State of Innovation

Patents and Innovation Economics

The High Cost of Marketing and Selling an Invention

Inventors and critics of the patent system often ignore or are ignorant of the high cost of marketing and selling a new product embodying an invention.   I discussed this cost in Invention- A Financial Analysis http://hallingblog.com/2010/08/13/invention-–-a-financial-analysis/.  This cost is the variable Mi in the equation I developed as part of the financial analysis.  Another paper that discusses this additional cost that inventor’s incur in marketing and selling their invention compared to a me-too produces, is The Nature and Function of the Patent System[1].  Kitch, the author, explains:

Even in the case of an innovation patented in fully commercial form – as is the case with many relatively trivial patents – the firm must make significant investments to simply distribute and market the invention.  But expenditures necessary to identify the market for the product and to persuade potential customers of its utility can easily be captured by competitive imitations.  Absent a patent on the product, the incentives to provide information to purchasers about their need for a product as opposed to information about the particular characteristics of the seller’s product are limited.  The trademark law protects only the names and symbols identifying the seller’s product; it confers no protection against imitators of the product itself.  Thus competitors can ride on the demand for the product created by the first seller without incurring the expenses necessary to inform buyers of the advantages of the product.  Only in the case of a patented product in a firm able to make the expenditures necessary to bring the advantages of the product to the attention of the customer without fear of competitive appropriation if the product proves successful.  This aspect of the cost of introducing innovations is stressed here both because managements find that marketing is a major cost in innovation and to illustrate that even in the case where nothing remains but to make and sell the patented invention, there are significant costs whose return could be appropriated by competitors.  Absent a patent, firms have less than the optimal incentive to invest in providing information about and techniques for using the new technology.[2]

Inventors need to take these additional costs into account when undertaking a new venture.  There are several strategies that can be used to reduce these costs.  For instance, teaming with an existing company that has a strong market presence (marketing channel partner) in your marketplace.  Another solution is to invent only line extensions to a company’s existing products.  This second solution is common for large companies and is why large companies are not known for inventing revolutionary or disruptive technologies.

Critics of the patent system have to answer why they believe inventors will develop new technologies when it puts them at a cost disadvantage compared to copiers.

[1] Kitch, Edmund W., The Nature and Function of the Patent System, Journal of Law and Economics, Vo. 20, No. 2 (Oct., 1977) pp. 265-290.

[2] Ibid. p. 277

September 6, 2010 Posted by dbhalling | -Economics, Innovation, Patents | , , , , , , | Leave a Comment

The US Economy and the State of Innovation

About a year ago I finished my book The Decline and Fall of the American Entrepreneur: How Little Known Laws and Regulations are Killing Innovation.  The book argues that the US economy was faltering long before the financial crises because changes to our laws were inhibiting investment in technological advances.  Intellectual, financial, and human capital are the three foundations necessary to develop new inventions and all three have been undermined since 2000.  In this post I will review how the policies affecting these foundations have changed in the last year.

Intellectual Capital: patents mainly represent this prong.  The good news is that David Kappos replaced the incompetent and traitorous Jon Dudas.  Kappos is a patent attorney and therefore also has a technical background.  Unfortunately, he spent his whole career working for large companies and does not understand the challenges of individual inventors and technology start-up companies.  The bad news is that Supreme Court again illustrated their utter incompetence in the Bilski decision.  None of the Justices understand the difference between the utility requirement under 35 USC 101, the novelty requirement 35 USC 102 and the obviousness requirement 35 USC 103.  The justices demonstrated that they do not understand the need for a working embodiment (35 USC 112) in order to even evaluate 101 and 102 issues.  They presented nonsense hypothetical’s in oral argument that were not enabled and then demanded to know whether these hypothetical’s meet the utility requirement.  They also made absurd statements that patents limit the flow of information.  Another low point in the year was the farcical ruling in the ACLU v. Myriad case.  The judge ignored the law and wrote 100 pages of nonsense to his cover up his crime.

Despite some progress in this area, overall the US continued to weaken the Intellectual Capital foundation necessary for economic growth, job creation, and investment in inventions.

Financial Capital: Sarbanes Oxley significantly undermined this foundation.  The only good news is that the financial reform bill raised the threshold for the application of SOX to $60 million in market capitalization.  However, SOX did incredible damage to our economy in only 60 pages.  The financial reform bill is 2700 pages and no one knows all the damage it will cause, but it certainly was not a step in the right direction.  The major issue financial reform should have addressed was Fannie and Freddie and it did not even address this issue.

There was no progress at all in this area.

Human Capital: this was undermined by the FASB rules requiring the expensing of stock options.  Despite the fact that accountants are unable to understand the simple fact that dividing a pie does not reduce the size of the pie, this idiotic policy continues unchallenged.

The US has made no progress in the last year in implementing policies that would encourage technological entrepreneurship.  The US is continuing its corny capitalism policies that reward political connections over true economic progress.

The US is also likely to increase the capital gains tax rate from 15% to 20% in 2011.  This will further damage the incentive to invest in new technologies.  The Obama administration is proving that it is even more incompetent than the Bush administration.

September 2, 2010 Posted by dbhalling | -Economics, Innovation, Patents | , , , , , | Leave a Comment

Rent Seeking and Patents

Patents are often analyzed as monopolies or rent seeking.  Patents are clearly not a monopoly.  A monopoly give the exclusive right to sell a product or service.  A patent does not give the holder this right.[1] For more information see The Myth that Patents are Monopoly.

The concept of economic rent is a more useful concept than monopoly for analyzing patent law. In the typical patent case production will either remain the same or increase compared to the pre-patent situation.  As a result of the invention, protected by the patent, the inventor has a cost advantage that allows him to make more money–economic rent–than his competitors.  In that sense there is no restriction of production and hence no monopoly.[2]

Economic rent is defined in Wikipedia as “excess returns” above “normal levels” and they are associated with a lack of competition in markets.[3] What is meant by “normal levels” of return?   Is it the same return that a person could make by putting their money in the bank?  Or is the same return a person could make by investing in the stock market?  Or is the same return that a person could make by investing in non-inventive manufacturing or service business?  The concept of “excess returns” suffers from the same flaws as all socialist concepts of fairness – who decides?  The concept of “excess returns” only makes any sense statistically.  We are not talking about the returns from a specific patented invention, but the average return from inventing versus other economic investments.  In addition, it only makes sense to compare the return on patented inventions to investments in private manufacturing or private service businesses.  Let’s assume that the people who suggest that patents are rent seeking mean, patent holders are on average (statistically) receiving a higher return (excess return) compared to other similar private investments.  For simplicity I will assume a private manufacturing business.  Based on these assumptions, would the fact that investors in patent inventions (hereinafter inventors) receive a higher return than other manufacturing business be bad for the economy or bad for consumers?  Let’s be clear that most commentators who state that patent holders are rent seekers, believe this would be damning evidence against patents.

There are several possible scenarios that meet the assumptions above: 1) inventors receive normal returns on manufacturing their invention, 2) inventors receive normal returns both on their manufacturing costs and their cost of inventing, 3) inventors receive normal returns both on their manufacturing costs and the risk adjusted costs of inventing and marketing a new invention, and 4) inventors receive excess returns both on their manufacturing costs and the risk adjusted costs of inventing and marketing a new invention.

My post Invention – A Financial Analysis , created the following mathematical model for the cost of inventing.

Ci(n) = (Inv + Mi)/P + NRE + PC*n + OH*n   (New Product based on invention)

Cmt(n) = NRE + PC*n + OH*n  (Me-too product)

Where Ci is the cost of creating a product for the owner of the invention, Inv is the cost of creating the invention, P is probability of that the invention will succeed in the market, Mi is the incremental marketing and sales cost of introducing a new invention, n is the number of products that have been produced, NRE is the nonrecurring engineering cost of setting up production, PC is the production cost of the making n products and OH is the cost of overhead for producing n products, Cmt is the cost of creating a me-too product. I will use this mathematical model to analyze the four scenarios discussed above.

Scenario 1 – Inventors Receive Normal Returns On Manufacturing Their Invention

In the above equation this means that the inventor can receive no compensation for cost of invention (Inv), the cost of marketing a new invention (Mi), or for the probability of success (P).  This means that the inventor will never be able to justify the cost of inventing (Inv, Mi, p), since it is a sunk cost that will always cause the inventor’s return to be less than they would receive by investing in other manufacturing businesses.  Why undertake the cost, risk, and hassle of inventing when you can obtain better returns by investing in any random manufacturing industry.  If this is patent critics’ idea of rent seeking, then they will essentially kill off all but accidental inventing and inventions that can be kept a trade secret.  It will also kill off all venture capital.

Scenario 2 – Inventors Receive Normal Returns on Both Their Manufacturing Costs And Their Cost Of Inventing

In this scenario inventors are allowed to receive normal returns on their inventing costs (Inv) and their manufacturing costs (NRE, PC, OH).  However, this does not compensate them for costs of marketing the invention (Mi) or their probability of success (P).  While this makes inventing slightly more favorable, it still does not justify investing in inventing instead of any random manufacturing industry.  If this is patent critics’ idea of rent seeking, then they will essentially kill off all but accidental inventing and inventions that can be kept a trade secret.  It will also kill off all venture capital.

Scenario 3 – Inventors Receive Normal Returns Both On Their Manufacturing Costs And The Risk Adjusted Costs Of Inventing And Marketing A New Invention

Now this scenario sounds fair.  Inventors (statistically) are compensated for all their true costs and risks.  Inventors are in exactly the same position as investors in any other (manufacturing) business.  In addition, inventors have the random chance of hitting the jackpot.  This supposedly fair mined solution to the problem of rent seeking by patent holders ignores the return received by the beneficiaries of the invention (hereinafter society).  Is this a fair solution if society receives an “excess return” when they buy (use) the invention?  Let’s look at a real world example to illustrate this point.  Because of the cotton gin, US cotton exports change from less than 500,000 pounds in 1793 to 93 million pounds by 1810.[4] A single cotton gin could generate up to 55 pounds[5] of cleaned cotton daily a 25 fold improvement over previous methods.[6] So Eli Whitney would receive a 10% or so return on his invention, while society (cotton farmers – owners of the cotton gin) would receive a 2500% return.  Why is it fair for Eli Whitney to receive a “normal return” of say 10% on his efforts while the purchasers of his cotton gin receive a 2500% return on their investment?  Who is the real rent seeker in this situation?

Is the Eli Whitney case an outlier case?  Real world purchasers in a B to B situation will only purchase an inventive product if they will receive more than an “normal return.”  If an invention only provides a “normal return” to the purchaser, then they will have a wide variety of known devices that will provide them average return.  There is no reason to select an inventive product that is going to require the purchaser to learn a new product and possibly alter their existing processes when they can get the same return from existing choices.  Similarly, no rational investor is going to invest in an invention if they can obtain the same return by investing in a number of other known projects.  This shows that in the real world both the inventor and the purchaser have to receive excess returns for an invention to be successful.

We know that neither the inventor nor the purchaser of the invention is expecting a normal return.  An invention will only be successful if both the buyers and the inventor receive an above normal return on their investment.  The inventor and the buyer are both rent seeking according to standard economic theory, which shows that the concept of “rent seeking” is seriously flawed.  I propose that real rent seeking is when one party to a transaction obtains above normal returns and while the other party obtains below normal returns.

It is clear that the real rent seekers are not patent holders but a society that wants to obtain the benefits of new technologies without paying the creators of these new technologies.

Scenario 4 – Inventors Receive Excess Returns Both on Their Manufacturing Costs and the Risk Adjusted Costs of Inventing and Marketing a New Invention

This is the only scenario under which inventing can be encouraged.  As explained above, both the inventor and the purchasers must receive above normal returns in order for the invention to successful in a free market economy.   This is the very definition of how economic progress occurs.  Economic progress (real increases in per capita GDP or per capita income) only occur because of increases in our level of technology.  Our patent system has to provide excess returns above normal levels for inventors if we want our economy and standard of living to increase.

[1] 35 USC 154 [2] Dam, Kenneth W., THE ECONOMIC UNDERPINNINGS OF PATENT LAW, JOHN M. OLIN LAW & ECONOMICS WORKING PAPER NO. 19 (2D SERIES), http://www.law.uchicago.edu/files/files/19.Dam_.Patent.pdf, p.4. [3] Wikipedia, Opportunity Costs, http://en.wikipedia.org/wiki/Opportunity_cost, 8/24/10. [4] Wikipedia, Eli Whitney, Jr., http://en.wikipedia.org/wiki/Eli_Whitney,_Jr., 8/24/10. [5] Wikipedia, Eli Whitney, Jr., http://en.wikipedia.org/wiki/Eli_Whitney,_Jr., 8/24/10. [6] Gordon, John Steele, An Empire of Wealth: The Epic History of American Economic Power, Harper Perennial, New York, 2004, p. 84.

August 26, 2010 Posted by dbhalling | -Economics, Innovation, Patents | , , , , | Leave a Comment

Makeup of the CAFC

I have been wondering about the number judges on the Court of Appeal for the Federal Circuit who were practicing patent attorneys.  I was surprised that I could not easily find this information.  Here is what I found (I believe this information is accurate, but if I am mistaken please let me know).  According the CAFC’s website there are 15 judges and five of them are patent attorneys.  Six of the judges have technical backgrounds.  I think this is pitiful.  The CAFC has jurisdiction over most patent appeals.  According to the CAFC website 39% of its cases relate to intellectual property – 36% of which are patent cases.  It might be argued that since only 36% of their cases are related to patents, then it makes sense that only 36% of the judges should be patent attorneys.  I would argue this is incorrect.  First of all, we have plenty of federal judges without technical backgrounds.  It is not necessary to populate the CAFC with judges that do not have technical backgrounds to provide balance to the makeup of our federal judges.  In fact, the exact opposite is true.  Second, it is easy for a judge with a technical background to pick up and new area of law, but it is almost impossible for a judge without a technical background to understand the technical concepts associated with genetic engineering, XML, spread spectrum, organic chemistry or numerous other areas of technology.  We perpetuate a myth that the facts are decided at the trial level, so the judges at the appeal level do not have to understand the underlying technology to reach a correct decision.  However the judges on the Supreme Court prove over and over again that their ignorance of basic technology and science results is bad decisions.  See Bilski: The Good, the Bad, and the Ugly and KSR: Supreme Ignorance by Supreme Court .  As a result, I believe that we need significantly more patent attorneys as judges on the CAFC.

Judge Patent Attorney Technical Background
Rader No No
Friedman No No
Newman Yes Yes – Ph.D
Archer No No
Mayer No No
Plager No No
Lorie Yes Yes – Ph.D
Clevenger No No
Schall No No
Bryson No No
Gayarasa Yes Yes – BSEE Patent Examiner
Linn Yes Yes – BEE
Dyk No No
Prost No Yes – BS
Moore Yes Yes – MSEE

August 17, 2010 Posted by dbhalling | Patents | , | 14 Comments

Invention – A Financial Analysis

Jacob Schmookler, an economist and author of Invention and Economic Growth, developed a financial analysis of the invention process.[1] The main point of this mathematical modeling of the invention process was to show that the probability of any invention being created is related to the size of the market for the invention.  I intend to present a model of the cost of inventing compared to creating me-too products.  I am not a fan of mathematical models for explaining most economic effects, because the terms in the equation are either unmeasurable or vary in an unpredictable manner.  As a result, I think these mathematical models give the impression of the accuracy of a physical science, which they clearly do not provide.  This can lead to logical errors.[2]

Despite this, I believe a simple mathematical model of the invention process will illustrate some important points.  In addition, some people understand concepts better when presented in a mathematical model.  Here is my model for the costs associated with introducing a new product based on an invention and me-too product:

Ci(n) = (Inv + Mi)/P + NRE + PC*n + OH*n   (New Product based on invention)

Cmt(n) = NRE + PC*n + OH*n  (Me-too product)

Where Ci is the cost of creating a product for the owner of the invention, Inv is the cost of creating the invention, P is probability of that the invention will succeed in the market, Mi is the incremental marketing and sales cost of introducing a new invention, n is the number of products that have been produced, NRE is the nonrecurring engineering cost of setting up production, PC is the production cost of the making n products and OH is the cost of overhead for producing n products, Cmt is the cost of creating a me-too product.

The reason I add the probability that the invention (P) will succeed is that not all inventions are successful.  An economist who wants to capture all the costs associated with introducing a product based on a new invention has to include this probability to determine the true cost of inventing.  This probability will vary based on the type of invention.  For instance, line extension inventions are much more likely to succeed than inventions that create whole new markets.  An example of an invention that created a new market was Webcrawler, which was the first full text web indexing search engine introduced in 1994.  On the other hand adding image or video searching to Google is a line extension.

The cost for marketing and selling a product based on an invention (Mi) is separate from the cost of marketing and selling a me-too product.  It takes significantly more money, time, and effort to sell a product based on an invention that is creating a whole new market than a me-too product.  Any sales person who has tried to sell a truly unique product knows that it is much easier to sell an existing product or a me-too product because you do not have to explain the value of the product, how the product works, and why the customer would want the product.  A true me-too product can be sold mainly on price.  A line extension product takes less marketing and sales effort than a revolution product.  Large companies tend to focus on line extension inventions because it reduces the risk that the product will not succeed and reduces the cost of marketing and selling.  Many start-ups sell through marketing channels in order to reduce this cost.

I include the cost of selling, advertising, and marketing of me-too product in overhead.  Once a product based on an invention is well known, then it will incur the same cost as a me-too product of selling, advertising, and marketing.  I believe this is an accurate characterization.  Non-recurring engineering (NRE) is the same for both the me-too product company and the inventor company.  The reason for this is that me-too products will incur approximately the same cost of setting up production as the owner of the invention.

The values of these variables will vary based on the type of invention involved, the type of market in which the invention is sold, and the point in time the product is introduced.  This model is not exact.  For instance, overhead (OH), production costs (PC), and marketing cost of the invention (Mi) should all be functions of the number of products sold (n).  Production costs usually decrease with the number of products sold.  Marketing costs of the invention (Mi) should be spread out of the first X number of products sold.  In addition, the total marketing cost of the invention (Mi) should not be included for failed products based on an invention, since the owner is likely to kill the project earlier and not spend as much as on a successful product launch.  There are probably other shortcomings of these equations.  However, certain facts are clear even with any flaws in these equations.  The cost of inventing increases the cost to the inventing firm over the me-too firm.  As a result, inventing is a market disadvantage without intellectual property.

Invention Law:  The cost of inventing increasing the expenses of the inventing firm compared to the expenses of the me-too firm.

There are only two common ways to compensate or incentivize inventors.  One is to provide the inventor with a property right (patent) in their invention.  The other is to have the government pay for the cost of inventing.  The first is consistent with a free market economy and has proven to be extremely successful.  The second is consistent with a command and control economy (statism) and has proven to be inefficient and political.

Intellectual Property Law: Inventing is a market disadvantage without intellectual property.

Now I will look at some specific scenarios to provide some insight to these laws.

Pessimistic Scenario

Scenario 1:

Consumer good sold through retail outlet

Inventing = New Market

Target Retail Price $10.00

Cost of inventing (Inv) = $100,000.00

Cost of Marketing Invention (Mi) = $900,000.00

Probability of Success (Pi) = 0.1

Nonrecurring Engineering (NRE) = $30,000.00

Production Costs per Unit (PC) = $2.00

Overhead Costs per Unit (OH) = $1.20

Unit Inventor’s cost per unit Copier’s cost per unit
1 10030003 30003.2
10 1003003 3003.2
100 100303.2 303.2
1000 10033.2 33.2
10000 1006.2 6.2
100000 103.5 3.5
1000000 13.23 3.23
10000000 4.203 3.203
100,000,000 3.3003 3.2003

It is assumed the manufacturers are selling their products $4.00, which is a standard double over manufacturing costs.  The 1/5th of retail price is a minimum necessary for the manufacturer to obtain a return that justifies manufacturing the product and selling it through a standard retail channel.  As you can see the inventor has to sell 100 million units ($1B in revenue) in order to get within 10 cents of the same manufacturing cost as the me-too manufacturer.  The copier’s break even[3] point is somewhere between 10 thousand units and 100 thousand units while the inventor’s break even is point is over 100 times as many units.

It is likely that this scenario overstates the difference between the costs of the inventor and the copier.  For instance, the inventor is unlikely to spend the full cost of marketing the invention (Mi) for the other nine failed product.  In addition, the percentage of successfully launched products is based on the stated success rate of venture capitalists.  Most VCs state that they have one highly successful company for every ten investments.  They also usually have 2-3 other companies in the portfolio that produce moderate returns or losses.  Not all of the other companies are in their portfolio are a complete loss.

Optimistic Scenario

Let’s look at a much more optimistic scenario.  Let assume the probability of success (P) includes these moderately successful investments and lets also include the idea that the probability includes some line extensions which have a 70% probability of success or higher.  We will also move up the probability of success to compensate for the fact that the inventor is unlikely to spend the full cost of marketing the invention (Mi) on failed inventions.  I will make the wild guess that setting the probability to 45% will compensate these differences.  I will also assume that instead of taking $1M to launch a new invention that it takes only $100 thousand.  Part of the justification for this difference is that the inventor and other founders are likely to not take a salary until the company has significant revenues.  I will also lower the overhead significantly, because this is one of the big advantages of a start-up.  My optimist scenario is:

Scenario 2:

Consumer good sold through retail outlet

Inventing = New Market

Target Retail Price $10.00

Cost of inventing (Inv) = $10,000.00

Cost of Marketing Invention (Mi) = $90,000.00

Probability of Success (Pi) = 0.45

Nonrecurring Engineering (NRE) = $30,000.00

Production Costs per Unit (PC) = $2.00

Overhead Costs per Unit (OH) = $0.50

Unit Inventor’s cost per unit Copier’s cost per unit
1 252224.7 30002.5
10 25224.72 3002.5
100 2524.722 302.5
1000 254.7222 32.5
10000 27.72222 5.5
100000 5.022222 2.8
1000000 2.752222 2.53
10000000 2.525222 2.50

In this scenario, the break even point for the copier is between 1000 and 10,000 units, while the break even point for the inventor just over 100,000 units.  The inventor is still at a significant disadvantage to the copier.  Some of this disadvantage may be offset by the first mover advantage.  However, if the inventor company is a start-up its first mover advantage is likely to be significantly offset by the established relationships of an established copier company.  In addition, the inventing company may sell more of their initial units directly (not through a retail channel) and their margins will be significantly higher for these units.

It is clear that inventing without intellectual property is a competitive disadvantage.  Large companies that invent can offset some of this disadvantage by using other competitive barriers to entry.  For instance, an established company can use its network of relationships to create a barrier to entry from start-up copier companies and may be able to use its relationships to provide some barrier to entry from other large established companies.  The empirical evidence is that established companies mainly produce incremental inventions.  This is because the invention process is risky and as an established company they often have less risky methods of providing incremental revenue or profit gains.

Start-up companies produce all the net jobs in America according to the Kauffman Foundation.   They are also the biggest producer of emerging technologies – see Do Individual Inventors and Start-ups Invent Anything Important?.  Advances in technology are the only way to increase our real per capita income.  We need to encourage investments in inventions, if we want to leave our children a better world than the one we live in.  Technology start-ups need the incentive of property rights in their inventions (patents) in order to justify the investment in these companies.

[1] Schmookler, Jacob, Invention and Economic Growth, Harvard University Press, Cambridge Massachusetts, 1966, pp 113-115.

[2] For instance, the measurement of GDP is said to be consumer spending plus investment plus government spending plus exports minus imports.  This equation leads to the logical error of assuming that consumer spending and government spending results in an increase in the output of a nation.  The reason this is a logical error is that people confuse the cause with the effect.  Consumption does not create goods and services.  Production creates goods and services, which is related to the consumption of good and services.  An engineering analogy is that temperature is often measured by determining a change in the resistance of a resistor.  If I change the resistance being measured by adding resistor in series with the thermistor this does not change the temperature of the environment being measured.  This is what economists are arguing when they suggest that increased government spending will cause the economy to grow.  Government spending does not create any new goods and services; it just either consumes production or transfers the return for production from one person to another.  Similarly, consumer spending is a way of measuring production.  Artificially increasing consumer spending does not increase production.  For instance, giving people income tax rebates when they never paid any income tax does not increase production, it just steals the productive effort of those who do pay taxes.

[3] The break even point is when the cost per unit is equal to the sales price per unit.

August 13, 2010 Posted by dbhalling | -Economics, Innovation, Patents | , , , , , , , , , | 6 Comments

Restore Patent Funding to Create Jobs

A NY times op-ed piece suggests that a relatively minor investment of $1 billion in the US Patent Office would create 1.5 million jobs for a cost of $660 per job.  Note that the $1 billion in funding would actual be repayment of user fees that Congress has stolen from the Patent Office over the last two decades.  The conclusion of the authors is:

So our guess is that restoring the patent office to full functionality would create, over the next three years, at least 675,000 and as many as 2.25 million jobs. Assuming a mid-range figure of 1.5 million, the price would be roughly $660 per job — and that would be 525 times more cost effective than the 2.5 million jobs created by the government’s $787 billion stimulus plan.

To encourage still more entrepreneurship, Congress should also offer small businesses a tax credit of up to $19,000 for every patent they receive, enabling them to recoup half of the average $38,000 in patent office and lawyers’ fees spent to obtain a patent. Cost, after all, is the No. 1 deterrent to patent-seeking, the patent survey found.

For the average 30,000 patents issued to small businesses each year, a $19,000 innovation tax credit would mean a loss of about $570 million in tax revenue in a year. But if it led to the issuance of even one additional patent per small business, it would create 90,000 to 300,000 jobs.

Please read the full article.

August 6, 2010 Posted by dbhalling | Innovation, Patents | , , , , , , | 1 Comment

Are Patents Relevant?

The more fundamental question in economics is whether inventions have any economic impact.  There is no role for inventions in classical economics[1], which focuses mainly on disruptions in supply and demand.  Marxist believe that all economic value is a measure of physical labor, so there is no room in the Marxist tent for inventions either.  Despite this modern economics has grudgingly admitted that inventions are key factor in economic growth.  However, they are torn on whether inventions (advances in technology) are endogenous or exogenous.  The exogenous camp believes that inventions occur separate from any incentives or spending on inventions.  Economists that fall into the exogenous camp clearly do not see any reason for a patent system, since they believe that inventions occur separate from any market forces.

The first widely acknowledged chink in the Marxist and Classical economics armor against inventions was Joseph Schumpeter who argued that creative destruction, caused by innovation, is the key to economic growth.  The hero in Schumpeter’s world was the entrepreneur not the inventor.  Despite this Schumpeter also was a determinist who believed in “natural” cycles and believed in the exogenous theory of inventions.

The next step in the economic analysis of invention was by Robert Solow.  Dr Solow published a paper in 1956 on economic growth that stated that four fifths of US worker output was due to technological progress (inventions).[2] Robert Solow would go on to win the Nobel Prize in Economics for this point.  However, Solow believed that technological progress was exogenous and therefore occurred separate from economic incentives to invent.  As a result, he argued that all countries would converge in their economic growth rates and their level of technology.  There has been no evidence for Solow exogenous theory of growth.[3] The growth and level of technology, inventions, and economic growth of countries has not converged as Solow predicted.  It is not surprising that Solow, in the exogenous camp, is a fan of the anti-patent book Against Intellectual Monopoly, by Michele Boldrin & David K. Levine.[4]

The next big advance in the analysis of inventions and economic progress was the book Invention and Economic Growth by Jacob Schmookler in 1966.  Schmookler undertook the most systematic analysis of invention of any economist.  He analyzes the issue of whether invention is exogenous, as argued by Solow, or endogenous.  He clearly shows that invention is mainly endogenous.  Schmookler does not directly address the question of the utility of a patent system in encouraging inventions.  However, he hints that attacks on the patent system in the 1930s and 40s was the cause for the decline in the number of patents issued to US inventors during this time.

In general, most economists in this area now acknowledge that invention is endogenous – subject to market forces.  If you accept that the invention process is endogenous, then the next question is whether patents encourage invention – are patents relevant?

One of the leading economists in the area endogenous growth is Paul Romer.  Romer thinks that the creation of inventions (he would call them recipes) are clearly subject to resource limitation.  He points out that researchers and laboratory equipment are not free and therefore we need a system to encourage people to invest in new inventions.  However, he believes that once an invention is created it cost virtually nothing to disseminate.  The example he uses is oral rehydration therapy.  While there are a small number of examples of inventions that are so simple and so easy to understand they can be disseminated at virtually no cost, most new inventions and technology do not fit into this category.  For instance, calculus is a very useful branch of mathematics and it has been known for centuries and yet most of us who learned calculus paid someone to teach us.  There were no intellectual property laws requiring us to pay a teacher to learn calculus, so if inventions (recipes) can be spread at no cost why did we undertake the irrational step of paying someone to learn calculus.  If technological can be disseminated at no cost then there is no reason for professors, doctors, lawyers, engineers, and especially marketers and sale people.  Romer is ambivalent about patents.  However, his ambivalence is based on the false assumption that technology dissemination is free.

Gregory Clark, an economist at UC Davis,  has written an interesting book in this area, entitled A Farewell to Alms.  In this book he states that the most important question in economics is explaining why

after millennia of per capita income being stagnant it takes off around 1800 in the West.  He provides an interesting answer.  The first part of his answer is that rate of technological progress increased at the beginning of the industrial revolution.  The second part of the answer is why the rate of technological progress suddenly increased.  He suggests that the industrial revolution takes of in Britain because of environmentally induced evolution.  Specifically, he suggests that the downwardly mobile society of Britain resulted in thrift and hard work being genetically selected in Britain.  These traits resulted in the industrial revolution taking off in Britain.  Clark appears to be part of the exogenous camp.  As a result, he does not think that patents are important in encouraging advances in technology or economic progress.

B Zorina Khan is another economist who has studied this issue.  She is author of the book, The Democratization of Invention: Patents and Copyrights in American Economic Development, 1790-1920.  She provides extensive evidence that the US patent system and economic forces affect both the level and direction of invention.  She shows that the US created the first modern patent system and the patent system provides the major incentive that causes the US to grow from an agrarian economy to a world economic and technology power in 70 years.

The economic literature on patents is littered with misunderstandings of the basic rules of the US patent system.  For instance, many economists do not understand that the patent system is designed to spread information.  In the US we did this by setting up patent depository libraries, so that all people could take advantage of the knowledge associated with an invention.  You will read many economists that believe patents inhibit the spread of information.  This is clearly incorrect.  They do inhibit practicing of the invention without the payment of a royalty, but the underlying information is free for all people to learn from.

Economists are also generally ignorant of the history of patents.  They do not realize that patents are designed to encourage people to disclose the information associated with their invention.  The alternative to patents is trade secrets and no government can force people to disclose their trade secrets.  Before patents people protected their economically important inventions by keeping them a secret.  This limits the area’s where people will invest in new technologies to those that can be kept a trade secret.  It also means that the public does not benefit from the knowledge of the invention.  Most economists do not understand the unintended consequences of their anti-patent position.

Economists generally want to model patents as a government granted monopoly instead of a property right.  This is logically incorrect.  In economics, a government-granted monopoly (also called a “de jure monopoly”) is a form of coercive monopoly by which a government grants exclusive privilege to a private individual or firm to be the sole provider of a good or service.  Since a patent does not even provide the holder the right to sell or practice their invention, it clearly does not grant an exclusive privilege to a firm to be the sole provider of a good or service.  Most economists do not understand this basic principle of patent law – a patent does not give the holder the right to produce or sell their invention.

It is straightforward economic analysis that investing in new technologies is an economic disadvantage for a company if there is no intellectual property protection.  The company’s research and marketing costs in creating a new product and new market clearly increase its cost of doing business over its competitors who do not spend money on new product development.  Their competitors just copy the new product and sell it into the markets the inventor created.  The inability of economists to grasp this simple point is mind boggling.  The only explanation I can come up with is that most of the economists who write about patents have not worked in the technology start-up market.  If they had, they would know that incredible additional expenses incurred not only in creating a new product, but in marketing and selling a new product.  This is particularly true the more unique the product.  It is always easier to sell a me-too product, since you do not have to explain how it works and why someone would want it.  This is why invention in most large companies is limited to line extensions.

Economists cannot provide meaningful input or commentary on the patent system unless they actually understand the patent process, the rights obtained with a patent, and the basic history of patent systems.  Ms. Khan and Pat Choate are some of the few economists who have a strong understanding of the patent system.  Unfortunately, Khan does not differentiate that patents are property rights, not a monopoly.

[1] However Adam Smith did mention inventions as one of three ways to increase the wealth of a nation.  “some addition and improvement to those machines and instruments which facilitate and abridge labor”, Smith, Adam, An Inquiry into the Nature and Causes of the Wealth of Nations, Edited by Edwin Cannan, New York, Modern Library, pp. 373-374.

[2] http://en.wikipedia.org/wiki/Robert_Solow 8/3/10.

[3] http://www.ecomod.net/conferences/ecomod2003/ecomod2003_papers/Ulku.pdf 8/3/10.

[4] http://reason.com/archives/2003/03/01/creation-myths 8/3/10.

August 4, 2010 Posted by dbhalling | Innovation, Patents | , , , , , , , , , , , | Leave a Comment

The Rational Optimist: Excellent Book, Disfigured by Open Source Utopianism

The author, Matt Ridley, has written an excellent book that is epic in the scope of issues he tackles.  The book covers why homo sapiens thrived while other members of the homo genus fail.  He shows that on average the human condition has gotten consistently better and this increase in wealth has been especially true in the last 200 years.  He destroys the noble savage myth.  He shows the intellectual failings of Marxism, environmentalism, self sufficiency, and renewable energy.  His two main themes underlying these vast topics are: 1) trade leads to division of labor, which leads to invention and 2) the inexorable march of human progress.

Despite Mr. Ridley’s incredible breadth of knowledge, there is a logical gap in his first thesis when he attempts to explain the industrial revolution and why it took off in England.  This logical gap is the result of his misunderstanding of intellectual property.

This misunderstanding of intellectual property is most likely due to his open source utopianism.  This utopianism leads the book to conclude “Thanks to the internet, each is giving according to his ability to each according to his needs, to a degree that never happen in Marxism.” P. 356.  Even with this imperfection, this is an incredible book that I highly recommend to anyone.

Population Density – Good or Bad for Wealth Creation?

The book argues that population density is necessary for trade and division of labor, which is the route to economic prosperity.  It also argues that the division of labor leads to inventions, which leads to further specialization.  Specialization requires a large enough market to support it and as a result population density is the friend of economic progress.  However, later in the book it argues that increasing population caused a decline in the living standards of Japan and Denmark.  This decline supposedly occurred because the increasing population decreased the value of labor and therefore the market for specialization and inventions.  England escapes this fate because of coal and phantom land in the colonies.  This contradiction between the need for human density for specialization and economic progress and the idea that increased population density reduced the value of labor destroying the market for inventions is not adequately resolved.

The book argues, starting on page 52, that trade is what allowed homo sapiens to succeed where other apes failed and even other humans failed such as Neanderthals.  It provides numerous examples of how various groups of humans regressed technologically because of inadequate population densities to support specialization, such as Tanzania.  The book summarizes the lessons by quoting economist Julian Simon “population leading to diminishing returns is fiction: the induced increase in productivity is scientific fact.”  P. 83.

In a chapter entitled “Escaping Malthus Trap,” Ridley discusses how Japan after a period of prosperity gives up its technology.  He states “that sometime between 1700 and 1800, the Japanese collectively gave up the plough in favour of the hoe because people were cheaper to hire than draught animals.”  P. 198.  The reason for this according to Ridley was rapid population expansion due to paddy rice technology.  This population boom made labor cheap and killed the market for technology.  Denmark follows the same path as Japan and by the 1800s becomes “trapped by its own self sufficiency.”  P. 200.  Britain escapes the Malthusian trap that Japan, Denmark, and Ireland suffer, according to Ridely, because of selective breeding (maybe p. 200), ghost acres provided by the colonies (p. 202), release valve emigration to the colonies (p. 202), and coal (sustained industrial revolution p. 216.)

There is a logical inconsistency between the conclusion early in the book that population density is necessary for prosperity, but later in the book arguing that prosperity stalled after a burst in population in various countries.  The explanation of selective breeding, does not explain why the US or Australia prospered.  These countries were heavily populated by British rejects.  Similarly, the ghost acres provided by the colonies were eventually used up.  It might be argued that there was some tipping point that could only be achieved with ghost acres.  I think this fails also, because it flies in the face of the book’s earlier argument that increased population densities allow more specialization and invention to increase everyone’s standard of living.  The release valve emigration fails for the same reasons as the ghost acres.  The emergence of coal is also unsatisfying.  Coal mining was known before the birth of Christ and trade in coal occurred in England as far back as the 1300s, according to Wikipedia.  The book also argues that many surges of economic growth were extinguished by parasitic political systems.  However, it never states this is why Japan’s and Denmark’s prosperity was reversed.

What was new in the industrial revolution was not coal, but the machines to use coal and numerous other inventions.  The book argues that these inventions were not in general due to new scientific discoveries, p. 255, and I agree.  So why at this particular point in time did we have a sudden increase in rate of technological advance, including machines that used coal?  The beginning of the industrial revolution coincides with the recognition of property right’s in inventions.  The US constitution states (Article 1, section 1, clause 8) that inventors have ‘RIGHTS” in their inventions.  Patents, which are legal title to an invention, are the only free market system for encouraging people to invent.  While Britain had a patent system at least back to the Statute of Monopolies, 1623, it did not recognize a right to property in one’s invention.  It was a royal grant, subject to the whims of the ruling monarch.  As a result, it was expensive and arbitrary.  However, when the United States recognizes that inventors have a property right to their invention, this provides a whole new incentive to inventors and their financial backers.  No doubt this attitude towards inventions also infected Britain.  For more on the correlation between real per capita increases in income and patent systems see Source of Economic Growth.

Mr. Ridley argues that patents at best have marginal effect on the rate of invention.  However, Mr. Ridley shows an appalling lack of knowledge about patents and intellectual property.  He also has a number of inconsistent statements about intellectual property.  For instance, on page 267, he states that copyrights have little effect on the creativity of musical composers.  However, on page 326 he states that Nashville was saved by music entrepreneurs using good local copyrights in the 1930s.  Not only are these two statements contradictory, there is no such thing as local copyrights in the United States.

Patents

The book has numerous other errors about intellectual property.  For instance, it states that intellectual property is not like other property, because it is useless if you keep it to yourself, p. 262.  This statement is nonsense.  The Coca Cola formula is not shared and this is the only reason it has any value.  A patent to an invention (legal title to an invention) only has value if there is some ability to exclude others from using it – as opposed to knowing about it.  If everyone can make a laser without pay royalties, then it may have value to the world but it has no differential value to the inventor.  Patents are derived from exactly the same philosophical basis as real property.  Namely,  Locke’s theory of Natural Rights.  For more information see Scarcity – Does it Prove Intellectual Property is Unjustified? Below are a list of some, but not all, of the book’s errors related to patents:

1) The book then states that people get rich by selling each other things and services not ideas, p. 263.  What are authors, professors, engineers, scientists, really selling?  Authors are not selling books, they are selling ideas that just happen to be embodied in books.  The Kindle proves this.  The Kindle does not allow the user to buy a book, but to buy the ideas in a book.  Professors are either selling the teaching of ideas or just an expensive way to bore students.  Engineers are selling a service, which encompasses ideas not the paper (digital ones and zeros) on which it is written.  Most companies do not make money manufacturing things, they make money with inventions (ideas) that are implemented in things.  When a company only sells things with no (new) ideas in these things, then their profit margins are extremely narrow.  One of the limitations on growth has been this Luddite refusal to allow inventors to specialize in inventing.  This book’s premise is built on the division of labor, but the author rejects this idea when it comes to inventing.

2) Mr. Ridley also seems to be confused between the spread of information related to inventions and the legal right to use that information to build an invention.  It is a major goal of modern patent systems to spread information about inventions so that they can be used by other people to build other inventions.  In the U.S. we built patent depository libraries to spread the wealth of information in patents (before the internet).  Patents encourage people to share the information associated with their inventions instead of keeping them a trade secret.  Countries without patent systems tend to invent mainly things that can be protected with a trade secret.  (See Switzerland before they adopt a patent system)  As a result, other inventors do not get learn from these inventions and the rate of technological progress is inhibited.

3) The book perpetuates the first mover advantage alternative to patents.  Xerox had the world’s greatest first mover advantage in plain paper copiers, when it agreed to settle an antitrust lawsuit in 1975 by giving away its patent portfolio.  Its market share went from almost 100% in plain paper copiers to 14% in just four years.  The first mover advantage is a fairy tale.

4) The book argues, p. 264, that there is no evidence that patents are what drive inventors to invent.  This statement is completely illogical.  Real property rights are not what drive farmers to farm or builders to build houses.  Nevertheless, there would be a lot less building and less efficient farming, if we did not have real property rights.  Just look at countries, where property rights in buildings and land are hard to impossible to obtain.

5) The book states that a number of inventions were never patented, p. 264, such as automatic transmission, Bakelite, ballpoint pens, cellophane, cyclotrons, gyrocompasses, jet engines, magnetic recording, power steering, safety razors and zippers.  While it is possible that the first version of some of these inventions were not patented, all of these inventions were subject to numerous patents.  This can be easily verified with a simple patent search.  For instance, there are at least 20 patents and probably hundreds of patents on automatic transmissions.  The same is true of ballpoint pens, gyrocompasses, jet engines, magnetic recording, power steering, safety razors and zippers.  A simple internet search shows that chemist Leo Hendrik Baekeland (1863-1944) invented and first patented the synthetic resin that we know as Bakelite in 1907.[1] Jacques E Brandenberger was granted patents to cover the machinery and the essential ideas of his manufacturing process of the new film (cellophane).[2] The assertions of no patents for the zipper is also easily shown to be incorrect.  Elias Howe, who invented the sewing machine received a patent in 1851 for an ‘Automatic, Continuous Clothing Closure’ (zipper).[3]

6) The book argues that the Wright brothers, enforcing their patent on airplane control surfaces, supposedly shut down the airplane industry in the US.  This is the typical propaganda of open source community.  First of all the Wright brothers were building airplanes, so the industry was not shut down by enforcement of the patents.  Second stealing other people’s property is not shutting down industry, it is shutting down theft.  We would not say that someone stopped the harvest of wheat, because they did not let someone else reap the wheat they planted on their land.

7) The patent thicket argument is repeated by Mr. Ridley to suggest that patents inhibit advances in technology.  A number of papers[4] have shown that there is no empirical evidence for the patent thicket argument and that the logical analogies on which it is based are flawed.  For more information see  Intellectual Property Socialism: Part IV USPTO Takes Aim at Inventors.

8) Mr. Ridley further demonstrates his ignorance of patents by repeating the concern that the US Patent Office was issuing patents for human genes in the 1990s, p. 265.  What the Patent Office did and does was issue patents on “isolated genes.”  This is similar to patents on things like isolated forms of vitamin B12, which was patented.  For more information see Gene Patenting Debate Continues.

9) The book also mistakenly calls a patent a “temporary monopoly.”  A patent is a property right, just like property rights in land, houses, cars, etc.  The logical basis for patents is exactly the same as other property rights.  Property rights are based on Natural Rights, which states that since you own yourself you own the product of your labor (physical and mental).  For more information see The Myth that Patents are Monopolies.

10) He also implies that patents are top down solution to encouraging invention.  Nothing could be further from the truth.  All a patent system does is provide property rights to inventors for their inventions.  This is similar to property rights for land, which is a bottom up way to increase the productivity of farming for instance.  Just giving pseudo property rights to peasants in the USSR and China caused enormous increases in farm production.  Property rights are a bottom up solution, not a top down solution.  In fact, the genius of the United States patent system (as opposed to Britain’s) is that it was accessible to all people, including women and slaves that had no property rights under their state laws.  This encouraged a torrent of inventive activity in the U.S. that propelled it from a backward farming country to an economic and technological powerhouse in the world in less than 60 years.  For more information see the excellent book by B. Zorina Kahn, The Democratization of Invention: Patents and Copyrights in American Economic Development, 1790-1920.

Open Source

I am convinced that Mr. Ridley’s poor research on patents and intellectual property is due to his infatuation with the open source movement.  On page 356 he opines that genetic research will soon go open source.  He is so excited about open source that he eventually suggests a Marxist’s open source utopia – “Thanks to the internet, each is giving according to his ability to each according to his needs, to a degree that never happen in Marxism.” P. 356

The open source movement has been a dismal failure.  Its biggest success has been to extend UNIX (LINUX) to personal computers, other platforms, and add new features.  Open source has mainly extended existing technologies, much like the incremental invention that can be expected from large companies.  The open source movement deludes itself into believing they are fighting some sort of David versus Goliath battle against large corporations and the patent system.  The reality is that open source developers are giving large corporations, such as IBM, their efforts for free and weakening the bargaining power of technical personnel.  The open source movement plays right into the hands of large corporations and other large institutions, by weakening the property rights of developers in their work.  It should be no surprise that open source has been an abysmal failure, since this exactly the situation most of the world lived under until 1800.  Before modern patent systems, new inventions were rare and the return for the invention was often controlled by a trade guild.  The members of the trade guild profited equally, meaning there was little incentive for the inventor to spend time creating.  Per capita income of the world before 1800 had been stagnant for millennia.  Where modern patent laws were adopted around 1800, incredible increases in per capita income occurred.  Mr. Ridley trumpets this progress throughout his book.  In areas without patent systems, we see stagnant growth in per capita income.  For instance, Japan’s per capita income does not take off until they copy the US patent system in the 1860s.

It is unfortunate that this excellent book is disfigured by the author’s irrational infatuation with the open source movement.  This infatuation causes the author to embrace the logical contradiction that increases in population density increase economic growth and also causes the Malthusian trap (decreases in economic growth).  It also causes him to reject the solution to the Malthusian trap, which is the recognition of property rights in inventions.

[1] http://bakelitecollector.com/bakelite-history 7/21/10

[2] http://inventors.about.com/od/cstartinventions/a/Cellophane.htm 7/12/10

[3] http://inventors.about.com/library/weekly/aa082497.htm

[4] Ted Buckley, Ph.D., The Myth of the Anticommons, Bio, www.bio.org (2007); Epstien, Richard A., Kuhlik, Bruce N., Is there a Biomedical Anticommons, Regulation, (Summer 2004), pp. 54-58

July 22, 2010 Posted by dbhalling | -Economics, -History, -Philosophy, Innovation, Patents | , , , , , , , , | 6 Comments

« Previous Entries