Dynamically Efficient Royalties for Standard-Essential Patents

Some economists have argued that a reasonable royalty for a standard-essential patent should be based on the patent’s ex ante incremental value. Others have argued that a patent’s ex ante incremental value is insufficient, that a reasonable royalty is more akin to the prize in a winner-takes-all tournament, and that it should reflect the R&D costs associated with both the winning technology and unsuccessful alternative technologies. The results presented in this paper are favourable to the latter view, but with the additional qualification that a reasonable royalty ought to cover the costs of only those R&D efforts—successful or not—that are efficiency enhancing from an ex ante perspective. The notion of ex ante incremental value is core to identifying these efforts and hence to determining what the dynamically efficient outcome is. A reasonable royalty is one that induces this dynamically efficient outcome (i.e. a dynamically efficient level of R&D), balancing the costs incurred by innovators with the benefits that go to implementers and/or consumers. As such, a reasonable royalty is significantly higher than a technology’s ex ante incremental value. High ‘winner’ margins are offset by losses incurred by ‘losers’, leaving a significant proportion of the total net value generated by R&D to implementers and consumers.