 2004. ‘The Collaborative Integrity of Open-Source Software,’ 2004 Utah Law Review 563–700. Wyman, Katrina M. 2005. ‘From Fur to Fish: Reconsidering the Evolution of Private Property,’ 80 New York University Law Review 117–240. Yoo, Christopher S. 2007. ‘Copyright and Public Good Economics: A Misunderstood Relation,’ 155 University of Pennsylvania Law Review 635–716. Yu, Peter K. 2005. ‘Intellectual Property and the Information Ecosystem,’ 2005 Michigan State Law Review 1–20.

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PART II IP AND INCENTIVES

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4.  Philosophical foundations of IP law: the law and economics paradigm Robert P. Merges*

Contents I. Introduction A. Consequentialism versus Deontology: Rudiments 1. Deontology II. Consequentialism and its Critique A. The Macro Theory B. Consequentialism ‘All the Way Down’: Micro-Consequentialist Roots of Macro-Consequentialism 1. Consequentialism with nuance C. Critiques of Consequentialism 1. The calculability critique D. An Illustration of the Problem: New Theories, Pro and Con E. Modest Consequentialism III. Deontological Theories, and Their Critics A. The Critique of Subjective Moral Intuitionism 1. A shared moral sense B. Empirical Studies of Moral Judgment 1. Studies of children’s judgments about ownership 2. Summary: a universal ‘intellectual property instinct’? IV. Reconciling Consequentialism and Deontological Approaches A. The Two-Level Approach 1. But is it not inconsistent? V. Conclusion References

I. INTRODUCTION This chapter describes various philosophical perspectives on the law and economic paradigms in intellectual property (IP). It begins with a description of utilitarianism, which is the philosophical foundation on which law and economics is built. It then describes an alternative way that law and economics can be understood: as a highly effective set of tools that are useful even if one is not convinced that IP law can be justified at the foundational *  Wilson Sonsini Goodrich and Rosati Professor of Law and Director of the Berkley Center for Law and Technology, University of California, Berkeley.

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Philosophical foundations of IP law  73 level by a utilitarian account. Various alternatives to foundational utilitarianism are described; the chapter seeks to explain how a law and economics approach to issues in the IP field is consistent with these alternative foundational justifications for IP law. A.  Consequentialism versus Deontology: Rudiments Utilitarianism is one form of consequentialism, which is the label applied to philosophies that direct us to choose from among alternative courses of action by deciding which will produce the best consequences in the world (Smart and Williams, 1973; Darwall, 2003; Scheffler, 1988; Kaplow and Shavell, 2006. We look at one course of action and add up all the positive effects it would have on all the people involved, then look at all the negative effects on all involved. Then we do the same with all other courses of action. The best course of action is the one that produces the highest ‘net positive.’ ‘Best consequences’ in this analysis can be described in a number of ways, but what they all have in common is the assumption that we can assess the state of the world using some sort of impersonal measuring stick. In other words, we can assess positive and negative effects using a common denominator, some measure that allows us to take account of the effects of the action on all persons, taken together. Put differently, this common measuring stick applies across all people and allows us to reach an aggregated result. Philosophers over the years have used various measuring sticks in this analysis. Utility, or hedonic pleasure, was the original one, suggested by Jeremy Bentham (with an assist from John Stuart Mill). A more generalized measure called ‘happiness’ is often invoked in more recent theories; this measure abstracts somewhat from the pure physical pain and pleasure of the Benthamite form of hedonism. The corollary measure of ‘welfare’ was proposed in the nineteenth century, and quickly taken up by economists, who found it more susceptible to mathematical modeling and therefore more tractable for their particular purposes (Harsanyi, 1990). This in turn gave rise to what is now known as ‘welfare economics’ (Feldman and Serrano, 2006). Because of the dominance of this form of social science analysis in the contemporary academy, it is safe to say that for many scholars outside philosophy proper, consequentialism equals utilitarianism, which equals welfare economics. This three-way approximation certainly prevails in the field of IP law. In its most frequent usage, utilitarianism means the use of economic principles and empirical evidence to determine what is the best course of action when confronted with a particular policy choice in the IP field. It is of course also defined partly in opposition: utilitarianism is the opposite of deontological theories. Legal scholars began applying economic logic to legal doctrines in the 1960s. The usual origin story centers on the University of Chicago (Rowley, 2005). Almost from the beginning, there was debate over how closely ‘law and economics’ followed the tenets of utilitarian philosophy. Some of the debates simply tracked traditional debates about the viability of utilitarianism itself, most notably the question whether interpersonal utility assessments can be aggregated or compared. There was also a robust early discussion over whether law and economics was a positive methodology (merely describing, and not evaluating, the content of legal rules) or had instead (or in addition) a normative agenda as well. This culminated in an oft-cited exchange concerning welfare: is it a neutral measuring stick? Is it an independent value that needs to compete with other values such as fairness or justice, when it comes to the final calculus for deciding on legal

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74  Research handbook on the economics of IP law volume 1 rules? Richard Posner, a founding figure in the movement, has expressed slightly different answers to these questions over time (compare Posner, 1979; Posner, 1980; Posner, 1988; Posner, 1998; Parisi, 2005). Because of this, and because consistent philosophical justification is not that central to the law and economics discipline, there is no strong consensus about these issues. Instead, there is general agreement on a loose set of understandings: rationality (perfect or constrained) drives most behavior; data-driven empirical findings (‘evidence-based reasoning’) take precedence over ‘value-laden’ analyses; and, above all, some generalized sense of welfare maximization (perhaps leavened at times with fairness considerations) is the proper organizing principle and operational methodology for legal scholarship. 1. Deontology A deontological theory is one, quite simply, based on notions of right and wrong. In this type of theory, a moral principle determines right and wrong; violating a principle cannot (in general) be justified by the fact that such a violation would produce good consequences. Deontological theories speak of individuals and their rights, and they are not in general oriented toward interpersonal aggregations or measures to figure out a correct course of action. These are, as the title suggests, rudimentary statements of each type of theory. The reality is much more complex, which should not be surprising, because philosophers have been debating these issues since at least the eighteenth century. Just to take some examples of many that might be chosen: there are consequentialist theories that try not to force individuals to make choices that override their own deeply held principles or values. And there are deontologists who defend vigorously the notion that part of being a moral person is taking account of how one’s actions affect other people – a form of interpersonal consideration, if not outright aggregation. But it is beyond the ken of this chapter to go too deeply into these nuances. For the most part I will take the conventional, rudimentary views at face value as they are used in the IP field. The goal here is simply to explain how these different foundational principles – consequentialism versus deontology – work as justifications for IP law, and as guides to policymaking with respect to discrete questions in IP law.

II.  CONSEQUENTIALISM AND ITS CRITIQUE The prevailing view is that US IP law has always had a utilitarian orientation.1 What has not received as much attention is the precise relationship between utilitarian foundations, law and economics as a scholarly orientation or methodology, and empirical evidence for various propositions about IP law. Those are the topics I take up in this section.

1

  See, for example, Fromer (2012, p. 1752):

  At bottom, utilitarian theories of intellectual property rest on the premise that the benefit to society of creators crafting valuable works offsets the costs to society of the incentives the law offers to creators. Because this utilitarian framework establishes a cost-benefit analysis, the leading scholarly analysis of intellectual property has used an economic lens.

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Philosophical foundations of IP law  75 In reality there are two varieties of consequentialist justification for contemporary IP systems. They are related in a general way, but quite different once one pokes beneath the surface of things. The first operates at the macro level, and asserts simply that the presence of a functioning IP system is correlated with (i.e., very often observed in conjunction with) objective indications of economic growth, such as rising Gross National Product (GNP). The second provides that the best way to decide about proper IP policy is to weigh the positive and negative effects of any proposed course of action, and then choose the action with the greatest net positive outcome. This second theory is what can be termed micro-level IP consequentialism. It is the unstated, but widely shared, philosophical orientation of many (if not most) US-based IP scholars. A.  The Macro Theory The first argument depends largely on macro-level studies showing a correlation between patenting behavior, copyright registrations, and so on, and well-respected indicators of economic growth and health: research and development (R&D) spending, GNP growth, and the like. We will therefore begin with these macro-level data. As we will see, while there is a fairly clear correlation between accepted indicators of economic growth and the presence of an IP system, the devilish problem is to determine which way causation runs. Put simply, it is just not clear if people file more patents because they are more prosperous; or if prosperity flows from having filed more patents. As two highly skilled, and neutral, observers put it: ‘[T]he availability of intellectual property for innovation creates incentives for investment as well as potential impediments to diffusion and cumulative innovation. The net effects are quite complex to sort out from both theoretical and empirical perspectives’ (Menell and Scotchmer, 2005). Let us put causation aside for a moment, however, and begin with correlation. Many scholars over the years have shown that there is a close relationship between productivity and economic growth. The basic idea is that economies grow when people learn to get more output from a fixed supply of inputs. Economic growth, in turn, is closely related to all sorts of positive trends such as improved health, longevity, greater personal autonomy, and so on. The next link in the chain centers around innovation. The key to productivity increase is to get new technologies that multiply the output from a given stock of inputs. The classic studies by Robert Solow showed that most of the increase in per capita GNP over time stems from increased productivity, as opposed to increases in the stocks of tangible resources (Solow, 1957). Technology is the key to this process. And, given that old technologies are quickly incorporated into the production function of an economy, new technologies are required if productivity is to grow. Thus the classic triad: economic growth; productivity; and innovation. Studies of innovation are based on empirical survey data. Over time, innovation research has expanded from an original focus on new products and processes; it now includes organizational innovations (new ways of arranging work flows, for example) and new marketing methods (OECD, 2005). Within this formulation, the typical proxy for investment in innovation is spending on R&D. R&D spending has been studied exhaustively, primarily because it is a

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76  Research handbook on the economics of IP law volume 1 ­ ell-accepted statistical measure, and it is represented in data gathered by many national w governments. The connection between IP protection and R&D spending is robust, and has been established in a variety of economies over an extended period of time. As usual for this sort of study, the results are stronger for patents than copyrights. But overall, IP can be said to be correlated with standard indicators of economic growth. If correlation were causation, this would be enough to show that IP is a beneficial social institution. It would answer what has been termed the foundational question in IP: whether society ought to establish an IP system at all (beyond foundations – the details of such a system – are another matter.) The problem is that causation is a tricky issue in this case. Perhaps stronger IP protection causes – or helps to cause – economic growth. But perhaps it is the other way around: as wealth increases, people seek to protect their intellectual creations more vigorously. The first description has IP causing growth. The second has growth leading to a demand for more IP protection. Disentangling the two has proven quite difficult. While some claim the macro evidence shows IP helps cause growth, it is also clear that IP alone does no such thing. Very poor countries that pass stronger IP laws have no positive net gain at all. The best that can be said, then, is that IP protection may help cause some part of a nation’s growth, when combined with other policies. Development economist Keith Maskus emphasizes in particular that a positive impact for IP rights depends on institutions that otherwise support economic competition: The evidence supports the view that product innovation is sensitive to IPRs in developing countries, while [foreign direct investment] and technology transfer go up when patent rights are strengthened. Overall, there is a positive impact on growth, but this impact depends on the competitive nature of the economy. (Maskus, 2000, p. 472)

Other scholars stress that IP is helpful only when it is strengthened at the ‘right’ moment in a country’s development trajectory (Kim et al., 2012). One key aspect of this is that a country must have evolved IP enforcement mechanisms, as well as having passed IP laws, to foster actual development (Eicher and Newiak, 2013). To summarize the macro case, we might say this. Although the data is incomplete, it is possible to put together a plausible case that IP law has proven to be an effective part of modern economic systems. IP law might be said then to have made a positive contribution to economic development. At a minimum, IP law has certainly not slowed economic development, at least not convincingly, in a way that empirics have been able to capture. Either argument might be enough to establish that the costs of having a patent system have not been proven to outweigh the benefits,2 thus making out a basic macro-level case for IP.

2   It is obvious from the formulation that this way of stating the issue favors the existence of a patent system. If the burden of proof was on someone trying to establish that the patent system actually confers net benefits, this would favor those who oppose patents. On this general point, David McGowan (2004) discusses the same point with respect to the copyright system, and argues that this points toward nonconsequentialist justifications for copyright.

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Philosophical foundations of IP law  77 B. Consequentialism ‘All the Way Down’: Micro-Consequentialist Roots of Macro-Consequentialism The methodology of macro-consequentialism leads directly to the application of consequentialist analysis to the details of an IP system. Indeed, the macro case can be seen as simply the aggregate result of the application of all the discrete rules and details of the IP system. This is not to say that every particular rule in an IP system is optimal, or even net positive; just that the aggregate result of all the detailed rules exerts a net positive effect on growth. The macro picture, in other words, in no way obviates the need to search for detailed data that might help determine correct choices concerning specific policy issues. This combination of macro-level faith in the IP system, together with a commitment to a consistent consequentialist approach to all detailed issues might be described as the working theoretical orientation of many US IP scholars. They take the macro case as more or less given, and then proceed to look for the best available data to help answer questions about the details of the IP system. Most scholars in effect combine macro consequentialist foundations with an aspirational micro-consequentialist orientation to specific policy issues. Despite this working consensus, micro consequentialism is actually compatible with two different views of the macro issue just described. As mentioned, one who believes that macro data prove IP is a net positive institution simply applies the empirical method ‘all the way down’: each micro-level decision within the system is made with reference to the best data available. Because one believes, for example, that copyright law makes overall economic sense, one applies consequentialist reasoning to the question of whether copyright law ought to include a ‘fair use’ privilege; and if so, how far that privilege should extend. Or one applies economic/consequentialist analysis to the question of how long the term of copyright protection ought to be. Indeed, a theoretically consistent consequentialist would say that the macro case is simply the outcome or sum of all the individual micro cases; the aggregate positive social welfare contribution of IP law is a product of the fact that each micro-level policy is maximized in terms of net positive social welfare, so that the net positive macro-level outcome is foreordained. It simply follows from the consequentialist approach to each micro-level issue. 1.  Consequentialism with nuance There are modifications and variations on consequentialism too numerous to detail here. Even so, a few of the more nuanced accounts bear directly on justifications for IP, so I will provide a brief sense of several relevant variants. One variant worth noting is the class of utilitarian theories that incorporates generalization. Utilitarian generalization is a form of utilitarianism under which an action is judged according to the effects that would follow if everyone acted similarly. The best-known form is rule utilitarianism; according to this approach, utilitarianism, ‘the rightness or wrongness of particular acts can (or must) be determined by reference to a set of rules having some utilitarian defence, justification, or derivation’ (Lyons, 1965, p. 11). (So-called ‘act utilitarianism’ looks instead at the non-generalized consequences only of one’s own individual action.) Utilitarian generalization is relevant in that it bears some similarity to Kantian ethics, in particular the categorical imperative. Both involve a universalizing step: actions are determined with reference to whether they would be

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78  Research handbook on the economics of IP law volume 1 desirable if pursued by all people. The difference, of course, is that for Kant the effects of actions generally do not matter, only their intrinsic rightness or wrongness. In any event Kantian style analysis has been applied both to a basic justification for IP rights (Merges, 2011), as well as to a number of specific problems within IP (see, e.g., Haemmerli, 1999; Treiger-Bar-Am, 2008). And utilitarian generalization is also related to contractarian models of government and social justice, though the contours of the fit are debated (Mueller et al., 1974; Mueller, 2002). Yet even though there is some family resemblance between generalized utilitarianism, Kant’s ethics, and contractarianism, in the end even this form of consequentialism encounters problems. The main one is that in some situations there is no single rule that both produces good consequences and complies with a basic sense of morality. The typical example involves cooperative interactions where multiple people must interact to produce a benefit, but adjustments are in order regarding situation-specific contributions by individuals. As Lyons (1965) shows, in such cases simple distributional rules (such as taking turns accessing a shared resource) are capable of both producing greater total benefits and complying with a basic sense of fairness. No single utilitarian rule does as well (if everyone acts first, there is congestion and overuse; if everyone refrains from acting, the benefits of access and use are lost) (Lyons, 1965, pp. 167–70). The general point is that under a number of plausible conditions rule utilitarianism, just as with act utilitarianism, leads to outcomes that seem unfair or unreasonable or both. The second variant worth mentioning concerns the special problem of how the individual treats him or herself. Utilitarianism requires that one’s personal preferences not be weighted in any way that distorts the consequentialist calculus. This seems implausible, in the sense that humans faced with a decision would seem to just naturally overweight the decision’s impact on themselves. In addition, it strikes some observers as unfair, in that it will often deprive the individual of the ability to shape his or her own life prospects; the relentless need to account for total consequences (i.e., the impact on everyone, not just one’s self) would seem a real burden. The relevance to IP law is that this is a branch of law that has often been understood as one that has special regard for the individual. Artists, writers, inventors, and all creators are involved in acts that not only benefit others but that also (and sometimes primarily) lead to self-fulfillment. In this context, the imperative to always include others (i.e., everyone else) in one’s decisional calculus seems especially onerous. Fortunately for the individual, at least one philosopher has addressed the issue. Samuel Scheffler (1994) provides a modified form of consequentialism that gives far greater leeway to the particularism of individuals. With what he calls an ‘agent-centered prerogative,’ Scheffler permits individuals in a consequentialist framework to weight the outcomes of their own projects more heavily than they weight general consequences, that is, outcomes with respect to everyone else. Indeed, Scheffler even provides that individuals can maximize value as calculated from their personal point of view. There is an upper bound, however; individuals cannot exceed some threshold level of cost imposed on others. Individual value calculations are permitted, in other words, but not beyond some level of ‘social’ cost. Agent-centered valuation is permitted, up to some level of socially determined (i.e., ‘impersonally valued’) cost. In addition, Scheffler says that it is always acceptable for people to maximize total benefits; they may, if they choose, be thoroughgoing consequentialists, with no special regard to their own projects.

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Philosophical foundations of IP law  79 Here is a form of consequentialism with real promise for the IP field. Under it, one may seek IP protection for a work that appeals to many people, and hence for which the restricted access that follows from IP protection might produce net negative social consequences. (Up to some threshold, anyway; at some point under Scheffler’s individualadjusted consequentialism the costs become too high and protection must be eschewed.) Yet this protection will be bounded, as mentioned, so that the individual IP right cannot harm others too much. It should be mentioned, however, that the self-regarding values Scheffler describes have a good deal of overlap with deontological considerations. ‘I want to protect that work despite (some) negative effects on others; I place a very high personal value on it’ comes awfully close to saying ‘That work has intrinsic value to me and it deserves protection; seeking protection for it is the right thing to do for me.’ Idiosyncratic valuation bumps up here against basic issues of fairness, or right and wrong. In that sense, Scheffler’s views can be seen as quite consistent with some justifications for IP rights that are not normally thought of as consequentialist in nature. Locke, for example, by virtue of his three provisos, explicitly recognizes the rights and needs of others when discussing the right of an individual to obtain property rights (Merges, 2011, ch. 2). Kant too, through his Universal Principle of Right, seeks to reconcile strong individual property claims with the need to account for the freedom of others (Merges, 2011, ch. 3). In this sense, Scheffler’s brand of consequentialism comes very close to philosophical views that treat property claims as more of an intrinsic right. If Scheffler’s notion of personal or idiosyncratic value can be expanded to include a sense of intrinsic right and wrong; or if the ‘third party effects’ recognized by Locke and Kant can be conceptualized as taking into account negative consequences for all others, the two families of theories might even be reconciled. C.  Critiques of Consequentialism There are two basic objections to consequentialism. One is that it can lead to outcomes that are morally reprehensible. The other is that it is impractical. I address them both briefly. In its pure form, utilitarian thinking can lead to things like this: given a certain demand for literature in a society, it could be plausible that the best way to obtain a steady stream of consumable literature would be to enslave a small group of high-output writers. Under threat of death or severe punishment, put them on a strict quota of words per day or chapters per month of novels, plays, short stories, and so on. Feed them and house them but otherwise pay them nothing. If the literature they produce is even mediocre, many dedicated readers might be tolerably satisfied. The cost of each book or story would be minimal; just the cost of confining and supporting the writers, spread over all the readers of their literature. How could this be defended? In a large enough society, the aggregated satisfaction of the readers might well outweigh the intense and concentrated disutility (i.e., agony) of the writers. If net total satisfaction is all that matters, the small pleasure of the many could dominate the deep pain of the few. Of course, it might bother some people that their literature is generated in such a fashion. That might reduce their utility in consuming it. But maybe not enough to make the practice overall net negative in terms of total utility. (One also wonders whether being

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80  Research handbook on the economics of IP law volume 1 ‘bothered’ in this way contains at least a hint of feelings of intrinsic right and wrong – shades of a deontological pull?) The point is not to predict what the net utility numbers would be. It is to point out the simple fact that if the numbers came out net positive, a consistent utilitarian would have to approve of the practice. The motto ‘live by the numbers, die by the numbers’ might be appropriate. In short: all sorts of things most of us find morally repulsive might be possible under a strictly utilitarian setup. It is that sense of moral repulsion that in effect constitutes the counterargument to pure-form utilitarianism. 1.  The calculability critique The second critique of consequentialist theories such as utilitarianism is that it is impractical. It is too difficult to determine the net consequences of almost any simple action, which means it is hopeless to attempt to make consequentialism the comprehensive basis for all social policy. This objection is about the limits of calculability. There are several dimensions to this. First, it is very difficult to predict all the consequences of a given action. This is of course well known in the literature on causation. Even deciding on what is an ‘important’ or ‘proximate’ cause of a downstream event is fraught with complexity. Matters become even more difficult when we take into account interaction effects – when we try to predict how one decision may affect others, and how related actions may interact with the first decision to produce final outcomes. Here is an example of this dimension of calculability. Let us say we are deciding whether the owners of internet platforms have to take responsibility for the copyright status of material that users post on the platforms. One proposal is to generally shield the platform owner from liability, subject to a duty to shut down the online posting activity of specifically identified, high-volume copyright violators. The other proposal is to raise the platform owners’ level of responsibility – to make them liable in more circumstances for online postings that infringe copyrights, whether the person posting the material can be identified or not. What are the consequences of this decision? The high-shield proposal will certainly benefit the platform owner; it need not worry much about ruinous copyright infringement liability. But perhaps the creators of copyrighted works will suffer if this shielding cuts into their ability to make money? Perhaps. But then again the relative openness of the platform may provide a forum for more creators. Perhaps amateur creators will gain a larger audience. Perhaps users of the platforms will benefit from a greater diversity of creative works in the low-copyright-enforcement milieu? On the other hand, perhaps the low-shield/high-liability option will lead to the creation of sophisticated filtering software that helps to identify copyrighted works. Maybe this software will abet censorship. Maybe it will lead to automated compensation mechanisms that help identify specific instances where copyrighted works are used, and provide direct small payments to creators. And perhaps this will lead to more creators entering the field in hopes of making a living. But then again if platform companies have to pay copyright infringement claims on a regular basis they may innovate less. They may not have the money to invest in creating their own studios for making videos and music. This may cause artists who would have benefitted from these investments to be worse off than they otherwise would be. Perhaps some of these artists who would have benefitted will leave creative industries and the world will

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Philosophical foundations of IP law  81 lose out on a masterpiece or two. One or more may even die in despair, fail to have children they otherwise would have had. Maybe one of these unborn children would have been the scientist to cure cancer or discover cheap, safe fusion energy. And so on. When we spin out the potential consequences in this way, what jumps out is the hopelessness of comprehensive consequentialism. As one philosopher put it: ‘We may not be strictly without a clue, but we are virtually without a clue. The trouble for consequentialism then is that the foreseeable consequences of an action are so often a drop in the ocean of its actual consequences’ (Lenman, 2000, p. 350) (emphasis in original). Even an attempt to mitigate the problem by assigning probabilities to various outcomes will not save the day. This just moves the necessary complexity to a different task (assigning weights to events), it does not eliminate it. Put simply, ‘if utilitarians are worried about the impracticality objection, they should not turn to expected utility utilitarianism. That theory does not provide the basis for a cogent reply to the objection’ (Feldman, 2006, p. 49). It is easy to see the force of this critique when applied to IP law. To begin, there is almost no area of IP law that has been studied extensively enough to warrant a ‘net grand total’ conclusion. The many empirical studies in this field often consider only one isolated doctrine or practice; very few are anywhere near comprehensive (Buccafusco and Heald, 2013; Budish et al., 2015; and generally Merges, 2016). There is, however, one possible exception. It seems safe to say that removing patent protection from the pharmaceutical and chemical industries would work a serious hardship on those industries as currently constituted (see Graham et al., 2010). Even here though, conclusions can only be tentative, because the studies concentrate on the industries in their current form. It is quite conceivable some fundamental restructuring (e.g., government subsidies; or strict regulation of consumer advertising expenditures relative to R&D investments) might work such changes that patent protection is no longer essential. So even in this canonical case we cannot conclude that we have sufficient data on which to base a permanent and comprehensive decision about the consequences of eliminating IP protection for these industries. D.  An Illustration of the Problem: New Theories, Pro and Con To show why there is uncertainty about the net benefits of IP law, it may help to review two waves of recent IP scholarship. One develops ideas about the benefits of patents that are a modern variant of the classic ‘incentive to invent’ theory. The other examines carefully industries where IP has largely not been available – and argues that thriving innovation in these industries demonstrates that IP rights are not necessary in them, and possibly in other industries as well. Both theories are interesting and innovative. But from the perspective of determining whether IP is a net positive or negative social institution, they are of no help. They point in precisely opposite directions. One new branch of literature emphasizes patent-related benefits in the form of enhanced incentives to disclose, exchange, and license information. Briefly put, this research emphasizes the transactional role IP rights play in economic activity. Traditional theory simplified research activity as taking place inside a large firm; the role of patents was to allow a firm to recoup expensive R&D costs. This newer literature emphasizes patents as facilitators of exchange. Thus, patents are said to make small, independent ‘idea shops’ more viable, because patents make possible a specialized market in pure ideas.

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82  Research handbook on the economics of IP law volume 1 Patents affect not only the overall volume of innovation, but, critically, they affect where innovation takes place. Because small companies have some recognizable benefits, patents may indirectly affect the overall volume and quality of innovative ideas. But they do so indirectly: by making it easier for more innovative small firms to earn income through the licensing of innovative ideas to other firms that engage in actual production. In some related research, two economists have shown that the availability of published patent applications (which came into US law in 2000) led to (1) a higher volume of patent licensing, and (2) more rapid licensing of inventions than in earlier periods (Hegde and Luo, 2016). These results show that patents tend to speed the transfer of ideas, and promote more rapid diffusion of innovations throughout the economy. Again, the effect of patents on innovation is positive but in a way different in kind from the classic treatment of patents as incentive to aggregate R&D spending. The other branch of theory I want to mention looks at industries where IP rights are not available, but which seem to foster significant innovation nevertheless. From French chefs (Fauchart and von Hippel, 2008) to stand-up comics (Sprigman and Oliar, 2008) and from fashion designers (Sprigman and Raustiala, 2006) to tattoo artists (Perzanowski, 2013), creative people working in various industries develop norms and practices that provide an adequate, and perhaps often superior, alternative to formal IP protection. Some have taken to calling these areas, collectively, IP’s ‘negative spaces’ (Rosenblatt, 2011). From these studies, a consensus theory has begun to emerge, which holds that IP law is far less necessary than many have traditionally supposed. The absence of IP, they say, not only fails to impede creative contributions in these areas; in some cases at least there is more activity. From a descriptive or positive beginning, in other words, negative space theory often moves to a more normative point: the essential wrongheadedness of the traditional story that IP rights are always and everywhere necessary to call forth creative works. One note of caution is in order here. Though the negative space literature looks impressive, the truth is that taken together, the ‘negative space’ industries studied to date (other than fashion) total roughly $12.75 billion in revenue per year (tattoos, French cooking, and stand-up comedy). The fashion industry is much larger – but the problem is that many believe the ‘negative space’ story (thriving innovation without IP rights) does not fit the industry at all (see, e.g., Hemphill and Suk, 2009). And if we remove fashion from the list of negative space industries, the fields studied in this research represent only a small percentage of the economic activity that appears closely tied to IP protection. The International Intellectual Property Protection Alliance (IIPPA), for example, estimates that the ‘copyright industries’ alone add $1 trillion to the US economy each year.3 It is very difficult to arrive at similar estimates for the ‘patent industries’ because companies in so many industries obtain large numbers of patents every year. But we can say that the pharmaceutical industry is worth nearly $300 billion per year alone (Statista, 2015) and that the chemical industry totals roughly $800 billion (Seijo, 2017). Add in medical devices, not to mention information technology, and it is apparent that the accounts of negative space fields show we have a long way to go before deciding that many other industries would benefit from the elimination of IP rights.

3   Figures such as these should always be taken with a grain of salt as they are (1) based on large aggregate data sources, and (2) prepared by interest groups with a string agenda (Verrier, 2013).

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Philosophical foundations of IP law  83 Yet another area where new data is available is in the area of small companies and patents. Here again a patent-positive story competes with one that is far less sanguine (Reidenberg et al., 2015). On the positive side, Reidenberg et al. constructed a random sample of small companies in the smartphone industry to assess how patents have affected them. The authors found that holding a small number of patents was associated with firm survival, financing, and other positive outcomes, and in addition that these firms were not subject to excessive patent litigation, as some had feared in this patent-intensive industry where many patents are held by large companies. On the other hand, Colleen Chien found that non-practicing entities or ‘patent trolls’ disproportionately harmed small companies with their activities (Chien, 2014). She reported that: Most unique defendants to [patent] troll suits are small. Companies with $100M of annual revenue or less represent at least 66% of unique defendants to troll suits and at least 55% of unique defendants in troll suits make $10M or less per year. . ..To the extent patent demands ‘tax’ innovation, then, they appear to do so regressively, with small companies targeted more as unique defendants, and paying more in time, money and operational impact, relative to their size, than large firms. (Chien, 2014, pp. 461, 462)

Chien even found that in at least one case, a formerly innovative startup, OpenWave, Inc., had shifted its own business model to become a patent troll itself (Chien, p. 479, n. 71). The point here is not to scrutinize the new research topics just mentioned. Instead, the object is to simply notice the enormous complexity of the economic landscape within which IP rights operate. And to observe that sometimes it seems in the IP literature as though one consequentialist/empirical step in one direction (either defending IP, or ­showing its inefficiency) is met immediately by a step in the opposite direction. E.  Modest Consequentialism So it is no wonder that many scholars are agnostic about the macro level; perhaps IP makes economic sense, in total, perhaps not. For these skeptics, the best approach in either case is to take each particular issue and maximize net social welfare based on the best available data about that particular issue. This view is closely compatible with the famous admonition by the Austrian economist Fritz Machlup, to the effect that it would be unwise based on current data to establish a patent system, based on what we know; but that it would also be unwise to do away with the patent system as we know it, now that it has been around for so long (Machlup, 1958). The idea is to maximize the net social welfare stemming from any particular decision about IP policy, notwithstanding an admission of ignorance regarding (and perhaps even the impossibility of knowing) the ultimate systemic net social welfare determination. When it comes to the macro question, Machlup himself falls right in between a ringing endorsement and a harsh rebuke. Yet this tepid assessment is still – many years after it was made – the starting point for most discussions of the field’s Big Question: are patents justified on the economic evidence, or are they not? The same conundrum has plagued copyright law (Breyer, 1971). And in copyright, even the micro-consequentialist theory has been called into doubt. As David McGowan states it:

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84  Research handbook on the economics of IP law volume 1 [O]ne cannot justify one or another copyright policy solely with consequentialist arguments. We do not even know such basic facts as how many people use the DeCSS program to make unauthorized copies of movies, or how much people who use file ‘sharing’ software to copy music would pay for that music if they had to. Worse yet, without some consensus on normative principles we could not make sense of the data even if we had them. If people who would not pay the lowest price a record company would accept for music copy the music on their own, is this bad or good? Should policy encourage or discourage it? (McGowan, 2004, p. 2) (footnotes omitted)

Other scholars agree (Zimmerman, 2011, p. 32; Boyle, 2008, pp. 207–8). A slightly different flavor of skepticism was described by Posner in 1998. He wrote: What the economist can say, which is a lot but not everything, is that if a society values prosperity (or freedom or equality), these are the various policies that will conduce to that goal, and these are the costs associated with each. The economist cannot take the final step and say that a society’s ultimate goal should be growth, equality, happiness, survival, conquest, stasis, social justice, or what have you. An economist discussing a ‘hot’ topic, such as whether human cloning should be permitted, might estimate the private benefits and social costs of human cloning, and even advise on the consequences of ignoring costs and benefits in fashioning public policy. But he could not tell the policymaker how much weight to give costs and benefits as a matter of social justice. (Posner, 1998, p. 1670)

Either Posner is saying that empirical data are ultimately inputs into a more value-laden welfare calculus, or that welfare itself must be subsumed into a more comprehensive decision-making process (based, perhaps, on deontological considerations). Either way, this is a more modest form of welfarism than strict micro-summing-to-macro-consequentialism as described earlier.

III.  DEONTOLOGICAL THEORIES, AND THEIR CRITICS Deontological theory is based on the simple idea of moral duties. We base our decisions on moral rules, on ideas of right and wrong, as opposed to basing them strictly on the consequences of our actions. Decisions about what to do are tested against compliance with rules of morality. Those rules inform whether an act is required, permitted, or prohibited. So for example, a deontological approach to murder would say it is wrong intrinsically. Thus even if the net consequences of a murder would be demonstrably positive (because the murdered person is very bad, for example, or because the murdered person is a billionaire who has pledged to leave his money to hundreds of people who are in great need), in general a deontological theory would prohibit it. Kantian deontological ethics are for the most part absolutist: rules of behavior do not change with context or circumstances. Lying, stealing, murder, and so on, are simply wrong – and that is it. Other forms of deontology are less absolute. They permit the pursuit of net positive outcomes, a la consequentialism, but subject to constraints. So for example, the pursuit of net positive welfare might be subject to the constraint that people should not be harmed in the process. Even these constraints may be overridden in some cases if enough good or bad is at stake; it may be permissible, for example, to kill a person in order to save the lives of hundreds or thousands of other people (Kagan, 1998; Zamir and Medina, 2008). As Rawls puts it ‘[D]eontological theories are defined . . . not

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Philosophical foundations of IP law  85 as views that characterize the rightness of institutions and acts independently from their consequences. All ethical doctrines worth our attention take consequences into account in judging rightness’ (Rawls, 1999, p. 26). The obvious question, however, is this: where do these deontological duties come from; how do we know what they are? Critics of deontological theories are quick to point out that these are inherently subjective judgments, that they will often differ among different people, and that they are not a trustworthy basis for making decisions, either individually or collectively. This is both a critique of deontology per se, and, indirectly, a defense of even a limited form of consequentialism. The implicit point is a version of the old academic adage, ‘it takes a theory to beat a theory.’ If consequentialism – whatever its deficiencies – is a real theory, while deontological theory is purely mush, then consequentialism wins by default. This is true regardless of its faults and limitations. Various forms of this argument can be found throughout the literature on law and economics. In the IP field, the strongest version calls one non-consequentialist theory a ‘retreat from evidence,’ and labels it with the pejorative of ‘faith-based IP’ (Lemley, 2015, p. 1337). It goes on to attack the theory by saying its ‘adherents are taking the validity of the IP system on faith and . . . the rationale for doing so is a form of religious belief’ (Lemley, 2015, p. 1337). Lemley in no way originated the claim that consequentialism has a unique and privileged status as a normative theory of law. In fact, this is a very old claim, in philosophy as well as law. As one commentator puts it: If normative law and economics is only one possible position in normative legal philosophy, then any suggestion that one should cede terrain in favor of the other seems out of place. However, economic lawyers might want normative law and philosophy to be the final position in normative legal theorizing, the ‘end of public ethics,’ so to speak. Interestingly, this tenet could not be grounded on any number of theoretical or empirical advances made in positive law and economics. Whatever its degree of explanatory or predictive success, positive law and economics cannot yield normative consequences. This is just a way of rephrasing Hume’s famous motto that ‘is’ does not imply ‘ought.’ A similar idea was defended in twentieth-century metaethics by claiming that—without assuming the proper naturalist definition—it is fallacious to draw moral judgments from a set of premises only containing factual statements. Normative law and economics, like any other consequentialist moral theory, is not ‘naturally’ true. It is absurd to attack nonconsequentialism as implausible or irrational just by noting that its results are at odds with consequentialism. In the absence of further argumentation, it is question-begging to dismiss nonconsequentialism by taking a stand on consequentialism. By the same token, it is question-begging to attack fairness-based theories of law by relying on the welfare maximization thesis of normative law and economics. (Spector, 2004, pp. 349–50)

The argument goes back much further however – to the debate over whether ‘wealth is a value’ that took place in the early days of law and economics ascendance in US law schools. From time to time, lawyers and judges seeking to promote economic values such as efficiency and wealth-maximization have taken the further step of arguing that competing paradigms of jurisprudence based on commonsense notions of justice are theoretically inadequate bases on which to ground a system of legal rights and obligations. [Oliver Wendell] Holmes himself is a leading example of this tendency. [Richard] Posner’s book (Posner, 1999) is perhaps the most ambitious attempt yet by a judge to attack the foundations of natural justice in order to promote the law and economics movement in this way. It contains many telling criticisms of

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86  Research handbook on the economics of IP law volume 1 recent ­professional moral philosophy, delivered with a force and directness only a secure outsider can provide. Nonetheless, the book’s central arguments are remarkably unsuccessful. In his zeal to criticize philosophers, Posner commits surprising mistakes that suggest he misunderstands basic questions, not only of moral philosophy, but of jurisprudence as well. (Mikhail, 2002, pp. 1057–8; for Holmes’s views, see Alschuler, 2000)

A.  The Critique of Subjective Moral Intuitionism The critique of deontology I have been describing boils down to the idea that notions of right and wrong are rooted in subjective judgments. They are the product of intuition, whim, or taste. And so they cannot form the firm foundation of any kind of rigorous, consistent theory about how people should act. Defenders of deontological theories have made various responses to this objection over the years. The most thorough perhaps comes from Kant, who wrote at great length about separating mere inclinations or intuitions from considered moral judgments (Kant, 1785). The key for Kant is the notion that every person has not just inclinations and preferences, but also an elaborate internal construct that seeks the good. This construct can be cultivated and consulted; it is a rational part of the self, distinct from pleasure-seeking aspects of the self. Kant said that we can use this rational apparatus to generalize any proposed action – to envision what the world would be like if, when we choose to act, that choice was embodied in a universal principle applicable to all. According to Kant, our internal reasoning mechanism can be combined with this universalizing step to produce the famous categorical imperative. This in turn provides a rational and consistent set of rules to govern human action (O’Neil, 1990). Another answer to the subjectivity critique of deontological systems takes a similar form. The philosopher John Rawls asks us to imagine making a list of moral rules, and then testing and refining them against moral judgments about specific acts or decisions. The back-and-forth between rules and applications produces what Rawls calls ‘reflective equilibrium,’ which is a much more refined and rational set of judgments as compared with initial, simple moral intuitions (Rawls, 1971, pp. 44–5). Others have extended this idea to more explicitly consider generalizing the equilibrium across a number of people (Scanlon, 2000). And there are of course defenders of a shared sense of morality who argue that this sense emanates from outside people and can be recognized and developed using spiritual practices (Kwall, 2009, pp. 139–40). 1.  A shared moral sense The elaborate procedures just described are meant to show that deontology need not be based on a primitive form of moral intuitionism. In fact the word ‘deontology’ derives from ‘duty’ (deon) and ‘the study or science of’ (logia). It is meant to be systematic, not ad hoc. Even so, without taking anything away from the systematic approaches described, a separate defense of deontology proceeds from the fact that people make moral judgments all the time. Despite the critics’ point that intuition is inherently subjective, whimsical, and unreliable, proponents of an innate deontology show that there is more overlap among people regarding moral intuitions than is sometimes supposed. Though deontology makes great efforts to distinguish between ‘raw’ moral intuitions and a refined system of

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Philosophical foundations of IP law  87 well-considered moral rules, there is solid evidence that some moral intuitions are in fact very widely shared. B.  Empirical Studies of Moral Judgment Evidence has mounted in the past 25 years or so that there are very extensive overlaps in people’s basic moral intuitions. Indeed, it has become common in some circles to speak confidently of ‘moral universals.’ And in general, recent research suggests that quick first impressions – based on intuition – are more reliable bases of judgment than many would suppose (Gladwell, 2007). Consider, for example, a well-known hypothetical situation designed to explore moral judgments. In the basic version of this scenario, called ‘the trolley problem,’ a person observes that an out-of-control trolley is heading for five people and will kill them unless it is diverted (Thomson, 1985; Kamm, 1989). The only way to divert it is to pull a switch that turns the train onto a different track – where it will kill one person. In another basic variation, the only way to save the five people is to throw a large person, standing on a walkway above the train track, in front of the trolley to stop it. Students of moral theory use these (and many other) variations to explore moral judgments. But an empirical branch of this field uses the trolley problem to test moral judgment across cultures, age groups, and other demographic categories. In one study, researchers asked people from many countries about two simple variations on the famous ‘trolley problem,’ and found widespread agreement about which actions were right and wrong across many ethnicities, religions, ages, and backgrounds: [A]cross a variety of nationalities, ethnicities, religions, ages, educational backgrounds (including exposure to moral philosophy), and both genders, shared principles exist. That is, across every subpopulation tested, scenario 1 (turning the train) elicited a significantly higher proportion of permissibility judgments than scenario 2 (shoving the man), suggesting that one of . . . three [common moral] principles . . ., or their combination, guided the moral judgments made by each group. (Hauser et al., 2007, p. 16)4

A number of influential scholars have also documented what they call ‘human universals’ – consistent moral judgments across cultures about important subjects such as murder, rape, and theft. Anthropologists, in particular, have revised the widespread view of ‘cultural relativism’ that prevailed in an earlier era, in part by revisiting some famous case

  The three principles are explained by the authors:

4

  [T]he observed pattern of judgments was consistent with at least three possible moral distinctions: (1) Foreseen versus intended harm (Principle of the double effect): it is less permissible to cause harm as an intended means to an end than as a foreseen consequence of an end; (2) Redirection versus introduction of threat: it is less permissible to cause harm by introducing a new threat (e.g. pushing a man) than by redirecting an existing threat (e.g. turning an out-of-control train onto a man); and (3) Personal versus impersonal: it is less permissible to cause harm by direct physical contact than by an indirect means. The first two distinctions have been discussed in the philosophical literature as the content of plausible moral principles, while the third has emerged from considerations of both behavioral and neurophysiological evidence (Hauser et al., 2007, p. 15).

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88  Research handbook on the economics of IP law volume 1 studies purporting to show aberrant practices, and revising those findings in light of more detailed research (see, e.g., Pinker, 2003; Brown, 1991). But some philosophers are less than convinced (Alfano and Loeb, 2014). Part of the misunderstanding about moral intuition has to do with the nature of intuition itself. Many casual observers equate ‘intuition’ with a ‘retreat from evidence,’ meaning a substitute for empirical observation or even scientific fact (Lemley, 2015, p. 1337). But this view seriously misunderstands the nature of moral reasoning. One prominent explanation of moral judgments is that they are based not on ‘irrational’ intuitions, but instead on a ‘universal moral grammar’ that is inherent to all human beings. This concept is based on an analogy to Noam Chomsky’s famous finding that all humans are born with a common human template for grammar and language (Mikhail, 2013). The key point is how researchers learned of this template. It was not itself invented speculatively, but instead was induced from extensive empirical observations. In the world of language, the universal grammar notion came to prominence because researchers constantly observed that native speakers without sophisticated language training ‘just knew’ proper word usage and sentence structure, even with regard to words and sentence-types they had never encountered before (Cook and Newson, 1996; Jackendoff, 1994; Pinker, 1994). This led linguists to look for further evidence of an ingrained, ‘hard-wired’ capacity for language and language structure – evidence which has mounted ever since. Moral philosophers familiar with empirical studies of moral judgment across cultures posited a similar type of template, only in the moral sphere. Observations, such as those centered on the trolley problem, confirm that people from all cultures and with all education backgrounds share similar judgments concerning right and wrong actions in several basic human situations (see also Pinker, 2008). These studies are not, unfortunately, widely known in law and economics circles – or perhaps among consequentialist thinkers generally. Leading law and economics pioneer and theorist Richard Posner, for example, has stated that ‘there are no general moral principles, just particular moral intuitions’ (Posner, 1999, p. 11). Moral philosopher John Mikhail critiques the Posner view this way: Posner takes for granted the standard ‘particularist’ assumption that moral judgments are made on a case-by-case basis, without the support of moral principles. This assumption is incompatible with the best explanation of the properties of moral judgment. To explain how the normal individual is able to make stable and systematic moral judgments about an indefinite number of novel cases, we must assume she is guided, implicitly, by a system of principles or rules. Without this assumption, her ability to make these judgments—and our ability to predict them—would be inexplicable. Posner’s insistence that the capacity for moral judgment consists of nothing more than ‘theoretically ungrounded and ungroundable preferences and aversions’ is therefore suspect from the start. (Mikhail, 2002, p. 1092)

To paraphrase: even if I could not explain an ‘objective’ set of moral principles to skeptics of deontology, that does not mean they do not exist. Mikhail once again explains: There is no justification for Posner to insist that the normal individual must be fully aware of the operative principles which constitute her moral knowledge, or that she can become aware of them through introspection, or that her statements about them are necessarily accurate. On the contrary, he should recognize that just as normal people are typically unaware of the principles guiding their linguistic or visual intuitions, so too might they be unaware of the principles guiding their moral intuitions. In any event, the important point is that, as with the

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Philosophical foundations of IP law  89 theory of language or of vision, the theory of moral cognition attempts to describe the operative principles of moral competence, not what experimental subjects may or may not report about them. (Mikhail, 2002, p. 1094)

1.  Studies of children’s judgments about ownership A different strain of empirical research has some important things to say about moral judgments concerning IP. Psychologists who study children’s responses to moral issues are interested in a number of issues, including the way moral sensibility develops as children grow. But one subfield in the area of children’s moral judgment is of particular relevance to issues of right and wrong as they pertain to IP. A group of studies with children subjects centers on questions of ownership. A brief review of these studies will be helpful in exploring further the issue of shared moral intuitions. One set of studies deals with judgments about ownership. In a typical experiment, pre-school age children are exposed to a person handling an object. The object is then left, and picked up by another person. A robust finding is that children infer ownership from first possession: [T]he first possession heuristic guides children’s ownership inferences. The findings provide the first evidence that preschoolers can infer who owns what, when not explicitly told, and when not reasoning about objects with which they are personally acquainted. (Friedman and Neary, 2008, p. 829)

Research shows that the first possession heuristic extends to ideas as well as physical objects. As one article title in this field says, ‘Children Apply Principles of Physical Ownership to Ideas’ (Shaw et al., 2012). At the same time, children are also able to distinguish ownership from possession. In studies where an object moves among a group of people, children track the person that others look to for permission to take possession. This person they infer is the owner. In this and other studies, it has been demonstrated that even very young children make sophisticated judgments about issues of ownership. The authors of one study put it this way: [C]hildren (6–8 years old) determine ownership of both objects and ideas based on who first establishes possession of the object or idea. Study 2 shows that children use another principle of object ownership, control of permission—an ability to restrict others’ access to the entity in question—to determine idea ownership. In Study 3, we replicate these findings with different idea types. In Study 4, we determine that children will not apply ownership to every entity, demonstrating that they do not apply ownership to a common word. Taken together, these results suggest that, like adults, children as young as 6 years old apply rules from ownership not only to objects but to ideas as well. (Shaw et al., 2012)

Other studies, concentrated on creative labor, are also highly pertinent to moral judgments about IP. For example, when presented with a conflict between someone who abandons an object and someone who finds it, adults are more likely to endorse the first owner when he or she has invested creative labor in the object (Beggan and Brown, 1993). In one study, children were shown an object, such as modeling clay, owned by person A; then observed as person B expended labor in making something creative (like a small figure) with the clay. In this and similar studies, ‘creative labor increases the likelihood that 3-year-old and 4-year-old children will endorse the creator and not the original owner of materials as the

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90  Research handbook on the economics of IP law volume 1 owner of a final product’ (Kanngiesser et al., 2010, p. 1238). And the instinct to recognize creative effort extends both to children’s own creations and those of others: [W]e found that children applied the same rules to their own property and to the property of the person they were directly interacting with. Although this behavior may have arisen as a by-product of the cooperative social setting of the experiment, our results do indicate that young children are able to overcome a previously established bias to maximize their own gain . . . (Kanngiesser et al., 2010, p. 1240)

Beyond the general assimilation of ideas to objects when it comes to notions of ownership, children also have a distinct reaction to plagiarism. In one article, the authors show that adults, older children (9–11 years old), and children from age 5 and up, all respond with negative moral judgments about plagiarism (Olson and Shaw, 2011). Original creativity is more highly valued, and one who copies and claims credit is assessed negatively even by these very young children. The study authors found that only 3- and 4-year-old children fail to distinguish between original creators and plagiarists. As the authors conclude, ‘by age 5 years old, children understand that others have ideas and dislike the copying of these ideas’ (Olson and Shaw, 2011, p. 431). 2.  Summary: a universal ‘intellectual property instinct’? What these studies show is that there are strong regularities in people’s thinking about ownership, fairness, and the importance of creative labor. And because the studies are cross-cultural, involve children, or both, they support the idea that moral judgments about these issues may be less due to socialization in a particular culture and more due to a basic shared moral sense. What these studies tend to prove is that moral judgments about ownership and creative labor are highly idiosyncratic and unstable. Critics of deontological theories, who argue against it as being ‘unscientific,’ should take note. As one commentator put it, in traversing the arguments of the critic Richard Posner: Posner fails to come to terms in any serious way with the hypothesis that human beings share a sense of justice rich enough to support a universal system of rights and obligations, ­including the right not to be murdered. This hypothesis is plausible and supported by a considerable body of empirical evidence. Throughout [his book] Problematics, Posner adopts the mantle of science and pokes fun at philosophers for being unscientific. But in truth, it is his relativism, not their universalism, that seems out of touch with modern science. (Mikhail, 2002, p. 1062)

The same may well be said of those who criticize deontological theories of IP law. It is they who are out of touch with modern science. Hence, even if one rejects the systematic deontological systems of Kant or Rawls, one must still confront the fact that, empirically speaking, when it comes to issues of property rights many people revert to a common, innate template for making moral judgments. Empirically speaking, when it comes to moral issues, people are not primarily empiricists. They rely on a set of moral judgments so common and pervasive they are close to being universal.

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Philosophical foundations of IP law  91

IV. RECONCILING CONSEQUENTIALISM AND DEONTOLOGICAL APPROACHES For many IP scholars the choice between deontology and consequentialism is difficult; each seems to capture something important about the field. Their instinct is to fight the binary choice, the compromise, to reconcile, to integrate. There are three ways to do that. The first two rely primarily on one methodology, using the other as a constraint. The other divides the methodological problem into two sharply delineated halves or levels. The threshold approach works like this: you begin by saying ‘I am consequentialist – but not all the way down the line. In the right circumstance, I might yield to a moral judgment, sacrificing some positive consequences because not to do so feels wrong.’ Or you say, ‘I am deontological in my approach – but not all the way down the line. In the right circumstances I might permit something that feels wrong in general, if there are overwhelming positive consequences for doing so’ (Kagan, 1998; Zamir and Medina, 2008). The other approach is to say, ‘I am not sure if there is an airtight consequentialist case for the existence of IP rights; but if I think IP is a morally just institution, something that would be included in any fair society, then I think the rules of IP should in general be designed to maximize positive consequences.’ This divides the problem of justifying IP into two distinct levels: the foundational level and a more policy-oriented, more operational level. A.  The Two-Level Approach The two-level approach is appealing because it recognizes the computational limits that plague the consequentialist argument for the existence of IP, yet preserves plenty of room for efficiency considerations. But is this too neat, or does the two-level approach suffer from a sort of fatal incompatibility between the two levels? To see how the two-level approach might hold together, consider the everyday problem of choosing whether to rent a home or buy one. Many people will say there is a solid, rational case for buying over renting. Given reasonable assumptions about interest rates, tax rates, the future trajectory for apartment rents, and real estate appreciation, buying just makes sense. There is, in other words, a solid foundation for this decision based on hard-headed, empirically-verified ‘dollars and cents’ considerations. One who is a bit skeptical, or who does not easily accept certain assumptions, might not be so sure. Maybe rental costs will be lower than projected; maybe the home mortgage deduction will be changed; maybe when one factors in the risk of uninsurable or expensive catastrophes, the case for ownership is not so solid after all. Within this latter group, even if one were to decide that the financial/economic case for home ownership is inconclusive based on available data, one might still decide to buy. This decision would simply be based on criteria other than strict dollars and cents calculations. Maybe ownership would bring a sense of accomplishment, or send a signal of commitment, that renting would not do. Whatever the alternate criteria, they would constitute the basic justification for the decision to buy. However, once the buy decision was made, cost minimization would provide a very important operational principle that should exert significant influence on the way the

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92  Research handbook on the economics of IP law volume 1 decision is implemented – that is, on exactly which house to rent or buy. The key distinction is that dollars and cents considerations – efficiency – is to be seen here as a tool in the service of some other, ultimate criterion. Efficiency is an operational principle meant to best implement a decision made for other (non-efficiency) reasons. If you are an IP scholar who is skeptical of the thorough consequentialist case for the existence of IP, then for you law and economics (or the efficiency principle) serves the same role in IP law as efficiency does in the case of a home buyer/renter who rejects the adequacy of the purely economic case for home ownership. It is a highly useful operational principle that can be deployed to help shape the precise contours of the IP system. It is not so powerful as to justify the system as a whole, but it is powerful enough to exert a strong influence on the way the system should be organized and administered. 1.  But is it not inconsistent? There are several references above to ‘consequentialism all the way down.’ It is also possible of course to be a deontologist ‘all the way down.’ Neither may seem ideal; but aren’t they both preferable to being nothing all the way down? Put differently, how can one defend switching approaches ‘mid-stream,’ as suggested by the two-level solution just described? This is of course a reasonable view. It has the obvious appeal of consistency. Yet it also makes sense to employ different theoretical tools at the two levels of analysis. To see why, consider those two levels again. The foundational question is whether the existence of any IP system can be justified or defended. Should a fair and well-organized society have IP protection? The book Justifying Intellectual Property (‘JIP’) (Merges, 2011) sets out a detailed discussion of this question, together with some attempts at an answer. JIP makes two basic points about the foundation level. First, reasonable people disagree. Some believe a good consequentialist defense of IP can be made. Others believe in foundational consequentialism in general, but are skeptical or agnostic about whether the consequentialist case has been made adequately. Others identify strong deontological roots for the IP field, and justify IP systems on this basis. Still others explain IP as consistent with conventional religious morality. JIP makes one observation on this topic. Although this level of disagreement may seem troubling, it is not a very big issue in the day-to-day debates in the field. This is because the debates take place on a different plane from that of foundational justification. Policy arguments employ standard themes that are distinct from the rigorous requirements needed to ground foundational justifications for the field. These themes are general principles. They are common policy tenets that are embodied in many diverse doctrines and rules. A good example is the principle of proportionality, which dictates that an IP right must be roughly commensurate in scope with the merit or value of the IP-protected work covered by the right. This principle can be found throughout patent law (nonobviousness, enablement, injunctions), copyright law (substantial similarity, thin copyright, fair use), and even trademark law (strength of marks, remedies). This principle is a general theme of IP law, and it does not depend for its force on any particular foundational justification. It is compatible with consequentialist and deontological theories alike. And it both transcends individual doctrines and shapes and guides the application of those doctrines.

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Philosophical foundations of IP law  93 Other general or ‘midlevel’ principles (so-called because they mediate between foundational justifications and specific doctrines) are efficiency, nonremoval (or solicitude for the public domain), and dignity (Merges, 2011). This is a nonexhaustive list; there are undoubtedly other primary themes in IP law that span specific doctrines and rules. One way to think about general or midlevel principles is that they are like a shared public space within which people holding divergent foundational belief can come together to discuss policy and reach consensus. They have been analogized to John Rawls’ idea of an ‘overlapping consensus’ among people holding different beliefs regarding religion and other fundamental life issues. Just as Rawls observed that the ‘public sphere’ can bring together people with divergent basic beliefs, so too JIP theorizes that the general or midlevel principles constitute a shared space that makes possible policy debate and consensus among people with differing opinions about the basic justifications for IP law (Merges, 2011; Rawls, 1971, p. 340). Another analogy is to Cass Sunstein’s idea of ‘incompletely theorized agreements,’ which in a similar way promotes consensus-building (Sunstein, 1995). For Sunstein, the solution comes by avoiding generalities and seeking consensus on specific, particular cases. But the result is the same: a procedure, vocabulary, or norm that permits consensus-building by avoiding the need to resolve issues at the most fundamental (and therefore most contentious) level. So the observation in JIP is that general policy principles allow us to avoid contentious arguments over the foundations of IP rights. The argument in JIP is something different. That book argues that we cannot justify IP rights based on current knowledge of their costs and benefits. The data is inadequate to the task. But, given the decision to have IP rights, important features of our current IP regime can be explained by recourse to the principle of efficiency. Using the best data and analytic techniques at our disposal, we as a society try to maximize the net benefits of IP rights. Put simply, the argument is that we do not have IP rights because we are sure they are efficient, but given that we have them – because they are justified by Lockean, Kantian, or other deontological normative precepts – we strive to make our IP system as efficient as possible. So, efficiency explains and ties together important aspects of the IP system as practiced, even though we cannot be sure of the utilitarian case for IP. To state this simply, one might say that efficiency is a good quality or feature for an IP system, but not an acceptable rationale for it (Merges, 2011, 2013). This has important implications for the way IP research is conducted. If one is a utilitarian or consequentialist, striving to rationalize each aspect of IP on the grounds of total social welfare or utility, a concern with efficiency is of course essential. If one does not agree that the consequentialist case has been made adequately to date, one can still take a great interest in efficiency. It is an important tool in the operation of an effective IP system. Even if the foundations of that system lie outside the realm of net consequences, efficiency considerations may still be highly relevant.

V. CONCLUSION Some scholars see little need for a deep discussion of whether IP law is necessary. It is obviously here, part of our world; why not just take it as it is, try to make the best of it given that it is here, and save the mental anguish of trying to justify it.

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94  Research handbook on the economics of IP law volume 1 For others, it only seems reasonable to sound the depths of the field. In this camp there are two primary options. The inquiry can center on whether the IP system as a whole leaves the world better or worse off. This measures the desirability of IP by looking at the consequences of having these rights. The good effects are weighed out with the bad ones; a net figure or assessment is made; and that is that. There are pluses and minuses to this. The other main avenue of inquiry looks to notions of right and wrong, to some set of moral or deontological rules. Different facets or qualities of the IP system are considered, and a general judgment is reached: IP either is, or is not, an institution that a good society would foster and support. Each of these two formulations has its attractions and problems. Toting up consequences gets very complicated, and it may prove difficult to reach a net determination. Deontology faces the criticism that it is too subjective, too unstable to support a viable justification. Each of these criticisms has answers. Calculability may be a problem, but at least consequentialism strives for precision and reproducibility; it has the aura of science and empirical fact on its side. Deontological judgments are more reliable than they appear, because they can be made systematically, and because even to the extent they are based on intuition, there is more consensus about moral intuitions than most critics believe. One way to bring these opposing justifications into greater harmony is to cordon off the foundational question – whether society should have an IP system – from the level of basic principles that are to operate if such a system is established. For a thoroughgoing consequentialist, this entails simply a two-step process; the net merits of each aspect of the IP system are plumbed, and then, in a separate step, a grand (net) total is arrived at. For one who relies on deontological foundations, such a procedure works especially well. He or she can arrive at an answer to the foundational question; if it is positive, then efficiency is one important tool that can be brought to bear on the running of the IP system in practice. Though consequentialist theory might seem lacking as a way to justify the IP system, consequentialist tools can be deployed once an IP system is established. This two-level solution to the problem of justifying IP has one attractive feature. It permits people to disagree about foundational justifications, while cooperating fully in the development of IP policies inside an actual IP system. It has the potential for us to hold to our deepest intellectual commitments, while debating policy on a more operational plane. So we can disagree, without being disagreeable.

REFERENCES Alfano, Mark, and Don Loeb. 2014. ‘Experimental Moral Psychology,’ Stanford Encyclopedia of Philosophy, accessed March 31, 2019 at https://plato.stanford.edu/entries/experimental-moral/. Alschuler, Albert W. 2000. Law without Values: The Life, Work, and Legacy of Justice Holmes. Chicago, IL: University of Chicago Press. Beggan, James K., and Ellen M. Brown. 1993. ‘Association as a Psychological Justification of Ownership,’ 128 The Journal of Psychology 365–80. Boyle, James. 2008. The Public Domain: Enclosing the Commons of the Mind. New Haven, CT: Yale University Press, 205–207. Breyer, Stephen. 1970. ‘The Uneasy Case for Copyright: A Study of Copyright in Books, Photocopies, and Computer Programs,’ 84 Harvard Law Review 281–351. Brown, Donald. 1991. Human Universals. New York, NY: McGraw-Hill Education.

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Philosophical foundations of IP law  95 Buccafusco, Christopher, and Paul J. Heald. 2013. ‘Do Bad Things Happen When Works Enter the Public Domain? Empirical Tests of Copyright Term Extension,’ 28 Berkeley Technology Law Journal 1–43. Budish, Eric, Benjamin N. Roin, and Heidi Williams. 2015. ‘Do Firms Underinvest in Long-Term Research? Evidence from Cancer Clinical Trials,’ 105 American Economic Review 2044–85. Chien, Colleen. 2014. ‘Startups and Patent Trolls,’ 17 Stanford Technology Law Review 461–506. Cook, Vivian J., and Mark Newson. 1996. Chomsky’s Universal Grammar: An Introduction. Maiden, MA: Blackwell Publishing. Darwall, Stephen. 2003. Deontology. Hoboken, NJ: John Wiley & Sons. Eicher, Theo S., and Monique Newiak. 2013. ‘Intellectual Property Rights as Development Determinants,’ 46 Canadian Journal of Economics 4–22. Fauchart, Emmanuelle, and Eric von Hippel. 2008. ‘Norms-Based Intellectual Property Systems: The Case of French Chefs,’ 19 Organization Science 187–201. Feldman, Alan M., and Roberto Serrano. 2006. Welfare Economics and Social Choice Theory, 2d ed. New York, NY: Spring Science + Business Media, Inc. Feldman, Fred. 2006. ‘Actual Utility, the Objection from Impracticality, and the Move to Expected Utility,’ 129 Philosophical Studies 49–62. Friedman, Ori, and Karen R. Neary. 2008. ‘Do Children Infer Ownership from First Possession,’ 107 Cognition 829–49. Fromer, Jeanne C. 2012. ‘Expressive Incentives in Intellectual Property,’ 98 Virginia Law Review 1745–824. Gladwell, Malcolm. 2007. Blink: The Power of Thinking Without Thinking. New York, NY: Back Bay Books. Graham, Stuart J.H., Robert P. Merges, Pamela Samuelson, and Ted Sichelman. 2010. ‘High Technology Entrepreneurs and the Patent System: Results of the 2008 Berkeley Patent Survey,’ 24 Berkeley Technology Law Journal 1256–327. Haemmerli, Alice. 1999. ‘Whose Who? The Case for a Kantian Right of Publicity,’ 49 Duke Law Journal 383–491. Harsanyi, John C. 1990. ‘Interpersonal Utility Comparisons,’ in John Eatwell, Murray Milgate, and Peter Newman, eds., Utility and Probability. The New Palgrave. London: Palgrave Macmillan. Hauser, Marc, Fiery Cushman, Liane Young, R. Kang-Xing Jin, and John Mikhail. 2007. ‘A Dissociation between Moral Judgments and Justifications,’ 22 Mind & Language 1–21. Hegde, Deepak, and Hong Luo. 2016. ‘Imperfect Information, Patent Publication, and the Market for Ideas,’ 14-019 Harvard Business School working Paper (Feb. 8, 2016), accessed April 1, 2019 at http://www.hbs.edu/ faculty/Publication%20Files/14-019_726e14eb-8ebb-49d9-ae75-f368916cdf60.pdf. Hemphill, C. Scott, and Jeannie Suk. 2009. ‘The Law, Culture, and Economics of Fashion,’ 61 Stanford Law Review 1147–99. Jackendoff, Ray. 1994. Patterns in the Mind: Language and Human Nature. New York, NY: BasicBooks. Kagan, Shelly. 1998. Normative Ethics. Boulder, CO: Westview Press. Kamm, Francis M. 1989. ‘Harming Some to Save Others,’ 57 Philosophical Studies 227–60. Kanngiesser, Patricia, Nathalia Gjersoe, and Bruce M. Hood. 2010. ‘The Effect of Creative Labor on PropertyOwnership Transfer by Preschool Children and Adults,’ 21 Psychological Science 1236–41. Kant, Immanuel. 1785. Groundwork for the Metaphysics of Morals. New Haven, CT: Yale University Press. Kaplow, Louis, and Steven Shavell. 2006. Fairness Versus Welfare. Cambridge, MA: Harvard University Press. Kim, Yee Kyoung, Keun Lee, Walter G. Park, and Kineung Choo. 2012. ‘Appropriate Intellectual Property Protection and Economic Growth in Countries at Different Levels of Development,’ 41 Research Policy 358–75. Kwall, Roberta. 2009. The Soul of Creativity: Forging a Moral Rights Law for the U.S. Stanford, CA: Stanford University Press. Lemley, Mark A. 2015. ‘Faith-Based Intellectual Property,’ 62 UCLA Law Review 1328–46. Lenman, James. 2000. ‘Consequentialism and Cluelessness,’ 29 Philosophy & Public Affairs 342–70. Lyons, David. 1965. Forms and Limits of Utilitarianism. Oxford: Oxford University Press. Machlup, Fritz. 1958. ‘An Economic Review of the Patent System, Study of the Subcommittee on Patent, Trademarks and Copyrights,’ Committee on the Judiciary, U.S. Senate, 85th Congress, 2nd Session. Maskus, Keith E. 2000. ‘Intellectual Property Rights and Economic Development,’ 32 Case Western Reserve Journal of International Law 471–505. McGowan, David. 2004. ‘Copyright Nonconsequentialism,’ 69 Missouri Law Review 1–72. Menell, Peter S., and Suzanne Scotchmer. 2005. ‘Intellectual Property,’ in A. Mitchell Polinsky and Steven Shavell, eds., 2 Handbook of Law and Economics. Oxford: North-Holland. Merges, Robert P. 2011. Justifying Intellectual Property. Cambridge, MA: Harvard University Press. Merges, Robert P. 2013. ‘Foundations and Principles Redux: A Reply to Professor Blankfein-Tabachnick,’ 101 California Law Review 1361–86. Merges, Robert P. 2016. ‘Economics of Intellectual Property Law,’ in Francesco Parisi, ed., The Oxford Handbook of Law and Economics. Oxford: Oxford University Press.

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96  Research handbook on the economics of IP law volume 1 Mikhail, John. 2002. ‘Law, Science, and Morality: A Review of Richard Posner’s the Problematics of Moral and Legal Theory,’ 54 Stanford Law Review 1057­–127. Mikhail, John. 2013. Elements of Moral Cognition: Rawls’ Linguistic Analogy and the Cognitive Science of Moral and Legal Judgment. Cambridge: Cambridge University Press. Mueller, Christian. 2002. ‘The Methodology of Contractarianism in Economics,’ 113 Public Choice 465–83. Mueller, Dennis C., Robert D. Tollison, and Robert D. Willett. 1974. ‘The Utilitarian Contract: A Generalization of Rawls’ Theory of Justice,’ 4 Theory and Decision 345–67. OECD (United Nations Organisation for Economic Co-operation and Development). 2005. Oslo Manual: Guidelines for Collecting and Interpreting Innovation Data. Paris, France: OECD Publishing. O’Neil, Onora. 1990. Constructions of Reason: Explorations of Kant’s Practical Philosophy. Cambridge: Cambridge University Press. Olson, Kristina R., and Alex Shaw. 2011. ‘“No Fair, Copycat!”: What Children’s Response to Plagiarism Tells Us about Their Understanding of Ideas,’ 14 Developmental Science 431–9. Parisi, Francesco. 2005. ‘Methodological Debates in Law and Economics: The Changing Contours of a Discipline,’ in Francesco Parisi and Charles K. Rowley, eds., The Origins of Law and Economics. Cheltenham: Edward Elgar Publishing. Perzanowski, Aaron. 2013. ‘Tattoos and IP Norms,’ 98 Minnesota Law Review 511–91. Pinker, Steven. 1994. The Language Instinct: How the Mind Creates Language. New York, NY: Harper Perennial Modern Classics. Pinker, Steven. 2003. The Blank Slate: The Modern Denial of Human Nature. New York, NY: Penguin Books. Pinker, Steven. 2008. ‘The Moral Instinct,’ The New York Times Magazine (Jan. 13, 2008), accessed April 1, 2019 at http://www.nytimes.com/2008/01/13/magazine/13Psychology-t.html. Posner, Richard A. 1979. ‘Utilitarianism, Economics, and Legal Theory,’ 8 Journal of Legal Studies 103–40. Posner, Richard A. 1980. ‘The Ethical and Political Basis of the Efficiency Norm in Common Law Adjudication,’ 8 Hofstra Law Review 487–507. Posner, Richard A. 1988. ‘The Ethics of Wealth Maximization,’ 36 University of Kansas Law Review 261–5. Posner, Richard. 1998. ‘The Problematics of Moral and Legal Theory,’ 111 Harvard Law Review 1637–717. Posner, Richard A. 1999. The Problematics of Moral and Legal Theory. Cambridge, MA: Harvard University Press. Rawls, John. 1971. A Theory of Justice. Cambridge, MA: Harvard University Press. Rawls, John. 1999. A Theory of Justice. Cambridge, MA: Harvard University Press. Reidenberg, Joel R., N. Cameron Russell, Maxim Price, and Anand Mohand. 2015. ‘Patents and Small Participants in the Smartphone Industry,’ 18 Stanford Technology Law Review 375­–429. Rosenblatt, Elizabeth L. 2011. ‘A Theory of IP’s Negative Space,’ 34 Columbia Journal of Law & the Arts 317–65. Rowley, Charles K. 2005. ‘An Intellectual History of Law and Economics: 1739–2003,’ in Franceso Parisi and Charles K. Rowley, eds., The Origins of Law and Economics. Cheltenham, UK and Northampton, MA, USA: Edward Elgar Publishing. Scanlon, Thomas. 2000. What We Owe to Each Other. Cambridge, MA: Belknap Press. Scheffler, Samuel. 1988. Consequentialism and Its Critics (Oxford Readings in Philosophy). Oxford: Oxford University Press. Scheffler, Samuel. 1994. The Rejection of Consequentialism: A Philosophical Investigation of the Considerations Underlying Rival Moral Conceptions. Oxford: Clarendon Press. Shaw, Alex, Vivian Li, and Kristina R. Olson. 2012. ‘Children Apply Principles of Physical Ownership to Ideas,’ 36 Cognitive Science 1383–403. Seijo, Bibiana Campos. 2017. ‘The business of chemistry,’ 95 Chemical & Engineering News (No. 19) 2 (May 8, 2017), accessed April 1, 2019 at https://cen.acs.org/articles/95/i19/business-chemistry.html. Smart, J.J.C., and Bernard Williams. 1973. Utilitarianism: For and Against. Cambridge: Cambridge University Press. Solow, Robert M. 1957. ‘Technical Change and the Aggregate Production Function,’ 39 Review of Economics and Statistics 312–20. Spector, Horacio. 2004. ‘Foreword: Law and Economics and Legal Scholarship,’ 79 Chicago-Kent Law Review 345–54. Sprigman, Christopher, and Dotan Oliar. 2008. ‘There’s No Free Laugh (Anymore): The Emergence of Intellectual Property Norms and the Transformation of Stand-Up Comedy,’ 94 Virginia Law Review 1787–867. Sprigman, Christopher, and Cal Raustiala. 2006. ‘The Piracy Paradox: Innovation and Intellectual Property in Fashion Design,’ 92 Virginia Law Review 1687–777. Statista. 2015. ‘Domestic and International Revenue of the U.S. Pharmaceutical Industry between 1975 and 2015 (in Million U.S. Dollars),’ accessed April 1, 2019 at https://www.statista.com/statistics/275560/domestic​ -and-international-revenue-of-the-us-pharmaceutical-industry/. Sunstein, Cass. 1995. ‘Commentary: Incompletely Theorized Agreements,’ 108 Harvard Law Review 1733–72.

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Philosophical foundations of IP law  97 Thomson, Judith J. 1985. ‘The Trolley Problem,’ 94 Yale Law Journal 1395–415. Treiger-Bar-Am, Kim. 2008. ‘Kant on Copyright: Rights of Transformative Authorship’, 25 Cardozo Arts & Entertainment Law Journal 1059–103. Verrier, Richard. 2013. ‘U.S. Copyright Industries Add $1 Trillion to GDP,’ Los Angeles Times (Nov. 19, 2013), accessed April 1, 2019 at http://articles.latimes.com/2013/nov/19/business/la-fi-ct-intellectual-prop​ erty-20131119. Zamir, Eyal, and Barak Medina. 2008. ‘Law, Morality, and Economics: Integrating Moral Constraints with Economic Analysis of Law,’ 96 California Law Review 323–91. Zimmerman, Diane L. 2011. ‘Copyrights as Incentives: Did We Just Imagine That?,’ 12 Theoretical Inquiries in Law 29–58.

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5.  Intellectual property law and the promotion of welfare Christopher Buccafusco* and Jonathan S. Masur** 5

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Contents I. Introduction II. IP Law and Consequentialism III. Versions of IP Consequentialism—What Should Congress Promote? A. Promoting Science and Useful Arts B. Promoting Social Welfare 1. Preferences/wealth 2. Objective approaches 3. Happiness IV. Implications for IP of Varying Approaches to Welfare A. Consumer-Side Welfare Effects 1. Patent law 2. Copyright B.  Producer-Side IP Effects 1. Creativity as benefit 2. Employment effects V. Conclusion References

I. INTRODUCTION The US Constitution grants Congress the power ‘to Promote the Progress of Science and the Useful Arts’ by granting copyrights and patents to authors and inventors (U.S. Const. art. I, § 8, cl. 8). This language is understood by most courts and scholars to entail a utilitarian or consequentialist approach to intellectual property (IP) law. The possibility of obtaining copyrights and patents encourages creators to produce new innovations that ultimately redound to the public good. By providing incentives to creators that are balanced with the interests of the public and with subsequent creators, IP laws can optimize creative

**  Professor of Law and Director of the Intellectual Property and Information Law Program, Cardozo School of Law, Yeshiva University. **  John P. Wilson Professor of Law and David and Celia Hilliard Research Scholar at the University of Chicago Law School. Masur thanks the Wachtell, Lipton, Rosen & Katz Program in Behavioral Law, Finance and Economics and the David and Celia Hilliard Fund for financial support.

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Intellectual property law and the promotion of welfare  99 and innovative production. Unlike IP systems in other parts of the world, US IP law generally eschews so-called ‘moral’ or deontological considerations such as justice and fairness. Although there is considerable consensus regarding IP law’s philosophical orientation, there has been little discussion of its deeper normative goals. Most courts and scholars agree with the idea that IP law should provide incentives to creators, but there has been almost no analysis of why creativity and innovation are good. This is simply taken as given. But what, exactly, are the interests that IP law should promote? How should we understand what constitutes ‘the Progress of Science and the Useful Arts?’ Various answers to these questions exist. One possibility would be to interpret the constitutional language literally and narrowly. On this view, IP laws should encourage developments in knowledge and technology irrespective of broader interests. Another option would be to interpret the constitutional language broadly to encompass a general social welfare calculus: IP laws should be subjected to some form of cost-benefit analysis to determine whether they ultimately make people better off. In this chapter, we discuss a variety of ways of understanding the normative goals of a consequentialist IP regime. We argue that the best approach derives from recent work in the field of hedonic psychology. The principal consequentialist goal of IP laws should be to maximize social welfare, where welfare is understood as subjective well-being. We do not argue that IP laws cannot have other interests beyond consequentialism; there may be room for concerns about fairness and justice, as well. But where IP law is motivated by welfare considerations, it should be evaluated in light of how laws and policies will affect people’s happiness. We begin by reviewing the commitments of US courts and scholars to a consequentialist orientation for IP law. Although there is a broad consensus that the law should promote good outcomes, there has been less discussion of the kinds of outcomes that the law should be promoting. In Section III, we address different ways in which IP law could promote good outcomes. For example, IP law could be narrowly focused on promoting creativity and innovation or it could be more broadly directed toward general social welfare. We argue that the latter, broader focus is more appropriate. We then consider three different accounts of human welfare and how the law can promote it: preferentist, objectivist, and hedonic. We support the hedonic account of human welfare and describe its strengths over the other options. Then, in Section IV, we discuss what a hedonically oriented IP policy would look like.

II.  IP LAW AND CONSEQUENTIALISM The constitutional text provides the foundation for IP law in the US, but, like most provisions of that document, it leaves considerable room for debate and interpretation. Most important for our purposes is the language ‘To Promote the Progress of Science and the Useful Arts.’ Each of the principal terms has been discussed by scholars at considerable length (Solum, 2002; O’Connor, 2015; Oliar, 2006). For example, scholars have questioned whether this text imposes a meaningful limitation on Congress’s power or whether, instead, it is simply preambular and non-limiting. They have also attempted to define ‘Science’ and ‘useful Arts’ and to understand their relations to copyright and patent law. One way or another, however, most courts and scholars have agreed that IP law in the

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100  Research handbook on the economics of IP law volume 1 US should be governed by some version of consequentialism. That is, IP laws exist to promote certain goals rather than, for example, to vindicate natural rights. This stands in stark contrast to the philosophical foundations of most European IP systems, where the moral rights of authors and inventors provide justification for the legal system. In the US, IP rights are merely the means to a desired end. As the Supreme Court has explained: The monopoly privileges that Congress may authorize are neither unlimited nor primarily designed to provide a special private benefit. Rather, the limited grant is a means by which an important public purpose may be achieved. It is intended to motivate the creative activity of authors and inventors by the provision of a special reward, and to allow the public access to the products of their genius after the limited period of exclusive control has expired. . ..The copyright law, like the patent statute, makes reward to the owner a secondary consideration. (Sony Corp. v. Universal Studios, 464 U.S. 417 (1984) (internal citations and quotations omitted))

In the patent context, the Court has offered similar reasoning: The  patent  laws promote this progress by offering a right of exclusion for a limited period as an incentive to inventors to risk the often enormous costs in terms of time, research, and development. The productive effort thereby fostered will have a positive effect on society through the introduction of new products and processes of manufacture  into the economy, and the emanations by way of increased employment and better lives for our citizens. In return for the right of exclusion—this ‘reward for inventions,’—the patent laws impose upon the inventor a requirement of disclosure. (Kewanee Oil Co. v. Bicron Corp., 416 U.S. 470 (1974))

On this view, the ‘rights’ that authors and inventors receive do not devolve from the spiritual connection between creators and their works, nor are they representative of the Lockean intellectual labor that creators have mixed with the common. Instead, copyrights and patents are an administrative solution to an economic problem (Aronson v. Quick Point Pencil Co., 440 U.S. 257 (1979)). The difference between these approaches is evident in a variety of legal doctrines. In US copyright law, for example, authors generally do not receive the right to attribution for their works or the right to prevent their destruction or defacement. These are important components of European systems that protect droit d’auteur, or moral rights. In the US, they are thought to excessively impinge upon speech interests, sequential creation, and creativity markets (Adler, 2009). In patent law, inventors must be named in patent filings, but US law imposes no further requirements that inventors be named in products commercializing inventions. To the extent that US IP law does incorporate non-consequentialist concerns, such as in the Visual Artists Rights Act (17 U.S.C. § 106A (2018)) or in the ability of authors to terminate transfers of their copyrights, these injections of justice and fairness concerns are the exceptions that prove the consequentialist rule. Academics in the US have generally followed the Supreme Court, and they have fleshed out the economic theory behind the rights (Landes and Posner, 2003; Cass and Hylton, 2013). Both in copyright and patent law, rights are understood to flow from the state’s desire to promote certain valuable outcomes by providing incentives to individuals and corporations (Lemley, 2005). Because creating new works and inventions is costly, and because the works and inventions can be cheaply copied, creators would not have sufficient incentives to invest in innovative activity. Copyrights and patents provide periods of exclusivity during which rights holders can charge supracompetitive prices to offset

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Intellectual property law and the promotion of welfare  101 the costs of their creative investments. Providing rights is costly, however, because they create deadweight losses and can inhibit further innovation. Accordingly, IP regimes seek to balance the rights given to creators with those available to subsequent creators and to the public. Although scholars often differ sharply with respect to how the law should maintain this balance, they generally concur in the belief that this is IP law’s overriding goal. And while important and forceful arguments in favor of natural rights or deontic approaches to IP law have been made (Hughes, 1988; Merges, 2011; Kwall, 2009), these approaches have yet to find consistent support.

III. VERSIONS OF IP CONSEQUENTIALISM—WHAT SHOULD CONGRESS PROMOTE? We join the belief that IP is best understood in consequentialist terms rather than deontic ones. The IP Clause seems to speak in consequentialist terms, and most courts and commentators to have considered the question have described the purposes behind IP in consequentialist terms as well. But the notion that IP is consequentialist raises as many questions as it answers. What, precisely, is IP meant to promote? What is the maximand, or across what factors should IP be maximizing? There is a wide variety of different options, and those options have significantly divergent ramifications for the shape of intellectual property law. In this section, we consider the various possibilities and highlight which of them have gained the greatest currency within the judicial and scholarly communities. A.  Promoting Science and Useful Arts First, as the Constitution suggests, IP could be meant to promote science and the useful arts, full stop. In other words, the Constitution could be dictating that IP be structured to maximize the production of useful innovations (patents) and creative works (copyright), with those innovations and works viewed as ends in and of themselves. This type of approach might be justified on a number of different theoretical grounds. First, it may be that the Constitution does not mean to instantiate one vision of the good, be it welfarist (in any of its forms) or non-welfarist. Accordingly, to avoid taking sides, the Constitution—and the law that springs from it—should perhaps be interpreted to maximize some other worthwhile quantities without striving for any greater theoretical ambitions. Innovation and creativity might be those quantities. Alternatively, one might imagine that it is too difficult for any social planner—court, Congress, or otherwise—to fashion rules that are effective at increasing welfare. Every rule will create too many unforeseen effects—too many ripples in the pond. Any attempt to manage welfare directly is doomed to failure through unintended consequences. Accordingly, it might be that social planners are advised to concentrate on more easily identifiable or obtainable quantities, such as innovative and creative works. We believe that these are defensible but ultimately unpersuasive arguments. Innovation and creativity are not ends in and of themselves under any view of the good. While we do not wish to minimize the difficulty involved in promoting welfare-enhancing law and

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102  Research handbook on the economics of IP law volume 1 policy, this is a task that policymakers regularly undertake. Indeed, the entire enterprise of cost-benefit analysis, which now pervades the regulatory state, is geared toward enhancing welfare. Moreover, if the goal were simply to maximize the production of innovation and creative works, patent and copyright law would likely assume very different shapes. Generally speaking, the longer the intellectual property term, the greater the incentive to innovate because the greater the rewards. We say ‘generally speaking’ because in some cases extensive IP protections might retard follow-on innovation, as when blocking patents or patent thickets increase the costs to subsequent inventors trying to follow in the footsteps of an initial inventor. In addition, there is reason to doubt the incentive effects of IP beyond a certain time horizon (Balganesh, 2009). Nonetheless, if the goal were only to maximize innovation and creativity, the patent term would likely be substantially longer, at least for certain types of inventions such as pharmaceuticals. (The copyright term is already extremely long and ever-increasing.) Accordingly, we are not surprised that this view of the IP Clause has acquired few adherents within either the courts or the scholarly literature. B.  Promoting Social Welfare If IP does not exist to promote science and the useful arts alone, then it must be geared toward promoting some view of social welfare. However, that very basic conclusion immediately raises a more vexing question: what is the proper measure of welfare? What, precisely, should IP law be maximizing? 1. Preferences/wealth The most widely adopted view of welfare is that it consists of the satisfaction of individual preferences—typically fully informed, rational preferences, but occasionally simple expressed preferences (Sumner, 1996). This view prevails among the vast majority of economists. It relies on a straightforward logic: if a person obtains what she desires, that must make her better off—otherwise, why would she desire it? Many economists would impose the additional limitation that the preference must be self-interested in order to cope with the issue of individuals with preferences for helping others at their own expense (Adler and Posner, 2006). Economists believe that an individual’s preferences are best measured by using market transactions: if an individual chooses to purchase a good for some amount of money, the transaction reveals that the individual values the good more than she values the money used to obtain it (Boyle, 2003). Accordingly, this theory of welfare comes with a mechanism for obtaining some understanding of how much welfare a society possesses, and whether that welfare is increasing or decreasing. This conception of welfare as preferences is the dominant view within intellectual property as well (Demsetz, 1969; Menell and Scotchmer, 2007; Boyle, 2007; Kapczynski and Syed, 2013; Tur-Sinai, 2016). Essentially all economists who study IP subscribe to it, and many legal scholars do as well. Indeed, the entire structure of IP in the United States seems to favor a preferentist account of social welfare. The market is the mechanism through which IP is meant to incentivize innovation. By rewarding inventors and creators with monopoly rights over their innovations and creative works, IP allows them to reap supracompetitive profits. But the owners of IP can only realize these profits if individuals are actually willing to purchase their products and services. If there are no market

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Intellectual property law and the promotion of welfare  103 participants with preferences for the patented or copyrighted goods, their creators earn nothing and IP is irrelevant. The value of IP is linked to the market value of the underlying good, and thus to individual preferences (Beebe, 2017). Contrast this system of intellectual property with alternative mechanisms for encouraging creativity and innovation, such as government-sponsored grants or prizes (Hemel and Ouellette, 2013). Mechanisms of promoting innovation that do not rely on the market similarly do not rely on preference satisfaction as the measure of whether an innovation should be produced or will be funded. The policymakers choosing which projects to fund could rely upon any other type of criteria, including deontic criteria. While there is a substantial amount of public grant-based funding for science and the arts, the vast majority of funding incentives for innovation and creativity are provided through intellectual property. Accordingly, while it is not the case that every type of innovation policy rests upon preferentist foundations, intellectual property—at least as currently conceived—generally does. Nevertheless, preferentist approaches to welfare are subject to trenchant critiques. Some opponents, typically from a philosophical tradition, argue that there is more to the good life—more to welfare—than realizing the things that an individual wants. These scholars locate human welfare in a more objective notion of human flourishing: either possessing a set of objective capabilities and entitlements (Sen, 1993) or doing well the things that humans should do (Foot, 2001). We discuss flourishing and objective approaches at greater length in the following section. A second type of objection, arising primarily from the disciplines of psychology and behavioral economics, observes that individuals often desire things that turn out not to make their lives better off by any observable measure (Bronsteen, Buccafusco, and Masur, 2014). A typical example involves a family that trades an apartment in the city, close to the parents’ offices, for a large house and a yard in the suburbs. In many cases it turns out that the larger house offers few hedonic benefits to the family. They do not appear happier living in it than they were in their smaller apartment, and they quickly adapt to the size of the house so that it soon feels as though it is not especially large. However, the move to the suburbs is tremendously costly in psychological terms. The parents must now drive in traffic an hour each direction, and driving in traffic makes them miserable. Not only is the experience itself very unpleasant, it also takes them away from their children—the entire purpose of moving to the suburbs in the first place. While this example is hypothetical, the data behind it are very real and well documented (Kahneman et al., 2004; Stutzer and Frey, 2008). And this is only one example of what is variously termed an ‘affective forecasting error’ or an instance of ‘mis-wanting.’ The upshot of this significant body of research is that individual preferences cannot be relied upon to increase well-being according to any other measure. Unless one accepts preferences as a tautological definition of well-being, there is ample evidence that preference satisfaction does not necessarily lead to the improvement of an individual’s life. For the most part, these critiques have not penetrated intellectual property. Most scholars persist in equating welfare with preference satisfaction for purposes of measuring the effectiveness of intellectual property. And as noted above, the intellectual property system continues to be organized predominantly around market mechanisms that rely upon preference satisfaction. But that should not obscure the fact that cracks are showing.

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104  Research handbook on the economics of IP law volume 1 2.  Objective approaches The leading alternative to preference-based conceptions of welfare is a set of loosely related philosophical approaches that are commonly grouped under the heading of ‘objective accounts.’ Some of these approaches, following Sen (2005) and Nussbaum (2001), describe welfare as the possession of a set of goods enumerated in a list. These ‘objective list’ theories of welfare do not always perfectly correspond, but they typically involve a related and overlapping list of objective goods as their measure of welfare (Lewinsohn-Zamir, 2003). Other objectivist theories borrow more heavily from the Aristotelian concept of flourishing, typically understood as ‘doing well that which it is characteristically human to do’ (Foot, 2001). These ‘flourishing’ or ‘virtue ethics’ conceptions of welfare tie individual well-being to participation in a set of positive or ‘virtuous’ activities. Here, too, there is substantial overlap with objective list approaches. While virtue ethics does not typically specify in advance the particular activities that lead to flourishing and a good life, the goods and activities that form the basis of ­objective list theories are commonly viewed as constitutive of flourishing by Aristotelians. What these two flavors of ethical theory have in common is that they locate welfare in a set of objective considerations outside of the subjective preferences or desires of any given individual. For the objectivist theorist, the goods on the objective list, or the activities constitutive of flourishing, are valuable regardless of whether (or how much) the individual desires them. The individual’s welfare is determined by the existence or non-existence of those quantities and activities, without reference to the individual’s own views. This approach has sown the seeds of criticism by preferentists (and hedonists, as we will describe below), who point out the incoherence of relating individual welfare—which would seem to be the most subjective and individual of quantities—to external objective considerations (Adler and Posner, 2006). Other scholars have observed that the selection of the particular items found on objective lists will typically reflect the preferences of the philosophers who put them there (Sumner, 1996). In addition, most objective theories do not offer mechanisms for weighing the various welfare goods against one another or for making inter- or intra-personal welfare comparisons. Regardless, objectivist theories are the principal competitor to preferentist theories of welfare, and they have gained significant currency within the philosophical and legal communities. Objectivist theories have recently begun to make their way into intellectual property as well. Some scholars have begun with objective approaches to welfare and argued that they should be imported directly into IP, equally with any other area of law (Frischmann, 2014; Derclaye, 2013; Derclaye, 2012; Fisher and Syed, 2007). Others have argued in reverse, claiming that IP cannot be justified or defended on preferentist or hedonic grounds (Tur-Sinai, 2016). These scholars argue instead that IP is best conceived as furthering and representing an objectivist conception of welfare and should be reformulated to better accomplish those ends. The connection between IP and objective theories of welfare is not difficult to understand. Creativity and innovation, the foundations of copyright and patent law, are canonically ‘virtuous’ activities that are commonly thought of as partially constitutive of a good life according to essentially every objective conception of welfare. If one imagines IP from the producer side—IP should exist to encourage and enable individuals to produce creative and innovative works—then it becomes natural to envision IP in objectivist terms.

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Intellectual property law and the promotion of welfare  105 In addition, numerous scholars have pointed to failures and shortcomings in the market for innovation and the ways in which ability to pay does not always map onto welfare (Kapczynski, 2012). For instance, pharmaceutical drugs that produce substantial benefits for poorer individuals—such as citizens of developing nations—might increase welfare dramatically by improving the lives of many people. But the market for such drugs might be quite meager because of the limited purchasing power of the individuals who could consume them. By contrast, pharmaceuticals that cater to wealthy individuals might be highly valuable in the marketplace even if they improve few lives (and improve those lives only marginally). In light of these pathologies, the natural step for many scholars is to argue that IP should be reformulated to advance a set of ends chosen objectively, without reference to the particular preferences of the affected individuals as expressed through their wealth. The problem with these objective welfare theories of intellectual property is that they are typically tied very closely to the outcomes of individual lives (Tur-Sinai, 2016). To proponents of objective conceptions of welfare and IP, what makes a particular innovation worth pursuing is that it improves the lives of some group of individuals—witness the emphasis on medicines, particularly medicines for the poor. Advocates for objectivist conceptions of IP have not offered independent justifications for these normative goals beyond the fact that they promise to improve the lives of the individuals concerned. In other words, these objective considerations are actually founded in traditional subjective conceptions of welfare—preferences or hedonics (Griffin, 1986). Proponents of objective conceptions of IP welfare have succeeded in demonstrating that the market, as it currently exists, is not the ideal mechanism for generating welfare-enhancing outcomes. They have not succeeded in demonstrating that objective conceptions of welfare are superior to hedonics-based formulations. Indeed, the fact that arguments regarding objective conceptions of welfare for IP inevitably resort to reliance upon subjective improvement of life is suggestive of the objective view’s inherent weakness. 3. Happiness In recent years, a third conception of welfare as based in subjective hedonic experience has returned to prominence within philosophy and legal academia (Bronsteen, Buccafusco, and Masur, 2014). This conception of welfare as subjective well-being (or ‘happiness’) dates back to Jeremy Bentham but fell largely out of favor over the course of nearly two centuries. It has lately been resurrected in part due to work by psychologists, who have innovated new mechanisms for measuring individual happiness (Kahneman et al., 1999). Their work has been followed by normative arguments from philosophers and legal scholars who press the point that happiness is the best way to understand what it means for an individual to live a good life. As these philosophers and legal scholars have pointed out, the subjective well-being conception of welfare holds several substantial advantages over preferentist and objectivist conceptions of welfare (Bronsteen, Buccafusco, and Masur, 2014). First, it accounts for the fact that individuals often desire goods that do not appear to improve their lives and that they cannot predict the types of things that will improve their well-being. Most notably, while individuals typically strive for ever-greater levels of wealth and material possessions, these goods do not appear to impact individuals’ subjective well-being significantly (Bronsteen, Buccafusco, and Masur, 2013). This is different from a claim, which

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106  Research handbook on the economics of IP law volume 1 objectivists might make, that there is nothing worthwhile or valuable in material wealth and possessions for theoretical normative reasons. Rather, it is an empirical observation that wealthier people do not lead lives that are substantially happier or better even by their own lights than people of more modest means. Second, unlike objectivist approaches the subjective well-being approach treats welfare as intimately related to an individual’s own well-being and desires, not an outsider’s. That is, whether a good or experience is welfare-enhancing for a given individual depends upon the feeling it produces in that individual and how that individual relates to it, not upon whether a third party judges the good or experience as valuable. Third, it possesses a close, intuitive tie to standard notions of welfare: if an experience makes a person happy or produces good feelings, it makes intuitive sense to say that it has increased her welfare. Fourth, it is just as easy to make inter- or intra-personal hedonic comparisons as it is to make such comparisons from a preferentist standpoint, and generally easier than such comparisons are within any type of objectivist account of welfare. Fifth and finally, the hedonic account of welfare does not rely upon any theoretically difficult constructs, such as ‘fully informed preferences,’ which are impossible to determine in practice. A policymaker or legal decision maker who wishes to assess whether some legal rule or project will increase subjective well-being need not engage in complicated and normatively fraught laundering of individual preferences (Adler and Posner, 2006). She need only measure the happiness of an affected population before and after a policy intervention to know whether the intervention produced a positive effect on well-being (Bronsteen, Buccafusco, and Masur, 2014). A hedonic approach to IP would in many respects resemble the objectivist approach described above. One of the fundamental precepts of a hedonic conception of welfare is that individuals often (mistakenly) desire things that do not make them happy and do not improve their own welfare, and they frequently fail to desire things that will make them happy and improve their welfare. This is true even when people’s desires are motivated by the goal of increasing their own happiness (Adler, Dolan, and Kavestos, 2015). Thus, markets cannot be relied upon to produce welfare-maximizing outcomes when participants are not making fully informed, rational, and self-interested decisions about which goods to consume. Accordingly, a happiness-based IP policy could be used to help determine the types of goods that are most likely to increase well-being, rather than simply relying upon market participants to select the goods they prefer. Policymakers could then structure IP law to help facilitate the production of those goods. The crucial difference between a hedonic approach to IP and an objectivist approach lies in how one determines the types of goods whose production IP law should be designed to promote. An objective approach would rely upon the intuition and reasoning of the policymaker, informed by philosophical theory. A hedonic approach would instead rely on empirical data: policymakers would study which goods and activities improve overall cumulative individual subjective well-being over time and then promote or advance the development of those goods and activities. The hedonic approach would be tied to lived individual experiences; the objectivist approach would be divorced from the experiences or feelings of the people who will be affected by IP. Given that welfare is intuitively understood as a subjective concept, tethered to the individual’s own life, we view this distinction as a decisive advantage for the hedonic conception. Partly because the study of law’s effects on subjective well-being is in its infancy (Bronsteen, Buccafusco, and Masur, 2014), relatively few scholars have adopted a hedonic

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Intellectual property law and the promotion of welfare  107 approach to IP. There is, however, a growing cohort who have at least explored the possibility that IP law might be reoriented in a hedonic direction (Manta, 2013; Derclaye, 2013; Rai, 2007). As we noted above, IP law in its current instantiation adopts a fundamentally preference-based approach to welfare. In the following section, we will sketch the outlines of how a hedonic-centered view of IP law might be constructed.

IV. IMPLICATIONS FOR IP OF VARYING APPROACHES TO WELFARE We have already alluded to the various ways in which different conceptions of welfare will affect IP policy differentially, and in this part of the chapter we sketch such competing conceptions more directly. Due to space limitations we focus on patent and copyright law, the two major areas of IP, although similar analyses of trademark, trade secret, design law, and others would undoubtedly be illuminating. IP law has typically focused on creating consumer welfare by giving producers economic incentives to do things they would not do without those incentives. The law thus affects welfare in two distinct ways: on the consumer side and on the producer side. This part differentiates between the two ways in which IP law affects welfare, turning first to consumer welfare and then to producer welfare. A.  Consumer-Side Welfare Effects 1.  Patent law One of the central teachings of the voluminous literature on hedonic psychology is that individuals are often mistaken as to what will improve their lives. People often believe that certain goods or experiences will increase their happiness, only to find their happiness unchanged or even diminished. The implication of this research is that the sorts of choices that individuals make in the marketplace—the goods or experiences they purchase—may not be a perfectly reliable indicator of what will improve these individuals’ welfare. On the contrary, there might be particular types of goods or services that will increase individual well-being much more than others, and much more than market-based decisions would indicate. This suggests that intellectual property policy should self-consciously favor innovation in welfare-enhancing technological sectors, even at the expense of other areas of technology that do not have the same effect on individual welfare. Which areas of technology are most likely to lead to gains in well-being? The leading candidates are technologies that improve health and prolong life. There is ample evidence that health is one of the primary drivers of well-being (Powdthavee and van den Berg, 2011). An individual’s health status is highly correlated with her well-being, and because most people’s lives are happy even through old age, extending their lives will typically provide significant boosts in their lifetime welfare. Improvements in pharmaceutical and medical device technology should thus lead to improvements in human welfare, perhaps more so than advances in any technological sector. A policymaker who has adopted a hedonic view of welfare would thus favor legal rules that optimize innovation in these technological fields. Because pharmaceutical drugs and medical

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108  Research handbook on the economics of IP law volume 1 devices have large up-front research costs and low copying costs, scholars tend to believe that progress in those fields is best served by longer patent terms and stronger IP rights (Burk and Lemley, 2009). There is also evidence to indicate that strong patent protection for pharmaceuticals does not significantly inhibit follow-on innovation (Sampat and Williams, 2015). And because most Americans are covered by health insurance, patented drugs and medical devices remain widely available despite monopoly prices. There is thus a plausible case for strong patent protection for medical technologies as a matter of hedonic welfare. The problem with attempting to favor health-related technologies is that patent law is generally technology-neutral. The same patent law that governs pharmaceutical drugs and medical devices also governs semiconductors, consumer electronics, and every other type of technology. Burk and Lemley (2009) have observed that in some cases judges can tailor patent law to fit the particular needs of a particular industry or technological field, but this is a marginal effect. To first approximation, patent law functions similarly across technologies. And while strong patents might increase innovation in pharmaceuticals and medical devices, the same might not be true in computers, software, or electronics. These fields of technology suffer more from problems of overlapping patents—thickets and anticommons problems—than medical fields (Burk and Lemley, 2009). Excessively strong and numerous patents might eventually begin to retard innovation. If courts or legislators were to make patents more powerful, this would likely inhibit progress in computers and consumer electronics at the same time that it promoted innovation in pharmaceuticals and medical devices. Under typical assumptions, scholars and policymakers would face significant uncertainty as to the proper course of action in the face of such competing considerations. There is no a priori reason to favor either electronics or pharmaceuticals over the other. The market heavily rewards innovation in both sectors, as evidenced by the volume and value of sales. On a preferentist account of welfare, a policymaker would be forced to conduct a complicated calculation to determine which area of technology yields the greatest returns, and thus whether increasing or decreasing patent strength would increase overall welfare. This type of cost-benefit analysis is extraordinarily difficult if not entirely impossible in the patent context (Masur, 2016). Yet a hedonic approach to welfare may offer an answer to this difficult problem. In contrast to health-related fields, some technologies—including computers and e­ lectronics— likely have relatively minor impact (if any) on overall welfare. A great deal of innovation in the computer, software, and consumer electronics sectors is directed at expensive consumer products (smartphones, tablets, plasma televisions, and so on) available only to individuals above a certain level of income. At the same time, there is mounting evidence that increases in wealth have only extremely minor impacts on happiness (Kahneman and Deaton, 2010; Oswald and Powdthavee, 2008). Even individuals who dramatically increase their income realize only marginal gains in well-being (Bronsteen, Buccafusco, and Masur, 2013). This implies that these consumer electronic devices are contributing very little to well-being, particularly given how much they are being used. The average American watches several hours of television per day, and smartphone users average more than an hour of daily use (Nielsen, 2014). If high-tech televisions and smartphones were contributing positively to our well-being, it should be reflected in higher hedonic levels for wealthier people. Yet the data reveal no such trend. In fact, at least one study has linked

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Intellectual property law and the promotion of welfare  109 smartphone use to depression, although the finding is correlative and not necessarily causal (Saeb et al., 2015). Accordingly, from a hedonic perspective it could be beneficial to pursue stronger patent protection in the interest of increasing innovation in pharmaceuticals and medical devices, even if this resulted in harm to other industries such as computers and electronics. If all technologies are not created equal for purposes of improving welfare, then policymakers need not refrain from taking steps that maximize innovation in some at the expense of others. Macro-level hedonic understandings of welfare provide a means for answering difficult policy questions without a full-blown cost-benefit analysis. A patent policy formulated on hedonic terms might thus be structured very differently than the status quo, and this could be accomplished while holding patents facially neutral with respect to technology. In addition to drugs and medical devices, there are other types of technology that likely have a meaningful impact on human welfare, measured hedonically. In particular, any technology that reduces environmental pollution—and thus morbidity and mortality from harmful exposure—should significantly improve welfare (Bronsteen, Buccafusco, and Masur, 2013). This is especially true in light of the catastrophic welfare effects predicted from global climate change (Masur and Posner, 2011). Likewise for technologies that improve automobile safety or reduce other types of everyday risks. And there are even more commonly overlooked types of technology with the potential for meaningful welfare impacts. For instance, hedonic studies have demonstrated that the manner, time, and distance of individuals’ commutes to and from work can dramatically affect individual welfare (Gilbert, 2006). Driving in traffic is one of the least pleasurable activities in which an individual can engage (Kahneman et al., 2004). If an individual moves an hour further away from her workplace, she substitutes two hours of leisure per day—during which she might engage in a pleasant activity—for two hours of unhappy driving in traffic. The diminution in overall well-being could be very substantial. Thus, a hedonic approach to welfare would support whatever intellectual property rules would maximize innovation in technologies to improve or shorten commutes, including driverless cars, more intelligent traffic management, railroad technology, telecommuting equipment, and the like. These industries have not been the subject of sufficient study to allow us to determine whether stronger or weaker patents would be more productive of innovation and development. Accordingly, it is possible that the same patent rules that are helpful for pharmaceuticals might be harmful for environmental technologies and other welfare-enhancing improvements. Regardless, the broader point is that a hedonic conception of welfare offers a set of prescriptions for patent law that differ substantially from the status quo. Once policymakers come to understand welfare in hedonic terms, a similar rethinking of patent law should not be far behind. 2. Copyright Understanding copyright law’s effects on human welfare is considerably more complex than understanding those of patent law. Few would doubt that contemporary science and technology are much better than they were in the past. Almost no one would choose nineteenth-century surgical practice over twenty-first century medicine. But there is not nearly the same uniformity of judgment about the superiority of Taylor Swift over

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110  Research handbook on the economics of IP law volume 1 Beethoven.1 Although many people accept that science and technology are capable of ‘progressing,’ it is difficult in the modern world to argue the same for the arts (Beebe, 2017). Assuming that one of the goals of creative production is to improve people’s lives, how could we know if it does so? The difficulty of answering questions like this one has led to nearly total dominance of copyright jurisprudence by preferentist thinking. If consumers are willing to spend money to purchase the latest books, albums, and movies, they must think that doing so will make them happier. Why should the law judge for people which works will most add to their happiness? De gustibus non est disputandum—in matters of taste, there can be no dispute. As Oliver Wendell Holmes, Jr. warned in his famous Bleistein opinion, ‘It would be a dangerous undertaking for persons trained only to the law to constitute themselves final judges of the worth of pictorial illustrations, outside the narrowest and most obvious limits’ (Bleistein v. Donaldson Lithographic Co., 188 U.S. 239 (1903)). Creative works have value to the extent that they ‘command the interests of any public.’ As Barton Beebe (2017) has recently argued, copyright law’s approach to aesthetic progress has largely been accumulative—more works and more sales equal more value and more welfare. From the perspective of consumer welfare, this approach seems difficult to debate. How could we measure whether television programs contribute more to happiness than sculpture and dance? Some people prefer television, and some dance. According to this approach, copyright law should encourage all of these products equally and let consumers choose. But do people make accurate judgments about their own welfare when it comes to consuming content? And do more options lead to more happiness? At least some evidence of television watching suggests otherwise. Heavy television viewing seems to be associated with lower levels of subjective well-being, although testing causality is often difficult when measuring people’s behaviors in the real world (Frey et al., 2007; Bruni and Stanca, 2008). There is some evidence that people who watch a lot of television do so at the expense of ‘relational’ activities with others that tend to make them happier (Bruni and Stanca, 2008). And some people, especially heavy television watchers, seem to do far worse when they have more channels to watch (Benesch et al., 2010). While we do not think that these studies are strong enough to recommend removing or reducing copyright protection for television programs, they are important because they illustrate potential limitations with the preferentist approach that dominates the field. The ‘more is better’ approach to creative production assumes that allowing people to find products that precisely match their tastes is valuable. Because consumer tastes are heterogeneous, people are more likely to find things that maximize their welfare if they have more options to choose from. But empirical social science research has called this view into question. Studies have shown that having more choices of products may not create greater happiness with the product chosen and, in fact, more choices may diminish happiness (Schwartz, 2003; Hsee and Hastie, 2006; Scheibehenne et al., 2010). When confronted with an enormous variety of goods, people struggle to decide which to choose, and they focus on irrelevant aspects of goods. In some cases, the people choosing from a wider set of options are less happy with their choices than those choosing from a narrower set. 1

  Even the authors of this chapter disagree.

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Intellectual property law and the promotion of welfare  111 In addition, the value that people obtain from creative works arises in part from the fact that they are often embedded within a larger shared cultural experience. Watching television is fun, but talking about a new episode with friends is often just as much fun. Copyright law’s accumulationist approach to creativity risks creating smaller and smaller pockets of cultural and social interaction over new works. Although people may be able to find works that satisfy their unique preferences, they may find that they have no one with whom to discuss them. If cultural heterogeneity becomes cultural atomization, people may lose out on the sorts of relational experiences that are most conducive to happiness. These concerns raise challenging questions for IP law’s accumulationist approach. More creative production will not necessarily produce more welfare. Unfortunately, given the current state of our knowledge, it is difficult to suggest how copyright law can strike the right balance between heterogeneous tastes and social cohesion. Further research is needed to more precisely understand the relationship between choice and welfare. Consumer preferences and consumer welfare may also diverge with respect to the pace of creative production in certain fields. In many areas, consumers seem to demand rapid replacement of existing cultural goods with new ones. Fashion design is the leading example. But consumers’ preferences for novelty may not be consistent with their subjective well-being. People buy clothes in order to stay on trend even though their old clothes are still functional (Hemphill and Suk, 2009). As William Shakespeare explained ‘fashion wears out more apparel than the man’ (Shakespeare, 2004). In these situations, works become ‘obsolete’ before they lose their function and before people stop getting pleasure from them. In fact, the very thing that makes them obsolete is the existence of new products to consume. To the extent that this is true (and it may be in many other creative fields as well), copyright law should not promote rapid cultural ‘progress.’ Unlike for cancer treatments, where we typically want the pace of innovation to be incredibly high,2 in these areas, slower rates of creation and replacement may be optimal. If the rate of innovation is slower, existing works will not lose their hedonic value as quickly, and consumers will not need to purchase new works to obtain the same amounts of pleasure. From a demandside perspective, this is preferable. In the context of fashion design, extending copyrights might, counterintuitively, improve consumer well-being by slowing down the pace of innovation. Raustiala and Sprigman (2006) argue that the current lack of protection leads to shorter fashion cycles as new designs get rapidly copied and become obsolescent. Giving designers protection for their creations could mean that they are not copied as rapidly and stay on trend longer, thereby allowing consumers to slow down their purchasing of new clothes. In other contexts, as well, copyright law might pay closer attention to how its doctrines affect the pace of creative production and obsolescence. For example, book publishers have little interest in maintaining consumer demand for older fictional works that are available in cheap used editions if that demand cuts into consumers’ desire for expensive editions of new works (Maurer, 2015). In fact, a similar dynamic might exist in the context of some patented goods such as consumer electronics. A piece of technology such as an iPod or iPhone becomes

2   In fact, we want the pace of innovation to be such that the benefits of a given pace exceed its costs. Innovation could arise too rapidly even for cancer treatments if the costs associated with a faster pace exceed its benefits.

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112  Research handbook on the economics of IP law volume 1 obsolete not just when it breaks or cannot handle modern song formats, but also when it is surpassed by newer and more exciting versions of itself. Yet, as we note above, there is scant evidence that these newer types of technology are contributing much, if anything, to happiness. If stronger patent rights slowed the pace of innovation in the computer and consumer electronics sectors and reduced the rate at which technologies became obsolete, this might impose little or no welfare cost while preserving resources that could be employed for other purposes. Such is the paradoxical conclusion we draw from the fact that improvements in these types of technology do not appear to be making our lives better. B.  Producer-Side IP Effects Thus far we have largely concentrated on demand- or consumer-side welfare effects of IP law and policy. That is, most of the discussion has centered on the consequences of various policy choices for the well-being of the individuals who consume the fruits of innovation and creativity. Yet there is an important second half to this question: the effects of IP on the well-being of the many individuals who produce innovative and creative works. Many millions of Americans work in industries that are shaped by patent and copyright law, and their welfare is in some ways dependent upon the form and substance of those laws. In the sections that follow, we survey how different conceptions of welfare might compel different types of IP law and policy. To be sure, there are limits on the strength of the effects that IP policy changes can generate. The work and responsibilities of a software engineer or semiconductor designer are not likely to change substantially in response to changes in patent law. The life of a visual artist may or may not undergo drastic revision if courts amend copyright law at the margin. But IP can impact well-being on the producer side as well, as explained below. Here, we believe that patent and copyright law can in many ways produce similar types of effects. Accordingly, we discuss patent and copyright law together and focus on the different types of welfare benefits that creative and innovative production can generate for those individuals on the production side. 1.  Creativity as benefit In the standard law and economics account of IP, the process of creation or invention is generally viewed as costly. Creating new works or inventions takes time and resources that people and firms would be unwilling to expend unless they were given the opportunity to obtain supracompetitive prices for their creations. On this view of creators’ cost-benefit calculations, the activities associated with creation enter exclusively on the costs side of the equation. Yet even without the benefit of happiness research it seems evident that this picture is too narrow. Many people create and invent for the joy that they experience while doing so (Devlin and Sukhatme, 2009). From the perspective of subjective well-being, however, we can more fully account for the positive value that creators experience while engaged in new challenges. Researchers studying well-being have observed that one of the most pleasurable experiences is ‘flow,’ the sense of being totally engulfed in a challenging task (Csikszentmihalyi, 1990). One of the most reliable ways of experiencing flow is to be involved in the process of creating something new. Writers, musicians, computer programmers, and scientists

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Intellectual property law and the promotion of welfare  113 often experience enormous positive affect when they are engaged in activities that prove difficult but susceptible to completion and mastery. To many of them, the hours spent writing, coding, and thinking are not costly; they are not simply the means to some other valuable ends. Instead, the activities associated with creating and inventing are often ends in their own right. The works and goods generated by these activities often seem to be by-products of the truly valuable goal. Once we see the processes of creativity and innovation not simply as costs that must be borne on the way to generating valuable goods but rather as goods in their own right, our perspective on IP law and policy changes. Most obviously, the law and economics account of costs and benefits is likely to go awry if it neglects the substantial benefits that creators and innovators experience. The addition of exclusive rights as an incentive to create will often be supernumerary when creators have derived sufficient benefits from the act of creating in the first place. This is not to suggest that monetary incentives are never necessary for creative work. There is bound to be substantial variation in the extent to which authors and inventors experience positive welfare from creating. Love poems rarely need monetary incentives to be produced, but databases might always need them. And even though creators might generate substantial amounts of joy from creating, they still need to live and eat. IP law would do well to understand and adapt to the variations in producers’ need for external stimuli. In addition, although creativity itself may need little incentive in many cases, other costly resources may be necessary to actually produce and distribute the goods associated with creative production. Although some number of screenplays would likely be written in the absence of copyright protection, movie studios will not produce movies unless they have a chance to recoup their investments. If we think that certain kinds of creativity and innovation demand the expenditure of significant capital resources to emerge, then we need to make sure that those supplying the capital have sufficient reason to do so. Thus, when analysing the kinds of IP rights that should be provided, the law should pay attention at least as much to production and distribution costs as it does to creation costs (Cohen, 2011). Finally, IP rights impose restrictions on creators’ opportunities to engage in the kinds of activities that produce flow. Drastic reductions in the costs of creative production, particularly in the form of digital technologies, have opened up opportunities for creative engagement to a larger proportion of the population. One of the principal ways in which creators engage with one another is through each other’s works. Creative engagement may take the form of individuals producing separate, independent works that they then share with one another. Increasingly, however, creators engage with their cultures by explicitly manipulating works within their cultures (Lee, 2008; von Hippel, 2005). In many contexts, creativity involves reworking and remixing existing ideas and inventions (Banks and Deuze, 2009). But IP laws, and copyright law’s derivative works doctrine in particular, can put creators at risk when they interact with protected works. Although copyright and patent laws might not affect artists who draw for private consumption and pleasure or inventors who enjoy tinkering but have no interest in making and selling their inventions, the law may limit their abilities to share their efforts with others. For example, an aspiring musician may derive considerable happiness from manipulating and editing existing works and sharing them on the Internet as a way of demonstrating mastery and connecting with a community (Silbey, 2014). But when she posts her work online, she

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114  Research handbook on the economics of IP law volume 1 may have infringed one or more copyrights. By limiting the uses that others can make of creative and innovative works, IP laws impede the potential benefits that follow-on creators experience from interacting with existing works and ideas. Just as the law needs to account for the pleasure that creators experience when generating new works, it needs to account for how IP laws potentially hinder the happiness of others who want to creatively engage with those works. 2.  Employment effects Patent and copyright law’s primary function is to redistribute surplus from the production of creative and innovative goods from consumers to producers. Instead of the goods being sold at the competitive price—which maximizes consumer surplus—patents and copyrights permit producers to sell at monopoly prices, which maximizes producer surplus at the expense of significant consumer surplus. This surplus is typically thought of in monetary terms, which reinforces the connection to a preference-based conception of welfare. For preference-satisfaction theories of welfare, patent and copyright law thus have significant first-order effects on welfare. If stronger IP laws enable producers—the owners (and employee-owners) of technology companies—to get rich from their inventions, this will increase their welfare significantly. As weaker IP rules diminish the returns from innovation and creativity, so too would producer-side welfare gains diminish. For this reason, IP scholars often describe stronger IP rules as benefitting large corporations (by which they mean the owners of those corporations) at the expense of individual consumers. From a hedonic perspective, however, the picture is not so clear. As we explained above, even significant increases in wealth have only minor effects on subjective well-being. Thus, marginally greater returns on investment will do little to improve the happiness of those who are already well off. It might seem, then, that IP law will not substantially affect the welfare of innovators. There is, however, one respect in which IP law could meaningfully affect producer-side welfare from a hedonic perspective. The mechanism is the role of IP rules, and innovation and creativity more generally, in promoting employment. Unemployment has dramatic negative effects on individual well-being, above and beyond its effects on income and wealth (Bronsteen, Buccafusco, and Masur, 2013). That is, not only does involuntary unemployment reduce an individual’s wealth and income, often to the point at which those reductions begin to affect well-being, it can also exact a psychological toll, lead to depression, and generally produce unhappiness. While patent and copyright laws that increase wealth will not have significant hedonic effects on people who are already relatively well off, laws that increase employment very well might. Patent law can, of course, affect overall employment if it affects economic growth and development. Policymakers should endeavor to select patent rules that maximize economic growth, though of course this will be extremely difficult (United States Patent and Trademark Office, 2013). At a more administrable level, patent law can also be used to favor certain industries over others, as we described in the previous section. There, we explained that certain types of technologies might produce greater welfare gains than others among the consumer population. Similarly, some technological industries might be more labor-intensive, and others might be more capital-intensive. A shift of R&D investment from a capital-intensive to a labor-intensive technology sector will increase overall technology-based employment, all other things being equal. There is now ample evidence

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Intellectual property law and the promotion of welfare  115 that these types of investments can affect overall employment and that labor markets do not function perfectly (Masur and Posner, 2012). Consequently, shifts in patent law that reroute R&D investment could conceivably increase employment at the margin and thus increase welfare, particularly when viewed from a hedonic perspective. Of course, it is difficult to know the magnitude of this effect. In addition, policymakers and courts would need detailed data on the relative labor intensity of various areas of technology. But the potential for beneficial policy intervention exists. Similar effects are likely present with respect to production of creative works. Stronger copyright rules will likely increase the production of some types of works—blockbuster movies, or mass-market novels, for instance—but decrease the production of others, such as fan fiction or other types of derivative works. Some of these types of works might be more or less labor-intensive than others; some might also generate more full-time employment than others.3 We do not have enough data to offer any definitive prescriptions yet. But a hedonically oriented policymaker would be well-advised to study the employment effects of various types of creative production and incorporate the welfare effects of employment and unemployment into the formulation of IP law and policy.

V. CONCLUSION IP laws exist to improve the quality of people’s lives by providing creations and innovations that make them better off. Although legal scholars have spent lots of time debating whether particular doctrines succeed in this goal, they have spent comparatively little time analysing what it means to improve the quality of people’s lives. IP law is committed to welfarism, but it has not grappled with what human welfare is. In this chapter, we have explained three competing conceptions of welfare and defended one of them—welfare as subjective well-being. Moreover, we have begun to suggest ways in which these different conceptions of welfare might affect IP law and policy. Definitions of welfare are not abstract philosophical questions; they have real-world significance that scholars should care about. Although sufficient data is still lacking to answer most IP law questions, new advances in data gathering and analysis will soon provide opportunities for rethinking many core doctrines.

REFERENCES Adler, Amy. 2009. ‘Against Moral Rights,’ 97 California Law Review 263–300. Adler, Matthew D., and Eric A. Posner. 2006. New Foundations of Cost-Benefits Analysis. Cambridge, MA: Harvard University Press. Adler, Matthew D., Paul Dolan, and Georgios Kavestos. 2015. ‘Would You Choose to Be Happy? Tradeoffs between Happiness and the Other Dimensions of Life in a Large Population Survey,’ accessed at https:// papers.ssrn.com/sol3/papers.cfm?abstract_id=2640117 (February 24, 2019).

3   To some extent, the suggestion above that copyright doctrine should consider slowing the pace of creativity to produce consumer-side benefits could conflict with the suggestion here about employment and producer-side benefits. As with most things, the devil will be the in the details of data that we do not yet have.

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116  Research handbook on the economics of IP law volume 1 Balganesh, Shyamkrishna. 2009. ‘Foreseeability and Copyright Incentives,’ 122 Harvard Law Review 1569–633. Banks, John, and Mark Deuze. 2009. ‘Co-Creative Labour,’ 12 International Journal of Cultural Studies 419–31. Beebe, Barton. 2017. ‘Bleistein: The Problem of Aesthetic Progress, and the Making of American Copyright Law,’ 117 Columbia Law Review 319–97. Benesch, Christine, Bruno S. Frey, and Alois Stutzer. 2010. ‘TV Channels, Self-Control and Happiness,’ 10 B.E. Journal of Economic Analysis and Policy 1–33. Boyle, James. 2003. ‘Enclosing the Genome? What the Squabbles over Genetic Patents Could Teach Us,’ in F. Scott Kieff, ed., Perspectives on Properties of the Human Genome Project. New York, NY: Academic Press. Boyle, James. 2007. ‘Cultural Environmentalism and Beyond,’ 70 Law and Contemporary Problems 5–21. Bronsteen, John, Christopher Buccafusco, and Jonathan S. Masur. 2013. ‘Well-Being Analysis vs. Cost-Benefit Analysis,’ 63 Duke Law Journal 1603–89. Bronsteen, John, Christopher Buccafusco, and Jonathan S. Masur. 2014. Happiness and the Law. Chicago, IL: University of Chicago Press. Bruni, Luigino, and Luca Stanca. 2008. ‘Watching Alone: Relational Goods, Television and Happiness,’ 65 Journal of Economic Behavior and Organization 506–28. Burk, Dan L., and Mark A. Lemley. 2009. The Patent Crisis and How the Courts Can Solve It. Chicago, IL: University of Chicago Press. Cass, Ronald A., and Keith N. Hylton. 2013. Laws of Creation: Property Rights in the World of Ideas. Cambridge, MA: Harvard University Press. Cohen, Julie. 2011. ‘Copyright as Property in the Post-Industrial Economy: A Research Agenda,’ 2011 Wisconsin Law Review 141–65. Csikszentmihalyi, Mihaly. 1990. Flow: The Psychology of Optimal Experience. New York: Harper & Row. Demsetz, Harold. 1969. ‘Information and Efficiency: Another Viewpoint,’ 12 Journal of Law and Economics 1–22. Derclaye, Estelle. 2012. ‘Eudemonic Intellectual Property: Patents and Related Rights as Engines of Happiness, Peace, and Sustainability,’ 14 Vanderbilt Journal of Entertainment and Technology Law 495–543. Derclaye, Estelle. 2013. ‘What Can Intellectual Property Law Learn from Happiness Research?,’ in Graeme B. Dinwoodie, ed., Methods and Perspectives in Intellectual Property. New York, NY: Edward Elgar. Devlin, Alan, and Neel Sukhatme. 2009. ‘Self-Realizing Inventions and the Utilitarian Foundation of Patent Law,’ 51 William and Mary Law Review 897–955. Fisher, William W., and Talha Syed. 2007. ‘Global Justice in Healthcare: Developing Drugs for the Developing World’, 40 U.C. Davis Law Review 581–678. Foot, Philippa. 2001. Natural Goodness. Oxford: Clarendon Press. Frey, Bruno S., Christine Benesch, and Alois Stutzer. 2007. ‘Does Watching TV Make Us Happy?,’ 28 Journal of Economic Psychology 283–313. Frischmann, Brett M. 2017. ‘Capabilities, Spillovers, and Intellectual Progress: Toward a Human Flourishing Theory for Intellectual Property,’ 14 Review of Economic Research on Copyright Issues 1–38. Gilbert, Dan. 2006. Stumbling on Happiness. New York, NY: Knopf. Griffin, James. 1986. Well-Being. Oxford: Oxford University Press. Hemel, Daniel J., and Lisa Larrimore Ouellette. 2013. ‘Beyond the Patent-Prizes Debate,’ 92 Texas Law Review 303–82. Hemphill, C. Scott, and Jeannie Suk. 2009. ‘The Law, Culture, and Economics of Fashion,’ 61 Stanford Law Review 1148–99. Hsee, Christopher K., and Reid Hastie. 2006. ‘Decision and Experience: Why Don’t We Choose What Makes Us Happy?,’ 10 Trends in Cognitive Sciences 31–7. Hughes, Justin. 1988. ‘The Philosophy of Intellectual Property,’ 77 Georgetown Law Journal 287–330. Kahneman, Daniel, and Angus Deaton. 2010. ‘High Income Improves Evaluation of Life but Not Emotional Well-Being,’ 107 PNAS 16489–93. Kahneman, Daniel, Ed Diener, and Norbert Schwarz. 1999. ‘Preface,’ in Daniel Kahneman, Ed Diener, and Norbert Schwarz, eds., Well-Being: The Foundations of Hedonic Psychology. New York: Russell Sage Foundation. Kahneman, Daniel, Alan B. Krueger, David A. Schkade, Norbert Schwartz, and Arthur A. Stone. 2004. ‘A Survey Method for Characterizing Daily Life Experience: The Day Reconstruction Method,’ 306 Science 1776–80. Kapczynski, Amy. 2012. ‘The Cost of Price: Why and How to Get beyond Intellectual Property Internalism,’ 59 UCLA Law Review 970–1026. Kapczynski, Amy, and Talha Syed. 2013. ‘The Continuum of Excludability and the Limits of Patents,’ 122 Yale Law Journal 1900–63. Kwall, Roberta Rosenthal. 2009. The Soul of Creativity: Forging a Moral Rights Law for the United States. Palo Alto, CA: Stanford University Press. Landes, William M., and Richard A. Posner. 2003. The Economic Structure of Intellectual Property Law. Cambridge: Belknap Press.

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Intellectual property law and the promotion of welfare  117 Lee, Edward. 2008. ‘Warming Up to User-Generated Content,’ 2008 University of Illinois Law Review 1459–548. Lemley, Mark A. 2005. ‘Property, Intellectual Property, and Free Riding’, 83 Texas Law Review 1031–75. Lewinsohn-Zamir, Daphna. 2003. ‘The Objectivity of Well-Being and the Objectives of Property Law’, 78 NYU Law Review 1669–753. Manta, Irina. 2013. ‘Hedonic Trademarks,’ 74 Ohio State Law Journal 241–83. Masur, Jonathan S. 2016. ‘CBA at the PTO,’ 65 Duke Law Journal 1701–35. Masur, Jonathan S., and Eric A. Posner. 2011. ‘Climate Regulation and the Limits of Cost-Benefit Analysis,’ 99 California Law Review 1557–600. Masur, Jonathan S., and Eric A. Posner. 2012. ‘Regulation, Unemployment, and Cost-Benefit Analysis,’ 98 Virginia Law Review 579–634. Maurer, Stephen. 2015. ‘The Economics of Memory: How Copyright Decides Which Books Do (and Don’t) Become Classics,’ 14 John Marshall Review of Intellectual Property Law 521–63. Menell, Peter S., and Suzanne Scotchmer. 2007. ‘Intellectual Property Law,’ in A. Mitchell Polinsky and Steven Shavell, eds., Handbook of Law and Economics, Vol. II. Amsterdam: North Holland. Merges, Robert P. 2011. Justifying Intellectual Property. Cambridge, MA: Harvard University Press. Nielsen. 2014. ‘How Smartphones Are Changing Consumers’ Daily Routines around the Globe,’ accessed at http://www.nielsen.com/us/en/insights/news/2014/how-smartphones-are-changing-consumers-daily-routinesaround-the-globe.html (February 24, 2019). Nussbaum, Martha C. 2001. Women and Human Development: The Capabilities Approach. Cambridge: Cambridge University Press. O’Connor, Sean M. 2015. ‘The Overlooked French Influence on the Intellectual Property Clause,’ 82 University of Chicago Law Review 733–830. Oliar, Dotan. 2006. ‘Making Sense of the Intellectual Property Clause: Promotion of Progress as a Limitation on Congress’s Intellectual Property Power,’ 94 Georgetown Law Journal 1771–845. Oswald, Andrew J., and Nattavudh Powdthavee. 2008. ‘Does Happiness Adapt? A Longitudinal Study of Disability with Implications for Economists and Judges,’ 92 Journal of Public Economics 1061–77. Powdthavee, Nattavudh, and Bernard van den Berg. 2011. ‘Putting Different Price Tags on the Same Health Condition: Re-Evaluating the Well-Being Valuation Approach,’ 30 Journal of Health Economics 1032–43. Rai, Arti. 2007. ‘The Ends of Intellectual Property: Health as a Case Study,’ 70 Law and Contemporary Problems 125–30. Raustiala, Kal, and Christopher Sprigman. 2006. ‘The Piracy Paradox: Innovation and Intellectual Property in Fashion Design,’ 92 Virginia Law Review 1687–777. Saeb, Sohrab, Mi Zhang, Christopher J. Karr, Stephen M. Schueller, Marya E. Corden, Konrad P. Kording, and David C. Mohr. 2015. ‘Mobile Phone Sensor Correlates of Depressive Symptom Severity in Daily-Life Behavior: An Exploratory Study,’ 17 Journal of Medical Internet Research e175, 1–11. Sampat, Bhaven N., and Heidi L. Williams. 2015. ‘How Do Patents Affect Follow-On Innovation? Evidence from the Human Genome,’ accessed at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2679705 (February 24, 2019). Scheibehenne, Benjamin, Rainer Greifeneder, and Peter M. Todd. 2010. ‘Can There Ever be Too Many Options? A Meta-Analytic Review of Choice Overload,’ 37 Journal of Consumer Research 409–25. Schwartz, Barry. 2003. The Paradox of Choice: Why More Is Less. New York, NY: Ecco. Sen, Amartya. 1993. ‘Capability and Well-Being,’ in Martha Nussbaum and Amartya Sen, eds., The Quality of Life. Oxford: Clarendon Press. Sen, Amartya. 2005. ‘Human Rights and Capabilities,’ 6 Journal of Human Development 151–66. Shakespeare, William. 2004. Much Ado about Nothing. New York: Washington Square Press. Silbey, Jessica. 2014. The Eureka Myth: Creators, Innovators and Everyday Intellectual Property. Palo Alto, CA: Stanford Law Books. Solum, Lawrence B. 2002. ‘Congress’s Power to Promote the Progress of Science: Eldred v. Ashcroft,’ 36 Loyola Los Angeles Law Review 1–83. Stutzer, Alois, and Bruno S. Frey. 2008. ‘Stress that Doesn’t Pay: The Commuting Paradox,’ 110 Scandinavian Journal of Economics 339–66. Sumner, L.W. 1996. Welfare, Happiness, and Ethics. Oxford: Clarendon Press. Tur-Sinai, Ofer M. 2016. ‘Technological Progress and Well-Being,’ 48 Loyola University of Chicago Law Journal 145–204. United States Patent and Trademark Office. 2013. ‘Regulatory Impact Analysis, Setting and Adjusting Patent Fees in Accordance with Section 10 of the Leahy-Smith America Invents Act,’ accessed at http://www. uspto.gov/sites/default/files/aia_implementation/AC54_Final_Regulatory_Impact_Analysis.pdf (February 24, 2019). von Hippel, Eric. 2005. Democratizing Innovation. Cambridge, MA: MIT Press.

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118  Research handbook on the economics of IP law volume 1 Cases Aronson v. Quick Point Pencil Co., 440 U.S. 257 (1979). Bleistein v. Donaldson Lithographic Co., 188 U.S. 239 (1903). Kewanee Oil Co. v. Bicron Corp., 416 U.S. 470 (1974). Sony Corp. v. Universal Studios, 464 U.S. 417 (1984).

Legislative Materials U.S. Const. art. I, § 8, cl. 8. 17 U.S.C. § 106A (2018).

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6.  Economic models of innovation: stand-alone and cumulative creativity Peter S. Menell* and Suzanne Scotchmer** 4

5

Contents Economic Models of Technical Change Stand-Alone Innovation A. Threshold for Protection B. Duration C. Breadth D. Rights of Others (and Defenses) 1. Rights arising from independent invention 2. Rights after sale 3. Rights to share copyrighted works E. Remedies F. Channeling Doctrines III. Cumulative Innovation A. A Preliminary Model: The Virtues of Licensing B. Duration C. Threshold Requirements and Breadth 1. Evolving doctrines regarding subject matter 2. Adequacy of disclosure requirements D. Rights of Others (and Limitations and Defenses) 1. Experimental use 2. Fair use 3. Reverse engineering 4. Other limitations: exemptions, compulsory licenses, voluntary licenses, open source, and dedication to the public domain I. II.

**  Koret Professor of Law and Director, Berkeley Center for Law and Technology, Berkeley School of Law, University of California. **  Formerly Professor of Economics, Public Policy, and Law, University of California, Berkeley, who died in 2014. Thanks to Concord Cheung, Amit Elazari, Megan McKnelly, and Reid Whitaker for excellent research assistance. This chapter updates Parts 1.1 and 1.3 of Peter S. Menell and Suzanne Scotchmer. 2007. ‘Intellectual Property Law,’ in A. Mitchell Polinsky and Steven Shavell, eds., Handbook of Law and Economics, vol. II. Amsterdam: North-Holland. Aspects of Parts 1.1 and 1.3 are reprinted with permission from Elsevier, © 2007. http://www.elsevier.com. This chapter is dedicated to Professor Scotchmer for her seminal contributions to the economics of intellectual property rights. Professor Menell bears responsibility for any mistakes in this updating of the prior work.

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120  Research handbook on the economics of IP law volume 1 E. Remedies F. Channeling Doctrines References Intellectual property law seeks to promote progress in science, technology, and expressive creativity (U.S. Const. art. I, § 8, cl. 8). The principal economic justification for intellectual property derives from a fundamental problem: the inability of a competitive market to support an efficient level of innovation. In a competitive economy, profits will be driven to zero, not accounting for sunk costs such as research and development (R&D) or costs of authorship. From an ex post point of view, this is a good outcome, as it keeps prices low for consumers and avoids deadweight loss. But from an ex ante point of view, it produces a sub-optimal level of investment in R&D. Most firms would not invest in developing new technologies, and potential creators might not spend their time on creative works, if rivals could enter the market and dissipate the profits. Unlike tangible goods, knowledge and creative works are public goods in the sense that their use is nonrival (Arrow, 1962; Nelson, 1959). One agent’s use does not limit another agent’s use. Indeed, in its natural state (cartooned in the digital age as ‘bits want to be free’), knowledge is also ‘nonexcludable.’ That is, even if someone claims to own the knowledge, it is difficult to exclude others from using it. Intellectual property law is an attempt to solve that problem by legal means; it grants exclusive use of the protected knowledge or creative work to the creator. For other forms of property, exclusion is often accomplished by physical means, such as building a fence. Intellectual property is a legal device by which the inventor can control entry and exclude users from intangible assets. Intellectual property results in deadweight loss to consumers, and that is its main defect. Two other defects are that it may inhibit the use of scientific or technological knowledge for further research, and, from an ex ante point of view, that there is no guarantee that the research effort will be delegated efficiently to the most efficient firms or even to the right number of firms. Commentators have been lamenting the defects of intellectual property since the nineteenth century, in more or less the same terms as today (Machlup and Penrose, 1950). But intellectual property also has virtues, of which we mention three powerful ones. Probably the greatest virtue is that every invention funded with intellectual property creates a Pareto improvement. No one is taxed more than her willingness to pay for any unit she buys; else, she would not buy it. In contrast, funding out of general revenue runs the risk of imposing greater burdens on individual taxpayers than the benefits they receive. A second great virtue is decentralization. Probably the most important obstacle to effective public procurement is in finding the ideas for invention that are widely distributed among firms and inventors. The lure of intellectual property protection does that automatically. Decentralization is especially important if private inventors are more likely than public sponsors to spawn good ideas for innovations. The third virtue is that intellectual property is an effective screening device (Long, 2002 (emphasizing the role of patents as a signaling device)). Since the private value of the invention often reflects the social value, inventors should be willing to bear higher costs for inventions of higher value. But these are not determinative, since other incentive mechanisms such as prizes and government funding may share the same virtues while at the same time reducing deadweight

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Economic models of innovation  121 loss. Whereas the earlier economics literature proceeded as if intellectual property protection was the self-evident solution to the R&D incentive problem, the modern literature has sought to understand when that is true and when other incentive mechanisms might dominate (Wright, 1983; Abramowicz, 2019; Price, 2018). The choice among incentive mechanisms, and even the optimal design of intellectual property laws, depends on the nature of the creative process or, in economists’ jargon, on the model of knowledge creation. Thus, this chapter proceeds in three stages. Section I sketches the principal economic models of technical change. Section II traces the economic modeling of stand-alone innovation. These models provide the foundation for cumulative innovation, the most prevalent and significant driver of economic activity, addressed in Section III. A recurrent theme is that advances in digital and network technologies have vastly eased access to prior works and reduced the costs of using them in new works.

I.  ECONOMIC MODELS OF TECHNICAL CHANGE Four principal models of technological change have been proposed in the economics literature: an evolutionary model, a model of induced technical change, a production function for knowledge, and an exogenous process of idea formation, with incentives determining investments. In the evolutionary model proposed by Nelson and Winter (1982) (see also Mokyr, 1990, ch. 11), technology develops through a process in which R&D investments occur whenever profit drops below a specified level. Hence, the evolutionary model is not set up to investigate incentives since investment is automatic. In the model of induced technical change, innovation occurs in response to changes in factor prices: ‘A change in the relative prices of the factors of production is itself a spur to invention and inventions of a particular kind—directed at economizing the use of a factor which has become relatively expensive’ (Hicks, 1932, pp. 124–5; see also Ruttan, 2001). Thus, rising energy prices can be expected to spur technological advances in energy conservation (Newell et al., 1999). In the production function model of discovery, which is the basis of almost all of the patent race literature, there is an exogenously given relationship which determines, as a function of research inputs or the number of researchers, either the quality of invention (de Laat, 1996; Shavell and van Ypersele, 2001; Che and Gale, 2003) or the likelihood of success in each time period (Loury, 1979; Lee and Wilde, 1980; Reinganum, 1982, 1985, 1989; Wright, 1983; Denicolò, 1996, 1997). In both the induced technical change model and the production function model, the profit opportunities are common knowledge. Decentralization is not important. The ‘ideas’ model of O’Donoghue et al. (1998) (see also Scotchmer, 1999; Maurer and Scotchmer, 2004) focuses directly on the scarcity of ideas. The basis of research is ‘imagination,’ and to achieve an innovation, a researcher must both have the idea for the innovation and an incentive to invest in it. Although it is the most widely used model, the production function model does not lead naturally to intellectual property as superior to other incentive schemes. For example, the advantages of decentralization are more important in a model where ideas are scarce than where they are common knowledge.

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II.  STAND-ALONE INNOVATION Much of the early economic modeling of the role of intellectual property in promoting innovation posed the following question: what system of incentives or rewards would best promote the attainment of a particular invention? Such models provide the basis for analyzing legal protection for a distinct and relatively narrow class of inventions which do not ultimately generate follow-on innovation. Examples from this class include the safety razor, the ballpoint pen, and pharmaceutical innovations for which the scientific mechanism is poorly understood (Nelson and Winter, 1982; von Hippel, 1988, p. 53). Even where inventors depend on prior knowledge, which is almost inevitable, the lag may be such that prior rights have expired so that the incentive system treats inventions as standalone. Examples are the bicycle and the early development of the light bulb (Dyson, 2001). Models focusing on stand-alone innovation can also be helpful in analyzing legal protection for expressive creativity. Although such works often draw upon prior works for inspiration or common reference points for the work’s audience, many authors, musicians, and artists have not traditionally built so extensively upon the work of prior creators as to require express permission. This proposition obviously turns on the underlying right structures—copyrights tending to be relatively narrow in comparison to utility patents—but it also reflects a fundamental difference between the fields of technological and expressive innovation: Science and technology are centripetal, conducing toward a single optimal result. One water pump can be better than another water pump, and the role of patent and trade secret law is to direct investment toward such improvements. Literature and the arts are centrifugal, aiming at a wide variety of audiences with different tastes. We cannot say that one novel treating the theme, say, of man’s continuing struggle with nature is in any ultimate sense ‘better’ than another novel—or musical composition or painting—on the same subject. The aim of copyright is to direct investment toward abundant rather than efficient expression. (Goldstein, 1986)

As copyright has expanded into functional subject matters, such as the design of useful articles, computer software, and architectural works, however, this distinction breaks down. Channeling doctrines aim to steer technological advances into the utility patent regime (Menell, 1987). The critical inquiry in seeking to promote stand-alone innovation is how much profit an inventor or creator should receive and how it should be structured. The focus for standalone innovation, therefore, is upon ex ante incentives. As we will emphasize below, all of the results in this area depend sensitively on what is assumed about licensing (see also Gallini and Scotchmer, 2002). Collaboration and the exchange of technological knowledge across firm boundaries encounter substantial transaction costs. Arora et al. (2001) find evidence that changes in the technology of technical change—most notably the growing use of digital information technologies—facilitate greater partitioning of innovation tasks across traditional firm boundaries. They foresee markets for t­ echnology—licensing and specialized technology transfer and innovation service firms—playing a more significant role in the production of innovation. (When we turn to cumulative innovation in Section III, ex post incentives enter the analysis.) The principal policy levers affecting incentives to invent are the threshold for protection, duration, breadth, rights of others (and defenses), remedies, and channeling doctrines.

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Economic models of innovation  123 A.  Threshold for Protection Because intellectual property protection results in deadweight loss to consumers (and can interfere with cumulative innovation), it should only be available for significant ­innovation—works that are new and would not be readily forthcoming without legal encouragement—that is, requiring substantial cost and substantial technological risk. Works already in the public domain should not be protectable and the threshold for protection should be sufficiently high (or the rights sufficiently narrow) to prevent easily achieved (‘obvious’) advances from being insulated from free market competition. Intellectual property regimes erect several types of threshold doctrines before protection is granted: (1) subject matter rules—categorical limitations on eligibility; (2) substantive requirements—minimum criteria for protection; and (3) formal requirements—­administrative and technical rules that must be complied with in order to obtain and maintain protection. Utility patent protection is available for nearly all forms of technological innovation (processes, machines, manufactures, and compositions of matter), but applies relatively stringent standards (utility, novelty, nonobviousness (or inventive step), and adequate disclosure) through a formal examination system. By contrast, copyright protection applies a very low threshold for protection—a work need only be fixed in a tangible medium of expression and reflect a modicum of ­originality—and does not require examination (registration is optional). Such a low threshold is counterbalanced by a relatively narrow scope of protection and limiting doctrines excluding protection for technological features. Design patent protection is similar to copyright protection for pictorial, graphic, and sculptural copyrighted works. Its ornamentality/non-functionality doctrine guards against protecting technological innovation as opposed to aesthetic creativity. Trade secret law requires merely that information derives economic value from not being generally known or readily ascertainable (by proper means) by others and from being the subject of reasonable efforts under the circumstances to maintain its secrecy. Trade secret protection does not, however, stand in the way of independent invention or reverse engineering. Utility patent law’s threshold requirements have received the most economic scrutiny. Due to the relatively uniform nature of patent protection, some have argued that certain classes of innovation (such as computer software and business methods) that may not require such lengthy protection should be subject to a sui generis form of protection (Menell, 1987 (software)) or excluded from intellectual property protection altogether (Thomas, 1999 (business methods); Dreyfuss, 2000; Menell, 2007, 2011). The basic contours of patent law were established during an age of mechanical innovation and were designed with this model (and the guild system that predominated) in mind (Menell et al., 2018, vol. I, ch. III). Mechanical innovation continued to comprise the bulk of patent applications well into the twentieth century. During the past half century, however, various newer fields—such as software, business methods, and biotechnology—have increasingly come into the patent system (Allison and Lemley, 2002), calling into question the premises on which patent law was built. If specialized protection systems are not developed to address new and distinctive fields of innovation (as was partially done in the case of semiconductor chip designs in the Semiconductor Chip Protection Act of 1984), the challenge remains of reshaping the relatively uniform

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124  Research handbook on the economics of IP law volume 1 patent system to accommodate the growing heterogeneity of inventive activity (compare Burk and Lemley, 2002, 2003). Patent law’s novelty requirement—what it means to be ‘first’—turns on the location of the ‘finish line’ in the race to invent. Most patent systems in the world apply a first-to-file standard. Until 2013, the United States determined the winner on the basis of who was the first to invent. In principle, the first-to-invent system rewards the first inventor to discover new knowledge, even if they lack the specialized patent filing resources of others. Thus, many small inventors defended the first-to-invent system as a means of leveling the playing field relative to large companies which have more resources available and personnel in place to file applications expeditiously. The first-to-file system significantly reduces the administrative costs of operating a patent system—priority depends solely on the time and date stamped on an application. Evidentiary disputes over the subtle nuances of who was first to grasp an invention can be quite costly to resolve (Macedo, 1990). Empirical studies cast doubt on the notion that small inventors tend to do better under a first-to-invent system, likely reflecting the high costs of resolving priority disputes (Mossinghoff, 2002; Lemley and Chien, 2003). The first-to-invent system also has incentive effects as to the choice between trade secrecy and disclosure (Scotchmer and Green, 1990). Inventors may be inclined to delay their applications in order to effectively extend the expiration date of a patent (20 years from the date of filing). In order to counteract this effect and promote prompt filing, US patent law adds an additional layer of legal complexity (and hence uncertainty and cost): requiring that an inventor file an application within one year after the invention is disclosed (either through patenting or publication anywhere in the world or in public use or on sale in the United States). This reduces the delay in disclosure of new knowledge, but does not eliminate it. The first-to-file system promotes earlier disclosure of technological advances. Grushcow (2004) finds that the growing interest in patenting by academic institutions since 1980 has delayed the publication of research, potentially increasing the risk of wasteful duplication of research. On March 16, 2013, the United States shifted from the first-to-invent system to a first-to-file system that recognizes a one-year grace period for inventor disclosure (35 U.S.C. § 102, as amended by the America Invents Act of 2011). The grace period serves to encourage prompt disclosure while affording inventors leeway to get their patent applications filed. Such pre-filing disclosure even by the inventor, however, will bar patenting in most other parts of the world. From an economic standpoint, patent law’s nonobviousness standard plays the most important role in determining which innovations qualify for protection (and hence what type of innovation patent law encourages). Patent law specifies that a claimed invention must go beyond readily predictable or conventional solutions to technical, engineering, or business problems. Articulating an objective and determinative standard for nonobviousness, however, has proven elusive. In the 1940s, US courts interpreted the law to require a ‘flash of creative genius’ (Cuno Engineering Corp. v. Automatic Devices Corp., 314 U.S. 84 (1941)). Such a demanding formulation generated a backlash within the patent community, leading Congress to frame the standard in the following manner: a patent may not be obtained ‘if the differences between the claimed invention and the prior art are such that the claimed invention as a whole would have been obvious before the effective filing date of the claimed invention to a person having ordinary skill

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Economic models of innovation  125 in the art to which the claimed invention pertains’ (35 U.S.C. § 103, as amended by the America Invents Act of 2011).What raises the nonobviousness hurdle above the novelty standard is that the patent examiner may consider multiple references simultaneously and use logical inferences and common sense. The examiner must also consider circumstantial evidence of nonobviousness (so-called ‘secondary considerations’)—long-felt but unsolved need, commercial success of the claimed invention, failed efforts by others, copyright by others, praise for the invention, unexpected results, and disbelief of experts—but only to the extent that such factors are connected to the inventive aspects of the patent. In its actual formulation and application, the nonobviousness rule falls short of implementing the economic gatekeeping principle. Whereas an economist would consider paramount among relevant considerations the R&D expense in making an invention (Merges, 1992), the US Patent Act states that patentability ‘shall not be negated by the manner in which the invention was made,’ implying that inventions requiring minimal effort (and hence likely to be obtained even without protection) may nonetheless qualify for protection. In addition, R&D are not among the traditional secondary considerations, although several court decisions on nonobviousness take note of such factors (Merges, 1992 (noting that the threshold for patentability should be lowered with regard to highcost research); Oddi, 1989, p. 1127 (recommending that courts expressly consider ‘qualitative and quantitative investment in research and development’ among the secondary factors)). The legal standard for nonobviousness does consider the level of uncertainty involved in research. In practice, the test depends on the number of parameters and the extent to which the relevant prior art guides the experimentation process. The role of commercial success in the nonobviousness determination has produced conflicting economic analyses and prescriptions. Drawing upon historical and empirical research on the innovation process, Merges (1988) finds commercial success to be a poor proxy for technical advance. What succeeds in the market tends to reflect product strategy and marketing more than technical advances over the prior art. Hence, Merges argues for downplaying this factor and scrutinizing the connection between market success and the technical advance. By contrast, Kitch (1977, p. 283) sees market success as consistent with the prospect theory. By using subsequent economic success as a factor favoring patentability, patent law increases ‘the security of the investment process necessary to maximize the value of the patent.’ Both analyses support the idea that the consideration of market success in assessing nonobviousness promotes commercialization, although it is not clear that a patent system is needed to achieve this end. Where adequate incentives exist to invent, free market forces should be adequate to promote commercialization (but compare Sichelman, 2010 (proposing a ‘commercialization’ patent); Kieff, 2001a (articulating a commercialization theory of patent law)). The nonobviousness standard may have some perverse collateral effects on the nature and timing of disclosure of new knowledge. By preemptively publishing work in progress, a firm that is ahead may induce a shake-out among rivals by raising the level of prior art to render a rival’s subsequent invention obvious (Scotchmer and Green, 1990); a laggard in a patent race may be able to reduce the likelihood that a leader will be able to obtain a patent by raising the level of the prior art sufficiently to defeat patentability by a leader (Lichtman et al., 2000; Parchomovsky, 2000; compare Bar-Gill and Parchomovsky, 2003).

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126  Research handbook on the economics of IP law volume 1 This possibility might also lead competitors to collude or collaborate to maximize patent opportunities. Under this theoretical account, a higher standard of nonobviousness increases the viability of a preemptive patenting strategy. The likelihood that such a strategy would be pursued by rivals has been questioned on doctrinal and practical grounds (Merges, 2004a, pp. 195–6; Eisenberg, 2000; compare Hicks, 1995). Much of the economics literature on trade secrets addresses the optimal level of expenditures to maintain secrecy—that is, what constitutes ‘reasonable efforts’ under the circumstances. Kitch (1980) argues that all such ‘fencing costs’ are inefficient and would require only such expenses as are necessary to provide evidence of the existence of a trade secret—that is, a notice or marking function. Friedman et al. (1991) make the related point that trade secret protection should be available when it is cheaper than the physical precautions that would be necessary to protect a particular piece of information. B. Duration Nordhaus (1969) offers the first formal model of the optimal duration of intellectual property protection. Nordhaus asks why the life of the intellectual property right should be limited, since a longer right leads to more innovation and more innovation creates social benefit. He argues that there is a countervailing cost. The longer right might increase innovation, but it also increases deadweight loss on all the inframarginal innovations that would occur even with shorter protection—that is, innovations that would be forthcoming even in the absence of the longer right. The optimal duration of a patent or copyright should balance the incentive effect against the deadweight loss in order to maximize social welfare. Many economists believe that copyright duration (life of the author plus 70 years) is much longer than justified to provide an appropriate ex ante incentive for creation of new works (see Akerlof et al., 2003; but compare Landes and Posner, 2003, p. 218 (noting that the deadweight loss from copyright protection is relatively small due to the narrow scope of copyright protection)). To see the Nordhaus argument, suppose that there is a universe of ‘ideas’ available for investment. Let an idea be a pair (s, c) where s measures the value of the resulting innovation and c is its cost. An idea with higher s can be interpreted as leading to a larger market; a higher s means that the demand curve is shifted out. Let Π(s, T) be the profit available to a right holder with an intellectual property right of length T and an idea of quality s. Π is increasing in both T and s. Let W(s, T) be the corresponding social welfare associated with investment in the idea. The welfare W(s, T) is the sum of consumers’ surplus for the infinite life of the innovation, sold at the competitive price, minus the deadweight loss during the period of protection. Thus, W is increasing in s and decreasing in T. Finally, suppose that for each R&D cost c, the distribution of ‘ideas’ is given by a distribution function F with density f, where F(s|c) is the fraction of ideas with cost c that have value less than s. Then the social value of investment in ideas with cost c is Ẇ(T, c) defined below, where s(T) is the minimum value that will elicit investment (Π(s(T), T) 5 c). That is,

W (T, c) 5 3

#

`

s (T )

[ W (s,T ) 2c ] f (s 0 c) ds

0 #  W (T, c) 5 3 [ W (s,T ) 2c ] f (s 0 c) ds 2W (s (T ) ,T ) (T ) 0T s (T ) `

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W (T, c) 5 3

#

`

s (T )

[ W (s,T ) 2c ] f (s 0 c) dsEconomic models of innovation  127

Notice that s’(T) , 0. A marginal increase in T will increase investment in amount 2W(s(T), T)s’(T). However, even though investment goes up with T, total social welfare Ẇ(T, c) may go down. The change in social welfare is 0 #  W (T, c) 5 3 [ W (s,T ) 2c ] f (s 0 c) ds 2W (s (T ) ,T ) (T ) 0T s (T ) `



The last term represents the welfare due to new innovations called forth by longer protection, but the first term, which is negative, represents the loss in consumers’ surplus on all the inframarginal innovations that would have been achieved even with shorter duration. As T becomes large DD and s(T) becomes small, it is reasonable to think that the first term 3 5 becomes largeRrelative to the last term. Increasing the duration T beyond that point will DC not be in the social interest. Of course the best length T must be established by adding up the marginal effects for all c. Depending on the distributions of (s, c) in different product classes, the one-size-fits-all nature of the patent system may provide excessive protection in some product classes and deficient incentives in others. Races for the intellectual property right introduce another inquiry as to how profitable the intellectual property right should be, regardless of how the profit is achieved.1 Unlike the Nordhaus argument, the inquiry leads to an argument for limited duration that applies even if the profit is given as a prize out of general revenue and involves no deadweight loss. The argument concerns the optimal amount of R&D effort. A more profitable right will encourage more entry into the race (the extensive margin) or more collective effort as each participant accelerates its effort (the intensive margin). The potential benefits of inciting more effort by offering more profit depend on the creative environment—the nature of the R&D process. Nordhaus implicitly addresses a creative environment where ‘ideas are scarce’ so that duplication of costs is not the focus. Suppose, however, that more than one potential innovator can serve the same market niche. Then there is a second reason to limit duration. Not only will there be excessive deadweight loss on inframarginal innovations, but the disparity between profit and cost will also lead to duplication of R&D cost as firms vie for the very profitable rights. Thus, part of the inquiry into the optimal strength (profitability) of an intellectual property right concerns the extent to which additional effort is duplicative. This issue takes us back to the question, what is the right model of the creative environment? If ‘ideas are scarce,’ then races are not an issue. But if all investment opportunities are commonly known, then races may or may not be efficient, depending on the ‘production function for knowledge.’ If successes and failures in the R&D process are perfectly correlated, then a race is duplicative. If successes and failures are independent, then a race increases the probability of at least one success or, in another interpretation, accelerates progress

1   Innovation races are more suited to patentable subject matter than to expressive works. Such races can only occur if several rivals are vying for a right that only one of them will receive. Rights to expressive works are generally narrow enough in scope that several authors can obtain protection for works that have some similarity (and hence can compete). Thus, an author may fear a reduced market due to competition from another author but does not generally fear that he or she will be wholly excluded from the market through a rival completing their work first.

M4754-Math Eqn.indd 1

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128  Research handbook on the economics of IP law volume 1 (Loury, 1979; Lee and Wilde, 1980; Reinganum, 1982, 1985, 1989). Further, if the creative environment is one in which different firms have different unobservable ideas for how to address a given need, then entrants to a race need not be the most efficient firms or those with the best ideas (Scotchmer, 2004, ch. 2). The number of entrants in a race may be too large or too small, as compared to the efficient number, depending on the size of the private reward. Suppose, for example, that two firms have different ideas about how to fill a market niche with value s. Suppose that each firm’s cost is c, and that each has probability 1/2 of succeeding. Suppose that the value of the property right will be Π(s, T), and that the firms’ prospects for success are independent. If both firms succeed, each will receive the property right with probability 1/2. Then a second firm will enter the patent race if Π(s, T)(3/8) . c, since its probability of receiving the patent is 3/8. On the other hand, entry by the second firm is only efficient if W(s,  T)(3/4) 2 2c . W(s,  T)/2 2 c or W(T, s)/4 . c. Thus, if Π(s, T)(3/8) . c . W(s,  T)/4, there will be excess entry to the patent race—the second firm will enter even though that is not efficient—and if Π(s, T)(3/8) , c , W(s, T)/4 there will be too little entry. Entry into a race may provide a private value to the entrant that is greater than the social value of the entry and always provides a private value that is greater than the increment to private value of both firms. The latter is because of the ‘business-stealing effect.’ The second entrant’s expected profit is Π(s, T)(3/8) 2 c, while the increment to joint profit is only Π(s, T)(1/4) 2 c. The second entrant’s chance of winning the race and getting the patent comes partly at the first entrant’s expense. It is this externality that may lead to excessive entry into a race. It also implies that if the reward were as large as the social value, there would be too much entry. In fact, the only thing that is clear in this environment, without imposing additional structure, is that the optimal reward is smaller than the social value of the innovation. But this is not a very useful design principle because rewards given as intellectual property will have that attribute almost inevitably. Landes and Posner (2003, pp. 222–8) suggest that some works may be diminished by a congestion externality. They illustrate their point by reference to the Disney Corporation’s self-imposed restraint on commercialization: To avoid overkill, Disney manages its character portfolio with care. It has hundreds of characters on its books, many of them just waiting to be called out of retirement. . ..Disney practices good husbandry of its characters and extends the life of its brands by not overexposing them. . . . They avoid debasing the currency. (Britt, 1990)

Landes and Posner (2003) assert that this concern justifies perpetual protection for some works. To balance the costs of protection, they advocate a system of indefinitely renewable copyright protection, with the renewal fee acting as policy lever for diverting works not subject to congestion externalities into the public domain. They note that a similar over-saturation can arise with regard to some rights of publicity (use of persona in advertising) and trademarks. C. Breadth The breadth or scope of an intellectual property right has critical bearing on its economic value, and hence its incentive effect. A broader right preempts more substitutes than a narrow right.

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Economic models of innovation  129 The scope of a utility patent is determined by the language of the claims, which define the boundaries of literal infringement, and the extent to which such boundaries will be stretched to cover similar, but not quite literal, embodiments. Under the ‘doctrine of equivalents,’ courts will find infringement where the accused device ‘performs substantially the same function in substantially the same way to obtain the same result’ (Graver Tank & Mfg. Co. v. Linde Air Products Co., 339 U.S. 605, 608 (1950) (quoting Sanitary Refrigerator Co. v. Winters, 280 U.S. 30, 42 (1929)); Warner-Jenkinson Co. v. Hilton Davis Chem. Co., 520 U.S. 17 (1997)). The scope of copyright is determined by the substantial similarity test in conjunction with copyright’s limiting doctrines (e.g., originality, scènes à faire, non-protectability of ideas and facts, fair use)—is the defendant’s work substantially similar to the protected elements of the plaintiff’s work? In practice, a copyright is quite narrow. J.K. Rowling can prevent others from copying Harry Potter novels, but she has no control over other stories about wizards. It is unlikely that different authors operating from the same ideas will produce substantially similar novels. Breadth issues can arise, however, with regard to works built on copyrighted works, such as sequels and film adaptations. We deal with these issues in the context of cumulative innovation. Breadth does not generally arise in the context of trade secrets. These legal tests do not map directly onto the economic concepts of breadth. Economic models of breadth have been developed for two market contexts: where an innovation is threatened by horizontal competition and where an innovation might be supplanted by an improved innovation. We take up the latter question in the analysis of cumulative innovation. For horizontal competition, breadth has been modeled in two ways: in ‘product space,’ defining how ‘similar’ a product must be to infringe a patent, and in ‘technology space,’ defining how costly it is to find a noninfringing substitute for the protected market. In the first notion of breadth, introduced by Klemperer (1990) using a spatial model, the size of the market for the patented product depends on the closeness of noninfringing substitutes. A broader patent covers more of the product space, meaning that more substitutes infringe. The right to keep a substitute out of the market is profitable for the patent holder in two ways: by shifting the demand for the protected good outward (where the intellectual property owner excludes the substitute from the market) or by allowing the intellectual property owner to charge higher prices for both the patented good and the infringing substitute. The second notion of breadth for horizontal substitutes, developed by Gallini (1992), is that it determines the cost of entering the market. In this conception, the goods are exact substitutes, and breadth implicitly refers to the technology of production (process innovation) rather than closeness of substitutes in the market. Entry by a second firm does not cause demand curves to shift, but instead causes the firms to compete in a given market. A narrower utility patent (lower cost of entry) will lead to more entry and lower prices. Entry stops when the cost of entry can no longer be covered by competing in the market. In both conceptions of breadth, a narrower utility patent leads to lower per-period profit. Thus, breadth might be conceived as a policy lever that governs profit, as described above, in a one-size-fits-all system where the duration of protection cannot be tailored to the cost of innovation. In the utility patent system, such tailoring is not generally done in any systematic way by the Patent Office. Examiners focus solely on ensuring that the

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130  Research handbook on the economics of IP law volume 1 application meets the threshold criteria and that the claims are clear. They do not adjust the ‘breadth’ of claims (Menell, 2013, 2019a). The courts exercise a modest degree of tailoring. In applying the doctrine of equivalents, courts accord ‘pioneering’ inventions greater scope than more modest inventions. Such a rule increases the reward for major breakthroughs. The copyright system does not systematically vary the scope of protection with the cost or importance of the work. Even within the one-size-fits-all system, there is a policy question as to whether, on average, rights designed to give a pre-specified reward should be structured as long and narrow or short and broad. The inquiry into how market rewards should be structured has led in several papers to a ratio test: a policy reform is desirable if it increases the ratio of profit to deadweight loss. The ratio test was devised by Kaplow (1984) in the patent/ antitrust context and was also used by Ayres and Klemperer (1999) in the enforcement context. It reappears in the cited discussions of patent breadth. The basic notion is that deadweight loss is the consumer cost of raising money through proprietary pricing. If the ratio of profit to deadweight loss is higher, the money being raised through proprietary pricing is raised more efficiently. In a broad class of demand curves including linear ones, any price reduction from the monopoly price will increase the profit-to-deadweight-loss ratio but will also reduce profit, thus necessitating a compensation such as longer protection. This can be seen in Figure 6.1, where the monopoly price is 1/2 and the lower price 1/3 is the duopoly price. At the price 1/3, the ratio of profit to deadweight loss is the ratio of the light grey areas (of size 2 × C) to the triangle D. At the monopoly price 1/2, the ratio of profit to deadweight loss is the ratio of the outlined box that represents monopoly profit to the triangle (B+M+D). One can see by inspection that the ratio of profit to deadweight loss is smaller at the monopoly price 1/2 than at the lower price 1/3. In fact, with the linear demand curve, this argument generalizes for any reduction in price: the lower the price, the higher the ratio of profit to deadweight loss. This is the argument given by Tandon (1982), arguing for compulsory licenses to lower prices, and Gilbert and Shapiro (1990), p

Demand q (P) = 1-p 1/2 A

B

1/3

C

M 1/3

1/2

D 2/3

q

Figure 6.1  Monopoly pricing and deadweight loss

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Economic models of innovation  131 arguing for narrow patents, which they interpret as lower prices, although they do not say how price reductions in a given market might flow from narrower scope. How, though, do narrow patents lower the price in a given market? In Gallini’s (2002) conception, breadth determines the cost that an imitator must pay to enter a proprietary market. Entry is only tempting if the market will be protected long enough so that the entrant, in competition with the patent holder, can still cover the cost of entry. If entry occurs, competition between the entrant and the right holder will lower the price. Figure 6.1 can be used to compare a relatively short period of protection where entry by an imitator is not tempting, with a longer period of protection, where entry is tempting even though the imitator must pay a cost. With the shorter period of protection, say TM, consumers will pay the monopoly price 1/2, but with the longer period of protection, say TD > TM, they will pay the duopoly price 1/3. Suppose that TM and TD are chosen so that the patent holder makes the same discounted profit in both regimes, and the cost of entry is such that exactly one imitator will enter if the patent lasts for length TD. Then by the above argument, consumers would be better off in the duopoly regime, despite the longer period of protection, because of the lower price. However, that argument does not account for the fact that the imitator must pay real resource costs to enter the market. Gallini (1992) argues that the duplication of costs is severe enough to overturn the above argument. Given that the price can only be reduced by costly entry, it is better for society as a whole—including consumers, the patent holder, and the imitator—to have a short period of monopoly pricing than a longer period that attracts entry. However, we have already stressed that the best design of intellectual property rights depends importantly on what one assumes about licensing. In this case, licensing again overturns the conclusion. Maurer and Scotchmer (2002) argue that the patent holder will anticipate entry and offer a license instead of tolerating unlicensed entry. In this way, the patent holder can increase his own profit without reducing the profit of the entrant, and at the same time can eliminate the wasteful duplication. The narrow patent thus has the effect of lowering price without imposing the social cost of duplication, and the above welfare analysis is restored. The better policy is a narrow patent for a relatively long time. D.  Rights of Others (and Defenses) The rights afforded others in protected works directly affect the profits from intellectual property. Many of these rules—such as blocking rights (patent and copyright) and exceptions for experimental use (patent), fair use (copyright), and reverse engineering (copyright and trade secret)—find their economic justification in the cumulativeness of innovation and hence are covered in Section III. Doctrines relating to independent invention, prior user rights, and ‘first sale’ (or exhaustion of rights) relate to stand-alone invention, as do proposals about extending user rights to limited sharing of copyrighted works. 1.  Rights arising from independent invention A right of independent invention means that, provided the independent inventor was actually an ‘inventor’ (and, in particular, did not learn the invention from any other party, such as a prior inventor), he or she is free to practice the invention. Both copyright law and trade secret law immunize independent inventors from liability, but patent law does not.

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132  Research handbook on the economics of IP law volume 1 In the case of trade secrets, it would be impossible for an independent inventor to know what had previously been invented. In the case of copyrights, which protect expression, any re-expression escapes liability (broadly speaking). In the case of patent law, the right is defined with respect to claims and (broadly speaking) not with respect to how a potential infringer achieved the potentially infringing innovation. Scholars have made three types of economic arguments about independent invention. First, in the context of trade secrecy, the absence of an independent invention defense would stifle innovation because inventors would be uncertain as to whether they could practice the new knowledge they create. Second, a right of independent invention can reduce the duplication of R&D costs in patent races (La Manna et al., 1989; Blair and Cotter, 2002; Maurer and Scotchmer, 2002; Leibovitz, 2002; Ottoz and Cugno, 2004). If the value of an exclusive right in the market is $100, and the R&D cost is $20, five firms may enter a race. But if all five firms have rights ex post, competition will reduce the private value of the right below $100, and fewer than five firms will enter. The right of independent invention reduces the duplication of costs and at the same time affords lower prices to users, all without undermining the incentive to invent. Landes and Posner (2003, pp. 361–2) make a similar argument for trade secrets. They compare the American rule, under which the owner of a trade secret loses his right to the invention if someone else patents it (W.L. Gore & Assocs. v. Garlock, Inc., 721 F.2d 1540 (Fed. Cir. 1983)), to the prior user right that prevails in some other nations. The prior user right divides the entitlement, enabling multiple independent inventors to share its value through an effective oligopoly structure. As in the foregoing argument, duplicative entry will only occur to the extent that all firms cover their costs. Third, giving rights to independent inventors can induce patent holders to license ex post on terms that reduce market price, in order to discourage ex post entry through independent invention (Maurer and Scotchmer, 2002). Suppose that a single patent holder is in the market. Then, whether or not the patent holder licenses, a right of independent invention will reduce the price in the market below the proprietary price. Without licensing, the price will fall due to entry by independent inventors. Instead, the patent holder can license at a fee equal to the cost of independent invention. Then independent inventors are indifferent to paying the license fee or paying the costs of independent invention, but the patent holder prefers licensing. The price reduction in the market (determined by the terms of license and number of licensees) must be large enough to deter further entry. The market price with licensing will thus depend on the cost of independent invention. If the cost is high enough, the right of independent invention can benefit users without undermining the incentive to invent. In fact, in plausible models, the cost of independent invention only needs to be greater than half the cost of the original innovator (Maurer and Scotchmer, 2002; Ottoz and Cugno, 2004). Nevertheless, Blair and Cotter (2002) rightly point out that the economic consequences depend critically on the relative costs of first inventors and imitators, which will differ across technologies. Giving a right of independent invention can have harmful consequences on innovation if imitation or independent invention is too cheap. Lichtman (1997) makes a similar argument in the context of unpatented inventions, advocating on grounds of cost that independent inventors be allowed to copy but not

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Economic models of innovation  133 clone them. Armond (2003) proposes that independent discovery be available as a defense to a preliminary injunction motion. Although independent inventors are not generally exempted from liability under US patent law, US law provides a limited prior user right where the technology was ‘commercially used . . . in the United States, either in connection with an internal commercial use or an actual arm’s length sale or other arm’s length commercial transfer of a useful end result of such commercial use’ and ‘such commercial use occurred at least 1 year before the earlier of either—(A) the effective filing date of the claimed invention; or (B) the date on which the claimed invention was disclosed to the public in a manner that qualified for the [grace period]’ (35 U.S.C. § 273(a)). In addition, state employment law provides an employer with a royalty-free, non­ exclusive, non-transferable license (‘shop right’) to use an employee’s invention where the employee makes a patented invention using the employer’s facilities. In most research environments today, employers require employees involved in research-related activities to assign their inventions to the employer, although some state laws limit such agreements to inventions developed within the scope of employment or developed using the employer’s facilities (e.g., Cal. Labor Code § 2870). Even where no express agreement has been signed by an employee, patents invented by the employee may nonetheless be deemed to have been assigned where an employee has specifically been employed to invent in the field in which the invention was made. In these circumstances, a court may imply an assignment clause into the employment contract. 2.  Rights after sale Under what is commonly referred to as the ‘first sale’ or ‘exhaustion’ doctrine, the intellectual property owner ‘exhausts’ the legal monopoly in a product by selling it to the public, thereby enabling the purchaser to use the work and resell it without infringing. Such a default right structure reduces transaction costs for subsequent transactions. Similarly, purchasers of patented products are deemed to have an implied license to make repairs, although this license does not extend to ‘reconstruction’ of the patented product. Intellectual property owners can, subject to anti-competitive restrictions, circumvent the first sale doctrine by imposing licensing restrictions upon the conveyance of a product. 3.  Rights to share copyrighted works Even though the purpose of copyright law is to prevent copying, a controversial idea that keeps resurfacing is that copying or sharing is less harmful to creators than meets the eye, at least where the sharing of each legitimate copy is limited. Where it is unlimited, such as in peer-to-peer networks or when users make copies of copies, sharing poses a greater threat to appropriability. The reason that sharing might be less harmful is that the proprietor will price in a way that anticipates sharing. Sharing allows the proprietor to charge a higher price, since demand is determined by the willingness to pay several parties. Limitations on sharing may arise because copies of copies degrade (Liebowitz, 1982, 1985; Liebowitz and Margolis, 1982 (arguing in the era of analog copies)) or because it is less costly to facilitate sharing than to produce a copy for every user, as in a video rental market (Varian, 2000), or because the probability of detection increases with the size of the sharing group.

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134  Research handbook on the economics of IP law volume 1 The earlier set of papers in this vein relied on the fact that copying is costly. Novos and Waldman (1984) and Johnson (1985) argue that proprietors may reduce price to avoid copying, but the cost of copying will nevertheless preserve the proprietor’s market. The market price will be lower than without copying, reducing the deadweight loss of excluding users, but the per-period reward to creative works will also be reduced, especially when there is heterogeneity in tastes as well as in copying costs. The welfare effects are different according to whether the cost of copying is per copy or per user, as when it requires the purchase of a copying device. Scholars have also argued that copying can have an affirmative benefit for right holders because it builds network effects (Conner and Rumelt, 1991; Shy and Thisse, 1999). A second set of papers focus on the fact that prices can be tailored to the groups that form. Liebowitz (1985) emphasizes price discrimination according to whether the purchaser will make the copy available to many users, as libraries do (see also Ordover and Willig, 1978). Bakos et al. (1999) argue that, depending on the groups, sharing might actually be more profitable than selling to individual users. This is true if, first, the willingnesses to pay within groups are negatively correlated or, second, if there is variance in the sizes of groups. Thus, whether sharing enhances profit depends on what governs group formation. However, Scotchmer (2005) argued that sharing groups will not be formed exogenously or even randomly, and if they form in a way that is efficient for the group members conditional on the proprietors’ prices, then group formation has no effect at all on profit opportunities. Sharing is neither profit-reducing nor profit-enhancing. Given that copying can have salutary effects as well as deleterious effects, these arguments have led authors to consider an additional set of policy levers specific to the copying context. These include taxes and subsidies on prices of legitimate copies, and taxes and subsidies on copying devices, as well as the optimal mix of enforcement activities and other incentives (Besen and Kirby, 1989a, 1989b; Chen and Png, 2003; Netanel, 2003; Fisher, 2004). E. Remedies As in other bodies of law, the remedial opportunities in intellectual property law are injunctions and damages. There are two branches of thought about the relative efficacy of these rules, one branch focusing on whether remedies will lead to efficient use of the property ex post and the other branch focusing on the ex ante effects. The first set of arguments (Calabresi and Melamed, 1972; Polinsky, 1980; Kaplow and Shavell, 1996) for the general framework, and Blair and Cotter (1998) for the intellectual property context, considered whether property rules (injunctions) are more or less likely than judicially imposed liability to encourage bargaining to an efficient outcome ex post. For example, property rules (injunctions) may be preferred when transaction costs of exchange are low and the costs of valuing violations of rights by courts are high. For the intellectual property context, Ayres and Klemperer (1999) add the consideration that ‘soft’ remedies, which do not actually restore the proprietary price, can be socially beneficial because they increase consumers’ surplus without impinging much on profit, at least for small price reductions. The second set of arguments are not concerned with what would happen in the out of equilibrium event of infringement but focus instead on how potential remedies affect

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Economic models of innovation  135 equilibrium profits and the ex ante incentives for R&D (Schankerman and Scotchmer, 2001; Anton and Yao, 2007). In these arguments, remedies are only important because they do or do not deter infringement, and because they determine the terms of an ex ante license. The terms of license that will be accepted by a potential licensee/infringer depend on the consequences of infringement, and this threat has an effect on the ex ante division of profit. Schankerman and Scotchmer (2001) argue that if infringement leads to profiteroding competition between the infringer and right holder, a wide range of remedies will deter infringement, at least for stand-alone innovations, and are therefore equivalent from an ex ante point of view. However, this is not necessarily true for research tools and other potentially licensed intellectual property where infringement does not dissipate profit. Merges and Duffy (2002) and Blair and Cotter (1998) argue, again from the ex post perspective, that patent and copyright law are better suited to a property-rule paradigm than a liability-rule paradigm. Since intellectual property rights are relatively well defined, disputants or potential disputants should have little trouble resolving their differences by negotiating licenses against the backdrop of an injunction. In contrast, if the setting of damages (an ex post ‘compulsory license’) is left to a generalist judicial institution under a liability rule, the court may have difficulty placing a value on the intellectual property or on the injuries caused by infringement. Further, judicially imposed licenses can undermine the prospect function of patent law (Kitch, 1977). Merges (1996) argues that for complex transactions involving many players, a property rule will facilitate the creation of private exchange institutions, such as patent pools, that can evolve in response to changing circumstances and draw upon industry and institutional expertise. Although infringed right holders generally have a right to enjoin unauthorized use, injunctions are backed up by compensatory damages for past violations. These may include enhanced (punitive) damages for patent infringement, statutory damages for copyright infringement, and attorney fees and costs in ‘exceptional cases.’ In several areas such as the covers of musical compositions, juke boxes, cable television broadcasts, satellite retransmission of television signals, and webcasting, copyright law provides for compulsory licensing. These regimes arguably economize on transaction costs, although commentators are divided on the economic effects of such compulsory licenses (compare Merges (1996, 2004b) with Netanel (2003)). Consistent with traditional economic analysis of damages (harm internalization), patent and copyright law award intellectual property owners the greater of lost profits or a reasonable royalty for the defendant’s unauthorized use of the protected works (Blair and Cotter, 1998). Calculating these measures, however, is quite complex, involving numerous subtle determinations of how markets would have evolved had infringement not taken place (Graham et al., 2017). It follows from general economic principles that enhanced damages should be awarded where improper behavior is costly to detect and where full compensatory damages are costly to prove (Polinsky and Shavell, 1997; Cooter, 1982; Cotter, 2004). Excessive damages (i.e., where expected damages exceed actual damages) could lead to overdeterrence in the sense that parties may exercise caution in order to avoid a risk of liability. Several studies indicate that courts may well be overdeterring patent infringement based on the high rate of enhanced damages awards (Lemley and Shapiro, 2007; U.S. Federal Trade Commission, 2003; Cotter, 2004; Moore, 2000). Due to the very different nature of trade secret protection, the remedies available for unauthorized use and dissemination of a trade secret are more limited. Where the secret

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136  Research handbook on the economics of IP law volume 1 has not been disclosed to the public, courts will generally enjoin further use of the secret by a misappropriating entity. But where the secret has been disclosed, the trade secret owner will be limited to damage remedies or limited injunctive relief against the entity that misappropriated the trade secret (such as a ‘head start’ injunction which excludes the misappropriator from the market for a designated period). Disclosure to the public destroys the secret and therefore it would be inappropriate (and infeasible) to enjoin use of the information by others. Nonetheless, Sidak (2008) argues an injunction against a misappropriating entity should be perpetual in order to encourage efficient post-litigation bargaining over the value of continued use. Such a rule would also avoid the expense and difficulty (error costs) of having courts adjudicate the option value of a trade secret. F.  Channeling Doctrines The various modes of intellectual property provide overlapping protection. For example, utility patent, copyright, and trade secret law all cover computer software. As noted earlier, however, copyright doctrines exclude ideas, processes, and methods of operation. Thus, software developers cannot gain copyright’s long duration of protection for the functional aspects of computer software. Such inventions must comply with utility patent law’s formal examination requirements and surpass utility patent law’s higher thresholds in order to obtain legal protection. In this way, intellectual property law prevents inventors from obtaining protection for functional features through the ‘backdoor’ of the copyright system. The relationship between patent and trade secret law is somewhat more complicated. Both regimes cover technological innovation. Where an inventor obtains a patent before a subsequent researcher invents the same technology, the patent trumps the subsequent inventor, regardless of whether the subsequent inventor seeks to protect the invention as a trade secret. (Such secrecy may well conceal infringement, particularly in the case of process inventions, but that does not suggest that the trade secret would have any validity vis-á-vis the patent.) A somewhat more complicated issue arises where the first inventor chooses to protect a particular technology as a trade secret. If a subsequent inventor independently discovers the same invention and obtains a patent, two overlapping issues arise: (1) does the trade secret invalidate the patent (on novelty grounds); and (2) if the patent is valid, can the trade secret owner continue to practice the invention—in essence, does the first inventor enjoy a prior user right. As suggested earlier, the trade secret will not invalidate the patent because it does not fall within the body of prior art that may be considered in judging novelty. Therefore, assuming the second inventor meets the other requirements of patentability, she will obtain a valid patent. As regards the rights of a trade secret owner, as noted previously, US patent law provides a limited prior user right (35 U.S.C. § 273(a)). The prior user right in this circumstance places the technology under duopoly rather than monopoly control. The profits available to the patentee are reduced accordingly. It can be argued, however, that such a structure of rights might partially improve the screening function of utility patent law—inventions that have been independently developed may not have needed as much of an ex ante incentive in the first place. To the extent that ex ante incentives are more than sufficient to generate the innovation, duopoly improves social welfare by reducing the deadweight loss from exclusive exploitation.

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III.  CUMULATIVE INNOVATION In the context of stand-alone inventions or creations, intellectual property rewards reflect the social value of the contribution, since the profit is determined by demand. That is one of the main virtues of intellectual property as an incentive system. However, when innovation is cumulative, the most important social benefit of an innovation may be the boost given to later innovators, and this may make the benefits harder to appropriate (Scotchmer, 1991). Moreover, the innovation may enable rivals to enter with improved products. In that case, social success may mean private failure—the boost given to the rivals may cause the innovation’s own demise (Scotchmer, 1991, 1996; Green and Scotchmer, 1995; Chang, 1995; O’Donoghue et al., 1998; O’Donoghue, 1998; Bessen and Maskin, 2009; Hunt, 1999, 2004). Merges and Nelson (1990) give an opposite perspective on the cumulative problem. Instead of worrying that later improvers pose a threat to earlier innovators, they worry that earlier innovators (earlier patents) pose a threat to later improvers. Galasso and Schankerman (2015) find that patent rights block follow-on innovation in a few specific technology fields (computers, electronics, and medical instruments), but not in drugs, chemicals, or mechanical technologies. They caution, however, against concluding that removing patent protection would be beneficial due to adverse incentive effects on upstream innovation (Green and Scotchmer, 1995), the benefits of signaling (Conti et al., 2013), and a shift toward trade secrecy (and less disclosure). The intellectual property system must resolve these contradictions. In general, the problem of appropriating benefits has two facets: the overall level of profit and how it is divided among the sequential innovators. The roles of the policy levers are closely intertwined in the cumulative context, and the best design of the system will depend on the transaction costs of licensing. Many scholars have emphasized the importance of cumulativeness in the process of knowledge creation, especially economic historians. As expressed by David (1985, p. 20), ‘Technologies . . . undergo . . . a gradual, evolutionary development which is intimately bound up with the course of their diffusion.’ Secondary inventions—including essential design improvements, refinements, and adaptations to a variety of uses—are often as crucial to the generation of social benefits as the initial discovery (Nelson and Winter, 1982; Taylor and Silberston, 1973; Mak and Walton, 1972; Rosenberg, 1972). Cumulative technologies tend to involve multiple components, serve as building blocks for further incremental innovation, and often spur wide-ranging applications. Automobiles, aircraft, electric light systems, semiconductors, and computers fall within this category. Some chemical technologies are hybrids of discrete and cumulative models. New chemical compounds are typically discrete in terms of the product market that they serve, but they can suggest promising new lines of research (e.g., penicillin, Teflon) (Nelson and Winter, 1982). The biotechnology field reflects several cumulative features. The development of research tools provides the means for decoding genomic information. Research decoding genomes provides the input for downstream biomedical research. Cumulativeness also extends to expressive creativity. All authors and artists draw, to some extent, on prior works. Sequels, translations, and screenplays build directly upon prior works. Parodies and satires comment on or employ other works. Most musical compositions reflect rhythm and other elements of established genres. The hip-hop and rap musical genres embody prior recordings through the use of digital sampling.

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138  Research handbook on the economics of IP law volume 1 A.  A Preliminary Model: The Virtues of Licensing One of the lessons that emerges powerfully below is that the best design of the intellectual property system depends on the fluidity of the market for licenses. Before turning to a more detailed analysis of design issues and how licensing affects them, we illustrate the importance of licensing by modifying the ‘reduced form’ model of Landes and Posner (2003), where a variable z is taken as the ‘strength’ of a right. For example, the strength of the right may be affected by breadth or exemptions such as fair use. Let q(·) be the demand function for a protected innovation, where q(p) is decreasing with p. Referring back to our discussion of copying, and how the threat of copying affects the market price, let y(p, z) be the supply of illicit copies. Then the net demand faced by the proprietor is q(p) 2 y(p, z). Assuming for convenience that the marginal cost of copies is zero, the proprietor maximizes p[q(p) 2 y(p, z)], and sets a profit-maximizing price p*(z) that depends on the strength of protection through the threat of copying. Now consider how the profit-maximizing price and the proprietor’s profit depend on the strength of protection, z. Assume that the supply y(p, z) of illicit copies increases with p and decreases with z. Because the supply of imitations y(p*(z), z) depends on the proprietor’s price as well as the level of protection, there is a potential indeterminacy in the model. An increase in protection could conceivably lead to a decrease in price and an increase in illicit copying. However, under reasonable assumptions we can assume that the profit-maximizing price increases with the level of protection, even though the increase in price has a feedback effect of increasing imitation or copying. Nevertheless, the profitability of creations and hence their supply will not necessarily increase with the level of protection z. This is because the cost of creation can also depend on z, for example, by creating a burden to innovate outside the scope of other rights. Suppose, in fact, that each potential innovator faces an R&D cost k plus additional costs e(z) that reflect the burdens imposed by other intellectual property rights. The creation is profitable if p*(z)[q(p*(z)) 2 y(p*(z), z)] 2 k 2 e(z) . 0 If potential creations differ in their markets (e.g., if we introduce a quality variable s into the demand function q), then the more valuable ideas will call forth investment, while the less valuable ones will not. Without formalizing this idea, we will let N(z|k) describe the number of profitable creations with cost k. The supply of new creations N(z|k) is not monotonic in the strength of protection z because raising z increases the creator’s costs. The punch line of this model is that too much protection can be bad for creators as well as for imitators. The point we would like to make, however, is that the punch line is largely reversed if firms can license to avoid conflicting property rights, rather than being forced into the costly activity of avoiding them. Following the perspective in O’Donoghue, et al. (1998), assume that each innovating firm will initially be in the position of paying license fees on the discoveries of its predecessors and then in the position of collecting license fees from its followers. The effect of strong rights, z, is to increase the licensing obligations, rather than to increase the real resource cost of avoiding prior rights. The essential point is that licensing also creates claims against future innovators.

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Economic models of innovation  139 Suppose, in fact, that all innovators are in symmetric positions: they pay for the same number of licenses and are paid by the same number of licensees. Then, since all the money must go somewhere in the end, symmetry means each innovator pays as much in licensing fees as it earns in licensing fees, say, l(z) on both sides of the ledger. The profitmaximizing decision is then to invest in the potential creation if p*(z)[q(p*(z)) 2 y(p*(z), z)] 1 l(z) 2 k 2 l(z) . 0 or equivalently, p*(z)[q(p*(z)) 2 y(p*(z), z)] 2 k . 0 Hence (assuming that the revenue p*(z)[q(p*(z)) 2 y(p*(z), z)] is increasing in z), the ambiguous effect of strong protection on innovation disappears. A strengthening of protection leads to more creations. Thus, with licensing, we are cast back to the same consideration as with stand-alone inventions, namely that there is a tradeoff between deadweight loss and innovation but no tension between protecting early innovators and protecting the later innovators who use the knowledge they create. Licensing will largely resolve that tension, to everyone’s benefit. These points about the salutary effects of licensing have mostly been made in models that distinguish between the policy levers of intellectual property, rather than lumping the policy levers into a single variable called the ‘strength’ of the right. We now turn to that more disaggregated discussion. B. Duration Although the length of protection has an obvious effect on the overall level of profit, the statutory length may be irrelevant. When innovations are under threat of being supplanted by improved innovations, market incumbency only lasts until that happens. O’Donoghue et al. (1998) define a notion of ‘effective patent life’ that focuses on the rate of market turnover and argue that the effective life of the patent may be determined by the breadth of the right, rather than its statutory length. This is because breadth determines how long it will take before the product is supplanted. In fact, there is considerable evidence that the ‘effective’ lives of most patents are shorter than their statutory lives. Mansfield (1986) reports, using survey evidence, that in some industries 60 percent of patents are effectively terminated within four years. The literature on patent renewals carries a similar message (Pakes and Schankerman, 1984; Schankerman and Pakes, 1986; Pakes, 1986; Schankerman, 1998; Lanjouw, 1998). For example, Schankerman (1998) reports that half of patents in France are not renewed beyond the tenth year, even though renewal fees are very low. Bessen and Maskin (2009) present a model of sequentialness where this endogeneity of patent life is absent (because the products do not compete in the market) but argue that statutory life should be shorter when innovators learn from previous innovators. Their model has sequentialness in innovation (because innovators learn from each other) but the resulting products are ‘stand-alone’ and live out their statutory lives. They argue that

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140  Research handbook on the economics of IP law volume 1 the optimal statutory life should be shorter if innovators learn from each other than if not, because the loss from impeding future innovation is greater. (This result depends sensitively on the absence of licensing; see below for an argument that all results in this arena turn on what is assumed about licensing.) For the case of basic and applied research, Green and Scotchmer (1995) argue that patent lives must last longer if the research is divided between sequential innovators rather than concentrated in a single firm, because of the problem of dividing profit in a way that respects the costs of both parties. To the extent that transaction costs may impede licensing and first stage inventors do not need large ex ante rewards to induce innovation, a shorter duration of intellectual property protection promotes cumulative innovation. Legal protection for computer software fits this profile (Menell, 1987). There are relatively strong non-intellectual property incentives for developing operating system and other platform technology for many product markets. Interoperability with widely adopted platforms is often critical to secondary innovation, such as application programs and peripheral devices. Owners of the intellectual property rights in widely adopted proprietary platform technologies can exercise tremendous market power due to network effects and consumer lock-in. Shortening the duration of protection for such technologies is one mechanism for constraining such market power and better equilibrating the incentives of first- and second-generation innovators. C.  Threshold Requirements and Breadth The status of an invention that builds on other inventions can be: (1) protected and noninfringing, (2) unprotected and noninfringing, (3) protected and infringing, or (4) unprotected and infringing (Scotchmer, 1996; Denicolò, 2002a). Thus, the economic effects of threshold (patentability) and breadth are hard to disentangle. Scenario (1) gives the best incentive for second-generation innovators but does not force the second-generation innovator to share the profit with the prior innovator. Scenario (2) will clearly stymie second-generation innovation unless there is a mechanism other than intellectual property to protect the innovator. In scenario (3)—which is possible under patent law—the works are considered ‘blocking’: the later work infringes the prior innovation and cannot be exploited without a license, and the later work is protected and cannot be exploited by the pioneering inventor without a license. Such a scenario encourages the inventors to share profit from the subsequent invention. Scenario (4), which approximates the treatment of derivative works under copyright law, discourages improvements or adaptations by subsequent inventors in the absence of ex ante bargaining. However, there is less difference between scenario (3) and scheme (4) than meets the eye. Even if the later product is not protectable, it can be protected by an exclusive license on the innovation it infringes. The literature draws widely differing conclusions about the optimal way to organize the rights of sequential innovations, largely because authors make different assumptions about when and whether licenses will be made and who can be party to the negotiation. Kitch (1977) was the earliest, and perhaps most extreme, licensing optimist. Licenses can be made either ex ante, before the follow-on innovator invests in his project, or ex post. If licenses must be negotiated ex post, after both innovations have been achieved, scenario (4) may stifle innovation, since the second innovator will fear that

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Economic models of innovation  141 the first innovator will simply appropriate it (Green and Scotchmer, 1995). On the other hand, if the second innovator can approach the first innovator for an ex ante license before investing in his idea, the second innovation is not in jeopardy under either of scenario (3) or (4). However, the first innovator will typically collect more of the profit in scheme (4) because the second innovator will have less bargaining power (Scotchmer, 1996). Denicolò (2002) considers a model where ideas are common knowledge, and asks how the various scenarios affect patent races, assuming that there will be ex post licenses but no ex ante licenses. He finds that the choice should depend on the relative costs of the innovators. If, for example, the cost of the first innovation is low and the cost of the second is relatively high, it may be better not to let the first innovator share in the second innovator’s profit. Of course, this also depends on whether the first innovation can earn profit in the market or only through licensing. Chang (1995) also considers a context where the firms could make ex post licenses, but not ex ante licenses, and concludes that the choice between (1) and (3) should depend on the relative costs of the innovators. The worst situation is when licensing may fail entirely, and when, in any case, the earlier innovator does not need to profit from licensing in order to cover his costs. Merges and Nelson (1990) draw on many actual examples to argue that such circumstances are quite plausible. A defect of the one-size-fits-all intellectual property regime is that it cannot distinguish cases where blocking rights are unnecessary for cost recovery from cases where earlier innovators would not invest unless they can profit from licensing. In part on this basis, Burk and Lemley (2002) argue that it would be better to make intellectual property protection more finely attuned to industrial contexts. But even in those cases where earlier innovators should be allowed to profit from the later innovations they enable, blocking rights are a blunt instrument for dividing profit. Profit shares will not necessarily reflect the cost shares. This is especially true if the licenses will be negotiated ex post, after all innovators’ costs are sunk (Green and Scotchmer, 1995), although Chang (1995) argues that the problem can be mitigated by making the infringement (breadth) responsive to cost. In copyright law, blocking rights are not available as a tool at all. Follow-on creators may not prepare infringing derivative works without permission of the owner of the copyright in the underlying work. Copyright law therefore has less flexibility than patent law in how it balances the incentives for sequential innovators (Lemley, 1997). In the case of product improvements, there is a question of whether a patent’s breadth can extend to slightly better products that have not yet been invented or only to inferior products. O’Donoghue et al. (1998) define a notion of ‘leading breadth’ that determines when there will be blocking rights in the cumulative context and also establishes the ‘effective life’ of the patent right. To see why leading breadth is useful as a policy lever, suppose to the contrary that every trivial infringement is noninfringing, even if patentable. A potential improver may discard ideas for small improvements because they lead to price-eroding competition between close, vertical substitutes. It is only the relatively big ideas that will become innovations. This problem can be solved by making the small improvements infringing. Firms may then be willing to invest in them, since control of the improvement and its predecessor can then be consolidated through licensing in the same firm. Instead of competing, both will be marketed together. Further, if the small improvements are infringing, and if it takes a relatively long time for large ideas to come along, the ‘effective life’ of each patent is prolonged. These effects cannot be achieved

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142  Research handbook on the economics of IP law volume 1 by choosing the patentability standard alone; the opportunity to consolidate successive improvements in the hands of a single firm arises because the patents are infringing. In the ‘ideas’ model, there is not much role for a nuanced patentability standard. However, in a ‘production function’ model, a patentability standard can make each successive innovator more ambitious in the size of improvement he invests in. This may be socially beneficial (O’Donoghue, 1998). Hunt (1999, 2004) presents a production function model motivated by the Semiconductor Chip Protection Act, in which eligibility for protection coincides with noninfringement of previous innovations (as with copyright). He argues that the standard for protection should be increasing in the ‘dynamicness’ of the industry. Since noninfringement coincides with protection, it is hard to sort out their respective roles. Whereas the effective patent life is determined by breadth in the model of O’Donoghue et al. (1998), it is determined in the Hunt model by both. Finally, we return to the idea of Kitch (1977), who argues that strong patent rights should be given to pioneers so that they can coordinate the subsequent development of the technology. These are called ‘prospect’ patents. The theory is not focused on the reward purpose of the patent, since it would apply even if the pioneer innovation were costless to achieve and no incentive for R&D were required. The theory thus rejects the line of reasoning that says intellectual property is at best a necessary evil, due to deadweight loss. The prospecting theory rests on the premise that social interests and the private interests of the patent holder are aligned. Scotchmer (2004, sec. 5.6) shows that this may be true in some ways, but is not true in other ways, and, in particular, that strong pioneer patents can preempt competition policy. As in later theories of cumulativeness, the prospector’s profit comes from getting the intellectual property into use. For this reason, the pioneer has an incentive to encourage use at a fee. Further, the pioneer can profit from delegating research effort to the most productive researchers and avoiding bad projects, as are socially efficient.2 These are ways in which the pioneer’s interest is aligned with the broader public interest. However, the pioneer can preempt competition policy in two ways: by avoiding competition in the ‘innovation market’ for second-generation products and by avoiding competition among second-generation innovators once the second-generation innovations exist. The first of these may or may not be socially harmful depending on the patent/antitrust interplay, but the second is clearly harmful to competition, assuming that patent law is well designed in the first place. If these harms to competition are important, it might be better to avoid pioneer patents even if second-generation innovators must then duplicate the cost of achieving the pioneer innovation. As with all intellectual property, the case for pioneer patents is strongest if the pioneer innovation is costly to achieve and the patent is actually needed as a reward. For radical improvements that read on existing patents, Merges (1994) suggests that it may be socially advantageous to exempt an improver from infringement under the ‘reverse doctrine of equivalents.’ Under this doctrine, a radical improvement may be deemed noninfringing even though it literally reads upon an existing patent. The doctrine would allow the radical improver to avoid a holdup by the underlying patent holder and to avoid

2   In fact, this is always true if the prospector can make deals with consumers as well as followon inventors, for example, if consumers can pay the prospector not to retard progress.

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Economic models of innovation  143 a potential bargaining breakdown (see also Lemley, 1997). This is again an argument that relies on difficulties in licensing. Such a doctrine avoids over-rewarding a first-generation inventor (who did not foresee a much greater advance) while providing strong encouragement to visionary subsequent inventors. The rule has rarely been applied in actual cases, although the possibility of its application may well have fostered licensing. 1.  Evolving doctrines regarding subject matter We turn now to how these economic arguments have been reflected in legal doctrines. Notwithstanding the broad scope of utility patents set forth in the Patent Act (‘any new and useful process, machine, manufacture, or composition of matter, or any new and useful improvement thereof’), the courts have barred inventors from claiming patents on natural physical phenomena (e.g., the properties of lightning), laws of nature (e.g., the theory of general relativity), mental processes, and abstract intellectual concepts (e.g., algorithms). Courts have noted that allowing exclusive rights for such fundamental discoveries would unduly impede future inventors—a cumulative innovation rationale (O’Reilly v. Morse, 56 U.S. (15 How.) 62 (1854)). Implicit in this justification is the notion that transaction costs could impede licensing. The courts have thus realized, as is more explicit in the economic models discussed above, that licensing plays an important role in balancing the rights of sequential innovators. Heller and Eisenberg (1998) argue that patenting of gene sequences generates a tragedy of the anticommons, a fragmentation of rights which vastly increases transaction costs, thereby impeding downstream research for medical advances. This is also, at root, an argument about the ease of licensing. Walsh et al. (2003) report survey research indicating that university research has not been impeded by concerns about patents on research tools as a result of licenses, inventing around patents, infringement (often informally invoking a research exemption), developing and using public tools, and challenging patents in court. The opening of the ‘business method’ patent floodgates raised concerns about whether patent protection is needed at all to promote such innovation and, more troubling, whether such protection is chilling innovation and competition. The idea of protecting business plans runs counter to a core premise of the free market system by offering a form of antitrust immunity for business models. As the rising tide of prior art raises the threshold for protection, such adverse effects may abate and innovation could well produce valuable new business methods. The Supreme Court has sought to restrain overbroad patent protection through a series of decisions tightening eligibility standards. The Court’s 2012 decision in Mayo Collaborative Services v. Prometheus Laboratories, 566 U.S. 66 (2012), imposed a new limitation on the scope of the patent system: that a useful application of a scientific discovery is ineligible for patent protection unless the inventor also claims an ‘inventive’ application of the discovery. The following year, the Court ruled that discoveries of the location and sequence of DNA compositions that are useful in diagnosing diseases are ineligible for patent protection (Ass’n for Molecular Pathology v. Myriad Genetics, 569 U.S. 576 (2013)). And in its 2014 Alice Corp. v. CLS Bank International, 573 U.S. 208, decision, the Court ruled that software-related claims are ineligible for patent protection unless the abstract ideas or mathematical formulas disclosed are inventively applied. The Court explained these interpretations on concern about impinging upon (‘preempting’) cumulative innovation (Mayo, 566 U.S. at 71).

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144  Research handbook on the economics of IP law volume 1 These decisions, however, conflate eligibility with other patentability requirements. An eligibility requirement of ‘inventive application’ eligibility threshold substantially overlaps the Patent Act’s Section 103 nonobviousness standard. In fact, it arguably is broader in that the Court’s articulation of ‘inventive application’ excludes consideration of scientific discoveries and algorithms, whereas Section 103 looks at the claimed invention as a whole. The Patent Act’s Section 112 provides the tools for ensuring that patents do not extend beyond their proper scope. That an inventor’s claim might practically preempt all use of a discovery will ‘show more clearly the great importance of his discovery, but it will not invalidate his patent’ (Dolbear v. Am. Bell Tel. Co., 126 U.S. 1, 535 (1888)). Thus, the Supreme Court’s recent eligibility jurisprudence raises serious concerns for medical diagnostic research and other innovation fields that build directly on scientific discoveries (Lefstin et al., 2018). These decisions directly confront the tension between promoting pioneering and follow-on innovation. Copyright law applies a different rights structure than patent law, with significant implication for the direction of cumulative innovation (Lemley, 1997). Unlike utility patent law, which allows anyone to patent improvements to patented technology, copyright owners have the exclusive right to prepare derivative works. Therefore, a novelist can prevent others from translating their work into another language, adapting the story for the stage or a motion picture, selling the story in narrated form (e.g., books on tape), and developing sequels that draw extensively on the protectable elements (including possibly character names and attributes—e.g., Rocky IV or the next James Bond film). As we will see below, some borrowing is tolerated under the fair use doctrine and various exemptions and compulsory licenses, but pioneers generally have exclusive authority to pursue the further development of their expressive work. Copyright law wholly excludes protection for ideas and functional attributes of a work but protects creators against direct or near exact copying of even a significant fragment of the whole for a tremendously long duration (life of the author plus 70 years), reflecting the notion that society prefers to have 100 different war novels embodying similar themes, ideas, and facts than 100 versions of War and Peace that differ only in their final chapter. Consequently, copyright protection for an author’s expression of ideas and the relatively long period of its duration effectuates a different balance than patent law. Patent law encourages cumulative innovation by allowing follow-on to secure rights on improvements and to enable any competitor to build upon the innovation in its entirety within a comparatively short period of time (20 years from the time of the application). By contrast, copyright law, with its narrow scope of protection, allows subsequent creators to pursue competing works using the same ideas as the ‘pioneer,’ but copyright law also allows the pioneer exclusive rights over the development of the expressed ideas. Fishman (2015) identifies a creativity paradox: that limits on follow-on expression can promote robust original pioneering creativity. He notes, for example, that George Lucas developed the plot for Star Wars only after he failed to get a license for a remake of Flash Gordon. Constraints of freedom to build on the works of others can promote creative breakthroughs. 2.  Adequacy of disclosure requirements Both patent law and copyright law provide for the disclosure and dissemination of knowledge, which promotes cumulative innovation (Menell, 2019a). Patent law requires

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Economic models of innovation  145 disclosure as the quid pro quo for patent protection. In the software field, however, disclosure of source code is not required under the best mode requirement—the inventor need only disclose the functions of the software on the grounds that a person of ordinary skill in the art could write software to perform the functions without undue experimentation. In practice, however, the knowledge protected by many software patents would be difficult and costly to decipher without access to the source code, which is usually maintained as a trade secret. This slows the process by which follow-on inventors can build upon earlier generations. In the case of most copyrighted works, the knowledge contained in the work may be comprehended from direct inspection (Menell, 2016a). Therefore, the publication of a work discloses and disseminates. Furthermore, the Copyright Act requires those who register a work, which is optional, to deposit a copy with the Library of Congress. Some copyrighted works, however, do not lend themselves to visual inspection and comprehension. Computer software cannot typically be perceived unless it is available in source code. Copyright Office regulations, however, do not require disclosure of the entirety of source code in order to secure copyright registration. Thus, as with utility patent law, copyright law allows protection of software without providing access to the underlying knowledge. As a result, follow-on invention is stifled, although such rules may deter infringement that would otherwise be difficult to detect. D.  Rights of Others (and Limitations and Defenses) Several doctrines provide safety valves, beyond the limitations embodied in scope of protection, for promoting cumulative innovation. These include the patent law’s experimental use doctrine, copyright law’s fair use doctrine, and the reverse engineering doctrines of trade secret law and copyright law. In addition, copyright law provides for several exemptions for educational and related purposes which can be viewed as promoting basic education for new authors and artists. Copyright law also provides several compulsory licenses. 1.  Experimental use A subsequent inventor who wants to improve a patented technology may benefit from experimenting with it. United States patent law has had a common law exemption for ‘philosophical experiments’ and research to ascertain ‘the sufficiency of [a] machine to produce its described effects’ (Whittemore v. Cutter, 29 F. Cas. 1120 (C.C.D. Mass. 1813)).3 Subsequent cases, however, have declared the defense to be ‘truly narrow’ and applicable solely to activities ‘for amusement, to satisfy idle curiosity, or for strictly philosophical inquiry,’ (Roche Prods., Inc. v. Bolar Pharm. Co., 733 F.2d 858, 863 (Fed. Cir. 1984); Madey v. Duke Univ., 307 F.3d 1351 (2002)), prompting several scholars to warn that patent law unduly hinders academic and basic research and unduly supplants academic and scientific norms promoting progress, disclosure, and cumulative innovation. Eisenberg (1989) proposes to exempt research that could potentially lead to improvements or design-arounds of patented technology, but she also points out the inherent

3   Article 27(b) of the European Patent Convention exempts ‘acts done for experimental purposes relating to the subject matter of the patented invention.’

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146  Research handbook on the economics of IP law volume 1 contradiction that arises when further research is the main use of the patented invention. A broad exemption could entirely undermine the profitability of the patent. However, the effect of a research exemption depends on an ancillary doctrinal question, namely, whether the invention that is achieved by using the prior invention will infringe the prior patent (Scotchmer, 2004, ch. 5). If so, the exemption may (counterintuitively) increase the patent holder’s profit. Exercising the research exemption can put the improver in the position of bargaining for a license ex post (after he has sunk his costs) rather than ex ante. This strengthens the bargaining position of the first patent holder. Kieff (2001b) contends that the exclusive rights provided by patents promote university research by increasing private investment in research and improving the efficiency of academic research environments. His analysis does not, however, directly address whether a more permissive experimental use doctrine would adversely affect the flow of private research investment into universities. Based on survey research, Walsh et al. (2003) find little evidence that patents on research tools have significantly impeded university research. There is one notable exception: the field of genetic diagnostics. Cai (2004) notes that the chilling effect of a narrow experimental use defense may not be very significant due to patent holders’ rational forbearance in enforcing against universities as well as legal constraints (sovereign immunity) on suing state actors (compare Menell, 2000). Many legal scholars in addition to Eisenberg propose alterations to existing law. Mueller (2001) endorses a broadened experimental use defense along the lines of the European system as well as compulsory licensing. Feit (1989) proposes a compulsory license for patents infringed during experimentation to improve patented technology. These authors, like Eisenberg, raise particular concerns about patents on upstream research tools, particularly in the bioscience field. O’Rourke (2000) proposes a fair use doctrine for patents that would go beyond the similar doctrine for copyright by allowing courts to judge permissible conduct and impose compulsory royalties. Dreyfuss (2003) proposes to allow experimental use if the investigator’s institution promptly waives patents on subsequent discoveries, subject to a ‘buyout’ provision. In cases where a patentee has refused to license to a nonprofit on reasonable terms, Nelson (2004) proposes a research exemption, provided the researcher agrees to publish his results and agrees either not to patent his own results or to license them on nonexclusive and reasonable terms. Strandburg (2004) proposes to exempt improvement patents and to provide for compulsory licensing of research tools. Other authors (Epstein, 2003; Merges, 1996) counter that such proposals would entail significant administrative costs and have complex effects upon licensing markets and the formation of licensing institutions. 2.  Fair use The fair use doctrine in copyright law exempts a user from liability for infringement when copyrighted works are used for criticism, comment, news reporting, teaching, scholarship, research, and other transformative uses (17 U.S.C. § 107). In applying this doctrine, courts balance the purpose and character of the use (including whether such use is of a commercial nature or is for nonprofit educational purposes), the nature of the copyrighted work, the amount of copying, and, most importantly, the effect of the use upon the potential market for or value of the copyrighted work. Transformative or product uses are more likely to be permissible, whereas uses that merely supplant the underlying work are disfavored. In this way, the fair use doctrine promotes significant creative advances while

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Economic models of innovation  147 protecting the pioneer from direct market competition. The fair use doctrine can also be seen as an efficient means for permitting uncompensated use of copyrighted material where the transactions costs of licensing or other means of exchange would prevent a transfer through the market (Gordon, 1982). Courts have applied the fair use doctrine to enable software developers to make copies of protected programs for purposes of learning how such software functions (Samuelson and Scotchmer, 2002). With such code deciphered, the rivals can discern unprotectable elements (e.g., interoperability specifications) which they can implement, using a clean room process,4 in their own commercial products. In this way, the fair use doctrine operates as a form of ‘experimental use’ exemption. The long duration of copyright protection can impede cumulative creativity. Liu (2002) and Hughes (2003) suggest that courts can ameliorate this concern by expanding the scope of fair use as copyrights age. Menell (1987, 2019b) advocates a genericide doctrine for software interface features that become widely adopted as a means to promote positive network externalities. 3.  Reverse engineering As with copyright law, trade secret law allows others not bound by contractual constraints to reverse engineer technology in order to determine how it functions. To the extent that they decipher trade secrets, they undermine the inventor’s advantage. By disclosing the information, they destroy the trade secret. The reverse engineering limitation on trade secret protection thus exposes the trade secret owner to free riding by others. Nonetheless, most commentators believe that it strikes a salutary balance between protection on the one hand and competition and the dissemination of knowledge on the other (Landes and Posner, 2003; Samuelson and Scotchmer, 2002). The trade secret owner can ‘purchase’ greater protection against this risk by investing in higher levels of security (e.g., more effective encryption for software-encoded technology). The inventor can also pursue patent protection, which proscribes reverse engineering, although only for the limited duration of the patent, and mandates disclosure of the invention to the public. By declining to pursue patent protection (or failing to satisfy the requirements thereof), however, inventors should not be able to secure potentially perpetual rights in technologies merely by encrypting them or otherwise obscuring how they function. To do so would undermine the larger balance of the federal intellectual property system. 4. Other limitations: exemptions, compulsory licenses, voluntary licenses, open source, and dedication to the public domain Intellectual property regimes can afford cumulative creators freedom to pursue follow-on projects through statutory exemptions and licensing options. In addition, intellectual property owners can sometimes benefit by promoting collaboration and widespread adoption of their technology or works.

4   Using only functional specifications that are outside of copyright protection (17 U.S.C. § 102(b)), clean room programmers can independently produce code that accomplishes the same functions as a target program without infringing copyright protection in the target program’s code (Sammi et al., 2013).

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148  Research handbook on the economics of IP law volume 1 The utility patent system has strong rights with relatively few limitations. Nonetheless, a variety of proprietors have chosen to share their technology with competitors and downstream innovators (Rice, 2015; Merges, 2004a). These firms can benefit through network effects (Menell 2019b) and preempting or undermining adversaries. These initiatives are often coordinated through open source or standard-setting organizations (SSOs) (Contreras, 2019; Mattioli, 2012). The free and open source software (FOSS) movement promotes ex ante dedication of technological advances to the public domain and commitment to open development principles. A growing number of companies have joined these efforts on an ex post basis by pledging their patents to the public. Technology companies have developed the Defensive Patent License and License on Transfer pledges as a means of reducing the costs and risks of opportunistic patent assertions (Schultz and Urban, 2012). SSOs seek to lessen the tension between employing the best technological solutions in industry standards and ensuring widespread access to standards by requiring members to disclose standard-essential patents (SEPs) and license them on fair, reasonable, and non-discriminatory (FRAND) terms (Contreras, 2019). The Copyright Act provides numerous exemptions for public interest (performance rights for designated educational, religious, and civic uses, reproduction for people with disabilities) and transaction cost (sound recording performance rights for small businesses, running software on computers) purposes. It also affords compulsory licenses to promote dissemination of existing works (juke boxes, cable television, satellite retransmission, public broadcasting, and webcasting) and cumulative creativity. The compulsory license mechanism for cover versions of musical compositions has spurred tremendous cumulative innovation in sound recordings. Once a musical composition has been released with consent of the copyright owner as a sound recording, any sound recording artist may record and distribute copies of that composition without consent of any copyright owner. This privilege is made possible by limiting the scope of the sound recording copyright to exact duplication5 and establishing a compulsory license rate for copies made of the underlying musical composition (currently 9.1 cents per copy) (17 U.S.C. § 115). The creative freedom associated with this privilege, however, is constrained by the statute—the follow-on recording artist may make ‘a musical arrangement of the work to the extent necessary to conform it to the style or manner of interpretation of the performance involved, but the arrangement shall not change the basic melody or fundamental character of the work’ (17 U.S.C. § 115(a)(2)). This privilege also does not extend to the use of prior sound recordings—as, for example, in digital sampling—without the consent of both the musical composition copyright owner and the sound recording copyright owner. Nonetheless, this compulsory license has fostered a wider body of interpretations of musical compositions than would have occurred if musical composition copyright owners held exclusive (blocking) rights. Menell (2016b) proposes bringing order to music mashup through a new compulsory license. 5   ‘The exclusive right of the owner of copyright in a sound recording . . . is limited to the right to prepare a derivative work in which the actual sounds fixed in the sound recording are rearranged, remixed, or otherwise altered in sequence or quality. The exclusive rights of the owner of copyright in a sound recording . . . do not extend to the making or duplication of another sound recording that consists entirely of an independent fixation of other sounds, even though such sounds imitate or simulate those in the copyrighted sound recording . . .’ (17 U.S.C. § 114(b)).

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Economic models of innovation  149 Building on the open source model, Creative Commons provides tools to assist authors in promoting the reuse and remixing of their works at the time of creation by opting into a different set of defaults than those provided by the Copyright Act (Van Houweling, 2008). Creative Commons also provides tools to assist creators in finding licensed works that can be shared, remixed, or reused. E. Remedies As noted above, the main remedies for patent and copyright infringement are injunctions and compensation for past injury, possibly compounded to treble damages in case of willfulness. As these laws are interpreted, courts operate from a baseline of prospective injunctive relief and compensatory damages for past injury. Hence, they do not generally adjust the level of damages as a policy lever, except in the context of enhanced damages, which we discuss below. With regard to awarding damages for past infringement, the court will often be in the position of having to decide whether, absent the infringement, the right holder would have licensed. If not, the lost profit may be the value lost to the patent holder because the follow-on product was preempted by the infringer. If licensing would (should) have occurred, the lost profit is lost royalty. These are two different inquiries. Lost royalty is even more speculative in the cumulative context than in the stand-alone context, for a sound theoretical reason (Schankerman and Scotchmer, 2001). On one hand, the potential damage award establishes the maximum license fee. On the other hand, the equilibrium license fee establishes the damage award. Hence, there is an inherent circularity that leads to multiple equilibria. Because of multiple equilibria, the profitability of the patent is unknowable in advance to a researcher investing in it. This problem is especially acute for research tools and will be less acute for inventions where infringement leads to competition and dissipates total profit. Because of the dissipation, infringement is its own punishment, and infringement is more easily deterred. The awarding of enhanced damages in patent law (up to treble) and statutory damages in copyright law can be a policy lever, although it is restricted to penalizing willful infringement. It is not generally seen as a way of addressing the cumulative innovation problem. The patent law standard for awarding enhanced damages produces a deleterious effect upon cumulative innovation. To reduce exposure for treble damages (which is based upon a finding of willfulness), patent attorneys routinely advise their clients (including research engineers and scientists) to avoid reading patent prior art, in effect negating a valuable aspect of the disclosure function of the patent system (Lemley and Tangri, 2003). This is a form of overdeterrence of socially beneficial behavior—learning from prior discoveries. The dissuasion to consult patent prior art undoubtedly results in duplication of research and may lead a researcher to overlook valuable potential solutions to scientific and technical problems. The growing use of SSOs to establish technical standards subject to FRAND licensing has promoted follow-on innovation by reducing the potential for exclusionary and extortionate remedies. Although most SSOs have not expressly barred injunctive relief or set FRAND licensing schedules, the Institute of Electrical and Electronics Engineers (IEEE) barred its members from holding patents covering IEEE standards from seeking or threatening to seek injunctions or exclusion orders against potential licensees who are

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150  Research handbook on the economics of IP law volume 1 willing to negotiate for licenses (IEEE, 2015). Furthermore, courts take FRAND commitments into account in evaluating requests for injunctive relief under the eBay standard (see Apple Inc. v. Motorola, Inc., 757 F.3d 1286, 1331–2 (Fed. Cir. 2014); but compare Apple Inc. v. Samsung Elecs. Co., 809 F.3d 633 (Fed. Cir. 2015) (emphasizing right to exclude and the importance of injunctions)). Moreover, although SSOs do not set the FRAND license rates, courts have interpreted the principal goal of standard-setting agreements to be widespread adoption of the standard and barring FRAND licensors from capturing the coordination and network value of the standard (CSIRO v. Cisco Sys., Inc., 809 F.3d 1295 (Fed. Cir. 2015); Ericsson, Inc. v. D-Link Sys., Inc., 773 F.3d 1201, 1229–35 (Fed. Cir. 2014); Microsoft Corp. v. Motorola, Inc., No. C10-1823JLR, 2013 U.S. Dist. LEXIS 60233, 2013 WL 2111217 (W.D. Wash. Apr. 25, 2013); In re Innovatio IP Ventures LLC Patent Litig., No. 11 C 9308, 2013 U.S. Dist. LEXIS 144061, 2013 WL 5593609 (N.D. Ill. Oct. 3, 2013)). F.  Channeling Doctrines Channeling doctrines play a critical role in ensuring that foundational technologies are protected unless they meet patent law’s relatively high innovation thresholds. Furthermore, patent law has a relatively short duration. In addition, SSOs and open licensing have promoted widespread adoption of network technologies. This rational hierarchical structure of the intellectual property system has been undermined by the Federal Circuit’s interpretation of copyright and design patent channeling doctrines. In Oracle America, Inc. v. Google Inc., 750 F.3d 1339 (Fed. Cir. 2014), the Federal Circuit’s narrow interpretation of copyright law’s channeling doctrines enabled Oracle to assert control over functional elements of the Java application program interface elements (Menell, 2018). As a result of this decision, the safe harbor of clean room implementation of functional specifications is no longer secure. The Oracle v. Google precedent creates the potential for software developers to assert long-lived copyright protection over interface specifications without meeting a substantial threshold of technological advance. In Apple Inc. v. Samsung Elecs Co., 786 F.3d 983 (Fed. Cir. 2015), the Federal Circuit’s narrow interpretation of design patent law’s functionality limitation enabled Apple to assert control over functional design elements of smartphone technology. This decision affords Apple protection for the rounded, rectangular shape of its iPhone and iPod devices and visual icons without any showing that they constituted novel and nonobvious technological advances.

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154  Research handbook on the economics of IP law volume 1 Merges, Robert P. 1988. ‘Commercial Success and Patent Standards: Economic Perspectives on Innovation,’ 76 California Law Review 803–76. Merges, Robert P. 1992. ‘Uncertainty and the Standard of Patentability,’ 7 High Technology Law Journal 1–70. Merges, Robert P. 1994. ‘Intellectual Property Rights and Bargaining Breakdown: The Case of Blocking Patents,’ 62 Tennessee Law Review 75–106. Merges, Robert P. 1996. ‘Contracting into Liability Rules: Intellectual Property Rights and Collective Rights Organizations,’ 84 California Law Review 1293–393. Merges, Robert P. 2004a. ‘A New Dynamism in the Public Domain,’ 71 University of Chicago Law Review 183–203. Merges, Robert P. 2004b. ‘Compulsory Licensing vs. The Three “Golden Oldies”: Property Rights, Contracts, and Markets,’ CATO Institute Policy Analysis No 508, accessed March 18, 2019 at http://www.cato.org/pubs/ pas/pa508.pdf. Merges, Robert P., and John F. Duffy. 2002. Patent Law and Policy: Cases and Materials. San Francisco, CA: Matthew Bender. Merges, Robert P., and Richard R. Nelson. 1990. ‘On the Complex Economics of Patent Scope,’ 90 Columbia Law Review 839–916. Mokyr, Joel. 1990. The Lever of Riches: Technological Creativity and Economic Progress. New York, NY: Oxford University Press. Moore, Kimberly A. 2000. ‘Judges, Juries, and Patent Cases: An Empirical Peek inside the Black Box,’ 99 Michigan Law Review 365–409. Mossinghoff, Gerald J. 2002. ‘The First-to-Invent System Has Provided No Advantage to Small Entities,’ 84 Journal of the Patent and Trademark Office Society 425–31. Mueller, Janice M. 2001. ‘No ‘Dilettante Affair’: Rethinking the Experimental Use Exception to Patent Infringement for Biomedical Research Tools,’ 76 Washington Law Review 1–66. Nelson, Richard R. 1959. ‘The Simple Economics of Basic Scientific Research,’ 67 Journal of Political Economy 297–306. Nelson, Richard R. 2004. ‘The Market Economy, and the Scientific Commons,’ 33 Research Policy 455–71. Nelson, Richard R., and Sidney G. Winter. 1982. An Evolutionary Theory of Economic Change. Cambridge, MA: Harvard University Press. Netanel, Neil Weinstock. 2003. ‘Impose a Noncommercial Use Levy to Allow Free Peer-to-Peer File Sharing,’ 17 Harvard Journal of Law and Technology 1–84. Newell, Richard G., Adam B. Jaffe, and Robert N. Stavins. 1999. ‘The Induced Innovation Hypothesis and Energy-Saving Technological Change,’ 114 The Quarterly Journal of Economics 941–75. Nordhaus, William D. 1969. Invention, Growth and Welfare: A Theoretical Treatment of Technological Change. Cambridge, MA: The MIT Press. Novos, Ian E., and Michael Waldman. 1984. ‘The Effects of Increasing Copyright Protection: An Analytic Approach,’ 92 Journal of Political Economy 236–46. O’Donoghue, Ted. 1998. ‘A Patentability Requirement for Sequential Innovation,’ 29 Journal of Industrial Economics 654–79. O’Donoghue, Ted, Suzanne Scotchmer, and Jacques-François Thisse. 1998. ‘Patent Breadth, Patent Life and the Pace of Technological Progress,’ 7 Journal of Economics and Management Strategy 1–32. O’Rourke, Maureen A. 2000. ‘Toward a Doctrine of Fair Use in Patent Law,’ 100 Columbia Law Review 1177–250. Oddi, A. Samuel. 1989. ‘Beyond Obviousness: Invention Protection in the Twenty-First Century,’ 38 American University Law Review 1097–148. Ordover, Janusz A., and Robert D. Willig. 1978. ‘On the Optimal Provisions of Journals qua Sometimes Shared Goods,’ 68 American Economic Review 324–39. Ottoz, Elisabetta, and Franco Cugno. 2004. ‘The Independent Invention Defence in a Cournot-Duopoly Model,’ 12 Economics Bulletin 1–7. Pakes, Ariel. 1986. ‘Patents as Options: Some Estimates of the Value of Holding European Patent Stocks,’ 54 Econometrica 755–84. Pakes, Ariel, and Mark Schankerman. 1984. ‘The Rate of Obsolescence of Patents, Research Gestation Lags, and the Private Rate of Return to Research Resources,’ in Zvi Griliches, ed., R&D, Patents, and Productivity. Chicago, IL: University of Chicago Press. Parchomovsky, Gideon. 2000. ‘Publish or Perish,’ 98 Michigan Law Review 926–52. Polinsky, A. Mitchell. 1980. ‘Resolving Nuisance Disputes: The Simple Economics of Injunctive and Damage Remedies,’ 32 Stanford Law Review 1075–112. Polinsky, A. Mitchell, and Steven Shavell. 1997. ‘Punitive Damages: An Economic Analysis,’ 111 Harvard Law Review 869–962. Price, W. Nicholson. 2018. ‘Grants,’ forthcoming Berkeley Technology Law Journal. Reavis, Conner Kathleen, and Richard P. Rumelt. 1991. ‘Software Piracy: An Analysis of Protecting Strategies,’ 37 Management Science 125–39.

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Economic models of innovation  155 Reinganum, Jennifer F. 1982. ‘A Dynamic Game of R&D: Patent Protection and Competitive Behavior,’ 50 Econometrica 671–88. Reinganum, Jennifer F. 1985. ‘Innovation and Industry Evolution,’ 100 Quarterly Journal of Economics 81–99. Reinganum, Jennifer F. 1989. ‘The Timing of Innovation: Research, Development and Diffusion,’ in Richard Schmalensee and Robert D. Willig, eds., Handbook of Industrial Organization. Amsterdam: Elsevier. Rice, James M. 2015. ‘The Defensive Patent Playbook,’ 30 Berkeley Technology Law Journal 725–76. Rosenberg, Nathan. 1972. ‘Factors Affecting the Diffusion of Technology,’ 10 Explorations in Economic History 3–33. Ruttan, Vernon W. 2001. Technology, Growth and Development: An Induced Innovation Perspective. Oxford: Oxford University Press. Sammi, P. Anthony, Christopher A. Lisy, and Andrew Gish. 2013. ‘Good Clean Fun: Using Clean Room Procedures in Intellectual Property Litigation,’ 25 Intellectual Property and Technology Law Journal 3–14. Samuelson, Pamela, and Suzanne Scotchmer. 2002. ‘The Law and Economics of Reverse Engineering,’ 111 Yale Law Journal 1575–663. Schankerman, Mark. 1998. ‘How Valuable Is Patent Protection? Estimates by Technology Field,’ 29 The RAND Journal of Economics 77–107. Schankerman, Mark, and Ariel Pakes. 1986. ‘Estimates of the Value of Patent Rights in European Countries during the Post-1950 Period,’ 97 Economic Journal 1052–76. Schankerman, Mark, and Suzanne Scotchmer. 2001. ‘Damages and Injunctions in Protecting Intellectual Property,’ 32 The RAND Journal of Economics 199–220. Schultz, Jason, and Jennifer M. Urban. 2012. ‘Protecting Open Innovation: The Defensive Patent License as a New Approach to Patent Threats, Transaction Costs, and Tactical Disarmament,’ 26 Harvard Journal of Law and Technology 1–68. Scotchmer, Suzanne. 1991. ‘Standing on the Shoulders of Giants: Cumulative Research and the Patent Law,’ 5 Journal of Economic Perspectives 29–41. Scotchmer, Suzanne. 1996. ‘Protecting Early Innovators: Should Second-Generation Products be Patentable?,’ 27 Journal of Industrial Economics 322–31. Scotchmer, Suzanne. 1999. ‘On the Optimality of the Patent System,’ 30 The RAND Journal of Economics 181–96. Scotchmer, Suzanne. 2004. Innovation and Incentives. Cambridge, MA: The MIT Press. Scotchmer, Suzanne. 2005. ‘Consumption Externalities, Rental Markets and Purchase Clubs,’ 25 Economic Theory 235–53. Scotchmer, Suzanne, and Jerry Green. 1990. ‘Novelty and Disclosure in Patent Law,’ 21 Journal of Industrial Economics 131–46. Shavell, Steven, and Tanguy van Ypersele. 2001. ‘Rewards versus Intellectual Property Rights,’ 44 Journal of Law and Economics 525–47. Shy, Oz, and Jacques-François Thisse. 1999. ‘A Strategic Approach to Software Protection,’ 8 Journal of Economics and Management Strategy 163–90. Sichelman, Ted. 2010. ‘Commercializing Patents,’ 62 Stanford Law Review 341–414. Sidak, J. Gregory. 2008. ‘Trade Secrets and the Option Value of Involuntary Exchange,’ accessed March 18, 2019 at http://ssrn.com/abstract=577244. Strandburg, Katherine J. 2004. ‘What Does the Public Get? Experimental Use and the Patent Bargain,’ 2004 Wisconsin Law Review 81–153. Tandon, Pankaj. 1982. ‘Optimal Patents with Compulsory Licensing,’ 90 Journal of Political Economy, 470–86. Taylor, Christopher Thomas, Aubrey Silberston, and Z.A. Silberston. 1973. The Economic Impact of the Patent System. London, England: Cambridge University Press. Thomas, John R. 1999. ‘The Patenting of the Liberal Professions,’ 40 Boston College Law Review 1139–85. Van Houweling, Molly Shaffer. 2008. ‘The New Servitudes,’ 96 The Georgetown Law Journal 885–950. Varian, Hal R. 2000. ‘Buying, Renting, Sharing Information Goods,’ 48 Journal of Industrial Economics 473–88. von Hippel, Eric. 1988. The Sources of Innovation. Oxford: Oxford University Press. Walsh, John P., Ashish Arora, and Wesley M. Cohen. 2003. ‘Effects of Research Tool Patents and Licensing on Biomedical Innovation’, in Wesley M. Cohen and Stephen A. Merrill, eds., Patents in the Knowledge-Based Economy. Washington, D.C.: National Academy Press. Wright, Brian D. 1983. ‘The Economics of Invention Incentives: Patents, Prizes and Research Contracts,’ 73 American Economic Review 691–707.

Legislative Materials 17 U.S.C. § 101, § 102(b), § 107, § 114(b), § 115, § 115(a)(2). 35 U.S.C. § 102, § 103, § 112, § 273(a).

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156  Research handbook on the economics of IP law volume 1 Cal. Labor Code § 2870. America Invents Act of 2011. Semiconductor Chip Protection Act of 1984.

Administrative and Other Materials Institute of Electrical and Electronics Engineers (IEEE). 2015. IEEE-SA Standards Board Bylaws, accessed March 18, 2019 at http://standards.ieee.org/develop/policies/bylaws/approved-changes.pdf. U.S. Federal Trade Commission. 2003. To Promote Innovation: The Proper Balance of Competition and Patent Law and Policy (Oct. 2003), accessed March 18, 2019 at https://www.ftc.gov/sites/default/files/documents/reports/ promote-innovation-proper-balance-competition-and-patent-law-and-policy/innovationrpt.pdf.

Cases Alice Corp. v. CLS Bank International, 573 U.S. 208 (2014). Apple Inc. v. Motorola, Inc., 757 F.3d 1286 (Fed. Cir. 2014). Apple Inc. v. Samsung Electronics Co., 809 F.3d 633 (Fed. Cir. 2015). Apple Inc. v. Samsung Electronics Co., 786 F.3d 983 (Fed. Cir. 2015). Association for Molecular Pathology v. Myriad Genetics, 569 U.S. 576 (2013). CSIRO v. Cisco Systems, Inc., 809 F.3d 1295 (Fed. Cir. 2015). Cuno Engineering Corp. v. Automatic Devices Corp., 314 U.S. 84 (1941). Dolbear v. American Bell Telephone Co., 126 U.S. 1 (1888). Ericsson, Inc. v. D-Link Systems, Inc., 773 F.3d 1201 (Fed. Cir. 2014). Graver Tank & Manufacturing Co. v. Linde Air Products Co., 339 U.S. 605 (1950). In re Innovatio IP Ventures LLC Patent Litigation, No. 11 C 9308, 2013 U.S. Dist. LEXIS 144061, 2013 WL 5593609 (N.D. Ill. Oct. 3, 2013). Madey v. Duke University, 307 F.3d 1351 (2002). Mayo Collaborative Services v. Prometheus Laboratories, 566 U.S. 66 (2012). Microsoft Corp. v. Motorola, Inc., No. C10-1823JLR, 2013 U.S. Dist. LEXIS 60233, 2013 WL 2111217 (W.D. Wash. Apr. 25, 2013). O’Reilly v. Morse, 56 U.S. (15 How.) 62 (1854). Oracle America, Inc. v. Google Inc., 750 F.3d 1339 (Fed. Cir. 2014). Roche Products, Inc. v. Bolar Pharmaceutical Co., 733 F.2d 858 (Fed. Cir. 1984). Sanitary Refrigerator Co. v. Winters, 280 U.S. 30 (1929). W.L. Gore & Associates v. Garlock, Inc., 721 F.2d 1540 (Fed. Cir. 1983). Warner-Jenkinson Co. v. Hilton Davis Chemical Co., 520 U.S. 17 (1997). Whittemore v. Cutter, 29 F. Cas. 1120 (C.C.D. Mass. 1813).

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7.  Economic analysis of network effects and intellectual property Peter S. Menell* 6

Contents I. Introduction II. Functioning of Network Markets III. Interplay of Business Strategy, Contract, Standard Setting, Intellectual Property, and Competition Policy IV. Ramifications for Intellectual Property and Competition Policy A. Parsimony Principle: No Intellectual Property Protection for Functional Attributes Absent Significant Technological Advance B. Proportionality Principle: Overcoming Excess Inertia without Undue Protection C. Deterrence Principle: Discouraging Overreach with Balanced Remedies V. Intellectual Property Protection for Network Features A. Trade Secret Protection B. Copyright Protection 1. Software copyright legislation: the Copyright Act of 1976, the CONTU Final Report, and the 1980 amendments 2. Software copyright jurisprudence: the first wave 3. Software licensing 4. Interoperability exception to the DMCA’s anti-circumvention prohibition 5. Software copyright jurisprudence: the Oracle v. Google litigation 6. Standards and codes C. Trademark Protection, Unfair Competition Law, and False Advertising Protection D. Patent Protection 1. Patentability requirements 2. Scope 3. Licensing 4. Remedies

*  Koret Professor of Law and Director, Berkeley Center for Law and Technology, Berkeley School of Law, University of California. Thanks to participants at the 2015 Economics of Intellectual Property Research Handbook Conference, the 2017 Intellectual Property Scholars Conference, and especially Michael Carrier for their comments on this project. I am grateful to Alex Barata, Louise Decoppet, Amit Elazari, Andrea Hall, Reid Whitaker, and Samantha Vega for research assistance.

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158  Research handbook on the economics of IP law volume 1 5. Design patents VI. Interplay of Intellectual Property Protection and Competition Policy in Network Industries A. Private Enforcement 1. Misuse doctrines 2. The principle of exhaustion 3. Ambush of standard setting processes 4. Breach of contract for failure to license SEPs on FRAND terms 5. Private antitrust liability B. Public Enforcement 1. Intellectual property licensing guidelines 2. Significant network market enforcement actions VII. Assessment of Intellectual Property Protection and Competition Policy for Network Technologies A. Institutional Considerations B. Measuring Progress Based on the Normative Principles 1. Parsimony principle 2. Proportionality principle 3. Deterrence principle VIII. Future Research Directions References

I. INTRODUCTION The economics of intellectual property begins with the classic appropriability problem: in a competitive economy, imitators can enter markets for information goods after inventors and authors have incurred research and development (R&D) costs and sell the innovative or creative product at the cost of reproduction. Without means for appropriating an adequate return on investment in R&D, the market will under-produce technological advances and creative expression (Menell and Scotchmer, 2007). The provision of intellectual property protection for technological advances and creative expression affords inventors and authors a mechanism to recoup their investments, although not without imposing the deadweight loss of monopoly exploitation and potentially interfering with cumulative creativity (Menell et al., 2018). Conventional analysis of intellectual property seeks to balance the duration and scope of intellectual property rights in order to optimize these tradeoffs (Nordhaus, 1969; Gallini, 1992). The conventional framework applies to goods and services for which consumer demand is independent—that is, where one consumer’s utility from consuming a good or service does not depend on choices of other consumers. Yet consumer demand for information goods and services can be interdependent, especially in the digital age. The value to consumers of systems technologies—such as telecommunication networks (including telephone networks, cable systems, satellite systems, and Internet protocols), interconnected devices (e.g., mobile phones, operating systems and application programs, printers and replacement cartridges, audio-video devices and media), databases (e.g., Internet searches), and electric charging stations

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Economic analysis of network effects and IP  159 (e.g., Tesla superchargers)—often depends upon other consumers’ choices. For example, a smartphone platform with many adopters will attract more app developers, thereby increasing the functionality and value of that platform for consumers, developers of complementary goods (e.g., apps), and the platform sponsor. Platforms function like a common language. Devices that ‘speak’ a common language (such as a programming language, application program interface (API), or set of graphical user icons) can communicate with other devices and humans familiar with that language. Innovators can more easily design peripheral equipment that expands the functionality of existing devices. Over time, users internalize how a computer language or application program represents functions, often memorizing the most commonly used series of keystrokes or developing macros customized to perform their most common tasks. These human capital investments commit users to particular languages and platforms and encourage employers to adopt systems that are widely known by prospective employees so as to recruit promising candidates and reduce training costs (Gandal, 1994). Thus, it is common for people seeking jobs in programming, accounting, and design fields to list those computer languages and application programs that they have mastered on their resumes. Network externalities arise from the enhanced labor mobility and reduced training costs produced by shared, or at least compatible, computer systems across different work environments. When people in different places can communicate more efficiently through compatible file formats, network externalities result. The value of networks grows disproportionately with their adoption bases. Such positive feedback dynamics drive a growing number of markets in the information economy (Shapiro and Varian, 1999), from computer operating systems to mobile phones, printers (and ink cartridges), video game consoles, Internet search engines (such as Google), Internet commerce (such as eBay and Amazon), social networks (such as Facebook, LinkedIn, and Tinder), cloud computing, the Internet of Things, and shared economy platforms (such as Airbnb and Uber). Advances in digital and network technologies have dramatically reshaped the competitive and innovative landscape. As a consultant for the Internet dating industry has remarked, ‘It’s never been cheaper to start a dating site and never been more expensive to grow one’ (Tugend, 2016). Dating apps usually start by offering free services to new users, seeking to build a viral bandwagon. If they gain traction through innovative features or marketing, they then face the daunting task of monetizing the network, typically through advertising or membership fees. Monetization, however, can reverse the positive feedback effects, thereby reducing the network’s size, unraveling the network’s benefits, and jeopardizing the platform’s sustainability. Finding the right balance between viral growth and monetization is the principal challenge of a growing range of enterprises in the Internet Age. The interdependence of consumer demand has important ramifications for the design of intellectual property and competition policy. In a static economic model (i.e., one without innovation), consumers benefit from robust competition within product standards. Open access to product standards encourages realization of network externalities. Although bandwagon effects can enhance consumer welfare in a static context, they can also make it more difficult for developers of improved platforms to enter the market. Consumers and suppliers of complementary products can face significant switching costs in migrating from one platform to another. For example, once businesses have invested

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160  Research handbook on the economics of IP law volume 1 heavily in developing programs to run on a software platform (e.g., macros for the Lotus 1-2-3 spreadsheet), it becomes much more difficult for a competitor offering an enhanced spreadsheet (e.g., Borland Quattro Pro) to enter the market unless they can provide a low-cost migration path. Facebook’s widespread success and user investment made it difficult for even Google to build a sustainable competing social network. Orkut, Google Buzz, Google Friend Connect, and Google+ have failed or languished. The technical standards governing access to platforms, commonly referred to as application program interfaces (APIs) in the software industry, play a critical role in consumer and programmer adoption decisions, market entry, and competition. Those who control a widely adopted platform can obstruct new innovative platforms and complementary products and services (such as refilling and repair). Familiarity with the user interface and features, connections to other network adopters (such as Facebook friends), and investments in complementary assets (such as macros that run on the platform) can keep consumers on an otherwise inferior platform. The human capital investment in learning an API can lock programmers into a platform, and sunk costs in manufacturing facilities, fabrication designs, and contracts with suppliers and customers can lock manufacturers into design choices. At the same time, the ability to secure an innovative platform can be vital to investing in the R&D needed to advance systems technologies. Without the prospect of earning a significant return on research, development, and marketing of a new platform, investors have little incentive to take on the risk of investing the substantial resources necessary to challenge an entrenched platform. Therefore, the availability, scope, and remedies for intellectual property protection for network features of systems technologies and platforms (e.g., interface specifications) provide both a key strategic asset for controlling network markets and a critical mechanism for promoting advances in network technologies. Demand-side or network effects, therefore, complicate the design of an optimal intellectual property regime. Control of interface specifications and other network features of computer technologies through intellectual property protection has become the key to market dominance in a growing number of important Information Age markets. Nearly all of the major software copyright disputes, as well as a key exception to the Digital Millennium Copyright Act of 1998’s (DMCA) anti-circumvention provisions, have revolved around the protectability of interface specifications. Patent protection for network technologies has also become a critical battleground with some disputes centered on licensing network technologies through standard setting organizations. Trade secrecy, trademark protection, and contract law are also important tools for regulating ­competition in network markets. This chapter explores the critical role of intellectual property in network markets as well as the ramifications of network effects for the design of intellectual property regimes. Section II describes the functioning of network markets. Section III examines the interplay of business strategy, contract, standard setting organizations, intellectual property, and competition policy. Section IV presents three principles for tailoring intellectual property regimes and competition policy for network technologies. Section V traces the evolution of intellectual property protection for network features of systems and platforms. Section VI discusses the interplay of intellectual property protection and competition policy. Section VII assesses the extent to which intellectual property protection and competition policy align with normative design principles. Section VIII identifies promising areas for future research.

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Economic analysis of network effects and IP  161

II.  FUNCTIONING OF NETWORK MARKETS In many market settings, consumers’ utility functions are independent. Take, for example, the market for ice cream. My enjoyment of a particular flavor (e.g., hazelnut chocolate chip), style (e.g., gelato), or brand (e.g., Talenti) does not depend significantly on the utility that other consumers derive from the purchase and consumption of ice cream. It is possible that greater popularity of a flavor, style, or brand makes that combination more widely available or lowers the price due to economies of scale on the production side, but competition usually ensures efficient allocation of resources in these circumstances. The effects are more likely pecuniary, which work through the market and only affect the distribution of value, than technological, which affect the economic efficiency of the economy (Liebowitz and Margolis, 1994). By contrast, some market equilibria depend critically on the number of consumers that have joined or are likely to join a particular platform. Take, for example, a social network like Facebook. A new entrant to this market, say Google+, might offer enhanced functionality. But if most of my social network is already on Facebook and I cannot easily bridge the two networks, then I am far less likely to switch. Network effects have long been central to human civilization and market economies. Languages, measurement systems (metric versus imperial), electrical equipment standards (alternating current versus direct current; computer networking protocols), driving conventions (left side versus right side), and railroad gauges (the width between and across rails) are notable examples where demand-side coordination greatly influences consumer welfare, economic efficiency, and social discourse. Standardized railroad gauge, for example, supported far-reaching railroad networks, promoted competition in locomotive and railcar markets, and enabled interconnected rail services (Puffert, 2000, pp. 944–7). Section III focuses on how such coordination or standardization occurs through business strategy, technological innovation, intellectual property law, industry and consumer coordination, and government policies (including antitrust law). The economic and social value of network effects can be substantial. According to Metcalfe’s Law—attributed to Robert Metcalfe, co-inventor of the Ethernet, a local computer network platform that foreshadowed and ushered in the Internet—the value of a telecommunications network is proportional to the square (n2) of the number of devices (or nodes (n)) of the system. This economic ‘law’ reflects the potential number of contacts within a network and assumes that they are each of equal value. Even though this theoretical maximum is unlikely to be obtained in the real world (Briscoe et al., 2006), the powerful growth potential of network systems drives much of the information economy. The net value, of course, also depends on the cost per user. In many telecommunications and computer applications, such costs are low and have declined over time because of Moore’s Law—Intel co-founder Gordon Moore’s audacious, yet remarkably accurate, prediction that the number of transistors on an integrated circuit would double every two years (later reduced to 18 months) (Moore, 1965; Borwein and Bailey, 2015). Both real and virtual networks can produce these effects (Shapiro and Varian, 1999, p. 183; Katz and Shapiro, 1985, p. 424). Real networks entail physical connectivity enabling a user to interact or communicate directly with others. They include transportation systems (such as railroad gauges), telecommunication systems (such as a telephone or broadcast network), and media systems (such as data storage devices). By contrast, virtual

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162  Research handbook on the economics of IP law volume 1 networks operate through the evolution of markets for complementary products. The supply of complementary goods typically drives these markets. For example, by enabling programmers to develop apps for the iOS platform, Apple promotes a virtual network surrounding its iPhone and other computer devices. The availability of apps on the iOS drives demand for iOS devices, which in turn attracts app developers. More apps generate a wide range of functionality, thereby spurring increased demand for iPhones. Other examples of virtual networks include application programs that enable users to share data files with other programs and users, ATM cards and automatic teller machines, credit cards, and the merchants who accept them, and next generation payment systems such as Apple Pay and Square. The defining feature of virtual networks is that the demand for the product depends significantly on the availability of complementary goods and services. The magnitude of network effects depends on several considerations: interdependencies of consumer utility functions, range of complementary products or services, availability of alternative platforms, switching costs, business strategies, and legal limits (such as intellectual property protection and competition policy) on leveraging network markets. In some cases, physical limitations govern network access—for example, where a device must physically or digitally interoperate with other devices. In others, the network is not physically constrained, but instead driven by consumer familiarity or ease of use. The design determinants of a network market—interoperability or compatibility standards—are shaped by the type and degree of ownership, sponsorship, and governance of network access. Some network standards are established or authorized by a government or international organization or formal standard setting organization (SSO). These are sometimes referred to as de jure standards as they have an official backing and can be enforced by law. Such enforcement can limit or afford access to standards. Individual companies or consortiums sponsor many important network standards. These are sometimes referred to as de facto standards, although they might be backed by patent, copyright, trademark, or false advertising law. A third important distinction in network markets relates to whether a standard is ‘free,’ open, closed (i.e., proprietary), or somewhere in the middle (Meeker, 2015, pp. 31–47; West, 2007). The free software movement allows other users to run, study, share, copy, and modify the software so long as these users permit use of any derivative works on the same terms. ‘Open source’ software typically connotes that the software or interface is freely available to any market participant, but there might or might not be restrictions on the availability of complementary goods embodying the standard. A closed or proprietary standard is one in which a sponsoring enterprise or organization regulates access, typically through licensing of intellectual property rights. Thus, the distinction between open and closed standards can be ambiguous. For example, many SSOs require that participating enterprises license standard-essential patents on fair, reasonable, and non-discriminatory (FRAND) terms. Which patents are ‘standard-essential’ and the license terms on which they are available are rarely fully specified in advance, creating substantial uncertainty (Contreras and Gilbert, 2015). On the other hand, ‘free’ software licensed pursuant to the General Public License (GPL) requires users to make available any software incorporating the licensed code under the same ‘share and share alike’ restriction (Carver, 2005). The controversy over the Java API platform illustrates the complexity that can arise surrounding intermediate—that is, partially open—platforms (Menell, 2018; Lemley and

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Economic analysis of network effects and IP  163 McGowan, 1998). Sun Microsystems released the Java programming language without restriction in part to prevent Microsoft from leveraging its Windows desktop computer operating system monopoly into dominance of website functionality. Sun’s Java strategy promoted the ‘Write Once, Run Anywhere’ (WORA) principle: the notion that any browser can execute Java applets (small application programs, such as those used for animated web pages)—including on Microsoft Windows, Unix, macOS, and Linux. Over time, Sun developed pre-written API packages to facilitate Java programming. Sun developed the Java Community Process (JCP), a quasi-public formalized administrative process, for developing technical specifications for Java technology and extensions. Sun used the JCP and licensing of the Java trademark to promote collaboration and commitment to the WORA principle. When Google sought to use some, but not all, of the Java APIs to develop the Android platform and licensed Android using a less restrictive licensing regime (i.e., not requiring that derivative works be shared on a ‘free’ basis), Sun and Oracle (which acquired Sun Microsystems in 2010) objected, resulting in one of the costliest intellectual property battles (Menell, 2018). Network effects arise whenever the value that consumers place on a product or service depends upon the number of other consumers or programmers purchasing that product or using that service. As the number of adopters (or the installed base) of a platform grows, the benefits of being part of that platform increase. For example, consumers generally prefer telephone networks or protocols offering the largest user bases. Like economies of scale (declining unit costs with increased production) on the supply side of a market, the value of a network generally increases with widespread adoption. The availability of better application programs to run on an operating system platform will lead more consumers to prefer that operating system, which in turn will spur a greater quantity and quality of application programs for that operating system. Whereas economies of scale typically fall off at some point due to technical or organizational limits, positive feedback on the demand side generally continues to increase with the size of the installed base. For this reason, one or a very small number of standards are likely to predominate in markets with strong network effects, as reflected in Microsoft’s dominance in microcomputer operating systems, Google’s dominance among Internet search engines, and Facebook’s dominance as a social network. The high value that consumers place upon standardization, however, can make it particularly difficult for improved products to break into the market. Such bandwagon effects can stifle development and diffusion of improved technology platforms (Farrell and Saloner, 1985).

III. INTERPLAY OF BUSINESS STRATEGY, CONTRACT, STANDARD SETTING, INTELLECTUAL PROPERTY, AND COMPETITION POLICY The dynamics of network technologies produce a particularly complex strategic playing field. Firms typically choose among three strategies when competing in network markets: (1) market dominance through establishing and controlling a new proprietary standard; (2) adopting an existing standard either through imitation (where it is legally permissible) or licensing; or (3) working with other firms in the industry—either informally,

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164  Research handbook on the economics of IP law volume 1 c­ ontractually, through formal industry organizations, or through governmental standardization bodies—to develop an open or quasi-open standard (Farrell and Saloner, 1998; Besen and Farrell, 1994; Shapiro and Varian, 1999; Farrell and Simcoe, 2012). Among the strategies firms use to establish their product or service as the de facto industry standard are: massive advertising campaigns; penetration pricing (pricing products or services below cost or giving them away in order to speed adoptions by consumers); issuing impressive product preannouncements to entice consumers and discourage competitors; providing adopters with various forms of insurance (such as short term leases or pricing arrangements that tie the price of the system to the number of adopters); licensing of the product in order to grow the network more rapidly (and to create competition in the expansion of the network); and vertical integration and strategic investments into markets for complementary products to assure consumers that valuable application programs will be available (Farrell and Simcoe, 2012; Farrell and Klemperer, 2007; Shapiro and Varian, 1999; Baseman et al., 1995; Farrell and Saloner, 1986; Dybvig and Spatt, 1983). Adopting an existing standard enlarges the size of a network comprising both the entrant’s product and its rival’s—the existing platform—products. This increases the desirability of the rival’s products to consumers, thereby reducing the adopter’s market share (although of a larger market) relative to what it would have been had the firm adopted an incompatible product standard. Thus, even though the net social welfare of adopting a rival’s standard may exceed the net social welfare of introducing an incompatible standard, the entrant may nonetheless prefer to adopt an incompatible standard because the entrant cannot appropriate all of the benefits of compatibility, some of which accrue to past and present purchasers of the rival’s products (Katz and Shapiro, 1985, p. 435; Katz and Shapiro, 1986). Firms often pursue Strategy 2 (adopting an existing standard) and Strategy 3 (collaborating with other firms in establishing a standard) in tandem. Both strategies create a more traditional market setting in which firms compete over price, quality, and services to win market share on a common platform. This achieves greater competition on a particular platform and fosters the realization of network externalities, but may impair competition to innovate better platforms (Katz and Shapiro, 1994). The market dominance strategy is often riskier but can produce the highest payoff for the winner. A firm’s strategy will depend on a range of factors, including its reputation among consumers for serving the type of network market that it has targeted, its available resources (and access to capital markets) to make the investments in distribution and marketing necessary to persuade consumers that the firm will prevail in the standard battle, the strength of its technology for establishing a standard (although such technology need not be superior to others on the market), and complementary assets within the firm or strong strategic alliances in vertical markets. The firm’s strategy will also depend upon the availability of intellectual property protection, contractual means, and technological controls (e.g., encryption technology) for precluding, limiting, or delaying access by competitors to the firm’s standard. IBM successfully pursued the market dominance strategy when it entered the microcomputer market in the early 1980s. IBM combined its reputation for serving the mainframe market and technological and marketing capabilities with copyright and trade secrecy protection for its basic instruction operating system (BIOS) chip. IBM’s

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Economic analysis of network effects and IP  165 strategic hold on the industry quickly unraveled, however, when competitors successfully reverse engineered the BIOS chip (Moy, 2000, pp. 72–3; Menell, 1987), making much less expensive, fully compatible IBM clones available on the market by the mid to late 1980s. IBM exited the microcomputer hardware industry soon thereafter. Microsoft emerged as the winner in the microcomputer industry during this upheaval. Its DOS operating system, on which IBM had previously built its microcomputers, emerged as the de facto standard. Robust competition in microcomputers using DOS and a growing array of application programs (including several Microsoft flagship products such as Word and later Excel) drove adoption of DOS-based computers and fueled Microsoft’s dominance. Microsoft skillfully migrated users from DOS to Windows, withstanding Apple’s assertion of intellectual property control of the Mac desktop graphical user interface. By the mid-1990s, Microsoft dominated the microcomputer industry through its control of the Windows platform. Apple was a distant second and fading. The emergence of the Internet in the mid-1990s opened new modes of competition in computer markets. Netscape’s Navigator Internet browser and Sun’s highly interoperable Java platform threatened Microsoft’s dominance in the microcomputer and software marketplace (Lemley and McGowan, 1998). Microsoft responded by integrating its browser technology, Internet Explorer, into the Windows operating system and engaging in restrictive licensing agreements with microcomputer manufacturers, thereby reducing the effective price of its browser to zero. Consequently, the market for Netscape’s browser evaporated. Microsoft also undermined Java’s efforts to establish a universal metaplatform for software application programs by offering a proprietary, non-interoperable version (Sun Microsystems, Inc. v. Microsoft Corp., 46 U.S.P.Q. 2d 1531 (N.D. Cal. March 24, 1998)). Network effects have allowed particular firms to dominate many Internet markets, including search (Google), social networks (Facebook), mobile (iOS, Android), and sharing networks (Airbnb, Uber). Apple successfully regained prominence in critical digital markets through its mobile and App Store network market strategies. Formal standardization plays a tremendous role in many electronics and telecommunications markets (Contreras, 2019; Lemley, 2002). Russell (2006) traces electrical standardization through formal standard-setting organizations over more than a century. These processes have relied on engineers and scientists seeking to promote the best engineering solutions to technical challenges. They form key infrastructure for the electronics and telecommunications industries. Engineers from major technology companies participate in dozens of standard-setting organizations, including many of the leading professional engineering societies, such as the Institute of Electrical and Electronics Engineers (IEEE) Standards Association and the Internet Engineering Task Force (IETF). These processes have carried over to semiconductor designs, mobile phones, Internet protocols, and computer devices. A typical laptop computer today embodies more than 250 technical standards (Contreras, 2019). Intellectual property protection for network technologies can significantly influence the development of standards, follow-on innovation, and market competition. Patents in the information and communication technology fields (semiconductors, computers, and mobile phones) have presented the most salient concerns. Building on Williamson’s (1985) classic treatment of economic holdup—whereby asymmetric information, transaction costs, and incomplete contracts create the potential

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166  Research handbook on the economics of IP law volume 1 for a contracting party to extract the value of sunk or locked in, relationship-specific investments—Lemley and Shapiro (2007a) posit a patent bargaining model in the shadow of strong potential remedies (automatic injunctive relief and large monetary awards) that generates an analogous inefficient dynamic. Companies that unwittingly sink large investments into infringing products are subject to having such investments extracted through patent infringement litigation. Such extraction can greatly exceed the contribution of the patented technology relative to the best non-infringing alternative. The presence of multiple patents covering a single product—what has been referred to as the patent thicket problem (Shapiro, 2001)—exacerbates holdup effects, creating a royalty stacking problem: total patent royalty demands may exceed the contribution of patented technologies to the market demand for the product. Various scholars have questioned Lemley and Shapiro’s assumptions and empirical basis for royalty stacking (Elhauge, 2008; Sidak, 2008; Geradin et al., 2008; Geradin and Rato, 2007; Geradin, 2007; Golden, 2007; but see Lemley and Shapiro, 2007b (responding to Golden, 2007)). They note that royalty stacking is unlikely to occur with full information and low transaction costs. There is good reason, however, to question optimism about ex ante bargaining. Ziedonis (2004), for example, finds that firms acquire patents more aggressively when the patents for numerous component technologies of an industry—like the semiconductor industry—are widely distributed. The proliferation of patent litigation over information and communication technology indicates that intellectual property protection imposes at least some implicit tax on these network industries. Nonetheless, more recent empirical research raises doubts about the severity of royalty stacking. Galetovic and Gupta (2016), for example, find that mobile wireless prices have fallen, quantities have grown, and the industry has become less concentrated over time, indicating that royalty stacking may not be as serious as prior research had claimed. Barnett (2017) surveys the growing literature and concludes that the evidence of royalty stacking is weak. All would agree, however, that industry coordination through patent pooling and SSOs can alleviate these problems (National Research Council of the National Academies, 2013). Such pools, however, can facilitate collusion, raise barriers to entry, and spark other public policy concerns. Notwithstanding the widespread use of standard-setting processes and agreements on technical standards, the rules governing access to standards and the licensing of patented technologies are rarely specified in advance. SSOs exercise caution to avoid violating antitrust laws barring price-fixing. In addition, many companies participating in standard setting processes do not wish to reveal their patent prosecution strategies or pre-commit to price terms. Thus, most technical standard setting organizations require only that participants disclose their patented technologies and agree to license standard-essential patents (SEPs) on FRAND terms. The potential for holdup and royalty stacking remains (Contreras, 2019; Federal Trade Commission, 2011; Lemley and Shapiro, 2007a). Some sectors of the software industry have alleviated or avoided these risks by committing to open source policies (Merges, 2004). Viral forms of open source licensing, such as the GPL, however, can discourage investment in downstream innovation by limiting direct appropriability for technological advances. For this reason, Google chose a more permissive open source license for Android (Menell, 2018). This fostered collaboration and rapidly expanded the Android network while encouraging innovation by handset makers and telecommunications companies.

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Economic analysis of network effects and IP  167

IV. RAMIFICATIONS FOR INTELLECTUAL PROPERTY AND COMPETITION POLICY As the preceding analysis suggests, intellectual property protection can play a critical role in network markets. As one software entrepreneur metaphorically explained, creating an API is analogous to building a city: First you try to persuade applications programmers to come and build their businesses on [your tract of land]. This attracts users, who want to live there because of all the wonderful services and shops the programmers have built. This in turn causes more programmers to want to rent space for their businesses, to be near the customers. When this process gathers momentum, it’s impossible to stop.   Once your city is established, owning the API is like being the king of the city. The king gets to make the rules: collecting tolls for entering the city, setting the taxes that the programmers and users have to pay, and taking first dibs on any prime locations (by keeping some APIs confidential for personal use). (Kaplan, 1996)

This section discusses the general economic considerations bearing on whether and to what extent intellectual property ought to protect network features of systems ­technologies—those features that affect access to or interoperability with a system. There are two market failures in play in optimizing intellectual property protection. First, network features of system technologies, like any other technology, are subject to the classic appropriability problem. Without intellectual property protection, inventors of more advanced platform technologies will be subject to being undercut by new entrants who imitate the innovations without bearing R&D costs. First-mover advantages, effective marketing, trade secrecy, and other strategies might provide sufficient motivation for some R&D, but there is reason to be concerned that the unregulated market will underproduce potentially high value, but risky and costly, innovation in network technologies. Demand-side effects in network markets, however, complicate the conventional analysis of intellectual property protection. Because of the dynamics of network markets, some firms might be motivated to limit access to their platforms to reap the outsize profits from controlling a network market. This strategy, however, can hinder the realization of network benefits by raising prices, limiting access by third parties, and discouraging innovation because of the high barriers to entry. Consumers benefit when they and their devices, systems, and programs ‘speak’ the most widely adopted platform—the lingua franca—or can translate that code into language their devices understand. This often provides for greater functionality, such as more software that will run on their platform and larger communication networks. At the same time, widely adopted product standards can strand the industry on an obsolete platform (Farrell and Saloner, 1985). Consumers resist switching costs—from learning new tools and languages to acquiring new devices. They demand substantial improvements in efficiency or functionality to jettison comfortable, well-worn devices and software tools for new tools and systems. Thus, the installed base built upon the dominant platform—reflected in durable goods and human capital (training) specific to the old standard—can create an inertia that makes it much more difficult for any one producer to break away from the prevailing standard by introducing a noncompatible product, even if the new standard offers a

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168  Research handbook on the economics of IP law volume 1 s­ignificant technological improvement over the current standard (Farrell and Saloner, 1986). In this way, network externalities can retard innovation and slow or prevent adoption of improved product standards. Therefore, companies seeking to leapfrog a widely adopted standard face substantial risk. They must not only invent an improved platform, but they must also devise and execute a successful strategy to migrate consumers from the dominant platform. They also face the challenge of encouraging other software and complementary product developers to build for the new platform. One strategy is to steeply discount the costs of the new platform or provide free access. This strategy is not sustainable unless the platform developer has ancillary revenue streams—such as bundled advertising or ties to other products and services—to cover their research, development, product, and support costs. Intellectual property protection can contribute to and alleviate the network externality dilemma. On the one hand, intellectual property protection for the network features of computer technology can discourage realization of positive network externalities by limiting access to network technologies. The sponsor of a particular network technology can use intellectual property protection to exclude competitors or charge a high licensing fee for access, thereby raising costs. The intellectual property owner can also limit innovation by restricting how the network technology evolves. On the other hand, intellectual property protection can provide valuable incentives for overcoming bandwagon effects that entrench obsolete standards (Menell, 1987, p. 1343). Without the potential for a large reward, inventors contemplating innovative new platforms might not be willing to make the substantial, risky R&D and marketing investments needed to challenge, and hopefully leapfrog, the incumbent platform. These considerations suggest three principles for intellectual property protection of APIs and other functional features of platform technologies: (A) a parsimony principle to prevent firms from establishing protection for product standards without providing a significant technological advance; (B) a proportionality principle to ensure that firms can appropriate a fair return on technological advances in platform innovation sufficient to overcome the excess inertia of network markets, but not so large as to stunt network externalities; and (C) a deterrence principle to discourage deceptive practices and overreach in network markets. A. Parsimony Principle: No Intellectual Property Protection for Functional Attributes Absent Significant Technological Advance Consumers benefit from access to platforms that produce network benefits. Those benefits can increase over time through positive feedback effects and the development of aftermarket enhancements and complementary products. The incentives for firms adopting product standards, however, are distorted. New entrants might choose an incompatible standard to differentiate their products from established brands, even where growing the established network would enhance consumer welfare (Katz and Shapiro, 1985, 1986). Intellectual property protection affects such choices by setting the ground rules for establishing proprietary platforms. Firms will be more inclined to build competing platforms where the thresholds for acquisition of intellectual property protection—and hence the power to exclude subsequent entrants and those seeking to bridge platforms—are low. Thus, intellectual property regimes should discourage platform adoption choices that undermine realization of network externalities unless there is a large countervailing ben-

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Economic analysis of network effects and IP  169 efit, such as substantial technological advance. Affording meaningful intellectual property protection for network technologies without requiring a significant technological advance encourages wasteful differentiation and increases the risk of undeserved monopoly power. With easy access to intellectual property protections—for example, by merely using arbitrary lock-out codes—firms can fragment platforms that would otherwise foster competition in the non-network product features and in downstream products competing on the platform. Through serendipity, first-mover advantage, clever marketing, or simply luck, market power can emerge through positive feedback effects without discernible consumer benefits. Therefore, intellectual property law should not simply reward novel (but obvious) or expressive functional features of network goods or services. Rather, strong protection should be reserved for substantial advances. B.  Proportionality Principle: Overcoming Excess Inertia without Undue Protection While low thresholds for intellectual property protection for network technologies undermine realization of network externalities, balanced protection for substantial technological advances may be necessary for entrants to overcome the strong inertial forces driving network markets. Switching costs discourage consumers from making the leap to a new platform. For network products and services, those costs can be particularly high due to network effects. The leap is likely not worth the cost for modest technological improvements. At some point, however, overall consumer welfare will be enhanced by migration to an alternative platform. The efficient tipping point depends on R&D and marketing costs as well as the contours of consumer demand. The excess inertia of network effects can hinder, delay, and possibly prevent the technological shift to a substantially more advanced technological platform. If all such advances were freely available to entrants, the free-rider problem would discourage the needed R&D and marketing investment needed to displace the obsolete platform. Yet providing strong intellectual property protection for such advances can lead to robust returns as the market tips to the new platform. The shift from ‘feature phones’—mobile phones ‘featuring’ voice and text messaging with rudimentary Internet access—to true ‘smartphones’ with email and robust web functionality illustrates the challenges and opportunities surrounding network markets. Through the 1990s, Motorola, Nokia, and a few other vendors established the first generation of mobile devices. Sun, Microsoft, and Symbian vied to establish the platform for mobile devices that integrated email and Internet capabilities. By 2005, Java’s Micro Edition (ME) was faring well, with adoption by Palm and Blackberry. As the first-generation smartphone battle was resolving, Apple was secretly investing heavily in an ambitious new platform. Intellectual property played a significant role in motivating Apple’s R&D. As Steve Jobs noted during the historic January 2007 iPhone announcement, ‘boy have we patented it!’ Meanwhile, Google was at work on its own skunkworks1 smartphone play: the Android

1   Derived from Lockheed’s code-named secret World War II project to develop a new fighter jet (‘Skunk Works’), which was taken from Al Capp’s Li’l Abner comic strip, a ‘skunkworks’ project brings together a small group of highly skilled researchers to pursue radical innovations.

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170  Research handbook on the economics of IP law volume 1 smartphone platform. Given Google’s concern that its success in search and online advertising could be displaced if Microsoft or Apple gained dominance in the shift to mobile devices, Google sought to develop an open platform that would perpetuate Google’s search and other services on mobile devices (Menell, 2018). This standards war illustrates the dynamism of network markets as well as the complex role of intellectual property protection. In the space of just a few years, the market shifted dramatically from feature phones to rudimentary smartphones and then to advanced smartphones. By 2011, Apple and Google dominated the market. Intellectual property protection played a central role in encouraging investment, but also resulted in massive resources devoted to intellectual property acquisition, coalition building, standard setting on upstream technologies, and litigation. There is no simple answer to the question of how much protection is enough, especially given the range of business strategies, institutions, and intellectual property regimes that can deliver appropriate returns on investment, the dynamism of network markets, and concerns about anti-competitive leveraging network technology dominance. Lichtman (2000) emphasizes strong property rights to promote platform competition, but this analysis assumes low transaction costs, overlooks consumers’ cognitive limitations stemming from lock-in, and risks leveraging monopoly power and inhibiting cumulative innovation. The optimal level of intellectual property protection has a dynamic quality, with the level of protection dissipating as network technologies and platforms become dominant. Menell (1987) recommends a limited patent-type regime to protect the functional features of computer software, although with shorter duration and more flexibility to promote access to platforms that become widely adopted. Menell (1989) advocates a genericide-type doctrine,2 which could protect emerging platforms but give way to broader access when a platform becomes dominant and risks affording the proprietor the ability to leverage that control to hinder cumulative innovators (Langlois, 2001). This analysis anticipated Microsoft’s rise and its abusive market tactics in undermining Netscape and Sun. At the same time, scholars have opposed copyright protection for the functional and interoperable aspects of computer technology so as to avoid large returns to first movers that win a standards battle without offering significant technological innovation (Menell, 1987; Karjala, 1987; Samuelson et al., 1994). Such limitations on copyright protection afford competitors freedom to use and build on unpatented methods of operation. In some circumstances, compulsory licensing of patents might be desirable. This can be achieved through injunctive relief. The proportionality principle ensures that platform innovators who choose proprietary strategies (as opposed to more collaborative approaches) have the potential to reap significant rewards if they prevail in a standards competition, but that their ability to control the platform (and charge monopoly prices) declines as the network becomes entrenched. Such a regime creates optimal conditions for overcoming excess inertia while promoting the realization of network benefits. It also allows for competition to enhance and improve established platforms. 2   A trademark can become generic and thereby lose protection if it becomes associated in the public’s mind with a category of product rather than the source of a particular brand of the product. See, e.g., The Murphy Door Bed Co., Inc. v. Interior Sleep Systems, Inc., 874 F.2d 95 (2d Cir. 1989) (‘Murphy bed’ for a bed that folds up into a wall cabinet); King-Seely Thermos Co. v. Aladdin Indus., Inc., 321 F.2d 577 (2d Cir. 1963) (‘Thermos’ vacuum insulated bottle).

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Economic analysis of network effects and IP  171 C.  Deterrence Principle: Discouraging Overreach with Balanced Remedies Intellectual property law and competition policy should also protect against deceptive practices and leveraging intellectual property rights to control network markets. The integrity of standard setting processes is particularly critical to efficient collaboration among enterprises and innovators working in network industries. The choice of standards depends on a range of factors, including potential restrictions on practicing technological standards. Hence, standard setting bodies should require disclosure of all potential intellectual property encumbrances or, at a minimum, advance commitment by SSO members to licensing such technologies on fair and reasonable terms. Courts should penalize efforts to reduce transparency in standard setting processes and take failure to abide by such commitments into consideration in enforcing patent rights. Antitrust law and competition policy should also take network effects into account in assessing monopoly power, scrutinizing collaborations and contractual agreements, and fashioning remedies. The consumer, competitive, and innovation ramifications of network markets are especially complex. What might appear to be benign and welfare-improving behaviors—such as integrating a ‘free’ browser into an operating system product or bundled aftermarket services—might ultimately lead to monopolization of important emerging and downstream markets. Hence, antitrust law must be vigilant in assessing the dynamism and path-dependence of network technologies. For example, advance determination of licenses for SEPs can promote competition in downstream products and services. In some circumstances, antitrust authorities should tolerate some collusive behaviors—such as ex ante negotiation of FRAND license rates by SSOs—that resemble forbidden price-setting. The Sherman Antitrust Act bars contracts and conspiracies that unreasonably restrain competition. In network markets, some collaboration promotes economic efficiency. The crafting of remedies to combat abusive and anti-competitive behavior in network markets requires careful consideration of effects on consumers and competitors. Once a standard has taken root and is generating substantial network benefits, traditional remedies—such as enjoining the offensive activities of breaking up dominant firms—can cause adverse effects on the consumers who have adopted the standard as well as other downstream users—such as programmers and competitors who have incurred sunk costs in joining the platform. Leveraging intellectual property rights to control network markets might also produce countervailing innovative efficiencies. Hence, antitrust authorities and courts should consider remedies that promote the realization of network benefits while promoting enhanced competition and innovation. In some circumstances, these considerations favor compulsory licenses, which can be flexible and adaptable, over injunctive remedies.

V. INTELLECTUAL PROPERTY PROTECTION FOR NETWORK FEATURES In view of the tremendous economic significance of controlling access to systems technologies by exploiting demand-side effects and excluding competition in complementary goods and services, such as repair services, replacement parts, and ancillary

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172  Research handbook on the economics of IP law volume 1 markets (e.g., advertising and consumer data), platform developers and entrepreneurs have sought to use intellectual property to protect APIs and other means to exclude competitors from their platforms and systems. As an alternative approach, computer programmers and a growing number of commercial enterprises in the open source community have deployed intellectual property protection as a tool for sharing technology and precluding proprietary control of core Internet and computer operating system technologies. Since the principal forms of intellectual property protections developed long before the advent of digital technology, which made network effects so important, the intellectual property statutes do not expressly reflect the aforementioned policy principles for APIs and other functional features of platform technologies. Nonetheless, the mixed statutory/ common law heritage of intellectual property law (Menell, 2013) has afforded courts discretion to interpret statutory provisions, adapt common law doctrines, and apply equitable enforcement principles to address network effects. Moreover, more recent legislation has integrated network economics into intellectual property law (see Section V(B)(4) exploring the DMCA interoperability exemption). Although patents have long protected platform technologies, such as electrical standards (e.g., AC/DC, phonogram, color television, and telecommunications) (Shapiro and Varian, 1999, pp. 210–23), the contours of intellectual property protection for network features of systems and platforms centers around software technology. Trade secrecy and contract law provided relatively effective protection for much of the software developed during the mainframe and minicomputer eras. And although advances in computer hardware fell squarely within the patent domain, there were significant doubts about the patentability of computer software into the 1990s. Hence, as microcomputers emerged, which spurred retail distribution of computer software, copyright law emerged as the primary battleground for computer software by the mid-1980s. This section begins by discussing how trade secrecy can protect the network features of systems technologies. It then traces the evolution of copyright protection for computer software. Almost all of the major computer software battles have focused on the extent to which copyright protection afforded protection to the network features of computer software. Section C discusses the role of trademark and related protections for network technologies. Section D examines the role of patent protection for network technologies, which emerged as a more robust and controversial form of protection for computer software in the 1990s. A.  Trade Secret Protection Trade secret protection protects against the misappropriation of confidential information that is subject to reasonable efforts to maintain secrecy, such as security and non-­disclosure agreements with employees and contractors (Menell et al., 2017, ch. II). Trade secret protection can last indefinitely, but once trade secrets become public, they lose protection. Trade secret protection came into common usage in the software industry as a tool for protecting algorithms, software design, and coding—including APIs. Trade secret protection of passwords is also commonly used today to control access to websites and cloud servers.

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Economic analysis of network effects and IP  173 Trade secret protection does not provide absolute protection for information. It only protects against misappropriation through improper means and unauthorized disclosure. Therefore, competitors do not violate trade secrecy protection through reverse engineering of publicly available products and websites. The reverse engineering limitation on trade secret protection thus exposes the trade secret owner to free riding by others. This limitation, however, strikes a salutary balance between protection on the one hand and competition and the dissemination of knowledge on the other (Landes and Posner, 2003; Samuelson and Scotchmer, 2002; Chisum et al., 1989). The trade secret owner can ‘purchase’ greater protection against this risk by investing in higher levels of security (e.g., more effective encryption for software-encoded technology). The inventor can also pursue patent protection, which proscribes reverse engineering, although only for the limited duration of the patent, and mandates disclosure of the invention to the public. By declining to pursue patent protection (or failing to satisfy the requirements thereof), however, inventors should not be able to secure potentially perpetual rights in technologies merely by encrypting them or otherwise obscuring how they function. To do so would undermine the larger balance of the federal intellectual property system. As the next section explains, courts have interpreted copyright law to permit multiple reproductions of copyrighted software programs as a means for reverse engineering unprotected (by copyright), but secret, elements of code necessary for interoperability. B.  Copyright Protection As the proliferation of microcomputers seeded a market for computer programs, software entrepreneurs saw copyright as an effective strategy to protect their programs from unauthorized reproduction and distribution. Computer software, however, does not fit easily within the copyright mold. Copyright law had long denied protection to functional elements. Although written in text, computer software provides the gears and levers for digital machines—which fits more naturally within the utility patent system (cf. Baker v. Selden, 101 U.S. 99, 102 (1879) (‘The claim to an invention or discovery of an art or manufacture must be subjected to the examination of the Patent Office before an exclusive right therein can be obtained; and it can only be secured by a patent from the government’). The rapid emergence of the computer software marketplace in the early 1970s posed a dilemma for intellectual property policymakers. Computer software could be expensive to develop and was easily pirated, creating a severe appropriability problem for the nascent, yet critical, software industry (Gates, 1976). Patent law, which had long served as the primary form of protection for technological advances in machines and processes, was thought to be too costly, time-consuming, stringent, and uncertain as a means for protecting software products against piracy (Menell, 1987, pp. 1347–51). Copyright law had long provided an effective means of protecting literary works from piracy, but its doctrines excluding ideas and functional elements from protection raised serious questions about its appropriateness for protecting inherently utilitarian works. Copyright’s low threshold for protection (mere originality), broad array of rights (including the right to adapt), and long duration created a high risk of overbroad protection for computer software products, in direct opposition to the parsimony principle. On the other hand, copyright law’s limiting principles, such as the idea-expression dichotomy (denying

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174  Research handbook on the economics of IP law volume 1 copyright protection to expression that encumbers the use of ideas) and the fair use doctrine, provided tools for aligning copyright protection with the parsimony principle. The interplay of copyright protection and network effects has played out on several fronts during the past four decades. Section 1 explains the principal legislation undergirding copyright protection for computer software. Section 2 traces the development of software copyright jurisprudence relating to APIs through 2010. Section 3 explores software licensing and the emergence and growth of the free and open source movements—key drivers of network technology markets. Section 4 explores the interoperability exception to the anti-circumvention provisions added to the copyright law in 1998. Section 5 picks up where Section 2 left off by examining the Oracle v. Google litigation. Section 6 examines copyright protection for standards and codes. 1. Software copyright legislation: the Copyright Act of 1976, the CONTU Final Report, and the 1980 amendments The software protection controversy of the early 1970s emerged at an inopportune time. Congress had been working for nearly two decades to overhaul the Copyright Act of 1909 and was nearing closure in the early to mid-1970s. Faced with the challenge of fitting computer and other new information technologies under the existing umbrella of intellectual property protection, Congress established the National Commission on New Technological Uses of Copyrighted Works (CONTU) to study the implications of the new technologies and recommend revisions to federal intellectual property law. As a stopgap, Congress included computer software within the scope of ‘literary works’ in the Copyright Act of 1976 (1976 Act). The House Report explains that [t]he term ‘literary works’ does not connote any criterion of literary merit or qualitative value: it includes catalogs, directories, and similar factual, reference, or instructional works and compilations of data. It also includes computer data bases, and computer programs to the extent that they incorporate authorship in the programmer’s expression of original ideas, as distinguished from the ideas themselves. (H.R. Rep. No. 94-1476, 94th Cong., 2d Sess. 54 (1976) (emphasis added))

Other provisions of the 1976 Act, however, maintained traditional exclusions for ideas and functional features. (17 U.S.C. § 102(b) (‘In no case does copyright protection for an original work of authorship extend to any idea, procedure, process, system, method of operation, concept, principle, or discovery’)). The CONTU Final Report concluded that copyright law should protect the intellectual work embodied in computer software, notwithstanding the fundamental principle that copyright cannot protect ‘any idea, procedure, process, system, method of operation, concept, principle, or discovery’ and the Supreme Court’s foundational decision in Baker v. Selden (CONTU, 1979, p. 1). Nonetheless, CONTU recommended that Congress immunize rightful possessors of a computer program from liability for using the program (which typically results in reproduction of computer code) and making a backup copy of computer programs, which Congress largely adopted in 1980 legislation (Act to amend the patent and trademark laws, Pub. L. No. 96-517, 94 Stat. 3015, 3028 (1980) (codified at 17 U.S.C. §§ 101, 117)). In keeping with copyright law’s fundamental limiting principles, the CONTU Final Report explained that while ‘one is always free to make a machine perform any conceivable process (in the absence of a patent), [] one is not free to take another’s program,’

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Economic analysis of network effects and IP  175 subject to copyright’s limiting doctrines—originality and the idea/expression dichotomy (CONTU, 1979, p. 20). The Report further explained that The ‘idea-expression identity’ exception provides that copyrighted language may be copied without infringing when there is but a limited number of ways to express a given idea. This rule is the logical extension of the fundamental principle that copyright cannot protect ideas. In the computer context this means that when specific instructions, even though previously copyrighted, are the only and essential means of accomplishing a given task, their later use by another will not amount to an infringement. (CONTU, 1979, p. 20 (footnote omitted))

Thus, while recognizing important limitations on copyright protection for computer software, including the § 102(b) limitations, Congress intended that software programmers would garner protection for their programming design and coding choices to the extent that the expression was separable from the underlying ideas. In this way, the general programming ideas and unoriginal programming choices remain free for others to use while the creative effort in particularized programming choices and compilations, especially in complex programs, gains protection from copyists. 2.  Software copyright jurisprudence: the first wave The 1976 Copyright Act, as well as the CONTU Final Report, pushed the availability and scope of copyright protection for computer software to the courts. The treatment of APIs under copyright law emerged over the next two decades as courts interpreted and applied the § 102(b) limitations (including the idea-expression dichotomy), infringement standards, the fair use defense, and other legal doctrines standards. Courts confronted battles across various software markets—from microcomputer operating systems to job scheduling software for mainframe computers, mobile phone networks, computer-user interfaces, video game devices, printer cartridges, garage door openers, and all manner of application programs (such as business systems, design programs, video games, and spreadsheets). Nearly every major software copyright litigation involved interoperability elements. After an inauspicious start, the federal courts implemented a balanced framework for both protecting computer software against piracy and interpreting the idea/expression doctrine to ensure that copyright law excludes functional features of computer technology (Menell, 1998). These decisions effectuated the subtle balance to which the CONTU Final Report referred. The courts came to appreciate that ‘creativity’ must be understood contextually. While programming a computer can unquestionably be termed ‘creative’ in a general sense, it is not necessarily ‘creative’ in a copyright sense. Just as the design of an efficient mechanical machine can be creative, such devices are not eligible for copyright protection unless the aesthetic features can be separated from the functional attributes (17 U.S.C. § 101 (‘“Pictorial, graphic, and sculptural works” include two-dimensional and three-dimensional works . . .; the design of a useful article . . . shall be considered a pictorial, graphic, or sculptural work only if, and only to the extent that, such design incorporates pictorial, graphic, or sculptural features that can be identified separately from, and are capable of existing independently of, the utilitarian aspects of the article’). Lines of code are the gears and levers of digital machines. The fact that computer software, like a sculptural work, is eligible for copyright protection does not authorize protection for functional features. The courts came to recognize that APIs have significant functional dimensions. They serve in many contexts as the basis for interoperability of computer technologies.

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176  Research handbook on the economics of IP law volume 1 The First Circuit held that the particular functional specifications, as opposed to the implementing code, can be fairly characterized as ‘methods of operation.’ Although the Supreme Court’s split decision in Lotus v. Borland (Lotus Dev. Corp. v. Borland Int’l, Inc., 516 U.S. 233 (1996) (affirming, without opinion by an equally divided vote, the First Circuit’s decision holding that the menu command structure for a spreadsheet is an uncopyrightable method of operation under § 102(b))) left some uncertainty, the resolution of that litigation marked the end of the major API copyright litigations that had raged since the early 1980s. This section traces that evolution. Section (i) examines the emergence of jurisprudence excluding functional and network features of computer software. Section (ii) explores the related issue of whether competitors can reproduce computer software as a means of learning unprotectable code elements. i.  Unprotectability of functional and network features    The first major cases to address copyright protection for interoperable features of computer software pitted Apple Computer Corporation, then a young, break-out microcomputer company, against cavalier, unscrupulous competitors offering discount ‘interoperable’ Apple II clones (Apple Computer, Inc. v. Franklin Computer Corp., 545 F. Supp. 812 (E.D. Pa. 1982), rev’d, 714 F.2d 1240 (3d Cir. 1983); Apple Computer, Inc. v. Formula Int’l, Inc., 562 F. Supp. 775 (C.D. Cal. 1983), aff’d, 725 F.2d 521 (9th Cir. 1984)). The clone makers quickly entered the market by simply copying, bit by bit, Apple’s operating system and application programs. The defendants in these cases argued that copyright protection did not extend to nonhuman readable (object code) formats of computer software and that the idea-expression doctrine barred copyright protection for operating system programs. They further argued that copyright protection should not stand in the way of their selling computers that can run programs written for the Apple II. The courts had little trouble validating Apple’s complaint that verbatim copying of millions of bits of code constituted copyright infringement. The 1976 Act, in conjunction with the CONTU Final Report, clearly extended copyright protection in this circumstance. Unfortunately, the Third Circuit’s decision included language suggesting that copyright protection could encompass the functional requirements for interoperability: ‘total compatibility with independently developed application programs . . . is a commercial and competitive objective which does not enter into the somewhat metaphysical issue of whether particular ideas and expressions have merged’ (Apple Computer, Inc. v. Franklin Computer Corp., 714 F.2d at 1253 (3d Cir. 1983)). Since two entirely different programs can achieve the same ‘certain result[s]’—for example, generate the same set of protocols needed for interoperability—the court was not justified in making such an expansive statement about the scope of copyright protection for computer program elements. CONTU was clear that ‘[o]ne is always free to make the machine do the same thing as it would if it had the copyrighted work placed in it, but only by one’s own creative effort rather than by piracy’ (CONTU, 1979, p. 21). Given the verbatim copying of millions of bits of object code, there was no need to address the interoperability issue. The defendant offered no explanation for which elements of the program were protectable and which were not. The Third Circuit’s decision in Whelan Associates, Inc. v. Jaslow Dental Laboratory, Inc., 797 F.2d 1222 (3d Cir. 1986), further expanded copyright protection for computer

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Economic analysis of network effects and IP  177 software. In that case, Jaslow Dental Laboratory had hired Whelan Associates, a custom software company, to develop a computer program to organize its bookkeeping and administrative tasks. When Jaslow developed and marketed its own program for managing a dental laboratory, Whelan sued Jaslow for copyright infringement. The evidence at trial showed that, although Jaslow had not literally copied Whelan’s code, there were overall structural similarities between the two programs. As a means of distinguishing protectable expression from unprotectable idea, the court reasoned: [T]he purpose or function of a utilitarian work would be the work’s idea, and everything that is not necessary to that purpose or function would be part of the expression of the idea. Where there are many means of achieving the desired purpose, then the particular means chosen is not necessary to the purpose; hence, there is expression, not idea (797 F.2d at 1236 (emphasis in original; citations omitted)).

In applying this rule, the court defined the idea as ‘the efficient management of a dental laboratory,’ which countless programs could express (797 F.2d at 1236, n. 28). Drawing the idea/expression dichotomy at such a high level of abstraction implied an expansive scope of copyright protection. Although the case did not directly address copyright protection for interoperable features of computer code, the court’s mode of analysis expanded the scope of copyright protection to all aspects of computer programs. If everything below the general purpose of the program were protectable under copyright law, then it would follow that particular protocols were protectable because there would be other ways to accomplish the program’s same general purpose. Such a result would effectively bar competitors from developing interoperable programs and computer systems. Commentators roundly criticized the Whelan test (Chisum et al., 1989, pp. 20–21; Menell, 1989, p. 1074; Englund, 1990, p. 881), and other courts developed alternative approaches. A few months after Whelan, the Fifth Circuit confronted a similar claim of copyright infringement based upon structural similarities between two programs designed to provide cotton growers with information regarding cotton prices and availability, accounting services, and a means for conducting cotton transactions electronically (Plains Cotton Coop. Ass’n v. Goodpasture Computer Serv., Inc., 807 F.2d 1256 (5th Cir. 1987)). In declining to follow the Whelan approach, the court found that the similarities in the programs were dictated largely by standard practices in the cotton market—what the court called ‘externalities’—such as the ‘cotton recap sheet’ for summarizing basic transaction information, which constitute unprotectable ideas. The court found persuasive the decision in Synercom Technology, Inc. v. University Computing Co., 462 F. Supp. 1003, 1013 (N.D. Tex. 1978), which analogized the ‘input formats’ of a computer program (the organization and configuration of information to be inputted into a computer) to the ‘figure-H’ pattern of an automobile stick shift. Drawing on the Fifth Circuit’s approach and Judge Learned Hand’s foundational test for analyzing copyright infringement (Nichols v. Universal Pictures Corp., 45 F.2d 119 (2d Cir. 1930)), the Second Circuit crafted what has become the leading framework for analysing infringement of computer software code (Computer Assocs. Int’l v. Altai, Inc., 982 F.2d 693 (2d Cir. 1992)). Computer Associates (CA), a leading mainframe software provider, had developed a job scheduling program (SCHEDULER) for IBM mainframe computers. Part of the success of this program was that it had a sub-component (ADAPTER) which interoperated with any of the three IBM mainframes. Thus, the user

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178  Research handbook on the economics of IP law volume 1 did not need to customize its programs for each of the IBM mainframes. CA’s ADAPTER program ensured that programs written for SCHEDULER would run on any of the three IBM mainframes. CA sued Altai, a competitor that pursued a similar strategy for designing its job scheduling software for the IBM mainframes. Unbeknownst to Altai’s management, one of its key programmers copied 30 percent of ADAPTER code into Altai’s job scheduling software product. When Altai management learned of the copying, the company initiated a ‘clean room’ process to insulate its programmers from copyright-protected code so as to ensure that the resulting program interoperated with the IBM mainframes without copying any ADAPTER code (Sammi et al., 2013). Altai accepted responsibility for copyright infringement based on the early version. Nonetheless, drawing on the Third Circuit’s Whelan decision, CA claimed that the clean room version was also infringing due to structural similarities at various levels, such as flow charts, inter-modular relationships, parameter lists, and macros. The Second Circuit rejected Whelan’s approach. The Second Circuit fleshed out a detailed analytical framework for determining copyright infringement of computer code: In ascertaining substantial similarity . . . a court would first break down the allegedly infringed program into its constituent structural parts. Then, by examining each of these parts for such things as incorporated ideas, expression that is necessarily incidental to those ideas, and elements that are taken from the public domain, a court would then be able to sift out all non-protectable material. Left with a kernel, or perhaps kernels, of creative expression after following this process of elimination, the court’s last step would be to compare this material with the structure of an allegedly infringing program (982 F.2d at 706).

The court’s ‘abstraction-filtration-comparison’ test recognized that an idea could exist at multiple levels of a computer program and not solely at the most abstract level. Furthermore, the ultimate comparison is not between the programs in their entirety. Rather, courts must focus solely on whether protectable elements of the program were copied. Of most importance for fostering interoperability, the court held that copyright protection did not extend to those program elements where the programmer’s ‘freedom to choose’ is circumscribed by extrinsic considerations such as (1) the mechanical specifications of the computer on which a particular program is intended to run; (2) compatibility requirements of other programs with which a program is designed to operate in conjunction; (3) computer manufacturers’ design standards; (4) demands of the industry being serviced; and (5) widely accepted programming practices within the computer industry (982 F.2d at 709–10).

Directly rejecting the Third Circuit’s dictum in Apple v. Franklin that achieving ‘total compatibility with independently developed application programs . . . is a commercial and competitive objective which does not enter into the somewhat metaphysical issue of whether particular ideas and expressions have merged,’ the Second Circuit recognized that external factors such as interface specifications, de facto industry standards, and accepted programming practices are not protectable under copyright law. The formulation of the Second Circuit test judges these external factors when the allegedly infringing activities (i.e., ex post) occur, not when the first program is written. The court emphasized that the first company to write a program for a particular application should not be able to ‘“lock up” basic programming techniques as implemented in programs to perform particular tasks’ (982 F.2d at 712 (quoting Menell, 1989, p. 1087)).

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Economic analysis of network effects and IP  179 Other circuits embraced the Second Circuit’s Altai framework (Gates Rubber Co. v. Bando Chem. Indus., Ltd., 9 F.3d 823, 836–43 (10th Cir. 1993); Eng’g Dynamics, Inc. v. Structural Software, Inc., 26 F.3d 1335 (5th Cir. 1994); Apple Computer, Inc. v. Microsoft Corp., 35 F.3d 1435 (9th Cir. 1994); Bateman v. Mnemonics, Inc., 79 F.3d 1532, 1547 (11th Cir. 1996); Mitel, Inc. v. Iqtel, Inc., 124 F.3d 1366 (10th Cir. 1997)). The Altai case addressed programmers’ freedom to write code to interoperate with externally established APIs—in that case by IBM. IBM had not challenged CA’s or Altai’s use of its interface specifications. It welcomed other companies to develop software for its mainframes. Thus, the case did not specifically address whether the API developer could assert a copyright infringement claim based on unauthorized use of their interface specifications. That issue would emerge in a series of cases involving video games and spreadsheets. The Ninth Circuit’s decision in Sega Enterprises Ltd. v. Accolade, Inc., 977 F.2d 1510 (9th Cir. 1992), expressly recognized the legitimacy of deciphering and copying particular lock-out codes for purposes of developing interoperable products. Sega developed a successful video game platform (Genesis) for which it licensed access to video game developers. Accolade, a video game manufacturer, wanted to distribute versions of its game on the Genesis platform. It did not, however, want to limit distribution exclusively to Genesis, as Sega required. Rather than license access to Sega’s code, Accolade reverse engineered the access code through a painstaking effort that entailed making hundreds of intermediate copies of Sega’s computer code. Accolade then incorporated only those code elements (approximately 25 bytes in games containing between 500,000 and 1.5 million bytes) that were necessary to achieve interoperability with the Genesis platform into Accolade game cartridges. Sega sued Accolade for copyright infringement. Given the relatively small amount of Sega code in the Accolade game cartridges, Sega focused its copyright claim on Accolade’s reproduction of the entirety of Sega’s program code for purposes of isolating those code elements needed to interoperate with the Genesis console. The district court rejected Accolade’s argument that such intermediate copies—made solely for the purpose of reverse engineering the platform—constituted fair use and granted a preliminary injunction. The Ninth Circuit held that ‘disassembly of object code in order to gain an understanding of the ideas and functional concepts embodied in the code is a fair use that is privileged by section 107 of the Act’ (977 F.2d at 1518). Balancing these factors, the Ninth Circuit ruled that ‘the functional requirements for compatibility with the Genesis [video game console are] aspects of Sega’s programs that are not protected by copyright’ (977 F.2d at 1522 (citing 17 U.S.C. § 102(b))). In effect, the court held that copyright law does not protect the particular code or process needed for interoperating with a copyrighted computer program (such as lock-out code). The Ninth Circuit reaffirmed and expanded the Sega decision in Sony Computer Entertainment, Inc. v. Connectix Corp., 203 F.3d 596 (9th Cir. 2000). The Northern District of California and the Ninth Circuit applied the Altai framework to the graphical user interface features of a computer program in Apple Computer, Inc. v. Microsoft Corp., 799 F. Supp. 1006 (N.D. Cal. 1992), aff’d in part, rev’d in part, 35 F.2d 1435 (9th Cir. 1994). Apple alleged that Microsoft’s Windows operating system infringed copyrights in the desktop graphical user interface of its Macintosh computer system. A licensing agreement authorizing Microsoft to use aspects of Apple’s graphical user interface muddied the copyright issue. The court determined, however, that the licensing

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180  Research handbook on the economics of IP law volume 1 agreement was not a complete defense to the copyright claims and therefore undertook an analysis of the scope of copyright protection for a large range of audiovisual elements of computer screen displays. In framing the analysis, the district court expressly recognized the relevance of network externalities and the cumulative nature of innovation to the scope of copyright protection: Copyright’s purpose is to overcome the public goods externality resulting from the nonexcludability of copier/free riders who do not pay the costs of creation. Peter S. Menell, An Analysis of the Scope of Copyright Protection for Application Programs, 41 Stan. L. Rev. 1045, 1059 (1989). But overly inclusive copyright protection can produce its own negative effects by inhibiting the adoption of compatible standards (and reducing so-called ‘network externalities’). Such standards in a graphical user interface would enlarge the market for computers by making it easier to learn how to use them. Id. at 1067–70. Striking the balance between these considerations, especially in a new and rapidly changing medium such as computer screen displays, represents a most ambitious enterprise. Cf. Lotus Dev. Corp. v. Paperback Software Int’l, 740 F. Supp. 37 (D. Mass. 1990).   While the Macintosh interface may be the fruit of considerable effort by its designers, its success is the result of a host of factors, including the decision to use the Motorola 68000 microprocessor, the tactical decision to require uniform application interfaces, and the Macintosh’s notable advertising. And even were Apple to isolate that part of its interface’s success owing to its design efforts, lengthy and concerted effort alone ‘does not always result in inherently protectible expression.’ [quoting Computer Assocs. Int’l v. Altai, Inc. 982 F.2d at 711]   By virtue of having been the first commercially successful programmer to put these generalized features together, Apple had several years of market dominance in graphical user interfaces until Microsoft introduced Windows 3.0, the first DOS-based windowing program to begin to rival the graphical capability of the Macintosh. . ..To accept Apple’s ‘desktop metaphor’/‘look and feel’ arguments would allow it to sweep within its proprietary embrace not only Windows and NewWave but, at its option, also other desktop graphical user interfaces which employ the standardized features of such interfaces, and to do this without subjecting Apple’s claims of copyright to the scrutiny which courts have historically employed. Apple’s copyrights would hold for programs in existence now or in the future—for decades. One need not profess to know for sure where should lie the line between expression and idea, between protection and competition to sense with confidence that this would afford too much protection and yield too little competition.   The importance of such competition, and thus improvements or extensions of past expressions, should not be minimized. The Ninth Circuit has long shown concern about the uneasy balance which copyright seeks to strike: ‘What is basically at stake is the extent of the copyright owner’s monopoly—from how large an area of activity did Congress intend to allow the copyright owner to exclude others?’ 799 F. Supp. at 1025–26 (quoting Herbert Rosenthal Jewelry Corp. v. Kalpakian, 446 F.2d 738, 742 (9th Cir.1971)).

The court found that most of the similar icons between Apple’s graphical user interface and Microsoft’s Windows that were not authorized by the licensing agreements were either not lacking originality or subject to one or more of copyright’s limiting doctrines. Drawing on the principle that compilations of largely uncopyrightable elements are only protected against ‘bodily appropriation of expression’ (see Harper House, Inc. v. Thomas Nelson, Inc., 889 F.2d 197, 205 (9th Cir. 1989)) the court applied a ‘virtual identity’ standard to compare the works as a whole and determined that no infringement had occurred. On appeal, the Ninth Circuit affirmed the district court’s dissection of the works to determine which elements are protectable, its filtering of unprotectable elements, and its application of the ‘virtual identity’ standard. The copyrightability of command systems for computer software arose most directly in

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Economic analysis of network effects and IP  181 Worksheet

Global

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Figure 7.1  Lotus 1-2-3 menu command hierarchy litigation surrounding spreadsheet technology. Building upon the success of the VisiCalc program developed for the Apple II computer, Lotus Corporation marketed an enhanced operating spreadsheet program incorporating many of VisiCalc’s features and commands into its 1-2-3 program for the IBM PC platform. Lotus 1-2-3 quickly became the market leader for spreadsheets running on IBM and IBM-compatible machines, and knowledge of the program became a valuable skill in the accounting and management fields. The 1-2-3 command hierarchy was particularly attractive because it logically structured more than 200 commands (see Figure 7.1). Users could create custom programs (called macros) to automate particular accounting and business planning tasks. Businesses and users increasingly became ‘locked-in’ to the 1-2-3 command structure as they invested time to learn the system and their libraries of macros grew (Gandal, 1994). By the late 1980s, software developers seeking to enter the spreadsheet market could not ignore the large premiums that consumers placed on their investments in the 1-2-3 system (Menell, 1998). After three years of intensive development efforts, Borland International, developer of several successful software products including Turbo Pascal and Sidekick, introduced Quattro Pro, its entry into the spreadsheet market. Quattro Pro offered improved design and graphics over Lotus 1-2-3. Computer magazines praised its innovation. Quattro Pro offered a new interface for its users, which many preferred over the 1-2-3 interface. Nonetheless, because of the large number of users already familiar with the 1-2-3 command structure and those who had made substantial investments in developing 1-2-3 macros, Borland considered it essential to offer an operational mode based on the 1-2-3 command structure as well as macro compatibility. Nonetheless, Borland’s visual representation of the 1-2-3 command mode substantially differed from the 1-2-3 screen displays. Lotus sued Borland for copyright infringement based on Quattro Pro’s emulation of the 1-2-3 menu command hierarchy. The First Circuit viewed the case as one of first impression: ‘[w]hether a computer menu command hierarchy constitutes copyrightable subject matter.’ (Lotus Dev. Corp. v. Borland Int’l, Inc., 49 F.3d 807, 813 (1st Cir. 1995)). The court distinguished Altai as dealing with protection of computer code as opposed to the results of such code. Instead, the First Circuit saw the subject matter of the Lotus case as a ‘method of operation’ falling directly within the exclusions from copyright protection set forth in 17 U.S.C. § 102(b). The court held the Lotus menu command hierarchy is an uncopyrightable ‘method of operation.’

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182  Research handbook on the economics of IP law volume 1 The Lotus menu command hierarchy provides the means by which users control and operate Lotus 1-2-3. If users wish to copy material, for example, they use the ‘Copy’ command. If users wish to print material, they use the ‘Print’ command. Users must use the command terms to tell the computer what to do. Without the menu command hierarchy, users would not be able to access and control, or indeed make use of, Lotus 1-2-3’s functional capabilities.   The Lotus menu command hierarchy does not merely explain and present Lotus 1-2-3’s functional capabilities to the user; it also serves as the method by which the program is operated and controlled. . ..(49 F.3d. at 815)

The US Supreme Court affirmed without opinion by an equally divided vote (Lotus Dev. Corp. v. Borland Int’l, Inc., 516 U.S. 233 (1996)). Subsequent appellate decisions reached similar outcomes, although they did not fully adopt the First Circuit’s categorical exclusion of menu command hierarchies from copyright protection. In MiTek Holdings, Inc. v. ARCE Engineering Co., 89 F.3d 1548 (11th Cir. 1996), the holder of a copyright in an application program that designed and arranged wood trusses for the framing of building roofs brought an infringement action against the maker of a competing program that featured a similar menu command tree and user interface. Affirming the lower court’s decision, the Eleventh Circuit held that the menu and submenu command structure of the truss design program was uncopyrightable under § 102(b) of the 1976 Act because it represents a process. The court did not need to reach the broader question, addressed in Lotus, of whether all menu command structures are uncopyrightable as a matter of law. In Mitel, Inc. v. Iqtel, Inc., 124 F.3d 1366 (10th Cir. 1997), Mitel, the maker of a widely adopted computer system for automating the selection of a particular telephone long distance carrier and remotely activating optional telecommunications features such as speed dialing, sued Iqtel, a competing firm that used the identical command codes, for copyright infringement. Because Mitel’s system had become a de facto standard, Iqtel defended its use of compatible controller codes on the ground that ‘technicians who install call controllers would be unwilling to learn Iqtel’s new set of instructions in addition to the Mitel command code set, and the technician’s employers would be unwilling to bear the cost of additional training.’ As Borland had done, Iqtel’s product included both its own set of command codes as well as a ‘Mitel Translation Mode.’ While commenting that a method of operation may in some circumstances contain copyrightable expression, the Tenth Circuit nonetheless concluded that the Mitel command codes, which were arbitrarily assigned, lacked the minimal degree of creativity necessary to qualify for copyright protection. The court further held that Mitel’s command codes should be denied copyright protection under the scènes à faire doctrine because external factors such as compatibility requirements and industry practices largely dictated the codes. There were no further cases reported addressing copyright protection for APIs over the next 15 years. We address the Federal Circuit’s decision upholding copyright protection for APIs in the Oracle v. Google case in subsection 5. ii.  Permissibility of reverse engineering    As discussed in section V(A), network system developers can use encryption and trade secret law to protect computer code. Distributing computer programs in object code (binary) format typically constitutes a reasonable effort to maintain secrecy. As noted, however, competitors can lawfully gain access to such information through reverse engineering. One such method is to experiment with object code

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Economic analysis of network effects and IP  183 to determine which bits are necessary for interoperability. Such forensic work typically requires the investigator to make many copies, raising the risk of copyright infringement. The LaST Frontier Final Report (Chisum et al., 1989), a consensus statement of leading intellectual property scholars, opined that ‘limited copying of programs for the purpose of examination and study . . . falls within the rigorous terms of the fair use provisions in section 107 of the Copyright Act’ (Chisum et al., 1989, p. 25; Samuelson and Scotchmer, 2002). In addition to holding that computer code necessary for interoperability is unprotectable under § 102(b), the Ninth Circuit’s Sega decision authorized the copying of entire computer programs for purposes of deciphering unprotectible code elements. In explaining why disassembly and reproduction of object code constitute fair use, the court reasoned that the ‘functional specifications’ of a computer program are unprotectable. The Ninth Circuit based its analysis on the architecture of the intellectual property system: [D]isassembly of the object code in Sega’s video game cartridges was necessary in order to understand the functional requirements for Genesis compatibility. The interface procedures for the Genesis console are distributed for public use only in object code form, and are not visible to the user during operation of the video game program. Because object code cannot be read by humans, it must be disassembled, either by hand or by machine. If disassembly of copyrighted object code is per se an unfair use, the owner of the copyright gains a de facto monopoly over the functional aspects of his work—aspects that were expressly denied copyright protection by Congress. 17 U.S.C. § 102(b). In order to enjoy a lawful monopoly over the idea or functional principle underlying a work, the creator of the work must satisfy the more stringent standards imposed by the patent laws. Bonito Boats, Inc. v. Thunder Craft Boats, Inc., 489 U.S. 141, 159–64 (1989). Sega does not hold a patent on the Genesis console. (Sega Enterprises Ltd. v. Accolade, Inc., 977 F.2d 1510, 1526 (9th Cir. 1993))

The Ninth Circuit reaffirmed and expanded the Sega analysis in Sony Computer Entertainment, Inc. v. Connectix Corp., 203 F.3d 596 (9th Cir. 2000). 3.  Software licensing Copyright law grants authors exclusive rights to copy, adapt, distribute, publicly perform, and publicly display protected works, subject to various limitations. The early computer industry, however, did not rely on proprietary control over their customers’ use or adaptation of their software programs. Nor did companies restrict customers’ access to source code. Rather, the industry—led by IBM and followed by Burroughs, UNIVAC, NCR, Control Data, General Electric, and RCA (often referred to as the ‘Seven Dwarfs’ due to IBM’s dominance in the computer industry)—bundled software with their mainframes and derived revenues from leasing computer usage and sales of complementary products and services (Ceruzzi, 2003, ch. 5). In this era, IBM actively facilitated sharing of software among its users as a way of increasing usage of its computers. The structure of the computer industry and copyright’s role dramatically changed during the 1970s. With technological advances creating a minicomputer market and IBM’s 1969 decision to unbundle software from mainframe leasing in the face of antitrust charges, computer hardware vendors and independent software developers came to use copyright licenses to protect computer programs. The opening of a competitive proprietary software marketplace ended an era in which software was freely shared (Phillips, 2009, pp. 113–15).

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184  Research handbook on the economics of IP law volume 1 This shift produced a backlash within the programmer community that continues to reverberate throughout the computer and software industries. The rapid rise of a robust microcomputer industry followed by the creation of the Internet generated a robust, independent software marketplace. These technologies had strong and complex network effects, which have been substantially affected by software licensing practices. While many hardware and software enterprises continue to rely heavily on proprietary software licensing agreements, the programmers’ backlash against restrictive software licensing as well as business strategies aimed at disrupting proprietary standards have dramatically reshaped software licensing institutions, practices, and patterns. This section explores this evolving landscape. Section (i) traces the emergence of the free software movement, which resourcefully uses copyright licensing to promote open platforms. The movement’s innovative licensing framework produced a form of network effects. Section (ii) examines the open source movement, based on a more permissive licensing model, which broadened the shift away from proprietary software licensing. Section (iii) discusses the use of dedication of software copyrights to the public domain as a third alternative for promoting network effects. Section (iv) surveys federal copyright preemption of licensing restrictions. i.  The free software movement (General Public License)   Many independent and academic programmers, who had long enjoyed free access to source code, viewed the shift to proprietary software licensing as a debilitating restriction on collaborative research, programming freedom, and software innovation. Beginning in the early 1980s, Richard Stallman, then a researcher in MIT’s Artificial Intelligence Laboratory, began a grass-roots ‘free software’ movement. Although Stallman was vehemently opposed to intellectual property protection for computer software, he came to see that the same copyright protections that exclude competitors could be deployed to prohibit restrictions on adaptation and reuse of code and to foster open platforms (Weber, 2004, pp. 47–9). Stallman established the Free Software Foundation (FSF) in 1985 to promote users’ rights to use, study, copy, modify, and redistribute computer programs. The FSF devised the GPL to prevent programmers from building proprietary limitations into software. The GPL guarantees end users the freedoms to run, study, share (copy), and modify the software so long as the users permit use of any derivative works on the same terms (Carver, 2005). In this way, GPL software ‘infects’ derivative works with user rights and virally spreads these rights through the collaborative software ecosystem. Stallman targeted the development of a viable UNIX-compatible open source operating as FSF’s initial goal. The UNIX operating system, developed by researchers at MIT, AT&T’s Bell Labs, and General Electric in the late 1960s and early 1970s, offered innovative time-sharing capability. It became a foundation for modern computer operating system design (McKusick, 1999). In 1972, two Bell Labs researchers—Dennis Ritchie, inventor of the C programming language, and Ken Thompson—rewrote UNIX in C, enabling UNIX to be installed on any advanced computer system. AT&T held the copyright to UNIX, which restricted its use and adaptation. Stallman sought to liberate UNIX through the GNU (‘GNU’s Not Unix’) GPL independent re-implementation project. Many programmers throughout the world contributed to this effort on a voluntary basis, and by the late 1980s most of the components had been assembled. The project

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Economic analysis of network effects and IP  185 reached fruition in 1991 when Linus Torvalds developed a UNIX-compatible kernel—the central core of the operating system. Torvalds structured the evolution of his component on the GPL model. The resulting UNIX-compatible free software program, dubbed ‘Linux,’ has become widely used throughout the computing world. While attractive to many independent, non-commercial programmers, the so-called ‘copyleft’ GPL licensing model posed a serious problem for many commercial software vendors. Although it afforded free access to GPL software, it prevented these cumulative developers from charging a royalty for their modifications and subjected further modifications by licensees to GPL restrictions (Determann, 2006, p. 1484). ii.  The open software movement (permissive licenses)    The ‘open source’ movement emerged as a middle ground between proprietary software distribution and the ‘free’ software movement. Like Linux, the open source movement traces its roots to efforts to liberate UNIX. In the mid-1970s, Ken Thompson at the University of California, Berkeley, spearheaded an effort by Berkeley faculty and students to enhance UNIX capabilities. In contrast to the GPL, the Berkeley Software Development (BSD) project offered its software on a ‘permissive’ basis: licensees could distribute modifications of the BSD software whether or not the modifications were freely licensed. Nonetheless, the licensee was still obliged to obtain a license from AT&T for the underlying UNIX code. As the Internet took off in the late 1990s, a growing number of hardware and software vendors embraced ‘free’ and ‘open source’ development and distribution strategies. They saw these non- or less-proprietary licensing models as means to prevent Microsoft from expanding its influence into the Internet and other platform technologies while simultaneously promoting competition and innovation (Lerner and Tirole, 2004, 2005; Merges, 2004; Benkler, 2002, 2004; McGowan, 2001). There is now a wide variety of permissive open source licensing models (Meeker, 2015, Appendix B). Free (GPL) and open source software play strong and increasing roles in network technologies, such as operating systems (e.g., Linux), Internet infrastructure (e.g., Apache Web Server) and mobile devices (e.g., Android), but have been less successful in penetrating consumer as opposed to programmer-centric product areas (Phillips, 2009, pp. 156, 158–68; Lerner and Tirole, 2005). Notwithstanding the proliferation of free and open source licenses, there have been relatively few litigated disputes (Jacobsen v. Katzer, 535 F.3d 1373 (Fed. Cir. 2008); Phillips, 2009, pp. 120–21). iii.  Dedication to the public domain    A further distribution alternative that has been especially important in the proliferation of network benefits is outright dedication of computer software copyrights (and other forms of intellectual property) to the public domain. Tim Berners-Lee, the developer of the World Wide Web (WWW), was initially attracted to releasing his hypertext software platform under the GPL (Berners-Lee, 2000, pp. 72–3). Internet engineers, however, raised the concern that any restrictions attached to its usage could limit its adoption and use. Some large companies were rumored to be opposed to allowing usage of any software that could trigger license restrictions, including GPL copyleft requirements. Berners-Lee ultimately chose to dedicate the WWW to the public domain. Notwithstanding concerns that unprotected software could be fragmented and captured through proprietary ­extensions, the WWW has thrived and

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186  Research handbook on the economics of IP law volume 1 remained remarkably stable (Phillips, 2009, p. 174). This is attributable to the very strong network effects of Internet protocols and the community and technically driven, open, standard setting processes administered by the WWW Consortium (W3C) headed by Berners-Lee and the IETF. iv.  Federal preemption of contractual restrictions   In contrast to the free and open software movements, some software developers use licensing provisions to restrict the use of their copyrighted software. Some licenses, for example, bar reverse engineering of software programs. Such a restriction affords the copyright owner greater control over the development of interoperable products. The courts are divided, however, on whether federal copyright law and intellectual property policies preempt such state law contractual provisions. In Vault Corp. v. Quaid Software, Ltd., 847 F.2d 255 (5th Cir. 1988), the Fifth Circuit Court of Appeals held that the Louisiana Software License Enforcement Act clause permitting a copyright owner to prohibit software decompilation or disassembly was preempted by the Copyright Act, and was therefore unenforceable. A more recent case interpreted the scope of federal copyright protection more narrowly, enforcing licensing restrictions that bar activities that would otherwise fall within copyright’s fair use privilege (Bowers v. Baystate Techs., 320 F.3d 1317 (Fed. Cir. 2003)). The dissenting opinion in that case, however, indicates that the scope of federal preemption of licensing restrictions that contract around the fair use privilege remains unsettled (Band and Katoh, 2011, pp. 121–33). Section VI examines the related questions of whether antitrust law or misuse doctrines further restrict licensing provisions that leverage intellectual property rights to hinder downstream innovation or competition. 4.  Interoperability exception to the DMCA’s anti-circumvention prohibition The permissibility of reverse engineering software to achieve interoperability arose during the legislative deliberations over the enactment of anti-circumvention prohibitions. With the emergence of the Internet in the mid-1990s, motion picture studios, record labels, publishers, and other content owners came to see encryption and other digital rights management technologies as a promising self-help means to discourage unauthorized distribution of their works. They recognized, however, that such technologies would be vulnerable to unauthorized circumvention of technological protection measures. Thus, they sought to expand copyright protection beyond its traditional prohibitions against infringement to include limits on the decrypting or circumventing of technological protection systems and the trafficking in such decryption tools. They contended that without such protection, they would be unwilling to release content onto the Internet, which in turn would hamper the adoption of broadband services. Various other interests—ranging from consumer electronics manufacturers, library associations, computer scientists, and law professors—expressed concern about potential chilling effects of such an expansion of copyright law upon those who wish to make fair use of copyrighted works. Congress crafted a compromise in the DMCA (17 U.S.C. § 1201). Section 1201(a) bans circumvention of technological protection measures put in place by copyright owners to protect copyrighted works. Section (b) prohibits trafficking in anti-circumvention tools. Section 1201(f)(1) provides that:

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Economic analysis of network effects and IP  187 a person who has lawfully obtained the right to use a copy of a computer program may circumvent a technological measure that effectively controls access to a particular portion of that program for the sole purpose of identifying and analyzing those elements of the program that are necessary to achieve interoperability of an independently created computer program with other programs, and that have not previously been readily available to the person engaging in the circumvention, to the extent any such acts of identification and analysis do not constitute infringement under this title.

The legislative history notes that this provision is intended to allow legitimate software developers to continue engaging in certain activities for the purpose of achieving interoperability to the extent permitted by law prior to the enactment of this chapter. The objective is to ensure that the effect of current case law interpreting the Copyright Act is not changed by enactment of this legislation for certain acts of identification and analysis done in respect of computer programs. See, Sega Enterprises Ltd. v Accolade, Inc., 977 F.2d 1510, 24 U.S.P.Q. 2d 1561 (9th Cir. 1992.). The purpose of this section is to foster competition and innovation in the computer and software industry. (S. Rep. No. 105-190, p. 13 (1998))

Because violations of the DMCA are not acts of copyright infringement, but rather separate offenses, courts have held that the defenses available under the Copyright Act, including fair use, do not apply to anti-circumvention violations (Universal City Studios, Inc. v. Corley, 273 F.3d 429 (2d Cir. 2001); 321 Studios v. Metro-Goldwyn-Mayer Studios, Inc., 307 F. Supp. 2d 1085 (N.D. Cal. 2004)). While § 1201(c)(1) provides that ‘nothing in this law’ shall interfere with ‘fair use’ among other defenses, the courts have reasoned that the DMCA does not interfere with fair use but merely renders it irrelevant by allowing copyright owners to bring a non-copyright claim. Furthermore, the larger structure of the DMCA provides additional safeguards to address free expression and other concerns. Beyond the statutory exemptions to the anti-circumvention ban, the DMCA established a triennial rulemaking process for exempting particular categories of works from the anti-circumvention ban for which ‘noninfringing uses by persons who are users of a copyrighted work are, or are likely to be, adversely affected’ (17 U.S.C. § 1201(a)(1)(B)– (D)). Several of the granted exemptions authorize decryption for purposes of developing interoperable products. Smartphones, tablets, other mobile computing devices, and smart TVs, all of which have networking aspects, have attracted particular attention. Several major manufacturers of these products have sought to use encryption technologies to bundle the devices in telecommunications service plans. In a series of rulemaking proceedings, the Copyright Office has exempted unlocking or ‘jail-breaking’ of these products from the anticircumvention ban. (Library of Congress, 2018). Congress and the FCC have reinforced, extended, and expanded these exemptions (Band, 2017, pp. 79–109; Unlocking Consumer Choice and Wireless Competition Act, Pub. L. 113-144, 128 Stat. 1751 (2014)). The DMCA’s anti-circumvention provisions have generated several cases involving the use of technological protection measures to exclude competitors from aftermarkets— goods or services supplied for a durable product after its initial sale (e.g., replacement ink for printers). Several companies embedded digital code into their products and aftermarket components that must interoperate to function as a means of exerting control over such aftermarkets. When competitors in these aftermarkets decrypted such digital

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188  Research handbook on the economics of IP law volume 1 codes to manufacture their own components, these durable product manufacturers sued, alleging violation of the anti-circumvention provisions of the DMCA. Some courts have declined to find liability, emphasizing that the careful balance that Congress sought to achieve between the interests of content creators and information users would be upset if the anti-circumvention prohibitions could be applied to activities that did not facilitate copyright infringement (Chamberlain Group, Inc. v. Skylink Techs., Inc., 381 F.3d 1178, 1202 (Fed. Cir. 2004) (holding that ‘section 1201 prohibits only forms of access that bear a reasonable relationship to the protections that the Copyright Act otherwise affords copyright owners’); Lexmark Int’l, Inc. v. Static Control Components, Inc., 387 F.3d 522 (6th Cir. 2005) (holding that the lock-out technology at issue did not effectively control access to a copyrighted work); Storage Technology Corp. v. Custom Hardware Eng’g & Consulting, Inc., 421 F.3d 1307 (Fed. Cir. 2005) (holding that decryption (by third-party software repair entity) to perform software maintenance activities is not actionable); but see MDY Indus., LLC v. Blizzard Entm’t, Inc., 629 F.3d 928, 948‒52 (9th Cir. 2010) (finding that only an incidental relation must exist between circumvention and copyright infringement)). i.  GPL 3.0—DRM provision    To bar intellectual property restrictions on software use and promote sharing of code, the FSF added a provision to the GPL 3.0 (released in 2007) barring licensors and those who use the licensed code from enforcing anti-circumvention prohibitions (GNU General Public License 3.0, 2007, § 3). GPL 3.0 has not been as widely adopted as prior GPL versions, particularly among commercial enterprises (Section D(3) (iii); Meeker, 2015, ch. 10). 5.  Software copyright jurisprudence: the Oracle v. Google litigation After the Lotus v. Borland case resolved, litigation subsided over copyright protection for the functional specifications of APIs and other network features of computer software (Menell, 1998). The Sega, Altai, and Borland decisions and software industry norms accorded competitors the ability to develop interoperable code and devices so long as they independently implemented the functional specifications of the target platform (Menell, 2018). If the programs were encrypted or only released in object code form, the competitor would need to reverse engineer the code, which could be costly and timeconsuming. Beyond the drudgery of reverse engineering, copyright did not stand in the way of developing and distributing interoperable code and devices. A shift in business strategy in the Internet Age reinforced these legal principles and industry norms. Whereas most software vendors in the pre-Internet era sought to appropriate a return on their investments directly through software and device sales and licenses, the Internet expanded the potential for multi-sided markets and indirect appropriability—principally through advertising, service plans, and use of customer data (Campbell-Kelly et al., 2015; Evans, 2003; Shapiro and Varian, 1999). These strategies harnessed the positive feedback effects of network technologies. Beginning with Netscape, a growing number of Internet Age entrepreneurs valued adoptions over revenues in the start-up phase of their enterprises. The Internet provided a low-cost means of distributing information and software, goods that had zero marginal reproduction cost. For example, Sun Microsystems released the Java programming language to the public as a means of promoting its hardware sales and forestalling

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Economic analysis of network effects and IP  189 Microsoft’s dominance of website development tools (Menell, 2018). Google developed a robust revenue stream for its search technologies without ever charging users. It profited handsomely from bundling search results with keyword-generated advertisements. Thus, many software and Internet companies welcomed adoption of their platforms, including interoperability with their APIs. Sun Microsystems dedicated the Java programing language to the public domain early on, and in 2006 licensed the Java Standard Edition, Enterprise Edition, and ME platforms—comprising packages of pre-written APIs— under the GPL. Unlike Sega, it published its API specifications for the world to see, adopt, and emulate. Its primary concern was maintaining the WORA interoperability of these platforms. Hence, it required licensees to verify that implementations satisfied the particular Java Technology Compatibility Kit (TCK) test. When Google ventured into mobile platform development, it sought to take advantage of the millions of programmers intimately familiar with Java, the most widely used programming language and platform for web development. But unlike Borland, which sought to achieve perfect interoperability with the Lotus 1-2-3 menu command hierarchy so that Lotus macros could run on Borland’s Quattro system, Google sought to customize Java for the smaller chip size of mobile handsets and add additional features, such as location tools and a camera. Consequently, Google did not plan to include all the Java APIs, which meant that the resulting system would not pass the Java TCK test. Moreover, Google and its open handset alliance partners did not believe that the GPL would provide sufficient flexibility for the range of players it believed would be needed to establish a robust new mobile platform. They worried that the viral share and share alike provision would discourage Google’s handset manufacturer and telecommunications partners from investing in innovative features. The members of the Android Open Handset Alliance believed that a more permissive licensing model, in which downstream suppliers could make proprietary extensions on top of the base platform, would better promote robust competition and innovation. When licensing negotiations between Google and Sun reached an impasse, Google chose to re-implement a subset of Java API packages independently to take advantage of the vast Java programming community and the decade of testing that the Java APIs had undergone. Google did not need to reverse engineer the Java API functional specifications because Sun disclosed them. Nonetheless, Google had to devote substantial resources to re-implementing the code using a clean room process. When Google introduced Android in late 2007, Sun’s CEO publicly praised the adoption of Java. Privately, however, he and other Sun leaders seethed at Google’s cavalier approach and forking of the Java platform. Nonetheless, Sun refrained from blocking Android through legal action (Menell, 2018). With its hardware business in decline and unable to monetize Java, Sun’s viability as an independent company came into question. Oracle Corporation, which had built many of its software products on the Java platform, acquired Sun in 2010. Oracle immediately pressured Google to license Java and when Google declined, sued alleging that Android infringed Java-related patents and copyrights. Oracle focused its copyright claim on Google’s copying of function labels, functional specifications (declarations), and the structure, sequence, and organization of 37 Java API packages. After the jury rejected Oracle’s patent causes of action, the district court ruled that the Java APIs were not copyrightable (Oracle America, Inc. v. Google, Inc., 872 F. Supp. 2d

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190  Research handbook on the economics of IP law volume 1 974 (N.D. Cal. 2012)). Judge Alsup cautioned that the ruling did not hold ‘Java API packages are free for all to use without license’ or that ‘the structure, sequence and organization of all computer programs may be stolen.’ He grounded his decision in the particular and distinctive functional attributes of the 37 Java APIs and that Google independently wrote its own implementing code using a clean room process. The principal copying concerned the lines of declarations, which are necessary to operate the particular methods of the APIs. As Judge Alsup explained, Significantly, the rules of Java dictate the precise form of certain necessary lines of code called declarations, whose precise and necessary form explains why Android and Java must be identical when it comes to those particular lines of code. That is, since there is only one way to declare a given method functionality, everyone using that function must write that specific line of code in the same way. (872 F. Supp. at 979 (emphasis in original))

While acknowledging that the overall structure of the Java API packages is creative, original, and ‘resembles a taxonomy,’ Judge Alsup nonetheless concluded that it functions as ‘a command structure, a system or method of operation—a long hierarchy of over six thousand commands to carry out pre-assigned functions.’ Applying copyright’s limiting doctrines as the Ninth Circuit has interpreted them, emphasizing the Sega decision, and following CONTU’s guidance that when specific computer instructions, ‘even though previously copyrighted, are the only and essential means of accomplishing a given task, their later use by another will not amount to an infringement,’ (872 F. Supp. 2d at 986 (quoting CONTU, 1979, p. 20) (emphasis added by Judge Alsup)), Judge Alsup determined that Google was free to write code that accomplished the same functionality as the Java APIs at issue even if it did not achieve complete compatibility with the full Java platform. Later developers can achieve the particular functionality or method of operation of an API subsystem (and even groups of subsystems) so long as they write their own code and no patent protects that method. Oracle appealed the copyright issues to the US Court of Appeals for the Federal Circuit. (Menell, 2016 (explaining and questioning the Federal Circuit’s jurisdiction over appeals from district court cases involving patent infringement allegations even if neither party challenges the district court’s patent rulings)). The Federal Circuit is bound by regional circuit law when reviewing questions that involve law and precedent not exclusively assigned to the Federal Circuit. Notwithstanding the Ninth Circuit’s holding in Sega and Sony v. Connectix that copyright law does not prohibit the precise coding necessary to achieve interoperability (Sega Enterprises Ltd. v. Accolade, Inc., 977 F.2d 1510, 1525 (9th Cir. 1993); Sony Computer Entertainment, Inc. v. Connectix Corp., 203 F.3d at 603 (‘There is no question that the Sony BIOS contains unprotected functional elements’), the Federal Circuit reversed the district court’s determination that the structure, sequence, and organization of the 37 Java APIs were not copyrightable (Oracle America, Inc. v. Google, Inc., 750 F.3d 1339 (Fed. Cir. 2014); Menell, 2018). The appellate court determined that even high-level API design choices—including function labeling choices and compilation of functions—satisfy copyright law’s low originality threshold. The court side-stepped the Sega and Sony cases by construing Ninth Circuit law to hold that ‘copyrightability is focused on the choices available to the plaintiff at the time the computer program was created,’ not the defendant’s desire to achieve interoperability. The court concluded that Google’s interoperability

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Economic analysis of network effects and IP  191 argument comes into play only as part of a fair use defense, an issue on which the jury had hung. Consequently, the court remanded the case for a fair use trial. On remand, the jury concluded that Android’s use of Java API declarations and structure, sequence, and organization constituted fair use. The Federal Circuit once again reversed, holding that the fair use balance tilted in Oracle’s favor (Oracle America, Inc. v. Google LLC, 886 F.3d 1179 (Fed. Cir. 2018)). The Federal Circuit’s decision gives no weight to the second fair use factor based on a questionable reading of Ninth Circuit jurisprudence.3 The Federal Circuit’s decision rejecting Judge Alsup’s API copyrightability ruling is the most significant recent federal appellate decision to confront the copyrightability of APIs. Given the proliferation of software patents, there is a high likelihood that a company with a widely-used set of APIs would be able to pursue both patent and copyright causes of action in the same litigation, thereby bringing the Federal Circuit’s exclusive jurisdiction over patent cases into play. Google is seeking Supreme Court review of both the Federal Circuit’s 2014 API copyrightability decision and its 2018 fair use decision. 6.  Standards and codes Copyright protection extends to any work of authorship fixed in a tangible medium of expression, subject to various limiting doctrines, such as the idea-expression dichotomy and fair use. Standard setting bodies generally promote access to their standards and codes. Sun (and later Oracle) published the Java API declarations. Their members typically wish to encourage widespread adoption of sponsored standards. Some developers of standards seek to control access to their specifications. As reflected in the Sega case, Sega controlled the access codes for the Genesis game platform through trade secret law. After Accolade successfully reverse engineered the interoperability code, Sega sought to bar its use by Accolade (and recover for copyright infringement). The Ninth Circuit held, however, that software code elements necessary for interoperability are unprotectable by copyright law. Various technical, building, and other standards development seek to control access to their work product principally to earn publication royalties. They contend that the royalty income provides vital funding for coordinating standard development, resulting in better formulated and maintained codes (Shannon, 2012). Scholars have questioned the need for copyright protection to promote standards developments. Professor Paul Goldstein contends that ‘[i]t is difficult to imagine an area 3   Oracle America, Inc. v. Google LLC, 886 F.3d 1179, 1205 (Fed. Cir. 2018) (explaining that “[t]he Ninth Circuit has recognized . . . that th[e] second factor ‘typically has not been terribly significant in the overall fair use balancing.’ Dr. Seuss Enters., L.P. v. Penguin Books USA, Inc., 109 F.3d 1394, 1402 (9th Cir. 1997) (finding that the ‘creativity, imagination and originality embodied in The Cat in the Hat and its central character tilts the scale against fair use’); Mattel[, Inc. v. Walking Mountain Prods., 353 F.3d 792, 803 (9th Cir. 2003)] (similar)”). The Federal Circuit’s reliance on Dr. Seuss Enters. and Mattel is misplaced. Those cases addressed familiar children’s stories and dolls; neither involved functional works, let alone computer software. By contrast, the Ninth Circuit’s decisions in Sega (977 F.2d at 1524-27 (9th (extensive discussion of the second factor connecting fair use to Baker v. Selden and § 102(b)) and Sony Comput. Entm’t (203 F.3d at 602-05 (leading its discussion of fair use with the second fair use factor and affording it great significance)), provide a far sounder footing for analyzing fair use in Oracle v. Google.

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192  Research handbook on the economics of IP law volume 1 of creative endeavor in which the copyright incentive is needed less. Trade organizations have powerful reasons stemming from industry standardization, quality control, and self-regulation to produce these model codes; it is unlikely that, without copyright, they will cease producing them’ (Goldstein, 2000, § 2.5.2). The accessibility of edicts of law raises fundamental constitutional and policy questions (Malamud, 2014). Federal, state, and local laws, judicial opinions, and regulations incorporate these codes. The Copyright Act expressly exempts works of the federal government from copyright protection (17 U.S.C. § 105). Court decisions on copyrightability of non-federal edicts of law have been mixed. The Fifth Circuit held that model codes enter the public domain when they enter into law (Veeck v. S. Bldg. Code Congress Int’l, Inc., 293 F.3d 791 (5th Cir. 2002) (en banc)). Building on that precedent, the Eleventh Circuit held that state law and the annotated compilation of such law are sufficiently law-like to be regarded as sovereign work constructively authored by the citizens and thus not copyrightable. (Code Revision Comm’n for General Assembly of Georgia v. Public.Resource.Org, Inc., 906 F.3d 1229, 1233, 1243-54 (11th Cir. 2018). By contrast, the First Circuit recognized that copyright law could potentially protect building codes (Building Officials & Code Admin. v. Code Technology, Inc., 628 F.2d 730, 736 (1st Cir. 1980)). The Ninth Circuit held that incorporation of a classification system (taxonomy) for medical procedures in Medicare and Medicaid regulations does not make them uncopyrightable (Practice Mgmt. Info. Corp. v. American Med. Assoc., 121 F.3d 516, 518–20 (9th Cir. 1997)). Nonetheless, the court held that the copyright misuse doctrine limited the ability of the AMA to enforce its copyright against a health maintenance organization that used the taxonomy to comply with federal law (see Section VI(A)(2)). Most recently, the D.C. Circuit overturned and remanded issuance of a permanent injunction barring a non-profit organization from distributing copies of technical standards produced by a private organization based on copyright and trademark grounds. (American Society for Testing and Materials, et al. v. Public.Resource. Org, Inc., 896 F.3d 437 (D.C. Cir. 2018)). As the court noted, ‘[f]ederal, state, and local governments . . . have incorporated by reference thousands of these standards into law.’ (Id. at 440.). The court avoided a constitutional ruling by finding that the district court ‘failed to adequately consider whether, in certain circumstances, distributing copies of the law for purposes of facilitating public access could constitute transformative use.’ (Id. at 450.). C.  Trademark Protection, Unfair Competition Law, and False Advertising Protection In contrast to patent, copyright, and trade secret protection—which seek to promote innovation—trademark, unfair competition law, and false advertising protection focus primarily on ensuring the integrity of the commercial marketplace (Menell et al., 2017, ch. V; Menell and Scotchmer, 2007). The federal Lanham (Trademark) Act as well as analogous state statutes and common law protects words, symbols, and other attributes, such as designs, slogans, and colors, that serve to identify the source of goods or services. Certification marks certify conformity with centralized standards. Collective marks connote that a product or service is manufactured or distributed by a member of a collective organization (e.g., Florists’

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Economic analysis of network effects and IP  193 Transworld Delivery Association (FTD)) or that a product or service provider is a member of a collective organization (e.g., American Automobile Association (AAA)). To receive trademark protection, a mark need not be new or previously unused, but it must represent a particular source of the good or service to consumers. It cannot merely describe the good (e.g., hotel) or represent a generic term (e.g., thermos) for the class of goods or services offered. Further, the identifying mark may not be a functional element of the product itself but must serve a purely identifying purpose. Trademarks do not expire, but continue in force unless their owner abandons them or they become generic. Unlike patents or copyrights, trademarks do not directly protect the technology, good, or work, but rather prevent others from creating a likelihood of consumer confusion as to the source of goods. Thus, competitors may use the trademark of other companies in nonconfusing ways, such as comparative advertising and descriptive usages. Furthermore, like copyright law, trademark law does not protect functional features of products. Thus, trademark law does not protect the shape of shredded wheat biscuits (Kellogg Co. v. National Biscuit Co., 305 U.S. 111, 122 (1938) (noting that the pillow-shaped form reduces the cost of manufacturing the biscuit and affects its quality)). Patent law provides the sole means of excluding competitors from utilitarian features of products. Similarly, trademark law cannot protect aesthetically functional features of goods or packaging. Thus, trademark law does not protect a red, heart-shaped box for packaging chocolates (Restatement of Torts, § 742, comment a). The Lanham Act and state laws prohibit false or misleading advertising. The Supreme Court applied the functionality doctrine in a case involving network effects (Inwood Labs., Inc. v. Ives Labs., Inc., 456 U.S. 844 (1982)). Ives Laboratories manufactured and marketed a patented prescription drug using distinctively colored capsules: a blue capsule for its 200-mg dosage and a combination blue-red capsule for its 400-mg dosage. Consumers and pharmacists came to associate the distinctive appearance of the capsules with the particular patented compound and dosages. Thus, a consumer could identify whether they were taking the proper drug and dosage from its appearance. In that way, the packaging served as a very simple language. Following expiration of the utility patent, generic drug manufacturers marketed the chemical compound using the same color capsules. Ives sued generic drug makers for indirect trademark infringement, alleging that they bore responsibility for pharmacists that mislabeled the source of the drugs. Many pharmacies distribute capsules in pharmacist-branded bottles. The pharmacists violated trademark law by filling requests for Ives capsules with generic versions. The generic companies, however, only bore liability if they intentionally induced pharmacists to infringe the Ives trademark or if it continued to supply its product to pharmacists that it knew were engaging in infringement. In finding that Ives had not proven that the generic manufacturers were indirectly liable for trademark infringement, the Supreme Court observed that ‘a product feature is functional if it is essential to the use or purpose of the article or if it affects the cost or quality of the article’ (456 U.S. at 850, n. 10). A concurring opinion goes further, noting that a finding of functionality offers a complete affirmative defense to a contributory infringement claim predicated solely on the reproduction of a functional attribute of the product. A functional characteristic is ‘an important ingredient in the commercial success of the product,’ and, after expiration of a patent, it is no more the property of the originator than the product itself. It makes no more sense to base contributory infringement upon the copying of

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194  Research handbook on the economics of IP law volume 1 functional colors than on the petitioners’ decision to use the same formulation of the drug, or even to market the generic substitute in the first place. To be sure, the very existence of generic drugs ‘facilitates’ illegal substitution. But Ives no longer has a patent for cyclandelate, ‘and the defendants have a right to reproduce it as nearly as they can.’ Saxlehner v. Wagner, 216 U.S. 375, 380 (1910) (Holmes, J.). Reproduction of a functional attribute is legitimate competitive activity. (Inwood Labs., Inc. v. Ives Labs., Inc., 456 U.S. at 862–3 (White, J., concurring) (some citations omitted))

Trademark and unfair competition regimes play a variety of roles in controlling and regulating information technology network markets by enabling platform sponsors to regulate the usage of terms and symbols that signal interoperability and compatibility with particular standards and interfaces (Lemley et al., 2011, ch. 4). Platform sponsors and standard setting organizations routinely establish certification and collective markets and use trademark law to police use of these designations. As noted above, Sun Microsystems (and now Oracle Corporation) uses the Java TCK test as well as certification marks to ensure that products using the Java trademark meet WORA interoperability standards. In the mid to late 1990s, Sun used the ‘100% Pure Java’ initiative to establish Java as a de facto industry standard (Floren, 1997). Sun successfully sued Microsoft for violating its agreement not to adhere to Java’s standardized application environment and compliance tests so as to ensure interoperability (Sun Microsystems, Inc. v. Microsoft Corp., 87 F. Supp. 2d 992 (N.D. Cal. 2000)). Platform sponsors have used trademark and false advertising law to combat confusing product names or packaging and police compatibility and interoperability claims. Apple Computer, for example, successfully prevented a competitor for using the term ‘Pineapple’ for its clone device (Apple Computer v. Formula Int’l, 562 F. Supp. 775 (C.D. Cal. 1983)). As another example, Hewlett-Packard blocked an ink refiller from using confusingly similar packaging for replacement cartridges (Hewlett-Packard Co. v. Nu-Kote Intern., Inc., 2000 WL 33992123 (N.D. Cal. 2000)). In an interesting application of trademark’s genericide doctrine, Intel Corporation sought to protect the ‘x86’ suffix from confusing use by a competitor. The court determined, however, that the ‘x86’ designation had become generic among buyers and sellers of microprocessor chips (Intel v. Advanced Micro Devices, 765 F. Supp. 1292 (N.D. Cal. 1991)). Consequently, Intel designated its fifth generation design the Pentium. By contrast, notwithstanding the serious questions a court raised about whether ‘Windows’ was generic for a graphical user interface, (Microsoft Corp. v. Lindows.com, Inc., 2002 WL 32153471 (W.D. Wash. 2002)), Microsoft obtained federal registration for the Windows term. Google has successfully fended off claims that ‘google’ has become a generic term for Internet search (Elliott v. Google, Inc., 860 F.3d 1151 (9th Cir. 2017)). Platform sponsors and complementary product manufacturers have used trademark and false advertising law to police use of compatibility and interoperability claims. In Princeton Graphics Operating, L.P. v. NEC Home Electronics (U.S.A.), Inc., 732 F. Supp. 1258 (S.D.N.Y. 1990), the court applied a restrictive definition of compatibility because of the importance of precise definitions in the computer industry (see also Creative Labs, Inc. v. Cyrix Corp., 42 U.S.P.Q. 2d 1872 (N.D. Cal. 1997)). In another interesting application of trademark law’s functionality doctrine, the Ninth Circuit declined to allow Sega to use trademark law to prevent Accolade from selling interoperable products that displayed Sega’s trademark as part of its lock-out code (Sega

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Economic analysis of network effects and IP  195 Enterprises, Ltd. v. Accolade, Inc., 977 F.2d 1510 (9th Cir. 1992)). The basis for the ­trademark claim was that the initialization code prompted a visual display for approximately three seconds that read ‘PRODUCED BY OR UNDER LICENSE FROM SEGA ENTERPRISES LTD.’ The court rejected the false labeling claim as inconsistent with the purposes of the Lanham Act. It also held that Sega could not use trademark law to prevent competitors from marketing interoperable devices if the software design required display of what might otherwise be confusing trademark information. The court ruled that Sega failed to prove the existence of a feasible alternative to using the particular lock-out code that produced the misleading label. Furthermore, Accolade had placed text on its packaging materials disclaiming any association with Sega. D.  Patent Protection Patents have long provided the potential for exclusive rights for network technologies. For example, Alexander Graham Bell, who edged out Elisha Gray in a patent race over the telephone, gained monopoly control over the quintessential network technology (Bruce, 1990). As the Supreme Court noted in Dolbear v. Am. Bell Tel. Co., 126 U.S. 1, 535 (1888), although an inventor’s claim might practically preempt all use of a discovery for the duration of the patent, this fact will ‘show more clearly the great importance of his discovery, [] it will not invalidate [the preempting] patent.’ Patents tracing back to Guglielmo Marconi wireless communications technology played a central role in the developments of the radio and television industries (Aitken, 1985). Xerox controlled the photocopying industry for several decades in the mid-20th century. Intel built its microprocessor juggernaut on patents. Other network technology industries—from modems (Gandal et al., 2007) to cell phones (Code Division Multiple Access (CDMA)) (Mock, 2005)—were built on patent portfolios. Concern over patents affects many standard setting processes (Contreras, 2019). The extent to which patents enable control of network technologies depends on a range of factors, including the extent to which the patent controls network features (patent scope), the effective duration of patent protection, licensing structures (including patent pools) (Mattioli, 2019), and antitrust constraints. The advent of computer software introduced several additional complicating factors. As courts limited copyright protection for network features of computer software and the Federal Circuit expanded patent eligibility for software-related inventions in the 1990s, the patent system emerged as a battleground for software-related network technologies. Patent law’s higher protection threshold compared to other intellectual property modes seeks to ensure that trivial advances remain available to the public while potentially providing substantial advances robust protection, thereby motivating platform developers to take on the challenge of overcoming the excess inertia of entrenched, but obsolete, platforms. Patent law’s disclosure requirements enable the public to learn from technological advances. Nonetheless, patent protection’s 20-year duration, although far less than copyright protection, might still be excessive for software technologies (Menell, 1987). The uncertain scope of patent protection also poses some concern. Patent remedies can be especially strong, although standard setting processes have tempered their effects and promoted collaboration. Finally, design patent protection has recently added a new weapon to the network technology arsenal.

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196  Research handbook on the economics of IP law volume 1 This section examines patent protection for network technologies. It emphasizes the most salient and contested area: computer software. Section 1 traces the evolution of patent protection for software-related inventions. Section 2 examines the complicated scope of patent protection. Section 3 discusses patent licensing. Section 4 explores patent remedies. Section 5 examines design patents and their emergence in network markets. 1.  Patentability requirements The Patent Act sets forth five patentability requirements: (1) patentable subject matter; (2) utility; (3) novelty; (4) nonobviousness; and (5) disclosure (35 U.S.C. §§ 101, 102, 103, 112; Menell et al., 2017, ch. III). Two of these requirements have been particularly pertinent to network industries: subject matter eligibility and nonobviousness. i.  Subject matter eligibility   As noted above, the patent system has long afforded protection for network and systems technologies, ranging from the telephone to wireless communication and xerography. These technologies fit comfortably within the traditional scope of patent protection. The patent system has, however, struggled to accommodate software-related inventions. As illustrated above, APIs and other software technologies are increasingly important in network industries. Notwithstanding that the patent statute expressly authorizes patenting of processes and machines (35 U.S.C. § 101), the availability of patent protection for software-related inventions has been in flux since the beginning of the computer age. The issue emerged in the 1960s as computer systems became more versatile, software languages developed, and computer programming emerged from the shadow of electrical engineering. The Patent Office struggled to fit software inventions within the traditional classification system and struggled to keep up with the tremendous volume of prior art being generated. In 1965, President Johnson appointed a commission to assess the overall efficacy of the patent system (Executive Order No. 11,215, 30 Fed. Reg. 4661 (1965)). In recommending that Congress exclude computer programs from patent eligibility, the Commission of government officials, leading scientists, and representatives of industry (including IBM) noted that ‘the creation of programs has undergone substantial and satisfactory growth in the absence of patent protection’ and that ‘copyright protection for programs is presently available’ (President’s Commission on the Patent System, 1967). But as discussed above, copyright excluded protection for functional features of expressive works. Congress did not act on this recommendation, and the eligibility of software-related inventions fell to the Patent Office and the courts. Although granting a smattering of software-related inventions in the mid to late 1960s, the Patent Office took a skeptical view of software eligibility. This in part reflected concerns about the Patent Office’s ability to examine this new and rapidly developing technological field. The Supreme Court was soon brought into the fray. An inventor challenged the PTO’s rejection of his claim to an algorithm that converted binary-coded decimal numerals into pure binary numerals on subject matter grounds (Gottschalk v. Benson, 409 U.S. 63 (1972)). The Court held that ‘[p]henomena of nature, though just discovered, mental processes, and abstract intellectual concepts are not patentable, as they are the basic tools of scientific and technological work’ (409 U.S. at 67). The Court noted, however, it was not categorically excluding software-related inventions from patent eligibility. Yet six years later, the Court ruled that even newly discovered algorithms should be treated as in the

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Economic analysis of network effects and IP  197 prior art, rendering software claims ineligible unless they contained some other inventive concept (Parker v. Flook, 437 U.S. 584, 594 (1978)). The Supreme Court reversed course in 1980, holding that software claims should be viewed as a whole and that the touchstone for patentability of a process embodying a mathematical formula was whether there was significant post-solution activity, that is, ‘transforming or reducing an article to a different state or thing’ (Diamond v. Diehr, 450 U.S. 175, 188–9, 191–2 (1981)). Over the ensuing 25 years, the Court of Appeals for the Federal Circuit loosened patent eligibility limitations. Building on Diehr, the Federal Circuit chipped away at the postsolution activity necessary to bring software-related claims within § 101 (In re Alappat, 33 F.3d 1526 (Fed. Cir. 1994) (holding that the display of data on a computer screen could suffice)). In 1998, the Federal Circuit held that business methods were eligible for patent protection so long as they produced a ‘useful, concrete, and tangible result’ (State Street Bank v. Signature Financial Group, 149 F.3d 1368, 1373 (Fed. Cir. 1998) (quoting In re Alappat)). In the aftermath of the Federal Circuit’s State Street Bank decision, the PTO shifted its position from skepticism about expansive patent eligibility to openness and even enthusiasm. Patents for software and business methods flooded the PTO. Entrepreneurs and venture capitalists saw patenting as a valuable tool for developing (or at least claiming) Internet businesses. The late 1990s witnessed unprecedented growth of start-up businesses based on speculative initial public offerings secured, in part, on patent portfolios. The bursting of the Internet (dot-com) stock bubble in 2000 produced a dramatic shakeout. Bankruptcies and, subsequently, the auctioning and trading of Internet-related patents, became widespread. Entities whose sole purpose was to assert these patents emerged. Patent holding companies and non-practicing entities sought to monetize their Internet patents, often purchased at bankruptcy auctions. Lawsuits by patent assertion entities produced a tidal wave of patent validity challenges as well as calls by Silicon Valley companies, policymakers, and scholars for policy reform. These concerns led the Federal Circuit to reinvigorate patent eligibility limitations (see, e.g., In re Nuijten, 500 F.3d 1346 (Fed. Cir. 2007) (holding that a watermarked electromagnetic signal does not fall into any of the four categories of patent-eligible subject matter); In re Comiskey, 554 F.3d 967 (Fed. Cir. 2009) (affirming rejection of a business method patent under § 101 as merely relying on mental steps)). In an en banc ruling, the Federal Circuit synthesized the Supreme Court’s Benson, Flook, and Diehr precedents into the ‘machine-or-transformation test’: a claimed process is patent-eligible under § 101 if it is tied to a particular machine or if it transforms a particular article into a different state or thing (In re Bilski, 545 F.3d 943, 961 (Fed. Cir. 2008) (en banc)). Applying this test, the Federal Circuit affirmed the Patent Office’s rejection of a claim for a method for managing the consumption risk costs of a commodity. The Supreme Court upheld the Federal Circuit’s decision, although it characterized the machine-or-transformation test as a ‘useful and important clue, an investigative tool, for determining whether some claimed inventions are processes under § 101,’ but too rigid a test of the Patent Act’s broad statutory definition of ‘process’ (Bilski v. Kappos, 561 U.S. 593, 604 (2010); 35 U.S.C. § 100(b)). The Court declined to rule that business methods are categorically ineligible for patent protection (Menell, 2011). Two years later, the Supreme Court revived the Flook decision’s rule that for a claim embodying a natural discovery or algorithm to be eligible for patentability, it must

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198  Research handbook on the economics of IP law volume 1 contain a sufficiently inventive concept beyond the natural law or algorithm, even where the ­patentee discovered the natural law or algorithm (Mayo Collaborative Services v. Prometheus Laboratories, Inc., 566 U.S. 66 (2012); Alice Corp. v. CLS Bank International, 573 U.S. 208 (2014)). These decisions have dramatically shifted the patent eligibility landscape, resulting in the invalidation of a vast swath of software-related claims and eliminating patent protection for pure business methods. The decisions have also reduced the availability of patent protection for software-based network technologies. ii. Nonobviousness  To ensure that patents are not granted to routine or conventional applications of known principles, the Patent Act requires that ‘the differences between the claimed invention and the prior art are such that the claimed invention as a whole would have been obvious before the [invention was made] to a person having ordinary skill in the art to which the claimed invention pertains’ (35 U.S.C. § 103). This requirement has long been difficult to apply due to the difficulty of ignoring the fact of the claimed invention. To avoid such hindsight bias, the Federal Circuit interpreted § 103 to require that the prior art teach, suggest, or motivate ordinary skilled artisans to combine prior art references to achieve the claimed invention. Absent such evidence, the claimed invention was nonobvious (Teleflex, Inc. v. KSR Intern. Co., 119 Fed. Appx. 282 (Fed. Cir. 2005); In re Dembiczak, 175 F.3d 994, 998 (Fed.Cir.1999); Application of Bergel, 292 F.2d 955, 956–7 (C.C.P.A. 1961) (predecessor court to the Federal Circuit)). While such suggestions can be relatively common in scientific publications—through cross-references of other publications—they are not readily found in more commercial and applied fields, such as software engineering. Software products do not typically cross-reference other products. As a result, many seemingly obvious inventions from the standpoint of common knowledge were able to clear the Federal Circuit’s nonobviousness test. As software patent litigation exploded following the burst of the Internet bubble in 2000, the Federal Circuit’s standard for determining whether an invention was sufficiently inventive came under scrutiny. In KSR Int’l Co. v. Teleflex Inc., 550 U.S. 398 (2007), the Supreme Court tightened the nonobviousness standard by holding that the teachingsuggestion-motivation test was too rigid. When there is a design need or market pressure to solve a problem and there are a finite number of identified, predictable solutions, a person of ordinary skill has good reason to pursue the known options within his or her technical grasp. If this leads to the anticipated success, it is likely the product not of innovation but of ordinary skill and common sense. In that instance the fact that a combination was obvious to try might show that it was obvious. (550 U.S. at 421)

The KSR decision raised the patentability bar, especially for software-related technologies for which market factors and advances in collateral technologies are likely to drive new products and processes. 2. Scope The extent to which patents control network technologies depends upon the scope of the patent claims. Pioneering patents can stake broad claims without fear of being anticipated by prior art, whereas incremental inventions in crowded technology fields only garner narrow protection. Moreover, pioneering inventors can often develop improvement patents that expand their control and duration of protection. Xerox successfully followed

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Economic analysis of network effects and IP  199 this strategy to monopolize the photocopying industry for several decades (Scherer, 1987, at 1016–17; Bresnahan, 1985). The resulting ‘patent thicket’ delayed entry into the plain paper copy industry. Software patentees have used broad, vague functional claim language to obtain broad coverage for their inventions (Menell and Meurer, 2013; Federal Trade Commission, 2011). By avoiding the statutory phrases ‘means’ or ‘step’ in their claims—which limit the scope of their claims to the particular embodiments in the specification and ‘equivalents thereof’ (35 U.S.C. § 112(f))—and instead using broad terms that lack structural limits such as ‘module,’ patent drafters have sought to control all software solutions to particular technological problems (Lemley, 2013). Such claims have caused substantial problems in the Internet Age, and have resulted in a proliferation of demand letters, costly litigation, and nuisance value settlements. The courts and the PTO have sought to rein in these problems. The Supreme Court invigorated the claim indefiniteness doctrine, enforcing the patent statute’s requirement to ‘particularly point[] out and distinctly claim[] the subject matter’ sought to be patented (35 U.S.C. §  112(b); Nautilus, Inc. v. Biosig Instruments, Inc., 134 S. Ct. 2120 (2014); Menell and Meurer, 2013). The Federal Circuit has interpreted claims terms like ‘module’ and other vague terms (which it refers to as ‘nonce’ words) to invoke the limitations of § 112(f) (Williamson v. Citrix Online LLC, 792 F.3d 1339 (Fed. Cir. 2015) (en banc)). This interpretation limits claim scope to the embodiments in the specification and equivalents thereof. Further upstream, the Patent Office is pursuing administrative efforts to improve claim clarity (General Accountability Office, 2016; Menell, 2013). 3. Licensing Patent licensing plays a critical role in many network industries. Patents afford patent owners the power to prevent others from making, using, offering to sell, selling, or importing the patented invention in the United States during the term of the patent (35 U.S.C. § 271). They do not, however, ensure that patentees can practice their own patented invention. The owner of a patent that improves on patented technologies controlled by others would need a license from the upstream patent owner to make, use, or sell the improvement. Licensing provides the key. Many network technologies employ patented technologies. Several distinctive licensing issues have developed to address network effects: (i) standard setting and commitments to license patents on FRAND terms; (ii) insurance pools and license on transfer commitments; and (iii) GPL viral license commitments. Over-reaching licensing provisions can raise misuse and antitrust issues addressed in Section VI. i.  Standard setting and FRAND commitments   SSOs seek to lessen the tension between employing the best technological solutions in industry standards and ensuring widespread access to standards by requiring members to disclose SEPs and license them on FRAND terms (Contreras, 2019; National Research Council, 2013). Most SSOs, however, have not expressly barred injunctive relief or set FRAND licensing schedules. In 2015, the IEEE barred its members from holding patents covering IEEE standards from seeking or threatening to seek injunctions or exclusion orders against potential licensees who are willing to negotiate for licenses (IEEE, 2015).

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200  Research handbook on the economics of IP law volume 1 ii.  Insurance pools and license on transfer (LOT) commitments   In response to widespread assertion of patents by non-practicing entities following the bursting of the Internet bubble in early 2000, several enterprises emerged to reduce patent risk (Rice, 2015, pp. 752–3). Since 2008, RPX (Rational Patent Exchange) Corporation has functioned as a consortium of technology companies that acquires patents that pose potential risks. RPX has promised not to assert patents in its portfolio. As a further pre-commitment strategy to prevent patent holdup, a growing number of technology companies have promised not to assert their patents under specified conditions (Rice, 2015, pp. 747–52). Google has led an initiative whereby companies agree to prevent their patents from ever being used by a non-practicing entity (NPE) against other member companies through a license on transfer (LOT) pledge (Rice, 2015; Shultz and Urban, 2012). The LOT network produces a network benefit. As more companies join the pact, the freedom to be insulated from NPE patent assertion entities expands. iii.  GPL 3.0    As noted earlier, patents did not play a substantial role in the software industry until the mid-1990s, after the GPL (1989) and the GPL 2 (1991) were established. Although neither of these versions of the GPL expressly licensed patents, the FSF took the position that the GPL 2 created an implied license (Meeker, 2015, p. 127). GPL 3.0 took aim at this issue. Section 10 provides that the licensee may not impose any further restrictions on the exercise of the rights granted or affirmed under this License. For example, you may not impose a license fee, royalty, or other charge for exercise of rights granted under this License, and you may not initiate litigation (including a cross-claim or counterclaim in a lawsuit) alleging that any patent claim is infringed by making, using, selling, offering for sale, or importing the Program or any portion of it.

Section 11 goes further: each ‘contributor’ to code governed by the GPL 3 grants a ‘a nonexclusive, worldwide, royalty-free patent license under the contributor’s essential patent claims, to make, use, sell, offer for sale, import and otherwise run, modify, and propagate the contents of its contributor version.’ That provision defines a contributor’s ‘essential patent claims’ to include ‘all patent claims owned or controlled by the contributor, whether already acquired or hereafter acquired, that would be infringed by some manner, permitted by this License, of making, using, or selling its contributor version.’ Section 11 does not extend to ‘claims that would be infringed only as a consequence of further modification of the contributor version.’ Section 11 further provides that a licensee who is aware of a patent license governing GPL 3.0 code must make the corresponding source code to run the object code and modify the work publicly available or extend the patent license to downstream recipients. Alternatively, the licensee must deprive itself of the benefit of the license. Section 11 further includes a non-discrimination provision ensuring that any patent licenses are extended to all recipients of the GPL 3 work and works based on it. These provisions pose several serious concerns to many commercial software developers (Meeker, 2015, pp. 129–30). For example, many patent litigation settlements provide only limited, non-sublicensable, and possibly royalty-bearing rights that would not comply with GPL 3.0 requirements. Thus, commercial enterprises have been reluctant to embrace GPL 3.0. As of February 2017, GPL 3.0 was the fourth most widely adopted open source license (8 percent of open source projects), behind the MIT License (a simple

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Economic analysis of network effects and IP  201 permissive) (31 percent), GPL 2.0 (18 percent), and Apache 2.0 (15 percent) (Black Duck Opensource Knowledge Base, 2017; see also Goldstein, 2018 (noting that use of permissive open source licenses are on the rise; reporting that in 2018, 64 percent of open source components have permissive licenses, an 8 percent rise over 2017). 4. Remedies Patent remedies play a critical role in the control of network technologies that are subject to patent assertions. The proliferation of software patents and litigation in the Internet Age generated tremendous exposure for network industry companies, leading to calls for statutory reform of patent remedies (Federal Trade Commission, 2011, 2003). i.  Injunctive relief    The patent right—the right to exclude others from practicing the patented technology— has historically been protected by injunctive relief. Courts traditionally viewed patent rights like other property interests and routinely protected them through a ‘property’ rule—barring transgressors from trespassing or using the ‘property.’ Thus, for most of the history of patent law, courts awarded a permanent injunction as the prospective infringement remedy absent extraordinary circumstances. The embrace of software and business method patents during the dot-com bubble of the mid to late 1990s gave way to concerns about injunctions threatening major technology companies in the aftermath of the NASDAQ market crash in the early 2000s. Patents that had been acquired to attract venture capital were auctioned off in bankruptcy sales to patent monetization entities. The proliferation of demand letters and patent lawsuits led scholars, technology companies, policymakers, and jurists to reconsider the traditional view of patents as property interests that deserve near-automatic injunctive relief (Lee and Melamed, 2016; Menell, 2007, 2011; Lemley and Shapiro, 2007a). The costs of identifying patent holders, negotiating among potentially hundreds of patent holders, and the disruption and delay of litigation created leverage for patent owners. The threat of injunctive relief and high monetary damages enabled holders of dubious patents to extract unwarranted and disproportionate value. In a watershed decision, the Supreme Court ruled in eBay, Inc. v. MercExchange, LLC, 547 U.S. 388 (2006), that the award of injunctive relief in patent cases turns on balancing of the traditional equitable factors associated with preliminary relief: (1) whether the harm is irreparable; (2) adequacy of monetary damages to compensate for the harm; (3) balance of hardships between the parties; and (4) the public interest. (Gergen et al., 2012, at 208–9). The eBay decision has changed patent remedies dramatically. Seaman (2016) finds that the overall rate of permanent injunctions being ordered as a remedy for patent infringement has dropped from near 100 percent to 72.5 percent. The drop is most significant in software cases (53 percent). Patent assertion entities (i.e., non-practicing patent owners) obtained permanent injunctions in just 16 percent of their victories. Courts take SSO FRAND commitments into account in evaluating requests for injunctive relief under the eBay standard. Although many SSO policies do not expressly address whether SEP owners can seek injunctive relief or exclusion orders, courts consider FRAND commitments in weighing the irreparable harm prong of the eBay equitable relief test (Apple Inc. v. Motorola, Inc., 757 F.3d 1286, 1331–32 (Fed. Cir. 2014) (noting that absent unusual circumstances, such as an infringer refusing a FRAND royalty or unreasonably delaying negotiations, it will be difficult for a patent owner subject to a

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202  Research handbook on the economics of IP law volume 1 FRAND commitment to establish irreparable harm or that damages are not an adequate remedy, and that even when an infringer has refused to accept any license offer, that does not necessarily justify injunctive relief); cf. Apple Inc. v. Samsung Elecs. Co., 809 F.3d 633 (Fed. Cir. 2015) (emphasizing right to exclude and the importance of injunctions)). The eBay decision does not, however, leave the patent owner without a prospective remedy. The court will fashion a prospective monetary damage measure, such as a running royalty or a permanent damage amount—essentially a compulsory license. The eBay decision has led to a rise in patent enforcement filings at the International Trade Commission, which enforces infringement findings with exclusion orders barring importation of infringing articles (Chien and Lemley, 2012). ii.  Monetary relief   The Patent Act authorizes the award of ‘damages adequate to compensate for the infringement but in no event less than a reasonable royalty for the use made of the invention by the infringer’ (35 U.S.C. § 284). Thus, patentees can recover lost profits or a reasonable royalty resulting from infringing activity. The Patent Act further authorizes judges to increase damages awards up to three times the compensatory level where the infringer has acted willfully or recklessly (35 U.S.C. § 284; Halo Electronics, Inc. v. Pulse Electronics, Inc., 136 S. Ct. 1923 (2016)). Policymakers and scholars see the goal of patent damages to restore the parties to the position they would have achieved had they negotiated a patent license before the infringement occurred (Lee and Melamed, 2016). Patent law has long struggled to deal with apportioning patent value when a patent covers only one component of a larger product or system (Cincinnati Car Co. v. New York Rapid Transit Corp., 66 F.2d 592, 593 (2d Cir. 1933) (Learned Hand, J.) (observing that the allocation of profits among multiple components ‘is in its nature unanswerable’)). The problem has become particularly acute in platform technologies involving multiple components and patented technologies. The serial nature of patent litigation, the economic complexity of multi-component products, and court-imposed time limits on the presentation of evidence make it difficult for juries to apportion value among multiple components and factors driving market demand for infringing products (Graham et al., 2017). In theory, a wide range of royalty bases can be used with appropriately calibrated royalty rates to account for the myriad factors affecting consumer demand. In practice, however, the open-ended nature of the inquiry (Georgia-Pacific Corp. v. U.S. Plywood Corp., 318 F. Supp. 1116 (S.D.N.Y. 1970) (identifying 15 factors)) can lead to a very large royalty range across comparable cases. The Federal Circuit has sought to rationalize awards by using the smallest saleable patent-practicing unit (SSPPU), as opposed to the entire market value of the product or system, as the royalty base (LaserDynamics Inc. v. Quanta Computer, Inc., 694 F.3d 51 (Fed. Cir. 2012); Cornell Univ. v. Hewlett-Packard Co., 609 F. Supp. 2d 279 (N.D.N.Y. 2009) (Rader, J., sitting by designation); Uniloc USA, Inc. v. Microsoft Corp., 632 F.3d 1292, 1320 (Fed. Cir. 2011); Lucent Techs., Inc. v. Gateway, Inc., 580 F.3d 1301, 1336 (Fed. Cir. 2009); Ericsson, Inc. v. D-Link Sys., Inc., 773 F.3d 1201, 1226 (Fed. Cir. 2014) (citing VirnetX, Inc. v. Cisco Sys., Inc., 767 F.3d 1308 (Fed. Cir. 2014) (‘[W]here multicomponent products are involved, the governing rule is that the ultimate combination of royalty base and royalty rate must reflect the value attributable to the infringing features of the product, and no more’))). As noted above, SSOs have sought to alleviate the tension between technological progress and widespread access to standards by requiring members to disclose SEPs during

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Economic analysis of network effects and IP  203 the standard setting process and license them to standards implementers on FRAND terms (National Research Council, 2013). Nonetheless, the valuation of SEPs is difficult, especially when industry standards encompass multiple technologies and hundreds of patents. The challenge lies in separating the value of the particular technologies and patents from the often tremendous value from standardization, which is attributable to network effects. Once consumers adopt a product, they become locked in to the standard to varying degrees. This can provide patentees with tremendous leverage. Courts have surmounted this challenge by interpreting the principal goal of standard setting agreements to be widespread adoption of the standard and barring FRAND licensors from capturing the coordination and network value of the standard (CSIRO v. Cisco Sys., Inc., 809 F.3d 1295 (Fed. Cir. 2015); Ericsson, Inc. v. D-Link Sys., Inc., 773 F.3d 1201, 1229–35 (Fed. Cir. 2014); Microsoft Corp. v. Motorola, Inc., No. C10-1823JLR, 2013 U.S. Dist. LEXIS 60233, 2013 WL 2111217 (W.D. Wash. April 25, 2013); In re Innovatio IP Ventures LLC Patent Litig., No. 11 C 9308, 2013 U.S. Dist. LEXIS 144061, 2013 WL 5593609 (N.D. Ill. October 3, 2013)). 5.  Design patents Design patents—which afford 15 years of protection for ‘new, original and ornamental designs for an article of manufacture’ (35 U.S.C. § 171)—have come into play in some network technology markets. As with copyright and trademark protection, design patents do not extend to the functionality of useful articles (Buccafusco and Lemley, 2016; Du Mont and Janis, 2012). Only utility patent protection can protect such elements. Separating ornamental from functional features has proven difficult. The Federal Circuit will invalidate a design patent only if the claimed design is dictated solely by the function of the article of manufacture (Best Lock Corp. v. Ilco Unican Corp., 94 F.3d 1563, 1566 (Fed. Cir. 1996)). Some decisions have applied a looser balancing test: asking whether a design is ‘primarily functional’ (L.A. Gear, Inc. v. Thom McAn Shoe Co., 988 F.2d 1117, 1123 (Fed. Cir. 1993) (‘[T]he utility of each of the various elements that comprise the design is not the relevant inquiry with respect to a design patent. In determining whether a design is primarily functional or primarily ornamental the claimed design is viewed in its entirety, for the ultimate question is not the functional or decorative aspect of each separate feature, but the overall appearance of the article, in determining whether the claimed design is dictated by the utilitarian purpose of the article’); Lee v. Dayton-Hudson Corp., 838 F.2d 1186, 1188 (Fed. Cir. 1988)). The difficulty lies in the fact that functionality is often intertwined with ornamentality, especially in minimalist designs that merge form with function. Furthermore, compilations of design features can themselves be functional. Some Federal Circuit decisions address this challenge by dissecting the claimed design through a process that aligns with copyright law’s treatment of the idea-expression dichotomy (see Section V(B)(2) (i)). Thus, if a claimed design contains ‘both functional and ornamental features, the patentee must show that the perceived similarity is based on the ornamental features of the design’ (OddzOn Prods., Inc. v. Just Toys, Inc., 122 F.3d 1396, 1405 (Fed. Cir. 1997). The courts ‘factor[] out the functional aspects of [the claimed design] as part of its claim construction’ (122 F.3d at 1405; Richardson v. Stanley Works, Inc., 597 F.3d 1288, 1293 (Fed. Cir. 2010)). This approach, however, is in tension with the Federal Circuit’s holding that claimed designs should be evaluated as a whole (Egyptian Goddess, Inc. v. Swisa,

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204  Research handbook on the economics of IP law volume 1 Inc., 543 F.3d 665, 679 (Fed. Cir. 2008) (en banc) (rejecting focusing on a design’s ‘pointof-novelty’; Crocs, Inc. v. Int’l Trade Comm’n, 598 F.3d 1294, 1302–03 (Fed. Cir. 2010)). Some decisions have suggested that courts can surmount the separability challenge by considering whether the protected design represents the best design; whether alternative designs would adversely affect the utility of the specified article; whether there are any concomitant utility patents; whether the advertising touts particular features of the design as having specific utility; and whether there are any elements in the design or an overall appearance clearly not dictated by function. (Berry Sterling Corp. v. Pescor Plastics, 122 F.3d 1452, 1456 (Fed. Cir. 1997); see also PHG Techs., LLC v. St. John Cos., 469 F.3d 1361 (Fed. Cir. 2006))

This standard parallels an earlier formulation of trademark law’s functionality doctrine (In re Morton-Norwich Prods., Inc., 671 F.2d 1332, 1340-41 (C.C.P.A. 1982); see also Amini Innovation Corp. v. Anthony Cal., Inc., 439 F.3d 1365, 1371 (Fed. Cir. 2006) (stating that an ‘aspect’ of a patented design is functional ‘if it is essential to the use or purpose of the article or if it affects the cost or quality of the article,’ a trademark functionality standard articulated in Inwood Labs., Inc. v. Ives Labs., Inc., 456 U.S. 844, 850, n.10 (1982), discussed in Section V(C)). This approach reflects a concern with design patents preempting competition. A design is functional if there are no alternative designs that accomplish a function equally well (Rosco, Inc. v. Mirror Lite Co., 304 F.3d 1373, 1378 (Fed. Cir. 2002) (reasoning that ‘if other designs could produce the same or similar functional capabilities, the design of the article in question is likely ornamental, not functional’); Seiko Epson Corp. v. Nu-Kote Int’l, Inc., 190 F.3d 1360, 1368 (Fed. Cir. 1999) (explaining that ‘the design must not be governed solely by function, i.e., that this is not the only possible form of the article that could perform its function’); L.A. Gear, Inc. v. Thom McAn Shoe Co., 988 F.2d 1117, 1123 (Fed. Cir. 1993) (‘When there are several ways to achieve the function of an article of manufacture, the design of the article is more likely to serve a primarily ornamental purpose’)). The Federal Circuit applied these principles in a case involving interoperability. In Best Lock Corp. v. Ilco Unican Corp., 94 F.3d 1563 (Fed. Cir. 1996), Best Lock claimed an unusual profile for a key blade blank, the form used for manufacturing (cutting) keys. Ilco distributed key blanks with that key blade shape. The Federal Circuit found that function alone dictated the key blade design because ‘no alternative blank key blade would fit the corresponding lock’ (94 F.3d at 1566). The integration of form and function in many product markets has brought design patents into play in some network technology markets. Most notably, Apple successfully asserted design patents covering the rounded rectangular shape of mobile communications devices against Samsung (Apple Inc. v. Samsung Elecs. Co., 786 F.3d 983 (Fed. Cir. 2015)) (holding that iPhone and iPad designs were functional (and hence unprotectable under trademark law) but not functional under design patent law). Technology companies and designers have also obtained design patents on virtual designs, patents that cover the designs of graphical user interfaces for smartphones, tablets, and other products, as well as the designs of icons or other artifacts of various virtual environments (Du Mont and Janis, 2012). The strong monetary remedies available for design patents further encourages seeking design patents to protect features of network technologies. The Patent Act provides

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Economic analysis of network effects and IP  205 for recovery of the ‘total profit’ on the sale of ‘any article of manufacture to which [a protected design] has been applied’ (35 U.S.C. § 289). Although the Supreme Court held that the term ‘article of manufacture’ encompasses both a product and a component of that product (Samsung Elecs. v. Apple Inc., 137 S. Ct. 429 (2016)), the apportionment of damages in design patent cases is uncertain.

VI. INTERPLAY OF INTELLECTUAL PROPERTY PROTECTION AND COMPETITION POLICY IN NETWORK INDUSTRIES The Sherman Antitrust Act prohibits contracts in restraint of trade and monopolization or attempts to monopolize markets. The courts have long recognized that patent and copyright protections—government-authorized rights to exclude others from using protected technologies and copying works of authorship—as exceptions to antitrust law. Yet, patent and copyright protections can concentrate economic power in ways that undermine competition. This is especially true in network technology markets, where positive feedback effects often lead to strong and durable monopolies. At the same time, high concentration can promote desirable network effects. These considerations ameliorate and complicate the interplay of intellectual property protection and competition policy. Section A explores limitations on improper leveraging of intellectual property rights that arise in private enforcement of intellectual property and contracts. Section B examines public enforcement of antitrust law and competition policy in network markets. A.  Private Enforcement Courts have recognized limits on the exercise of patent and copyright protection that apply with special force in network industries. As we have already seen, various internal intellectual property doctrines—such as copyright’s fair use doctrine and the use of equitable balancing in dispensing remedies—bring competition policy concerns into intellectual property law. In addition, courts have developed equitable and contract-based defenses to prevent anti-competitive abuses of intellectual property rights. 1.  Misuse doctrines Drawing on tort law’s ‘unclean hands’ doctrine, courts developed the patent misuse doctrines as a common law equitable defense to an infringement claim (Bohannan, 2011). Unlike the purely equitable defense of ‘unclean hands,’ the misuse doctrines apply to suits for damages as well as equitable relief. The misuse doctrine bars patent owners from expanding the scope or term of the intellectual property right through licensing restrictions. The Supreme Court prevented Thomas Edison from leveraging a patent on motion picture projectors to control what films could be exhibited using that projector (Motion Picture Patents Co. v. Universal Film Mfg. Co., 243 U.S. 502 (1917) (refusing to enforce a licensing provision restricting use of the machine to motion pictures licensed by Edison’s film company); see also Carbice Corp. v. American Patents Development Corp., 283 U.S. 27 (1931); Morton Salt Co. v. G.S. Suppiger Co., 314 U.S. 488 (1942)). The doctrine bars

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206  Research handbook on the economics of IP law volume 1 enforcement of the patent until the anti-competitive effects of the restriction have been purged. The patent misuse doctrine applies whether or not an antitrust violation has been established. The expansion of the patent misuse doctrine in the 1940s led Congress to exclude contributory patent infringement claims from the ambit of patent misuse in the 1952 Patent Act. (35 U.S.C. § 271(d)(1)–(3)). Nonetheless, the uncertain scope and severe remedy of patent misuse continued to generate criticism, especially as economists and courts came to question categorical antitrust prohibitions in favor of rule of reason balancing (Hovenkamp, 2015, 2017; Bohannan, 2011; Lemley, 1990; but see Feldman, 2003; Merges, 1988 (noting that ‘the often very limited (or “thin”) markets for patented technology make it difficult to apply antitrust law’s consumer-demand definition of the relevant market’)). Congress amended the Patent Act in 1988 to codify two additional patent misuse limitations (Patent Misuse Reform Act of 1988, Pub. L. No. 100-703, 102 Stat. 4674 (H.R. 4972)). Congress insulated refusals to license any rights to a patent from charges of patent misuse (35 U.S.C. § 271(d)(4)). This provision, however, can effectively be side-stepped through contract, such as a FRAND commitment. In that circumstance, the third-party beneficiary of the SSO agreement has a breach of contract action for failure to license SEPs on FRAND terms (see Section VI(A)(4)). Furthermore, Congress barred application of the patent misuse doctrine to tying arrangements unless the patentee has market power in the relevant market for the patent or has patented tying a product on which the license or sale is conditioned (35 U.S.C. § 271(d)(5)), thereby bringing patent misuse more closely in line with antitrust liability (Hovenkamp, 2017). The courts have struggled to disentangle patent misuse doctrine from antitrust analysis (Bohannan, 2011; Feldman, 2003; Mueller, 2002; Pitofsky, 2001). Although the two fields share common concerns, the misuse doctrine has sought to promote intellectual property policies of encouraging innovation, freedom to operate outside of intellectual property protections, and access to the public domain even when objectionable practices do not violate antitrust law (Bohannan, 2011). In a case echoing the Motion Picture Patents case, a music copyright licensor sought to require theaters to obtain a performance license before they even knew what music would be incorporated into the films they would show (M. Witmark & Sons v. Jensen, 80 F. Supp. 843 (D. Minn. 1948), appeal dismissed sub nom., M. Witmark & Sons v. Berger Amusement Co., 177 F.2d 515 (8th Cir. 1949)). The district court found that such a license agreement improperly asserted control over all films and hence constituted copyright misuse. As a result, the court barred enforcement against the theater owner. As the emergence of computer software brought copyright more directly into play in innovation markets, the copyright misuse doctrine has come into wider use. In Lasercomb America, Inc. v. Reynolds (911 F.2d 970 (4th Cir. 1990)), a software copyright licensor prohibited licensees from ‘writing, developing, producing or selling computer assisted die making software, directly or indirectly without Lasercomb’s prior written consent’ for a term of 99 years. Drawing on the principles underlying intellectual property protection as well as patent misuse jurisprudence, the court determined that copyright misuse is a valid defense and barred Lasercomb’s infringement action. In this case, the licensor sought to foreclose competition in computer software innovation. The copyright misuse doctrine has since been raised in a variety of settings, including tying arrangements, anti-competitive clauses in licensing agreements, mandatory blanket

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Economic analysis of network effects and IP  207 licenses, and refusals to license, but it remains murky (Herrell, 2011; Fellmeth, 1998). Several cases in which copyright misuse has been found to be viable involve network effects. For example, the Ninth Circuit found copyright misuse in Practice Mgmt. Info. Corp. v. American Med. Assoc., 121 F.3d 516, amended by, 133 F.3d 1140 (9th Cir. 1997). The court held that the licensing terms of the AMA’s Physician’s Current Procedural Terminology to the Health Care Financing Administration gave the AMA a substantial and unfair advantage over its competitors and hence constituted copyright misuse. The Fifth Circuit in DSC Communications Corp. v. DGI Technologies, Inc. held that the copyright misuse doctrine might be viable to defend assertions of copyright protection over interoperable features of computer software (681 F.3d 597 (5th Cir. 1996)). The Seventh Circuit in Assessment Techs., LLC v. WIREdata, Inc. held that licensing restrictions on a tax assessment database to control access to public domain data inputted by public tax assessors could constitute copyright misuse (350 F.3d 640, 647 (7th Cir. 2003)). As with the patent misuse doctrine, the interplay of copyright misuse doctrine and antitrust liability remains unclear. Courts applying the copyright misuse doctrine generally evaluate whether the conduct thwarts the underlying policies of copyright law. Some courts, however, mistakenly view the doctrine as co-extensive with antitrust law (Fellmeth, 1998, pp. 22–3). 2.  The principle of exhaustion With some resemblance to misuse, the long-standing common law doctrine of exhaustion (also known as first-sale) preserves the public interest in free competition by limiting the ability of intellectual property (IP) owners to control secondary markets for patented products and copyrights works (17 U.S.C. § 109(a), Adams v. Burke, 84 U.S. 453 (1873)). The idea is straightforward: the first authorized sale of the patented or copyrighted product exhausts the monopolistic power given to the owner as a reward for his efforts and contribution to society. Following the first-sale, the owner can no longer control the manner in which the product is sold or used in secondary markets, either by downstream purchasers or subsequent sellers. This limitation on monopoly, which traces back to the common law’s general hostility toward restraints on alienation, fosters competition in secondary markets for innovative and creative works. Recently, in a much-debated decision involving Lexmark cartridges, the Supreme Court emphasized the destructive anti-competitive effects post-sale restrictions (with servitude-like features) that ‘run with’ the product have on free commerce (Impression Prods. v. Lexmark Int’l, Inc., 137 S. Ct. 1523, 1532 (2017); Van Houweling, 2008, 2019). Refusing to allow patentees to ‘[sputter] the smooth flow of commerce,’ the Court held that the principle of exhaustion prevents the enforcement of contractual post-sale restrictions through patent law. The patentee can impose contractual restrictions on secondary markets, but cannot use patent law to control how the product is being used or sold downstream after the point of the first sale. The Lexmark decision reaffirmed the vital role IP limiting doctrines such as preemption, exhaustion, and misuse play in limiting IP owners’ ability to hinder downstream innovation thorough over-reaching, often boilerplate, contractual language (Elazari Bar-On, 2019; Perzanowski and Schultz, 2016, chs 9–10).

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208  Research handbook on the economics of IP law volume 1 3.  Ambush of standard setting processes As highlighted in Section V(D)(3), SSOs play a critical role in addressing the market failures surrounding network technologies. These organizations require companies that participate in standard setting processes to disclose relevant information about actual and potential patents implicated by draft standards and commit to license such technologies on FRAND terms (Patterson, 2012, pp. 513–21). Given the dynamic nature of technological progress, such conditions can be open to interpretation. The two most prominent cases alleging that SSO participants engaged in deceptive practices—one involving Rambus and the other involving Qualcomm—reached different conclusions. The Rambus litigation grew out of standards development for dynamic random-access memory (DRAM) chips, a memory technology that was widely adopted throughout the computer industry. In 1990, Rambus sought patents on its architecture for such chips. Around that time, the Joint Electron Device Engineering Council (JEDEC) organized an open standard setting process with a broad range of industry participants including Rambus. As would be revealed in later litigation, Rambus used information gained at the meetings to amend its patent applications so that the standards would read on its patents. Rambus concealed these efforts and subsequently withdrew from JEDEC. After the JEDEC standards gained widespread acceptance in products, Rambus began making royalty demands from implementers and, beginning in 2000, brought a series of enforcement actions. The jury in one of the key cases found that Rambus committed fraud and breached JEDEC obligations by failing to disclose its patents. The Federal Circuit reversed in a divided opinion, with the majority finding that the JEDEC policy statements were too vague to support a fraud finding (Rambus Inc. v. Infineon Technologies AG, 318 F.3d 1081, 1098 (Fed. Cir. 2003)). The Qualcomm litigation grew out of the development of the Joint Video Team (JVT) standard for video compression technology. Qualcomm, a pioneer in semiconductor design for mobile communications devices and various other technologies, participated in the JVT standard setting process. It later sought to enforce several patents applicable to that standard against Broadcom. Broadcom successfully defended on the ground that Qualcomm had waived its rights to enforce the patent as a result of its failure to disclose the patents as part of the standard setting process (Qualcomm Inc. v. Broadcom Corp., 548 F.3d 1004 (Fed. Cir. 2008)). The court barred Qualcomm from enforcing the patents at issue against any products implementing the pertinent JVT standard. The different results in these litigations reflect several factors. SSO policies in the early 1990s varied in how clearly they set forth disclosure requirements. Furthermore, defendants in these cases faced a variety of complex evidentiary requirements and heightened pleading standards to equitable defenses such as laches, waiver, actual or implied license, equitable estoppel, and fraud (Royall et al., 2009). The Rambus controversy led to public enforcement actions in the United States and Europe that are discussed in Section VI(B) (2). 4.  Breach of contract for failure to license SEPs on FRAND terms As explored earlier (Section V(D)(3)–(4)), SSOs typically require companies participating in standard setting processes to commit to license SEPs on FRAND terms. The litigation between Microsoft and Motorola established key principles regarding the determination of FRAND licensing terms and provided for the award of contract damages for breach of

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Economic analysis of network effects and IP  209 the FRAND commitment. Motorola participated in standard setting processes governed by the IEEE and the International Telecommunication Union (ITU) establishing Wi-Fi (802.11) and video compression (H.264) standards. As part of its participation in these processes, Motorola agreed to license its patents that are essential to those standards on reasonable and non-discriminatory (RAND)4 terms. The controversy began in October 2010 when Microsoft filed actions in the U.S. International Trade Commission and the Western District of Washington alleging that Motorola was infringing several Microsoft smartphone patents. Those filings immediately led to settlement negotiations involving cross-licensing of patents between the two companies. Later that month, Motorola sent letters to Microsoft requesting royalties equal to 2.25 percent of Microsoft’s sales revenues from Windows and Xbox products incorporating the standards. Microsoft declined and immediately filed suit in the Western District of Washington alleging that Motorola’s offer breached its RAND commitment. Microsoft asserted that it was a third-party beneficiary of the SSO agreements. Thereupon Motorola filed patent enforcement suits with the ITC, seeking an exclusion order against importing Microsoft’s Xbox products into the United States, and with a German court, seeking an injunction against sales of Microsoft’s H.264-compliant products. The German action threatened all of Microsoft’s Windows and Xbox European sales because its distribution center was located in Germany. As a result, Microsoft immediately relocated its distribution center to the Netherlands at substantial cost. Judge Robart adapted the Georgia-Pacific reasonable royalty framework to the FRAND context (Microsoft Corp. v. Motorola, Inc., 2013 WL 2111217 (W.D. Wash. 2013)). In so doing, he set forth the following principles: (1) ‘A RAND royalty should be set at a level consistent with the SSOs’ goal of promoting widespread adoption of their standards’; (2) a proper methodology should ‘recognize and seek to mitigate the risk of patent hold-up that RAND commitments are intended to avoid’; (3) ‘a proper methodology for determining a RAND royalty should address the risk of royalty stacking by considering the aggregate royalties that would apply if other SEP holders made royalty demands of the implementer’; (4) ‘At the same time, a RAND royalty should be set with the understanding that SSOs include technology intended to create valuable standards,’ which requires that the RAND commitment [] guarantee that holders of valuable intellectual property will receive reasonable royalties on that property’; and (5) ‘From an economic perspective, a RAND commitment should be interpreted to limit a patent holder to a reasonable royalty on the economic value of its patented technology itself, apart from the value associated with incorporation of the patented technology into the standard’ (2013 WL 2111217 at 12; Page, 2014). Applying these economic guideposts, Judge Robart concluded that the reasonable royalty should be approximately 1/100th of Motorola’s 2.25 percent license offer. Motorola’s

4   FRAND and RAND are used interchangeably in the technology industries. FRAND is the more common usage.

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210  Research handbook on the economics of IP law volume 1 patents constituted less than 10 percent of the WiFi 802.11 pool and none were shown to be of special importance. Judge Robart noted that if each of 92 companies that owned SEPs for the 802.11 and H.264 standards demanded a royalty rate comparable to Motorola’s offer, the sum of the royalties would exceed the selling price of the Xbox (2013 WL 2111217 at 52, 72–73). In a later proceeding, a jury awarded Microsoft $14.52 million ($11.49 million for relocating its distribution center and $3.03 million in attorneys’ fees and litigation costs) for Motorola’s breach of its contractual commitment to license its SEPs on RAND terms. The Ninth Circuit upheld these determinations, expressly recognizing the key role of RAND commitments in ‘mitigating the risk that a SEP holder will extract more than the fair value of its patented technology . . . Under these agreements, an SEP holder cannot refuse a license to a manufacturer who commits to paying the RAND rate’ (Microsoft Corp. v. Motorola, Inc., 795 F.3d 1024, 1031 (9th Cir. 2015) (affirming Judge Robart’s decision)). 5.  Private antitrust liability Section 4 of the Clayton Antitrust Act of 1914 authorizes recovery of damages by ‘any person injured in his business or property by reason of anything forbidden in the antitrust laws,’ including the Sherman Act (15 U.S.C. § 4 (1914)). Companies have used this private right of action to combat anti-competitive practices in network industries. Three issues are particularly relevant to network technology markets: (i) refusal to license patented technologies; (ii) patent thickets; and (iii) leveraging of monopoly power. i.  Refusals to license patented technologies and copyright-protected works   As noted above, the Patent Act grants patentees the exclusive right to use patented technologies. Congress reinforced that power by expressly providing that a refusal to license a patent cannot be the basis for a patent misuse defense. The courts are divided over whether a refusal to license patented technology can constitute an antitrust violation. The so-called ‘essential facilities’ doctrine, which holds that ‘an owner of a crucial input cannot deny access if a firm seeking access cannot practicably obtain the input elsewhere’ (Ratner, 1988, p. 330; Otter Tail Power Co. v. United States, 410 U.S. 366 (1973)), has lost favor among commentators (Areeda, 1990; Ratner, 1988) and the courts (see Eastman Kodak Co. v. Image Technical Services, Inc., 504 U.S. 451 (1992) (declining to apply essential facilities doctrine); Aspen Skiing Co. v. Aspen Highlands Skiing Corp., 472 U.S. 585 (1985) (same)). The courts focus on whether the defendant has a legitimate business justification for its conduct (Baker, 1999). The key modern cases involve the control of service and replacement part aftermarkets. In the late 1980s, a variety of companies that had entered the market to service Kodak photocopiers found themselves cut off from replacement parts. Kodak ended its practice of licensing and selling replacement parts to competing service companies and required that its original equipment manufacturers not sell parts to independent service operators. The independent service organizations brought suit, claiming that Kodak unlawfully tied the sale of service for Kodak machines with the sale of parts in violation of § 1 of the Sherman Act, and monopolized or attempted to monopolize the sale of service for Kodak machines in violation of § 2 of the Sherman Act. Kodak defended in part on its intellectual property rights.

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Economic analysis of network effects and IP  211 While recognizing that patent and copyright owners have exclusive rights to their protected works, the Ninth Circuit nonetheless held that these laws only afford the intellectual property owner a rebuttable ‘presumptively valid business justification’ for consumer harm (Image Tech. Servs., Inc. v. Eastman Kodak Co., 125 F.3d 1195, 1218 (9th Cir. 1997) (quoting Data General Corp. v. Grumman Systems Support Corp., 436 F.3d 1147, 1187 (1st Cir. 1994))). The court upheld a jury verdict finding Kodak liable for monopolizing or attempting to monopolize the service aftermarket for Kodak copiers. In an analogous case involving Xerox’s refusal to sell patented parts and copyrighted manuals and to license copyrighted software, the Federal Circuit declined to follow the Ninth Circuit’s analysis (In re Independent Service Organizations Antitrust Litigation, 203 F.3d 1322 (Fed. Cir. 2000); see also Intergraph Corp. v. Intel Corp., 195 F.3d 1346 (Fed. Cir. 1999)). The Federal Circuit limited its focus to whether Xerox’s refusal to sell its patented parts exceeded the scope of the patent grant. Finding that it did not, ‘Xerox was under no obligation to sell or license its patented parts and did not violate the antitrust laws by refusing to do so’ (203 F.3d at 1328). The court ruled that so long as a patent infringement suit would not have been objectively baseless, the patentee’s motivations for asserting its statutory right to exclude are immaterial. Similarly, the Federal Circuit further held that so long as Xerox’s copyrights were not ‘obtained by unlawful means or were used to gain monopoly power beyond the statutory grant,’ then ‘Xerox’s refusal to sell or license its copyrighted works was squarely within the rights granted by Congress to the copyright holder and did not constitute a violation of the antitrust laws’ (203 F.3d at 1329). ii.  Patent thickets    In a related vein, competitors have sought to challenge the accumulation of a broad portfolio of patents on antitrust grounds. Accumulation and pooling of patents can broaden the effective scope and reduce the uncertainty surrounding inventions, thereby enhancing appropriability (Parchomovsky and Wagner, 2005, pp. 32–41). Nonetheless, strong and broad patent portfolios can discourage innovation and entry by potential competitors (Hall et al., 2016; Hovenkamp, 2012, p. 1130 (discussing the costs of defending against many patents of ambiguous scope); Rubinfeld and Maness, 2005). The leading case involved Xerox Corporation, which built a portfolio of over 1,000 patents relating to its plain paper copying technology. Xerox only used 35 to 40 percent of those patents in actual Xerox products (Sobel, 1984), relying on the balance to erect a defensive thicket around its photocopier technology (Saunders, 2002). Xerox refused to grant licenses for plain paper copying, although it did grant some licenses for other fields, including coated paper copiers. SCM Corporation, which had licensed some of Xerox’s patents for coated paper copies, filed an antitrust claim against Xerox alleging that ‘Xerox’s acquisition of its patents and subsequent exercise of the exclusionary power in them violated the antitrust laws and injured SCM’ (SCM Corp. v. Xerox Corp., 645 F.2d 1195, 1203 (2d Cir. 1981)). SCM asserted that Xerox’s patent accumulation strategy was intended to forestall competition, as reflected in its failure to use many of its patents. SCM claimed that ‘Xerox’s patents were so numerous and complex that they created a “thicket” that prevented [SCM from] designing around the patents.’ The Second Circuit acknowledged that ‘tension between the objectives of preserving economic incentives to enhance competition while at the same time trying to contain the power a successful competitor acquires is heightened tremendously when the patent laws come into play,’ emphasizing

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212  Research handbook on the economics of IP law volume 1 that the Xerox case ‘demonstrate[s that] the acquisition of a patent can create the potential for tremendous market power’ (645 F.2d at 1205). Nonetheless, the court ultimately ruled that ‘where a patent has been lawfully acquired, subsequent conduct permissible under the patent laws cannot trigger any liability under the antitrust laws’ (645 F.2d at 1206). The anti-competitive concerns relating to patent thickets are exacerbated by the ambiguity of many software patent claims (Bessen, 2004). Cross-licensing and patent pools can, however, alleviate concerns about patent thickets (Barnett, 2014, 2015; Gilbert, 2004; Shapiro, 2001; Merges, 2001). Economists generally believe that the inclusion of complementary and potentially blocking patents in a patent pool promotes competition by reducing the transaction costs and promoting licensing (Shapiro, 2001, p. 144). iii.  Improper leveraging of market power  In the mid-1990s, Microsoft Corporation held a dominant position in the desktop software marketplace just as the Internet emerged as an economic platform. Sun Microsystems’s Java programming language for websites was rapidly gaining salience as a technology for easily transforming static webpages into engaging, animated, interactive websites. After failing to develop its own web development package, Microsoft entered into a Technology License and Distribution Agreement (TLDA) with Sun that allowed Microsoft to use, modify, and adapt Java technology in developing MS Internet Explorer 4.0 and other software products. To safeguard Sun’s WORA interoperability principle, the TLDA required that Microsoft adhere to Java’s standardized application environment and compliance tests. Microsoft’s deployment of its own version of Java, compatible only with other Microsoft products in violation of the WORA principle, threatened Sun’s Java development strategy. In October 1997, Sun sued Microsoft for breach of contract, trademark infringement, copyright infringement, false advertising, and unfair competition (Markoff, 1997). In early 2002, Microsoft agreed to pay Sun $20 million and was permanently prohibited from using ‘Java compatible’ trademarks on its products (Shankland, 2002a). The following year, Sun brought an antitrust and patent infringement action against Microsoft resulting in an award of over $1 billion (Pruitt and Roberts, 2004; Shankland, 2002b). B.  Public Enforcement Federal and state antitrust authorities have long played substantial roles in policing network market competition. The US Department of Justice’s filing of an antitrust action against IBM in 1969 reshaped the competitive landscape of the computer hardware industry and paved the way for a vibrant software industry. At the time, IBM bundled software and services into the cost of leasing use of its hardware, making it difficult for competitors to charge for software development and products. Immediately following the filing of the enforcement action, IBM unbundled software and services from its hardware sales thereby opening up markets for software products (Grad, 2002). Although the antitrust case dragged on for more than a decade and was ultimately dropped, IBM’s unbundling decision in conjunction with the emergence of mini- and microcomputers markets revolutionized the computer industry. Similarly, the US Department of Justice’s filing of antitrust litigation against AT&T in 1974 led to the breakup of the largest corporation in the United States nearly a decade later and hastened the modern competitive and highly innovative telecommunications marketplace.

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Economic analysis of network effects and IP  213 Advances in the information, financial, and communications technologies have vastly increased the significance of network markets as well as the government’s role in regulating these markets. As highlighted in Sections II and III, network technologies are prone to high concentration levels that can enhance consumer welfare through network effects. Therefore, antitrust authorities have had to shift their focus away from market concentration toward anti-competitive tactics such as leveraging market power into new markets and stifling innovation. This section summarizes the major contours of this shift. Section 1 discusses the evolution of Department of Justice and Federal Trade Commission guidelines for intellectual property licensing. Section 2 discusses significant network market enforcement actions and the challenges of crafting remedies. 1.  Intellectual property licensing guidelines Beginning in the 1930s, antitrust regulators took a skeptical view of intellectual property (Briggs, 2009, pp. 67–8). By the early 1970s, these concerns reached their apex in the US Department of Justice Antitrust Division’s ‘Nine No-No’s’: (1) It is unlawful to require a licensee to purchase unpatented materials from the licensor; (2) It is unlawful for a patentee to require a licensee to assign to the patentee any patent which may be issued to the licensee after the licensing arrangement is executed; (3) It is unlawful to attempt to restrict a purchaser of a patented product in the resale of that product; (4) A patentee may not restrict his licensee’s freedom to deal in the products or services not within the scope of the patent; (5) It is unlawful for a patentee to agree with his licensee that he will not, without the licensee’s consent, grant further licenses to any other person; (6) Mandatory package licensing is an unlawful extension of the patent grant; (7) It is unlawful for a patentee to insist, as a condition of the license, that his licensee pay royalties in an amount not reasonably related to the licensee’s sales of products covered by the patent—for example, royalties on the total sales of products of the general type covered by the licensed patent; (8) It is unlawful for the owner of a process patent to place restrictions on his licensee’s sales of products made by the use of the patented process; and (9) It is unlawful for a patentee to require a licensee to adhere to any specified or minimum price with respect to the licensee’s sale of the licensed products. (Wilson, 1970)

Furthermore, even if a patent-related restraint was not per se unlawful under one of the Nine No-No’s, the Department of Justice would still consider bringing an enforcement action if the particular provision was not necessary to the patentee’s exploitation of its lawful monopoly and there were less restrictive alternatives to the restrictions that were more likely to foster competition (Briggs, 2009; Wilson, 1970). These enforcement principles focused on attempts by patent holders to extend their patent monopolies to unpatented supplies, to gain control over improvements of their innovations, to determine prices for resale of their patented products, or to engage in market allocations. With the growing importance of intellectual property assets in the 1970s and 1980s and the dawning of the digital age, economists came to see unconstrained patent licensing as an innovation driver (Gilbert and Shapiro, 1997, p. 286). In 1988, the Antitrust Division shifted from absolute (per se) opposition to licensing restrictions to a ‘rule of reason’ approach to patent licensing that balanced the pro-competitive effects of licensing against potential anti-competitive effects in related markets (U.S. Dep’t. Justice, 1988). In 1995, the Department of Justice and the Federal Trade Commission (FTC) expanded upon

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214  Research handbook on the economics of IP law volume 1 the 1988 guidelines in crafting the ‘Antitrust Guidelines for the Licensing of Intellectual Property’ (U.S. Dep’t. Justice and Federal Trade Commission, 1995; U.S. Dep’t. Justice and Federal Trade Commission, 2007). These guidelines expressly recognized the generally pro-competitive nature of licensing arrangements, rejected the presumption that intellectual property necessarily creates market power in the antitrust context, and endorsed applying the same general antitrust approach to the analysis of conduct involving intellectual property that the agencies apply to conduct involving other forms of tangible or intangible property. With the growing role of patents in network industries, the Department of Justice and the FTC increasingly recognized the importance of licensing standards-essential patents on FRAND terms (U.S. Dep’t. Justice and PTO, 2013; Federal Trade Commission, 2012a; Federal Trade Commission, 2011; U.S. Dept. of Justice and Federal Trade Commission, 2007). Accordingly, the Department of Justice and the FTC have been far more receptive to patent pools (see, e.g., U.S. Dep’t. Justice, 2006; U.S. Dep’t. Justice, 2007; U.S. Dep’t. Justice, 2015; In re Negotiated Data Solutions LLC (N-Data), No. C-4234, 2008 WL 4407246 (F.T.C.); In re Motorola Mobility LLC, F.T.C. File No. C-4410 (2013)). As Gilbert (2010) explains: Competition policy toward patent pools has focused on the prevention of anticompetitive practices by patent pool members—individually or collectively through the licensing policies of the pool—and has generally paid little attention to the question of how to encourage the formation and stability of patent pools that benefit consumers. While patent pools have substantial procompetitive benefits when the manufacture or use of products may infringe multiple patents, powerful economic forces prevent beneficial patent pools from forming or limit the patents in the pool to only a fraction of the patents that cover the products.   Competition policy should recognize the fragility of patent pools and ensure that patent pool members acting collectively have the same latitude to determine royalties and licensing terms as a single licensor, provided that the pool does not harm lawful competition that would have occurred in the absence of the pool’s licenses. In determining which types of patents should be allowed in a pool, competition policy should recognize that a patent pool confers potential benefits if it includes two or more valid complementary patents, and need not harm competition if it has at least one valid patent that is essential to make, sell, or use a product. Inclusion of inessential patents raises potential concerns about foreclosure of alternative technologies and higher royalties for some licenses than would have occurred if these patents were excluded from the pool. However, these concerns should be balanced against the costs of excluding potentially essential patents from the pool.

Disappointingly, the US Dep’t of Justice and the FTC’s updated intellectual property guidelines (U.S. Dep’t. Justice and Federal Trade Commission, 2017) (largely reaffirming and modestly updating the 1995 guidelines)) omit mention of SEPs and FRAND (Comments of Law and Business Scholars Submitted to the U.S. Department of Justice and Federal Trade Commission Regarding a Proposed Update to the Antitrust Guidelines for the Licensing of Intellectual Property, 2016). 2.  Significant network market enforcement actions Notwithstanding the Department of Justice’s and FTC’s loosening of licensing restrictions, antitrust authorities have pursued several notable enforcement actions in network industries over the past two decades. In 1996, the FTC alleged that Dell Computer Corporation had violated the Federal

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Economic analysis of network effects and IP  215 Trade Commission Act by failing to disclose its patent rights during the Video Electronics Standards Association standard setting process and then threatening to enforce those rights against others involved in that process (Matter of Dell Computer Corp., 121 F.T.C. 616, 1996 WL 33412055 (May 20, 1996)). The resulting consent decree barred Dell from enforcing its patent against computer manufacturers incorporating the pertinent standard. In 1998, the FTC issued a complaint against Intel Corporation alleging that Intel had sought to maintain its dominance in the microprocessor marketplace by denying essential technical information and product samples of new microprocessors to companies that, because of intellectual property disputes, had initiated or threatened to initiate litigation against Intel or Intel’s customers (In re Intel Corp., No. 9288, 1999 F.T.C. LEXIS 145 (Aug. 3, 1999); Pitofsky, 2001). The resulting consent decree recognized Intel’s right to withhold licenses of its product or information, but limited Intel’s ability to retract licenses when customers sought to vindicate its intellectual property rights. Most significantly, the Department of Justice and 18 states brought actions against Microsoft in 1998 alleging that Microsoft’s bundling of its browser (Internet Explorer) with its Windows operating system along with restrictive licensing agreements with original equipment manufacturers (such as pricing use of its operating system based on a per processor basis) violated antitrust law (United States v. Microsoft Corp., No. 98-1232 (D.D.C. May 18, 1998); New York v. Microsoft Corp., No. 98-1233 (D.D.C. May 18, 1998)). The government specifically targeted Microsoft’s efforts to exclude Netscape from the browser market and to suppress Sun’s Java web programming platform. The federal government settled its claims with Microsoft in 2001. The consent decree required Microsoft to share its application programming interfaces with third-party companies and established a process for supervising compliance with the agreement over a five year period. Nine states proceeded to trial and ultimately implemented somewhat greater oversight over Microsoft’s activities. Crafting a remedy proved especially difficult due to the strong consumer benefits attributable to Microsoft’s widely adopted and highly integrated computing platform (see United States v. Microsoft Corp., 253 F.3d 34, 102 (D.C. Cir. 2001) (reversing the district court order that would have broken Microsoft up because it failed to address Microsoft’s contention that such an order would ‘lower [] rates of innovation and disrupt [] the evolution of Windows as a software development platform’)). Breaking up the company would certainly have caused substantial consumer harm. In the end, the rapid emergence of the Internet Age and mobile computing—along with the ascendance of a new set of competitors such as Google and Facebook, as well as the resurgence of Apple—eroded Microsoft’s dominance. In 2012, the FTC required that Robert Bosch GmbH sell SPX Service Solutions, a business that makes equipment used to recharge vehicle air conditioning systems, grant licenses to key patents needed to compete in the market for such equipment on the ground that SPX harmed competition by reneging on a commitment to license SEPs on FRAND terms. The FTC declared that ‘[p]atent holders that seek injunctive relief against willing licensees of their FRAND-encumbered SEPs should understand that in appropriate cases the Commission can and will challenge this conduct as an unfair method of competition under Section 5 of the FTC Act’ (Federal Trade Commission, 2012b). The Department of Justice has conditioned its approval of acquisitions of

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216  Research handbook on the economics of IP law volume 1 s­ ubstantial patent portfolios by firms with substantial market presence on the commitments to license SEPs on FRAND terms. Prominent examples include: (1) Google’s acquisition of Motorola Mobility’s portfolio of 17,000 patents and 6,800 patent applications; (2) Apple’s acquisition of the nearly 900 patents originally held by Novell and purchased in 2010 by a coalition including Apple, EMC, Microsoft, and Oracle; and (3) acquisition by the ‘Rockstar’ group (made up of Apple, Microsoft, and RIM) of the 6,000 patents and applications made available in the Nortel bankruptcy auction (Carrier, 2014).

VII. ASSESSMENT OF INTELLECTUAL PROPERTY PROTECTION AND COMPETITION POLICY FOR NETWORK TECHNOLOGIES Drawing on the evolution of intellectual property protection and competition policy explored in Sections V and VI, this section assesses how the various legal, market, and policy institutions have adapted to the emergence of network technologies in the Information Age. Section A discusses institutional and policy economy considerations. Section B then assesses the performance of legal and policy institutions against the normative principles highlighted in Section IV. A.  Institutional Considerations Intellectual property is not a single, monolithic protective system but rather a complex, overlapping set of protections. Inventors and platform developers can utilize various modes of protecting their innovative endeavors. In addition, they can coordinate with other entrepreneurs to promote and leverage network effects, subject to antitrust constraints. Protectionist entrepreneurs will naturally exploit the weakest link within the intellectual property chain to gain market advantage. As a result, the efficacy of the intellectual property system depends critically upon intellectual property gatekeepers—judges, patent examiners, and antitrust enforcers—to ensure that the system coheres. Therefore, the intellectual property system can be strained and fail to promote balanced protection where critical gatekeepers lack adequate understanding of the overall system or the technologies and economics at issue. The structure of the federal courts creates two opposing vulnerabilities. On the one hand, the regional circuit courts—which handle most copyright and trademark disputes—lack specialization and technological training. They can struggle to understand the complexities of computer software and other technical subject matter in the network technology fields. On the other hand, the Federal Circuit— which handles all patent appeals and some copyright and trademark appeals—is specialized, which can skew their perspective. As numerous scholars have explored, specialty courts, such as the Federal Circuit, are prone to tunnel vision and political capture which could lead to more protectionist interpretations of intellectual property law (Dreyfuss, 1989, p. 26; Allison and Lemley, 1998, p. 251; Merges, 2000, p. 2224; Landes and Posner, 2003, pp. 334–53; Landes and Posner, 2004, p. 128). As the Open Handset Alliance and the open source movement have demonstrated, free

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Economic analysis of network effects and IP  217 market institutions can check overbroad intellectual property protection. Entrepreneurs can contract around intellectual property systems in creative ways (Merges, 2004). B.  Measuring Progress Based on the Normative Principles The past half century, spanning the birth and ascendancy of the Information Age, has included dramatic evolution of intellectual property protection for network technologies. The process has not always been smooth, but has generally been inclined toward more efficient and effective rules and institutions. Nonetheless, the complexity of the intellectual property system and the dynamism of network technologies has produced persistent pathologies. Fortunately, the flexibility afforded by free market competition and new technologies (such as cloud-based computing) have been valuable antidotes and alternatives to unwarranted intellectual property protection and the accompanying market power. The evolutionary process continues to unfold and adherence to the key normative principles will benefit from the lessons of the past and ongoing vigilance. 1.  Parsimony principle The parsimony principle aims to promote realization of network benefits by denying intellectual property protection for functional attributes of network technologies absent significant technological advance. This principle comes into conflict with the motivation of some platform developers to control platform development and profit from network effects. Thus, leading platform technology companies advocate robust intellectual property protection for network features of computer software and other technologies through copyright, trademark, and design patent law. These legal regimes do not require assessment of novelty or nonobviousness. In an effort to garner long-lived copyright protection for interface and other software components, they have characterized software code as ‘high-tech poetry’ and analogized computer programs to epic poems and great literature (Clapes et al., 1987, p. 1500, 1584; see also Clapes, 1994). Some general jurisdiction judges, with little technical background, were initially receptive to such arguments. They perceived the textual form of software code as more analogous to more conventional literary works than the gears and levers of machines and were less attuned to the broader intellectual property landscape channeling protection for functional features to the utility patent system. Dicta in the Apple v. Franklin decision opined that ‘total compatibility with independently developed application programs . . . is a commercial and competitive objective which does not enter into the somewhat metaphysical issue of whether particular ideas and expressions have merged’ (Apple Computer, Inc. v. Franklin Computer Corp., 714 F.2d 1253 (3d Cir. 1983)). In Whelan Associates, Inc. v. Jaslow Dental Laboratory, Inc., 797 F.2d 1222 (3d Cir. 1986), the Third Circuit’s conflation of merger analysis and the idea-expression dichotomy implicitly allowed copyright protection of procedures, processes, systems, and methods of operation that are expressly excluded under § 102(b). Fortunately, a series of cases in the early to mid-1990s better appreciated the distinction between functionality and creative expression (see Computer Assocs. Int’l v. Altai, Inc., 982 F.2d 693 (2d Cir. 1992); Sega Enterprises Ltd. v. Accolade, Inc., 977 F.2d 1510 (9th Cir. 1993); Apple Computer, Inc. v. Microsoft Corp., 799 F. Supp. 1006 (N.D. Cal 1992),

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218  Research handbook on the economics of IP law volume 1 aff’d in part, rev’d in part, 35 F.2d 1435 (9th Cir. 1994); Lotus Dev. Corp. v. Borland Int’l, Inc., 49 F.3d 807, 813 (1st Cir. 1995), aff’d by equally divided Court, 516 U.S. 233 (1996)). As a result, while programming a computer can unquestionably be considered ‘creative’ in a general sense, limiting doctrines ensure that the functional aspects are unprotectable under copyright law. The design of an efficient mechanical machine likewise can be creative, but such devices are not eligible for copyright protection unless the aesthetic features can be separated from the functional attributes under the useful article doctrine (17 U.S.C. § 101 (definition of ‘Pictorial, graphic, and sculptural works’ excludes functional features)). Lines of code are the gears and levers of digital machines. The fact that computer software, like a sculptural work, is eligible for copyright protection does not authorize protection for functional features (17 U.S.C. § 102(b)). Several major technological advances beginning in the mid-1990s de-emphasized the role of copyright protection for computer software. The emergence of the Internet as a low-cost, highly scalable distribution ecosystem in the mid to late 1990s vastly expanded the potential for indirect appropriability (e.g., through keyword advertising), and shifted software developers toward open source development. Advances in mobile, Internetconnected digital devices in the early-2000 period paved the way for using software to promote sales of hardware and vastly expanded software distribution through app stores. The new app economy opened a vast array of non-copyright-based business models, such as new forms of advertising ranging (e.g., Yelp). The emergence of cloud-based computing (Software as a Service) reinvigorated digital rights management. These shifts, in combination with the norms that took hold following the Lotus v. Borland litigation, produced a period of relative peace with regard to copyright protection of network features of computer software (Profitt, 2011 (observing that ‘[h]istorically, APIs have been regarded as not falling under copyright—the reasoning being that APIs are not creative implementations but rather statements of fact,’ but also noting the issue had been clouded by the distinction of ‘open’ and ‘closed’); Menell, 1998). The parsimony principle prevailed. That peace was shattered in 2010 with Oracle’s filing of a copyright (and patent) infringement lawsuit against Google alleging that the Android operating system infringed copyright protection for the declarations (function names and definitions) in the Java APIs. Drawing on the strategy of the first wave of API copyright litigation, Oracle analogized the labels and code used in the Java APIs to the chapter titles, character names, and plot elements of Harry Potter novels (Opening Brief and Addendum of PlaintiffAppellant, Oracle America, Inc. v. Google, Inc., 2013, pp. 12–13). Based on a questionable interpretation of Ninth Circuit precedent (Menell, 2018), the Federal Circuit ruled that the structure, sequence, and organization of the 37 Java APIs were copyrightable and remanded the fair use issue for retrial (Oracle America, Inc. v. Google, Inc., 750 F.3d 1339 (Fed. Cir. 2014)). Apple’s garnering of design patent protection for the rounded, rectangle shape of its iPhone and iPod devices and visual icons also undercut the parsimony principle (U.S. Design Patent Nos. D618,677, D593,087, and D604,305; Apple Inc. v. Samsung Elecs. Co., 786 F.3d 983 (Fed. Cir. 2015) (affirming decision that design patents were valid and had been infringed)). These functional elements garnered substantial protection without any showing that they constituted novel and nonobvious technological advances.

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Economic analysis of network effects and IP  219 These decisions directly undermine the parsimony principle. As a result of the Oracle v. Google decision, the safe harbor of clean room implementation of functional specifications is no longer safe. The Oracle v. Google precedent creates the potential for software developers to assert long-lived copyright protection over interface specifications without meeting a substantial threshold of technological advance. Thus, the Oracle v. Google decision warns innovators to steer clear of proprietary software in developing platforms and extensions. Future developers will be careful to avoid using APIs that are vulnerable to copyright assertion. This will reduce the flexibility to join or interoperate with platforms that are not open, but will encourage greater use of open platforms, collaboration, and ex ante resolution of legal rights. Thus, even though the parsimony principle has been undermined, the flexibility to work around copyright protection through open source and collaborative solutions limits its adverse effects. 2.  Proportionality principle The proportionality principle is the flip side of the parsimony principle coin. Balanced protection for true technological advances in network technologies might be needed to overcome the excess inertia generated by network bandwagons. Patent law provides protection for novel, nonobvious, and adequately disclosed advances in computer systems, processes, and interface design, and other network technologies. Unlike copyright, trademark, or design patent law, utility patent protection protects the functional aspects for network technologies. In theory, therefore, patent protection can provide meaningful protection for overcoming excess inertia. Its efficacy, however, depends on whether it provides the right balance. In practice, patent protection for interface design and other network technologies has been decidedly mixed. The standards for patent protection might be too low or too high and the duration of protection might be too short or long to provide the optimal incentive. Moreover, unlike lock-out code, the scope of patent protection does not necessarily align with network features. Furthermore, the costs of pursuing and enforcing patents can distort incentives. Patent protection of computer software, a principal source of network effects, has experienced a roller coaster over the past four decades. The Patent Office resisted patent protection for computer software in the 1960s and only grudgingly afforded such protection in the 1970s and 1980s (Moskowitz, 1982, pp. 281–2, 309–11). The Supreme Court struggled to resolve the eligibility of patent protection for computer software in the 1970s (Gottschalk v. Benson, 409 U.S. 63 (1972); Parker v. Flook, 437 U.S. 584 (1978)), but ultimately cautiously held that computer programs were eligible in 1981 (Diamond v. Diehr, 450 U.S. 175 (1981)). Nonetheless, software companies were reluctant to pursue such protection, preferring technical protection measures and copyright protection. Several factors shifted the software industry toward patent acquisition in the early 1990s. Fading hardware companies turned to patent licensing and enforcement campaigns (Phelps and Kline, 2010; Jaffe and Lerner, 2004, pp. 14–15; Rivette and Kline, 1999). In addition, some smaller software companies succeeded in enforcing software patents against larger software companies (see, e.g., Stac Elec. v. Microsoft Corp., No. 93-0413 (S.D. Cal. 1994), appeal dismissed per stipulation, 38 F.3d 1222 (Fed. Cir. 1994)). These developments prompted software companies to pursue defensive patenting (Federal Trade Commission, 2011, pp. 43–5, 56 (discussing defensive patenting)). Furthermore,

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220  Research handbook on the economics of IP law volume 1 the Federal Circuit liberalized the standards for protecting computers software (see In re Alappat, 33 F.3d 1526 (Fed. Cir. 1994); State Street Bank and Trust Company v. Signature Financial Group, Inc., 149 F.3d 1368 (Fed. Cir. 1998)), just as the Internet (dot-com) era was taking off. This led to a software patenting gold rush in which start-up companies sought patents as signals for raising venture capital and established companies stockpiled patents for defensive purposes. As discussed in Section V(D), the bursting of the dot-com bubble in 2000 resulted in many software patents falling into the hands of patent aggregators, such as Intellectual Ventures, which produced an unprecedented wave of costly and disruptive patent assertion activity. The low quality and amorphous scope of many of these patents imposed tremendous costs on the software industry and complicated entry into many network technology markets. In addition, new network technologies, such as smart phones, developed in a patent thicket ecosystem. The effects of patent aggregation and assertion were somewhat alleviated by standard setting organizations requiring FRAND cross-licensing, the emergence of defensive buying funds, such as RPX and Allied Security Trust, and patent pledges (Schultz and Urban, 2012). Moreover, the Supreme Court substantially reduced the risk of injunctive relief (eBay, Inc. v. MercExchange, LLC, 547 U.S. 388 (2006)), tightened the nonobviousness standard (KSR Int’l Co. v. Teleflex Inc., 550 U.S. 398 (2007)), promoted clearer patent boundaries (Nautilus, Inc. v. Biosig Instruments, Inc., 134 S. Ct. 2120 (2014)), and restricted patent eligibility (Bilski v. Kappos, 561 U.S. 593, 604 (2010); Mayo Collaborative Services v. Prometheus Laboratories, Inc., 566 U.S. 66 (2012); Alice Corp. v. CLS Bank International, 573 U.S. 208 (2014)). Congress passed legislation streamlining administrative patent review (America Invents Act, Pub. L. No. 112-29, 125 Stat. 284 (2011)). Nonetheless, patent protection for network technologies has proven to be a complex and costly tool for achieving proportional appropriability for network technology innovations. The system has, however, become more balanced and predictable, with improved screening of patent applications, more timely and cost-effective means for invalidating dubious patents through inter partes review at the Patent Trial and Appeal Board, and improved coordination through standard setting and FRAND licensing. 3.  Deterrence principle The deterrence principle stems from, and interacts with, the proportionality principle. Network effects often lead to high market concentration levels, which bring market power with them. The deterrence principle seeks to stunt abuse of such power while promoting network benefits. One of the main antidotes to market dominance by a single platform sponsor is collaboration through standard setting organizations and licensing agreements, such as FRAND commitments. While such private solutions can promote innovation and downstream competition, they create the potential for anti-competitive behavior. The past several decades have witnessed substantial evolution of antitrust doctrines and enforcement policies toward a balanced innovation and competitive ecosystem. Antitrust enforcers have come to appreciate the economic benefits of high concentration in network technology markets while also focusing on abusive practices, such as failure to disclose essential patents to standard setting organizations. Standard setting organizations have developed more sophisticated disclosure requirements. In addition,

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Economic analysis of network effects and IP  221 courts have broadened their assessment of antitrust, contract, and patent remedies in view of network effects. The dynamism of network technologies and markets, however, will continue to challenge enforcers, policymakers, and courts. As reflected in the Sun v. Microsoft and Oracle v. Google litigation, there is a subtle line between promoting interoperability and encouraging innovative forking of established standards (cf. Farrell, 2007).

VIII.  FUTURE RESEARCH DIRECTIONS Following Moore’s and Metcalfe’s ‘Laws,’ network technologies are growing at exponential rates. Digital technologies increasingly drive economic growth. Due in substantial part to the Internet and advances in digital technology, network effects are rapidly diffusing across the economic landscape. Consequently, the interplay of network technologies and intellectual property will continue to evolve rapidly in the coming years and decades. The opportunities for further research in this field are nearly limitless. Network effects are increasingly important across a growing swath of industries: consumer and industrial products (Internet of Things), energy (smartgrid, autonomous driving, renewable energy), bioinformatics, machine learning, social media, advertising, content creation, and science (database development). The interactions with the range of economic modes (such as contract, business associations, and multi-sided markets), as well as other areas of law (such as privacy and civil liberties) provide a wealth of important research opportunities to explore.

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228  Research handbook on the economics of IP law volume 1 In re Bilski, 545 F.3d 943 (Fed. Cir. 2008) (en banc). In re Comiskey, 554 F.3d 967 (Fed. Cir. 2009). In re Dembiczak, 175 F.3d 994 (Fed. Cir. 1999). In re Independent Service Organizations Antitrust Litigation, 203 F.3d 1322 (Fed. Cir. 2000). In re Innovatio IP Ventures LLC Patent Litig., No. 11 C 9308, 2013 U.S. Dist. LEXIS 144061, 2013 WL 5593609 (N.D. Ill. Oct. 3, 2013). In re Intel Corp., No. 9288, 1999 F.T.C. LEXIS 145 (Aug. 3, 1999). In re Morton-Norwich Prods., Inc., 671 F.2d 1332 (C.C.P.A. 1982). In re Motorola Mobility LLC, F.T.C. File No. C-4410 (2013). In re Negotiated Data Solutions LLC (N-Data), No. C-4234, 2008 WL 4407246 (F.T.C.) (2008). In re Nuijten, 500 F.3d 1346 (Fed. Cir. 2007). Intel v. Advanced Micro Devices, 765 F. Supp. 1292 (N.D. Cal. 1991). Intergraph Corp. v. Intel Corp., 195 F.3d 1346 (Fed. Cir. 1999). Inwood Labs., Inc. v. Ives Labs., Inc., 456 U.S. 844 (1982). Jacobsen v. Katzer, 535 F.3d 1373 (Fed. Cir. 2008). Kellogg Co. v. National Biscuit Co., 305 U.S. 111 (1938). King-Seely Thermos Co. v. Aladdin Indus., Inc., 321 F.2d 577 (2d Cir. 1963). KSR Int’l Co. v. Teleflex Inc., 550 U.S. 398 (2007). L.A. Gear, Inc. v. Thom McAn Shoe Co., 988 F.2d 1117 (Fed. Cir. 1993). Lasercomb America, Inc. v. Reynolds, 911 F.2d 970 (4th Cir. 1990). LaserDynamics Inc. v. Quanta Computer, Inc., 694 F.3d 51 (Fed. Cir. 2012). Lee v. Dayton-Hudson Corp., 838 F.2d 1186 (Fed. Cir. 1988). Lexmark Int’l, Inc. v. Static Control Components, Inc., 387 F.3d 522 (6th Cir. 2005). Lotus Dev. Corp. v. Borland Int’l, Inc., 516 U.S. 233 (1996). Lotus Dev. Corp. v. Borland Int’l, Inc., 49 F.3d 807 (1st Cir. 1995), aff’d equally divided Court, 516 U.S. 233 (1996). Lucent Techs., Inc. v. Gateway, Inc., 580 F.3d 1301 (Fed. Cir. 2009). M. Witmark & Sons v. Jensen, 80 F. Supp. 843 (D. Minn. 1948), appeal dismissed sub nom., M. Witmark & Sons v. Berger Amusement Co., 177 F.2d 515 (8th Cir. 1949). Matter of Dell Computer Corp., 121 F.T.C. 616, 1996 WL 33412055 (May 20, 1996). Mayo Collaborative Services v. Prometheus Laboratories, Inc., 566 U.S. 66 (2012). MDY Indus., LLC v. Blizzard Entm’t, Inc., 629 F.3d 928 (9th Cir. 2010). Microsoft Corp. v. Lindows.com, Inc., 2002 WL 32153471 (W.D. Wash. 2002). Microsoft Corp. v. Motorola, Inc., No. C10-1823JLR, 2013 U.S. Dist. LEXIS 60233, 2013 WL 2111217 (W.D. Wash. Apr. 25, 2013). Microsoft Corp. v. Motorola, Inc., 795 F.3d 1024 (9th Cir. 2015). MiTek Holdings, Inc. v. ARCE Engineering Co., 89 F.3d 1548 (11th Cir. 1996). Mitel, Inc. v. Iqtel, Inc., 124 F.3d 1366 (10th Cir. 1997). Morton Salt Co. v. G.S. Suppiger Co., 314 U.S. 488 (1942). Motion Picture Patents Co. v. Universal Film Mfg. Co., 243 U.S. 502 (1917). Nautilus, Inc. v. Biosig Instruments, Inc., 134 S. Ct. 2120 (2014). New York v. Microsoft Corp., No. 98-1233 (D.D.C. May 18, 1998). Nichols v. Universal Pictures Corp., 45 F.2d 119 (2d Cir. 1930). OddzOn Prods., Inc. v. Just Toys, Inc., 122 F.3d 1396 (Fed. Cir. 1997). Oracle America, Inc. v. Google, Inc., 872 F. Supp. 2d 974 (N.D. Cal. 2012). Oracle America, Inc. v. Google, Inc., 750 F.3d 1339 (Fed. Cir. 2014). Oracle America, Inc. v. Google LLC, 886 F.3d 1179 (Fed. Cir. 2018). Oracle America, Inc. v. Google, Inc., 750 F.3d 1339 (Fed. Cir. 2014) (Opening Brief and Addendum of PlaintiffAppellant, Oracle America, Inc. v. Google, Inc., 2013, pp. 12–13). Otter Tail Power Co. v. United States, 410 U.S. 366 (1973). Parker v. Flook, 437 U.S. 584 (1978). PHG Techs., LLC v. St. John Cos., 469 F.3d 1361 (Fed. Cir. 2006). Plains Cotton Coop. Ass’n v. Goodpasture Computer Serv., Inc., 807 F.2d 1256 (5th Cir. 1987). Practice Management Information Corporation v. American Medical Assoc., 121 F.3d 516, as amended, 133 F.3d 1140 (9th Cir. 1997). Princeton Graphics Operating, L.P. v. NEC Home Electronics (U.S.A.), Inc., 732 F. Supp. 1258 (S.D.N.Y. 1990). Qualcomm Inc. v. Broadcom Corp., 548 F.3d 1004 (Fed. Cir. 2008). Rambus Inc. v. Infineon Technologies AG, 318 F.3d 1081 (Fed. Cir. 2003). Richardson v. Stanley Works, Inc., 597 F.3d 1288 (Fed. Cir. 2010). Rosco, Inc. v. Mirror Lite Co., 304 F.3d 1373 (Fed. Cir. 2002).

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Economic analysis of network effects and IP  229 Samsung Elecs. v. Apple Inc., 137 S. Ct. 429 (2016). SCM Corp. v. Xerox Corp., 645 F.2d 1195 (2d Cir. 1981). Sega Enterprises, Ltd. v. Accolade, Inc., 977 F.2d 1510 (9th Cir. 1992). Seiko Epson Corp. v. Nu-Kote Int’l, Inc., 190 F.3d 1360 (Fed. Cir. 1999). Sony Computer Entertainment, Inc. v. Connectix Corp., 203 F.3d 596 (9th Cir. 2000). Stac Elec. v. Microsoft Corp., No. 93-0413 (S.D. Cal. decided Feb. 23, 1994), appeal dismissed per stipulation, 38 F.3d 1222 (Fed. Cir. 1994). State Street Bank and Trust Company v. Signature Financial Group, Inc., 149 F.3d 1368 (Fed. Cir. 1998). Storage Technology Corp. v. Custom Hardware Eng’g & Consulting, Inc., 421 F.3d 1307 (Fed. Cir. 2005). Sun Microsystems, Inc. v. Microsoft Corp., 46 U.S.P.Q. 2d 1531 (N.D. Cal. Mar. 24, 1998). Sun Microsystems, Inc. v. Microsoft Corp., 87 F.Supp. 2d 992 (N.D. Cal. 2000). Synercom Technology, Inc. v. University Computing Co., 462 F. Supp. 1003 (N.D. Tex. 1978). Teleflex, Inc. v. KSR Intern. Co., 119 Fed.Appx’ 282 (Fed.Cir. 2005). The Murphy Door Bed Co., Inc. v. Interior Sleep Systems, Inc., 874 F.2d 95 (2d Cir. 1989). Uniloc USA, Inc. v. Microsoft Corp., 632 F.3d 1292 (Fed. Cir. 2011). United States v. Microsoft Corp., 253 F.3d 34 (D.C. Cir. 2001). United States v. Microsoft Corp., No. 98-1232 (D.D.C. May 18, 1998). Universal City Studios, Inc. v. Corley, 273 F.3d 429 (2d Cir. 2001). Vault Corp. v. Quaid Software, Ltd., 847 F.2d 255 (5th Cir. 1988). Veeck v. S. Bldg. Code Congress Int’l, Inc., 293 F.3d 791 (5th Cir. 2002) (en banc). VirnetX, Inc. v. Cisco Sys., Inc., 767 F.3d 1308 (Fed. Cir. 2014). Whelan Associates, Inc. v. Jaslow Dental Laboratory, Inc., 797 F.2d 1222 (3d Cir. 1986). Williamson v. Citrix Online LLC, 792 F.3d 1339 (Fed. Cir. 2015) (en banc).

Legislative Materials 17 U.S.C. § 101, § 102(b), § 105, §109(a), § 117, § 1201 35 U.S.C. § 100(b), § 101, § 102, § 103, § 112, § 171, § 271(d)(1)–(3), § 271(d)(4), § 271(d)(5), § 284, § 289 Act to amend the patent and trademark laws, Pub. L. No. 96-517, 94 Stat. 3015 (1980). America Invents Act, Pub. L. No. 112-29, 125 Stat. 284 (2011). Clayton Antitrust Act, Pub. L. No. 63-212, 38 Stat. 730, codified at 15 U.S.C. §§ 12–27 (1914). Copyright Act of 1976, Pub. L. 94-553, 90 Stat. 254, codified at 17 U.S.C. § 101 et seq. Establishing the President’s Commission on the Patent System, Executive Order No. 11, 215, 30 Fed. Reg. 4661 (1965)). Federal Trade Commission Act, Pub. L. No. 63-203, 38 Stat. 717 (1914). H.R. Rep. No. 94-1476, 94th Cong., 2d Sess. (1976). Institute of Electrical and Electronics Engineers (IEEE), 2015. IEEE-SA Standards Board Bylaws, accessed March 21, 2019 at http://standards.ieee.org/develop/policies/bylaws/approved-changes.pdf. Lanham (Trademark) Act (Pub. L. 79-489, 60 Stat. 427, codified at 15 U.S.C. § 1051 et seq. Patent Act of 1952, Pub. L. 93-596, 66 Stat. 792, codified at 15 U.S.C. § 1 et seq. Patent Misuse Reform Act of 1988, Pub. L. No. 100-703, 102 Stat. 4674 (H.R. 4972). President’s Commission on the Patent System, To Promote the Progress of Useful Arts, Report to the Senate Judiciary Committee, S. Doc. No. 5, 90th Cong., 1st sess. (1967). S. Rep. No. 105-190 (1998). Sherman Antitrust Act, Pub. L. No. 103-325, 26 Stat. 209, codified at 15 U.S.C. §§ 1–7 (1890). The Digital Millennium Copyright Act of 1998, Pub. L. No. 105-304, 112 Stat. 2860 (1998) (codified in scattered sections of 5, 17, 28, and 35 U.S.C.). United States General Accountability Office. 2016. Intellectual Property: Patent Office Should Define Quality, Reassess Incentives, and Improve Clarity, GAO-16-490. Unlocking Consumer Choice and Wireless Competition Act, Pub. L. 113-144, 128 Stat. 1751 (2014).

Administrative and Other Materials Comments of Law and Business Scholars Submitted to the U.S. Department of Justice and Federal Trade Commission Regarding a Proposed Update to the Antitrust Guidelines for the Licensing of Intellectual Property (2016). Federal Trade Commission. 2003. To Promote Innovation: The Proper Balance of Competition and Patent Law and Policy (Oct. 2003), accessed March 21, 2019 at https://www.ftc.gov/sites/default/files/documents/reports/ promote-innovation-proper-balance-competition-and-patent-law-and-policy/innovationrpt.pdf.

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230  Research handbook on the economics of IP law volume 1 Federal Trade Commission. 2011. The Evolving IP Marketplace: Aligning Patent Notice and Remedies with Competition (Mar. 2011), accessed March 21, 2019 at https://www.ftc.gov/reports/evolving​-ip​-marketplace​ -aligning-patent-notice-remedies-competition. Federal Trade Commission. 2012a. FTC Order Restores Competition in U.S. Market for Equipment Used to Recharge Vehicle Air Conditioning Systems (Nov. 26, 2012), accessed March 21, 2019 at http://www.ftc.gov/ news-events/press-releases/2012/11/ftc-order-restores-competition-us-market-equipment-used-recharge. Federal Trade Commission. 2012b. Third Party Statement on the Public Interest, In re Certain Gaming and Entertainment  Related Software, and Components Thereof, ITC Investigation No. 337-TA-752 (June 6, 2012), accessed March 21, 2019 at https://www.ftc.gov/sites/default/files/documents/advocacy_documents/ftccomment-united-states-international-trade-commission-concerning-certain-wireless-communication/1206ftcw​i​ relesscom.pdf. Library of Congress. 2018. U.S. Copyright Office, Exemption to Prohibition on Circumvention of Copyright Protection Systems for Access Control Technologies, 83 Federal Register 54010 (Oct. 26, 2018). Restatement of Torts, § 742. U.S. Dep’t. Justice. 1988. Antitrust Enforcement Guidelines for International Operations (Nov. 10, 1988). U.S. Dep’t. Justice. 2006. Business Review Letter relating to VMEbus International Trade Association. U.S. Dep’t. Justice. 2015. Business Review Letter relating to IEEE from Acting Assistant Attorney General Renata B. Hesse to Michael A. Lindsay. U.S. Dep’t. Justice and Federal Trade Commission. 1995. Antitrust Enforcement Guidelines for International Operations. U.S. Dep’t. Justice and Federal Trade Commission. 2007. ‘Letter from Assistant Attorney General, Thomas O. Barnett, to Dorsey & Whitney Partner, Michael A. Lindsay’ (Apr. 30, 2007). U.S. Dep’t. Justice and Federal Trade Commission. 2017. Intellectual Property Guidelines. U.S. Dep’t. Justice and PTO. 2013. Policy Statement on Remedies for Standards-Essential Patents Subject to Voluntary FRAND Commitments.

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8.  Intellectual property and competition Herbert Hovenkamp*

5

Contents I. II.

Introduction: The Political Economy of Intellectual Property Law The Relationship Between the IP Policy and Antitrust Policy A. Approaches to Market Diversity B. Changing Attitudes toward Antitrust and IP C. Assessing Anticompetitive Restraints: ‘Scope-of-the-Patent’ Test III. IP and Antitrust: Specific Issues and Applications A. Assessing Market Power in IP-Intensive Markets B. Horizontal Restraints: Price Fixing and Market Division C. Vertical Restraints Involving IPRs D. Patent Pools E. Exclusionary Practices 1. Walker process and unreasonable infringement claims 2. Acquisitions 3. Refusal to license IV. IP Law’s Own Internal Rules for Facilitating Competition A. The First Sale (Exhaustion) Doctrine B. ‘Misuse’ C. Competition-Based Limitations on ‘Functionality’ Protection References

I. INTRODUCTION: THE POLITICAL ECONOMY OF INTELLECTUAL PROPERTY LAW A legal system that relies on private property rights to promote economic development and progress must consider that profits can come from two different sources. First, both competition under constant technology and innovation promote economic growth by granting some returns to the successful developer and some to society. An effective innovation policy will ensure developer returns adequate to compensate for its investment and risk. Competition and innovation both increase output. Second, however, profits can also come from practices that reduce output, in some cases by reducing quantity, or in others by reducing innovation. Intellectual property rights (IPRs) and competition policy were once regarded as being

*  James G. Dinan University Professor, Penn Law and the Wharton School, University of Pennsylvania. Thanks to Peter S. Menell and Erik Hovenkamp for comments.

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232  Research handbook on the economics of IP law volume 1 in conflict. IPRs create monopoly, which was thought to be inimical to competition. By contrast, competition policy favors free entry and asset mobility, which IPRs limit in order to create incentives. Today our view of this relationship is more complex. First, most IPRs are insufficient to produce durable monopoly, although they do facilitate product differentiation. Second, we tend to see intellectual property (IP) rules as creating a property rights system in which competition exists for the property rights themselves. Firms compete by innovating and appropriating whatever payoffs they can capture, including IPRs. Third, and most importantly, we define competition in terms of output or welfare rather than simple rivalry. A market structure or practice that increases output is more ‘competitive’ than a lower output alternative, even though the amount of immediate rivalry among firms is less. For example, output in the cellular phone market is much higher because hardware, software, and telecommunications links are all networked by cooperative agreements and standard setting. Under conventional neoclassical assumptions, both innovation and competition increase output, whether measured by the number of units or their quality. At the same time, however, excessive IP protection limits competition by reducing asset mobility further than necessary to facilitate innovation. The policy trick is to find the ‘sweet spot’ where the aggregate effects of IP competition and exclusion are optimized. It is firmly established that innovation contributes significantly more to economic growth than does competition under constant technology (Solow, 1957; Bohannan and Hovenkamp, 2012; Grossman and Helpman, 1994; Aghion and Howitt, 1998). While the theoretical and empirical literature employ different and sometimes inconsistent models, all agree on this basic conclusion (Helpman, 2004; Schumpeter, 1943; Solow, 1956; Romer, 1990; Aghion and Howitt, 2007). In addition, the ‘debate’ between Joseph Schumpeter’s (1943) position that monopoly is more favorable to innovation and Kenneth Arrow’s (1962) position that competition is more favorable is somewhat settled, mainly in Arrow’s favor. A broad consensus today is that the market structure/innovation curve is a lopsided, inverted ‘U’ (Scott and Scott, 2014; Arai, 2013; Aghion et al., 2005). Neither monopoly nor atomistic competition is especially conducive to innovation. Rather, most innovation occurs in moderately competitive, product differentiated markets. Some more recent literature tilts the inverted U more to the competitive side, concluding that on balance more competition yields more innovation (Hashmi, 2011; Schmitz and Holmes, 2010; Menell and Scotchmer, 2007, pp. 1526–30)). Although the relationship between innovation and economic growth is clear, the relationship between innovation rates and particular IPR systems is not. One problem is that while IP systems may encourage innovation, they also act as impediments to the diffusion or cumulation of ideas through the economy (Menell and Scotchmer, 2007; Moser, 2013). The literature on the relationship between the strength of patent systems and the rate of economic growth is at best inconclusive, with most of it suggesting little or no correlation (Gould and Gruben, 1996; Park and Ginarte, 1997; Belleflamme, 2006).1 Relatively little

1   One study finds a correlation between the existence of a patent system and total factor production (TFP) growth, but also concludes that there is an inverse correlation between the strength of patent rights and TFP growth (Chang et al., 2014). The authors conclude that while patent rights lead to more patents,

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Intellectual property and competition  233 literature exists that correlates innovation or growth rates with the existence or strength of any specific patent doctrine, although there is a robust ‘meta’ empirical literature on the behavior of courts or judges with respect to certain doctrines (Rantanen, 2013; Mojibi, 2010; Anderson and Menell, 2013; Seaman, 2012; Crouch, 2010). Further, the innovation effect of IPRs is market specific, just as is true of other market characteristics such as economies of scale, product differentiation, ease of entry, or nature of information flow. The competitive impact of IPRs also varies with differences in industry structure and the market position of the rights owners. For example, for a dominant firm additional IP protection may serve to entrench or prolong its monopoly position, while the same right held by a small rival might serve to destabilize the dominant firm and make the industry more competitive. Therefore, who gets a particular IPR can be important for competition policy. That IPR performance varies from one market to another seems beyond dispute. For example, chemical and pharmaceutical innovations tend to benefit from a robust patent system with protection of fairly long duration. By contrast, in some markets for information technologies the patent system is much less valuable and may even produce greater harms than benefits. The same thing is true of copyright. For example, many books have long economic lives and can benefit from a lengthy term of protection, while more journalistic writing and software does not. The optimal term may also vary with the degree of market competitiveness, with greater competition conducive to shorter terms. Further, a trade-off exists between duration and breadth: a patent with a shorter life but broader protection may provide the same incentives as one with longer life but narrower protection (Gilbert and Shapiro, 1990; Merges and Nelson, 1990; Khoury, 2010). Unfortunately, our knowledge about market diversity has had little impact on the creation or application of intellectual property law, which is not particularly sensitive to issues of market structure, information transmittal, ease of copying, and other barriers to market entry or mobility. This is in very sharp contrast to antitrust law, which is acutely sensitive to market differences, perhaps overly so. For example, questions concerning the legality of a merger or allegedly monopolistic practice can be answered only after a detailed expert inquiry into the markets at issue and the rationally expected results of certain practices. By contrast, questions of patent validity, scope, and infringement are largely indifferent to the markets in which these queries occur. Likewise, the legislated term of IPR protections is largely invariant to the particular market in which the protected product is sold. Because our information about the relationship between innovation and specific IP rules is so inadequate, opinions often go to extremes. Some believe that the patent or other IP systems are worthless or even harmful because they hinder rather than promote   our findings also suggest that patent rights slow the diffusion of new innovations throughout the economy, as we find that the effect of patents on TFP growth is weaker in countries with stronger patent rights. Our results suggest that finding the optimum level of patent protections requires the consideration of these two offsetting effects. (Falvey, 2006)   According to Falvey (2006), at least in middle income countries, IPRs cause more harm by restricting the dissemination of technology than they contribute to economic growth. In Torrance and Tomlinson (2011), an experimental test showed an inverse relationship between innovation and patenting.

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234  Research handbook on the economics of IP law volume 1 i­nnovation (Boldrin and Levine, 2008), while others defend IPRs enthusiastically (Epstein, 2010; Mossoff, 2013). Even within the United States Supreme Court these views have gyrated from periods when the Court was extremely tolerant of patenting and patent practices, to periods in which it struck down nearly every patent it encountered and held exaggerated views about the anticompetitive effects of patent practices (Hovenkamp, 2015d). Further, IPRs are hardly the only inducement to innovation, and their relative importance varies from one market to another. When firm managers are questioned, a plurality believe that the biggest inducement is first mover advantages, while patent protection is at best secondary (Bohannan and Hovenkamp, 2012, pp. 100–102).2 In some markets, such as digital content, copying is so cheap and quick that little innovation would occur but for IP protection. Innovations in processes that are not readily observable or reverse engineered might be better protected by simple first mover advantages or trade secrets. Patent protection is secondary and may even be counterproductive to the extent that patenting requires disclosure. Some markets exhibit high rates of innovation without any intellectual property protection at all (Raustiala and Sprigman, 2012). The lack of empirical validation for specific IP rules is troublesome, because some rules may be far from optimal. A good example is the way that patent law’s requirement of nonobvious subject matter (35 U.S.C. § 103) is administered. Because patent infringement does not require copying or even knowledge of another’s patent, it is crucial that the nonobviousness requirement be interpreted strictly, keeping patent issuance within proper bounds: we do not want to give patents on things that independent entrepreneurs would develop on their own. An empirically based inquiry into nonobviousness would consider the extent to which new technology results from copying rather than independent invention, a forward-looking inquiry. Whether one can infer nonobviousness from commercial success is debatable, but doubtful (Merges, 1988). But in any event, that is not how nonobviousness subject matter is actually determined. Patent examiners or courts deciding infringement cases assess nonobviousness, or ‘inventive step,’ by looking backward through prior art. By contrast, entrepreneurs think forward, considering new things to try from their current position. The likely result is that far too many patents are granted on things that other businesses develop on their own in the ordinary course of competition. The recent experience with non-practicing patent holders in information technology markets suggests as much. Most of the defendants in those cases are independent developers rather than copyists. The statutory systems of competition law and IPRs differ significantly from one another. Most of the United States antitrust laws are highly general and do not reflect specific ‘deals’ between legislators and particular special interests. The Sherman and Clayton Acts simply condemn practices that ‘restrain trade,’ ‘monopolize,’ or have effects that ‘may be substantially to lessen competition’ (15 U.S.C. §§ 1, 2, 14, 18).3 As a result, assessment of specific practices is left largely to judges. In addition, after more than 30 2   On the use of alternative funding mechanisms, such as prizes or direct government finance of research (Menell and Scotchmer, 2007, pp. 1530–34). 3   One exception is the Robinson-Patman Act, which was in fact the product of a deal between retailers and Congress during the Great Depression (15 U.S.C. § 13; Hovenkamp, 2015d, pp. 225–32).

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Intellectual property and competition  235 years of redefinition and retrenchment, antitrust policy in the United States has become much more focused on promoting consumer welfare, which it does by facilitating structures or practices that maximize output, measured by quantity or quality (Bohannan and Hovenkamp, 2012). By contrast, most IPR systems are detailed codes that reflect considerable producer involvement but relatively little input from consumers. The 1976 Copyright Act currently in force, together with the Copyright Term Extension Act, are examples (Bohannan, 2006; Patry, 1996), but the patent laws are not far behind (Merges, 2000). For example, over history Congress has repeatedly granted retroactive term extensions to both patents and copyrights (Ochoa, 2001; Hovenkamp, 2016c). Retroactive extensions do not facilitate innovation to the extent that the inventions to which they apply have already been created. They are pure rent seeking, prolonging exclusive rights, and reducing output. Such extensions have come to the Supreme Court twice, 150 years apart. In Bloomer v. McQuewan, 55 U.S. 539 (1852), the Supreme Court held that retroactive patent extensions could not be applied to patented articles that had already been sold, thus creating the foundation for the modern patent ‘exhaustion’ doctrine (Hovenkamp, 2016b, 2016c). In Eldred v. Ashcroft, 537 U.S. 186 (2003), the Supreme Court upheld a retroactive extension of the copyright term. This history is unsettling because consumer welfare should be the ultimate goal of innovation policy just as it is of traditional competition policy. Consumers profit from lower prices and higher innovation rates, giving them the correct set of incentives to determine optimal IP rules. By contrast, producer incentives are more mixed. While producers profit from lower costs and increased innovation, they also profit from increased protection for their own IPRs or reduced protection for the innovations of rivals, whether or not these protection levels are optimal (Hovenkamp, 2014).

II. THE RELATIONSHIP BETWEEN THE IP POLICY AND ANTITRUST POLICY A.  Approaches to Market Diversity While the antitrust laws do not explicitly require different analysis for different markets, the spare, highly general statutes have been interpreted that way at least since the Supreme Court’s Chicago Board of Trade decision in 1918. That decision approved an agreement that literally fixed prices for after-hours trading occurring after the open market had closed. Such price-fixing was unique to that market and, in the Court’s view, promoted rather than restricted competition. The antitrust merger provision contained in the Clayton Act, 15 U.S.C. § 18, condemns acquisitions whose ‘effect may be substantially to lessen competition or tend to create a monopoly’—a requirement that has always been held to require highly specific market analysis. For well over a half-century the law of monopolization under Sherman Act § 2, 15 U.S.C. § 2, has required detailed inquiries into market structure, producing different outcomes in different industries (United States v. Aluminum Co. of Am., 148 F.2d 416 (2d Cir. 1945); United States v. E.I. du Pont de Nemours and Co., 351 U.S. 377 (1956); Brooke Group Ltd. v. Brown and Williamson Tobacco Corp., 509 U.S. 209 (1993)). By contrast, IP law largely disregards market differences (Burk and Lemley, 2003;

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236  Research handbook on the economics of IP law volume 1 Menell and Scotchmer, 2007). Terms of protection are largely invariant to the industry, even though rates of technological turnover vary widely. If protected technology or expression routinely becomes obsolete in the market before IPRs expire, then the Constitution’s provision authorizing Congress to create patents or copyrights only for ‘limited times’ (U.S. Const. art. I, § 8, cl. 8) is largely meaningless. The premise of that provision is that the protection period should be sufficient to induce innovation, but after expiration the protected good goes into the public domain. Even requirements such as nonobvious subject matter for patents generally avoid market specific questions about how information is disseminated in a particular market. An ideal IP policy truly concerned with innovation would need to develop more empirically driven, market specific rules, reflecting how innovation works in different situations, what amount and nature of inducement is required, and the extent of harm caused by the resulting exclusion. Offsetting this, of course, would be the higher transaction and enforcement costs involved in enforcing a system that contemplates greater market diversity. B.  Changing Attitudes toward Antitrust and IP Competition policy and IP policy should be regarded as complements. They share economic welfare as a goal, and an optimal policy includes elements of both. Public policy has been erratic, however, and the two legal systems have not always accommodated each other in socially beneficial ways. Prior to 1917 the Supreme Court approved nearly every patent practice that had been alleged to restrict competition, including toleration of product price-fixing in a patent pool (E. Bement & Sons v. Nat’l Harrow Co., 186 U.S. 70 (1902)); granting a dominant firm an injunction against infringement of an externally acquired but unpracticed patent (Cont’l Paper Bag Co. v. E. Paper Bag Co., 210 U.S. 405 (1908)); and permitting tying of patented and unpatented goods (Henry v. A.B. Dick Co., 224 U.S. 1 (1912)). One important exception was Standard Sanitary Mfg. Co. v. United States, 226 U.S. 20 (1912), which condemned a product price fix covering the entire bathroom fixture industry. The price stipulation was included in a patent license for an enameling process that represented a minor component of the finished product. A single mention of patents in the 1914 Clayton Act, 15 U.S.C. § 14, provoked a dramatic change. Beginning in the 1917 Motion Picture Patents case, which overruled Henry, the Supreme Court embarked on a war against patent practices thought to be anticompetitive, in the process developing an expansive, judge-made doctrine of patent ‘misuse,’ of which more later (Motion Picture Patents Co. v. Universal Film Co., 243 U.S. 502 (1917); Henry v. A.B. Dick Co., 224 U.S. 1 (1912)). Beginning in the late 1930s the Supreme Court applied increasingly harsh standards for patent issuance, eliciting Justice Robert H. Jackson’s famous complaint that ‘the only patent that is valid is one which this Court has not been able to get its hands on’ (Jungersen v. Ostby & Barton Co., 335 U.S. 560 (1949)). Three dispersed events gradually turned the tide again. First was the 1952 Patent Act, a significant revision, which restated the patentability requirement as ‘nonobvious’ subject matter and also limited the reach of patent misuse law (Duffy, 2007; Hovenkamp, 2015d). The second was the establishment of the Federal Circuit Court of Appeals in 1982, with a mandate to unify and strengthen patent law (Dreyfuss, 1989, 2008). The third development, which occurred more gradually and within antitrust and patent

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Intellectual property and competition  237 misuse law, was a doctrinal reformulation that required much more explicit proof of anticompetitive effects (Bohannan and Hovenkamp, 2012). The high point of antitrust hostility toward perceived patent abuses was 1970, when the US Antitrust Division issued its ‘nine no nos’ of patenting that were almost certain to provoke an antitrust challenge (Wilson, 1970; Hovenkamp, 2015d). Today nearly all of the ‘nine no nos,’ including such things as mandatory packaging licensing, grantback clauses, reach through royalties, and resale price maintenance, are widely regarded as competitively benign in most situations (Hovenkamp, 2015a). Antitrust courts and scholars increasingly came to believe that many post-issuance patent practices that had been condemned as ‘misuse’ were in fact competitively harmless. This was particularly true of tying arrangements, the most frequent generator of misuse findings, as well as vertical price and nonprice restraints, package licensing, provisions that tied royalty payments to unpatented goods, and most unilateral refusals to license (Bowman, 1973; Hovenkamp, 2018a). One important result of significant antitrust revision is that overreaching is less likely to occur today than it was 30 years ago. By contrast, patent law has continued on an expansion course in both issuance and doctrine that until recently seemed unstoppable. Today antitrust law is in a much better position to accommodate concerns about innovation than patent law is to accommodate concerns for competition. Antitrust law’s sensitivity to innovation manifests itself in several ways. One is a very broad rule that innovation itself can almost never be an antitrust violation, no matter how exclusionary, as several courts have held (Allied Orthopedic Appliances, Inc. v. Tyco Health Care Grp. LP, 592 F.3d 991 (9th Cir. 2010); In re Apple iPod iTunes Antitrust Litig., 2014 WL 6783763 (N.D. Cal. 2014); Areeda and Hovenkamp, 2009–15). One limited exception is situations where the cost of product changes is very small in relation to competitive harm and the changes are readily reversible. This is true mainly of software, where a minor change in code can serve to make rivals’ products incompatible (Newman, 2012). Another area is the deferential treatment that the courts have afforded to settlements of IP lawsuits. For example, in Clorox Co. v. Sterling Winthrop, Inc., 117 F.3d 50 (2d Cir. 1997), the court approved a market division agreement settling a trademark dispute (Hovenkamp, 2015a). A third area is increasingly strict limitations on the use of antitrust to challenge anticompetitive IP infringement actions, as created by the Supreme Court in Walker Process Equip., Inc. v. Food Mach. and Chem. Corp., 382 U.S. 172 (1965), but limited by Dippin’ Dots, Inc. v. Mosey, 476 F.3d 1337 (Fed. Cir. 2007) (Bohannan and Hovenkamp, 2012, pp. 290–324). Yet another is deferential treatment of technology sharing agreements under antitrust law, which rarely condemns them unless they involve explicit restraints in the product market (Hovenkamp, 2015a). By contrast, patent case law sometimes operates as if competition were the affirmative evil to be resisted. One example is the Federal Circuit’s 2014 decision in Trebro Mfr., Inc. v. Firefly Equip., LLC, 748 F.3d 1159 (Fed. Cir. 2014) (Hovenkamp and Cotter, 2015). The court permitted a dominant firm in a concentrated market to enjoin patent infringement on unpracticed patents. The dominant firm had purchased two patents from a third party that covered an alternative technology to that in its own product. After the acquisition, it continued to use its older technology and brought an infringement suit against the defendant, a recent entrant whose technology very likely infringed the acquired patents. The Federal Circuit distinguished a line of lower court decisions which had refused injunctions to non-practicing entities, following the Supreme Court’s decision in eBay Inc.

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238  Research handbook on the economics of IP law volume 1 v. MercExchange, L.L.C., 547 U.S. 388 (2006) (Sichelman, 2014). In this case the patentee was actually competing in the market, even though it was not practicing the patent whose infringement was claimed. No one apparently raised an antitrust issue. Nevertheless, the Court’s lack of foresight did considerable harm to competition by giving dominant firms an excuse to buy up competing technologies in order to keep them out of production, thus limiting the avenues through which new entry can occur. C.  Assessing Anticompetitive Restraints: ‘Scope-of-the-Patent’ Test Historically, competition policy presumed that an IP practice that increased the profitability of an IP right would also increase the incentive to innovate. Competition law enforcers should stand aside if the practice fell ‘within the scope of the patent’ (Hovenkamp, 2015e). This formulation originated in the nineteenth century as a rationale for the exhaustion, or ‘first sale,’ doctrine, which held that ‘when the machine passes to the hands of the purchaser, it is no longer within the limits of the monopoly’ (Bloomer v. McQuewan, 55 U.S. 539 (1852)). For example, even if a patent license limited the geographic range over which a good could be used, once the good was sold that right could no longer be enforced against the purchaser by means of a patent infringement suit (Adams v. Burke, 84 U.S. 453 (1873)). Later on, the Supreme Court used the ‘beyond the scope’ formulation to describe overly broad patent claim constructions, as in Coupe v. Royer, 155 U.S. 565 (1895); or overly broad interpretations of the patent doctrine of equivalents, which extended patent coverage to things that did not literally fall within the patent’s claims. Johnson & Johnston Assocs., Inc. v. R.E. Serv. Co., 285 F.3d 1046 (Fed. Cir. 2002) concluded that a broad infringement claim under the doctrine of equivalents was an attempt to extend patent beyond its rightful scope (Sarnoff, 2005). Beginning in the 1930s, the formulation was also employed in patent ‘misuse’ cases, particularly those involving the tying of unpatented goods. The tie was said to extend the patent’s power beyond its proper scope by bringing the unpatented tied product within the patent monopoly. For example, in Carbice Corp. of Am. v. Am. Patents Dev. Corp., 283 U.S. 27 (1931), the Supreme Court held that a patentee’s tie of unpatentable dry ice to its patented ice box was an attempt to control ‘unpatented material’ and thus ‘beyond the scope of the patentee’s monopoly.’ The scope-of-the-patent formulation was also used defensively, however, to exonerate practices challenged as anticompetitive but that were found to be within the patent’s scope. For example, in 1926 the Supreme Court upheld product price-fixing contained in patent licenses on the theory that setting the product price was the patentee’s right, and the license agreement did no more than retain that right, while transferring the right to produce to the licensee (United States v. General Electric Co., 272 U.S. 476 (1926)). In the 1970s Ward Bowman’s important book on patent and antitrust law envisioned the patent as a walled garden protecting everything within its scope, but not necessarily activities that spilled outside (Bowman, 1973). In its decision in United States v. Line Material Co., 333 U.S. 287 (1948), however, the majority condemned a product price fix in a cross-license, over the dissent of three Justices who objected that the price fix was within the scope of the patent. The dissenters in the Supreme Court’s 2013 Actavis decision would have exonerated a settlement agreement in which a patentee paid an accused infringer a large sum to delay its entry into production, provided that the permitted entry date was prior to the expiry of the patent (F.T.C. v. Actavis, Inc., 570 U.S. 136 (2013)). In that case, the

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Intellectual property and competition  239 settlement agreement would be no more exclusionary than a judicial determination of validity and infringement; thus, the agreement fell within the scope of the patent (F.T.C. v. Actavis, Inc., 570 U.S. 136 (2013); Edlin et al., 2015). Pay-for-delay settlements came into existence with the passage of the Hatch-Waxman Act, which rewards a generic firm for being the first to challenge a pioneer’s patent or entering upon that patent’s expiry. Under the Act, no subsequent generic can enter the market until 180 days after the first generic to file an Abbreviated New Drug Application (ANDA) actually starts producing. Prior to generic production the patent is virtually immune from challenge by other potential competitors, because they have no right to produce in any event. The situation gives the patentee and the generic infringement defendant a strong incentive to share the patent monopoly, thus largely eliminating adversity between them. Under the ‘scope-of-the-patent’ test the equilibrium duration of such an agreement is the remaining term of the patent, assuming that the antitrust laws permit such an agreement (Edlin et al., 2014; Hovenkamp, 2015e). That is, the joint-maximizing agreement for the settling parties would share the returns permitted by the patent for its full period. But the Actavis majority rejected a scope-of-the-patent approach, perhaps heralding an important change in antitrust analysis of patent practices. If patent rights are presumed to be valid, valuable, and clearly defined, then the scope-of-the-patent formulation functions much like similar scope formulations might do for, say, real property. But if patents are of questionable validity, dubious value, or ambiguous scope, then the scope-of-thepatent formulation can permit significant anticompetitive overreaching. This issue was highlighted in Actavis because the legislative framework largely immunized suspiciously weak patents from challenge while the pay-for-delay agreement was pending. Further, because the owner of a robust patent would not pay much more than avoided litigation costs in order to enforce its rights, the high pay-for-delay payment (often several hundred million dollars) is a strong signal that the patent is invalid or, in a few cases, not infringed (Edlin et al., 2013; Edlin, et al., 2014). For example, a landowner attempting to exclude a trespasser would not pay the trespasser a large sum of money to stay off her land unless she had serious doubts about the validity of her legal claim. If her title were good she could exclude the trespasser by paying nothing more than litigation costs. In other cases, the scope-of-the-patent formulation fails, not because the patents in question are invalid, but because their value is very low in relation to the restraints in question. Licenses that include product price-fixing are a good illustration. Even for relatively sound patents, license fees range from 0.5 to 6 percent of sales, with rates below 3 percent being the norm. The rates on individual patents can be much lower in patent intensive technologies such as computers and telecommunications. Further, these rates are for licensed patents, and only a small percentage of patents are ever licensed. By contrast, the markups of successful cartels often run in the range of 10 to 50 percent (Connor, 2014). If the firms in an industry cross-license their patents and also fix the product price, the agreement as measured by a scope-of-the-patent test attributes the value of the entire cartel markup to the patents. Justice Breyer’s majority opinion in Actavis held that courts evaluating such settlements need not address questions of patent validity or infringement. That proposition is consistent with long-standing reluctance by federal judges to review the IP merits when considering competition-based challenges to settlements, except for obvious cases of

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240  Research handbook on the economics of IP law volume 1 patents that are almost certainly invalid or not infringed. Most of those cases go on to uphold the settlement, however, while the Actavis decision did not. More importantly, as Actavis recognized, antitrust’s economic approach is designed to create appropriate incentives at the point of decision. The relevant question is not the ex post one whether the patent was valid and infringed, but rather the ex ante question of what the parties’ expectations were at the time the settlement was entered. By settling, the parties have already implicitly agreed that getting a judicial determination of patent validity and infringement is not worth the cost and attendant risk of a judicial determination. As a result, it makes little sense to insist on that same query before passing judgment on the settlement (Edlin, et al., 2015). Of course, most settlements raise no competition issues because the settlements themselves tend to increase rather than decrease output. The most common settlement of an IP infringement dispute is a production license under which the defendant pays the plaintiff for the right to produce. Such a license is likely to increase rather than decrease output, but in any event production licenses are explicitly authorized by § 261 of the Patent Act. They are legal whether or not they are in settlement of litigation. The more problematic settlements are those that fix product prices, divide product markets (as in Actavis), or in some cases that involve an agreement among the settlors not to license to or otherwise deal with third parties, such as the Supreme Court condemned in United States v. Singer Mfg. Co., 374 U.S. 174 (1963). Finally, one thing that makes an Actavis style pay-for-delay settlement unusual is that it does not involve a license at all, but at most an agreement to license at some future date. That is why Justice Breyer’s opinion for the Court observed that, while the Patent Act explicitly permits licensing, the agreement providing for delayed entry was not authorized by the Patent Act. Indeed, an equilibrium agreement under the scope-of-the-patent test advocated by the dissenters would never be a license: for the entire remaining duration of the patent the generic would not produce. Once the patent expires the generic is free to produce without a license. Until actual production under a license occurs, the settlement is nothing more than a naked market division agreement. Even so, Actavis held that the agreement in question should be addressed under antitrust’s rule of reason, which requires proof of market power and anticompetitive effects. It also held, however, that both power and harmful effects could be inferred from the large payment itself.4

III. IP AND ANTITRUST: SPECIFIC ISSUES AND APPLICATIONS Prior to patent issuance the patent process operates under intensive government supervision and control. To be sure, improper conduct in patent prosecution is not rare, but the patent system itself has tools for policing it. Further, riding herd on the procedures and rules of other federal agencies is not antitrust’s purpose. Even if we believe that the existing system issues too many patents, that too many of these are worthless, or that

4   Reverse payments in the context of adjudication before the Patent Trial and Appeal Board (PTAB) can raise analogous issues (Hovenkamp and Lemus, 2016).

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Intellectual property and competition  241 the process has other flaws, these are virtually never antitrust problems. This position is mandated by the ordinary antitrust rules of implied immunity, which limit or remove antitrust involvement from activities that are actively regulated by other federal agencies (Areeda and Hovenkamp, 2009–15). Once a patent is issued, however, the situation is much different. Patents are largely treated as property rights requiring little government supervision, other than the United States Patent and Trademark Office’s (USPTO) power to re-examine, collect renewal fees, and a few other housekeeping matters (Hovenkamp, 2015c). Because issued patents are largely subject to private control, antitrust policy becomes relevant. One important factor is whether the practice in question is expressly authorized by the Patent Act. Under the rules of express immunity, a practice that is compelled or authorized by a federal statute cannot be an antitrust violation, provided that the practice stays within the expressly authorized boundaries. After considering how market power should be assessed in IP-intensive markets, this section briefly addresses specific intellectual property practices that might also be challenged as antitrust violations. All are post-issuance practices and most of them are either not authorized by the Patent Act itself, or else they fall outside the scope of the authorization. As a result, antitrust analysis is appropriate. Of course, this does not mean that they are unlawful. Nor does it entail that the presence of an IP right or license is irrelevant (Cotter, 2015). A.  Assessing Market Power in IP-Intensive Markets No anticompetitive practice can succeed unless its participants have significant market power, which is the power profitably to raise prices above cost by reducing output. This requirement applies both to anticompetitive exclusion and anticompetitive collusion. To be sure, certain practices such as price-fixing are said to be unlawful ‘per se,’ which means that proof of illegality does not require a showing of market power. This is not because market power is irrelevant, however. To the contrary, naked practices such as price-fixing, which produce no efficiency gains to the participants, are profitable only on the premise that power exists. As a result, proper identification of the practice eliminates the need to assess market power separately (Areeda and Hovenkamp, 2009–15). In 2006 the Supreme Court overruled a half-century old presumption that a patent conferred sufficient market power on its owner to make certain anticompetitive practices such as tying unlawful (Illinois Tool Works Inc. v. Indep. Ink, Inc., 547 U.S. 28 (2006), overruling International Salt Co. v. United States, 332 U.S. 392 (1947)). In United States v. Loew’s, Inc., 371 U.S. 38 (1962), the Supreme Court had also extended the presumption to copyrights, and a few lower courts had applied it to trademarks (Siegel v. Chicken Delight, Inc., 448 F.2d 43 (9th Cir. 1971)). Most courts limited the presumption to tying cases, but where it applied the challenger needed to show only that the challenged restraint involved an IPR-protected product, and the requisite market power would then be presumed. All these decisions are now overruled. The end of the power presumption hardly means that IPRs are irrelevant to inquiries about market power. Today, they are properly regarded as an important factor in establishing power (Areeda and Hovenkamp, 2009–15). A few very powerful patents and some software copyrights may have so much exclusionary power that they give their owners

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242  Research handbook on the economics of IP law volume 1 dominant market positions. One likely historical example is Microsoft’s Windows operating system, which is protected from duplication by copyright and some patents (United States v. Microsoft Corp., 253 F.3d 34 (D.C. Cir. 2001)). Other good historical examples are the patents that protected Polaroid’s self-developing camera and film system, which Kodak tried in vain to invent around (Fierstein, 2015), and the array of patents that Xerox acquired from outside inventors that led to its long-held dominance of plain paper copying technology (SCM Corp. v. Xerox Corp., 645 F.2d 1195 (2d Cir. 1981)). Some aggregations of patents can become so essential to operation that they give significant market power to their owners, at least when the aggregation is owned by a single firm. Of course, aggregations of essential patents are often owned by pools in which a large number of firms have nonexclusive rights. Good examples are MPEG-LA, a patent pool and standards association whose members control standards for digital video technology; and 3GPP, whose members control the technology for 3G and 4G wireless telecommunications. Once a particular patent in such a pool is declared ‘standards essential,’ it may be necessary for any firm wishing to compete in that technology to purchase a license. That obligation can confer significant market power, limited by the fact that standards-essential patents, or SEPS, are also typically subject to FRAND (‘fair, reasonable, and non-discriminatory’) licensing obligations, which are generally interpreted to require licensing to willing participants at fair and nondiscriminatory rates (Contreras, 2015). So far there have been few antitrust cases challenging the creation and enforcement of SEPs or FRAND obligations, and these have been largely unsuccessful. For example, Golden Bridge Tech., Inc. v. Motorola, Inc., 547 F.3d 266 (5th Cir. 2008), rejected the antitrust claim of an inventor whose technology was rejected by a standard setting organization (SSO) in favor of alternative technologies. Legal control of SEPs lies largely with patent law, contract law, or the court’s general equity powers. In Apple, Inc. v. Motorola, Inc., 757 F.3d 1286 (Fed. Cir. 2014), the court held that the owner of a SEP could not obtain an injunction against a user; and in Qualcomm, Inc. v. Broadcom Corp., 548 F.3d 1004 (Fed. Cir. 2008), the court applied the judge-made doctrine of estoppel against one who reneged on its promise to subject its patents to a FRAND commitment. At this writing Qualcomm is facing separate lawsuits brought by the Federal Trade Commission and Apple, claiming that Qualcomm is tying SEPs to devices that it sells, or licensing only on the condition that its patents be used exclusively with Qualcomm devices (E. Hovenkamp, 2018). IPRs of all forms can limit asset mobility and facilitate product differentiation. In such markets prices will be higher than short-run marginal cost, even though the market has several competing firms. The impact of IPRs in these situations depends heavily on the number of firms in a market and the strength of the IPRs in question. Suffice it to say that many products from automobiles to computers to kitchen appliances contain numerous patents but are yet sold in moderately competitive, product differentiated markets. One technical difficulty for assessing power is that IP development often requires high fixed costs invested at the front end, and fairly low marginal costs. Whether acquisition costs are fixed or variable depends heavily on whether the IPRs in question are developed internally or licensed from outside inventors. For example, internal research often is very costly at the front end and these costs, once invested, do not vary with output. By contrast, licensing in the same technology by per unit or per dollar royalties becomes a variable

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Intellectual property and competition  243 cost to the licensee. Most of the technical tools used for market power measurement examine the relationship between price and marginal cost. The result can be false positives, depending on the prevalence of IPRs and the extent of fixed costs. For example, an unpatented living room chair with a patented recliner button may sell at a small markup over cost, reflecting licensing of the button patent. At the other extreme, purely digital products such as streamed e-books, songs, or software may have distribution costs very close to zero, meaning that the licensor’s entire price is markup. In that case, any measure of market power based on the relationship between price and short-run marginal cost will exaggerate the seller’s power. Because digital content is so easily duplicated, the ability to sell at a substantial markup over short-run cost is largely a result of IP protection. For example, one can obtain an e-book version of Moby Dick at a price of zero, even though it is very famous and widely read. Moby Dick is in the public domain, which means that no one is earning a royalty on its sales and copying is free. By contrast, the e-book version of a mediocre but recent novel will be much higher because royalties must be paid and it cannot be copied without a license from the publisher or author. For antitrust purposes, the main takeaway from these situations is that assessment of price-cost margins is rarely a useful way of assessing market power in markets for purely digital goods. Theoretically, one could address the problem by querying whether the returns to a product are significantly positive over its entire life. For example, the fact that a digital computer program sells at a high ratio of price to short-run cost tells us nothing if the product becomes obsolete or loses its commercial viability before recouping development costs. As a practical matter, these measurements can be very difficult to make, particularly when the IP right in question is a copyright with an effective duration of a century (Hovenkamp, 2016a). With some exceptions, non-patent IPRs make even smaller contributions to power than do patents. Copyrights and trademarks are easier to obtain than patents are. A few highly popular publications or computer programs are counterexamples, but generally one cannot infer significant power merely from the existence of an IPR of any kind (Areeda and Hovenkamp, 2009–15). B.  Horizontal Restraints: Price Fixing and Market Division A restraint is ‘horizontal’ if the participants are competitors or would be competitors but for the restraint. Identification of firms as ‘competitors’ is usually a reference to the product or service markets in which the firms operate, although it may also refer to the technologies that they develop or license. In any event, it is always important to distinguish restraints in the patent and licensing market from restraints in the product market. An example is price-fixing. Setting a price is inherent in licensing and rarely anticompetitive. If firms cross-license, they must necessarily agree on the price that each will charge to the others, even if the price is zero. Price-fixing in the product market is another matter and is highly suspicious. For example, firms with worthless patents or other IPRs might use licenses or cross-licenses as a cover for price-fixing, as Judge Posner observed in his opinion in Asahi Glass Co. v. Pentech Pharm., Inc., 289 F. Supp. 2d 986 (N.D. Ill. 2003). As noted previously, the competition problem with product price-fixing actually reaches far beyond invalid patents. Even if a patent is valid and essential, it may contribute

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244  Research handbook on the economics of IP law volume 1 only a small amount to a product’s value. As a result, the market price of the license can be far less than the cartel markup on the product. For this reason, product price fixes in IP licenses should be regarded as competitively harmful whether or not the IPRs in question are valid. The corollary is that product price fixes in patent licenses can be condemned without inquiry into patent validity or infringement. Market division agreements operate economically much like price-fixing. By dividing up the market (by territory, customer, or product) a group of firms can create individual monopolies for themselves. As a cartel device, market division can be superior to pricefixing if the firms have differing costs or, for other reasons, disagree about the price that a cartel should charge. One important difference between price-fixing and market division is that the Patent Act expressly authorizes patentees to grant exclusive licenses to ‘any part’ of the United States (35 U.S.C. § 261), thus making most domestic territorial division agreements lawful. While the Patent Act says nothing about licenses restricted to specific customers or products, these ‘field of use’ restrictions are treated leniently, mainly because they are viewed as organizers of production enabling the patentee to take advantage of the unique characteristics of different producers. For example, in Gen. Talking Pictures Corp. v. W. Elec. Co., 304 U.S. 175 (1938), the Supreme Court upheld an arrangement in which the patentee reserved to itself the market for commercial use of its patented sound amplifier, while other licensees were authorized to make the amplifiers only for residential customers. The Federal Circuit Court of Appeals has held that field of use restrictions must be evaluated under antitrust’s rule of reason (B. Braun Med., Inc. v. Abbott Labs., 124 F.3d 1419 (Fed. Cir. 1997)). Field of use restrictions become more suspect, however, if they take the form of product market division among competing manufacturers. It is also worth noting that while § 261 of the Patent Act authorizes an exclusive territory agreement between a patent owner and a licensee, it does not authorize agreements among the licensees themselves. As is true of price-fixing, the tolerance for market division agreements applies to the IP right, not to products that might include it. For example, suppose that Ford patents a desirable windshield wiper blade and licenses Chrysler to sell cars with the patented blade in any state except California. That would be a territorially restricted license expressly authorized by the Patent Act. Ford could very likely also authorize Chrysler to put the blade only on its pickup trucks, but not its cars. That would be a field of use restriction and would ordinarily be lawful under antitrust law’s rule of reason. What Ford could not do, however, is agree that Chrysler would not sell any pickup trucks in California, whether or not they contain the patented blade. That would be a restraint on the product market rather than on use of the patent. Unless other factors suggesting joint development were present, that agreement would be unlawful per se under the antitrust laws. C.  Vertical Restraints Involving IPRs A restraint is purely vertical when the parties stand in a buyer-seller relationship but are not actual or potential competitors in either the product market or the licensing market. Because every license agreement has a buyer and seller, they are all vertical as to the IPR license itself. The more important question is the relationship of the parties in the underlying product (or service) market. Today the antitrust attitude toward vertical restraints is

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Intellectual property and competition  245 benign, although it was not always so (Hovenkamp, 2015d). Resale price maintenance (RPM), vertical nonprice restraints, and tying were all once unlawful per se. Vertical restraints come in two classes, generally called ‘intrabrand’ and ‘interbrand,’ even though at least some of the products and services that they control are not branded at all. A restraint is said to be intrabrand if it controls distribution only of the supplier’s own product. It is interbrand if it places limits on the products of rivals. The principal intrabrand price restraint is RPM, or seller dictation of the price at which its own product can be resold. As a general rule, the fact that the price restraints are included in an IP license is irrelevant, and when the per se rule against RPM was in place it applied to patented and copyrighted goods, as well as those protected by trade secrets (Areeda and Hovenkamp, 2009–15). Since 2007, RPM has been assessed under the rule of reason (Leegin Creative Leather Prod., Inc. v. PSKS, Inc., 551 U.S. 877 (2007)). Today, few instances are found to be unlawful. Vertical nonprice restraints restrict a dealer’s or retailer’s sale of the supplier’s own product in some way other than by setting price. The most common ones are territorial restrictions, customer restrictions, and product restrictions. There are also numerous others, such as restrictions regulating the hours that a firm is open for business, fast food franchise restrictions dictating menu items, employee uniforms, hours of operation, and the like. Section 261 of the Patent Act expressly permits territorial restrictions in patent licenses, but in any event the Supreme Court has been applying the rule of reason to purely vertical nonprice restraints since its decision in Continental TV, Inc. v. GTE Sylvania, Inc., 433 U.S. 36 (1977). They are rarely found to be unlawful. The Copyright Act expressly permits many nonprice restrictions, both horizontal and vertical, by making separate statutory authorizations for the right to reproduce, to prepare derivative works, to distribute, to perform, and to display, depending on the nature of the copyrighted good (17 U.S.C. § 106). However, even a purely vertical licensing restriction that is not expressly authorized by the Copyright Act would probably be legal under the antitrust laws. Restrictions that attached to a copyrighted article after it is sold might not be enforceable under copyright law’s statutory first sale doctrine (Kirtsaeng v. John Wiley & Sons, Inc., 133 S. Ct. 1351 (2013)). These are not antitrust challenges, however. Interbrand vertical restraints, which include tying and exclusive dealing, have historically been treated with greater suspicion than intrabrand restraints, mainly because they can reduce the opportunities of rivals. Under exclusive dealing a firm, typically a retailer or other intermediary, promises to deal exclusively in the supplier’s product or service. An ‘output contract’ does the same thing except that it places the exclusivity obligation on the seller rather than the buyer. In the IP context, the exclusive license is a form of output contract, under which the IP holder promises to license only one firm for all or a particular subset of production under the license. The Patent Act expressly authorizes domestic exclusive patent licenses in 35 U.S.C. § 261. The Copyright Act also authorizes exclusive licenses, although without an express territorial limitation (17 U.S.C. § 106). By contrast, § 3 of the Clayton Act makes it unlawful to sell a good or article, ‘whether patented or unpatented,’ on the condition that the buyer not deal in the goods of a competitor, provided that the agreement’s effect ‘may be to substantially lessen competition or tend to create a monopoly . . .’ (15 U.S.C. § 14). In addition, anticompetitive exclusionary contracts are prohibited by § 1 of the Sherman Act, as well as § 2 if the firm imposing them is a monopolist (United States v. Dentsply Int’l, Inc., 399 F.3d 181 (3d Cir. 2005)).

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246  Research handbook on the economics of IP law volume 1 The Patent Act’s explicit authorization of exclusive licenses exists in some tension with the Sherman Act’s prohibition of anticompetitive contracts. The tension is partly reduced by the first sale doctrine (patent exhaustion), which exhausts the patents in any good once it is sold, thus preventing many instances of post-sale exclusivity enforced by infringement actions. However, that solution is incomplete because it is still possible to license or lease patented goods, and the first sale doctrine does not apply unless there is a sale. The best view is that the antitrust laws qualify the Patent Act in those cases where competitive harm can be shown. This is consistent with the general rule of statutory interpretation in this area, which is that the simple statutory authority to do something is not authority to do so in violation of the antitrust laws. For example, numerous state and some federal corporation acts authorize corporations to acquire the stock or assets of other corporations, but that does not mean that they can make an anticompetitive stock or asset acquisition in violation of § 7 of the Clayton Act, which condemns anticompetitive mergers. In F.T.C. v. Phoebe Putney Health Sys., Inc., 568 U.S. 216 (2013), the Supreme Court held that a hospital corporation’s statutory power to acquire other hospitals did not immunize an anticompetitive acquisition. Already in the 1916 antitrust decision in United States v. Am. Can Co., 230 F. 859 (D. Md. 1916), the court held that it was unlawful for the defendant to purchase exclusive rights to patented can making machinery when the effect was to deny mechanization to rivals. Because American Can made no can making machinery itself, these agreements were purely vertical. In any event, after a lengthy period of hostility the courts now accept that exclusivity provisions in sale or license contracts are only infrequently anticompetitive, depending on such factors as the market share foreclosed by the agreement, ease of entry, the duration of the contracts and frequency of rebidding, and offsetting efficiencies that might justify an exclusive deal (Areeda and Hovenkamp, 2009–15). A tying arrangement occurs when a firm conditions the sale of one product or service (the ‘tying’ product) on the purchaser’s taking of a second product or service (the ‘tied’ product). The courts first confronted tying arrangements in patent law cases, long before the antitrust laws were enacted (Hovenkamp, 2018a). Most ties are contractual, which means that the tie is imposed by agreement. A few are ‘technological,’ or ‘tech ties,’ which means that tying is accomplished by a technological design or feature that makes the seller’s tying product incompatible with the tied products of rivals. Well-known examples are Microsoft’s ‘commingling’ of the code for the Internet Explorer browser into the Windows operating system in United States v. Microsoft Corp., 253 F.3d 34 (D.C. Cir. 2001); or Apple’s technological tying of its iTunes content and devices so that they worked best only when used together, in Apple iPod iTunes Antitrust Litig., 2014 WL 4809288 (N.D. Cal. 2014). Another was Kodak’s introduction of the Instamatic pocket camera, which was compatible only with its own film cartridges, approved in Berkey Photo, Inc. v. Eastman Kodak Co., 603 F.2d 263 (2d Cir. 1979). Because product design is a unilateral act, technological ties are usually treated under antitrust’s monopolization provision, § 2 of the Sherman Act. By contrast, ordinary contractual ties are addressed under § 1 of the Sherman Act or § 3 of the Clayton Act, both of which require an agreement. Today legal and scholarly opinion has shifted dramatically from the belief expressed in the mid-1900s that tying arrangements serve ‘hardly any purpose beyond the suppression of competition,’ to the view that most ties are competitively benign or beneficial (Standard Oil Co. of Calif. v. United States, 337 U.S. 293 (1949). The Patent Act expressly addresses

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Intellectual property and competition  247 tying arrangements in the 1988 Patent Misuse Reform Act (35 U.S.C. § 271(d)(5)), which provides that patent ties are not unlawful unless the tying firm has market power in the tying product. This provision was passed in response to serious excesses in the application of misuse doctrine, which refused to enforce patent ties in markets where there was no serious risk of competitive harm. For example, Justice Brandeis’s opinion in Carbice Corp. of Am. v. Am. Patents Dev. Corp., 283 U.S. 27 (1931) found patent misuse when the manufacturer of a patented ice box required purchasers of the box to use its own unpatentable dry ice. The market for the unmechanized boxes was competitive and dry ice was a common commodity produced in ‘carbonic’ plants in many places. Proving unlawful tying under the antitrust laws requires proof of tying product market power. In Illinois Tool Works Inc. v. Indep. Ink, Inc., 547 U.S. 28 (2006), the Supreme Court held that this power may not be inferred simply from the existence of a patent covering the tying product. Beyond that, the analysis depends in part on whether the tying and tied products are used in fixed or variable proportions. The tie of Microsoft’s Windows computer operating system and its Internet Explorer browser is a fixed proportion tie. A buyer purchases one copy of each, although she might use them in different proportions. The most common anticompetitive rationale for such a tie is exclusion of rivals in the tied product market, which requires that the firm employing the tie have dominance in the tying market. For example, by tying Windows and Internet Explorer (initially by contract and later by technological integration of the code), Microsoft was able to dry up the market for independent web browser Netscape. However, fixed proportion ties can also be beneficial when joint production or distribution reduces costs or makes a product work better. Many fixed proportion ties are a consequence of nothing more than technological improvement, which often proceeds by making products more integrated (Hovenkamp, 2018a). For example, IBM’s desktop computers were attacked as tying arrangements to the extent that they merged processors, motherboards, controllers, storage devices, and memory into a single box. Previously these products had been sold separately and connected by cables, making it possible for one person to sell the processing box and another the disc drive, and so on. But the new systems were more reliable, faster, and cheaper (Fisher, 1983). In sum, overly aggressive use of the law governing technological tying can serve to limit innovation. Thus, the decision in California Computer Prod., Inc. v. IBM Corp., 613 F.2d 727 (9th Cir. 1979) rejected the claim that innovative product integration resulting in a technological tie was simple ‘design manipulation’ intended to ruin competing disc drive manufacturers. Variable proportion ties can serve all of the same functions as fixed proportion ties. In addition, however, variable proportioning can operate as metering or price discrimination devices. These are usually either competitively harmless or beneficial to the extent that they increase overall output. For example, the manufacturer of a printer that uses ink cartridges might tie the printer and the cartridges, either by contract or technological design. It then drops the price of the printer, often substantially and sometimes even to zero, but charges a premium for the ink cartridges. The result of this practice is that the firm obtains a higher overall return from high intensity users who consume more ink. This is a form of second degree price discrimination which results in larger printer sales to the extent the printer price is lower, but also captures more revenue from higher intensity users. In most cases consumers as a group are better off, although high intensity consumers may be injured (Hovenkamp and Hovenkamp, 2015). While such ties may

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248  Research handbook on the economics of IP law volume 1 reduce welfare if the firm has an absolute monopoly in the tying product and the tie reduces output (Elhauge and Nalebuff, 2017), they clearly increase welfare in cases where the seller is not a monopolist or in collusion with the other sellers in the market. In such cases any purchaser required to pay a monopoly price will purchase from a different seller (Hovenkamp, 2018a). In virtually all litigated variable proportion tie cases the seller is not a monopolist, and often it is not even among the largest firms in the market. For example, in Impression Prod., Inc. v. Lexmark Int’l, Inc., 137 S. Ct. 1523 (2017), a variable proportion tying case that the Supreme Court decided under the patent exhaustion doctrine, Lexmark’s share of the highly competitive computer printer market was less than 5 percent (Hovenkamp, 2018b). Variable proportion ties are also commonly used by franchisors, such as those in the fast food industry, where the tying product is commonly trademarked or occasionally copyrighted rather than patented. For example, the franchisor might charge a very low price or even zero for the right to a franchise, but then place an overcharge on various food products or supplies that the franchisee uses in variable proportions. As a result, the franchisor makes more money from franchisees that sell more (Queen City Pizza Inc. v. Domino’s Pizza Inc., 124 F.3d 430 (3d Cir. 1997)). Importantly, the profitability of these variable proportion ties does not depend on the seller’s market power, but only on sufficient product differentiation or branding to make its tying product attractive. Many of the defendants in franchise tying claims have been relatively minor firms. For example, Siegel v. Chicken Delight, Inc., 448 F.2d 43 (9th Cir. 1971) found antitrust liability for a variable proportion franchise by a struggling, minor fast food franchisor. The market power requirement was thought to be met because the defendant’s name was trademarked. As noted earlier, that legal conclusion has now been overruled. D.  Patent Pools In a patent pool, several patent holders license their patents into a common ‘pool,’ or organization that relicenses them out to members. The pool may also license to outside manufacturers who do not own relevant patents of their own. While patent pools have existed for a long time, in recent decades their growth has been exponential, thanks largely to the rapid development of networked products sold by multiple firms. The products include telecommunications and other digital devices as well as computer and video technology. A patent pool is a ‘horizontal’ restraint to the extent that its participants are competitors in the product market or license competing technologies. The relationship among the parties is often more complex, however. First of all, one important value of patent pooling is to facilitate the coordinated use of complementary technologies, but firms that produce pure complements are not competitors. Another use, equally or more important in some markets, is to minimize the transaction costs of patent management. For such savings to occur the pool members can have any relationship, from competitor, to vertically related, or complementary. Historical rationales for pooling focused on the differences between complements and substitutes (Gilbert, 2004; Santore, 2010). Pooling or cross-licensing among different producers in the same industry was thought to be procompetitive if the shared patents were complements with one another, but more likely to be anticompetitive if they were

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Intellectual property and competition  249 substitutes (Shapiro, 2001). If a patent is a discrete unit of innovation whose validity and boundaries are easily assessed, this distinction makes sense. Complements are ordinarily used together, meaning that joining them can create social benefits. For example, if one firm owns a patent on a desirable lawn mower motor and another owns a patent on a desirable throttle, pooling will enable the two firms to produce mowers that have both improvements. By contrast, substitutes are used in the alternative rather than together. This makes price-fixing a more likely explanation. The distinction between complements and substitutes is less important, however, in a world where patents are numerous and complex, with many claims, costly to interpret, and of uncertain quality (Lerner and Tirole, 2004). In such a setting, the economics of transaction costs and boundary enforcement dominates other explanations. That is to say, the modern patent pool in information technologies is a type of commons for which sharing with management rules is cheaper and more effective than individual appropriation and enforcement. Patent pools for complex information technologies can contain thousands of patents. For example, the MPEG-LA pool for digital video technology controls about 5,000.5 Subsequent to issuance, most of these patents have never been assessed for validity and scope. Even getting a legal opinion on these issues can be very costly. Many of the patents have numerous claims, often making the relationship among different patents far more complex than simple substitutes or complements. Further, the substitute/complement question often cannot be answered until one examines the device that intends to use them. For example, the licensees of the MPEG-LA pool include multiple competing makers of digital cameras and phones, but also producers of complementary products such as flash memories, video displays or projectors, film or photo editing software, and the like. Whether two patents are substitutes, complements, or simply not practiced at all can depend on the type of device that the manufacturer produces. One illustration of these complex relationships is the Princo litigation in the Federal Circuit, which involved shared technology for developing rewritable digital discs (Princo Corp. v. Int’l Trade Comm’n, 616 F.3d 1338 (Fed. Cir. 2010)). A feature that located the stylus on a rewritable disc came in both patented analog and digital versions. The two versions were substitutes in the product market, because a manufacturer would use one of them but not both. However, at least one claim of the analog version wrote on the digital patent, making the two patents legal complements as well. Regardless of their function, two patents are complements if someone cannot practice one without infringing the other (Princo Corp. v. Int’l Trade Comm’n, 616 F.3d 1338 (Fed. Cir. 2010); Bohannan, 2011, pp. 510–11). Indeed, not until after costly claim construction would we know how the patents relate to one another. Even then, claim construction reversal rates are unacceptably high (Teva Pharmaceuticals USA, Inc. v. Sandoz, Inc., 2014 WL 2885379 (U.S.) (U.S., 2014)) (amicus brief). Finally, the relationship between substitutes and complements is relevant to one additional factor: in markets where multiple technological alternatives exist, the pooling of substitutes may serve to deny access to outsiders. For example, if there are three known technological alternatives for solving a particular problem a pool that acquires   See http://www.mpegla.com/main/Pages/AboutHistory.aspx.

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250  Research handbook on the economics of IP law volume 1 the patents to all three may be in a position to exclude non-pool members from the product market. A more robust explanation for pooling in high tech information markets comes from the theory of commons development (Bohannan and Hovenkamp, 2012). As Ronald Coase argued in The Nature of the Firm (Coase, 1937), the boundaries of a firm are determined by its costs of doing business. A firm makes for itself or buys from others, depending on which alternative is more profitable. When it makes something for itself its boundaries expand, and when it buys from others they contract (Hovenkamp, 2011a). Property rights, including IPRs, provide the legal power to exclude, but they do not always make individual exclusion the best choice. The traditional property world is full of instances, ranging from shared driveways and party walls to community owned tennis courts and swimming pools, where individuals share because sharing is cheaper or more productive than exclusion. The same thing has been true for many centuries of so-called common pool resources such as fisheries, irrigation rights, or grazing rights. One hundred fishermen who own a large lake could if they wished build fences cutting the lake into 100 pieces. But subdividing would be costly, would very likely produce many disputes, and would be devastating to the yield of a mobile species of fish (Ostrom, 1990). Patent rights in information technologies are similar. While firms are certainly entitled to own patents individually, defining and defending boundaries might be much less productive than sharing them reciprocally with others. While patent pools created to limit boundary problems have some similarities to common pool resources, they are not identical and some differences are critical to competitive impact. Most traditional common pool resources are ‘rivalrous,’ which means that each unit taken depletes what is left. Uncontrolled sharing leads to overuse, as shown by the fate of the American Bison as well as chronic overfishing in many fishing commons. For this reason, catch or harvest limitations are essential if the commons is to operate efficiently. Indeed, a principal difficulty in commons management is making and enforcing access or harvest rules (Ostrom, 1990). By contrast, IPRs are generally nonrivalrous. An IP right such as a patent can be used many times without depleting what is left over. As a result, output restraints in the product market are more suspicious in IP commons than in traditional commons (Bohannan and Hovenkamp, 2012). Another difference between modern information technology patent pools and traditional commons is the diversity of the participants. All those sharing rights on a common fishery or pasture are likely to be fishermen and ranchers with relatively undifferentiated businesses. By contrast, given the nature of multi-claim patents, those who practice them might be highly diverse, producing complements or unrelated technologies as much as they produce substitutes. That is clearly true of the previously described MPEG-LA pool. A complex device such as a digital video camera might practice many patents in the pool, while a simple device such as a memory chip or photo editing software employs only a few. These differences have led to claims akin to anticompetitive tying. A firm that is required to license all of a pool’s package of 5,000 patents may complain that it really uses only 200 of the patents. In this case, the patents it uses are the ‘tying product,’ while the unwanted patents are the ‘tied product.’ These antitrust claims nearly always fail, for the simple reason that competition is not injured. Forcing someone to take a bigger product than he might want—such as 100 acres of land instead of a single residential lot—might present a bargaining problem. It is not anticompetitive, however, because no one is being

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Intellectual property and competition  251 excluded. Further, the cost of determining which of the pool’s patents the complaining licensee actually practiced could be much greater than the cost of the license fee itself. As one court observed in rejecting such an antitrust claim, ‘[I]t is not anticompetitive for a patent pool to include numerous potentially blocking patents, patents which may or may not be essential but which are more efficient to license as part of the pool than to risk the expense of future litigation’ (Nero AG v. MPEG LA, LLC, 2010 WL 4366448 (C.D. Cal. 2010)). E.  Exclusionary Practices 1.  Walker process and unreasonable infringement claims By their nature IPRs create a power to exclude. Asserting that right is protected by § 271(d)(3) of the Patent Act as well as constitutional protections of the right of access to the courts (Areeda and Hovenkamp, 2009–15). No protection exists, however, for ‘baseless’ claims having no foundation in fact or law. The Supreme Court’s decision in Walker Process Equip., Inc. v. Food Mach. and Chem. Corp., 382 U.S. 172 (1965) recognized that improper patent infringement actions could violate § 2 of the Sherman Act if they excluded another firm unreasonably. As noted previously, antitrust has little or no role in policing pre-issuance patent applicant conduct. Many Walker Process cases, including Walker Process itself, involve some pre-issuance conduct. In Walker Process, the patent applicant failed to inform the patent examiner about sales made prior to patent application that, if disclosed, would have barred the patent. See 35 U.S.C. § 102(a) (1). Other cases have involved other forms of inequitable conduct before the USPTO, including failures to inform the examiner of known prior art that would have defeated patentability (Nobelpharma AB v. Implant Innovations, Inc., 129 F.3d 1463 (Fed. Cir. 1997)). Importantly, however, merely obtaining a patent improperly is not an antitrust violation. Further the patent system has numerous remedies for improper conduct before the USPTO. Walker Process itself involves the post-issuance practice of filing an infringement suit, or engaging in other enforcement activity such as a threat to sue, on a patent that the owner should reasonably have known to be invalid or unenforceable under the circumstances. Antitrust liability for Walker Process violations requires not only the improper infringement action, but also a structural basis for thinking that the lawsuit either perpetuates or threatens to create a market monopoly. This makes the antitrust remedy much less readily available than the ‘exceptional case’ remedy in § 285 of the Patent Act, which authorizes a judge to award attorney’s fees against a patentee who makes an improper claim or commits other litigation misconduct. The Supreme Court’s decision in Octane Fitness, LLC v. ICON Health & Fitness, Inc., 134 S. Ct. 1749 (2014) made such awards easier to obtain. At this writing, it remains to be seen if this decision will have any impact on the availability of antitrust remedies. One 2014 decision did find some basis for comparison (Tyco Healthcare Group LP v. Mutual Pharma. Co., Inc., 762 F.3d 1338 (Fed. Cir. 2014)). As formulated, Walker Process reaches no more than a small portion of socially harmful infringement actions. It applies in cases where questions of validity or infringement are relatively clear and, given that, the patent holder has sued unreasonably. A far larger number of harmful infringement actions arise out of problems of ‘notice failure’ (Menell and Scotchmer, 2007; Hovenkamp, 2011b). Because patent infringement does not require

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252  Research handbook on the economics of IP law volume 1 advance notice of someone else’s patents, many innocent innovators are later caught by surprise simply because the cost of searching patents or interpreting their claims is so high and the results so unreliable. These are features of the patent system itself, however, and generally cannot be remedied by the antitrust laws. 2. Acquisitions Section 261 of the Patent Act expressly authorizes patentees to assign their patents to others, although it does not authorize anticompetitive assignments. Even monopolists should be entitled to acquire technology that they need to improve their own products or processes. Nevertheless, a few qualifications are important. First, to improve its own technology a dominant firm requires no more than a nonexclusive license. Second, acquiring a patent in order to improve one’s own technology necessitates practicing the patent; acquisition and nonuse does nothing to improve the acquirer’s own product, but may serve to exclude rivals from access to alternative technologies. Third, under some circumstances the acquisition of exclusive rights in competing patents can be a significant threat to competition, particularly when the patents represent all of the best alternatives for operating in some market. Suppose, for example, that patent portfolios Alpha, Beta, and Gamma represent the only three commercially feasible ways of providing a particular service. If a dominant firm acquired exclusive rights in all three it would be able to exclude competitors from the market even though it would likely be practicing only one of the three alternatives. Such acquisitions of competing portfolios should be challengeable as unlawful mergers under § 7 of the Clayton Act, which expressly applies to asset as well as stock acquisitions. The courts have repeatedly held that a patent is a qualifying ‘asset,’ provided that anticompetitive effects are shown (Areeda and Hovenkamp. 2009–15). If market dominance results, the acquisitions could also be unlawful monopolization under § 2 of the Sherman Act, at least if followed by an infringement action. For example, in Intellectual Ventures I, LLC v. Capital One Financial Corp., 99 F. Supp. 3d 610 (D. Md. 2015), the court held that a non-practicing entity’s acquisition of some 3,500 patents covering an entire segment of the banking industry and subsequent enforcement could amount to unlawful monopolization (Hovenkamp and Hovenkamp, 2017; Areeda and Hovenkamp, 2009–15). If the firm has acquired only one or two patents, however, the courts have been willing to sustain infringement actions even if one or more of the patents are unused, as the Supreme Court held in Cont’l Paper Bag Co. v. E. Paper Bag Co., 210 U.S. 405 (1908), and the Federal Circuit much more recently confirmed in Trebro Mfr., Inc. v. Firefly Equip., LLC, 748 F.3d 1159 (Fed. Cir. 2014). Neither case raised an antitrust issue (Hovenkamp and Cotter, 2015). 3.  Refusal to license Neither United States antitrust law nor the Patent Act recognizes a general duty to license a patent or to share patented technology. Indeed, § 271(d)(4) of the Patent Act provides that a refusal to license is not ‘misuse or illegal extension of the patent right. . . .’ This language appears to refer to unilateral refusals to deal, but some language in a Federal Circuit dissent in Princo Corp. v. Int’l Trade Comm’n, 616 F.3d 1338 (Fed. Cir. 2010), suggested that it could reach concerted refusals to deal as well (Bohannan and Hovenkamp, 2011). That rule, if accepted, would be unfortunate, for concerted refusals

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Intellectual property and competition  253 have significantly more anticompetitive potential than unilateral refusals (Areeda and Hovenkamp, 2009–15). In its decision in Image Tech. Servs., Inc. v. Eastman Kodak Co., 125 F.3d 1195 (9th Cir. 1997), the Ninth Circuit held that the antitrust laws did give Kodak a duty to sell patented parts to independent repair persons who wished to fix its high-speed photocopiers. The decision has been widely criticized and was expressly rejected by the Federal Circuit in the ISO Antitrust Litigation, 203 F.3d 1322 (Fed. Cir. 2000), a similar case involving Xerox. As of this writing the Supreme Court has not resolved the split (Areeda and Hovenkamp, 2009–15). Currently the courts have not settled on the scope of a patentee’s duty to license a patent encumbered by a FRAND commitment, or a promise made as part of a standard setting process to license on ‘fair reasonable, and nondiscriminatory terms.’ Patentees generally make these commitments as a condition of having their patents declared ‘standards essential,’ or part of the technology to be adopted by a network. In Apple, Inc. v. Motorola, Inc., 757 F.3d 1286 (Fed. Cir. 2014), a panel of the Federal Circuit split three ways on the question. Nonetheless, it seems clear that if the owner of a FRAND-encumbered patent has executed a contractual promise to license to all on FRAND terms, then an infringement suit in conflict with that contractual obligation would be improper, as the court found in Microsoft Corp. v. Motorola, Inc., 795 F.3d 1024 (9th Cir. 2015). It could occasion antitrust liability, although antitrust would not necessarily be the best vehicle for assessing it because the challenger must also establish market power and the creation of monopoly. The Patent Act’s own remedial measures, such as the previously discussed ‘exceptional case’ provision, would provide a more direct route to relief, although not treble damages. One must also distinguish between simple and conditional refusals to grant an IP license or sell a good covered by an IP right. Section 3 of the Clayton Act, discussed above, expressly limits certain conditional licensing contracts that threaten competition, and expressly covers goods that are patented as well as unpatented. For example, a tying arrangement can readily be construed as a refusal to sell or license a tying product unless the buyer also takes the tied product. The legality of a conditional refusal depends on the legality of the underlying condition. Another important distinction is between compulsory licensing as a general antitrust duty and compulsory licensing as a remedy for some other antitrust violation. In many antitrust cases the courts have determined that compulsory licensing is the best way to undo the effects of some other violation. Merger remedies often require IP licensing as a condition for approval and many structural breakups, such as the one that dismantled the nationwide AT&T telephone network, could not have succeeded unless each of the spun off companies received nonexclusive licenses to the parent’s intellectual property portfolio (United States v. AT&T, 552 F. Supp. 131 (D.D.C. 1982)). Finally, it is worth noting that the question of compulsory licensing duties is an important and controversial one, raising serious questions in market dominating networks, lifesaving pharmaceuticals, national defense, and other areas involving questions about patent social value. Antitrust is a poor vehicle for resolving most of these issues. It offers no useful tools for determining when such a dealing obligation is socially necessary. Nor does it have any mechanisms for setting a price, other than through ordinary damages measurement tools.

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254  Research handbook on the economics of IP law volume 1

IV. IP LAW’S OWN INTERNAL RULES FOR FACILITATING COMPETITION Intellectual property law also has internal rules for facilitating competition in the scope or use of IPRs (Cotter, 2006). Most of these rules are quite different from antitrust rules. IP law’s internal competition rules do not require a market definition, proof of anticompetitive market exclusion, or even an attempt to measure the impact of a particular practice on price or output. Rather they are best seen as rules that limit IP ‘overreaching’ of various kinds. A.  The First Sale (Exhaustion) Doctrine Patent and copyright law’s ‘first sale,’ or exhaustion rule, limits the power of a right holder to restrict the use or resale of a protected good once it has been sold. Both the patent and copyright exhaustion rules were originally judge-made, but subsequently Congress enacted the copyright first sale doctrine into the statute, at 17 U.S.C. §109(a). In its simplest form the exhaustion rule states that the sale, not the license or lease, of a patented or copyrighted good exhausts the right holder’s legal interest in that particular copy. The exhaustion doctrine has been used to strike down resale price restrictions, under both copyright (Bobbs-Merrill Co. v. Straus, 210 U.S. 339 (1908)); and patent (United States v. Univis Lens Co., 316 U.S. 241 (1942)). It has been applied to quasiexclusive dealing restrictions in patents (Quanta Computer, Inc. v. LG Elecs., Inc., 553 U.S. 617 (2008)), and has also been used to strike down limitations on where purchased goods can be sold, in both copyright (Kirtsaeng v. John Wiley & Sons, Inc., 133 S. Ct. 1351 (2013)) and patents (Adams v. Burke, 84 U.S. 453 (1873)); Hovenkamp, 2011c). In 2017 the Supreme Court held that a patentee could not avoid exhaustion by making its sale ‘conditional’ on certain post-sale restrictions, no matter how clearly the condition was stated (Impression Products, Inc. v. Lexmark, Inc., 137 S. Ct. 1523 (2017)). The Court located the policy rationale for this concern in the common law rules limiting restraints on alienation. Even though the first sale rule reaches many of the same practices that antitrust law reaches, such as tying, exclusive dealing, or RPM, it cannot be counted as an antitrust provision. Its application is completely indifferent to competitive effects, requiring only that there be a qualifying ‘sale.’ Once such a sale has been found6 the post-sale restraint becomes unenforceable per se, without regard to competitive effects. One view of the doctrine is that it is intended to limit the reach of patent law in order to leave space for other bodies of commercial law (Duffy and Hynes, 2016; Hovenkamp, 2011c). Another view is that it is a creature of federalism, limiting the reach of federal IP supremacy in order to ensure that states retain the power to control post-sale restraints on protected goods (Hovenkamp, 2016b).

6   Bowman v. Monsanto Co., 133 S. Ct. 1761 (2013) held that exhaustion did not apply to selfreplicating seed where the replanted seed was a subsequent generation and not the selfsame seed that the infringement defendant had purchased.

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Intellectual property and competition  255 B. ‘Misuse’ The misuse doctrine originated in patent law and was later expanded to copyright. It is entirely judge-made, and the only references to it in the Patent Act are limitations contained in the Patent Misuse Reform Act, 35 U.S.C. § 271(d), rather than recognition. Almost from the beginning misuse doctrine got off to a troublesome start. The Supreme Court’s decision in the Motion Picture Patents Co. v. Universal Film Co., 243 U.S. 502 (1917) case, where a version of the doctrine was first recognized, almost surely involved an anticompetitive restraint. The owner of a market dominant projector sold it subject to a license restriction permitting projection only of its own films. But the Clayton Act had already been passed, and in 15 U.S.C. § 14 it expressly prohibited patent ties that injured competition. To be sure, the competition issue was raised as a defense to an infringement action rather than an antitrust claim, but by this time the Supreme Court had already held in Cont’l Wall Paper Co. v. Louis Voight and Sons Co., 212 U.S. 227 (1909) that illegality under the antitrust laws was a complete defense to an enforcement action, such as a breach of contract suit. Therefore, a patent-law-generated misuse doctrine was unnecessary. In subsequent decades, misuse doctrine was applied aggressively to patent tying, exclusive dealing, royalty extensions, and other licensing arrangements where injury to competition was nowhere in view. It is no wonder that during a later era of antitrust contraction both courts and commentators severely criticized ‘misuse’ unless its application was limited to conduct that violated the antitrust laws (USM Corp. v. SPS Tech., Inc., 694 F.2d 505 (7th Cir. 1982); Bohannan, 2011; Lim, 2013). The courts have also recognized copyright ‘misuse’ where the copyright infringement plaintiff had attempted to ‘sequester’ uncopyrightable public data in a copyrighted database program. Judge Posner made clear that the violation in question was not of the antitrust laws. It was a unilateral act and there was no finding that the infringement plaintiff had sufficient market power (Assessment Tech. of Wisconsin., LLC v. Wiredata, Inc., 350 F.3d 640, 646 (7th Cir. 2003)).7 Rather, the concern was strictly one of copyright law, which both protects copyrighted content but also seeks to ensure that material in the public domain can be accessed. In 2015, the Supreme Court breathed new life into one particular variation of the misuse doctrine. In Kimble v. Marvel Entm’t Co., LLC, 135 S. Ct. 2401 (2015), it adhered to the much-criticized rule adopted by the Supreme Court in Brulotte v. Thys Co., 379 U.S. 29 (1964), that a license agreement basing royalties on post-expiration patent use is unenforceable per se. Kimble did not attempt to justify the original Brulotte rule, but held only that reliance plus stare decisis required adherence (Hovenkamp, 2015b). The overuse and subsequent undermining of ‘misuse’ doctrine was an opportunity lost. Courts have legitimate concerns about IP overreaching as a matter of intellectual property law. The 70-year-long escapade, stretching from the 1917 Motion Picture Patents case 7   The court also relied on the Fourth Circuit’s decision in Lasercomb Am., Inc. v. Reynolds, 911 F.2d 970 (4th Cir. 1990), which found misuse in a restriction on a copyright licensee’s development of new technology, even though that restraint did not violate the antitrust laws. The concurring opinion in Omega S.A. v. Costco Wholesale Corp., 776 F.3d 692 (9th Cir. 2015) argued that a copyright holder committed misuse by trying to leverage copyrighted design into prohibition on product sale in the United States.

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256  Research handbook on the economics of IP law volume 1 to the 1988 Patent Misuse Reform Act, represented gross overreaching in tying doctrine under both misuse and antitrust, including the doctrine developed in Morton Salt Co. v. G.S. Suppiger Co., 314 U.S. 488 (1942), that someone who was misusing its patent as against one firm could not sue anyone else, even an admitted infringer. In U.S. Gypsum Co. v. National Gypsum Co., 352 U.S. 457 (1957), the Supreme Court globalized that remedy, holding that once misuse was found the patent would be unenforceable against the entire world until the misuse was ‘purged.’ A revitalized doctrine of patent misuse should do two things. First, it should identify conduct that is socially harmful because it threatens the balance between exclusion and access created by the intellectual property laws themselves. Second, the remedy should ordinarily be limited to an injunction against the practice, or recognition that violation of the practice is not an act of infringement (Bohannan, 2011). C.  Competition-Based Limitations on ‘Functionality’ Protection One important limiting principle of IP law is that protection of a ‘function’ must come by means of a utility patent, which is more difficult to obtain than other IPRs and has a shorter duration than copyrights or trademarks. For this purpose, design patents are treated more like copyrights and trademarks rather than patents. The fundamental principle undergirding functionality limitations is that people should not be able to use IPRs to create product monopolies any more than is justified by the limitations inherent in utility patents. An important corollary is that people should not be able to turn other IPRs into quasi-patent rights in order to broaden their scope or duration. The grandparent of the doctrine is Baker v. Selden, 101 U.S. 99 (1879), which held that a copyrighted book teaching the author’s method of accounting served to protect against making unauthorized copies of the book, but not against using or teaching the method itself. That decision was followed in Bikram’s Yoga College of India, L.P. v. Evolation Yoga, LLC, 803 F.3d 1032 (9th Cir. 2015), holding that a book illustrating yoga poses and movements did not prohibit someone from teaching those motions in a class. In the area of trademark or trade dress, the Supreme Court’s important decision in TrafFix Devices, Inc. v. Market Displays, Inc., 532 U.S. 23 (2001) held that a traffic sign support that was an essential element of an expired utility patent could not be grandparented into a trademark, effectively extending the right over this functional design indefinitely (Rosetta Stone, Ltd. v. Google, Inc., 676 F.3d 144 (4th Cir. 2012); 1-800-CONTACTS, Inc. v. WhenU.Com, Inc., 414 F.3d 400 (2d Cir. 2005)).8 Similarly, copyright protection does not extend to purely functional names or commands in computer programs if good alternatives are lacking and the result serves to limit the ability of rival programmers to replicate that function (Lotus Dev. Corp. v. Borland Int’l, Inc., 49 F.3d 807 (1st Cir. 1995); Oracle Am., Inc. v. Google Inc., 750 F.3d 1339 (Fed. Cir. 2014)). Several lower courts have also held that design patents cannot be expanded so as to perform a utility function, thus excluding the products of rivals. For example, in Chrysler

8   The so-called ‘trademark use’ doctrine in its most extreme form would make it unlawful under the Lanham Act to use the trademarked name of a competitor for purposes such as comparative advertising.

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Intellectual property and competition  257 Motors Corp. v Auto Body Panels of Ohio, Inc., 908 F.2d 951 (Fed. Cir. 1990), and Best Lock Corp. v. Ilco Unican Corp., 94 F.3d 1563 (Fed. Cir. 1996), the Federal Circuit held that the owner of design patents could not use a design feature to exclude complementary products. In the first, it rejected Chrysler’s attempt to enforce a design patent on an automobile bumper mount so as to exclude competing bumper makers who could not make a Chrysler-compatible bumper without infringing the design patent (Chrysler Motors Corp. v Auto Body Panels of Ohio, Inc., 908 F.2d 951 (Fed. Cir. 1990)). In the second it prevented the owner of a design patent on a door key from enforcing a patent so as to make competitors’ keys incompatible with its locks (Best Lock Corp. v. Ilco Unican Corp., 94 F.3d 1563 (Fed. Cir. 1996)). In both cases the design patentees were attempting to create ‘technological ties.’ No determination of the patentee’s market power was made, and the ties may or may not have been antitrust violations. But that is beside the point. The issue was sequestration, not monopoly. Utility patents may permit firms to keep rivals out of the product market, but design patents should not.

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Intellectual property and competition  261 SCM Corp. v. Xerox Corp., 645 F.2d 1195 (2d Cir. 1981). Siegel v. Chicken Delight, Inc., 448 F.2d 43 (9th Cir. 1971). Standard Oil Co. of Calif. v. United States, 337 U.S. 293 (1949). Standard Sanitary Mfg. Co. v. United States, 226 U.S. 20 (1912). Teva Pharmaceuticals USA, Inc. v. Sandoz Inc., 2014 WL 2885379 (U.S.) (U.S., 2014). TrafFix Devices, Inc. v. Market Displays, Inc., 532 U.S. 23 (2001). Trebro Mfr., Inc. v. Firefly Equip., LLC, 748 F.3d 1159 (Fed. Cir. 2014). Tyco Healthcare Group LP v. Mutual Pharma. Co., Inc., 762 F.3d 1338 (Fed. Cir. 2014). U.S. Gypsum Co. v. National Gypsum Co., 352 U.S. 457 (1957). United States v. Aluminum Co. of Am., 148 F.2d 416 (2d Cir. 1945). United States v. Am. Can Co., 230 F. 859 (D. Md. 1916). United States v. AT&T, 552 F. Supp. 131 (D.D.C. 1982). United States v. Dentsply Int’l, Inc., 399 F.3d 181 (3d Cir. 2005). United States v. E.I. du Pont de Nemours and Co., 351 U.S. 377 (1956). United States v. General Electric Co., 272 U.S. 476 (1926). United States v. Line Material Co., 333 U.S. 287 (1948). United States v. Loew’s, Inc., 371 U.S. 38 (1962). United States v. Microsoft Corp., 253 F.3d 34 (D.C. Cir. 2001). United States v. Singer Mfg. Co., 374 U.S. 174 (1963). United States v. Univis Lens Co., 316 U.S. 241 (1942). USM Corp. v. SPS Tech., Inc., 694 F.2d 505 (7th Cir. 1982). Walker Process Equip., Inc. v. Food Mach. and Chem. Corp., 382 U.S. 172 (1965).

Legislative Materials U.S. Const. art. I, § 8, cl. 8. 15 U.S.C. §§ 1, 2, 13, 14, 18, 68b–68c, 70b. 17 U.S.C. §§ 106, 109(a). 35 U.S.C. §§ 102(a)(1), 103, 261, 271, 271(d)(3), 271(d)(4), 271(d)(5), 285. Copyright Act of 1976, Pub. L. No. 94-533, 90 Stat. 2541 (1976), 17 U.S.C. § 101 et seq. Copyright Term Extension Act of 1998, Pub. L. No. 105-298, 112 Stat. 2827 (1998), codified in relevant part at 17 U.S.C. § 302.

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9.  Intellectual property and the economics of product differentiation Christopher S. Yoo*

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Contents I. Introduction II. The Economics of Product Differentiation A. Monopolistic Competition B. Spatial Competition C. Implications III. Patent IV. Copyright A. Differentiated Products Competition between Different Works B. Spatial Competition and Impure Public Goods V. Trademark VI. Conclusion References

I. INTRODUCTION To date, economic analyses of intellectual property (IP) have been dominated by models that frame IP as monopolies and/or public goods. These approaches have given rise to general policy inferences, such as systematic underproduction, deadweight losses resulting from pricing above marginal cost, and the supposedly inevitable tradeoff between access to IP and the incentives to create it. These inferences in turn have led many commentators to call for calibrating different aspects of IP protection to mitigate these problems. A new literature is emerging that relaxes the assumption implicit in these models that the relevant products are homogeneous and instead proceeds from the premise that all IP faces competition from imperfect substitutes. Allowing for the possibility of product differentiation provides new insights into the economics of IP. It helps explain persistent features of IP markets that the traditional approaches cannot. It challenges the extent to which IP allows rightsholders to earn monopoly profits. It makes the market dynamics more complex by opening up new dimensions along which companies can compete. This in turn allows for possible sources of welfare outside of price and quantity and yields equilibria with different welfare characteristics. The inevitable tendency towards systematic underproduction is replaced by a more contingent world in which either underproduction *  John H. Chestnut Professor of Law, Communication, and Computer and Information Science, University of Pennsylvania.

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Intellectual property and the economics of product differentiation  263 or overproduction is possible. It also suggests a broader range of policy options for promoting optimality in IP markets. These insights have led some commentators to call this literature ‘the most important development in the economic analysis of copyright in recent years’ (Bracha and Syed, 2014, p. 1842). This chapter will review the economics of product differentiation and the literature applying that literature to IP. Section II introduces the economics of product differentiation. Sections III, IV, and V survey the literature applying these approaches to patent, copyright, and trademark respectively.

II.  THE ECONOMICS OF PRODUCT DIFFERENTIATION The seminal works in the economies of product differentiation are the monopolistic competition theory advanced by Edward Chamberlin (1933) and the spatial competition models pioneered by Harold Hotelling (1929). Each approach emphasizes different aspects of the underlying economics. Monopolistic competition models the market dynamics in the traditional price-quantity space of Marshallian economics and takes product differentiation indirectly. Conversely, spatial competition portrays differentiation directly and deals with price and quantity indirectly. A.  Monopolistic Competition Monopolistic competition retains most of the assumptions underlying perfect competition, including free entry and the presence of a substantial number of sellers.1 The key difference is that monopolistic competition relaxes the assumption that products are homogeneous and serve as perfect substitutes for one another. When products are differentiated, the structure of demand for any particular product allows producers to raise their prices without losing all of their demand, because they will be able to retain those customers who place the highest value on the particular variant that they offer. Product differentiation thus provides each producer with a degree of power over price sufficient to justify modeling each product as facing a downward-sloping demand curve. Monopolistic competition theory simplifies the analysis by assuming that consumer preferences are symmetric with respect to each product in the group. The differences across different products were abstracted away by product differentiation as consumer demand as reflecting a generic preference for variety rather than for any particular form of differentiated product. Most importantly for the purposes of this chapter, Chamberlin (1933, pp. 57–64) regarded patents, copyrighted works, and trademarks as examples of differentiated products to which his theory applied. The primary effect of this assumption is to place each product in equal competition with all other products in the group rather than in localized competition with a smaller set of near neighbors. Chamberlin’s original formulation also assumed that each producer

1   Robinson (1933) proposed a related theory of imperfect competition at roughly the same time as Chamberlin. Chamberlin’s approach focused explicitly on product differentiation and provides the more appropriate focus for this chapter.

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264  Research handbook on the economics of IP law volume 1 faced identical cost curves. This allowed him to employ a single graph portraying the price-quantity response of a representative firm to model the entire market, although relaxing the symmetry assumptions were later shown not to affect the core analysis (Kaldor, 1935; Archibald, 1961). Because monopolistic competition portrays market interactions in a classic pricequantity space, it is quite easily integrated into a conventional welfare analysis based on economic surplus. In the short run, profit-maximizing producers will produce at the quantity (QSR) where their marginal revenue (MRSR) and marginal cost (MC) curves intersect. Because monopolistically competitive producers face downward-sloping demand curves (DSR), in the short run they will set prices in the same manner as a monopolist (PSR), as depicted in Figure 9.1. This results in a significant short-run deadweight loss (DWLSR). Should price exceed average cost (AC), producers may also earn short-run supracompetitive profits (ProfitSR). Were entry impossible, this short-run equilibrium would be stable, and the long-run outcome would be the same as under the monopoly analysis. Monopolistic competition, however, assumes that entry by close substitutes is always possible. As a result, the presence of supracompetitive profits attracts other producers selling similar products. Because all of the products in the market are in equal competition with one another, new entrants take business equally from each of the incumbents, with the demand and supply curves representing the decision confronting a representative firm, with the entire industry constituting the sum of all such graphs. Entry causes the demand curve confronting each incumbent to shift inwards (DLR), as customers substitute purchases of the new product for those of the incumbents. Although some have suggested that the demand curve could either increase or decrease in slope, the increase in the number of imperfect substitutes should generally cause demand to become more elastic (Varian, 2010). The resulting long-run equilibrium is depicted in Figure 9.2. Entry continues until no profits remain, at which point the long-run equilibrium price $

PSR ProfitSR

DWLSR AC MC DSR QSR

Q MRSR

Figure 9.1  Short-run equilibrium under monopolistic competition

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Intellectual property and the economics of product differentiation  265 $

PSR PLR DWLLR

AC DLR

QLR

QSR

MC DSR Q

Figure 9.2  Long-run equilibrium under monopolistic competition (PLR) will be lower than the short-run equilibrium price (PSR). Under Chamberlin’s original formulation, this occurs when the surplus appropriated by each producer is just enough to cover the fixed costs of entry, a condition which exists when the long-run demand curve (DLR) is tangent to the average cost curve (AC). There is, however, a wellknown exception to Chamberlin’s zero-profit result. The indivisibility of fixed costs may create a situation in which n products would earn small profits while n + 1 products would run losses. This so-called ‘integer problem’ allows for an equilibrium in which n products each earn sustainable profits (Kaldor, 1935). So long as the economy is sufficiently ‘large’ (i.e., so long as n is relatively sizeable), such profits will be negligible (Eaton and Lipsey, 1989). As entry causes the demand curve to flatten, long-run deadweight loss shrinks (DWLLR). Note that whether the market will reach long-run equilibrium on a flatter portion of the demand curve depends on the assumption that the relevant demand curve is linear. If the demand function is curved, it could be tangent to the average cost curve at any one of a number of points. In that case, it is no longer inevitable that the market will reach equilibrium at a place where the spread between price and marginal cost is narrower. In addition, the tangency solution also presupposes that the producer is charging the same price to all consumers. Allowing for price discrimination raises the possibility that a firm might still earn supracompetitive profits even at the point of tangency, meaning that further entry would occur. The equilibrium number of products can be determined