Katonomics 15: the economics of IP litigation

IP litigation -- just
an application of
game theory?

Here's the second post in the third series of Katonomics from the Kats' treasured friend and colleague Doctor Nicola Searle.  Katonomics is the Kat's IP-friendly version of economics, which the dedicated members of this blog team bring to you, sparing literally no expense. The idea is that economics, which almost exclusively drives IP these days, should be demystified and made more accessible to the IP community. If you don't believe that this can be done, or done well, you can check out the details of the two earlier series here and last week's gem on design right here. 

This week Nicola has chosen intellectual property litigation as her topic for analysis.  Ready for some fascinating revelations?  You should be! She writes:

"Like medical malpractice suits, IP litigation theoretically serves to keep practitioners in check and test the system. Side effects may occur. An argument in favour of a European unified patent system is that it reduces litigation costs. The expense of IP litigation, the perception that the use of litigious threats is increasing (e.g. ACS Law) and the rising role of tr... ehm, non-practising entities (NPEs) means that the role of litigation in IP merits examination.

For economics, litigation offers two main areas of analysis: policy and firm strategy. As a policy tool, litigation is a means to adjust IP strength. For example, a national office could choose to grant all patent applications and allow litigation to determine the validity of a patent. Or, the office could grant only the most innovative patents and have no litigation over validity. In reality, we have a balance between these two scenarios where IPR are granted above a certain level of innovation and the court system clarifies disputed rights. However, this system may not benefit everyone and small firms, in particular, are disadvantaged.

IPKat readers should enjoy this quote by Suzanne Scotchmer in her book, “One of the things that economists have difficulty explaining is why disputes ever reach the courts.” Two opposing parties with relatively the same amount of information (via disclosure) should have reasonably close expectations of the outcome of court case. Settlement is a logical outcome as it allows for the parties to avoid the expense of litigation. In practice, we know that a good deal of cases reach court.

The evidence suggests firms use litigation strategically. In particular, firms may seek to build up a reputation to dissuade would-be infringers. Litigation represents an important threat-point in bargaining situations. Ending up in court may the result of a failed brinkmanship strategy where one party has attempted to force the other to back down. Counter-litigation by defendants may be an example of a tit-for-tat strategy. Here we delve into the economic area of game theory. Readers may be familiar with game theory from the movie A Beautiful Mind about the famous game theorist and Nobel Prize winner, John Nash.

A lot of excellent work on patent litigation was done by the late American economist Jenny Lanjouw and her co-authors. With British-based economist Mark Shankerman, Lanjouw finds that 95% of patent suits settle before trial. Litigated patents are more valuable than non-litigated patents. Where competitors have patents citing a particular firm’s patent, that firm is more likely to litigate to build reputation. They also argue that small firms are disadvantaged in patent litigation. Larger firms tend to have larger patent portfolios and more resources which improves their bargaining position and the likelihood of cross-licensing. Larger firms are more likely to repeatedly interact with other IPR holders in their sector, which again creates an environment more suited to out of court resolutions.

With Harvard economist Josh Lerner, Lanjouw argues that preliminary injunctions allow stronger firms to prey on weaker firms. In cases where preliminary injunctions are requested, plaintiff firms are nearly twice are large as in cases where preliminary injunctions are not requested, and defendants tend to be smaller. This again suggests that the litigation system disadvantages smaller firms. (Lerner and Lanjouw have a survey of litigation research and the UK Intellectual Property Office has related SME papers)).

The work mentioned here covers American patent litigation which is both important and more easily analysed due to the availability of data. The general conclusions of patent analysis should also be true for other IPR and other countries. However, Hoti et al argue that, unlike patents, trade mark litigation is likely cyclical and peaked in 2000. As mentioned previously, very little evidence exists for copyright, design rights and trade secret litigation. Economic analysis of non-American IP litigation is uncommon. Chief Economist of the European Patent Office Nikolaus Thumm notes that European litigation of patent infringement is relatively rare in comparison to the U.S.

The costs of litigation, like profits lost to infringement, reduce the value of IP as an incentive to innovate. Bessen and Meurer calculate that lawsuits cost infringers, on average, US$500k in legal fees. However, the negative impact on stock market value means that these firms lose on average US$28.7M. With Ford, they argue that NPEs create billions of dollars of lost wealth which is not transferred to innovators. The success of NPE litigation increases incentives for broad, low-quality patents and therefore decreases the ability of patents to incentivise innovation.

NPEs represent a business model based on a particular litigation strategy. Are they a nasty side effect of the litigation system or merely another means to keep the system in check?".