Capturing the Consumer Surplus through Downstream licensing and Infringement Lawsuits

by Dennis Crouch

Downstream users have been increasingly subject to patent infringement lawsuits even when the product manufacturer would seemingly have been a more natural and focused target. Many assign nefarious intent to these downstream user lawsuits, but it turns out there is a good faith economic reason why the lawsuits make sense for a patentee. The basic insight here is that lawsuits against parties further downstream in the market chain allow the patentee to capture a portion of the economic consumer surplus that is not available at manufacturer-level lawsuits.

A U.S. patent provides its owner with the right to exclude others from making, using, selling offering-to-sell, importing or exporting the patented invention. 35 U.S.C. § 271. The statute is broad enough to allow a patentee to target any point along the supply chain.* However, the rules on exhaustion and multiple recovery prevent a patentee from collecting duplicative royalties at from different points along the supply chain.

In a market economy, consumers typically purchase goods when the prices of those goods are less than what the consumers are willing to pay. Consumer surplus is defined as the difference between that highest price that they would be willing to pay and the price that they actually did pay. Because of pricing difficulties for producers and market competition, almost all goods and services are associated with some consumer surplus. This consumer surplus is a spillover benefit that simply cannot be fully captured by the manufacturer. Each step along a supply chain also typically involves consumer surplus, with the result being that the end-user places a substantially higher value on the good than did the original manufacturer.

This notion of consumer surplus ties back into the patent laws at the point of collecting damages. Under the patent laws, a patentee is due at least “a reasonable royalty for the use made of the invention by the infringer.” And, because downstream users place a higher value on the goods than do upstream manufacturers and distributers, it makes sense that the reasonable royalty award will also be relatively higher.

A typical patent scenario might involve a software developer who made check-processing software that was then sold through a vender to banks around the country. The developer, vender, and banks are all potentially liable for infringement and the patentee wanting to enforce its patent would then need to choose whom to sue for infringement. Here, the banks likely paid the vender significantly less than the actual value they receive from using the software. Similarly, a successful vender would have paid the software developer significantly less than the resale price. These differences in valuation offer fuel for the ‘hypothetical negotiation’ that serves as the fundamental basis for reasonable royalty damages. Simply stated, a party who values the invention more would tend to pay more for use of the invention.

A difficulty with customer-lawsuits is the large number of lawsuits and negotiations. Rather than dealing with a single manufacturer that may result in a single large payout, the patentee is working through dozens or even hundreds or thousands of customers who each pay their bit. In addition, patentees whose preference is to stop infringing use rather than collect royalties will likely prefer to cut focus on the manufacturer level as a better chokepoint.

Now, taking a step back toward reality: It is unlikely that these differences in valuation are driving the current preference for customer lawsuits. Rather, the settlement value of most of the customer lawsuits are driven by the cost-of-defense rather than the merits of the patent at issue or its value to the user. This means that my reasonable royalty calculation from above, even if mathematically correct, is largely irrelevant in the current climate. I should note that there are at least several legitimate criticisms to my analysis and underlying assumptions above, but I’ll save those for a later post.

DC

= = = = =

* With method-of-use claims, the end users end users are the only likely direct infringers, but even there, the suppliers may be liable for inducement or contributory infringement. (Recent cases tightening the mens rea requirement limit this somewhat).

 

31 thoughts on “Capturing the Consumer Surplus through Downstream licensing and Infringement Lawsuits

  1. 6

    The downstream consumer surplus can be captured in the hypothetical negotiation with the manufacturer. 7-20 Chisum on Patents S 20.03:[iii] Manufacturers, Resellers, and Users: The Full Compensation Rule.In considering a patent owner’s remedies against manufacturers, resellers, and users, it is important to differentiate the issue of liability from that of monetary recovery. As to liability, when a patented product passes without authority through successive hands from manufacturer to reseller to user, each party clearly is liable for his or her own infringing acts. The patent owner is entitled to obtain a judgment against each. Furthermore, the appropriate measure of damages against one actor in such a succession may take account of the acts of others. Thus one who makes and sells an infringing machine for use and one who purchases such a machine for use or resale may beconsidered joint tort-feasors, each liable for the full amount of lost profits or royalty income suffered by the patent owner as to that machine.As to recovery, entry of judgment alone against one infringer will not relieve other related infringers from liability, but, in a number of circumstances, the courts have held that actual recovery–through payment of a judgment, or through a settlement–will relieve other infringers because the patent owner has already been fully compensated. The most common situation is that of prior recovery against a manufacturer and an attempt to obtain further relief against resellers and users of the very products which were the basis of that first recovery. The three major SupremeCourt decisions on the general subject fail to provide clear guidance. Not surprisingly, one finds conflicting lines of authority in the lower courts, some stating broadly that prior recovery against a manufacturer relieves sellers and users from liability, and some saying the opposite. The basic idea of the full compensation rule is sound: a patent owner ought not to recover twice for the same injury. The confusion arises in determining what constitutes full compensation when an infringing product passes through several hands–from manufacturer to user. To reach a sensible solution, one should examine the injury suffered by the patent owner in the particular case and the basis of the prior recovery (i.e., was it suitably measured to compensate the whole injury). …Some of the confusion in the case law on multiple recoveries may be traceable to ill-founded doubts or assumptions as to whetherrecovery against an infringing manufacturer can take into account subsequent resales and uses of the infringing product by other parties. Quite clearly it can and should do so because the infringing manufacture is a primary cause of damage to the patent owner.

    1. 6.1

      Actually as seen here, quite clearly recovery (strictly from manufacturers) cannot take into account subsequent resales and uses.That’s the entire point of the graph.

  2. 5

    Dennis,I don’t understand what you mean by “good faith economic reason.” It seems all you are saying is that it is privately economically rational for patentees to bring these suits, which is of course true because patentees in fact bring them.The nefarious aspect of these suits, as I understand it, is that they are socially inefficient while being privately beneficial; nobody contends they are not privately beneficial. What your argument seems to boil down to is a price discrimination argument: that the patentee can implement first order price discrimination (which is simply a wealth transfer without loss of efficiency). But that begs the question: if first order price discrimination were possible, then why isn’t the manufacturer doing it? The answer is almost certainly that the transaction costs (e.g. to discern the buyer’s willingness to pay and to foreclose a secondary market) would burn up whatever additional private surplus is captured. And at this point we reach full circle with your last point, which is effectively that the discovery system allows patentees to externalize some of those costs to defendants and to courts, which is the real advantage they have over manufacturers, and which is why the whole thing is nefarious.

    1. 5.2

      “The nefarious aspect of these suits, as I understand it, is that they are socially inefficient while being privately beneficial’Except for the designation of “nefarious,” since obeying the law cannot (or in any rational sense, should not) be considered “nefarious.”End users are still violating the law when they engage in patent infringement.This is not a small point to be ignored.

      1. 5.2.1

        I can’t disagree more strongly. It is a non-sequitur to argue that merely because something is legal, it cannot be nefarious or bad. If something nefarious happens to be legal, it simply means that the law ought to be changed. It is true that end users are deemed by the patent statute to commit infringement, but since when was Title 35 descended from Mount Sinai?

        1. 5.2.1.1

          Disagree all that you want – as long as you are clear that you want the law to change and not pretend that the abiding by the law is in fact ‘nefarious.’We do change laws, but let’s be intellectually honest about the process. Let’s not change things by subtle intimation.If, as you admit, end users are breaking the law – SAY SO. But to pretend otherwise and use such terms as bandied about is simply disingenuous. Title 35 may not have descended from Mount Sinai, but you sure the h311 have not either.btw, the law you want to change has been on the books for quite some time (add: like throughout, plus you are messing with the notion of exclusive, since exclusive nowhere in patent law has ever meant exclusive except end users) – I hope you have better reasons for change than those found in the Infringer’s Handbook.

  3. 4

    I think General Pictures Co. v. Electric Co., 305 U.S. 124, 59 S. Ct. 116, 83 L. Ed. 81 (1938) bears on the point. The Supreme Court in this case held that field-of-use licenses were justifiable where the value of the invention varied according to use. I presume, that in settling with a patent infringer, that a patentee might impose upon that infringer different royalties depending upon end use. I further assume that in proving damages in a patent case, that the patentee should be entitled to prove different royalties depending on the customer.However, I believe the courts do not allow this granularity in damages awards. This forces patentees to avoid suing and granting licenses to manufacturers for the very reason that they cannot capture full value of their inventions to various users. Dennis is exactly right.In my own practice I once encountered a situation where we were sued for incorporating into a disk drive a certain kind of motor that was otherwise a staple item in commerce. The value of that motor in a disk drive that sold for more than $100 was far higher than the value of the same motor in a fan that might’ve sold for $10. The motor itself was sold generically for perhaps 2 dollars.When we asked the motor company for indemnity we were told that if they agreed to indemnify us they could potentially go bankrupt because of damages for the use of the motor in the disk drive not only would exceed the price of the motor by significant amount, but could be so great as to exceed the total profits of the company for years.Thus it is impossible to sue a manufacturer and expect to receive full value for the invention in circumstance like this.

  4. 3

    Capturing the consumer surplus is a poor justification for end-user infringement lawsuits, primarily because “I wouldn’t have bought and used X if I’d realized there were these additional costs involved.” Moreover, it won’t work beyond the small scale or beyond markets with so few transactions that the consumer surplus is extremely large. The reason: if these lawsuits become frequent enough, people will actually stop buying X in the first place, which will require indemnification guarantees from X’s manufacturer just to sell X, which essentially means that the patentee will essentially be going up against the manufacturer anyway.

      1. 3.1.1

        Perhaps in the short term, it looks like, “Oh, the end user derives benefit from my invention, so they owe me a royalty.” But my argument was that in the long term / steady state, this tactic results in potential end users not actually buying the infringing product because of the not-easily-quantifiable risks involved (unless the manufacturer steps in to help ensure continued sales). In the long term, the market corrects because of the change in incentives, with the end result being that the (possibly infringing) manufacturer absorbs the risk and parcels it out evenly to their customers in the form of an increased price that the market will bear. Therefore, the “correct” target for the infringement suit is the manufacturer rather than the end user. The infringement suit against the end user is targeting a sort of arbitrage from having a transient in the market, rather than actually targeting the consumer surplus.As Dennis noted, the real reason why the end users are currently preferable targets (at least to some patent holders) is that most of them are ill-equipped to deal with this sort of thing. It’s clear that, say, MPHJ is not interested in extracting consumer surplus in the scan-to-email demand letters, because the consumer surplus alone (which is necessarily greater than the actual damages incurred by an end user) probably isn’t even worth the time and effort to send the letters.

        1. 3.1.1.1

          ill-equipped or not, infringement is still infringement.”I’m not equipped” is NOT a legal excuse.

    1. 3.2

      APoTU, Demanding and getting indemnity are two different things. A manufacturer may not be able to indemnify its customer for the value of the invention to the customer because to do so could potentially force the manufacturer out of business. I actually had such a case a while back where we requested indemnity of the manufacturer and were told exactly this.As the Supreme Court is already held in General Pictures Co. v. Electric Co., 305 U.S. 124, 59 S. Ct. 116, 83 L. Ed. 81 (1938), the value of the use of an invention may vary according to use. In such a circumstance, the patentee has a right to set different prices for use of its invention according to use.

  5. 2

    “This notion of consumer surplus ties back into the patent laws at the point of collecting damages. Under the patent laws, a patentee is due at least “a reasonable royalty for the use made of the invention by the infringer.” And, because downstream users place a higher value on the goods than do upstream manufacturers and distributers, it makes sense that the reasonable royalty award will also be relatively higher.”Dennis, I’m all for an economic analysis of “reasonable royalty,” and I agree that an understanding of consumer (and supplier surplus) is essential to any such analysis. But your analysis skips straight to the conclusion. Yes, there is a larger surplus to go around on upstream goods. But WHY does it make sense that the royalty should be higher? Shouldn’t the total value of the patented innovation be captured in the price of the component that embodies the innovation? After all, that’s the level at which the designer of the upstream goods would be evaluating substitutes.

    1. 2.1

      LB – I think that this is the best argument against my approach above. Essentially, you are arguing that the inventor should be relegated to a pre-manufacturer position in the supply chain.

      1. 2.1.1

        I’m not necessarily arguing the “should” part – I’m just challenging the assumptions. Microeconomics works great when you assume that everything is a commodity, but patented inventions are not a commodity. When you throw monopoly-pricing power into the mix, it becomes a lot harder to talk about how the various surpluses are divided, and you also have to consider what happens to the aggregate surplus when prices are distorted from the standard market- clearing model. While I think a thorough understanding of the microeconomics involved is important, I suspect that when all is said and done we have to step outside the microeconomics to figure out the “should.”

    2. 2.2

      Shouldn’t the total value of the patented innovation be captured in the price of the component that embodies the innovation? After all, that’s the level at which the designer of the upstream goods would be evaluating substitutes.Right, that’s the point where the patented invention adds whatever value it might have. For the most part, the “consumer surplus” captured at later market stages is from distribution – making the product available at a location the consumer can easily access during his busy day. It’s also less relevant now that anybody can buy a product from a manufacturer online and have it shipped. It’s no wonder that nobody can isolate the “value” of one patented feature from the retail price of an iPhone.patentees whose preference is to stop infringing use rather than collect royalties will likely prefer to cut focus on the manufacturer level as a better chokepoint.A handy counterpoint to those people who insist that injunctive remedy is the “essence” of the patent right, and no amount of money can make the patentee whole for an act of infringement. It’s not very consistent with the idea of suing anybody other than the source of the infringing article.

      1. 2.2.1

        The counter point is meaningless when you understand what the patent right actually is, INANE.Of course, you already know that..” other than the source”You need to check out the actual law again too.

    3. 2.3

      Price to the infringer – of value from the infringer down the next link of the chain…?If you settle at the front end, there is no real ‘penalty’ being applied in order to attempt to stop the infringer, and you (again) enter the efficient breach model of ‘promoting’ the infringer to see if he can get away with infringement.Stronger – not weaker – patent rights are what are necessary.

  6. 1

    This appears to stem from my comment (which Malcolm and Leopold took exception to) as to what constitutes a violation of law.

      1. 1.1.1

        As if you cannot recognize your cheer-leading missteps…Do you really need me to find the comment I made about infringement and removing the fallacy of “innocent” infringers, Malcolm’s off-base comment, and your attempted chime-in with Malcolm while missing the legal point under discussion?As if that instance was not embarrassing enough for you, do you really want it repeated?

        1. 1.1.1.1

          What I cannot recognize is any semblance of sense in what you’ve said here. If you’ve got something to say about Dennis’s post, why don’t you simply say it?

          1. 1.1.1.1.1

            Yes, Leopold, your inability to understand things is quite legendary.Here’s a hint: “A U.S. patent provides its owner with the right to exclude others from making, using, selling offering-to-sell, importing or exporting the patented invention. 35 U.S.C. § 271. The statute is broad enough to allow a patentee to target any point along the supply chain.”Here’s another hint: there is no such thing as an innocent infringer.

            1. 1.1.1.1.1.1

              “Here’s another hint: there is no such thing as an innocent infringer.”Of course there is. You’re confusing liability with culpability.

              1. 1.1.1.1.1.1.1

                No. I am not. And no, there is no such thing.You are confusing some type of intentionality into the tort of infringement.’Wanting’ infringement to be an ‘innocent’ action is a poor excuse for not understanding the law.

                1. “You are confusing some type of intentionality into the tort of infringement.”No, I’m not. The fact that there is no “type of intentionality” in the tort of infringement is precisely why there is such a thing as innocent infringement.

                2. Actually, the opposite Leopold. “Innocent” simply does not fit.I “get” that some want to create some type of ‘fair use’ innocent factor for patents (i.e., according to the Infringer’s Handbook), but that simply is not how the law is. Period.I would have much more respect if the attempts at adoption by implication were not attempted and a point blank honest attempt to change the law was attempted.

Comments are closed.