A couple of weeks ago, and again last week, I suggested a reason why, despite the general proposition that non-lump-sum taxes are distortionary, reduced marginal tax rates since the 1980s could have slowed down US economic growth. In illustrating how this might have happened, I focused mainly on the growth of the financial sector, hypothesizing that investments by financial firms in “research” and in devising trading strategies are socially wasteful, because the return on those investments stems from trading profits reflecting not additions to output but transfers from other less knowledgeable and sophisticated traders.
An article (“AOL Strikes $1.1 billion Patent Deal with Microsoft”) in today’s New York Times gives another illustration of this phenomenon, a difference in the social and private value of information, except that the difference between the social and private value of information in the AOL/Microsoft patent deal results not so much from the information as such, as from the creation of property rights in ideas, i.e., intellectual property, especially patents.
AOL agreed on Monday to sell a portfolio of over 800 patents, and license about 300 more, to Microsoft for $1.056 billion, amid an arms race within the technology industry over intellectual property.
Under the terms of the transaction, AOL will retain a license for the patents it is selling, while Microsoft will receive a nonexclusive license for the technologies AOL is retaining.
It is the latest big deal for patents, at a time when tech companies are amassing intellectual property rights as ammunition against competitors. Last year, Google purchased Motorola Mobility for $12.5 billion, largely for its patent portfolio.
And scores of companies, including Apple, Samsung, Facebook and Yahoo, are clashing in courtrooms over claims to technology underpinning some of the basic functions of smartphones and social networks alike.
The deal will also provide AOL with some sorely needed cash as the struggling Internet company continues its attempt to refashion itself as a media content provider.
AOL began shopping around the patents in the fall, in what it said was a “robust, competitive auction.” The results of the sale may be surprising to some analysts. Two weeks ago, an advisory firm estimated that the sale could yield as little as $290 million.
“The combined sale and licensing arrangement unlocks current dollar value for our shareholders and enables AOL to continue to aggressively execute on our strategy to create long-term shareholder value,” Tim Armstrong, the company’s chairman and chief executive, said in a statement.
The company said it would distribute a “significant portion” of the proceeds to restive shareholders, who have been awaiting positive results from the turnaround campaign from Mr. Armstrong.
Among those investors is Starboard Value L.P., which currently owns a 5.2 percent stake. In a letter on Feb. 24, the investment firm wrote that it remained disappointed in AOL’s progress, and announced a slate of candidates for the company’s board.
Shares in AOL leaped 35.6 percent, to $24.98, in premarket trading on Monday. They had fallen more than 8 percent over the last 12 months.
AOL was advised by Evercore Partners, Goldman Sachs and the law firms Wachtell, Lipton, Rosen & Katz and Finnegan, Henderson, Farabow, Garrett & Dunner.
Microsoft was advised by the law firm Covington & Burling.
The benefits from inventive activity are systematically overstated. Take for example a classic argument by George Stigler, in his book The Organization of Industry (Chapter 11: “A Note on Patents”). Stigler posed the following question:
The main theoretical question posed in the production of knowledge . . . is how to bring about the correct amount of resources in the search for new knowledge. Does our present [published in 1968] patent system with its 17-year grant of exclusive possession of the knowledge bring forth approximately the right amount of research effort?
To which Stigler offered a further question and a tentative answer:
We normally give perpetual possession of a piece of capital to its maker and his heirs. The reason is simple: the marginal social product is the sum of all future yields of the piece of capital, and if capital is to be produced privately to where its marginal social product equals its marginal cost, the owner must receive all future yields. Why not the same rule for the producer of new knowledge?
The traditional formal answer, I assume, is that the new knowledge is usually sold monopolistically rather than competitively. The inventor of the safety razor does not have to compete with 500 equally attractive other new ways to shave, so he may charge a monopoly price for his razor. . . . Thus with a perpetual patent system too many resources would go into research and innovation.
Stigler’s answer is correct, as far as it goes, but it doesn’t go very far. There is another, perhaps greater, problem with treating knowledge like a piece of physical capital than the one addressed by Stigler: it presumes that new knowledge created at time t would not have been created subsequently at any later date, say, time t+x. If the knowledge created at time t would, in any case, have been created subsequently at time t+x, then giving the inventor a perpetual right to the invention overcompensates him inasmuch as he contributed only x years, not an infinite length of time, to society’s use of the invention. The analysis is further clouded by the fact that every inventor faces uncertainty about whether he or some other inventor will obtain the patent for the invention on which he is working. The existence of patents creates countervailing incentives to engage in inventive activity.
But the AOL/Microsoft patent deal illustrates another, wholly insidious, result of the explosion in intellectual-property enforcement, which is that patents have become weapons with which competitors in high-tech industries engage in a zero- (or even negative-) sum game of legal warfare with each other (“an arms race within the technology industry”). The resources devoted to the creation and protection of intellectual property are largely wasted, making it very questionable whether the benefits from encouraging investment in inventive and innovative activity that the patent system is theoretically supposed to encourage are now, in fact, greater than the value of resources wasted in the process of obtaining and using those right.
In his seminal 1959 article on the Federal Communications Commission – how many people know that it was in this article, not the better known “The Problem of Social Cost” published the following year, that the Coase Theorem was first stated and proved? – Ronald Coase made the following incredibly important observation at the end of footnote 54 on p. 27.
A waste of resources may result when the criteria used by courts to delimit rights result in resources being employed solely to establish a claim.
So it seems that the current intellectual property regime is causing a substantial, perhaps huge, shift of resources from inventive activity, i.e., creating new and better products or creating new and less costly ways of producing existing products, to establishing claims to intellectual property that can then be used offensively or defensively against others (“amassing intellectual property rights as ammunition against competitors”). Such gains as are being generated from this kind of activity are, I conjecture, going disproportionately to those earning high incomes from intellectual property rights established through this costly process. The corresponding losses associated with creating intellectual property rights are probably distributed more evenly across individuals than the gains, so that the net effect is to increase income inequality even as the rate of growth in aggregate income and wealth is slowed down.
Uneasy Money 
Good piece. I especially agree with “If the knowledge created at time t would, in any case, have been created subsequently at time t+x”. Does anyone think “One-Click” or “Buy-It-Now” would have gone undiscovered had Amazon or Ebay not invented them? Many inventions are straightforward outgrowths of a year or two of market experience and come from customer feedback.
Also, I’ve seen discussions among people who have more experience in this than either of us, and a common complaint is that the patent system hurts entrepreneurs. There is a certain cost threshold, and economy of scale, involved in mass patent filing for every aspect of a small internet business or tech start-up. Small businesses on a shoestring don’t necessarily have the funds to attempt patent filings on every minor aspect of their business.
I see your point that patent rents go into the pockets of the few. I just wonder if a redesign could be more effective than a redistribution.
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I definitely agree on the major issues with the patent regime. However, it is important on certain types of patents to provide some protection – mostly on easy to copy but hard to produce inventions, such as books, software, music, and even drugs. However, I think that the protection afforded should be a function of the investment required, which would cap (or in some cases extend) the proceeds.
There is an inconsistency, however, in some of your comments, as financial innovations can be difficult to patent.
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Here is what I believe to be a more pertinent question:
Titles 35, 17, and 15 of the U. S. Constitution grants the federal government the ability to recognize patents, copywrights, and trademarks.
Should the federal government have the ability to grant ownership of an idea where no ownership existed previously? If you are true to Lasseiz Faire economic ideas you would have to say no.
Congress took this a step further back in 2011 with this:
http://en.wikipedia.org/wiki/Leahy-Smith_America_Invents_Act
Basically this act is what started the “intellectual property” arms race. Now you don’t even have to build, demonstrate, or try to sell what you have invented.
Imagine this: A machine cranking out inventions at random and robo-filing them with the U. S. patent office.
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I like this conversation, but I also wonder what fraction of inventions or ideas in software or the Internet will be worthless in another 10 years.
LIke having a patent on the eight-track or vinyl records. I am hoping that if someone roadblocks development in one way, another way will be used. Protecting a patent may result in your technique becoming a backwater.
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That 17-year patent duration that Stigler mentions sounds pretty quaint nowadays!
Besides the problems with IP rents that David lays out, it seems to me that it’s problematic to allow ownership of an idea to the inventer–more problematic than, say, granting an author or artist a copyright–since science and invention are generally more social processes than that model envisions: the research of the group enables individual breakthroughs. I would also note that the existence of these and other legally-created rents (e.g., higher costs in licensed professions) strike me as one of the best arguments for a progressive income tax, which will tend to fall largely on such revenue streams.
Benjamin’s caveat is worth keeping in mind too. Facebook and AOL could be long gone in ten years.
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Another key point in this discussion is that our system for granting patents is seriously broken. Patents should only be granted for inventions that are “not obvious to one skilled in the art.” However, it is clear that many, many existing patents do not pass this test. I can only speculate about the reasons, but surely the number, prestige, and compensation of the patent examiners play a role.
If a patent is granted incorrectly, it is in theory possible to overturn it in the courts. But there are costs and uncertainties in this process that make it unwieldy.
So what is the economic benefit of an “invention” that adds nothing at all to our store of knowlege? Only rent-seeking by those who manage to slip something through the system.
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