Katonomics 7: Trade Secrecy and Economics

Essential reading for
all IP economists

The IPKat is delighted to welcome this first post in the second series of Katonomics, hand-crafted by the IPKat weblog's resident Katonomite, Dr Nicola Searle. in a cunning attempt to introduce intellectual property enthusiasts and scholars to the murky world of economics.  Nicola's subject this week is one on which this Kat freely confesses he has never read anything even remotely economics-oriented: trade secrecy. To discover the secrets of this subject which Nicola boldly shares with us, read on:

"Trade Secrecy and Economics 

Continuing with some recent IPKat coverage of trade secrets (here and here), this post looks at the economics of trade secrets. 

Roald Dahl’s Charlie and the Chocolate Factory combines two fabulous topics: chocolate and trade secrets. The story was reportedly inspired by the 1920s industrial espionage between Cadburys and Rowntree. Throughout the novel, Willy Wonka, the owner of the Chocolate Factory, protects his innovations with trade secrets (for more on trade secrets in confectionery, see Fromer’s analysis). Wonka’s use of trade secrets hints at the strategic advantages trade secrets offer.

Trade secrets are not universally acknowledged as intellectual property. They are also a bit tricky to fit into social contract theory, as they lack the necessary public domain element. One argument is that the intellectual property regime, by acknowledging innovators’ right to disclose, implicitly recognises the right not to disclose. Further, the protection trade secrecy offers is relatively weak which, in the context of the social contract, means that the lower payoff to society comes with lower payoffs to innovators. 

Trade secrets are often framed in contrast to patents. In some ways, trade secrets are the antithesis of patents – they require no formal registration and no disclosure. In other ways, trade secrets are a perfect complement to patents – they pick up where patents leave off. 

A lot of attention in the economic analysis of trade secrets focuses on the decision to use trade secrets. The Coca-Cola formula, or in bonny Scotland, the Irn-Bru formula, are classic examples. Both formulas were created in the late 19th century. Had the inventors used patents, the formulas would have become part of the public domain years ago. Instead, trade secrecy was chosen as the means of protection, and the owners enjoy potentially never-ending protection and a nice marketing tool. 

An excellent primer on the economics of trade secrets is the Friedman, Landes and Posner article. They argue that firms choose trade secrets over patents in three main cases. First, if the cost/benefit of the trade secret is greater than a patent. As patent protection may cost more than trade secrecy, the benefits should outweigh the costs. Second, if the trade secret is likely to outlive the length of a patent term. Third, if the trade secret is non-patentable but still valuable. Additionally, analysis predicts that trade secrets are more effective for process innovations than product innovations. The argument is that product innovation is easier to reverse engineer, and thus patent protection may be more appropriate. 

Surprising insights into the use of trade secrets came in 2000 when Cohen, Nelson and Walsh’s empirical research showed that firms increasingly rely on secrecy to protect innovations. Going against conventional wisdom that patents are the golden ticket, their research suggests that trade secrecy, lead-time and complementary capabilities are more important to appropriate the returns from innovation. 

Economic models also predict reliance on the use of trade secrets, depending strength of IP enforcement and competitor’s ability to imitate the innovation. The idea of little patents and big secrets (Anton and Yao’s work) argues that, in the face of weak IP regimes and strong imitation, smaller innovations are patented and big innovations are protected by trade secrets. French researchers Encaoua and Lefouili, also support this argument.

Policy interest in trade secrets is likely to increase. With the digital era, trade secrets have become more vulnerable to theft. Theft may be as easy as sending an email or accessing wifi. Trade secret policy may also negatively impact labour mobility as employers use accusations of misappropriation of trade secrecy to restrict employees from working for competitors. 

In the U.S., concerns over theft, particularly by foreign entities, resulted in the 1996 Economic Espionage Act. This act elevated the theft of trade secrets to a felony. The act is controversial amongst researchers as it broadens the definition of trade secrets, elevates a civil malfeasance to a criminal act and has extraterritorial applications(for details, see here and here. However, it seems popular with politicians, as the U.S. is debating an enhancement of its penalties . (should you feel inclined to read more, check out my thesis. I recommend reading it with chocolate covered coffee beans).

Another concern is that of uncertainty. As noted in Friday’s IPKat post, there are a lot of ill-defined areas in trade secrecy. Even the existence of a trade secret may not be recognised until it is disputed. Valuation of trade secrets is tricky as market comparisons are also secrets. Enforcement efforts risk the exposure, hence loss, of the trade secret. This suggests trade secrets incorporate a lot of uncertainty for owners, which, from a policy perspective, translates to weakened incentives to innovate. 

Willy Wonka went as far as employing only Oompa-Loompas to protect his trade secrets. However, he might not fare as well in today’s era of digital storage. So, my question to readers is, should more countries increase trade secrecy protection? Or should we deploy trade secret toffee so thieves are left with sticky fingers?"