New Product Development and the Optimal Duration of Patents

Abstract

Economists and policy makers have always argued that the patent system is necessary for a growing economy despite the fact that temporary monopoly rights to innovators imply a distortion of the price system. However, economists have not yet come up with a unified theory to determine the optimal duration of patents. In this paper, we develop a simple dynamic model which identifies two important welfare effects of the patent system, the effect on the incentive to innovate and that of the price distortion caused by the monopoly rights of patent holders. Using this framework, we analyze the factors which determine the optimal duration of patents awarded to new product developers. We argue that the possibility of a finite optimal patent life does not arise in the literature on product development since it considers only a constant returns to scale technology for developing new products. We first confirm the optimality of an infinite patent life for this technology and then show that if the cost of developing new products is increasing with the rate of instantaneous product development then the optimal patent life for economies with a population growth rate less than the interest rate is finite. In addition, we show that for economies with population growth rate exceeding the interest rate, the optimal patent life may also be finite provided that the degree of product substitution is sufficiently high. The patent system can be viewed as a method of assigning property rights to innovators in order to encourage research and development. Theoretically, the optimal R&D level can be tackled using a standard public goods analysis (such as the problem of financing a new bridge) yielding a result that optimal allocations can be achieved at the cost of a significant amount of government intervention. Perhaps for this reason most decentralized societies have chosen a different way to motivate people to engage in R&D, and this is done by assigning temporary monopoly rights to innovators.