Would one ever put a quarter in a parking meter if the fine for illegal parking were $0.25? The most common remedy for patent infringement is a reasonable royalty, which is estimated as the outcome of a hypothetical negotiation at the time of first infringement. That is, the most common remedy for infringement is the price the infringer would have paid absent the infringement. Such a remedy minimizes the incentive for a potential licensee to seek a license before infringement. In addition, the remedy grants to the infringer a valuable real option to infringe a patent and pay a royalty in the future roughly equal to the royalty that would be paid today. That royalty is paid only if (1) the infringement is discovered, (2) the potential royalty is significant enough to cover the transaction costs of licensing, and (3) the patent holder is successful in enforcing its patent rights.

In this article, I show how the reasonable royalty as traditionally calculated by U.S. courts is not “adequate to compensate for infringement” as required by the Patent Act, and how the inclusion of the real option value rectifies the shortcomings of traditional damages calculations, fits within the existing legal framework for damages, and improves economic welfare. Simply put, the real option’s inclusion contemplates a negotiation in which licensor and licensee negotiate over a license to start paying royalties at some point in the future, more closely aligning the negotiation with observed behavior. In addition to the expected gains from reducing the free riding on the patented innovation, the inclusion of the real option value of infringement within the hypothetical negotiation leads to increased rates of licensing early in the period of infringement, efficiently allocates risk between licensee and licensor, and reduces the costs of entry, increasing long-run economic welfare.