TABLE OF CONTENTS
INTRODUCTION 2 II. THE ECONOMICS OF INNOVATION AND IP PROTECTION 2 A. Innovation Incentives 5 B. Licensing 8 C. Compulsory Licensing 9 D. Standards Development and Standard Essential Patents 15 E. Industrial Organization (IO) Toolkit for Vertical 19 Restraints III. POLICY IMPLICATIONS FROM ECONOMICS 21 A. General Principles 21 B. Market Definition and Monopoly Power or Market 23 Dominance C. Refusals to License 27 D. Tying and Bundling 28 E. Grantbacks and Cross-Licenses 32 F. Excessive Pricing Prohibitions (Including Injunctive 35 Relief) IV. CONCLUSION 40 APPENDIX A: SURVEY OF THE APPROACHES IN CHINA, THE 41 EUROPEAN UNION, INDIA, JAPAN, KOREA, AND THE UNITED STATES I. INTRODUCTION
In recent years, there has been significant scrutiny of what the holder of a standard-essential patent ("SEP") who has made a commitment to license on fair, reasonable, and nondiscriminatory ("FRAND") terms may do when seeking to license it. Antitrust authorities have undertaken numerous investigations, and several have issued new guidelines. In an effort to promote an exchange of views and to better understand the proper antitrust analysis of these topics, the organisation for Economic Co-operation and Development ("OECD") held a roundtable discussion on June 6, 2019, on antitrust analysis of intellectual property rights ("IPRs"), including SEPs. (1) Given that antitrust analysis is fundamentally economic analysis, any discussion of these issues should be grounded in empirical and other economic learning regarding innovation, intellectual property ("IP") protection, and related business arrangements.
This Article addresses the proper analysis for antitrust matters involving SEPs. Part II summarizes the relevant economic literature, namely the economics of innovation and IP protection, licensing, and compulsory licensing, with specific applications to standards development and SEPs. Drawing upon these economic principles, Part III provides a blueprint that antitrust agencies and courts may apply when evaluating market definition; monopoly power (or market dominance, depending on the jurisdiction); and particular business practices, such as refusals to license, tying and bundling, grantbacks and cross-licenses, and excessive pricing and injunctive relief. Appendix A surveys major jurisdictions to understand how closely each follows these economic principles and our proposed blueprint.
THE ECONOMICS OF INNOVATION AND IP PROTECTION
Firms innovate to reduce their costs (process innovation) or to launch new products and services (product innovation). Product innovation may lead to better products (vertical product innovation) or products that are different from the existing ones without being superior (horizontal product innovation). (2) It may also lead to entirely new products or ways of doing things (often referred to as drastic or leapfrog innovation). Process and product innovations are extremely valuable to social welfare. In the short run, consumers gain from increases in static efficiency--for example, by requiring forced sharing of IP. But economics teaches us that the gains from dynamic efficiency, including innovation--for example, by protecting IP--are an even greater driver of consumer welfare. (3) Process innovation allows firms to produce the same output while using fewer inputs and hence, to economize on scarce resources. Product innovation expands choice and allows consumers to obtain better products or products that better fit their needs or preferences.
Modern economic research shows that new products, including even small changes in product design, can result in remarkable increases in social welfare, including significant consumer benefits. (4) Professor Jerry Hausman of the Massachusetts Institute of Technology calculated that value in a concrete example. He found that a new cereal--one made by adding apple and cinnamon to an existing cereal--created $78.1 million per year of added value to the U.S. economy. (5) The creation of a new drug is a more intuitive example. The value of saving or improving lives dwarfs the very high price of some drugs. (6) Likewise, technological change (due to product and process innovations) has resulted in rapid increases in productivity and improved standards of living around the world. (7)
The conventional economic diagram of supply and demand helps to understand these results (see Figure 1 below). When a new product is introduced, the value created is the area between the demand curve (D) and the cost or supply curve (S). That is, each unit of output has a social value that is the difference between the value shown by the demand curve and the cost of producing it. The overall social value of a product innovation is the sum of those differences: the area CS + n.
Policies and laws that encourage investment and innovation increase welfare and thus are optimal, while interventions that risk thwarting incentives to innovate are not appropriate public policies. (8) This is why understanding what drives innovation incentives has focused the attention of the economics profession for a long time.
Though some individuals and firms may invest resources in innovation projects for philanthropic reasons, there is a wide consensus in economics that profits are the key driver of innovation. Firms and investors are generally willing to incur the large costs needed to obtain meaningful innovations only because they expect to obtain a significant return on those investments. (9) Investors in innovation may expect to open new markets and thus appropriate part of the value generated for consumers. They may try to reduce their costs or improve their offerings in order to obtain a competitive advantage vis-a-vis their rivals, increasing both their market share and their profits. Innovation is also used to mitigate the rigors of head-to-head competition; but unlike other ways of softening competition, such as collusion, innovation enhances social welfare. It allows society to produce the same quantity of goods at lower costs and increases the gains from trade by bringing new products and services to meet the needs of consumers. (10)
The social value of process and product innovation is very large. (11) The problem is that the social value of innovation typically exceeds the private value of innovation. This is mainly due to the so-called "appropriability problem." (12) Consider, for example, the case of a product innovation: innovators will not be able to fully appropriate the value generated by their inventions unless they are able to engage in first degree price discrimination and charge a different, targeted price to each consumer equal to that consumer's willingness to pay for the new product. There are many reasons, even in the Internet Age, why first degree price discrimination is merely a theoretical possibility. Firms often cannot identify their customers and, even when they can, are unable to ascertain precisely their willingness to pay for the new product.
The appropriability problem opens a wedge between the private and social returns to innovation and leads to underinvestment. It plays a role even when successful inventors enjoy full monopoly power over their inventions. But it becomes even more problematic when that is not the case. (13) Inventions can often be imitated. When that is the case, the firm that sunk considerable resources to develop the new product will face competition after its new product is launched, which forces it to reduce prices. (14) Some of the returns to its investment will therefore be appropriated by competitors and a significant fraction will go to consumers.
Ex ante competition at the innovation stage encourages investment since firms try to acquire a competitive advantage over their rivals by differentiating their products or reducing their costs. However, ex post competition after the innovation has been developed and proven successful aggravates the appropriability problem and therefore is bound to have a negative effect on investment. Because imitation results in fiercer ex post competition, its anticipation discourages innovation by reducing the returns a successful innovator can expect. Furthermore, it encourages free riding, whereby potential innovators wait for others to develop new products and then introduce copycats into the market.
Not surprisingly, economists who have investigated the rational basis for granting and protecting IPRs conclude that there is a need to control the risk of imitation and limit the strength of ex post competition. (15) IPRs stimulate innovation by increasing the return on costly investments in research and development ("R&D").
An IPR, like any other property right, gives its holder the ability to exclude others from using that property and thereby enables the holder to appropriate some of the value of the property. Whether that right is exercised in practice is typically inconsequential from a social viewpoint because most IPRs are worthless. (16) Some IPRs, however, are immensely valuable for the patent holder because the right to exclude can result in large monopoly profits. In fact, as explained above, the value to society of the products and services covered by those IPRs is bound to exceed the value to the holder because even monopolists are typically unable to extract all the consumer surplus generated by the products and services they commercialize.
Society generally allows successful innovators to enjoy some market power because they must receive a reward for their risky and costly investments. otherwise, there is little incentive to invest in innovation. The reward must be higher for innovations that require larger investments. Getting a new drug to market, launching a new Hollywood film, developing a new application for a smartphone, or developing a new algorithm for an ecommerce platform are all costly endeavors. Investors can recover the significant...