INTELLECTUAL PROPERTY LAW AND THE BOUNDARIES OF THE FIRM Oren Bar-Gill' and Gideon Parchomovsky C 2004 Oren Bar-Gill and Gideon Parchomovsky. All rights reserved 1. Introduction Innovation is crucial in technology intensive markets. For many firms inventions are a critical factor of production. Examples of downstream firms purchasing or licensing technology from upstream innovators are common(see, e.g., Arora et al., 2001). Indeed both Transaction Costs Economics (TCE)and the property rights Theory(prt)suggest that in many cases, efficiency requires that the inventive process-from the conception of an idea through its development and ultimate commercialization-be divided among several firms(Williamson, 1975; Aghion and Tirole, 1994; Arora et al., 2001; Arora and Merges, 2004) The question thus becomes which stages of the inventive hould be integrated in a single firm and which should be divided among different firms and traded on the market? We argue that the theoretic investigation of the optimal boundary between firm and market cannot be carried out in a legal vacuum. Ideally, only the economic considerations identified by TCE and Prt should affect the "make or buy"decision. In practice, however, law imposes an important constraint on the economic balance between firms and markets Critically, the law defines which stages of the inventive process are amenable to market trading. As Arrow (1962) recognized, information that is not afforded legal protection cannot be bought or sold on the market. Absent legal protection, the information holder is in a bind in order to sell the information she must disclose it to the potential buyer, but once she does, she has nothing left to sell. This paper emphasizes the important relationship between Arrow's paradox of disclosure and the question of the boundaries of information intensive firms. Only legally protected inventions,i.e patented inventions, may be traded; pre-patent stages of the innovation process may not Consequently, by force of law, rather than by the guidance of economic principle, pre- patent innovation must be carried out within the boundaries of a single firm Intellectual property law is therefore an important factor influencing the boundary between the firm and the market. When it is more difficult to obtain a patent more Innovative activity mus integrated within a single firm (or be forgone altogether) Harvard University, the Society of Fellows, and Harvard Law School, the John M. Olin Center for Law Economics and business University of Pennsylvania Law s This paper greatly benefited omments and criticisms by lan ayres, Lucian bebchul Ben-Shahar. Yochai Benkler. James Chaim Fershtman. Zohar Goshen. Oliver Hart. Josh L Robert Merges, Eric Posner, Ariel Mark Ramseyer, Edward Rock, Chris Sanchirico Siegelman, Omri Y adlin and seminar participants at boston university and penn we thank efrat procaccia or excellent research assistance. Finally, we thank the John M. Olin Center for Law, Economics and Business at Harvard Law School and the William F. Milton Fund of Harvard University for generousINTELLECTUAL PROPERTY LAW AND THE BOUNDARIES OF THE FIRM Oren Bar-Gill* and Gideon Parchomovsky** © 2004 Oren Bar-Gill and Gideon Parchomovsky. All rights reserved. 1. Introduction Innovation is crucial in technology intensive markets. For many firms inventions are a critical factor of production. Examples of downstream firms purchasing or licensing technology from upstream innovators are common (see, e.g., Arora et al., 2001). Indeed, both Transaction Costs Economics (TCE) and the Property Rights Theory (PRT) suggest that in many cases, efficiency requires that the inventive process—from the conception of an idea through its development and ultimate commercialization—be divided among several firms (Williamson, 1975; Aghion and Tirole, 1994; Arora et al., 2001; Arora and Merges, 2004). The question thus becomes which stages of the inventive process should be integrated in a single firm and which should be divided among different firms and traded on the market? We argue that the theoretic investigation of the optimal boundary between firm and market cannot be carried out in a legal vacuum. Ideally, only the economic considerations identified by TCE and PRT should affect the “make or buy” decision. In practice, however, law imposes an important constraint on the economic balance between firms and markets. Critically, the law defines which stages of the inventive process are amenable to market trading. As Arrow (1962) recognized, information that is not afforded legal protection cannot be bought or sold on the market. Absent legal protection, the information holder is in a bind: in order to sell the information, she must disclose it to the potential buyer, but once she does, she has nothing left to sell. This paper emphasizes the important relationship between Arrow’s paradox of disclosure and the question of the boundaries of information intensive firms. Only legally protected inventions, i.e., patented inventions, may be traded; pre-patent stages of the innovation process may not. Consequently, by force of law, rather than by the guidance of economic principle, pre￾patent innovation must be carried out within the boundaries of a single firm. Intellectual property law is therefore an important factor influencing the boundary between the firm and the market. When it is more difficult to obtain a patent more innovative activity must be integrated within a single firm (or be forgone altogether). * Harvard University, the Society of Fellows, and Harvard Law School, the John M. Olin Center for Law, Economics and Business. ** University of Pennsylvania Law School. This paper greatly benefited from comments and criticisms by Ian Ayres, Lucian Bebchuk, Omri Ben-Shahar, Yochai Benkler, James Bessen, Chaim Fershtman, Zohar Goshen, Oliver Hart, Josh Lerner, Robert Merges, Eric Posner, Ariel Porat, Mark Ramseyer, Edward Rock, Chris Sanchirico, Peter Siegelman, Omri Yadlin and seminar participants at Boston University and Penn. We thank Efrat Procaccia for excellent research assistance. Finally, we thank the John M. Olin Center for Law, Economics and Business at Harvard Law School and the William F. Milton Fund of Harvard University for generous financial support. 1