Do Stronger Patents Stimulate or Stifle Innovation? The Crucial Role of Financial Development

• Published date: 01 August 2020
• Author: ANGUS C. CHU,GUIDO COZZI,HAICHAO FAN,SHIYUAN PAN,MENGBO ZHANG
• Date: 01 August 2020
• DOI: http://doi.org/10.1111/jmcb.12629

DOI: 10.1111/jmcb.12629

ANGUS C. CHU

GUIDO COZZI

HAICHAO FAN

SHIYUAN PAN

MENGBO ZHANG

Do Stronger Patents Stimulate or Stifle Innovation?

The Crucial Role of Financial Development

This study explores the effects of patent protection in a research and devel-

opment (R&D)-based growth model with financial frictions. We find that

whether stronger patent protection stimulates or stifles innovation depends

on credit constraints faced by R&D entrepreneurs. When credit constraints

are nonbinding (binding), strengthening patent protection stimulates (sti-

fles) R&D. The overall effect of patent protection on innovation followsan

inverted-Upattern. By relaxing the credit constraints, financial development

stimulates innovation. Furthermore, patent protection is more likely to have

a positiveeffect on innovation under a higher level of financial development.

We consider cross-country panel regressions and find supportive evidence

for this result.

JEL codes: E44, O31, O34

Keywords: patent protection, credit constraints, economic growth,

convergence.

The authors would like to thank two anonymous referees and seminar participants at Fudan University

and the Universityof Liverpool for their insightful comments and also Margaret Davenport for her excellent

research assistance. Haichao Fan acknowledges the financial support from the Natural Science Foundation

of China (No. 71603155). Shiyuan Pan gratefully acknowledges financial support from the Key Project

of the National Social Science Foundation of China (No. 15AJY003) and the Project of the Scientific

Research Foundation for the Returned Overseas Chinese Scholars of the Ministry of Education of China.

Mengbo Zhang gratefully acknowledges financial support from the State Scholarship Fund of China

Scholarship Council. The usual disclaimer applies. Please send all correspondence to Shiyuan Pan, who

is the corresponding author.

ANGUS C. CHU is a professor of economics at the University of Liverpool Management School, Uni-

versity of Liverpool (E-mail: angusccc@gmail.com). GUIDO COZZI is a professor of macroeconomics

at the Department of Economics, University of St. Gallen (E-mail: guido.cozzi@unisg.ch). HAICHAO

FAN is a professor of economics at the Institute of World Economy, School of Economics, Fudan Uni-

versity and a research fellow at Shanghai Institute of International Finance and Economics (E-mail:

fan_haichao@fudan.edu.cn). SHIYUAN PAN is a professor of economics at the Center for Research of

Private Economy, Schoolof Economics, ZhejiangUniversity (E-mail: shiyuanpan@zju.edu.cn). MENGBO

ZHANG is a PhD candidate of economics at the Department of Economics, University of California, Los

Angeles (E-mail: mbzhangucla@g.ucla.edu).

Received July 26, 2018; and accepted in revised form February 12, 2019.

Journal of Money, Credit and Banking, Vol.52, No. 5 (August 2020)

C

2019 The Ohio State University

1306 :MONEY,CREDIT AND BANKING

IN THIS STUDY,WE EXPLORE the effects of patent protection in an

R&D-based growth model. Our growth-theoretic analysis of patent policy features

financial frictions in the form of potentially binding credit constraints on R&D

entrepreneurs. As in Aghion, Howitt, and Mayer-Foulkes(2005), due to moral hazard,

R&D entrepreneurs may not be able to borrow as much as they want for their R&D

investment. When these credit constraints are nonbinding, we find that strengthening

patent protection by increasing patent breadth leads to a larger amount of monopolistic

profit, which stimulates R&D and technological progress. This positive monopolistic-

profit effect captures the traditional view of patent protection. However, when the

credit constraints are binding, we find that the monopolistic distortion arising from

patent protection leads to more severe financial frictions, which stifle R&D and

slow down technological progress. We refer to this effect as a negative financial

distortionary effect of patent protection.

The intuition of this financial distortionary effect can be explained as follows. As

in the seminal study by Nordhaus (1969), patent protection causes monopolistic dis-

tortion, which, in turn, reduces aggregate income in general equilibrium and tightens

credit constraints faced by R&D entrepreneurs in the presence of financial frictions.

Our mechanics relies on credit constraints to make R&D a constant fraction of ag-

gregate income. Then, the monopolistic distortion of patent protection on aggregate

income reduces R&D and economic growth when credit constraints are binding.

Hence, we find that credit constraints jeopardize the classical Schumpeterian trade-

off between static and dynamic efficiency: less static efficiency (i.e., lower output)

by causing less R&D entails less dynamic efficiency (i.e., lower growth).In this case,

stronger patent protection reduces the rates of innovation and economic growth, in

addition to reducing the level of output.

This finding is consistent with recent studies that often find the presence of nega-

tive effects of patent protection on innovation.1Furthermore,we find that the positive

monopolistic-profit effect of patent protection prevails when the level of patent pro-

tection is below a threshold value, whereas the negative financial distortionary effect

of patent protection prevails when thelevel of patent protection is above the threshold.

Therefore, the overall effect of patent protection on research and development(R&D)

and innovation follows an inverted-U pattern that is commonly found in empirical

studies.2

Weconsider the case in which a higher level of financial development relaxes credit

constraints by making it more difficult for borrowersto defraud. As in Aghion, Howitt,

and Mayer-Foulkes (2005), we find that a higher level of financial development

stimulates innovation. Intuitively, when R&D entrepreneurs are less likely to defraud,

banks are more willing to lend to them for R&D investment. Furthermore, we have

1. See, for example, Jaffe and Lerner (2011), Bessen and Meurer (2008), and Boldrin and Levine

(2008).

2. See, for example, Qian (2007) and Lerner (2009).