Shapiro on Property Rules, Liability Rules, and Patent Infringement

Carl Shapiro has posted a new paper on ssrn titled Property Rules v. Liability Rules for Patent Infringement.  Here is a link to the paper, and here is the abstract:

When a patent has been infringed, the court can impose a forward-looking remedy based on a property rule or based on a liability rule. Under the property rule, the court issues an injunction ordering the infringing party to stop infringing. Under the liability rule, the court allows the infringing party to continue to infringe the patent in question so long as it pays specified ongoing royalties to the patent holder. Since the Supreme Court’s landmark 2006 decision in the eBay case, the United States has employed a hybrid system: the lower courts have discretion, on a case-by-case basis, to issue an injunction or to establish ongoing royalties. This article develops a simple model, including the possibility of patent holdup, in which the court has an imperfect ability to measure the harm to the patent holder caused by ongoing infringement. In the model, the patent holder and the infringing firm can negotiate efficiently over a patent license following the court’s imposition of a remedy, subject to some antitrust limits. Remedy regimes are evaluated based on how close they come, in expected value, to compensating the patent holder for any ongoing infringement. The model identifies a fundamental tradeoff: ongoing royalties perform better, the greater are the switching costs the infringing firm would bear to redesign its product to avoid infringing, but an injunction performs better, the greater is the court’s uncertainty about the harm that ongoing infringement will cause to the patent holder. Based on this analysis, recommendations regarding prospective patent remedies are offered to the courts.

This is an important and thought-provoking paper.  Following the presentation of his mathematical model, Professor Shapiro sets out the following practical implications (p.24), which seem both intuitively right and feasible for courts to implement:

Our analysis indicates that the court should carefully assess the switching costs that the infringing party would incur if forced to stop selling infringing products. These switching costs include the out-of-pocket costs of redesigning the product plus any disruption costs that the downstream firm would bear during the redesign stage. If these switching costs are small relative to the value of the patented technology, an injunction is likely to be the better remedy. In terms of the eBay four factors, if the downstream firm’s switching costs are small, the balancing of harms favors the patent holder.

Conversely, if the court believes it can measure the harm to the patent holder caused by infringement and the benefits to the downstream firm from infringement with a high degree of accuracy, then ongoing royalties are likely to be the better remedy. In terms of the eBay four factors, this is the situation in which there is no irreparable harm and monetary damages are adequate to compensate the patent holder.

To go beyond these rules of thumb, it is helpful to distinguish between cases in which the patent owner has been awarded damages based on reasonable royalties and those in which the patent holder has been awarded damages based on lost profits.