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.