This paper – which can be found here – criticises the patent hold-up theory, which underpins most antitrust concerns regarding SEPs.
- The first section describes patent hold-up theory, which is said to: “consist of five nested claims. First, that patent owners can systematically overcharge manufacturers for licenses to their patents through the economic mechanism of holdup—the opportunistic appropriation of a downstream firm’s quasi rents (revenues in excess of short-run costs). Second, that when there are multiple patent holders, each practicing holdup on a downstream firm, cumulative patent royalty rates become astronomically high—a phenomenon patent-holdup theorists termed “royalty stacking. Third, that the holdup problem is exacerbated when patented technologies are included in the industry standards necessary to make IT products interoperable and compatible. Fourth, that patent holdup, royalty stacking, and the inclusion of patented technologies in industry standards are strangling innovation, most particularly in SEP-intensive IT products. Fifth, that the government must intervene to solve this problem; the market, left on its own, will fail.” This section also contains a rather complete review of the main literature on patent hold up.
- The second section adduces evidence that innovation and competition intensity in SEP sectors has been increasing. It also reviews the academic literature on patent holdup, patent thickets, and royalty stacking, and finds that: “All of these studies reach the same general conclusion, which is perhaps best summed up by Layne-Farrar: “Certainly the theories have been developed, but the empirical support is still lacking. Despite the fifteen years that proponents of the theories have had to amass evidence, the empirical studies conducted thus far have not shown that holdup or royalty stacking is a common problem in practice.”
- The paper then moves on to criticising the underpinnings of patent hold-up theory. It begins by arguing that patent-holdup theory conflates two different economic mechanisms: holdup – the mechanism through which one firm can appropriate another firm’s quasi rent (i.e. a revenues minus its short-run costs) through opportunistic behaviour; and market power – a firm’s ability to set prices such that it appropriates a monopoly rent from a market.
Specific attention is devoted to the economics of hold up: “The transaction-cost literature has always been clear that there are three necessary conditions for holdup to occur. There must be: (1) a sunk investment in a relationship-specific asset; (2) an incomplete contract; and (3) opportunistic surprise.” In particular, hold-ups are always surprises in the sense that “particular conditions that will lead to the hold-up are considered unlikely and, because it is costly to negotiate and specify contract terms, these unlikely conditions are not taken into account in the contract”. Very importantly: “One central policy implication of the mainstream theory of holdup therefore is that the potential problem of holdup should not be an antitrust concern. Williamson suggests that antitrust authorities should not mistake firms’ structural and contractual adaptations for the exercise of market power. Klein goes further, concluding that “‘hold-up’ problems, which are pervasive throughout the economy, do not involve an exercise of monopoly power, and, therefore, are problems for contract law, not antitrust law.” However, the authors hold that these insights have been ignored in the hold-up literature, which instead predicts that patent-holdup theory will lead to: “market failure, and call for intervention in markets by government competition authorities.”
- In section III, the authors criticise the conflation of hold-up and market power: “We cannot stress strongly enough that an input provider does not need market power to engage in holdup. All he needs is another firm that has sunk investments that are specific to him, an incomplete contract, and the willingness to engage in opportunistic surprise.” The elision of holdup and market power occurs by not paying attention to the requirement of opportunistic behaviour. The conflation of holdup and market power leads to three fallacies that underpin patent-holdup theory:
- It mistakes necessary for sufficient conditions of patent holdup – “if it is not necessary for one party to opportunistically surprise the other, then holdup could be claimed to be taking place any time that there is a relationship-specific investment and an incomplete contract, which now become sufficient conditions, not merely necessary conditions.” However, this patent theory hold up ”does not explain why a firm would make an investment specific to a particular standard knowing that it will be held up”. In effect, “In the established theory of holdup, firms—working together—will make structural, contractual, and behavioural adaptations in order to solve the holdup problem, thereby sustaining trade and investment. In patent-holdup theory, by contrast, firms cannot adapt and solve the problem of opportunistic renegotiation of a contract because the game begins [only] after the R&D is completed and manufacturers invest. [In antitrust theories of patent hold up, contractual] Adaptations to prevent holdup have been ruled out by construction. Both variants of patent-holdup theory therefore make a single, stark prediction: affected industries will stagnate, wither, or die. The policy prescription of patent-holdup theory is that government must intervene to fix the holdup problem.” However, this is based on faulty assumptions and does not happen in practice. As such, there is no good reason for governments to intervene.
- It mistakenly claims that the same manufacturing firms can be held up many times over, resulting in a phenomenon called royalty stacking. However: “The mechanics of royalty stacking mean that it would only take a few patent owners to devastate an industry. High cumulative royalty rates levied on manufacturers mean that they must charge a price for their products that is so high that it will exclude all but a few buyers. Royalty stacking is not, therefore, consistent with a thriving industry: the incentives for incumbent manufacturing firms to invest are weak, the incentives for new manufacturing firms to enter are nil, and the incentives for technology developers are eroded by royalty rates that might not pay for their R&D expenditures.” Furthermore, “Holdup and royalty stacking have opposite empirical implications when it comes to the prices charged by upstream technology firms to downstream manufacturers. The point of holdup is to extract the appropriable quasi rents of the downstream manufacturers by setting a high royalty for the right to use a patent. By contrast, with royalty stacking, the profit-maximizing royalty rate falls with the number of patent holders. If royalty stacking is actually occurring, the observed cumulative royalty rate is high, but individual royalty rates are low—the opposite of what happens if a patent holder engages in holdup.”
- It mistakenly concludes that patent-holdup is exacerbated when patented technologies are included in the industry standards that make IT products interoperable and compatible, and that this justifies antitrust intervention. The argument starts from the premise that, once a standard is chosen: (i) from the supply side, manufacturers are locked into the standard by their own standard-specific investments, whereas (ii) on the demand side, consumers would not unilaterally switch to products that use an alternative technology because their devices would no longer be compatible with those owned by other consumers. The firms which patented technologies have been chosen are now free, at least according to this theory, to charge excessive royalties. A variant of this argument is that the value of a standard stems from standardization itself, that the technologies that underpin the standard add little or no value to consumers, and that appropriating the value of standardization is an undue exercise of market power not granted by the patent. The problem with this theory that it presumes that the holder of a SEP will automatically hold market power, and this should be controlled. Furthermore, “a well-functioning technological standard is like money; it reduces transaction costs, which is valuable, but it does not create value by itself. Maintaining that technology developers should not appropriate the surplus that can appear because consumers can interact seamlessly while using a particular technology is equivalent to saying that sellers should not get any benefit from the reduction of transaction costs wrought by the U.S. dollar.” Lastly, “whether the firm that triumphed in that competition is actually exercising market power is a hypothesis to be tested, not a fact to be assumed a priori.”
- These criticisms lead to three conclusions: (i) any claim that a firm is charging an excessive royalty for a patented technology that is included in an industry standard is a statement about that firm trying to exploit market power; however, it has nothing to do with holdup; (ii) second, any claim that a firm is trying to exploit market power by charging an excessive royalty for a patented technology that is included in a standard must begin by establishing that the innovation reflected in its patents is non-drastic; and (iii) any claim that the inclusion of multiple patented technologies in an industry standard confers market power on multiple patent owners ultimately means there are many firms exploiting monopoly power over the same final demand.
In short, the logical flaws of patent-holdup theory, as well as the theory’s lack of empirical support, leads the authors to the conclusion that a new theory about the mechanics and dynamics of SEP-intensive IT industries is needed, both as a matter of science and to guide antitrust action and patent policy.
I’m afraid the economics of this article are beyond my full grasp, but to my untrained eye it seems like a well-structured, punchy demolition attempt of the most far-reaching attempts to make antitrust a permanent fixture of SEP disputes. The authors’ attitude is “this is not actually broken, so don’t try to fix it” – the system is pro-competitive, and the downsides are better managed through IP and contractual arrangements / litigation than through antitrust.
For my part, and despite some doubts about the suitability of competition law intervention on this field, I think that competition law may have a role to play, particularly in the presence of worse institutional alternatives. However, I also consider that we need a lot more clarity is necessary regarding the basis of market power and applicable theories of harm before antitrust plays any role in this.