25 Pages Posted: 23 Feb 2017 Last revised: 10 Mar 2017
Date Written: February 21, 2017
In the U.S., the judge-made doctrine of “patent exhaustion” implies that the authorized sale of patented goods “exhausts” the patent rights in the goods sold and precludes additional royalty payments from downstream buyers. However, in some instances, patent owners attempt to contractually restrict downstream buyers in order to preserve their right to collect such payments. Whether and when such contractual restrictions can overcome the doctrine of patent exhaustion has been the subject of many conflicting judicial decisions.
This paper offers a formal economic model of domestic patent exhaustion that explicitly incorporates transaction costs in licensing to consumers, and examines how a shift in patent policy from absolute to opt-out patent exhaustion (in which the patent owner can opt-out via contract) affects social welfare. The results show that when transaction costs are low, the regime of opt-out patent exhaustion is socially optimal, because it allows welfare-enhancing price discrimination via downstream licensing. Conversely, when transaction costs are high, the regime of opt-out patent exhaustion leads to a greater loss of static efficiency, because the benefits of price discrimination are offset by transaction cost frictions. However, even when transaction costs are high, dynamic benefits in promoting ex ante investment in product quality may outweigh any static inefficiencies.
Keywords: Intellectual Property, Patent Exhaustion, First Sale Doctrine, Patent Licensing
JEL Classification: F10, O34
Suggested Citation: Suggested Citation
Ivus, Olena and Lai, Edwin L.-C. and Sichelman, Ted M., An Economic Model of Patent Exhaustion (February 21, 2017). San Diego Legal Studies Paper No. 17-265. Available at SSRN: https://ssrn.com/abstract=2921443 or http://dx.doi.org/10.2139/ssrn.2921443