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As far as the firm is concerned, the program’s net profit is 12  15 $3

million. Thus, the firm will choose not to undertake the program. Taking

account of total benefits, however, the program shouldbe undertaken. (In total,

net benefits come to 12  6  15 $3 million.) Clearly, the profit motive alone

is not enough to induce the firm to go ahead. What incentive is needed? Simply

stated, the government should offer the firm a “carrot,’’ that is, an R&D sub-

sidy. What kind and magnitude of subsidy? The answer is straightforward. The

crux of the externality problem is that the firm faces paying the entire cost of

the R&D program but reaps only two-thirds of the total benefit ($12 million of

the $18 million total). Accordingly, the remedy is a “one-third’’ subsidy. For

every $1.00 of the firm’s R&D expenditures, the government reimburses or

pays for $.33. With the subsidy, the firm’s net R&D cost becomes (2/3)(15) 

$10 million. Therefore, its net profit becomes 12  10 $2 million, and the

firm elects to undertake the program.

The general rule (of which this example is a specific case) is this: To induce effi-

cient behavior, the subsidy should be set equal to the ratio of external benefit to total benefit.

THE PATENT SYSTEM In the United States, patent law grants the holder

exclusive rights to an invention for 20 years. An invention must take the form

of a product or process. Intangible knowledge (say, a mathematical theorem)

is not patentable. Moreover, the invention must contain a minimum degree of

novelty. A mere improvement does not constitute a patentable invention. At the

time the patent is granted, the invention becomes public knowledge.

What is the economic rationale for patent laws? Their most important role

is to provide incentives for firms (and individuals) to pursue inventions and

innovations. Absent patent protection, why should an inventor work to develop

an invention, or why should a firm incur the costs to bring it to market? If one

did, another firm could duplicate any successful invention and so profit at the

expense of the inventor. Without patent protection, a firm that creates an

invention would be able to claim only a small portion of the profit generated

by the invention. Patent protection encourages the process of invention by

allowing the inventor to capture a greater portion of the benefits created.

Patent laws represent a trade-off. On one hand, they provide strong incen-

tives for research and invention in the first place. On the other hand, the patent

grants the successful inventor a monopoly over the sale of knowledge embod-

ied in the invention. Like any monopolist, the inventor will set a high price to

maximize his or her profit. Because some would-be customers will be unwilling

to pay this monopoly price, the knowledge will not be as widely used as it might

be.^12 As in any monopoly, there is a deadweight loss due to underprovision. To

sum up, patent protection represents a trade-off between encouraging inven-

tion before the fact and disseminating knowledge after the fact.

(^12) Indeed, if the actual marginal cost of additional people using this knowledge is essentially zero,
then maximizing social benefits requires making the invention available to all for free.
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