Katonomics 1: An Economic Perspective on IP: The Social Contract Theory of IP

Looking attentive in Economics classes
was the easy bit. The big problem was
remembering all those funny terms ...
Who or what is Katonomics? There is no science of that name as yet, but it's the title of the promised mini-series on IP economics for IPKat readers -- the vast majority are either not economists or don't think they like them very much, perhaps having been bitten by one at a tender age or, more likely, having found that, while economists talk about their beloved IP rights in cold, abstract terms, governments and policy-makers tend to pay more attention to those of us who are happier dealing with actual events like licensing our friends and suing our foes.

This weblog is proud to welcome its own Katonomist, Nicola Searle, who has kindly agreed to give of her time and effort in order to bring the economics of IP to lawyers in a clear, intelligible, friendly manner by providing the IPKat and his friends with a short series of Katonomics articles. The first installment in the Katonomics series tackles something that even IP lawyers who aren't too focused on economics have some familiarity with: social contract theory.  Let Nicola Searle take it from here:
"An Economic Perspective on IP: The Social Contract Theory of IP 
For the first in this series in economics of IP, I thought I would start by looking at a key economic approach to IP.  Economists look at the IP system and ask “why”?  Why would you have a system that rewards rights holders with monopolies?  Why does the state regulate private transactions?  Why do we spend so much money on a system that appears to benefit the few at the expense of the many?  Yes, these are the questions that keep economists awake at night. 
The short answer to these questions is innovation.  From an economic perspective, innovation contributes to growth and increases the overall welfare of economies (e.g. better medicines, more efficient cars, improved cultural experiences). In order to have long-term, continued innovation, there must be incentives for innovators (for more on this topic, I highly recommend Suzanne Scotchmer’s book Innovation and Incentives). For IP, the incentive created is the legal monopoly created by exclusive rights.  The legal monopoly allows innovators the means to capture the financial rewards of their innovation. 
A popular theory that furthers this incentives-to-innovate concept is the social contract theory (also known as contract theory).  Social contract theory argues that IP is a contract between society and innovators.   Society recognises that innovation is socially beneficial and that the knowledge underlying innovation is intangible.  Given that the knowledge is intangible, innovators may have difficulty capturing the rewards from innovation.  Without rewards, innovators may stop innovating and society loses out. The solution to reward innovators is the IP system. 
"Monopoly? I distinctly heard
you say 'temporary monogamy'..."
However, the IP system is not without costs.   Society grants the innovator a temporary monopoly via exclusive rights.  This temporary monopoly means that the innovation will be sold at lower quantities and higher prices than if there were no monopoly.  This is a cost to society that translates into a benefit for innovators who earn more from their innovation.  Running the IP system is also not without costs as administering and enforcing rights can be expensive (indeed, costs were cited in two of the four points of investigation for the Hargreaves review). In return for these costs to society, the innovator eventually turns the innovation over to the public domain. Once in the public domain, the innovation is no longer constrained by exclusive rights and may be freely used to develop further innovations. 
The underlying concept is that the short-term inefficiency of the monopoly created by IP is tolerated in order to achieve the long-term efficiency of continued innovation.  Therein lies the social contract: a contract between society and innovators in which innovators reap the rewards to innovation and society benefits from continued innovation.  
Social contract theory differs significantly from other theories of IP including that of the labour-deserve theory (or labour theory of acquisition).  Labour-deserve theory argues that an individual has rights over the fruits of their labour.  For example, I have natural rights over this blog post because I have applied my labour to write it.  To generalise, labour-deserve theory begins with the individual, while social contract theory begins with society.  They both come to the same conclusion: that the IP system should exist.  However, the two theories get there in different ways. 
The IPKat fondly recalls
the days before the current
Eurozone crisis, when
nations still had wealth ...
These are not new concepts.  John Locke looked at labour-deserve theory in the 1700s (Chapter 5 of his second book).  At the same time, Adam Smith argued for property rights as a means of increasing efficiency (see An Inquiry into the Nature and Causes of the Wealth of Nations).  Their contemporary, Johann Gottlieb Fichte, also recognised the tensions between the fairness of rewarding innovation and the social benefits of innovation (see Proof of the Illegality of Reprinting: a Rationale and a Parable).  Debate between these theories is also not new and has erupted many times over the years (for a good discussion cataloguing the historical debates, see Christine MacLeod here).  Modern analysis of IP and social contract theory can be found in a number of papers including those of Landes and PosnerDenicolo and Franzoni and Lemley.  
The debate over copyright term extension is a good example of how social contract theory and other theories can clash.  Under social contract theory, increasing the rewards to an existing innovation represents a violation of the contract.  The innovator and society entered a contract at the time of the publication of the copyright-protected work; later changes to this contract break this agreement.  
  Amendments also fail to provide incentives to innovate: how does extending the term of protection now encourage innovation occurring 50 years ago?  For supporters of labour-deserve theory, term extension is less problematic.  Innovators still deserve to benefit from the fruits of their labour and to receive a “just reward”.  If these fruits are still culturally and economically relevant, why shouldn’t innovators still benefit from their efforts? 
And here, I leave you to contemplate the relative merits of social contract theory with my question of the week: Is IP a social contract or an inherent individual right? Do economists really lose sleep over innovation? Comments on a postcard.  Or in the handy box below".
Okay, readers: you've had your first lesson. What do you think?
Katonomics 1: An Economic Perspective on IP: The Social Contract Theory of IP Katonomics 1: An Economic Perspective on IP: The Social Contract Theory of IP Reviewed by Jeremy on Monday, November 07, 2011 Rating: 5


  1. It seems easy enough to find economic studies that suggest the absence of correlation let alone causality regarding the hypothesis that patents promote innovation

    Bessen & Meurer, August 2008, “Do patents perform like property?” Academy of Management Perspectives, pp. 8-20.

    discussed here http://keithsawyer.wordpress.com/2008/10/31/do-patents-increase-innovation/

    and another http://rufuspollock.org/economics/papers/patents_and_ir.html

    Moreover, given the dubious origins of royal favours and letters patent, let's not get too worked up about individual rights.

    Moving on, in a sort of mad inventor spends twenty years, money and material in designing, prototyping and manufacturing some perpetual motion machine kind of way, qualitatively, I can see that if I buy one, then the costs of all that mad invention, time and material plus a rate of return are amortised in a small fee attached to an excludable good. Sufficiently fair enough for me to stop posting here (you wish...)

    However when a company can get a patent for a metaphor, and here I'm thinking the sliding lock on school toilet doors that have existed prior to when I was knee high to a mad inventor's perpetual motion machine, (yes, that will be Apple and yet another software patent) then we seem to be adrift from any concept of innovation.

    According to Gladwell http://www.newyorker.com/reporting/2011/11/14/111114fa_fact_gladwell it was all about tweaking, (hardware) “micro inventions necessary to make macro inventions highly productive and remunerative.”

    On software I am indebted to him for reminding me about this exchange (on Jobs claiming that Gates had stolen Apple's ideas for a WIMP interface):

    “Well, Steve,” Gates responded. “I think there’s more than one way of looking at it. I think it’s more like we both had this rich neighbour named Xerox and I broke into his house to steal the TV set and found out that you had already stolen it.”

  2. Looking forward to more of these posts. Perhaps one will revisit how trade marks fit into the social contract theory, since their costs to society are not balanced by inevitable release into the public domain. Do I hear the "trade marks encourage innovation" debate getting started again?!

  3. If I may respond more abstractly and take issue with the underlying dichotomy.

    It seems to me that a reasonable top-level distinction in theories of IP might start with a split between deontological and consequentialist ethical theories. The labour-deserve theory is then deontological in nature - the right to the fruits of our labour is inherently "just so". The social contract theory has a strong consequentialist element since policy is guided by the social good generated by a particular policy which is traded for the IP right at the time of creation.

    But the social contract theory is also founded on a prior notion of contract. Attitudes to contract rights will then condition attitudes to IP rights so derived. Eg Thomas Jefferson's view that only a majority could bind society to such a contract, so that the copyright term could be computer from actuarial data (see his letter to Madison September 6,

    So I'd like to offer an alternative which doesn't fit either of these descriptions. In my view Thomas Acquina's view on property rights (in the Summa, part 2 Q66) comes closest to the best early expression of my view.

    Acquinas analyses property rights as the product of human (not natural law). It is human law that decides how to distribute property ownership among people. The motivation for this division is partly an expression of the anachronistically named "tragedy of the commons" -- individuals will more efficiently exploit property they own than if property is held in common. To him, property ownership has a moral dimension. He anticipates (in objection 2) an argument that there is something inherently wrong about a rich person appropriating common property to their own use by pointing out that they would be sinning if they excluded others from it entirely.

    It seems to me that what is going on here is a view of property as a form of *regulation* rather than contract or inherent right. We (society, the law) grant property rights as a way of ordering the use and exploitation of the property over which the rights are exercised. And we do so for the common good.

    A regulatory theory of IP permits term extension but also term reduction. Rights which have been created for a purpose may be taken away for that same purpose.

    English law is not entirely hostile to such an idea. This kind of conduct is inherent in the regulatory approach taken by the legislature to ownership of land for at least a century. The deal can be changed for good reason (see in particular the House of Lords in Spath Holme Ltd).

    William Patry's (rather American) characterisation of copyright as a "government program" seems to me spot on and very much in this (regulatory theory) line of argument rather than contract or behaviour-deserve theory.

    Now every theory of IP will be interested in the economic effects of IP. I'm obviously interested because that's all (I believe) there should be to IP. A contract theorist will have to factor in their own theory of the social contract as well and anyone with a deontological view (which are essentially impossible to argue with) will only care when the law balances up inherent rights (such as free speech v property rights) and then in so far as rights (rather than monetary values) are being compared.

    Rather amusingly the Digital Economy Act 2010 requires initial obligations code notifications to include a statement about copyright "and its purpose". Good luck with that.

  4. First of all, it's a great article and great question.

    I believe that when we talk about intellectual property, we talk about a certain kind of social contract. Undoubtedly, each of us has individual rights, but modern intellectual property is more than usual individual right.
    For example, innovations has always existed in human history. People create innovations for millennia.
    But before the Industrial Revolution these innovations were not so powerful generator for creating new innovations. This was because the creators of these innovations did not have intellectual property rights as these today.
    After the emergence of intellectual property rights, innovators were been guaranteed by the society that when they create something new, they are going to benefit from it.
    This is one of the reasons for the rapid technology development over the past 200 years compared with developments in previous centuries.
    Nowadays a good example of this development is technology communications . These technologies are developing very quickly. 20-30 years ago, nobody could imagine a situation in which we will use tablets or smart phone as thin as a ordinary magazine.
    So I think that intellectual property is a kind of social contract with society which provides an incentive for future development.
    Naturally, it is only the base. On this basis, however, various new issues are emerged, such as the constant struggle between the owners of intellectual property rights and the society. Owners want to take advantage of these rights as long as possible to generate more and more profits, while the position of society is on the other pole.

  5. IP rights are absolutley essential to promote much important innovation and if economic anlyses are struggling to come to that conclusion then that tells us all we need to know about the importnace of economists.

    Innovation will, of course, continue without the grant of govt monopoly rights but I can give one obvious and importnat example where it will not: Pharmaceuticals.

    Now, many will say that new pharmaceuticals will be developed in the absence of the current major pharma who rely so much on IP and that it is govt funded research that is responsible for most current drugs. No-one would disagree about the contribution made to science research that underpins the pharmaceutical companies' own work, but that does not mean that without the investment of big pharma that new drugs would still come to market.

    The economic analysis is really quite simple. A project team has a good idea and some exciting compounds. They ask their big pharma employer for funding for the next stage. The patent attorney provides their report on potential exclusivity which states that the compounds are not patentable due to a recent journal disclosure (by whom and when is only relevant to the US grace period).

    The attorney advice is that funding should not be provided for further work in this area because the company will not be able to obtain sufficient exclusivity in order to make a return on their investment. The attorney considered the significant benefits of data exclusivity, but as this would only kick in 10 years down the line, there was no interim protection for the company's IP. The money will be spent on a project where patent exclusivity can be obtained.

    Whether everyone wants to disagree with the reasoning for the project being dropped, the fact remains that this is what happens in practice on a daily basis. No exclusivity = no funding = no product.

  6. In the absence of patent protection there would be major changes to the pharma industry. However, it is unlikely that all new drug development would stop. More interestingly, is whether overall health and the economy would be improved or harmed.

    Research and development of new drugs would likely be reduced, and only partially redirected to other areas. For example natural products and traditional medicines, which might be difficult to obtain a patent on currently, but could offer long term profits if properly standardized and branded.

    Pharma also benefits from confidentiality laws in many countries and this could easily be expanded on (ex. don't require public disclosure of trade-secrets and regulatory tests, or alternatively don't allow competitor use for a given period of time).

    There is also the issue of the billions currently spent by government and consumers on patented drugs. In the absence of patent protection this money could be reallocated towards other health objectives.

  7. Interesting article and I look forward to more.

    I am not sure the short answer is appropriate to explain trade mark law, which does not protect innovation. A trade mark does however act as a contract with society: in exchange for a right to prevent third parties from using this sign granted by society, the owner is obliged to ensure it indicates origin. As soon as it fails to do so, the contract is broken and the right is lost.

    More holistically, this ensures successful brands can be identified repeatedly and succeed in commerce. This does not encourage innovation as such but is beneficial for consumers, for example knowing who to sue when things go wrong.

  8. While the inventor’s temporary monopoly can sometimes mean that “the innovation will be sold at lower quantities and higher prices than if there were no monopoly”, this is not necessarily a wholly bad thing. A lesson from the early days of the electric lighting industry is to compare the way in which the patents for the carbon and tungsten lamps were utilised by their respective exclusive licensees, and the negative consequences of a new invention being made available with no restrictions on its exploitation to provide quality control.

    Swan spent an awful lot of time and money in defending and enforcing Edison’s Carbon Filament Lamp patents against third parties, and, while he was ultimately successful, litigation costs meant that the company made no profit until 1887, by which time the patents only had 6 years left to run. Swan decided to retain exclusive manufacturing rights to obtain economy of mass production. However, this meant that, during those 6 years, UK consumers were unable to benefit from improved designs of higher luminous efficiency.

    At least UK customers were guaranteed lamps of good quality while the licensee had control of manufacture: in continental Europe, where Edison’s patents were either not granted or unenforceable, a situation developed where free-for-all competition and price cutting had lead to poor quality lamps of short life. While lack of protection certainly resulted in the availablilty of large quantities of cheap lamps, the customer didn't really benefit as they burned out quickly. Good quality lamps only became available when the manufacturers got together and formed a lamp cartel to fix minimum prices.

    Conversely, when GEC acquired the UK rights to the Tungsten Filament Lamp, they had clearly learned from Swan’s experiences and freely granted licences to their competitors on reasonable terms. This not only brought in significant royalties and an increased profit margin on their own lamps [sold at the same retail price as their licensees’], but also avoided the expense of litigation and the considerable capital outlay in new plant that would have been necessary had they sought to meet the huge demand for the new lamps themselves.

  9. A fascinating article, and I look forward to reading more.

    I find the labour-deserve theory deeply flawed as a justification for our current system. If we apply labour-deserve to a situation where 2 companies have been working on a particular idea, and one files a patent a day before another, labour-deserve surely implies that both their efforts should be rewarded equally, rather than the spoils going to the first to file? Labour-deserve also implies ruling out assignment of rights, since the reward may not go to the labourer.

    I think it might be possible to justify an IP system starting with labour-deserve, but not necessarily one that looks anything like the system we have today.

  10. I don't think Anon at 1:36pm has any understanding of the pharma industry or the benefits provided in the past 40 years by the medicines developed. To suggest we may be better off without this industry is absolutely ridiculous.

    Q:What traditional medicines which have been proven to work?
    Q: What confidentiality law will protect a pharmaceutical from being reverse-engineered?
    Q: What regulatory tests are to remain confidential?
    Q, Q, Q????

    Re-allocation of funds towards burial pits is the most-likely scenario.

  11. Society needs treatments for illnesses, including pharmaceuticals. The worse you are, the more you will accept medical treatment that has doubtful (but still hopeful) outcome.

    Pharmaceuticals have a larger or smaller effect on the illness, and they have larger or smaller side effects. In order that doctors can responsibly prescribe these pharmaceuticals, both types of effect have to be identified and documented.

    At present this research is largely done by pharmaceutical companies who spend time and publicly regulated efforts on documenting these things in novel (and hopefully inventive) substances or novel uses of known substances (or novel and not-so-novel methods of dissolving them in the stomach). Documentation takes a long time, and until you can sell the pharmaceutical, no money at all is coming in - the company has invested. For this reason a time-limited possibility to prevent others from reaping the benefits of the invention will ensure that the industry capitalises on its investment.

    This has the negative effect that substances or uses that cannot be patented will not be researched, because the investment is not protected.

    That is not a problem for society, because we have research departments in universities who can perform this research and create pharmaceuticals that are well-documented. The only problem is that it is costly. It does not cost more to do for universities than it does for a pharmaceutical company. And the population base for comparative studies is the same. Since it is to a large degree society that pays for both publicly funded universities and the pharmaceuticals that are sold by the industry, it must be a reasonably simple economic exercise to determine where you get the most for your money. The only problem is that the money has to come from different money-bags in the national budget. Another problem is that modern parliamentary society has a shorter time-horizon than a pharmaceutical company. They can wait for ten years until the investment pays off – modern politicians cannot wait for two years.

    A third problem is the enormously efficient lobby of the pharmaceutical companies, taking patient associations as their hostage. As long as society cannot guarantee treatments created in universities, worried parents are the best advocates for convincing national as well as European Parliament politicians that pharmaceutical companies are best.

    We obviously live in the best of possible worlds, stressing 'possible'.

    George Brock-Nannestad

  12. The current system of funding pharmaceutical research through the grant of patent monopolies has one major drawback that rarely gets mentioned. The subject of research is inevitably chosen for it's potential value to the company, not it's potential value to society. Assuming that value to society and value to the company are interchangeable is sorely tempting, but they are clearly not. Imagine you are the a member of the board of a pharmaceutical company, faced with two research projects, which would require equal funding, and stand equal chances of succeeding. You can only afford to fund one. Your choices are a cure for male pattern baldness, which will cost £20,000 per treatment, or a new anti-malarial drug that will reduce the treatment cost for patients in sub-saharan africa to just pennies. Which does your legal resonsibility to your shareholders force you to choose?

    The Pirate Party's solution is to have the research done by the drug companies, just as it is now, but instead of funding it indirectly through the allocation of monopolies, to fund it directly. This means the funds can be allocated on the merits of current research, not on the sale price of the results of the last 20 years research, that manufacturing will be done more efficiently since competition isn't just restricted to drugs out of patent, and that research can be directed at issues that are less profitable, but more likely to save lives.

  13. Andrew, your drawback down't exist. It is correct to say that pharma compnaies invest in treatments that will provide a return, however, this does not exclude yourself or others from spending your time and money seeking treatments for diseases such as malaria.

    You may as well say that the problem with Mother Teresa was that while she was looking after the poor in India, she wasn't looking after the poor in Africa This is not any attempt to compare the actions of any company with Mother Teresa, but to point out that as long as anyone is doing their bit that provides a benefit to society, it is wrong to unjustly find fault for what they do not do.

    George, you are also way off in your fault-finding. "taking hostage of patient groups"!!! Twadle and nonsense.

    Regarding your funding comment that payment basically all comes from the same pot, just taking different routes. This is an interesting point, but could only be considered if the global economy was controlled by a single government, otherwise you'd have the UK taxpayer, for example, paying for the development of medicines for 6 billion people. The economics wouldn't quite work unless the UK govt was a pharmaceutical company operating to make a financial return on its investment.

    As for currently marketed drugs, it is the financial clout nd experience of big pharma that is responsible for bring the majority of drugs to market, even those originating in some way (large or small) from universities.

    The pharmaceutical companies cannot and will not be replaced by university research so the recent demise of pharma R&D is is no-one's interest.

  14. Anonymous, me draback does exist, because I (and everyone lese in the uk) already spend their money on drug research - we fund whatever the pharmaceutical industry decides to research through the long-winded route of taxation going to the NHS monopoly, which goes to the drug companies by virtue of their drug patent monopolies. I see nothing wrong in directing that research based on medical needs rather than commercial gain. I'm not criticising the drug companies for what they are effectively forced to do by their legal responsibilities to their shareholders, or suggesting that their research funding be reduced, or that the research should be done elsewhere, I'm simply pointing out that the method of selecting their priorities imposed by the patent system isn't ideal.

  15. Andrew, you forget that you (and other UK taxpayers) insist on funding research only into those areas where there is a large market in the UK, because the NHS only pays for drugs to treat the ills of the UK citizen. Even for many other UK-suffered diseases, the NHS refuses to pay for the drugs, and hence the research, by virtue of the extra requirements of NICE (possibly having some contribution to the demise of UK pharma research - companies like to spend their money in countries that buy their products). The UK taxpayer isn't a substantial funder of pharma research either. That honour rests with the Americans via their medical insurance.

    If you can persuade your MP to persuade the govt to agree to an increases in drug re-imbursement, of 10%, say, then we can insist that the extra money goes directly to research treatments for diseases badly affecting the poorest couintries of the world. We can all also save the lives of millions, not by spending extra money on these diseases, but simply providing the treatments already available at insignificant cost to save te lies of those suffering from diarrhoea etc.

  16. Fellow commenters, we are falling off the cliff now (who wants to go to "older posts" in this day and age?)


  17. At last, something I agree with George on. Let the active posts survive!

  18. This comment has been removed by a blog administrator.

  19. This was a surprisingly interesting comments section and article. I wouldn't believe I could learn this much from a blog I just stumbled on but in a few minutes, I have learnt about the ethics, economics and mechanisms of IPs.
    Of course, I am aware I know very little about the topic but my curiosity is piqued. I will appreciate any book recommendations for further reading.
    Thanks to the authors for sharing this and the commenters for their interesting contributions.


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