Patent Exhaustion Regime and International Production Sharing: Winner and Losers?

On May 30, 2017, the Supreme Court held that the initial authorized sale of a patented item within or outside the U.S. "exhausts" all rights of the patentee to that item under the Patent Act. This decision goes against the Government’s position that a foreign sale authorized by the U.S. patentee should exhaust U.S. patent rights by default unless the patentee expressly reserved those rights. We examine how a shift in Northern regime from presumptive international exhaustion (PIE)---which presumes that a foreign sale triggers exhaustion but permits express-reservation of rights---to absolute international exhaustion (AIE)---which effectively precludes express-reservation of rights---impacts global welfare and its distribution. PIE subjects the firms that source in the South and sell in the North to the risk of a patent infringement lawsuit but allows the firms to price discriminate internationally. AIE allows the firms to avoid a patent infringement lawsuit but also precludes international price discrimination. Firms differ in the extent to which they engage in international fragmentation of their production process. We find that being engaged in the international fragmentation of production is neither a necessary nor a sufficient condition for a firm to prefer AIE over PIE. Nonetheless, it is still true that Northern firms with high cost share of the components that can be outsourced to the South tend to prefer AIE, while firms with low cost share of those components tend to prefer PIE. A shift from PIE to AIE increases fragmentation, lowers production costs, and eliminates North-South price discrimination in the final good. Global welfare rises. Welfare also rises in the North but falls in the South if the impact on firms' incentive for production fragmentation is weak, cost savings from sourcing in the South are low, or the Northern and Southern markets are dissimilar in size and average willingness to pay for each good.