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Pervasive externalities and intellectual property

The authors of this paper address the relationship between (overly rigid) intellectual property laws, in copyright and patents, and externalities (spillovers), with a rethink of the assumptions driving the economics.


Stanford Law School
Loyola University of Chicago – Law School

Stanford Law and Economics Olin Working Paper No. 321
Columbia Law Review, Vol. 100, No. 2, 2006


Economists since Demsetz have viewed property rights as a way to internalize the external costs and benefits one party’s action confers on another. They have thought this internalization desirable, reasoning that if a party didn’t capture the full social value of her actions she wouldn’t have optimal incentives to engage in those actions. Measured by this standard, IP rights are inefficiently weak. There is abundant evidence that the social value of innovations far exceeds the private value. But there is also good evidence that, contrary to what economists might assume, these spillovers actually encourage greater innovation. The result is a puzzle for Demsetzians.

In this article, we offer three insights that help to explain the positive role of innovation spillovers. First, we note that in IP, unlike real property, a wide range of externalities matter, because IP rights are much less certain than property rights, and because the decision to create a legal entitlement will determine whether or not a transaction must occur. Second, we make the point that while society needs some ex ante incentive to innovate, it doesn’t need (and doesn’t particularly want) full internalization of the benefits of an invention. Third, we observe that even where internalizing externalities is desirable, property rights do not in fact do so perfectly, and they create problematic distortions in circumstances in which the buyer in a transaction makes productive reuse of the work. The result of combining these insights is that at least where innovation is concerned, we cannot rely on the easy equation of property rights with efficient internalization of externalities.

And an excerpt from the Conclusion:

As we have discussed, the conventional law and economics thinking about externalities is that they are a bad thing, a market failure in need of correction. On this view, externalities interfere with rational decisionmaking and distort market allocation of resources. Internalization is needed, and private property rights are the preferred institutional mechanism for internalization.

But as our argument demonstrates, there are some fundamental flaws in this thinking. First, externalities do not always distort market allocation. Many externalities are in fact irrelevant and thus not worth internalizing because internalization would not change anything other than the distribution of wealth. The marginal benefits of internalization approach zero at some point (for example, when there is no change in the producer’s incentive structure). Second, there may be costs to internalization beyond the transactional costs associated with internalization itself. Internalizing spillovers may impact user behavior in a manner that reduces social welfare.

Together, these conclusions lead us to a simple but important point: Even where externalities distort market allocation, those distortions may be social welfare enhancing. Conversely, extending property rights to internalize externalities may distort market allocation in a manner detrimental to social welfare. We can generalize this point: Property rights distort resource allocation in the same way as externalities, although perhaps in the opposite, or at least a different, direction. A Coasean analysis of externalities suggests that they are reciprocal in nature; externalities are neither positive nor negative in the abstract. They are jointly produced by agents with interdependent relations, and whether an externality is positive or negative depends on how and to whom we allocate rights. Here we find a wonderful Coasean symmetry between externalities and property rights. When relevant, both externalities and property rights distort the market allocation of resources; when irrelevant, neither does. Under the same Coasean logic, as with an externality, a priori, one simply cannot say that the distortion caused by a new property right (or an incremental change in a property right) has a positive or negative effect on social welfare.

Coase warned us to avoid reflexively invoking externalities to justify government intervention in the form of taxation, regulation, or subsidies. Often, he showed, such intervention is unnecessary because affected parties will be able to work things out privately. Our basic point is the mirror image: One cannot simply invoke externalities and the weakness of existing rights to justify propertization and privatization. The processes by which property rights are created almost always involve “government intervention” in one form or another. Such intervention may be unnecessary and in fact may lead to welfare-reducing distortions.

The importance of our argument extends well beyond property rights. Many laws, and perhaps even bodies of law, can be understood as attempts to internalize externalities. Environmental pollution is an archetypal example of an externality. Acme Factory produces widgets and in doing so emits pollutants into the environment. People living downstream or downwind from Acme receive the pollutants and bear some costs as a result. These costs are external to Acme’s decision to produce widgets unless the government forces Acme to take the costs into account by taxing Acme, for example. Environmental laws and regulation generally aim to force externalityproducing agents, such as Acme, to fully account for the consequences of their actions.

As we have discussed, however, it turns out that externalities are not always a problem in need of a solution. In some situations, externalities ought to be simply ignored. In those cases, the policy solution is to let the costs and benefits fall where they may and not to worry about whether parties have taken all costs or benefits into account. Internalizing so-called irrelevant externalities will not change behavior or resource allocation, so internalization is not worth the effort. In such cases, there really is no problem for the law to solve.

More importantly, though, some externalities should be encouraged rather than eliminated or ignored. In many different contexts, the law actually is designed to encourage certain externality-producing activities. As we have discussed, IP laws unequivocally promote externality-producing activities— invention, creative expression, and innovation. Participation in these productive activities generates social returns that exceed private returns by a substantial margin.

Many public policy debates over legal and economic issues boil down to a debate over which types of externality-producing activities to be concerned with and the extent to which institutions should be designed to regulate some and promote other externality-producing activities.158 The broader lesson of our paper is that courts and scholars must resist the easy answer of equating public and private value by internalizing externalities. Spillovers aren’t always bad, and more property rights aren’t always good. Only if we understand when and why each can enhance social welfare can we hope to design legal rules that do more good than harm.

UPDATE: Just after posting this, I saw that Economist’s View featured  a column by Hal Varian on why intellectual property law is not always appropriate, using the example of the fashion industry. It is here.

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