No Empirical Evidence that Standard Essential Patents Hold-Up Innovation

EDITORIAL NOTE: What follows is the Introduction of “An Empirical Examination of Patent Hold-Up.” The full article has been accepted for publication in the Journal of Competition Law and Economics. A draft of the article is available through SSRN.

_______________

Economic theory offers conflicting perspectives on whether “patent hold-up” is slowing American innovation. Based on seminal work by Williamson (1967, 1979), Klein, Crawford, and Alchian (1978), Joskow (1985,1988) and Grossman and Hart (1986), the patent hold-up hypothesis asserts that patent holders charge licensing royalties to manufacturing firms that exceed the true economic contribution of the patented technology, thereby discouraging innovation by manufacturers and hurting consumers. Recent work, including by Shapiro (2001), Swanson and Baumol (2005), Farrell, Hayes, Shapiro and Sullivan (2007), Lemley and Shapiro (2007) and Miller (2007) emphasizes that the patent hold-up problem is particularly acute for Standard Essential Patents (SEPs).[1] SEPs are patents on inventions that form the standards essential for the inter-operability of connected systems, such as cell phones, personal computers, televisions, and audio-visual systems. It is theorized that hold-up might be especially pronounced for SEPs because once manufacturing firms make large investments based on an accepted technological standard, SEP holders might be able to extract the value of their patents being part of that standard, not merely the technical contribution of the patent to the final product. From this perspective, granting too much protection to SEP holders slows innovation.

Other work, however, argues that the proposed remedies to mitigate SEP hold-up, such as ex ante determination of royalty rates at the time a patent is declared standard essential, will result in royalty rates that are too low, thereby reducing the incentives for firms to innovate (Elhauge 2008, Ganglmair, Froeb, and Werden 2012). In a similar vein, Schmalensee (2009) Sidak (2009), and Kieff and Layne-Farrar (2013) argue that the ex post bargaining position of a monopsonistic collection of manufacturers—especially given their abundant legal resources—is much stronger than the bargaining position of patent holders. This reduces the expected returns to inventions and lowers investment in the costly, risky process of developing and patenting new technologies.

These scholarly debates shape policy disputes. Arguing that excessive protection of patent holders slows innovation, President Obama has issued five executive orders that reform the current system of patent review and award. In addition, Congress considered, but ultimately rejected, nine different patent reform bills in 2013-14. In 2015, the Congress is focused on two strikingly different bills—one that strengthens patent holder rights, and one that weakens those rights.

In this paper, we contribute to these debates by providing empirical evidence on whether SEP hold-up slows innovation. While an extensive theoretical literature examines the possibilities for SEP hold-up, Gerardin, Layne-Farrar, and Padilla (2008) and Barnett (2014) note that there is very little empirical evidence that SEP hold-up actually occurs, and that such evidence as exists is inconclusive. Although policy analysts, lawyers, and practitioners provide anecdotes about SEP hold-up, we are unaware of previous systematic evaluations of the core predictions emerging from IO-based theories of SEP hold-up.

We assess one of the central empirical implications of the SEP hold-up hypothesis: If SEPs are slowing the rate of innovation, then products that are highly reliant upon SEPs will experience slower rates of decreases in quality-adjusted price (more stagnant quality-adjusted prices) than similar products that do not rely heavily on SEPs. That is, if the patenting system empowers SEP holders to negotiate excessive royalty payments and this in turn slows innovation by discouraging investment and market entry, then SEP hold-up will harm downstream consumers in the form of slower price declines and slower improvements in product quality and variety. This prediction emerges from a wide assortment of IO-based models of SEP hold-up. Furthermore, this prediction focuses on the essential issue in the policy debate: Are SEPs impeding improvements in consumer welfare by slowing reductions in quality adjusted prices?

To conduct our analyses, we use quality-adjusted price data on a variety of consumer and producer products. Most of our analyses cover the period between 1997 and 2013. We also examine the period from 1951 through 2013 for a smaller cross-section of products due to data availability. We primarily use Consumer Price Series (CPS) from the Bureau of Labor Statistics (BLS). They provide quality-adjusted price data that reflects the prices paid by consumers, not the prices paid by intermediate producers. However, when firms primarily purchase the product (e.g., computers), we use the Producer Price Series from the Bureau of Economic Analysis (BEA), which also provides quality-adjusted prices. We describe these quality adjustments in Appendix A.

To assess whether SEP hold-up slows innovation, we use two methods. First, we examine the evolution of the quality-adjusted prices of different industries. We differentiate industries by the degree to which their products rely on SEPs. We compare the quality-adjusted price dynamics of SEP-reliant industries, non-SEP-reliant industries, and a textbook hold-up industry: electricity distribution.

We categorize SEP-reliant and non-SEP-reliant industries as follows. A rich literature emphasizes that the personal computer, smart phone, audio and video equipment, and TV industries rely heavily on SEPs.[2] These are all industries that require interoperability and thus have formal organizations that meet regularly to agree on industry-wide standards. Firms that own patents that read on these standards may then declare their patents as standard essential. Consequently, we categorize products as being SEP-reliant if they are meant to operate as part of a connected system and if there are one or more formal organizations that set technical standards for interoperability in that system. Smartphones provide a classic example: they must not only be interoperable across a variety of different manufacturers and phone service providers, but the photos and video they produce must be compatible with a variety of other products, such as personal computers and video monitors, while their internet capabilities must be compatible with the technical capabilities of various WiFi routers. Standards for smartphones are established by the 3rd Generation Partnership Project (3GPP), which includes a wide variety of network providers, phone manufacturers, component producers, and chip design firms.

We compare these SEP-reliant products against a set of industries whose products have high patent counts, but whose core functions do not require interoperability or compatibility—and therefore do not rely heavily on SEPs. Automobiles provide a classic example: there are SEPs in non-core functions such as Tire Pressure Monitoring Systems, or Rear Set Entertainment Systems, but core functions—most particularly the drive train—are self-contained and thus are proprietary across manufacturers. Table 1 presents summary information about each of the products included in each category: SEP-reliant industries, non-SEP-reliant industries, and a classic hold-up industry.

The second method for assessing whether SEP hold-up slows innovation involves a quasi-natural experiment in which we evaluate whether a Supreme Court decision that weakened the power of SEP holders accelerated the rate of quality-adjusted price reductions in SEP-reliant industries relative to other industries. The 2006 Supreme Court’s eBay Inc. v. MercExchange LLC decision made it more difficult for SEP owners to obtain injunctions against infringers than the holders of non-SEP patents.[3] Critically for our analyses, proponents of the SEP hold-up hypothesis advocate for limiting injunctions by SEP holders (Lemley and Shapiro, 2007). They argue that such limits would spur innovation by reducing the excessive power of SEP holders.[4] We examine the impact of this “eBay treatment” effect. Specifically, we employ a difference-in-differences specification and test whether quality-adjusted prices fall faster in SEP-reliant industries after eBay, while controlling for industry and year effects. That is, if hold up had been slowing innovation in SEP-reliant industries prior to eBay, then we should see a more rapid decrease in the quality-adjusted prices of SEP-reliant products relative to non-SEP-reliant products after eBay.

In examining the dynamics of quality-adjusted prices, we do not find support for the SEP hold-up hypothesis. On the contrary, we find that products that are SEP-reliant have experienced faster price declines than any other good in the CPI over the past 16 years. In contrast, the quality-adjusted prices of a classic holdup industry—electricity distribution—increased. The differences in the movement of the relative prices of electricity and SEP-reliant products have to be expressed as orders of magnitude. The prices of SEP-reliant products have fallen at rates that are not only fast relative to a classic hold-up industry, they are fast relative to other patent-intensive products that benefit from Moore’s law but are not SEP-reliant.

Two interrelated concerns are that SEP-reliant products might be more innovative than non- SEP-reliant products for technological reasons and the rate of innovation of SEP-reliant products would have been still faster if SEP hold-up were not slowing innovation. We address these concerns formally when we conduct the quasi-natural experiment based on eBay. We can address these concerns informally be examining only digital technologies that follow “Moore’s Law.”[5] If the SEP Hold-up hypothesis holds, we would find that the quality-adjusted prices of Moore’s Law products that are non-SEP-reliant would fall faster than the quality-adjusted prices of products that are SEP-reliant. The data indicate the opposite, however: the prices of non-SEP-reliant Moore’s Law products fall more slowly than the prices of SEP-reliant Moore’s Law products. This finding, however, does not fully address the concern that among Moore’s Law products, those that rely on SEPs might be more technologically dynamic than other such products. Thus, we examine the differential impact of eBay on SEP-reliant and non-SEP-reliant industries.

In examining the quasi-natural experiment involving eBay, we also cannot reject the null hypothesis of no SEP hold-up. The difference-in-differences results do not indicate that quality-adjusted prices fall faster in SEP-reliant industries after eBay. We use several specifications and try de-trending the data to control for potential differences in underlying innovation rates by product. But, in contrast to the SEP hold-up view, we cannot reject the null hypothesis that eBay did not differentially affect SEP-reliant industries.

It is important to emphasize that we are not claiming that the patent system as currently defined cannot be improved. Rather, we offer evidence on two interrelated predictions of the SEP hold-up hypothesis. First, if SEPs are holding up innovation, then products that are highly reliant upon SEPs should experience more stagnant quality-adjusted prices than similar non-SEP-reliant products. Second, if SEPs are holding-up innovation, then changes in the legal system (eBay) that weaken the excessive negotiating strength of SEP holders should accelerate reductions in quality-adjusted prices in SEP-reliant industries relative to non-SEP-reliant industries. We find no evidence for either prediction.

__________________

[1] See Egan and Teece (2015) for a comprehensive survey.

[2] For example, Lemley and Shapiro (2007: 1992) state that: “In the information technology sector in particular, modern products such as microprocessors, cell phones, or memory devices can easily be covered by dozens or even hundreds of different patents. As a striking example, literally thousands of patents have been identified as essential to the proposed new standards for 3G cellular telephone systems.” Their case studies (2025-29) focus on 3G cellular technologies, Wi-Fi 802.11 technologies, DVD media, the MP3 music format, and RFID chips. Farrell, Hayes, Shapiro, and Sullivan (2007) also call attention to the potential problem in IT industries. They motivate their paper with seven cases: three of which are about computer technologies, two of which are about modems, and one of which is about cell phones. Swanson and Baumol (2005) point to “computers, software, telecommunications, consumer electronics, and the Internet…” Miller (2007) argues that standard setting organization pervade the information and communication technology industries.

[3] There is a broad consensus in the legal literature that the firms that license their patents, which by definition includes the holders of SEPs, face greater difficulty in meeting the Supreme Court’s “four-factor test” for a permanent injunction. See Balganesh (2008), Beckerman-Rodau (2007), Ellis, Jarosz, Chapman and Oliver (2007), Diessel (2007), Hand (2007), Golden (2007), Grab (2006), Jones (2007), Klar (2006, 2008), Mersino (2007), Mulder (2007), Newcombe, Ostro, King and Ruben (2008), Reis (2008); Rendleman (2008), Solomon (2010), Stockwell (2006), and Tang (2006).

[4] Sidak (2008, 2015), however, challenges the plausibility of the Lemley-Shapiro holdup conjecture with respect to the decision in eBay.

[5] Moore’s Law is the observation that the number of transistors in a dense integrated circuit doubles approximately every two years.