International Think-Tank on Innovation and Competition
Trade secrets and interoperability
December 22nd, 2005
New ideas are often protected with patents, but these are not the only form of protection for innovations. Not all inventive and innovative activities fall under the scope of patentability and it is not always in the interest of a firm to patent every single innovation: some of them are just kept secret. Trade secrets exist in any business, they are also the result of years of investments and experience, and often represent a deserved comparative advantage in the market. In most high tech sectors, firms adopt a combination of patents and trade secrets to protect products which are the result of multiple innovations. Defending (intellectual or material) property rights is one of the fundamental conditions for a proper functioning of the market economy: defending trade secrets has not a minor role in this context. But there is more than that. Let us start from one of the most famous trade secrets.
A key of the success of Coca-Cola has been, for more than a century, the formula of its famous soft drink. More precisely, in 1886, in Atlanta, the pharmacist Dr. Pemberton’s prepared the popular syrup added of carbonated water for the first time in his backyard. At first he distributed the new product by carrying Coca-Cola in a jug down the street to Jacobs Pharmacy. The bookkeeper of the pharmacy, Frank M. Robinson, suggested the name and penned Coca-Cola in the unique flowing script that now is well known worldwide. As the company expanded, the new owner Candler could not prepare the syrup all himself, so the ingredients were all simply labelled 1 to 9 and the managers at the branch factories were only told the proportions required and the mixing procedure. Today, the secrete of Coke lies in a safe deposit vault at the Trust Company of Georgia (USA) and, it is said, only the company directors can authorise the opening of the vault. Although numerous outlets around the world have a franchise to bottle or can and to distribute the beverage, none knows the precise ingredients. They are simply supplied with syrups and other ingredients from the Coca-Cola company and mix them with carbonated water.
This trade secret represents a competitive advantage for Coca-Cola, but many companies around the world invest to prepare new and original soft drinks competing with Coke. While there is at least one well known global competitor, Pespi, which has created a similar successful drink (as well known, behind the vanilla, coca and kola tastes, Coke is more orange-biased, and Pepsi is more lemon-flavoured and sweeter), the market for soft drinks is quite competitive and there is substantially free entry at the local level. Many competitors have tried to discover Coke’s trade secret. William Poundstone did some painstaking research when he published in his 1993 book “Big Secrets”. He suggests that the basics ingredients of Coke are: 1) sugar, 2) caramel, 3) caffeine, 4) phosphoric, 5) coca leaf extract (with its cocaine content removed) and a small amount of cola nut extract, 6) citric acid and sodium citrate, 7) lemon, orange, lime, cassia (a type of cinnamon), nutmeg oils, and probably others, 8) glycerine, 9) vanilla. Although the proportions of some of these ingredients all mixed with carbonated water can be discovered by chemical analysis; the most important and most elusive is the mixture of essential oils is merchandise 7). The flavour of the mixture is not simply the sum totals of the oils, because other flavours are created by the interaction of the oils. Anyone trying to reproduce the mixture would need to know the exact ingredients which are difficult to analyse with certainty and their precise proportions. It is rumoured that not less than two and no more then three picked people ever know it at the same time, and they never travel together.
Now imagine that Coca-cola was required to disclose its secret formula. Anybody could reproduce the very same drink, “clone” it under a different name if you like, but it is hard to believe that this would create large gains for consumers. Close substitutes to Coke already exist and there are small margins to substantially reduce prices. However, the incentives for any other firm to invest and create new products could be drastically reduced if trade secrets would not be protected (again, not all innovations are patentable and, in general, trade secrets can be advantageous over patents for certain innovations).
Things get more complicated in high-tech sectors. In these sectors trade secrets often cover fundamental innovations and protecting them amounts to promote new fundamental innovations, which are the main engine of growth. In some fields, however, there maybe, at least apparently, a trade-off between trade secret protection and “interoperability” between products, which is, broadly speaking, the ability to exchange and use information and data, especially in networks (like telecommunications, on line business, software). For instance, take in consideration the leading on line search engine in the world, Google. We may look at its patented innovations, but after that, we would need to know its trade secrets to fully discover the mechanism of its precious algorithms. This would help many software companies and websites to interoperate with Google even better than they already do, as it would allow other search engines to improve their performances compared to that of the leading search engine. But after that, we can bet, few companies would invest huge resources and take substantial risks to create a leading search engine or other brilliant ideas like Google when they can just free ride on other’s ideas.
Fortunately, giving up to the precious role of trade secrets, or other IPRs, in promoting innovations is not the only way to solve interoperability challenges. The market can do it much better! Valuable ideas can be selectively commercialized on a voluntary basis through licenses. The Nobel prize R. Coase (1960, The Problem of Social Cost, Journal of Law and Economics) has clarified that whenever there is social value to generate, the market will properly allocate even the IPRs, insuring the accessibility of the information that fuels interoperability and acknowledging legitimate ownership rights of the innovators, and hence enhancing R&D investments. This result is just strengthened in the markets of the New Economy, where interoperability enhances network effects and hence it is in the interest of the largest firms to promote it adequately to strengthen demand for their products. In particular, as the new theory of market leaders as shown, market leaders have a further incentive to promote high levels of interoperability through licenses of their IPRs so as to increase the size of their networks and markets, while any exogenous weakening of IPRs can only reduce the incentives to invest in R&D by both the leaders and their competitors.
And dynamic market forces can do even more. As long as IPRs are well protected and firms can invest with the safe confidence that successful innovations will be rewarded, market forces can select the best standard when multiple standards are available and interoperability is only partial. In a famous book, S. Liebowitz and S. Margolis (1999, “Winners, Losers, and Microsoft: Competition and Antitrust in High Technology”) have shown that this was the case in many episodes. For instance, in the adoption of the QWERTY keybord, the one which is probably in front of you while reading Intertic (look at the first five letters on the top left of your keyboard): for years it has been claimed that the usual allocation of letters of this keyboard was an inefficient standard, while these researchers found out that all the evidence suggests that the Qwerty keyboard, somehow selected by the market, is not worse than any other alternative.
It can be very dangerous to weaken the protection of trade secrets and IPRs in high tech sectors, even under the purpose of promoting interoperability. Markets can properly balance the short run and long run interests of the consumers: promote innovation, enable an efficient degree of interoperability and select the best standards.
