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Product Versus Process Patents: A Theoretical Approach
Product Versus Process Patents: A Theoretical Approach Sugata Marjit, Indian Statistical Institute, Calcutta, India Hamid Beladi, Department of Economics and Finance, University of Dayton, Dayton, Ohio In this paper we develop a simple theoretical model to focus on the debate related to the granting of product patents in the developing countries. We discuss conditions under which “sleeping patents” might emerge. We argue that, for “poor” countries, allowing product patents cannot be justified on pure economic grounds. 1998 Society for Policy Modeling. Published by Elsevier Science Inc.
1. INTRODUCTION Recent years have experienced intensive debate on the Dunkel proposal, particularly in the area of trade-related intellectual property protection, more popularly known as TRIPS. Countries such as India are being advised to introduce a system of product patents along with the patenting of new processes that already exist in some of the countries.1 Process patents alone do not seem to eliminate the “free rider” problem associated with the new innovations.2 The argument often put forward in justifying the necessity 1
See Government of India (1992). The industries that are likely to face problems with the provision of product patents in India are pharmaceutical and computer software. It has been argued elsewhere (see Marjit, 1994, and the references herein) that cheaper ways of producing major drugs benefits poor customers. Now if there is product-patent, then some of the more efficient ways of production would be potentially eliminated. In case of computer software, India’s highest export-growth area, definition of a “product” may be quite crucial. Since the GATT-directed patent regulations are going to take effect after a certain period of time, at this state we can make the best possible conjectures. Address correspondence to Dr. Hamid Beladi, Department of Economics and Finance, University of Dayton, Dayton, OH 45469-2240. We are grateful to an anonymous referee for helpful comments. The usual disclaimer applies. Received December 1995; final draft accepted July 1996. 2
Journal of Policy Modeling 20(2):193–199 (1998) 1998 Society for Policy Modeling Published by Elsevier Science Inc.
0161-8938/98/$19.00 PII S0161-8938(96)00091-9
194
S. Marjit and H. Beladi
of product patents runs as follows: Consider a firm that introduces a new product A that can be produced by a certain mix of two inputs X and Y. If the patent is guaranteed only on the compound of X and Y, the innovating firm might be exposed to a competition by another firm in the following way: The new firm, although unable to incur huge research and development (R & D) expenses that led to the introduction of A to start with, can observe the process technology and can substitute X by X9 and Y by Y9 to produce a cheaper A. the particular mix of X9 and Y9 will be patented by the new firm, eating on the profits of the original innovator. Simply because if X9 and Y9 were available locally, the innovating firm could do the same as the new entrant. A patent for the product A itself would not allow the second firm to produce it for a specified period of time, enabling the leading firm to retain its monopoly profits probably needed to finance the huge R & D expenses incurred for conceiving a product such as A. Therefore, it is natural that countries that can and do spend billions of dollars on R & D would push for product patents on top of the existing system of process patents.3 It is also quite obvious that the poor countries that have cheaper supply of alternative process inputs would not like the idea of product patents. All said and done, it is not clear, at least theoretically, that the exclusion of product patents would necessarily lead to a cutback in potential profits of the innovating firm. This paper tries to answer the following question in this context: Even if product patent is allowed to a multinational firm, thus preventing a local entrant from adopting a cheaper technology to produce the same product, is it necessarily true that the leading firms would at all supply the product to the local market? In that case, the multinational firm does not like to exploit the local market; product patents would lead to significant loss in terms of consumers’ surplus for an economy. This sometimes is called the problem of “sleeping patents.” We propose a simple theoretical model in this paper to highlight some of these points. Even if the cheap local technology is franchised to the innovative firm, it might not have any incentive to sell the product in the local market. In a world characterized by a significant dispersion in the international distribution of income, multinational firms might not be interested in servicing a few corners of the world. The paper builds on this intuition to pinpoint the latest sources 3
See Maskus (1990) and Subramanian (1990a, 1990b).
PRODUCT VERSUS PROCESS PATENTS
195
of the current debate. Section 2 describes the model and the results. The concluding section highlights other related issues and some generalizations. 2. THE MODEL AND ANALYSIS Consider a case where the multinational firm, henceforth called the MNC, can potentially supply a product to two markets: Rest of the World (ROW) and India. The demand functions are represented by q 5 (a1 2 p) for the ROW and q 5 (a2 2 p) for India, a1 . a2. For the same price quoted in either market, the level of demand in India is much lower compared to that in the ROW. We assume-away price discrimination. For a1 . p . a2 there is no Indian customer who can buy the product. One can use the “ROW” as representing the richer part of the globe and “India” as its “poorer” counterpart. Marginal cost of production for the MNC is denoted by cm. There is also an Indian firm that is a latecomer in the technology race but has a better way of producing the same product. The marginal cost faced by the Indian firm is c , cm. A process patent enjoyed by the MNC cannot prevent the local firm from producing an identical product with a marginal cost of c. At this stage we assume that India adheres to the Dunkel proposal and allows a product patent to the MNC barring the Indian firm to produce the product. We divide the subsequent analysis in three steps. Step 1: MNC chooses the local supply as a part of the profitmaximizing exercise. Step 2: MNC is allowed to use local resources and replicate. Step 3: India sticks to the process patents only, and the Indian firm is allowed to produce locally, whereas the ROW agrees with the Dunkel draft thwarting the global entry by the India firm. The relevant demand levels faced by the MNC are as follows. q5
5a
1
a1 2 p, 1 a2 2 2p,
for for
p > a2 p , a2
6
(1)
For the equilibrium price being sufficiently high, the Indian market will not be served by the MNC. We now look for the precise condition under which this would be true. While serving both markets, the MNC’s profit is given by,
196
S. Marjit and H. Beladi Π1 5
3a
1
4
1 1 a2 q 2 q2 2 cmq 2 2
a 1 a2 ]Π1 5 0 ⇒ qo 5 1 2 cm ]q 2
(2)
so that, po 5
3a
1 1 a2 1 cm 4 2
Πo1 5
1 a1 1 a2 2 cm 2 2
1
2
1
4
(3)
and, 2
(4)
The MNC could also choose to serve only the “rich” market enjoying a profit of Πo2 5
(a1 2 cm)2 4
(5)
Now the condition under which the MNC will not serve the Indian market, is given by (a1 2 cm)2 1 a1 1 a2 . 2 cm 4 2 2
3 1
24
(6)
(√2 2 1) 2 a2
4
(7)
2
which reduces to
3a
1
√2
1 (√2 2 1) cm . 0
If a2 is fairly small relative to a1, the MNC does not want to serve the Indian market. The higher is cm, the firm has to charge a highenough price that cannot be paid by the Indians. If Condition 7 is satisfied and the Indian Government agrees on a product patent, then it loses the entire consumers’ surplus in addition to the producers’ surplus that could be generated through local production. Equation 7 would imply that the MNC should not be bothered about the Indian market to recoup its sunk cost in the form of R & D. One wonders how the validity of Equation 7 depends on the marginal cost of production cm. Had it been the case that the MNC could actually manage the process technology at a marginal cost of c from the local source itself and then look at Equation 7 to decide its action, there was no guarantee that it would have supplied to the Indian market. Consider the case where c 5 0, the
PRODUCT VERSUS PROCESS PATENTS
197
cheapest possible process technology. In this case, the MNC would continue to shy away from the Indian market provided that a1 .
3(√2 a2 1)4 2
(8)
Although lower cm leads to a decline in the profit-maximizing price, it is still not clear that even with c 5 0 such a price would attract poor Indian customers. The main thrust of our analysis originates from the idea that the Indian firm cannot enter the global market. We have implicitly assumed that the ROW has product patents in practice or at least has agreed to the Dunkel proposal. If the Indian firm cannot introduce a novel product, it stands no chance of making a dent in the ROW. Ruling out such a threat of entry, coupled with a valid Condition 7, hardly justifies the introduction of product patents in India to the extent it seeks to straighten the R & D incentives for the MNC. However, one does not know whether Equation 7 actually has reverse sign. If Equation 7 is positive, the MNC has its reasons to be worried about an Indian competitor even if it fails to penetrate the ROW market. If India has potentially a large market for the product, reflected in a high a2, the MNC would like to serve the market. If R is the sunk cost of R & D, a ranking such as Equation 9 would make the MNC fight hard for the Indian market.
3(1 Π2 r)4 . R . 3(1 Π2 r)4 o 1
o 2
(9)
where r is a rate of discount. Allowing the entry of an Indian firm with c , cm, would lead to an erosion of profits of the MNC from the Indian market, reducing IIo1 . Once entry takes place, firms would be involved in a duoplistic game. If IIo1 is sufficiently reduced, there might not be any ex-ante incentive for introducing the new product. The largeness of a market is extremely important as an issue in the whole debate on TRIPS. One can extend the argument developed earlier to see whether a violation of Equation 7 provides sufficient justification for product patents everywhere. We can easily bring another nation, even poorer than India, which may not have any technological base to offer an alternative process technology. If the MNC decides not to operate in such a market, there is no harm in allowing an Indian producer to export to such a market. Insisting on a product patent
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S. Marjit and H. Beladi
in that third country also cannot be supported by any economic reasoning. 3. CONCLUDING REMARKS The purpose of this paper has been to put one aspect of the debate on TRIPS in its proper perspective. The debate on product versus process patents has been summarized in terms of a simple theoretical model. We have argued why blanket patent protection provided to “products” might not be justified on economic grounds. There are two possible theoretical extensions of this paper. First, one can focus on the choice problem of a MNC faced with a continuum of markets differentiated in terms of the levels of income. In that case, apart from deciding on the price and aggregate quantity to be sold, the MNC can also choose a set of regions where it would not like to supply. That cut-off point may be considered in determining the operational spheres of process and product patents. The second possible extension of our model is related to export promotional policies and TRIPS. In our framework, the MNC may not like to serve the Indian market even if cm is reduced to c. (cm 2 c) probably measures the locational advantage of the business if Indian resources are utilized in the production process. Ceteris paribus, the MNC might have all the reasons in the world to set up a 100-percent export-oriented unit in India, thus promoting exports from India. The welfare comparison between such a regime and the one where the product patents are not entertained must include the part of the export income accruing to India and the surplus earned by violating product patents. Since we use a very simple linear structure, welfare comparison is straightforward and is given by the following. If
3
4
3 (a1 2 c)2 2 (a1 2 cm)2 . (a2 2 c)2, 4 8
promoting exports through the MNC potentially pays more than the local surplus generated through process patents. For example, if a1 5 4, a2 5 1, c 5 0, cm 5 2, then the above condition along with Equation 7 are satisfied.4 As trade barriers are lifted gradually, 4 We can highlight the possible existence of “sleeping patents” in a model with a general demand function. The demonstration has been provided in the appendix. It implies that the basic idea of the paper is not an outcome of the simple expository model.
PRODUCT VERSUS PROCESS PATENTS
199
effective market size expands to the MNC’s. “Sleeping patents” today could be reactivated tomorrow with the eventual freeing up of international trade. Such issues and others might motivate further research in this area. APPENDIX Consider the following general demand functions. Let A denote Rest of the World (ROW) and B represent India. Also let, pA 5 f A(aA, qA) pB 5 f B(aB, qB)
f A1 . 0, f B1 . 0,
f A11 5 0, f B11 5 0,
f A2 , 0, f B2 , 0,
f A22 , 0, f B22 , 0,
f A12 5 0 f B21 5 0
It is quite straightforward to show that by manipulating the purchasing power parameters aA, aB, then a case for sleeping patents can be generated. If aA is very high relative to aB and the multinational corporations cannot pricediscriminate, it is easy to prove that IIB may be greater than the joint profits attained by serving the two regions. The linear model used in the main test of the paper allow us to pinpoint the required difference between aA and aB as reflected in the simple monotonic transformations in the form of a1 and a2. It is interesting to note that the general idea of the paper remains valid even with a general demand function.
REFERENCES Government of India (1992) Note on Proposals Made by Mr. Arthur Dunkel—Official document. Marjit, S. (1994) Trade Related Intellectual Property Rights and GATT—A Theoretical Evaluation. Economic and Political Weekly. Maskus, K. (1990) Normative Concerns in the International Protection of Intellectual Property Rights. The World Economy 13:387–410. Subramanian, A. (1990a) TRIPS and the Paradigm of GATT: A Tropical Temperate View. The World Economy 15:509–522. Subramanian, A. (1990b) Discrimination in the International Economics of Intellectual Property Protection. Economic and Political Weekly 11:549–554.
1. INTRODUCTION Recent years have experienced intensive debate on the Dunkel proposal, particularly in the area of trade-related intellectual property protection, more popularly known as TRIPS. Countries such as India are being advised to introduce a system of product patents along with the patenting of new processes that already exist in some of the countries.1 Process patents alone do not seem to eliminate the “free rider” problem associated with the new innovations.2 The argument often put forward in justifying the necessity 1
See Government of India (1992). The industries that are likely to face problems with the provision of product patents in India are pharmaceutical and computer software. It has been argued elsewhere (see Marjit, 1994, and the references herein) that cheaper ways of producing major drugs benefits poor customers. Now if there is product-patent, then some of the more efficient ways of production would be potentially eliminated. In case of computer software, India’s highest export-growth area, definition of a “product” may be quite crucial. Since the GATT-directed patent regulations are going to take effect after a certain period of time, at this state we can make the best possible conjectures. Address correspondence to Dr. Hamid Beladi, Department of Economics and Finance, University of Dayton, Dayton, OH 45469-2240. We are grateful to an anonymous referee for helpful comments. The usual disclaimer applies. Received December 1995; final draft accepted July 1996. 2
Journal of Policy Modeling 20(2):193–199 (1998) 1998 Society for Policy Modeling Published by Elsevier Science Inc.
0161-8938/98/$19.00 PII S0161-8938(96)00091-9
194
S. Marjit and H. Beladi
of product patents runs as follows: Consider a firm that introduces a new product A that can be produced by a certain mix of two inputs X and Y. If the patent is guaranteed only on the compound of X and Y, the innovating firm might be exposed to a competition by another firm in the following way: The new firm, although unable to incur huge research and development (R & D) expenses that led to the introduction of A to start with, can observe the process technology and can substitute X by X9 and Y by Y9 to produce a cheaper A. the particular mix of X9 and Y9 will be patented by the new firm, eating on the profits of the original innovator. Simply because if X9 and Y9 were available locally, the innovating firm could do the same as the new entrant. A patent for the product A itself would not allow the second firm to produce it for a specified period of time, enabling the leading firm to retain its monopoly profits probably needed to finance the huge R & D expenses incurred for conceiving a product such as A. Therefore, it is natural that countries that can and do spend billions of dollars on R & D would push for product patents on top of the existing system of process patents.3 It is also quite obvious that the poor countries that have cheaper supply of alternative process inputs would not like the idea of product patents. All said and done, it is not clear, at least theoretically, that the exclusion of product patents would necessarily lead to a cutback in potential profits of the innovating firm. This paper tries to answer the following question in this context: Even if product patent is allowed to a multinational firm, thus preventing a local entrant from adopting a cheaper technology to produce the same product, is it necessarily true that the leading firms would at all supply the product to the local market? In that case, the multinational firm does not like to exploit the local market; product patents would lead to significant loss in terms of consumers’ surplus for an economy. This sometimes is called the problem of “sleeping patents.” We propose a simple theoretical model in this paper to highlight some of these points. Even if the cheap local technology is franchised to the innovative firm, it might not have any incentive to sell the product in the local market. In a world characterized by a significant dispersion in the international distribution of income, multinational firms might not be interested in servicing a few corners of the world. The paper builds on this intuition to pinpoint the latest sources 3
See Maskus (1990) and Subramanian (1990a, 1990b).
PRODUCT VERSUS PROCESS PATENTS
195
of the current debate. Section 2 describes the model and the results. The concluding section highlights other related issues and some generalizations. 2. THE MODEL AND ANALYSIS Consider a case where the multinational firm, henceforth called the MNC, can potentially supply a product to two markets: Rest of the World (ROW) and India. The demand functions are represented by q 5 (a1 2 p) for the ROW and q 5 (a2 2 p) for India, a1 . a2. For the same price quoted in either market, the level of demand in India is much lower compared to that in the ROW. We assume-away price discrimination. For a1 . p . a2 there is no Indian customer who can buy the product. One can use the “ROW” as representing the richer part of the globe and “India” as its “poorer” counterpart. Marginal cost of production for the MNC is denoted by cm. There is also an Indian firm that is a latecomer in the technology race but has a better way of producing the same product. The marginal cost faced by the Indian firm is c , cm. A process patent enjoyed by the MNC cannot prevent the local firm from producing an identical product with a marginal cost of c. At this stage we assume that India adheres to the Dunkel proposal and allows a product patent to the MNC barring the Indian firm to produce the product. We divide the subsequent analysis in three steps. Step 1: MNC chooses the local supply as a part of the profitmaximizing exercise. Step 2: MNC is allowed to use local resources and replicate. Step 3: India sticks to the process patents only, and the Indian firm is allowed to produce locally, whereas the ROW agrees with the Dunkel draft thwarting the global entry by the India firm. The relevant demand levels faced by the MNC are as follows. q5
5a
1
a1 2 p, 1 a2 2 2p,
for for
p > a2 p , a2
6
(1)
For the equilibrium price being sufficiently high, the Indian market will not be served by the MNC. We now look for the precise condition under which this would be true. While serving both markets, the MNC’s profit is given by,
196
S. Marjit and H. Beladi Π1 5
3a
1
4
1 1 a2 q 2 q2 2 cmq 2 2
a 1 a2 ]Π1 5 0 ⇒ qo 5 1 2 cm ]q 2
(2)
so that, po 5
3a
1 1 a2 1 cm 4 2
Πo1 5
1 a1 1 a2 2 cm 2 2
1
2
1
4
(3)
and, 2
(4)
The MNC could also choose to serve only the “rich” market enjoying a profit of Πo2 5
(a1 2 cm)2 4
(5)
Now the condition under which the MNC will not serve the Indian market, is given by (a1 2 cm)2 1 a1 1 a2 . 2 cm 4 2 2
3 1
24
(6)
(√2 2 1) 2 a2
4
(7)
2
which reduces to
3a
1
√2
1 (√2 2 1) cm . 0
If a2 is fairly small relative to a1, the MNC does not want to serve the Indian market. The higher is cm, the firm has to charge a highenough price that cannot be paid by the Indians. If Condition 7 is satisfied and the Indian Government agrees on a product patent, then it loses the entire consumers’ surplus in addition to the producers’ surplus that could be generated through local production. Equation 7 would imply that the MNC should not be bothered about the Indian market to recoup its sunk cost in the form of R & D. One wonders how the validity of Equation 7 depends on the marginal cost of production cm. Had it been the case that the MNC could actually manage the process technology at a marginal cost of c from the local source itself and then look at Equation 7 to decide its action, there was no guarantee that it would have supplied to the Indian market. Consider the case where c 5 0, the
PRODUCT VERSUS PROCESS PATENTS
197
cheapest possible process technology. In this case, the MNC would continue to shy away from the Indian market provided that a1 .
3(√2 a2 1)4 2
(8)
Although lower cm leads to a decline in the profit-maximizing price, it is still not clear that even with c 5 0 such a price would attract poor Indian customers. The main thrust of our analysis originates from the idea that the Indian firm cannot enter the global market. We have implicitly assumed that the ROW has product patents in practice or at least has agreed to the Dunkel proposal. If the Indian firm cannot introduce a novel product, it stands no chance of making a dent in the ROW. Ruling out such a threat of entry, coupled with a valid Condition 7, hardly justifies the introduction of product patents in India to the extent it seeks to straighten the R & D incentives for the MNC. However, one does not know whether Equation 7 actually has reverse sign. If Equation 7 is positive, the MNC has its reasons to be worried about an Indian competitor even if it fails to penetrate the ROW market. If India has potentially a large market for the product, reflected in a high a2, the MNC would like to serve the market. If R is the sunk cost of R & D, a ranking such as Equation 9 would make the MNC fight hard for the Indian market.
3(1 Π2 r)4 . R . 3(1 Π2 r)4 o 1
o 2
(9)
where r is a rate of discount. Allowing the entry of an Indian firm with c , cm, would lead to an erosion of profits of the MNC from the Indian market, reducing IIo1 . Once entry takes place, firms would be involved in a duoplistic game. If IIo1 is sufficiently reduced, there might not be any ex-ante incentive for introducing the new product. The largeness of a market is extremely important as an issue in the whole debate on TRIPS. One can extend the argument developed earlier to see whether a violation of Equation 7 provides sufficient justification for product patents everywhere. We can easily bring another nation, even poorer than India, which may not have any technological base to offer an alternative process technology. If the MNC decides not to operate in such a market, there is no harm in allowing an Indian producer to export to such a market. Insisting on a product patent
198
S. Marjit and H. Beladi
in that third country also cannot be supported by any economic reasoning. 3. CONCLUDING REMARKS The purpose of this paper has been to put one aspect of the debate on TRIPS in its proper perspective. The debate on product versus process patents has been summarized in terms of a simple theoretical model. We have argued why blanket patent protection provided to “products” might not be justified on economic grounds. There are two possible theoretical extensions of this paper. First, one can focus on the choice problem of a MNC faced with a continuum of markets differentiated in terms of the levels of income. In that case, apart from deciding on the price and aggregate quantity to be sold, the MNC can also choose a set of regions where it would not like to supply. That cut-off point may be considered in determining the operational spheres of process and product patents. The second possible extension of our model is related to export promotional policies and TRIPS. In our framework, the MNC may not like to serve the Indian market even if cm is reduced to c. (cm 2 c) probably measures the locational advantage of the business if Indian resources are utilized in the production process. Ceteris paribus, the MNC might have all the reasons in the world to set up a 100-percent export-oriented unit in India, thus promoting exports from India. The welfare comparison between such a regime and the one where the product patents are not entertained must include the part of the export income accruing to India and the surplus earned by violating product patents. Since we use a very simple linear structure, welfare comparison is straightforward and is given by the following. If
3
4
3 (a1 2 c)2 2 (a1 2 cm)2 . (a2 2 c)2, 4 8
promoting exports through the MNC potentially pays more than the local surplus generated through process patents. For example, if a1 5 4, a2 5 1, c 5 0, cm 5 2, then the above condition along with Equation 7 are satisfied.4 As trade barriers are lifted gradually, 4 We can highlight the possible existence of “sleeping patents” in a model with a general demand function. The demonstration has been provided in the appendix. It implies that the basic idea of the paper is not an outcome of the simple expository model.
PRODUCT VERSUS PROCESS PATENTS
199
effective market size expands to the MNC’s. “Sleeping patents” today could be reactivated tomorrow with the eventual freeing up of international trade. Such issues and others might motivate further research in this area. APPENDIX Consider the following general demand functions. Let A denote Rest of the World (ROW) and B represent India. Also let, pA 5 f A(aA, qA) pB 5 f B(aB, qB)
f A1 . 0, f B1 . 0,
f A11 5 0, f B11 5 0,
f A2 , 0, f B2 , 0,
f A22 , 0, f B22 , 0,
f A12 5 0 f B21 5 0
It is quite straightforward to show that by manipulating the purchasing power parameters aA, aB, then a case for sleeping patents can be generated. If aA is very high relative to aB and the multinational corporations cannot pricediscriminate, it is easy to prove that IIB may be greater than the joint profits attained by serving the two regions. The linear model used in the main test of the paper allow us to pinpoint the required difference between aA and aB as reflected in the simple monotonic transformations in the form of a1 and a2. It is interesting to note that the general idea of the paper remains valid even with a general demand function.
REFERENCES Government of India (1992) Note on Proposals Made by Mr. Arthur Dunkel—Official document. Marjit, S. (1994) Trade Related Intellectual Property Rights and GATT—A Theoretical Evaluation. Economic and Political Weekly. Maskus, K. (1990) Normative Concerns in the International Protection of Intellectual Property Rights. The World Economy 13:387–410. Subramanian, A. (1990a) TRIPS and the Paradigm of GATT: A Tropical Temperate View. The World Economy 15:509–522. Subramanian, A. (1990b) Discrimination in the International Economics of Intellectual Property Protection. Economic and Political Weekly 11:549–554.