Ebook Financially Constrained Innovation, Patent Protection, and Industry Dynamics
This paper assesses the importance of intellectual property (IP) for innovation and welfare in the context of a model of industry dynamics where innovations are generated by financially constrained entrepreneurs. The increase in IP protection and the development of alternatives for the financing of high-tech start-ups (most notably, venture capital) are in the list of factors that may have facilitated the unprecedented prosperity of innovative entrepreneurial activities since the early 1990s, which also includes the opportunities and technological changes associated with the information technology (IT) revolution, the reduction in setup costs and other barriers to the creation and development of new firms, and the emergence of a new “entrepreneurial culture” that has increased the social recognition and other rents associated with being and succeeding as an entrepreneur.
Regarding IP protection, it is commonly understood that, in the United States, the creation of a unique Court of Appeals of the Federal Circuit in 1982 strengthened the position of patent holders against potential infringers. Other legislative changes, such as the 1984’s Semiconductors Act or the extension of patent duration to 20 years, has contributed to this increase in protection. However, there is considerable empirical and theoretical controversy on whether these reforms actually promote innovation. Some quantitative assessments based on US data conclude that higher protection would induce more innovation (Denicol`o (2007)), while others suggest that the greater protection brought about by recent reforms may have actually reduced innovation (Levin et al. (1985), Hall and Ziedonis (2001)). Practitioners express their doubts regarding the role of IP protection by referring to issues such as the “tragedy of the anti-commons” that deems strategic patenting and patent stacking as obstacles to innovation (Heller and Eisenberg (1998)). At a theoretical level, advice against excessive IP protection can be found in papers such as Boldrin and Levine (2002), Hunt (2004) or Bessen and Maskin (2006). None of these papers, however, makes explicit reference to the innovators’ financing problem and the direction in which financial constraints might change their normative prescriptions.
Regarding the financing of innovative start-ups, it is widely admitted that the access to informal sources of capital (such as private equity financing from friends and relatives, or from business angels) and venture capital are very important, since these start-ups typically lack the collateral required for the access to more conventional financing sources (such as bank loans). But the availability and degree of sophistication of these sources of capital vary notably across industries, countries, and time periods, so the incidence of financial constraints may also vary a lot. Most papers on entrepreneurial financing consider the traditional partial equilibrium setup of corporate finance and focus on understanding microeconomic issues such as the staging of finance (Gompers (1995) and Neher (1999)), the use of convertible securities (Casamatta (2003) and Schmidt (2003)), or optimal contracting when venture capitalists play an advising role (Repullo and Suarez (2004)). Some papers, including Holmstrom and Tirole (1997), Inderst and Muller (2004), and Michelacci and Suarez (2004), examine the equilibrium implications of financial constraints, but make no explicit reference to IP protection.
In this paper we construct a model of industry dynamics that allows us to judge the effects of IP protection and financial constraints on the equilibrium levels of innovation, competition, entrepreneurship, and social welfare. We consider an industry made up of a continuum of business niches. The successful developers of new products contribute to welfare and appropriate temporary monopoly profits like in a standard quality ladder model with limit pricing. Temporary monopolies are based on the protection granted by IP and are threatened by the entry of the developers of newer products, as well as imitators. The success of the developers of new products is compromised by the competition coming from other developers and by the opposition of the incumbent monopolists, who use their IP to fight imitators and innovators alike. In non-monopolized niches, the hurdle for innovative entry is lower since the incumbents have less incentives and capability to defend their IP.
Formally, we model the generation of new products as an uncoordinated costly-entry process subject to congestion. From the perspective of a niche (and its occupants) innovation and imitation are random arrival processes and we assume that IP provides incumbent monopolists with (random) protection against them, thereby affecting their survival as monopolists and the barriers faced by their potential challengers.
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