FRAND Rules to Incentivize Innovation in Collective Standard Setting: What Golf Tournaments Can Teach Us

Alden Abbott —  3 November 2015

One baleful aspect of U.S. antitrust enforcers’ current (and misguided) focus on the unilateral exercise of patent rights is an attack on the ability of standard essential patent (SEP) holders to obtain a return that incentivizes them to participate in collective standard setting.  (This philosophy is manifested, for example, in a relatively recent U.S. Justice Department “business review letter” that lends support to the devaluation of SEPs.)  Enforcers accept the view that FRAND royalty rates should compensate licensees only for the value of the incremental difference between the first- and second-best technologies in a hypothetical ex ante competition among patent holders to have their patented technologies included in a proposed standard – a methodology that yields relatively low royalty rates (tending toward zero when the first- and second-best technologies are very close substitutes).  Tied to this perspective is enforcers’ concern with higher royalty rates as reflecting unearned “hold-up value” due to the “lock in” effects of a standard (the premium implementers are willing to pay patent holders whose technologies are needed to practice an established standard).  As a result, strategies by which SEP holders unilaterally seek to maximize returns to their SEP-germane intellectual property, such as threatening lawsuits seeking injunctions for patent infringement, are viewed askance.

The ex ante “incremental value” approach, far from being economically optimal, is inherently flawed.  It is at odds with elementary economic logic, which indicates that “ratcheting down” returns to SEPs in line with an “ex ante competition among technologies” model will lower incentives to invest in patented technologies offered up for consideration by SSOs in a standard- setting exercise.  That disincentive effect will in turn diminish the quality of patents that end up as SEPs – thereby reducing the magnitude of the welfare benefits stemming from standards.  In fact, the notion that FRAND principles should be applied in a manner that guarantees minimal returns to patent holders is inherently at odds with the justification for establishing a patent system in the first place.  That is because the patent system is designed to generously reward large-scale dynamic gains that stem from innovation, while the niggardly “incremental value” yardstick is a narrow static welfare measure that ignores incentive effects (much as the “marginal cost pricing” ideal of neoclassical price theory is inconsistent with Austrian and other dynamic perspectives on marketplace interactions).

Recently, lawyer-economist Greg Sidak outlined an approach to SEP FRAND-based pricing that is far more in line with economic reality – one based on golf tournament prizes.  In a paper to be delivered at the November 5 2015 “Patents in Telecoms” Conference at George Washington University, Sidak explains that collective standard-setting through a standard-setting organization (SSO) is analogous to establishing and running a professional golf tournament.  Like golf tournament organizers, SSOs may be expected to award a substantial prize to the winner that reflects a significant spread between the winner and the runner-up, in order to maximize the benefits flowing from their enterprise.  Relevant excerpts from Sidak’s draft paper (with footnotes omitted and hyperlink added) follow:

“If an inventor could receive only a pittance for his investment in developing his technology and in contributing it to a standard, he would cease contributing proprietary technologies to collective standards and instead pursue more profitable outside options.  That reasoning is even more compelling if the inventor is a publicly traded firm, answerable to its shareholders.  Therefore, modeling standard setting as a static Bertrand pricing game [reflected in the incremental value approach] without any differentiation among the competing technologies and without any outside option for the inventors would predict that every inventor loses—that is, no inventor could possibly recoup his investment in innovation and therefore would quickly exit the market.  Standard setting would be a sucker’s game for inventors.  . . .

[J]ust as the organizer of a golf tournament seeks to ensure that all contestants exert maximum effort to win the tournament, so as to ensure a competitive and entertaining tournament, the SSO must give each participant the incentive to offer the SSO its best technologies. . . .

The rivalrous process—the tournament—by which an SSO identifies and then adopts a particular technology for the standard incidentally produces something else of profound value, something which the economists who invoke static Bertrand competition to model a FRAND royalty manage to obscure.  The high level of inventor participation that a standard-setting tournament is able to elicit by virtue of its payoff structure reveals valuable information about both the inventors and the technologies that might make subsequent rounds of innovation far more socially productive (for example, by identifying dead ends that future inventors need not invest time and money in exploring).  In contrast, the alternative portrayal of standard setting as static Bertrand competition among technologies leads . . . to the dismal prediction that standard setting is essentially a lottery.  The alternative technologies are assumed to be unlimited in number and undifferentiated in quality.  All are equally mediocre. If the standard were instead a motion picture and the competing inventions were instead actors, there would be no movie stars—only extras from central casting, all equally suitable to play the leading role.  In short, a model of competition for adoption of a technology into the standard that, in practical effect, randomly selects its winner and therefore does not aggregate and reveal information is a model that ignores what Nobel laureate Friedrich Hayek long ago argued is the quintessential virtue of a market mechanism.

The economic literature finds that a tournament is efficient when the cost of measuring the absolute output of each participant sufficiently exceeds the cost of measuring the relative output of each participant compared with the other participants.  That condition obtains in the context of SEPs and SSOs.  Measuring the actual output or value of each competing technology for a standard is notoriously difficult.  However, it is much easier to ascertain the relative value of each technology.  SEP holders and implementers routinely make these ordinal comparisons in FRAND royalty disputes. Given the similarities between tournaments and collective standard setting, and the fact that it is far easier to measure the relative value of an SEP than its absolute value, it is productive to analyze the standard-setting process as if it were a tournament. . . .

[I]n addition to guaranteeing participation, the prize structure must provide a sufficient incentive to encourage participants to exert a high level of effort.  In a standard setting context, a “high level of effort” means investing significant capital and other resources to develop new technologies that have commercial value.  The economic literature . . . suggests that the level of effort that a participant exerts depends on the spread, or difference, between the prize for winning the tournament and the next-best prize.  Furthermore, . . . ‘as the spread increases, the incentive to devote additional resources to improving one’s probability of winning increases.’  That result implies that the first-place prize must exceed the second-place prize and that, the greater the disparity between those two prizes, the greater the incentive that participants have to invest in developing new and innovative technologies.”

Sidak’s latest insights are in line with the former bipartisan U.S. antitrust consensus (expressed in the 1995 U.S. Justice Department – Federal Trade Commission IP-Antitrust Guidelines) that antitrust enforcers should focus on targeting schemes that reduce competition among patented technologies, and not challenge unilateral efforts by patentees to maximize returns to their legally-protected property right.  U.S. antitrust enforcers (and their foreign counterparts) would be well-advised to readopt that consensus and abandon efforts to limit returns to SEPs – an approach that is inimical to innovation and to welfare-enhancing dynamic competition in technology markets.

Alden Abbott

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I am a Senior Legal Fellow at the Heritage Foundation. I write on antitrust, domestic and international regulatory policy, and law and economics. I am an Adjunct Faculty Member at George Mason Law School.

One response to FRAND Rules to Incentivize Innovation in Collective Standard Setting: What Golf Tournaments Can Teach Us

  1. 

    Mr. Abbott, you are nothing if not persistent.  Once again, you warn us of the dire threat presented by SEP royalty rates actually being set by free market forces — now so much so, that you effectively propose that such prices should be set via central planning (guided by your and your cohorts’ theoretical musings as to what would constitute fair pricing, of course).

    I really can’t understand your selective antipathy to allowing market forces to shape SEP royalty rates.  And I particularly don’t understand how the views you advance are supposed to reconcile with the rest of what gets posted here.

    This forum routinely hosts criticism of regulatory antitrust intervention on the basis of mere “speculations about the possibility of harm,” yet you repeatedly argue that antitrust regulators should intervene to prevent standards organizations (actually, just one particular standards organization, at the moment) from taking rational steps (actually baby steps) to protect their legitimate self-interest by addressing real-world problems that have regularly arisen, on the basis of nothing more than your own ideologically-driven speculations about the possibility of harm.  There is nothing fact-based or evidence-driven about the parade of horribles you propose are certain to occur if, god forbid, standards body consumers of intellectual property products actually negotiate some of the terms of their “purchase” of those products from producers, just like any other consumer.  (On the contrary, evidence which I have cited previously demonstrates that even in many cases where standards bodies have required contributors to make royalty-free contributions, innovation and standards have proceeded robustly.)

    What justification do you present for intervening in a market that shows absolutely no evidence of failure, beside mere ideologically-driven speculation?

    Am I the only person here who can see the patent (no pun intended) irony of your interventionist preaching vs. the typical criticism here when others propose intervention based on mere speculation?

    Given the absence of contrary views being posted by your colleagues here, it would seem that this glaring contradiction must be common to those who post here.

    It would be perplexing if it didn’t otherwise seem clear that the group here holds such a strong ideological belief in the importance of patents as to simply be in the tank for patent holders.

    Perhaps going back to the basics of free market processes would be helpful here.  You complain that “the notion that FRAND principles should be applied in a manner that guarantees minimal returns to patent holders is inherently at odds with the justification for establishing a patent system in the first place.”  It’s really very simple — and to keep it simple, let’s say that buyers want to pay as little as possible, and sellers want to be paid as much as possible.  These two positions are inherently at odds.  In the free market, transactions occur based on buyers freely deciding what they are willing to pay, and sellers freely deciding what they are willing to accept.  And if they can’t agree, that transaction won’t occur, but with a panoply of standards organizations out there — and the unfettered ability to create new ones — any intellectual property that’s actually worth what its holder demands, can be expected to find a willing buyer.

    It’s not about a regulatory view, and it shouldn’t be about a regulatory view unless and until real-world facts demonstrate market failure.

    Your golf tournament analogy in not particularly illuminating, but let’s run with it for a moment.  You see, if I have a golf tournament where I offer to pay too little in prize money to the winner, I might fail to attract the best golfers to participate.  Or I might fail to attract any golfers to participate.  And I might fail to sell tickets or attract a television deal, as a result.  I might actually go out of business.  C’est la vie.  If I have proven too niggardly, another tournament promoter will probably not.  If all promoters prove too niggardly, new promoters will probably appear to remedy their errors.  And the golfers, themselves, are always free to organize their own tournaments, if the market is otherwise failing to satisfy them.

    There’s absolutely no need for regulatory intervention to step in and dictate what prize structures will be.

    If you would like to present an argument to convince golf promoters that they should voluntarily adopt the prize structure you speculate is optimal — by all means, feel free to do so.  But nobody has any business attempting to impose such by regulatory force absent evidence of market failure.

    And so too it is with standards setting.

    The debate you raise is not about market failure.  There has been no market failure, and there is no evidence whatsoever of market failure.  There is only your speculation about the possibility of harm, and frankly, that speculation isn’t even remotely close to compelling.  You can repeat it in new posts as many times as you like, but that won’t make it any more compelling.

    What we have is very simple: patent holders participating in many standards processes have, for decades, enjoyed being in a position of unilaterally imposing their terms.  There was effectively nobody on the other side of the negotiating table.

    Now, one standards body has decided to take a seat at the table, and to make what amount to some limited demands.  Not surprisingly, the patent holders aren’t happy with losing their privileged position of unilateral imposition of terms.  But rather than exercise their legitimate means for pushing back on the change — such as refusing to participate, lending their support to competing standards efforts, or starting new standards efforts of their own — they cry that the end of the world is nearing and seek to have regulators intervene on their behalf, and impose their will by force.

    To do so is crony capitalism.  Corporate welfare.  Picking winners.  What are you so anxious to indulge them in it?

    And btw, tactics such as seeking injunctions for infringement of patents subject to FRAND licensing are quite properly viewed askance.  In fact it, it is a travesty that our system allows such.  The notion that a patent holder who is obligated to license their technology should be able to obtain equitable relief while a purely monetary dispute is pending is simply ludicrous.  The only purpose such an injunction can possibly serve is to irretrievably stack the deck in favor of the patent holder, and to foreclose other actually-appropriate processes from achieving a more balanced outcome.

    Not surprising that patent holders would want to stack the deck like that.  Nothing but crony capitalism to indulge them in such, however.