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Theory: Scott Stern
Intellectual property and the market for ideas

By Scott Stern, associate professor of management and strategy

Intellectual property rights (IPR) such as those provided through the patent system seem to play a simple economic role, providing incentives for innovation by giving inventors the right to limit imitation. However, while the role of IPR in enhancing the value of intellectual capital is indeed important, the more subtle strategic role of IPR in fostering cooperation among potential competitors is at least as important for competitive advantage.

Consider the options facing a technology entrepreneur. Though brimming with ideas, start-up innovators usually have limited experience and capabilities in the markets where their innovations are appropriate. Their challenge is translating promising technology into economic returns: the problem is not invention but commercialization.

Developing a value chain from scratch allows the innovator to enter the product market and compete with more established players. When Sun Microsystems initially entered the workstation market, established firms such as Digital and Apollo discounted them, giving Sun the time to translate its vision into a concrete set of technological, organizational and market-positioning choices.

Alternatively, strategic cooperation with more established players— whether through licensing, an alliance or outright acquisition — allows the innovation to be embedded into an already functioning value chain at a lower cost. Much biotechnology innovation is commercialized in this fashion, with firms leveraging the capabilities of established pharmaceutical companies in bringing their ideas to the marketplace.

When should a technology entrepreneur compete with established firms in the product market versus pursuing cooperation with established firms via the "market for ideas"? The strength and effectiveness of IPR is crucial. When IPR such as patents are enforceable, start-up innovators are able to contract with partners capable of bringing the technology to market most effectively. While the start-up must maintain the threat of entry, most small firms do not have the resources or capabilities to realize the full potential of their ideas. However, when IPR are weak or absent, entrepreneurs must also face the threat of expropriation: the disclosures required to negotiate a deal undermine the innovator's bargaining power. Potential partners can exploit the disclosed technology even in the absence of an agreement, undermining the entrepreneur's competitive potential.

So, even if cooperation makes sense for overall value creation, a weak IP environment can steer a firm towards stealth, secrecy and inefficient independent entry. In a study of more than 100 start-up innovators conducted with Joshua Gans and David Hsu, we find that the probability of cooperation between start-up innovators and established firms is reduced by more than 50 percent when IPR are not available.1

Explicitly considering how competing in the product market compares with cooperating through the market for ideas holds important implications for industry dynamics and strategic management. To the extent that a weak IP environment increases the relative returns to competition over cooperation, the potential for disruptive technologies to overturn established firms is higher when IPR are weaker. Conversely, in industry segments such as biotechnology where IPR are strong, even radical innovation may be commercialized through cooperative contracting, limiting the impact of innovation on market structure.

Three lessons stand out. First, a proactive approach to intellectual property management yields more than simply legal or financial benefits. Strong IPR expands the range of available strategic options, and allows even a small firm to leverage the capabilities and resources of industry leaders. Second, the benefits of cooperation must be balanced with the potential for expropriation. A reputation for nonexpropriation may be as important as commercialization capabilities per se. Finally, as Professor Conley rightly emphasizes, the management of IPR must be proactive for firms whose competitive advantage is built on "ideas." Rather than treating IPR as an independent legal matter, the development and execution of firm strategy cannot be disentangled from the effective management of intellectual property.

1 See Joshua Gans, David Hsu, and Scott Stern, "When Does Start-Up Innovation Spur the Gale of Creative Destruction?" RAND Journal of Economics, 2002, pp. 571-586, and Joshua Gans and Scott Stern, "The Product Market and the Market for Ideas," Research Policy, 2003, pp. 333-350.

In addition to his academic role at the Kellogg School, Scott Stern is a faculty research fellow at the National Bureau of Economic Research.

Read what Professor James Conley says about putting this theory into practice