Editorial Note: This article follows immediately upon Correlation of U.S. Patent System and Productivity Growth. To begin reading the series from the beginning please see Economic Trends and Productivity Decline in America.
When a company invests in a new technology, it commits capital and human resources in the long-run and expects a return on this investment. Historically, the U.S. patent system was a fundamental mechanism to enable a return on investment by embedding a limited exclusive right in patents for innovations. The genius of the U.S. patent system was to embed rights in microeconomic entities and to provide access to the patent system for anyone.
However, after a decade of attacks by anti-patent critics, the patent system has been destabilized by the disintegration of private property rights as the examination system in the PTO and the enforcement mechanism in the courts has been redesigned to require substantial capital resources. While a few mid-sized companies can marshal the capital resources to enforce their patent rights, the small entities that require patent rights the most in order to compete do not have these resources. Consequently, business starts have declined dramatically in the last decade to the lowest numbers recorded.
Strong productivity growth requires incentives to innovate offered by a strong patent system. The patent system has traditionally provided strong enforcement mechanisms to protect investments in innovation. Consequently, in a strong patent system, we witness the virtuous cycle of innovation investment protection and productivity growth. It is not a radical view to suggest that strong property rights in the patent system enables a level playing field and promotes competition among rivals big and small. Strong institutions – such as the judicial system – protect intellectual property rights as an incentive to invest in risky inventions and to solve complex technical problems that often don’t pay off for several years.
On the other hand, in a weak patent regime, capital investments are not protected since anyone can use the patented inventions as free riders. In fact, it is difficult to obtain any investments in a weak patent regime if one’s competitors can use the innovations with little or no compensation
These observations of a weakened patent system in the last decade explain the background for a dramatic decline in productivity growth during the same period. Worse yet, the structure of technology industries in the past decade have revealed a profound concentration of resources among the largest companies, with very little competition in the middle market and slow growth patterns of start-ups. These data suggest that the weakened patent system has a critical role in the general economy that affects market competition and enables the large technology companies to perpetuate competitive advantages.
Mechanisms of a Weak Patent System on Declining Business Investment
Recent data show declines in small business starts, technology business investment and big tech investment.
Despite the decline in business investment, the largest technology companies enjoy extraordinary profits, often over $10B annually. Apple alone enjoyed an annual profit in the year ended October 1, 2015, of $53.4B, the largest in the history of capitalism. Because of these extraordinary profits, these companies hold extraordinary amounts of cash on hand, with Apple holding over $230B alone and the top five tech companies collectively holding $504B, or 30% of cash of all non-financial companies, in the first quarter of 2016. Much of these capital resources are stored offshore to avoid taxes. Nevertheless, these companies are not spending more capital resources on investments into innovation. Rather, they are hoarding their capital resources.
The consistent pattern of investment declines are a key factor behind the productivity growth declines and the weak aggregate economic growth. What mechanism lies behind these across-the-board declines in business investment?
Technology transfer is blocked in a weak patent system since companies employ the “efficient infringement” model. In a weak patent system, enforcement is expensive and burdensome, supplying the infringer with incentives to infringe. Rather than voluntarily license technology, incumbents engage in reverse hold out in which they ignore patents and refuse to deal with patent holders. When an entire industry engages in reverse hold out, that is, collective refusal to deal, which is enabled by a weak patent system with high barriers to enforcement, they exhibit anti-competitive behaviors. In fact, enforcement in the courts, as expensive as it is, is generally caused by the belligerence and refusal to deal by technology incumbents which force matters to the courts. Particularly in the absence of an injunction as a remedy for the patent holder, the patent holder can no longer possibly be considered a hold out because their patents cannot enforce an exclusive property patent right. In the pervasive business and political environment that enables the collective refusal to deal with patent-holding market entrants, with high transaction costs to patent enforcement and with reduced compensation from enforcement because of a reduction in patent remedies, there is no incentive to invest in innovation.
When a patent holder seeks to enforce a patent, the infringer challenges the patent in an IPR in the PTO, with asymmetric risks and costs to the patent holder. If the patent survives the IPR, the patent holder must still expend considerable capital and time in search of a fair royalty. Without an available injunction in most cases, the only remedy for the patent holder is monetary damages. In many cases, the infringer has little downside risk and only seeks to pay the license they would pay if they negotiated in good faith. With increased risks to the patent holder, the costs increase, which require a greater return in order to justify the investment; however, the infringer blocks a reasonable return on investment by forcing the patent holder to expend substantial resources on litigation. The higher burdens in the enforcement regime of a weak patent system supply a dramatically high tax on the most productive and innovation companies that perform original research. The system clearly becomes biased to large companies, representing a major power shift from small companies to incumbents. Consequently, technology progress lags in a weak patent regime and, with it, productivity growth and aggregate economic growth.
The Connection of Declining Investment and Market Distortions
A critical benefit of strong patent rights is that patents enable fair competition between rivals. If all companies in an industry compete on an even playing field, each company can invent and protect products from infringement. Without a patent system, the strongest companies can perpetuate their advantages, not by investing in innovation but in stealing others’ technologies and fighting them in court with more substantial resources. Patents are thus an essential tool to enable competition only in a healthy patent system. In fact, without patents, there is no systematic mechanism to enable start-ups to compete with incumbents.
The Schumpeterian theory of creative destruction advocates that the dynamism of profit-seeking companies is driven by entrepreneurial activity of multiple competitors. As companies innovate to solve problems and meet customer needs, the companies grow. A key to economic growth is the dynamism of multiple rivals as they compete by constantly innovating. For this reason, technology companies provide the engine of economic growth. In fact, companies with fewer than 500 employees supply two-thirds of U.S. job growth. In addition, technology companies tend to provide higher-quality and higher wage jobs.
Oligopolous industry structures tend to dominate the innovation-centric technology, telecommunications and pharmaceutical industries. In general, only a few companies in each industry hold the majority of the revenues and profits. Many of these market incumbents enjoy high profits because of market position and brand recognition rather than intellectual property rights. By contrast, smaller market entrants require patents on novel inventions in order to compete with the larger rivals. Hence, the patent system has historically provided the mechanism to enable competition for market entrants.
When market incumbents, individually or collectively, ignore patents and misappropriate technology, patent enforcement is the only tool available for competitors. However, with the dramatic changes in the patent system in the last decade, the competition from small companies has been highly constrained. The entry barriers for start-ups are now so high to pursue patent enforcement as to require substantial capital resources and long delays for return on investment. In addition, there has been a dramatic decline in small entities and independent inventors procuring patents in the U.S. PTO, with the rate of American inventors procuring patents declining from 15% in 2000 to less than 5% today. These facts explain the record low small company formation rates in recent years.
Patents have been at the core of a company’s ability to procure capital. With a weak patent regime, capital is extremely difficult to procure and very expensive when it is procured.
Economist Douglas North advocated that oligopolies tend to influence rules that benefit and perpetuate their own power. The technology industry incumbents, a group that consists of about a dozen mega-cap corporations, appears to follow this pathway by advocating for a weak patent regime that benefits their monopoly profits at the expense of start-ups. However, the technology industry has a unique catalytic effect on the overall economy because adoption of its products enhances other industries’ productivity. The technology industry, although oligopolously configured, has an outsized effect on productivity growth and total factor productivity (TFP) growth in particular. Consequently, since the tech cartel has extraordinary market power, the degradation of the patent system in recent years becomes an anticompetitive phenomenon that ultimately retards investment in new technology by incumbents and start-ups alike. The effective hostile takeover of the U.S. patent system by the big tech cartel has a simple effect of retarding productivity growth. This suggests that the U.S. economy has a fundamental structural problem and that productivity growth will not be improved until the government changes policies to modify the structural problem itself. Whereas the federal government ought to recognize the antitrust and anticompetitive nature of the tech cartel problem, and seek to resolve it, in point of fact, the government itself was party to the problem by enabling the cartel to obtain benefits of a weak patent system at the expense of smaller competitors. Ultimately, not only did the government engage in weak antitrust monitoring and action, but the government substantially destabilized the only mechanism for competition for market entrants by weakening the patent system.
While the U.S. sabotaged its only sustainable competitive advantage of promoting a strong and democratized patent system, China has committed to investing in its technology industry.
Consequences of a Weak Patent System Explain a Persistent Productivity Growth Decline
A weak patent system has a number of adverse consequences for businesses. First, in a weak patent regime, larger firms engage in “efficient infringement” in which they infringe with impunity and only when caught pay the original licensing fee and transaction costs in a calculation that they profit by infringing many more times than the number of times of getting caught. The incumbents then become free riders. Second, incumbents engage in reverse hold out by refusing to deal with patent holders, thereby forcing much higher transaction costs for patent holders to enforce their patents. Third, in the absence of a willingness to negotiate licenses by incumbents, there is no voluntary licensing market. This market has been referred to as an honor system in which ethical companies would honor others’ IP; this honor market has effectively dissolved in a weak patent regime. Fourth, all patent infringement suits are driven to the courts, which dramatically increase transaction costs for all parties, but which costs fall as a burden particularly on the smaller entities enforcing patents. Fifth, with the high barriers to enforce IP, the valuation of patents drops dramatically. In point of fact, patents are completely valueless in the absence of enforcement, which is prohibitively expensive if the market size does not justify the expected rewards. If patents are without any value in the majority of cases, there is zero incentive to develop innovation. Sixth, in an environment with high costs to process research and enforce patents, investment in research, particularly at the margins for risky innovation, is scarce. Seventh, with a high bar to enforce IP, incumbents themselves have a disincentive to invent or invest in innovation since they can steal others’ IP with impunity in most cases without risk of expensive enforcement. Eighth, other than the big tech cartel, by far the biggest beneficiary of a weak U.S. patent system is the East Asian manufacturers, particularly in China, that benefit at the expense of American innovators. Hence, a weak U.S. patent system provides a free ride to Asian rivals.
The ubiquitous “efficient infringement” model forces all matters to the courts for adjudication, with corresponding high transaction costs. This is a perverse outcome of attacking patent holders, but only the courts supply a remedy for innovators in the face of persistent refusal to engage in voluntary licensing by incumbents. In the aftermath of the AIA, it is now easier to burden the patent holder with validity challenges at the PTAB than to communicate about a fair license. The existence of the new layer of the PTAB in the patent system supplies a further argument for incumbents to engage in “efficient infringement” and ignore patent holders. The net effect of high barriers to patent enforcement is to promote monopoly profits of market incumbents. These analytical mechanisms describing changes to the patent system explain the facts of oligopolist market power, historically high incumbent profits, historically low business start-ups, law business investment and the difficulty for start-ups to obtain capital. In a weak patent regime, these trends are intractable.
High transaction costs, in the PTO and in the courts, provide a capital liquidity squeeze to innovators. On the one hand, in addition to R&D costs, transaction costs are increased substantially by instituting reexams and requiring enforcement in the courts. On the other hand, there is reduced compensation for licenses when infringers limit remedies of injunctions or enhanced damages. The increased transaction costs require substantial capital resources – typically seven figures – in order to enforce patents against infringers as well as elongating the period from invention to compensation to five to ten years or more. The effect of this shift from labor (human capital) to capital removes incentives to invent. In particular, small and mid-sized company licensing deals evaporate in an environment with high transaction costs, increasing risks for innovations at the margins.
Small companies are particularly affected by the capital liquidity squeeze. Ultimately, small companies are blocked from reinvesting capital into R&D since they cannot easily receive returns on the first generation of their technology or the returns are sharply reduced. Not only are the transaction costs dramatically higher now than they were a decade ago before the transformation of patent law, but the time to receive a return on investment is substantially elongated by delays. Consequently, investments, especially at the margins with the greatest need for new discovery, are withdrawn as risks, costs and time to returns are increased.
The left’s ideological preferences for a weak patent system to enable their goals of diminishing the property right in patents represents an intentional engineering to help devalue patents. The net effect of these policy changes has been to benefit infringers. In an environment in which free riders dominate by exploiting the “efficient infringement” model, there is no compelling reason for investors to risk capital resources in innovation.
When taken to its extremes, the “efficient infringement” model is employed by a group of companies simultaneously, illustrating its anti-competitive aspects. Many tech incumbents practice collective refusal to deal which represents a type of restraint of trade. When these anticompetitive practices are employed by the American tech cartel, they are given a free pass by regulators, but when they are employed by foreign manufacturers, these anticompetitive practices become highly problematic.
In the exact period of decline of the U.S. patent system, from approximately 2001 to the present, the U.S. manufacturing sector declined. East Asian manufacturing, particularly Chinese manufacturing, became relatively more competitive during the period, as reflected by millions of lost U.S. manufacturing jobs. The U.S. economy is now about ten percent manufacturing, with half of this represented by only five companies. It is a utopian dream to consider the U.S., or any European industrial nation, a major manufacturer. At best, the U.S. economy is based on innovation, with massive R&D performed at U.S. universities and start-ups and diffused to Asian manufacturers through licensing relationships.
However, in a weak patent system, a major class of beneficiary is the Asian manufacturer. The many barriers enacted in recent years against patent holders in order to stop the dreaded “patent troll” have effectively helped American foreign competitors. In every industry, from chips to electronics, American innovators invented the technology but eventually shipped the production offshore. This phenomenon reflects the American strength in innovation, not in manufacturing. Nevertheless, the weak patent regime hurts these innovators and helps foreign rivals.
As American investment in R&D declines, the investment in technology research is increasing dramatically in China. If the trends continue, China will become the largest investor in technology within a decade, particularly in strategic technologies such as semiconductors.
Thus, not only is a weak patent system anticompetitive by enabling the big tech cartel to flourish at the expense of smaller rivals, but the weak patent system benefits our foreign rivals at the expense of American innovators. In other words, the U.S. patent system was sabotaged at precisely the worst possible time that corresponded to the rise of American rivals.
The existence of a weak patent system illustrates key economic challenges. First, incentives to invest in research are diminished when incumbents can infringe with impunity. Incentives to invest in innovation by incumbents themselves are diminished since they calculate it is cheaper to infringe than innovate. Second, the weak patent regime is anticompetitive since patents supply critical tools to innovators in order to protect their investments. The main beneficiaries of a weak patent regime are the incumbents that protect their monopoly profits. Third, with diminished investment in innovation and reduced competition from entrants, there is diminished productivity growth. The productivity growth declines show a clear trend that corresponds to the weakening of the patent system. With reduced productivity, there is slower aggregate economic growth. Therefore, the mechanisms of a weak patent system described in this article clearly explain the economic phenomena of recent years.
Productivity growth declines explain slow aggregate economic growth in recent years. Poor economic growth affects Fed policy on interest rates, supplying little justification to increase interest rates, which perpetuates persistent economic stagnation. If productivity growth declines are caused by diminished technology investments and these declining investments are caused by a weakened patent system, it is clear that we need to address ways to improve the patent system in order to improve technology investment and overall economic performance.
Given these observations, it is recommended that the U.S. ends its ten-year experiment with a weak patent system and restore strong patent rights.
TO BE CONTINUED: Up next will be the final installment of this series, which will discuss prescriptions to restore productivity growth.
 The argument for constrained demand to justify lack of investment is a vicious circle since wages are suppressed by lack of investment and economic growth, with higher wages generating greater demand for goods.
 There is not an incentive for an industry monopolist to invest in innovation at a rate that they may invest if there was industry competition. For example, in the case of microprocessor monopolist Intel, the rate of change of the speed of microprocessors has declined without competition. Since Intel has slowed down Moore’s law due to this lack of competition, they are not providing customers a reason to replace computers. Intel complains about a slowing market for its goods but creates the slowdown itself by not having an incentive to develop better technologies.
 See North, D., Institutional Change and American Economic Growth, 1971.
 There is good news about the U.S. patent system only if you are a Chinese company. While the transformed U.S., patent system makes it much easier for Chinese companies to misappropriate U.S. company technologies by increasing transaction costs for examination and enforcement, the Chinese government is instituting an aggressive twenty year plan to increase scientific funding by 12-20% annually. In 2010, China surpassed Japan in spending on R&D. Over 40% of Chinese university degrees are awarded in STEM fields. In specific technology sectors, China has committed tens of billions of dollars a year for investment, including strategic technologies of semiconductors and communications.
 When China misappropriates technology, Congress considers the problem a national security issue. See the Defend Trade Secrets Act, which passed nearly unanimously. When big tech incumbents misappropriate technology, Congress is paid to look the other way. Congress should be reminded that China is a competitive threat while American innovators are the heroes of the economy.