Patents and contracted research

The two mechanisms for securing innovation that immediately come to mind are patents and contracted research. As we have already explained on this blog (e.g., here), the main drawback of patents is that they impose a monopoly deadweight loss. We have also argued here and here that patents can be diverted from their economic rationale and that such abuses may hinder innovation instead of fostering it. A third potential problem, as we explain here, is that the race to obtain a patent may generate a wasteful duplication of research efforts.

Instead of relying on market forces, governments can choose to fund R&D activities, especially basic research, directly. R&D is either conducted in government laboratories and research centers, or is outsourced to universities or private institutions. The main difficulty with contracted research comes from the moral hazard problems that it raises. As Clancy and Moschini (2013, p. 207) writes:

(…) ultimately the research work is the responsibility of scientists and engineers working either individually or as part of teams. Because research work relies on very specialized knowledge and skills that are heterogeneously distributed, and typically unobservable, and because the production of knowledge is inherently risky, asymmetric information distribution and moral hazard are common in this setting.

Innovation inducement prizes

A third way to secure innovation may be to set up innovation inducement prizes, i.e., ex post rewards for innovations meeting certain prerequisites. As described in a 2009 report by McKinsey and Company, this innovation policy measure is one of the oldest:

Prizes have a long history that includes many examples of award-driven change. For centuries, they were a core instrument of sovereigns, royal societies, and private benefactors alike who sought to solve pressing societal problems and idiosyncratic technical challenges. Famous examples (in addition to the Longitude Prize [established in 1714 by the British Parliament to solve the problem of measuring longitude at sea]) include the Food Preservation Prize—one of several prizes established in Revolutionary and Napoleonic France—designed to help supply the army. The winner established the basic method still in use today for canned foods. Similar awards have been sponsored privately, for instance the Orteig Prize for the first nonstop flight between New York and Paris (claimed by Charles Lindbergh). (…) But in the modern era, as patents and grants have continued to mature, prizes became to some extent peripheral instruments for encouraging innovation.

Yet, the same report shows that today, “prizes are booming once again. Both their value and their absolute numbers have risen sharply.” One well-known example is the H-Prize,which was passed in May 2006 by the US House of Representatives with the objective of overcoming technical challenges related to hydrogen. Modelled after the successful X Prize (which spurred the first privately funded suborbital human spaceflight in 2005), the H-prize offers prizes in three categories: (i) technological advancements (four prizes of up to $1 million awarded biennially in the categories of hydrogen production, storage, distribution and utilization); (ii) prototypes (one prize of up to $4 million awarded biennially that forces working hydrogen vehicle prototypes to meet ambitious performance goals); and (iii) transformational technologies (one grand prize consisting of a $10 million cash award). Another recent example is the £10m Longitude Prize 2014, which focuses on antibiotic resistance.

How do innovation inducement prizes compare to patents and contracted research as an incentive mechanism for innovation? A priori, prizes seem to overcome the main limitations of the other two mechanisms: contrary to patents, prizes do not entail any deadweight loss as no exclusive rights are granted and the innovation is therefore immediately in free access; contrary to government-funded research, prizes do not raise any moral hazard issues as the initiative and the decisions remain with the innovator themselves.

Yet, prizes also have difficulties of their own, or they may not be appropriate for every type of research. This is what I would like you to investigate.

In 2010, the European Commission has revised its rules for the assessment of co-operation agreements between competitors. Some of these so-called “horizontal agreements” have the potential to reduce competition (and thus harm consumers); it is certainly so when the agreements involve price fixing or limiting production; such agreements are clearly prohibited. On the other hand, other types of agreements may promote innovation and competitiveness and should then be facilitated. This is the rationale behind the Block exemption of R&D agreements:

Since cooperation on R&D generally helps to promote the exchange of know-how and technologies, to facilitate technical and economic progress, and to rationalise the manufacture and use of products that benefit consumers among others, this Regulation exempts not only agreements the primary object of which is R&D but also all agreements directly related to and necessary for the implementation of cooperation in R&D, provided that the combined market share of the parties does not exceed 25% of the relevant market.

On the other hand, the Regulation does not apply to agreements that are not indispensable to attaining the positive effects mentioned above.

In 2010, the Commission has extended the scope of this regulation:

With a view to facilitating innovation in Europe, the Commission has considerably extended the scope of the R&D Block Exemption Regulation, which now not only covers R&D activities carried out jointly but also so-called ‘paid-for research’ agreements where one party finances the R&D activities carried out by the other party. In addition, the new Regulation gives parties more scope to jointly exploit the R&D results.

This policy is clearly supported by the economic theory. As I explained it in a previous post (see also Belleflamme and Peitz, 2010, p. 498-99), when comparing different modes of organizing R&D activities among firms active on the same market, the mode that dominates (in terms of propensity for R&D, firms’ profits, consumer surplus, and thus social surplus) is an R&D agreement such that firms not only coordinate their R&D decisions but also share their information completely so as to eliminate duplication of effort.

It must be stressed, however, that this conclusion holds provided that firms act non-cooperatively on the product market. If, on the contrary, cooperation in R&D paves the way for collusive behaviour in the product market, then the block exemption of R&D agreements may not be such a good policy tool. Competition authorities would face a trade-off between enhanced innovation and reduced competition.

It is therefore crucial to assess to which extent R&D agreements may facilitate collusive behaviour. As explained in Belleflamme and Peitz (2010, Case 18.4, p. 502), answering empirically this question is extremely difficult, as it requires one to isolate the impact of the returns to collusion on the decision to join an R&D agreement from the other factors determining this decision.

Sovinsky and Helland (2012) have found a clever way around this difficulty. They exploit the variation in Research Joint Ventures (RJV) formation generated by a quasi-experiment that affects the collusive benefits of an RJV while not directly affecting the research synergies associated with that venture. Their identification strategy is simple: if product market collusion is not a motivation to form an RJV then, after controlling for firm, RJV and industry characteristics, the propensity to enter into an RJV should not be impacted by changes in the antitrust policy aimed at deterring collusion in the final goods market.

The change in antitrust policy that the authors consider took place in 1993 in the US: at that date, the revision of the so-called ‘leniency policy program’ made it more attractive for cartel members to report illegal behaviour, thereby making collusion harder to sustain. The authors apply their analysis to three industries: petroleum manufacturing, computer and electronic product manufacturing, and telecommunications. These industries share two characteristics: RJV participation is very high and there is a history of antitrust suits.

The results drawn from their econometric analysis suggest that R&D cooperation can indeed be seen as a steppingstone to collusion:

We find that the decision to join a RJV is impacted by the policy change and that this impact is very significant across relevant market definitions. Specifically, we find that the revised leniency policy reduces the average probability that telecom firms join a given RJV by 34%; the reduction among computer and semiconductor manufacturers is 33%; and among firms in petroleum refining the probability decreases by 27%: Our results are consistent with RJVs serving (at least in part) a collusive function.

In view of these results, which policy should competition authorities follow? Was it really a good idea to extend the scope of the R&D block exemption in the EU? Are there other remedies to this problem? I’d be happy to hear your views about that issue.

R&D cooperation across firms is often celebrated as it allows firms to better manage the R&D process by pooling risks, sharing costs, eliminating useless duplication of efforts, pooling complementary skills, or exploiting economies of scale. However, a recent publication by Bernard T. Ferrari and Jessica Goethals from McKinsey&Company advocates instead the use of rivalry to spur innovation: according to the authors,

“Productive rivalry stimulated artistic innovation during the Renaissance, and according to the director of General Electric’s Global Research Group, it also has helped his company develop better products and services.”