Introduction to the Economics of Trade Secrets

Introduction

One of the key questions in evaluating potential firms is whether their competitive position is sustainable. Firms can protect these positions in many ways, including by developing a favorable reputation ("brand equity") and economies of scale in manufacturing that other firms cannot duplicate. In most high-technology industries, however, two methods of protecting discoveries are most critical: patents and trade secrets.

Volumes can—and have!—been written about each of these ways to protect intellectual property. These notes on the economics of patent and trade secret protection can do little more than provide an introduction to these sources of protection. I also include a bibliography of several articles and books, however, that provide much more detailed information.

Trade Secret Protection

The definition of trade secrecy with the widest acceptance is that in the American Law Institute's Restatement of Torts [1939]:

A trade secret may consist of any formula, pattern, device or compilation of information which is used in one's business, and which gives him an opportunity to obtain an advantage over competitors who do not know or use it. . . . A substantial element of secrecy must exist, so that, except by the use of improper means, there would be difficulty in acquiring the information.

Trade secrecy is quite different from other forms of intellectual property protection. This note will highlight three of these differences. [For fuller discussions, see Kitch, 1980 and Cheung, 1982.]

First, in at least three respects trade secrecy provides stronger protection than patents. While other forms of intellectual property protection are contingent on novelty or originality, the standard for trade secret protection is lower. A firm can protect an innovation in this manner, even if several competitors have made the same discovery independently. (The other firms, however, also must not disclose the discovery.) The span of trade secret protection is indefinite, not limited to a set term as other forms of protection. An inventor need not (indeed cannot) disclose a trade secret, while publication by the U.S. Patent and Trademark Office is a requirement for the award of a patent.

In other ways, the nature of trade secret protection is more limited than alternative forms of intellectual property protection. Trade secrets are only protected against misappropriation: "the acquisition of a trade secret by a person who knows or has reason to know that the trade secret was acquired by improper means" [Milgrim, 1993]. Thus, a firm whose trade secret is discovered by another firm independently or through "reverse engineering" (the disassembly of a device to discover how it works) would not have grounds to sue. This is unlike patent protection, which allows the awardee to prosecute others who infringe, regardless of the source of the infringers' ideas.

Finally, while the other forms of intellectual property protection are governed by federal law, trade secrets are protected by state laws. As of July 1994, 40 states had adopted the Uniform Trade Secrets Act [Jager, 1994]. This Act codifies many of the features of trade secret law that were already incorporated in the common law [Friedman, Landes, and Posner, 1991]. The essence of trade secret law was already established in the United States by the end of the nineteenth century, and the law has changed relatively little since the publication of the first edition of the Restatement of Torts in 1939 [Milgrim, 1993].

Trade secrecy has also been the subject of ongoing public policy activity. A substantial reform of trade secret policy has recently been implemented in Japan [McKeown, 1993]. The U.S. Senate recently passed the Patent Prior User Rights Act of 1994 [S.2272], which would insulate those who protect discoveries through trade secrecy from subsequent patent infringement suits. (The 103rd Congress adjourned before this issue was considered by the House of Representatives.) More changes are anticipated as nations struggle to harmonize their intellectual property systems. In addition to legislative initiatives, governmental agencies are devoting greater administrative resources to the prevention of trade secret theft. In the United States and other Western nations, intelligence agencies have made a major effort to shift resources from monitoring Communist nations to thwarting trade secret spying by foreign industrial concerns [for an overview, see U.S. House, 1992].

Economists and lawyers have devoted relatively little attention to firms' choice between trade secrecy and other methods of protecting intellectual property. Two rationales, however, are suggested by the limited work on this question.

First, firms may choose to employ trade secrecy because it is more cost effective than patent protection. Friedman, Landes, and Posner [1991] suggest several examples where this rationale might hold. The innovation may be relatively minor, and hence the cost of filing and prosecuting an application may exceed the benefit of patent protection. Second, the expected duration of trade secret protection (i.e., until a rival discovers the secret independently or through reverse engineering) may exceed the fixed length of a patent grant. Finally, the firm may believe that the invention is not patentable.

Two other models of the decision to patent introduce an additional cost of patenting: the disclosure of information to rivals. In Horstmann, MacDonald, and Slivinski [1985], a patent reveals to competitors that a certain technological area is promising, but does not always block rivals from imitating the patent. Firms consequently only patent discoveries with some probability that is positive but less than one. As patents become less effective in blocking infringements, the propensity of firms to patent declines. Scotchmer and Green [1990] develop a model in which a relatively minor finding provides information about an as-yet-undiscovered innovation. A firm may choose not to patent the intermediate discovery, lest the information disclosed allow its rival to catch up in the race to make the ultimate innovation. The probability that a firm will patent an intermediate discovery decreases with the cost of pursuing the innovation and the probability of discovery. While not discussed by the authors, the process of applying for international patent protection may also contribute to the reluctance to patent. Patent applications in the U.S. are held confidential until the time of award: hence, rejected applications are not made public. But firms that seek patent protection in the U.S. are almost certain to also seek it in other major markets as well. Patent applications in Europe and Japan are published 18 months after the original application is filed. Because firms often do not know at the time that they pursue an European patent whether the invention is patentable, they run the risk of losing both patent and trade secret protection if the application is subsequently denied after its publication. [A case in which these issues figured prominently is Paterson v. Chemical Engineering, Docket No. 82-10-1709, State of Michigan Circuit Court, County of Lewanee, June 10, 1983; aff'd, Michigan Supreme Court, March 8, 1985; cert. denied, 479 U.S. 828, 107 S.Ct. 109 (1986).]

Evidence on the Choice Between Patents and Trade Secrets

In the paper mentioned above, Lerner examines the importance of trade secrecy relative to other forms of intellectual property protection for a sample of 530 manufacturing firms based in Middlesex County, Massachusetts. He examines this by using civil litigation case files. While the pattern of litigation is certainly not a perfect indicator of economic importance, it can suggest where particular forms of intellectual property protection are most critical.

He identifies all litigation involving these firms in the federal and state judicial districts encompassing their headquarters over a four-and-a-half year period. Patent and trade secret issues are commonplace and occur with about the same frequency. He examines how the involvement of firms in trade secret and other forms of intellectual property litigation varies with firm size, research intensity, and access to capital. Intellectual property cases litigated by smaller firms disproportionately involve trade secrecy. The coefficients in a regression analysis are economically as well as statistically significant. In the average firm, 43% of the intellectual property cases involve trade secrecy. In a firm with employment one standard deviation above the mean, for each additional trade secret case, only 33% of the intellectual property cases involve trade secrecy. This result is consistent with the view that less established firms employ trade secrecy because the direct and indirect costs of patenting are too large.