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IP Law and “Market Failure”

As I have argued, one argument for intellectual property, sometimes implicit, often explicit, is that on the free market there is an underproduction of intellectual goods such as technical innovations and artistic works, because it is so easy for would-be customers and competitors to copy the good that it is not profitable to create it in the first place. I.e., there is a “market failure” that can be fixed by granting temporary monopoly privileges (patent and copyright, mislabeled as “intellectual property”)1 to technical innovators and artistic creators.2

This type of “market failure” reasoning, implicit or explicit, is common in the literature. For example, this type of reasoning is at least implicitly relied on by Tabarrok; see “Tabarrok: Patent Policy on the Back of a Napkin“.  For another, as I point out in “IP Needs A World of Scarcity: Comment to New Book: Innovation, Intellectual Property, and Economic Growth“:

From a quick skim of ch. 1 (available here), it appears to adopt a mainstream approach–finding out whether there is market failure or a public goods problem (see Hans-Hermann Hoppe’s “Fallacies of the Public Goods Theory and the Production of Security,” in The Economics and Ethics of Private Property for criticism of the concept of “public goods”), and then asking whether we can fix it with some kind of state invervention. The same old “the market is not perfect, so let’s let the thugs with guns have more power” song and dance.

In particular, the authors write:

“Section 1.5 considers the important question of whether or not the private market can deliver the optimal amount of innovation. If there is market failure, there will be less innovation than the amount society would ideally want. Here we stress two aspects of the process of innovation that suggest possibilities for market failure. The first is that new knowledge—which is created during the innovation process—is what economists term a public good and such goods tend to be underprovided by the private market. The second is that innovation can create positive externalities in the form of spillover benefits to customers and other firms and these cannot be captured as revenue by innovating firms, again leading to underprovision of innovation. Section 1.6 introduces the ways in which public policies, such as subsidies to research and development or the award of IPRs, can, to some degree, restore the efficiency of private firms and markets in the supply of innovation.”

See also Desrochers, “Excludability, Creativity and the Case Against the Patent System”:

“One of the few topics over which free-market proponents often radically disagree is the relevance of the patent system. According to some, without patent protection an inventor has no incentive to invest time and money into something that can be easily copied by its competitors without incurring significant R&D costs. Patents therefore correct this market failure by providing a temporary monopoly to the inventor. Even though monopolies typically involve a misallocation of society’s resources, any welfare losses due to the restrictions in disseminating an invention are outweighed by the incentive to invention they provide.”)

And see Brink Lindsey & Steven M. Teles, The Captured Economy: How the Powerful Enrich Themselves, Slow Down Growth, and Increase Inequality (2017):

“IN OUR ROGUES’ GALLERY OF case studies, copyright and patent laws are the wolves in sheep’s clothing. [p. 64]

The case for IP turns on the peculiar economic characteristics of ideas. Because ideas are nonrivalrous (one person’s use of an idea does not diminish others’ ability to use that same idea) and nonexcludable (once an idea is made pub- lic, its originator has no control over who else has access to it), producers of ideas have serious disadvantages (relative to producers of tangible goods) in making money from their intellectual creations. Copyrights and patents remedy this dis- advantage by granting temporary monopolies to producers of protected ideas, thus raising the returns to creative expression and innovation.

In other words, copyright and patent laws are regulatory responses to what economists call “market failure.” Specifically, if the fixed costs of creative expression or innovation are high, but the costs of imitation are low, artists and inventors would frequently be unable to recoup those fixed costs in the absence of copyright and patents. Accordingly, they would tend to underinvest (from the perspective of total social welfare) in expression and innovation. By allowing producers of ideas to recoup more of the value they create, they “internalize” some of the “externalities” associated with their efforts, thereby better aligning both resource allocation and incentives with maximi- zation of welfare. Or at least that’s the idea. [p. 68]

David Encaoua, Dominique Guellec, and Catalina Martínex, “The economics of patents—from natural rights to policy instruments” (2003):

The corner stone of the traditional argument in favour of patent protection is the non-rival character of knowledge, and more generally the idea that an invention can be imitated with no additional cost apart from the cost of the factors used in the production process.

… Let us begin by recalling the usual argument in favour of intellectual property protection as it appears in the seminal works of Arrow (1962), Nordhaus (1969) and Romer (1990). The innovation process amounts essentially to the production of knowledge or informational assets. Even if knowledge is generally embodied in new physical products or new technologies, the main point is that knowledge presents some features that distinguish it from usual private goods.

Whereas private goods belong to the class of rival goods, knowledge is inherently non-rival. This means that, once produced, knowledge can be subsequently used by others without its value being reduced. In other words, consumption of knowledge does not require any additional resources than the ones devoted to its initial production. This non-rivalry property, satisfied by public goods, is to be contrasted with the rivalry property satisfied by private goods for which the quantity produced must be at least equal to the total number of consumed units. Knowledge is also a non-exclusive good, in the sense that everyone can use it unless a specific property right legally protects it. Thus, as long as the production of knowledge requires a fixed cost in terms of R&D investment, and the goods and services in which the knowledge is embedded can be reproduced and distributed at low marginal cost, perfect competition in the product markets does not allow the innovator to recoup his initial investment. Whereas the production of knowledge is socially valuable, its non-rivalry and non-exclusivity features make it questionable for a competitive market mechanism to perform properly and public intervention is needed to re-establish private incentives to engage in R&D activities.

IPR [intellectual property rights], as an ex-ante incentive mechanism giving the inventor the exclusive right to use or sell its invention, have been generally considered as being a valid policy instrument to overcome those problems.

Michael Spence, “Workers in the ‘Groves of Academe’: The Claim of Academics to Copyright and Patents,” in Rochelle Dreyfuss and Justine Pila, eds., The Oxford Handbook of Intellectual Property Law (2018) [Amazon], pp. 832–33:

“the community-centered (or “economic”) argument is that granting the creators of works or inventions IPRs is essential to correct the market failure caused by an inability to exclude non-purchasers from their use because of their essential character as “public goods.” Because of that market failure, works will not be created, disseminated, or efficiently exploited without the incentives provided by the IP regimes. The creation thereby of a market for works and inventions will ensure that they are ultimately within the control of the user who values them the most highly, absent wealth effects. This is thought to be a more efficient manner of correcting this market failure than, for example, taxation and patronage, because it trusts the market to determine which works or inventions will be created, disseminated, and exploited. This argument can often be relied upon to justify the IP regimes, although it will only apply where the relevant incentive is in fact necessary, and where the scope of the control over the work or invention afforded by the relevant IP regime is that which is necessary to provide the requisite incentives, and no more.”

Maureen A. O’Rourke, “Toward a Doctrine of Fair Use in Patent Law,” 100 Colum. L. Rev. 1177 (2000):

“economic theory supports the grant of intellectual property protection as a response to the public goods problem inherent in the production of information. In simpler terms, intellectual property protection is a response to the problem of “too little property.” Because information is by its nature fluid and can be consumed by more than one person without depleting the amount available to others, once the originator releases the information, he or she cannot easily exclude others from its benefits whether or not they pay. In the absence of some mechanism to allow the originator to
at least recoup his or her investment, information will be under-produced. One scheme that can function to allow investment recoupment is a grant of exclusive property rights to the originator. Such a grant of exclusive rights forms the basis of American intellectual property
law in copyright and patent today.”

Kenneth Arrow, “Economic welfare and the allocation of resources for invention” (1962): “we expect a free enterprise economy to underinvest in invention and research (as compared with an ideal) because it is risky, because the product can be appropriated only to a limited extent, and because of increasing returns in use.”

Adam B. Jaffe & Josh Lerner, Innovation and Its Discontents:

“The economic logic of granting patent protection to inventors is straightforward. If there were no incentives for those who discover and develop new technology, it is likely that fewer innovations would be developed, slowing progress and the benefits it brings. Potential inventors realize that without adequate protection rivals will rapidly copy their discoveries, and that therefore innovation is at best an uncertain route to future profits. As a result, companies would be unlikely to spend significant amounts of money on the Research and Development (R&D) that is the source of new products and processes in a modern economy. They would instead choose to spend their money pursuing other activities (for example, marketing campaigns) or just pocket it as profit.

… In summary: we want investments to be made in technological innovation. We do not think it will work well to have all or most such investments made using public funds, so we need to provide incentives for private individuals and firms to make the investments. The likelihood of imitation if new products are successful makes such investments very risky, and, hence, in the absence of a way to protect against imitation, we worry that not enough would be spent on R&D in the private sector. Patents provide such a mechanism, although we will soon see that even the best-functioning patent system is not costless.”

Sinclair Davidson & Jason Potts, “The Stationary Bandit Model of Intellectual Property,” Cato Journal, Vol. 37, No. 1 (Winter 2017) [pdf]:

In the standard model of intellectual property, benevolent national governments grant a temporary monopoly privilege to protect the creative inventor citizen from the unscrupulous depredations of private competitors or even consumers. The argument goes that without a legislative prohibition on copying …, a competitive market will provide only weak incentives to invest in creating new ideas—that is, there will be market failure (Arrow 1962), and society will suffer a suboptimal level of creative-inventive activity (Posner 2005).

The standard economic model of intellectual property is market failure, corrected with a monopoly rent.

Benjamin Tucker hinted at the market failure rationale given for IP, in Benjamin Tucker, “The Attitude of Anarchism Toward Industrial Combinations” (1899):

For the fourth of these monopolies, however, – the patent and copyright monopoly, – a more plausible case can be presented, for the question of property in ideas is a very subtle one. The defenders of such property set up an analogy between the production of material things and the production of abstractions, and on the strength of it declare that the manufacturer of mental products, no less than the manufacturer of material products, is a laborer worthy of his hire. So far, so good. But, to make out their case, they are obliged to go further, and to claim, in violation of their own analogy, that the laborer who creates mental products, unlike the laborer who creates material products, is entitled to exemption from competition. Because the Lord, in his wisdom, or the Devil, in his malice, has so arranged matters that the inventor and the author produce naturally at a disadvantage [i.e., the “market failure” argument], man, in his might, proposes to supply the divine or diabolic deficiency by an artificial arrangement that shall not only destroy this disadvantage, but actually give the inventor and author an advantage that no other laborer enjoys, – an advantage, moreover, which, in practice goes, not to the inventor and the author, but to the promoter and the publisher and the trust.

Tom W. Bell, “Indelicate Imbalancing in Copyright and Patent Law,” in Adam Thierer & Wayne Crews, eds., Copy Fights: The Future of Intellectual Property in the Information Age (2002):

Courts and commentators agree that copyright and patent represent statutory responses to a looming market failure—namely, the market’s failure to provide adequate supplies of original expressions and novel inventions.29

29. See, for example, Mazer v. Stein, 347 U.S. 201, 219 (1954), describing copyright and patents as a response to market failure and analyzing them in cost/benefit terms; United States v. Paramount Pictures, Inc., 334 U.S. 131, 158 (1948) (same with regard to copyrights); John R. Thomas, ‘‘Collusion and Collective Action in the Patent System: A Proposal for Patent Bounties,’’ (2001) University of Illinois Law Review 2001 (2001): 305, 308–09 (describing patents as a response to market failure). Also see Brett Frischmann, ‘‘Innovation and Institutions: Rethinking the Economics of U.S. Science and Technology Policy,’’ Vermont Law Review 24 (2000): 377–82; Wendy J. Gordon, ‘‘Fair Use as Market Failure: A Structural and Economic Analysis of the Betamax Case and Its Predecessors,’’ Columbia Law Review 82 (1982): 1610–14; Stephen Breyer, ‘‘The Uneasy Case for Copyright: A Study of Copyright in Books, Photocopies, and Computer Programs,’’ Harvard Law Review 84 (1970): 281; William M. Landes and Richard A. Posner, ‘‘An Economic Analysis of Copyright Law,’’ Journal of Legal Studies 18 (1989). [hyperlinks added]

In other words, copyright and patent law provide emergency shelter to creations that, but for such special statutory protection, would have fallen between the common law’s cracks and been left wandering unprotected through the market economy.

This concern about the free market and its “failures” abounds in arguments for IP. See, e.g., “Intellectual Property Advocates Hate Competition”  (July 19, 2011):

As I noted in my post IP Rights as Monopolistic Grants to Overcome the Public Goods Problem, IP proponents support these monopoly privileges on explicitly anticompetitive grounds. Take this explicit opening passage in an article by an ardent IP advocate, Jerome H. Reichman, a law professor at Duke:

Governments adopt intellectual property laws in the belief that a privileged, monopolistic domain operating on the margins of the free-market economy promotes long-term cultural and technological progress better than a regime of unbridled competition.

… Intellectual property laws typically provide qualified creators with temporary grants of exclusive property rights that derogate from the norms of free competition in order to overcome the “public goods” problem inherent in the commercial exploitation of intangible creations.1

Here we have an explicit admission that IP grants are monopolistic and derogate from free market norms and are opposed to a regime of “unbridled competition”–i.e., IP is anti-competitive. As is to be expected–after all, it’s a monopoly grant. Also, a recognition that the legitimacy of IP is based on the modern economic idea of “public goods” (see, on this fallacious notion, Hans-Hermann Hoppe, “Fallacies of the Public Goods Theory and the Production of Security,” in The Economics and Ethics of Private Property).

As Thomas, cited by Bell in n.29 above, notes:

Like other goods, innovative products and processes may be analyzed in terms of two economic characteristics. The first is whether the benefits of the good are excludable. The owner of a bottle of wine may prevent others from drinking, but the producer of radio signals broadcasts for all to hear. The second trait is whether consumption of the good is rivalrous. If one person’s use of the good necessarily diminishes the benefits of another’s use, then it is said to be a rival good. For nonrival goods such as pleasing parkway scenery, all may benefit from the good without diminishing the benefits of others.

Goods vary in their degrees of excludability and rivalrousness. Those that are fully nonexcludable and nonrivalrous are termed public goods. The production of public goods is subject to market failure, for their nonexcludable and nonrival traits suggest that they will be underproduced relative to social need. Potential producers of public goods are uncertain whether they will benefit from the good sufficiently to justify their labors [i.e., “recoup their costs” —SK]. They would also prefer to free ride off the labors of others, certain that they can enjoy the benefits of the good once someone else builds it. Individuals will therefore tend to produce goods with greater excludability and rivalrousness.

The production of desirable public goods is said to present a problem of collective action. Society as a whole favors the development of certain public goods, ranging from military defense to flood control projects. Private citizens may lack sufficient incentives to produce them, however, leading to suboptimal social outcomes. Government is uniquely suited towards solving collective action problems by modifying individual incentives to engage in desirable behavior.

The patent system is exemplary of this sort of market intervention. As information products, inventions exhibit the characteristics of public goods. They are nonexcludable, for whether the invention consists of a new machine, molecule or merchandising concept, others who learn of its nature may become imitators. They are also nonrival, for competitive uses do not impact an inventor’s personal ability to exploit the invention. These externalities are said to discourage inventive activity and diminish progress.

The patent law ameliorates this market failure by allowing individuals to obtain proprietary rights in their inventions. This property rule entitlement creates excludability for patented information products, allowing inventors to prevent free riders from benefiting from their inventions. By diminishing the public goods aspects of inventions, the patent system encourages individuals to increase their investment in innovative activities.3

And see Chandra: Intellectual Property Rights as “exceptions to market mechanisms”:

The basic public policy rationale for intellectual property laws is that they protect the rights of the inventor, author, or creator. IPRs have been conceived as a tool to reward innovators and creators, for their contributions to society, for a statutory period of time.They are intended to provide the necessary incentives to the generation and dissemination of knowledge as well as to encourage the transfer and diffusion of technology. IPRs constitute exceptions to market mechanisms as competition and free access were not considered adequate enough to provide incentives for innovation and development. It is typically suggested, usually by IP theory, that free market with no exclusive rights will lead to too little production of intellectual works. The economic rationale for IPRs is that unless invention or creation is compensated, invention and creation will be underprovided and economic development, even the development of science, will suffer. It is also designed to combat the ‘free rider’ problem, given that recent changes in technology have made replication and duplication much simpler. Individuals and firms will hesitate to make costly investments in innovation if imitators can reproduce these at a fraction of the cost and technological progress will be hampered.

See also:


  1. See “Intellectual Properganda.” []
  2. See various posts and talks where I mention IP being a response to so-called “market failure”: “KOL364 | Soho Forum Debate vs. Richard Epstein: Patent and Copyright Law Should Be Abolished“; “KOL365 | Guest Lecture on IP for Walter Block’s Law and Economics Class“; “Federalist Society Panel: Undermining or Preserving Property Rights? The New Administrative Patents“; also “KOL375 | Mentally Unscripted Ep55 – Why IP Laws Destroy Innovation and How Creatives Can Profit Without Them“; “Patent Lawyers Who Don’t Toe the Line Should Be Punished!“; “KOL289 | Scottish Liberty Podcast: Discussing the Mossoff-Sammeroff IP Debate, Take 2: A Sober Conversation…“; “KOL320 | Stephan Livera Podcast # 249–Bitcoin Patents & Open Crypto Alliance“. See also “David Friedman on Intellectual Property (and Market Failure),” though I am not sure Friedman explicitly argues for IP based on the “market failure” type reasoning many of his Chicagoite law & economics colleagues do. []
  3. John R. Thomas, ‘‘Collusion and Collective Action in the Patent System: A Proposal for Patent Bounties,’’ (2001) University of Illinois Law Review 2001 (2001): 305, 308–09 (describing patents as a response to market failure); footnotes omitted; bold emphasis added. []
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