The Welfare Implications of Non-Patentable Financial Innovations

Investment Banks invest in R&D to design innovative securities even when imitation is possible, i.e., when innovations cannot be patented. We show how a financial institution can profit from the development of financial products even if they are unpatentable. For certain types of financial products innovating investment banks have an information advantage over imitators. This information advantage makes them better competitors and market leaders. The mere possibility of costless imitation drives innovators profits down, but still keeps them positive. The absence of patents allows part of the surplus generated by the innovation to be allocated to investors. The extent of surplus sharing depends on the degree of asymmetry in the information owned by imitators and innovators and on the total number of innovators. The larger this asymmetry, the higher the innovators profits and the lower the investors surplus. With more than one innovator all the surplus goes to investors.