Innovation, Duplication, and the Contract Theory of Patents

In this paper we look at patents as alternative to trade secrets. We disentangle the disclosure motive for patent protection from the traditional reward motive by adjusting the level of patent protection so as to make the innovator just indifferent between patenting and keeping the innovation secret. Thus, we keep the reward (expected profits) to the innovator fixed and concentrate on ex-post efficiency. When duplication is not feasible and secrecy only entails the risk of public disclosure (a leakage), patents and secrets are perfect substitutes. Yet, a distinctive features of trade secret protection is that it allows for independent creation. The duplicative efforts to reproduce a concealed innovation make patents and secrets imperfect substitutes. If such duplicative efforts are actually exerted under secrecy, patents provide the pre-specified incentive to innovate at least social cost. If, however, the threat of duplication induces the innovator to preemptively license her trade secret, and such licensing agreements allow the innovator to appropriate all the saved duplication costs, then secrets can reward innovative activity more efficiently than patents. Thus, the issue of whether patents are socially preferable to secrets boils down to an assessment of the prevalence and the efficiency of trade secret licensing. The available empirical evidence suggests that licensing of trade secret information is limited and therefore hints at the superiority of patents