Public Good Economics and Standard Essential Patents

Standard essential patents have emerged as a major focus in both the public policy and academic arenas. The primary concern is that once a patented technology has been incorporated into a standard, the standard can effectively insulate it from competition from substitute technologies. To guard against the appropriation of quasi-rents that are the product of the standard setting process rather than the innovation itself, standard setting organizations (SSOs) require patentholders to disclose their relevant intellectual property before the standard has been adopted and to commit to license those rights on terms that are fair, reasonable, and non-discriminatory (FRAND). To date courts and commentators have provided relatively little guidance as to the meaning of FRAND. The most common approach is to impose a uniform royalty based on a percentage over overall revenue. The baseline for setting this uniform royalty is the royalty that the patentholder could have charged had the standard had not been created. In essence, this approach takes the ex ante distribution of entitlements as given and attempts to ensure that the standard setting process does not increase patentholders’ bargaining power. However, comparisons to the ex ante baseline do not provide a basis for assessing whether the resulting outcome would maximize economic welfare. Fortunately, public goods economics can provide an analytical framework for assessing whether a particular licensing structure is likely to maximize economic welfare. Although it is often observed that patentable inventions are public goods, key concepts of public good economics (such as the Samuelson condition that provides public good economics’ key optimality criterion) are rarely explored in any depth. A close examination of public good economics reveals that it has important implications standard essential patents and FRAND. The resulting framework surpasses the current approach by providing a basis for assessing whether any particular outcome is likely to maximize welfare instead of simply taking the existing distribution of entitlements as given and allocating them in the most efficient way. In addition, the insight that demand-side price discrimination is a necessary precondition to efficient market provision suggests that economic welfare would be maximized if holders of standard essential patents were permitted to charge nonuniform royalty rates. At the same time, the optimal level of price discrimination would allow consumers to retain some of the surplus. It also underscores that the fundamental problem posed by standard essential patents may be strategic behavior and incentive incompatibility. The literature also suggests several alternative institutional structures that can help mitigate some of these concerns