Real Option and Patent Damages: The Legal Treatment of Non-Infringing Alternatives, and Incentives to Innovate
15 September 2006
By Dr. Gregory K. Leonard with MIT Department of Economics Professor Dr. Jerry Hausman
Over the past 20 years, patent litigation has become an increasingly important consideration in US business strategy. Damages are awarded to compensate patent owners for economic harm created by infringement and to protect returns to innovation. In this article from the Journal of Economic Surveys, NERA Senior Vice President Dr. Gregory Leonard and MIT Department of Economics Professor Dr. Jerry Hausman analyze the effects that the 1999 Grain Processing decision has had on the legal framework under which patent damages are calculated. The authors find that the decision has decreased the expected value of damages awards in patent cases by conferring a "free option" on the infringer, where the infringer is permitted to claim that in the but-for world it would have adopted a non-infringing technology, if such a technology exists. The infringer does not actually have to practice the technology; the existence of the technology is sufficient. This free option transfers economic value to the infringer and transfers economic value away from the patent holder. Thus, it decreases the economic incentives to innovate, which is one of the primary goals of the US patent system.
Dr. Leonard and Dr. Hausman also demonstrate that the conclusion of the District Court with respect to the absence of lost profits is contradicted by most models of firm behavior and profit maximization. When a firm's costs increase, it typically will increase its price. Thus, if the infringer were to adopt the higher-cost non-infringing technology, prices typically would increase and the patent holder would both increase its price and gain greater sales. Calculation of lost profits in most economic models, plus a reasonable royalty on those infringing units that do not represent lost sales to the patent holder, will then exceed the cost difference between the infringing low-cost technology and the non-infringing high-cost technology multiplied by the sales made by the infringer. From this calculation the hybrid lost profits and reasonable royalty damages award will typically substantially exceed a reasonable royalty only damage award. Thus, the authors conclude that the Court's decision that no lost profits existed if the infringer were assumed to have adopted the non-infringing technology is inconsistent with most models of profit maximization by firms acting in an economically rational manner.
