Defining Patent Holdup

There are few patent law topics that are so heatedly debated as patent holdup. Those who believe in it, really believe in it. Those who don't, well, don't. I was at a conference once where a professor on one side of this divide just..couldn't...even, and walked out of a presentation taking the opposite viewpoint.

The debate is simply the following. The patent holdup story is that patent holders can extract more than they otherwise would by asserting patents after the targeted infringer has invested in development and manufacturing. The "classic" holdup story in the economics literature relates to incomplete contracts or other partial relationships that allow one party to take advantage of an investment by the other to extract rents.

You can see the overlap, but the "classic" folks think that patent holdup story doesn't count, because there's no prior negotiation - the party investing has the opportunity to research patents, negotiate beforehand, plan their affairs, etc.

In their new article forthcoming in Washington & Lee Law Review, Tom Cotter (Minnesota), Erik Hovenkamp (Harvard Law Post-doc), and Norman Siebrasse (New Brunswick Law) try to solve this debate. They have put Demystifying Patent Holdup on SSRN. The abstract is here:

Patent holdup can arise when circumstances enable a patent owner to extract a larger royalty ex post than it could have obtained in an arm's length transaction ex ante. While the concept of patent holdup is familiar to scholars and practitioners—particularly in the context of standard-essential patent (SEP) disputes—the economic details are frequently misunderstood. For example, the popular assumption that switching costs (those required to switch from the infringing technology to an alternative) necessarily contribute to holdup is false in general, and will tend to overstate the potential for extracting excessive royalties. On the other hand, some commentaries mistakenly presume that large fixed costs are an essential ingredient of patent holdup, which understates the scope of the problem.

In this article, we clarify and distinguish the most basic economic factors that contribute to patent holdup. This casts light on various points of confusion arising in many commentaries on the subject. Path dependence—which can act to inflate the value of a technology simply because it was adopted first—is a useful concept for understanding the problem. In particular, patent holdup can be viewed as opportunistic exploitation of path dependence effects serving to inflate the value of a patented technology (relative to the alternatives) after it is adopted. This clarifies that factors contributing to holdup are not static, but rather consist in changes in economic circumstances over time. By breaking down the problem into its most basic parts, our analysis provides a useful blueprint for applying patent holdup theory in complex cases.

The core of their descriptive argument is that both "classic" and patent holdup are based on a path dependence: one party invests sunk costs and thus is at the mercy of the other party. In this sense, they are surely correct (if we don't ask why the party invested). And the payoff from this is nice, because it allows them to build a model that critically examines sunk costs (holdup) v. switching costs (not holdup). The irony of this, of course, is that it's theoretically irrational to worry about sunk costs when making future decisions.

But I guess I'm not entirely convinced by the normative parallel. The key in all of these cases is transactions costs. So, the question is whether the transactions costs of finding patents are high enough to warrant the investment without expending them. The authors recognize the problem, and note that when injunctions are not possible parties will refuse to pay a license because it is more profitable to do so (holdout). But their answer is that just because there is holdout doesn't mean that holdup isn't real and a problem sometimes. Well, sure, but holdout merely shifts the transactions costs, and if it is cheaper to never make an ex ante agreement (which is typical is these days), then it's hard for me to say that being hit with a patent lawsuit after investment is the sort of path dependence that we should be worried about.

I think this is an interesting and thoughtful paper. There's a lot more than my brief concerns. It attempts to respond to other critiques of patent holdup, and it provides a framework to debate these questions, even if I'm not convinced by the debate.