Thursday 20 May 2010

IP valuation: don't underestimate the endowment effect

IP Valuation is not an exact science and the cold rationality of classical economics often fails at giving a value to items of Intellectual Property that satisfies owners and buyers equally. In the specific case of standard-essential technology for instance, it often appears that owners of patents cling on to them with iron claws and will not license it unless the benefits of the transaction largely outweigh the cost of divulging the technology. However according to Prof. Christopher J. Buccafusco (Chicago-Kent College of Law) and Prof. Christopher Jon Sprigman (University of Virginia School of Law) IP law is still largely governed by the rational choice model, which "posits that, when making decisions, people rationally weigh the utility they will derive from different choices and assign monetary values to the options based on the anticipated utility these choices will provide". The two professors decided to call this assumption into question by applying the findings of the behavioural research to the field of IP, as it was clear to them from the beginning that IP owners aren’t more rational than any other individual engaged in a transaction. Their article entitled "Valuing Intellectual Property: An Experiment" (download here) reports on the results of an interesting experiment they carried out in order to determine if IP transactions are subject to the endowment effect, which is the most important contribution of the behavioural research in the field of economics.

“A mountain of survey and experimental data have shown that people attach substantially higher value to goods if they own them then if they are considering purchasing them. People are reluctant to part with their property, and the amount that they are willing to accept (WTA) to sell it generally far exceeds the amount that others are willing to pay (WTP) for it. This WTP/WTA gap has been termed the “endowment effect,” and it has been detected for an astounding variety of forms of property."

As Buccafusco and Sprigman asserted, the endowment effect seriously eroded the “sacrosanctness” of the rational choice model and also had repercussions on many areas of law (such as tort, contract or tort, contract, property, and criminal law).They realized nevertheless that IP law has been relatively immune to this groundbreaking finding of the behavioural research and decided to set things right. Their experiment is all the more interesting so as IP goods are actually created by the owners and are non-rival (their consumption by one person does not prevent their consumption by another). Moreover their experiment – based on a market for poems – is the first one to ask subjects to actually create an object and then value it.

Not so surprising yet quite thought-provoking, the results of Buccafusco and Sprigman's experiment prove that actors engaging in an IP transaction are only "boundedly rational", much like in any other transaction environment. They surely are utility-maximisers, however the preferences on which they based their decisions are very unstable instead of being a constant, as the rational actor model assumes. Their experiment also showed that the difference between WTA and WTP is even higher than expected, even though poems are non-rival goods.

Our findings suggest that private transactions in creative goods may face significant transaction costs arising from cognitive biases that drive the price that creators and owners of IP are likely to demand for transfers considerably higher than what buyers will, on average, be willing to pay. This does not mean, of course, that transactions in IP will not take place – we see such transactions happening out in the world every day. Our research suggests, however, that IP transactions may occur at a level that is significantly suboptimal and that the baleful effect of cognitive and affective biases is likely to be more serious for transactions in works of relatively low commercial value, or for which no well established custom or pattern helps to inform valuation.”

The result of this experiment could have far-reaching implications in the field of IP transaction and calls for more research on other types of IP goods, notably in the case of patents. It could be argued for instance that due to years of R&D - which are intense and costly all of points of view - the sense of ownership of scientists and researchers toward their inventions is probably exacerbated and higher than in any other field of IP. If this hypothesis were correct, the transaction costs related the licensing of a patent would be much higher than expected and would drive down the overall level of patent transactions significantly.

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