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Bounded Rationality and Related Concepts Fundamental toIntellectual Property Analysis
Long-term Overseas Research Fellow: Tetsuo Wada

With the spread in use of the concepts of "laws and economics" in intellectual property studies,
jurists as well as economists have recognized the importance of an ex-ante perspective in theanalysis, i.e., how incentives can be changed by alterations in legal systems. While the concept ofbounded rationality used to be frequently neglected in conventional "laws and economics," it has,since the 1990s, become a major issue in microeconomics. The concept of bounded rationality is
the source of fundamental questions and study incentives for those who are engaged in ex-ante
incentive analysis. Moreover, the patent system itself and various transactions related to patents
inevitably entail transaction costs formulated by use of such concepts as "incompleteness,""indescribability," and "non-verifiability," all of which stem from bounded rationality. In this study,
we reviewed the history of the previous studies and reconsidered the basis of the concept ofefficiency in the economic analysis of patents. We also conducted empirical studies based on thepresumption that the rationality is bounded.

even greater because the main purpose of
those rules is to serve as a code of conduct for
private economic entities.
Economists use the game theory as astandard tool, when conducting an analysis
concerning the effects of ex-post rule-making
on incentives and also concerning theireffects on efficiency from an ex-ante
viewpoint. Models were applied to various
strategic relationships including information
asymmetry and repeated relationships. For
example, models were used to analyze
competition between patent applicants andchanges
incompetitive
relationships
depending on how patents are licensed.
Thanks to the models, a large number ofapplication studies were conducted on
patents. In order to apply the models to thosecases in an appropriate manner, we need todefine the probability space regarding future
events and the strategy space regarding theactions by each entity. In other words, thestandard framework of the game theory does
not function properly if each respective entity
is unable to define in advance individual
events that could happen in the future, i.e.,
in cases where each economic entity is unable
to fully define every element of the event

Introduction
As an increasing number of people
recognize the applicability of “laws andeconomics” to intellectual property study,
legal scholars as well as economists are
increasingly aware of the importance of theex-ante viewpoint that enables them topredict what kinds of incentive-basedchanges an institutional change will bringabout. For instance, the court decision for a
dispute serves as a rule that fills gaps in laws
or regulations. Moreover, the court decision
will be used not only as a precedent for the
purpose of court judgments in the future but
also as a code of conduct applicable to privatetransactions. In short, it will influence
incentives of individual economic entities inchoosing what action to take. For this reason,
it would be desirable for ex-post court
settlement of individual disputes to take into
consideration both the fairness and theeconomic efficiency of the court decision as acode of conduct that individual entities referto before they take any actions. Needless tosay, in the case of laws and regulations,which are established as general rules in thefirst place, the importance of rule efficiency is
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companies often do not maximize the social
welfare. This problem could take the form ofeither underinvestment due to the lack of apatent system or overinvestment due to theexistence of a patent system, whichsometimes overstimulates corporate researchand development activities, causing them tomake duplicate efforts to develop the same
technology. Either case would be socially
undesirable.
Regarding this model, it should be notedthat the rationality of the acting entity is
unbounded even though there is uncertainty
in problems related to the decision-making
process of each firm. Even though the successof the research and development activities is
uncertain, this uncertainty does not meanthat the rationality is bounded. The
presumption of the model is that each firmmakes a decision based on the predicted
returns, which are completely computable.
Another presumption is that the technologythat should be developed is known and thesocial value of the technology is known to thecompanies.
However, this presumption does not
apply to the actual development of newtechnology for which a patent will be sought.
This is because technology should at least be
considered to be lacking non-obviousness if
the technology that should be developed ispredictable or definable by everyone inadvance. Technology cannot be regarded as
patentable unless it is new and difficult toconceive based on existing technology. A
prerequisite for a patentable invention isthat it cannot be accurately defined inadvance. In short, the model is applicable as
far as the probability space can be strictly
defined ex ante. As a result, the model
excludes a large part of the race fortechnological development in the real world,which is difficult to define in advance inprinciple.
Similarly, a patent, which functions as
an exclusive right, is never granted as a“technology with certain value V.” Thecontents of each patentable technology can bespace for which the probability should bedetermined (whereas the existence of
uncertainty itself does not cause a problem).
In such a case, some alteration of theframework is necessary. In this paper, we will
first look at concepts such as describability
and bounded rationality, which are used to
predict future events or to define the limits interms of calculativeness. After reviewing
these concepts from theoretical studies
accumulated in the past, we will describe how
those concept can affect the framework ofpatent analysis. We will also conduct anempirical analysis on the patent system withthe explicit application of the concept ofbounded rationality.

Chapter I
Chapter I points out the importance ofthe concept of bounded rationality, whichmeans that “the rationality of human being isbounded.” This concept was established by
Herbert Simon(*1) and Kenneth Arrow(*2)
several decades ago. Chapter I also outlines
other concepts that have been developed inclose relation to the concept of bounded
rationality. Those other concepts include
describability,
verifiability,
incomplete
contracts, and transaction costs.
<Approach that does not take bounded
rationality into consideration>
If we consider a simplified model ofpatent race, it would be clear that one of thebasic issues of the patent system is whether
the event space can be fully defined. The
direct implication of this model is that thesocial welfare would be damaged if a patent
system prompts companies to make many
duplicate investments in their respective
research and development activities. Wheneach firm calculates the expected profits it
could gain in return for its investment, thefirm focuses only on itself and decides what
action to take based on the calculated result.
For this reason, collective decisions of(*1) Simon, Herbert. Administrative Behavior. New York: Macmillan; 1961.
(*2) Arrow, Kenneth. The Limits of Organization. New York: Norton; 1974.

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from transaction costs. In microeconomics, it
is assumed in general that the allocation of
resources in society is made through themarket. However, the market is not the only
resource allocation mechanism. Another formof resource allocation mechanism exists
within firm organizations well. There must
be a rational reason that justifies theexistence of a resource allocation mechanism
at each firm in addition to such a mechanismof the market economy. Coase concluded that
there must be some mechanism to savetransaction costs and presented the conceptof “transaction cost” that affects “boundariesof the firm.” In other words, the hightransaction costs for market transactions
must be responsible for a company’s practiceof conducting transactions within itself andnot conducting market transactions to
procure goods and services from outside,although such procurement from the market
is possible. What is important about thisconcept is that the issue is the relativeadvantage between the “methods of economictransaction management” such as market
transactions
andinternal
corporatetransactions. The relative difference among
those methods in terms of efficiency is called
transaction costs.(*4)
In contrast to this concept of Coaseestablished in 1937, Williamson pointed outthat the core of the problem was therelationship between the characteristics of atransaction and those of the inter-temporalgovernance structure. He showed some of theattributes of a transaction as the elementsthat change the relative efficiency differenceof the governance structures. For example,
his conclusion is that, due to thecharacteristics of human beings such as
bounded rationality(*5) and opportunism, themoreasset-specificandcomplexatransaction is, the more disadvantageous it
would become in relative terms to manage

defined only ex post through the patent
granting process because the technology has
countless attributes that are difficult to
identify in advance. If the goal cannot be
specified beforehand even stochastically, it is
impossible to determine the incentive
mechanism. One of the characteristics of thepatent system is to set the scope of amonopoly right ex post on the presumptionthat no one can accurately predict thetechnology to be invented.
<Approach that takes bounded rationality
into consideration>
Tirole argues in his paper entitled“Incomplete contracts, where do we stand?”(*3)
that the existence of incompleteness in thesense that no one can tell what to invent inadvance is the reason for a nation to promotetechnological development through a patent
system, which grants monopoly rights toinventors, and not through a national bonus
system. He also reiterates that one of themost important issues in economics is theconcept of incomplete contracts and related
concepts such as property rights andauthority. In sum, an intrinsic and uniquecharacteristic of the patent system is that itis difficult to tell a patentable invention inadvance in principle. The concept ofincompleteness is indispensable in theanalysis of a wide range of property rights
and contracts because such a concept has aclose relationship with ex-ante bounded
rationality. In other words, the concepts ofbounded rationality and incompleteness are
not special concepts used only to explain
certain policies. Those concepts are basic
concepts applicable to general matters. These
concepts have a long research history and are
not limited only to patent issues. Therefore,
it would be useful to review the developmentof the concepts.
The concept of incompleteness stems(*3) Jean Tirole (1994), “Incomplete contracts, where do we stand? ”, Walras-Bowley lecture delivered at the North American summer
meetings of the Econometric Society, Quebec City.
The revised version of this paper does not address the issues related to the patent system as a system of incomplete contracts probably
because of the limitation on the number of words imposed by the publisher.
Tirole, Jean, 1999, "Incomplete Contracts: Where Do We Stand?" Econometrica, vol.67, no.4, pp.741-781(*4) It should be noted that Coase examined static aspects only. Presuming that the searching cost was the major component of thetransaction cost, he did not examine the efficiency of each governance structure from an inter-temporal perspective.
(*5) Simon, Herbert, 1961, "Administrative Behavior," Macmillan.

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economists as Coase, Arrow, and Simon.
There
are
many
definitions
forincompleteness and incomplete contracts.
One of the definitions does not assume theexistence of indescribability and includes
such an incomplete contract between theparties who have chosen not to fully specify
the future events in advance although they
could have done so if they chose to do so. A
similar development has been observed in ananalysis of a contract that takes a simple
form but has self-binding functions over along-term business relationships.(*6) In
essence, while the axiomatic conditions are
yet to be established clearly,(*7) what thesearguments have in common is their claim
that, in some cases, the non-market economic
governance structure becomes necessary andmore efficient when some of the following
three conditions are met: (i) indescribability,(ii) non-verifiability, and (iii) inability toprohibit ex-post renegotiations based on
mutual agreement between the parties
concerned. While the definition of an
incomplete contract and the scope of thedefinition are yet to be determined, it seems
to be widely accepted that the concept ofincomplete contracts and relevant concepts
play extremely important roles for further
understanding of the effectiveness ofproperty rights and contracts. Underneaththe widely accepted belief, there lies theunanswered question as to how the concept ofbounded rationality should be treated from atheoretical perspective.

the transaction as a simple market
transaction. In sum, it becomes relatively
more advantageous to conduct a transaction
internally within one firm. In other words, heanalyzedinter-temporalgovernancestructures in a way that the efficiency as awhole would change as a result of governancechoice.
Based on this concept, Grossman, Hart,
and Moore created an original model called
incomplete contracts models around 1990.
These models are sometimes referred to as
the description of hold-up problems throughthe property right approach because themodels made it possible to explain the
problems by use of simple models that
disregard information asymmetry. Thisapproach contributed to spreading theconceptof“transaction
cost”
among
economists once again following a period
during which the concept of “transactioncost” was long rejected simply as tautology
due to the lack of theoretical grounds. It isparticularly meaningful that those models
have made the following two ideas widely
accepted. The first one is that the transaction
costs other than those costs monetarily liketelecommunications costs and the cost of theforms and manpower to prepare and conclude
contracts are fundamentally important for acompany to make a decision on the choice ofgovernance. The other idea is that it isimportant to keep an inter-temporalperspective.
The important presumption within theframeworks
proposedby
Williamson,
Grossman, Hart, and Moore is that it isdifficult to define the scope of events that
could happen in the future. The concept ofbounded rationality was one of the essential
elements of incomplete contracts because it
was impossible for the party involved in atransaction to fully specify the subject matterof the transaction in advance. In sum, in theworks of Williamson and Hart, we can see thetrace of the concept of “bounded rationality,”
which was regarded as intrinsic by such<Twostandpoints
regardingboundedrationality>
As described above, Most of the many
economic models for patent analysis
accumulated up till now were created basedon the presumption that the probability
space can be properly defined in advance sothat ex-ante analysis is made possible. This
presumption is, however, questionable. The
presumptionisratheratheoreticalassumption made for the sake of convenience.

(*6) Levin, Jonathan, 2003, "Relational Incentive Contracts," American Economic Review, vol.93, no.3, pp.835-857.
(*7) Hideshi Ito, Keiyakuno keizai riron (Economic Theory on Contracts), Chapter IX [Yuhikaku, 2003]

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equal to the cost of carrying out the sametransactions
throughopenmarketexchanges .” For example, it is commonly
believed that a firm makes a choice frombetween institutional options such as its
internal system and a contract for market
transactions based on the difference inrelative costs (in such a way that makes
marginal costs equal). In short, it is
implicitly assumed that any economic entitythat chooses an inefficient option will
eventually cease to exist. The choices madeby companies and the market are assumed to
be a static equilibrium in the long run. Thus,
anything that continues to exist in reality
could be statistically suggesting that thecontinued existence is attributable to its
relative efficiency.
We take an endogenous approach to
studying the legal structure including rights
and contracts in the sense that privateordering is established in the pursuit ofrationality and cost saving. In this respect,
we try to expand the conventional frameworkof “laws and economics” by replacing a part ofits presumptions with new ones.
These standpoints have been taken byresearchers who tried to analyze the researchand development processes and the functionsof patents in the society as a whole. Initially,studies concerning the forms of technology
transactions were conducted by examining
methods of technology transfer to anothercountry, such as internal transfer or licensing
the technology to a third party. It is predicted,
based on the concept of transaction costs,
that a firm that has developed technology
will choose to use it internally if the cost of
preparing a contract to license the technology
to another party is very high. In the case of
an international technology transfer, it would
take the form of direct investment rather
than licensing. Empirical studies verified thefact that technology is likely to be transferredthrough direct investment if the technology
has recently been developed or the technology
consists of knowledge that is difficult to

Therefore, the assumption could be a subjectof study in itself and should not, by anymeans, be regarded as the only possibility. In
order to study how those models function inreality, it is important to take an empiricalapproach.

Chapter II
Chapter II examines how those basic
concepts are applied. As outlined in Chapter I,
this paper focuses on various concepts suchas bounded rationality. Those concepts areoften excluded from current analyses on
incentives. As no uniform method for using
concepts such as bounded rationality has
been established, there are mixed views on
the meaning of those concepts in reality. It istherefore not our intention to deny the mainstream analytical freamwork and propose areplacement. What we can do instead is todescribe empirical studies with the explicit
application of the concept of bounded
rationality. Such a study is proven to bepossible as it has been conducted for morethan ten years. Chapter II briefly describes“transaction cost,” which is one of the basic
concepts used in such empirical study, and“the optimization of the private governancestructure.”
Coase adopted the viewpoint of choicewith marginal costs in his original paper inwhich he presented the concept of transaction
costs. The market mechanism can becharacterized by the problem of marginal
choice, which can be summarized as “if theprice of a production factor A is higher in X
than in Y, the factor A will be adjusted fromX to Y until the price difference between X
and Y disappears (other conditions being
equal).” Similarly, the expansion of a firm isinterpreted as an issue of choice in an
attempt to make the marginal costs equal as
he explained that “--- until the cost of
establishing an internal structure within thefirm for additional transactions becomes5
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to legally monopolize an invention. However,it should not be limited to permission for the
exclusive use of the invention but should
rather contribute to promoting business
transactions.
Furthermore,businesstransactions connected with any technology
protected under the intellectual propertysystem are indispensable for the process ofsocial diffusion of technical development
results. Promotion of such transactions is oneof the major purposes of the intellectual
property system. Therefore, for our better
understanding of the diffusion mechanism oftechnology after its development, it isbeneficial to examine which technology“transaction” method is selected by eachprivateeconomic
entityundertheintellectual property system.

explain in writing.(*8) This indicates that thedegreeofindescribability
positively
correlates with the frequency of the use of thenonmarket transaction management method.
This correlation is also suggested by the logicof transaction costs.
A study conducted by use of the patentcitation data(*9) of the United States verified
that the nonmarket governance is likely to bechosen by a firm involved in a knowledgetransaction where it is difficult for a court toenforce the contract ex post. For example, one
study(*10) shows that mutual patent citation ismade more often in the case of a technology
transfer and joint research development
among companies that have capital ties with
one another than in such transfer anddevelopment between companies that haveno capital ties. This finding is the same asthat of an empirical study(*11) whichconcluded that a contract is likely to be
struck among companies that have capitalties with one another especially when thelicensing of the technology is likely todamage the appropriability of the technology.
A citation can be used as a proxy variable ofknowledge transfer because the citation is a
result of new technology development basedon the transferred knowledge. This indicatesthe fact that the licensing of existing
technology contributes to future innovationand therefore that the indescribable resultsof ex-post technology development are also
implicitly subject to the transaction.
Many studies have taken the approachthat the research and development process
should be analyzed on the assumption thatthe private governance structures differ in
efficiency. Above all, it is necessary torecognize that transactions exist in theprocess of research and development in thesociety as a whole. A patent allows the owner

Chapter III
Chapter III presents some examples of
empirical study that take the concept ofbounded rationality into account in ways
other
than
the
above-mentioned“optimization of the private governancestructure.” More specifically, we focus ondivisional applications that tend to be
conducted for technology of important value.
We analyze data to examine whether theconcept of bounded rationality is applicableto the use of the divisional application systemby patent applicants anticipating subsequent
research and development. If an applicant isable to predict development trends in the
distant future and devise measures inadvance accordingly, he will try to refine his
claims as much as possible throughmodifications and divisions. This would
especially be true if the patent application isfor promising technology that is expected to(*8) Davidson, W.H. and Donald McFetridge,1984, “International Technology Transactions and the Theory of the Firm,” Journal of Industrial
Economics, vol.32, no.3 pp.253-264.
Kogut, Bruce, and Udo Zander, 1993,”Knowledge of the firm and the evolutionary theory of the multinational corporation,” Journal of International
Business Studies, vol.24 no.4, pp.625-645.
(*9) Jaffe, Adam, Manuel Trajtenberg, and Michael Fogarty, 2000, “Knowledge Spillovers and Patent Citations: Evidence from a Survey of Inventors,”
American Economic Review, vol.90 no.2 pp. 215-218(*10) Mowery, David, Joanne Oxley, and Brian Silverman, 1996, “Strategic Alliances and Interfirm Knowledge Transfer,” Strategic Management
Journal, vol.17 pp.77-91.
Wada, Tetsuo, 2001, “Equity Joint Ventures and the Scope of Knowledge Transfer between Diversified Firms: Evidence from U.S.-Japan Alliances,”
paper presented at the 5th Annual Conference of the International Society for New Institutional Economics.
(*11) Oxley, Joanne, 1997, “Appropriability Hazards and Governance in Strategic Alliances, Journal of Law, Economics, and Organization, vol.13
no.2, pp.387-409.

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observable from even the time prior to thecommencement of the patent examination.
In addition to the differentiation between
the proactive division and reactive division ofa patent, we classified divisional applications
into two groups based on the timing for thedevelopment of related technology. Then weanalyzed each class and found thatapplicants’ choice of divisional application,i.e., which type of division was conducted, isdependent on the cumulative technologicaldevelopment. We noticed that proactive
division, which is carried out voluntarily andstrategically, was more strongly influencedbythesurrounding
technologicaldevelopment. In other words, in view of thefact that division can be a private andex-ante value indicator, we were able toconclude that proactive division was probably
influenced by the trends in the surrounding
technological development observable at thattime. If an applicant was able to predict
trends in technological development into the
distant future and devise countermeasuresaccordingly, he would carefully refine theclaims for any technology that is expected togive rise to a series of products to which thetechnology would be applied. However, thefact that this is not the case in reality, seems
to indicate the existence of the bounded
rationality of the applicant.
These study results would have policy
implications as follows. The systems ofdivisional application and correction as wellas the United States’ system of continuation
applications are socially costly systems
because the permission for division andcorrection of an application over a long periodof time tends to result in a prolonged
examination period. The resulting delay inthe finalization of the right would also deter
investment by rival companies and cause
other problems. Admittedly, technology
subject to divisional application usually has ahigh social value as shown in this paper.
Therefore, it would be justifiable to someextent to pay the public costs of conducting
additional examination for the purpose ofallowing applicants to modify and refine theirrespective claims. Such public cost incurred

have very long-term implications significance.
If the applicant has bounded rationality, itmeans that he has the limited ability to
predict basic technology trends. If this is thecase, there is always a discrepancy between
the value index predicted from the ex-anteaction of the applicant and the ex-post value
index.
As a precondition, we need to consider
the probability of divisional applications
becoming a proxy variable of economic value.
Many empirical studies conducted in the past
support the argument that the length of aperiod during which a patent is kept renewed
can be an indicator of the ex-post private
value of a patent. If a patent is expected togenerate private profits, a proportionate
amount of costs will be paid. Therefore, theprivate costs can be an ex-post indicator of
the private value of the patent. Since
divisional applications incur a certain
amount of expenses, they would not be
conducted if a proportionate amount ofprivate profits are not expected to begenerated. For these reasons, there is alikelihood that divisional applications will be
used as a private value indicator.
Based on information on the frequency of
forward citations, which indicates how often
a certain patent is cited by subsequent
patents, we conducted a study to find out
whether divisional applications can be used
as an indicator of economic value. In thisstudy, we differentiated proactive divisions,which are conducted voluntarily andstrategically, from reactive divisions, which
are conducted in response to an external
event such as the receipt of a notice about thereason for rejection. We combined the patent
data of Japan with that of the United States
through use of international patent family
data and analyzed the combined data. We
found that patent division showed the level of
economic value of the original applicationeven after we controlled many other relevant
factors. The same applies to the case ofproactive division, which is voluntarily
conducted by the applicant. Thus, it can besaid that divisional application can be a
private and ex-ante indicator externally
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its interpretation, he/she can not be
exempted from the cost. Furthermore, as
discussed in Chapter III, a patent right itself
is intrinsically incomplete in principle.
Therefore, applicants should deal with such
issues as the equivalents and the prosecution
history estoppel, which tend to cause
problems attributable to future uncertainty.
For this reason, applicants have to incur
costs that are difficult to express in monetary
terms. As described in Chapter I, the patent
system itself and various transactions
relatedtopatents
inevitably
entailtransactions costs formulated by use of suchconcepts
as“incompleteness,”“indescribability,” and “non-verifiability,”
which stem from bounded rationality. Related
to these theoretical issues, many problems
remain unsolved. Further study should be
conducted by adopting new approaches andrevising current ones.
A study approach that should be newly
adopted or revised is not designed to directly
question the appropriateness of laws
themselves in normative sense but is rather
designed to deepen the understanding of
behavioral
laws
applicabletotherelationships between the rules and the
conduct of private economic entities. It would
not be enough to pay attention only to thepatterns of the direct effects of legal norms,
which can be regarded as outside conditions,on conduct. For example, self-enforcing
contracts, which are privately created,managed, and implemented rules applicable
to individual economic entities, are, in fact,
endogenous rules established by respective
private economic entities by choice andtherefore should be regarded as an object foranalysis and not as given outside conditions.
In other words, a two-way analysis isnecessary whereas the classic “laws andeconomics” consider the rules are given as
outside conditions and subserviently observe
the choice of conduct. Endogenous study ofboth conduct and a part of the rules willremain important. Such study should include
themethodtoprivately
managetransactional relationships. One example ofsuch study is an empirical study of thewould also contribute to the private interestof any applicant who submits a divisional
application in spite of additional costs suchas a handling fee.
However, any applicant who intends tosubmit a divisional application is not in aposition to do much more than observe thetechnological development currently inprogress due to the limited ability to predict
future trends in technological development.
Therefore, he is unable to judge the necessityof modifying his claims in anticipation of thelong-term technological effects on the society
as a whole. This explains the inevitable
failure experienced by an applicant in an
attempt to choose the most fundamental andbasic innovation from among cumulative
innovations that could be made many years
after the original invention. The applicant
tries to make such a choice before submitting
a divisional application in order to gainstrong protection for the fundamental
innovation, but cannot avoid his limitation inpredicting future developments.

Conclusion
The concept of bounded rationality used
to often be neglected in the conventional
sphere of “laws and economics.” Since the1990s, however, it has become a major issue
in economics. This paper aims to review thebasis for economic analysis of intellectual
property rights. It also studies future
possibilities by presenting other approaches
that could provide appropriate researchframeworks.
The cost to exercise a patent right has
become an increasingly important issue forcompanies in the face of an increase in thenumber of patent infringements, patentdisputes, damages claimed, and litigation
costs. Needless to say, one of the actual
problems is a direct cost of exercising apatent right. This cost takes the form of asearch for a latent infringement in order toexercise the right in question. Even if aholder of a patent that is established soclearly that allows no room for dispute over
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contractual relationships conducted inconsideration of transaction costs. As seen in
Chapter II, many high-quality studies havebeen carried out through this approach,suggesting clues for theoretical and empiricaldevelopment. Future study is expected toempirically verify theoretical predictions byusing an economic theoretical framework
based mainly on the concept of bounded
rationality and, as described in Chapter III,to gain a new theoretical insight byidentifying
contradictions
betweentheoretical predictions and actual data.

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