Patent rights, innovation, and firm exit

• DOI: http://doi.org/10.1111/1756-2171.12219
• Date: 01 March 2018
• Author: Alberto Galasso,Mark Schankerman
• Published date: 01 March 2018

RAND Journal of Economics

Vol.49, No. 1, Spring 2018

pp. 64–86

Patent rights, innovation, and firm exit

Alberto Galasso∗

and

Mark Schankerman∗∗

We study the causal impact of patent invalidation on subsequent innovation and exit by patent

holders. The analysis uses patent litigation data from the US Federal Circuit Court and exploits

random allocation of judges to control for endogeneity of the decision. Invalidation causes

patent holders to reduce patenting over a five-year window by 50% on average, but the effect

is heterogeneous. The impact is large for small- and medium-sized firms, particularly where

they face many large competitors, and for patents central to their research portfolio. We find no

significant effect for large firms. Invalidation also increases exit from patenting by small firms.

1. Introduction

Innovation lies at the heart of high-tech entrepreneurship and economic growth. Modern

macroeconomic growth models givea central role to innovation and the competition that generates

incentives for it, including the interaction between small entrants and large incumbents in this

process (Aghion and Howitt, 1992; Acemoglu Akcigit, Bloom, and Kerr, 2013). At the same

time, a large body of microeconomic evidence shows that there is underinvestment in Research

and Development (R&D), with social rates of return being more than twice as large as the private

rates (Jones and Williams, 1998; Bloom, Schankerman, and Van Reenen, 2013). This is a primary

justification for government support of innovation, and patent rights are one of the key policy

instruments for this purpose. It is important to understand whether patents are actually an effective

innovation incentive and, importantly, whether they work equally well for small and large firms

and in different competitive environments.

A number of economic and legal scholars have raised serious doubts about whether

patent rights actually promote innovation, and there is a widespread view that current patent

∗University of Torontoand NBER; alberto.galasso@rotman.utoronto.ca.

∗∗London School of Economics and CEPR; M.Schankerman@lse.ac.uk.

Weare g rateful to the Editor,Chad Syverson, and two anonymous referees for very constructive suggestions that greatly

improved the article. We also thank Philippe Aghion, Iain Cockburn, Petra Moser, Florian Schuett, Carlos Serrano,

Mariagrazia Squicciarini, Heidi Williams, and participants in seminars at Bocconi University, Cattolica University,

CEPR Conference on Applied IO, Duke, Einaudi Institute in Rome, IESE Barcelona, TelAviv University,UC Berkeley,

University of Toronto, ZEW Mannheim, NBER, and Paris School of Economics for helpful comments. We thank John

Golden and David Schwartz for their help in clarifying points regardingthe legal doctrine and procedure governing patent

invalidation suits. Joanne Evangelista providedexcellent research assistance.

64 C2018, The RAND Corporation.

GALASSO AND SCHANKERMAN /65

policy, and debates over patent reform, are not based on empirical evidence (Boldrin and Levine,

2013; Burk, 2016). One of the most prominent legal scholars in the area argues that much

of the patent policy discussion is “faith-based,” with “participants on both sides of the IP de-

bates increasingly taking out positions that simply do not depend on evidence at all” (Lem-

ley, 2015). In a recent article, Williams (2017) provides a thoughtful and balanced analysis of

the issues and the evidence on how patent rights affect innovation and welfare and identifies the

gaps in our empirical knowledge that need to be filled to reach definitive conclusions. As she

puts it, “While patent systems have been quite widely used both historically and internationally,

there is nonetheless a tremendous amount of controversy over whether the patent system is—in

practice—improving the alignment between private returns and social contributions.”

To address this need for more empirical evidence, in this article, weanalyze how the loss of

patent rights affects a firm’s level of subsequent innovation and the likelihood that a firm exits

from patenting activity entirely, for small and large firms across a range of technology fields. To

do this, we study the impact of judicial invalidation of existingpatents on the owner’s subsequent

patenting activity over a five-year window. Our analysis shows that patents have an impact on

future innovationby small- and medium-sized firms, but we find no evidence of significant impact

on large firms. We also show how the effectiveness of patent rights depends on specific features

of competition in the technology markets.

From a theoretical perspective, the impact of patent invalidation on future innovation is not

obvious. The conventional view is that patents enhance the ability of firms to capture innovation

rent, but at the cost of creating a static efficiency loss from higher prices (Arrow, 1962). We show

that more complex interactions arise from two sources when innovation is cumulative. The first

is complementarity between the current and subsequent generations of innovation: the ability of

a firm to innovate in the future and capture the rents from that innovation will depend on the

firm’s current stock of patents. Second, patent invalidation triggers a patent race building on the

innovation by opening up the technology to potential competitors. The model developed in this

article highlights the trade-offs involved and shows that the qualitative effect of patent rights

on future patenting is ambiguous, as it depends on features of the firm and the technological

competition they face. Thus, empirical analysis is essential to inform patent policy.

Despite its central importance, there are relatively few studies with causal evidence on

whether patent rights are an effective incentive for innovation, and the existing studies do not

speak with one voice.1For example, Budish, Roin, and Williams (2015) show that there is more

innovation, as measured by clinical trials, on late-stage cancer drugs that have longer effective

patent lives (due to shorter regulatory screening times). Similarly, Farre-Mensa, Hegde, and

Ljungqvist (2015) use the quasirandom assignment of patent examiners to study the impact of

patent rights on new start-up firms. They find that a patent grant strongly increases subsequent

patent applications and growth and also raises the probability of an Initial Public Offering (IPO).

On the other hand, Sampat and Williams(2015) use quasirandom assignment of patent examiners

to study whether human gene patents affect subsequent innovation by the patentee (and others)

and find no significant effect. Even more surprising, Baten, Bianchi, and Moser (2015) show

that the imposition of compulsory licensing on chemical patents by German firms after World

War I increased subsequent patenting by the (large) chemical firms that owned them. Our article

develops a model which reconciles these apparently contradictory findings in the literature.

Patent rights can affect innovation, especially for small firms, through several channels.

First, patents shape the nature of competition in product and technology markets, especially in

settings where small firms interact with large incumbents (Spulber, 2013; Aghion, Howitt, and

Prantl, 2015). Although the relationship between patent rights, competition, and innovation is

1In a related strand of the literature, there are studies that use patent renewaldata and other approaches to measure the

incremental incentives providedby patent rights (Schankerman and Pakes, 1986; Schankerman, 1998; Arora, Ceccagnoli,

and Cohen, 2008). They show that patents are associated with greater private value derived from inventions. However,

these studies do not provide causal evidence on the link betweenpatent rights and the level of innovation.

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The RAND Corporation 2018.