The contract theory of patents

Two distinct theories of patents - the reward theory and the contract theory - are customarily adopted by the courts to justify the patent system. The reward theory maintains that the function of the patent system is to remunerate successful innovators so as to encourage R&D effort. In contrast, the contract theory holds that the function of the patent system is to promote the diffusion of innovative knowledge. Assuming that innovators would rely on trade secrecy in the absence of patent protection, it views patents as a contract between innovators and society whereby a property right is granted in exchange for disclosure. This paper develops an economic analysis of the contract theory of patents. To disentangle the disclosure from the reward motive for granting patents, we assume that the innovation process is entirely serendipitous, so that R&D effort is not a concern. We take for granted that trade secrecy represents an alternative to patenting, which may be more or less appealing depending on the type of innovation (specifically, the ease by which it can be duplicated). We analyze the patenting/secrecy choice and characterize the socially optimal patent duration. We find that disclosure through the patent specification is socially valuable for marginal innovations (i.e., those for which the innovator is just indifferent between patenting and not). However, since the patent duration cannot be tailored to each individual innovation, the patent system will tend to over-protect infra-marginal innovations (i.e. those which are more easily duplicated). As a result, the optimal patent duration must balance the incentive to induce disclosure (long duration) with the aim of limiting the monopoly distortion (short patent). This result stands in contrast to the traditional one (reward theory) where the benefit of longer patents is greater innovative activity. The optimal patent length is positive; it increases with the discount rate and decreases with the size of the innovations. As product market competition becomes more intense, the (social) gain from disclosure becomes smaller. Thus, a lower fraction of innovations should be protected by the patent system.