Intellectual Property Rights, Input Markets, and the Value of Intangible Assets

Abstract

Intellectual property rights (IPRs) appear to play an important role in facilitating production and exchange in certain input markets. This paper provides a simple theory about the relationship between stronger IPRs and contract-based production under assumptions of incomplete contracting. Employing some features of Grossman and Hart, Hart and Moore, and Hart (1995) (“GHM”), it is shown that property rights over intangible assets create incentives for independent supplier firms to produce research and development (R&D)- intensive inputs for use by downstream producers of a final product. Legal rights over intellectual property allow these important assets to be “owned,” in the GHM sense of providing residual rights exercisable in the event of incomplete contractibility. Weak or nonexistent property rights create severe misappropriation risks for firms with intangible assets who must adapt them to make a specialized input. Once property rights are created or strengthened, it is feasible in some cases for an input maker to constitute itself as an independent firm, rather than as an integrated unit inside a larger firm. Asset ownership can then be allocated per standard GHM theory to provide proper incentives to make investments specific to the supplier-manufacturer relationship. In this way, IPRs are seen to contribute to an increase in the value of underlying assets, and hence ultimately to firm specialization and even industry structure. The theory of this paper accounts for recent empirical evidence linking stronger IPRs to a greater incidence of licensing activity. It also contributes to the ongoing modification of the economic theory of property rights associated with the early work of Harold Demsetz (1967).