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?"
Katonomics 7: Trade Secrecy and Economics Katonomics 7: Trade Secrecy and Economics Reviewed by Jeremy on Tuesday, January 10, 2012 Rating: 5


  1. I think that the protection of trade secrets must be more serious and mostly more clear as a concept. The legislation in the world on this matter is different. Sometimes the protection of trade secrets at the international level is extremely complex.
    I think there should be a trade secret management that carefully consider what should be protected by trade secret. Management is particularly important here, random decisions can lead to undesired results. There should also exist an assessment of the risk of trade secret protection.

  2. Great series of IP and economics, thanks. I would like say something: trade secrets may help avoid the inefficient effects of patent races.
    I remember reading Freidman some time ago (Law’s Order). More or less, I think he suggested that to the extent patent races/strategies may encourage inefficiently early disclosure, trade secrets could – at least where costs of a given field of technology (re. the invention) are falling, provide a better economics-viewed option. The gist is that applying for a patentable invention sooner rather than later makes commercial sense. But that strategy, on a wide scale, may mean many inventions are not quite ‘ready’ for protection. In contrast, trade secrets do not need disclosure and first-to-file credentials to exist. They just exist, and on this basis, perhaps only intuitively, are more likely to be optimally developed technologies at ‘the right time’. There is still a race aspect, first-to-market etc., but the stakes are different: fighting for part of the non-exclusive space in the market. And the evidence in the post indicates trade secrets may be more popular than we might imagine. I wonder if this description has any explanatory force.
    And in terms of incentives and changing “rational” behaviour for the better, I'm thinking here not only about global welfare, but also for the private incentives and interest of start-ups and SMEs that may be poorly placed to race for a patent. We are often told of the SME role in assisting with innovation. Perhaps trade secrets – despite their drawbacks, can provide serious competition to ‘proprietary-based’ technical solutions. The drinks ingredients/formulas are all well and good, but I’m thinking more about genuine technological advances that have constructive application.
    Any thoughts?

  3. > should more countries increase trade secrecy protection?

    How? By offereing hacking-proof physical and digital vaults for depositing trade secrets?

    A trade secret is only effective as long as it is kept secret. The government cannot take that responsibility. Governments can only enforce law, award damages to be paid and put people in jail. But only once trade secrets are already disclosed - voiding the value of the information being secret.

    Defining higher penalties? And how to apprehend that Anonymous (deliberate use of capital A, yes) person that cannot be tracked, having disclosed that secret recipy of Slugworth?

    By keeping information secret, companies - or governments - deliberatly take the risk of the information ending up in the streets. They can decrease the risk to virtualy zero, but the risk will always be there (because we do not put people away for life anymore with iron masks).

    In my home country, the last time the article defining tort it was following a ground breaking decision by our highest court defining that breach of a trade secret is tort and that damages are to be compensated. That should be enough - from the government side.

    Companies - and institutions - having trade secrets should just properly protect them instead of having USB stick lying around in rental cars, using outdated software for their firewalls and not properly monitoring data usage by employees.

    Or just apply for an enforceable patent - if possible.

  4. A fourth reason for using trade secrets which is not considered in the Friedman, Landes and Posner article, is where an invention is clearly patentable, but unenforceable.

    When I was in industrial practice, this was the usual reason for relying on trade secrets. A typical situation was where the process by which an article had been manufactured was not apparent from inspection of the article, and the inventive process did not involve the use of any special equipment or substances that might draw attention to the use of the method.

  5. The law does not protect trade secrets as such. Much of this commentary suggests that trade secrets come into existence a bit like copyright. They don't. You have to lock you secrets away you have to have some way of making it clear what you don't want anyone else to disclose. Whis can be quite a problem, especially for start-ups. When you try and define your trade secret for the purpose of your know-how licensing, you generally find that it isn't there or, like the reggae reggae sauce recipe has somehow lost its definition. Therefore, it's not surprising that the economic issues of trade secrets are quite different from property rights. Confidentiality is about relationships between people individuals and is more akin to contract than property law. The fact that you can keep a secret forever is in some ways detrimental to the advancement of knowledge within society and therefore excessive protection could well be, like copyright law, an inhibition on entrepreneurship. Be very wary of codifying trade secret law.

  6. The piece seems to focus on trade secrets as secret formulations,
    processes and the like. i.e. easily understood, well-defined and non-controversial species of information that are unlikely to prove a significant or controversial part of a court's deliberations as to whether that species is protectable at all as a trade secret or not.

    However, my thesis is that the internal secrecy under which the totality of day-to-day discourse within a business is, rather than "gold nugget" trade secrets, is also crucial. i.e. secrecy in modus operandi matters at least as much as well-delineated knowledge chunks. One's working environment is an all-pervasive "ether" of secrecy across which business discourse is conducted. Org charts, casual mail messages, hand-written notes on scribble pads, voice mail messages etc. are all the stuff of the ether. So how does one put a $$$ value on all that?

  7. Anonymouse makes a good point and one that I think is lost when trade secrets are viewed solely as an alternative to patents. Trade secrets encompass a much broader range of innovation/information than do patents. Bid information, customer lists etc. can all be considered trade secrets.

    As for putting $$$ on that, well, that is for another post ...

  8. @Filemot. You caution against strengthening the law such that trade secrets can become perpetual, and contrast this with copyright protection. I suggest a comparison with trade marks would be more apposite, since if they are well managed, they can also become perpetual.
    But surely there is very little detriment to society if a trade secret remains just that. For example despite Coca Cola's famous secret recipe we have Pepsi and many other colas which can fairly co-exist and compete, which is surely in the consumer's interest. What value is there in having two companies producing exactly the same drink?
    The point about copyright is that generally speaking it was created to protect the arts rather than goods (cf Lucasfilm) and in many instances society is enriched by the transfer to the public domain of the original work. With the current copyright terms, I suggest that that is not being acheived, but that's a separate argument. Returning to the enrichment proposition, Glyn Moody over on Techdirt makes the point that jazz music as we know it probably would not exist today if its pioneers had not freely used each other's musical ideas. Compare that to today when sampling can often lead to major litigation.
    Apologies to Nicola for going slightly off topic.

  9. I am surprised nobody has yet made the link between trade secret and know-how in the technical field. You make contracts concerning the dissemination of know-how, and they frequently have clauses stipulating how this know-how is returned when the contract ends. The best type of clauses are those that stipulate the responsibility of the receiver to monitor the internal distribution and to request confidentiality undertakings on the part of the individuals receiving the know-how. This way you may assign blame if a leak occurs. If you are prudent, there is also a clause defining a severe consequence.

    In this scenario, a trade secret is something you would never make an item of a contract, because of the very much increased risk of it losing its secrecy. Hence, it is a limit case of know-how.

    Kind regards,

    George Brock-Nannestad

  10. Globalisation has made the use of patents v trade secret protection more important. The world of Willy Wonka style factories where only a handful of trusted employers have access to the trae secrets (or know how) are diminishing rapidly. Outsourcig of manufacture to lower-cost countries is now the mainstay of global businesses (and the downful of the economies where those products are eventually sold).

    India and China are not renowned for their respect for IP. Keeping information confidential in India is not the way they traditionally do things as they have a culture of sharing information. A Chinese factory that by day produces your product for you, may be night be producing the counterfeit versions.

    If you can keep trade secrets in today's world then you are a better man than me!

    I must admit to being amused by the comment: "One argument is that the intellectual property regime, by acknowledging innovators’ right to disclose, implicitly recognises the right not to disclose."

    For all those millenia, long before the invention of the wheel, inovators have been forced to publish their secrets for no return until the great patent system was born in Venice?

  11. @Anonymous 12:29 and anybody else who is as interested as I in Dr. Searle's series:

    --- it was a rare insight on the part of the Venetian city council that they did not have to spend any money on innovation themselves, but they could let the general public pay the only source for a particular innovation directly, when the general public wanted to get what the city council had got (clean water, was it?). The much touted "social contract" was in fact no more than a successful attempt to let others pay for the development that you wanted. And because you were in power, you could grant a monopoly. And because you did not want to appear greedy, you made it time-limited. It is very similar to the subscription-based publishing of books. Or the "Society" issues of gramophone records, devised by Walter Legge for HMV ca. 1930.

    George Brock-Nannestad


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