A Chicago School Take on Patent Licensing : Understanding the Economics of the Patent Exhaustion Doctrine

Under the legal doctrine of patent exhaustion, a patent holder's ability to license multiple parties along a production chain is restricted. How and when such restrictions should be applied is a controversial issue, as evidenced by the Supreme Court's granting certiorari in the Quanta case. The issue is an important one, as it has important implications for how firms can license in vertically disaggregated industries. We explore this issue from an economic viewpoint and find that under ideal circumstances how royalty rates are split along the production chain has no real consequence for social welfare, but rather what matters is the total royalty burden. Even when we depart from ideal conditions, however, we still find no economic justification for a strict application of the patent exhaustion doctrine. To the contrary, we that there are often private and social advantages to charging royalties at multiple stages. Overall, our results advocate for a flexible application of the patent exhaustion doctrine, where exhaustion holds as a default rule but one that can be easily overwritten in patent contracts