It is the premise of this post that economics is objective and therefore can be a hard science, based on empirical observation, logic, and reason. Some clear objective results in economics include that failure of a person to produce (consume) enough food results in starvation and death. It does not matter how much someone feels or believes (or has faith) that they should not have to produce (consume) enough calories, they will starve to death. There is overwhelming empirical evidence for this proposition, including the purposeful starvation of numerous people by totalitarian governments in the last century. Another example is that if the government raises the cost (or reduces the return) of performing an activity, you will have less of this activity than would have occurred without the government interference, as long as you have statistically large enough group. For instance, if a government raises the cost of food or reduces the return for producing food enough people starve. The empirical evidence includes numerous African countries that have held the cost of food below the cost of production and this inevitably results in mass starvation. This is true no matter how much faith the government has that it should not occur, or how much they feel it will not occur, or how much they believe it should not occur. Similarly, a person can deny the existence of gravity, but gravity will act on the person no matter what they believe about gravity. Gravity is not a matter of belief, it is a matter of understanding. It is clear that at least some of the laws of economics are as immutable as the laws of gravity.
All science is based on certain fundamental empirical observations. One of these fundamental observations is that reality is objective. This means that reality exists independent of any persons’ belief, hope, faith, or desire. The evidence for this proposition is overwhelming and includes all the incredible advances in physics, chemistry, biology, geology and the applied sciences (engineering).
Fundamental Observation: Reality is Objective
The second fundamental observation of science is that reality is understandable or discoverable using observation, logic, and reason. In science, we follow logic and reason even if it seems counterintuitive. For instance, the implications of special and general relativity predict that clocks on GPS (Global Position Satellites) will run at a different rate than clocks on earth. This appears counterintuitive, but empirical evidence shows that this is true and that failure to account for this difference will result in meaningful navigational errors.
Fundamental Observation: reality is understandable or discoverable using observation, logic, and reason
If economics is going to be a science, it must be based on these two fundamental observations/assumptions. Some people may object that science is based on observations. It has been shown that all logical systems are based on either an observation or an assumption, in the case of mathematics. For instance, Euclidean geometry is based on the assumption that a line goes on forever and two parallel lines never intersect. Spherical geometry is not based on these assumptions. It assumes that a line will wrap around on itself. In science we do not arbitrarily pick the starting point, we base them on observations. Unfortunately, the science of economics is in the same state as physics before Newton.
Life is a fight against entropy, the second law of thermodynamics. Entropy is normally defined as the measure of the disorder of a system. Entropy was discovered as part of thermodynamics (statistical mechanics) and it explains that a perpetual motion machine is impossible. Entropy always increases in a closed system. Luckily for us, the Earth is not a closed system. For instance, we receive energy from the Sun. The only way to increase order is by the input of energy. Life represents increasing order and therefore just to sustain life at its present level requires energy to overcome entropy. Edwin Schrödinger, Nobel Prize winning physicist, proposed this in his 1944 book, What is Life.
Fundamental Observation: Life is a fight against entropy
Plants create this energy by photosynthesis. They convert carbon dioxide into sugars (energy) using light. They use this energy to create order. Animals eat plants or other animals and use the energy to create order. Note that when animals eat plants or other animals, they are increasing the disorder of the plants and animals they eat. Thus, there are two general mechanisms which increase the entropy of life forms: 1) internal and 2) external. Internal mechanisms are those that result from the failure to consume enough calories (energy) and aging. Animals require oxygen, water, and food in that order to survive. Without oxygen, the animal cannot oxidize enough sugar (fat, protein) to survive – overcome entropy. Without water, the animal’s cells are unable to absorb energy and expel wastes. As a result, the animal does not receive sufficient energy to overcome entropy. Aging is a process of increasing disorder – entropy. This disorder is caused at least in part by disorder in genetic information. External mechanisms include being eaten or attacked by other living organisms, diseases, accidents (for animals), and the elements.
In general, living organisms use energy to overcome entropy first and then to increase their size. However, some animals also create simple shelters or seek shelter to ward off the entropy increasing effects of the elements and predators. Rain, sun, hail, snow, heat, or cold all contribute to the increase in entropy of living organisms (disorder). A living organism dies when its entropy increases above a certain level. Life has two main methods of overcoming the effects of the second law of thermodynamics: 1) food consumption and 2) shelter creation (inhabitation).
A species of life becomes extinct when the species as a whole reaches a certain level of entropy either because it cannot consume enough energy or because external mechanisms increase its entropy to the extinction level. A species reaches the Malthusian Trap when increases in population of the species results in the total required energy (food) to support the population is greater than supply of food. Total available energy is less than the energy required to overcome the total entropy of the species population. Most life forms exist in the Malthusian Trap, including humans until the Industrial Revolution.
Homo sapiens also consume food and create shelter to overcome the effects of entropy. Unlike other living organisms, homo sapiens also organize their environment to minimize the effects of entropy. For instance, humans have invented agriculture to increase their supply of food (energy) and therefore order. Humans also harnessed the physical strength of animals, created internal combustion machines, electric lights, electricity, washing machines, tractors, computers, the internet, email, lasers, fiber optics, etc. All of these are inventions. Humans alter their environment by creating inventions. This is different from every other animal. This should not surprising, since the distinguishing characteristic of homo sapiens is their ability to reason. Man is a rational animal according to Aristotle’s classical definition. Being rational is the distinguishing characteristic of humans. Man uses his reason to alter his environment (invent) and increase order for himself. Invention is the unique way in which man is able to create order – this is the fundamental observation of economics.
Fundamental Observation of Economics: Man’s unique ability to increases order (wealth) is his ability to invent.
Inventing first results in the increased success of the species. Homo sapiens populated most of the world in less than 500,000 years because of this unique ability. As long as the rate of technological progress is slower than the growth in population, man is stuck in the Malthusian Trap. Sometime around 1800 in Europe and the United States, the rate of invention exceeds the rate of growth in population and man escapes the Malthusian Trap at least in the West. When man escapes, he is no longer subject to biological evolution. As far as we know, homo sapiens are the only species to ever escape the Malthusian Trap.
Trade enhances man’s ability to invent. By trading the products of each others’ inventions both trading partners can specialize in the inventions and both end up wealthier. David Ridardo explained how both parties are better off because of trade using the example of England trading cloth for Portuguese wine:
England may be so circumstanced, that to produce the cloth may require the labour of 100 men for one year; and if she attempted to make the wine, it might require the labour of 120 men for the same time. England would therefore find it in her interest to import wine, and to purchase it by the exportation of cloth. To produce the win in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth. This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced with less labour than in England.
Using the example above if England produces twice as much cloth as it needs, it has invested 200 man hours. If Portugal produces twice as much wine as it needs it has invested 160 man hours. Now if England and Portugal trade their excess cloth for the excess wine, England has invested 200 man hours for all its cloth and wine, while Portugal has invested 160 man hours for all its cloth and wine. If England had produced both all its cloth and all its wine locally, then it would have invested 220 man hours for the same goods. This means that England requires 10% more man hours if it does not trade. If Portugal had produced both all its cloth and all it wine locally, then it would have invested 170 man hours for the same goods. This means that Portugal requires 6.25% more man hours if it does not trade.
Trade is a rational activity and humans are the only animals to engage in trade of non-like items and trade between non-related individuals. Classical economics has focused on trade and the related supply and demand curves instead of the role of invention in economics. This might have occurred because the beginning of classical economics was in reaction to the Mercantile system and its limitations on trade. Adam Smith’s book, The Wealth of Nations, is often seen as a refutation of the Mercantile system. Matt Ridley, in his book, The Rational Optimist, has suggested that trade is the key to creating wealth. This emphasis on trade has been misplaced. Invention proceeds trade. If everyone produces the same thing, then there is no reason to trade. It is only because someone has invented a new product that trade becomes a rational choice. For instance, one group of people may have invented a process for skinning animals and using them as clothing. They may have traded this with people who had access to flint and invented a system for making simple axes. Invention has to proceed production, which has to proceed trade logically. Of course, without trade the value of invention is severely diminished.
 Hard science, such as physics, chemistry, and biology, as opposed to “soft science”, such as psychology, sociology, and political science. In general, soft sciences are not science at all. For instance, Freud’s formulation of the id, ego, and super ego is not science. This formulation is not testable and is not based on objective empirical evidence. In fairness, psychology to the extent it is based on neurobiological processes is real science. The first step in any science is categorization and psychology has attempted to categorize various behaviors. Unfortunately, many of these categorizations are too vague to be testable or objective. As we have gained more information some formally vague definitions have become objective. Political science is not a science it is a study of politics. Sociology also has no basis in science. This is not to say that there is no value to studying politics or the interaction of groups. History and literature do not call themselves a science, but there is great value in the study of history and literature. History even uses science to discover new facts about history, but it is not a science. The soft sciences use the nomenclature of science to aggrandize themselves. This propaganda has undermined the value of science in the eyes of the general public.
 Even the bizarre results of quantum mechanics are repeatable and independent of the observer’s hopes, desires, faith, opinion.
 Real-World Relativity: The GPS Navigation System, http://www.astronomy.ohio-state.edu/~pogge/Ast162/Unit5/gps.html, October 3, 2010.
 Wikipedia, What is Life?, http://en.wikipedia.org/wiki/What_is_Life%3F_(Schrödinger), 10/6/10.
 BNET, Physiological Effects of Dehydration: Cure Pain and Prevent Cancer, http://findarticles.com/p/articles/mi_m0ISW/is_2001_August/ai_78177228/, 10/6/10.
 Hayflick, Leonard, Entropy Explains Aging, Genetic Determinism Explains Longevity, and Undefined Terminology Explains Misunderstanding Both, PLoS Genetics, http://www.plosgenetics.org/article/info:doi/10.1371/journal.pgen.0030220, 10/7/10.
 Ridley, Matt, The Rational Optimist: How Prosperity Evolves, Haper Collins, New York, 2010, p. 75.
 Ridley, Matt, The Rational Optimist: How Prosperity Evolves, Haper Collins, New York, 2010, p. 56.
I believe there is a lot of confusion regarding the difference between invention and innovation. This confusion is the result of erroneous definitions and the purposeful intent of some to increase their importance by belittling the contributions of others.
I believe that most of this mischief started with the great economist Joseph Schumpter. According to Wikipedia:
Following Schumpeter (1934), contributors to the scholarly literature on innovation typically distinguish between invention, an idea made manifest, and innovation, ideas applied successfully in practice
There is nothing inherently wrong with the distinction above, but the way it is applied blurs together a number of different skills. Blurring skills together shows a misunderstanding of the process of innovating. Broadly speaking, innovation can be broken into two distinct sets of skills: creation and dissemination. By creation I mean creating something new, not production – creating something old.
A subset of creation is invention. An invention is a creation with an objective repeatable result. A creation that is not an invention has a subjective result, such as the effect of a painting on a viewer, or the effect of a book on a reader. Many activities combine both a subjective creation and an invention, such as architecture. However, we can separate out the invention from the other creative elements and this helps our understanding of the process.
Dissemination may include a number of processes, such as education (marketing, sales), manufacturing, finance, and management. This is not to say that marketing cannot be creative, it clearly often is very creative. However, the creative part of marketing can be separated out from the dissemination or execution part of marketing. The same is true of manufacturing, which can definitely include inventing. But an invention related to manufacturing is part of the creation step not part of the dissemination step.
Finance can also have inventions. For instance, the invention of a fractional reserve ratio bank is clearly an invention. It has the objective result of securitizing assets and turning them into loans and currency. A fractional reserve bank will securitize land and turn into a loan and currency. Despite this, it is important to understand that the first person to develop the fractional reserve bank is inventing and the person operating the fractional reserve bank is disseminating.
All real per capita economic progress is the result of inventing. This is not to say that it is unnecessary to disseminate inventions, but if there were no new inventions there would not be any economic progress. We would be stuck in static world once all the inventions had been completely disseminated. Of course, if we stop all dissemination activities we will quickly starve to death.
It is my belief that business and economic professors have focused on “innovation” instead of “invention” because they have no idea how to invent or how the process of how inventing works. They concentrate on what they know, i.e. business and economic practices. As a result, the focus is dissemination, under-appreciating the importance of inventing. In addition, it results in misleading business theories, such as:
– Management teams are more important than the quality of the invention.
– Execution is everything; patents and other IP do not matter.
– Get Big Fast.
The truth-test of these theories is directly related to the strength of the patent laws at the time the company is created. When patent laws are weak, these theories are more true and when patent laws are strong, these theories are less true. Unfortunately, when patent laws are weak these theories do not overcome the disincentive to invest in risky new technologies. Management teams do not build revolutionary or disruptive technologies, they just disseminate these technologies. These sorts of teams are like large companies and generally can produce a return with less risk by NOT developing high-risk technologies. They tend to focus on incremental technologies or on stealing someone else’s technology. While this may be good business advice in a period of weak patents, it is bad for our country’s competitiveness and our standard of living.
Technological progress (i.e., inventing), in the long run, is the only competitive business advantage. The best management team in the world selling buggy whips at the turn of the century could not overcome the technological advance of the automobile and stay a buggy whip company. The best management team in the world selling vacuum tubes in the 1940s, could not overcome the advance of transistors and semiconductors and stay a vacuum tube company. This country is littered with companies that had great management teams that were overwhelmed by changes in technology. For instance, Digital Computers had a great management team, but they could not overcome the advance of the personal computer. Digital Computers failed to invent fast enough to overcome the onslaught of small inexpensive computers. US steel was not able to overcome the onslaught of mini-mills, aluminum, and plastics. This was not because they did not have a good management team, it was because the management team under- prioritized invention and over-prioritized execution or dissemination skills. Ford & GM have not become walking zombies because they did not have strong management teams, but because they have not invented. As a result, they have antiquated production systems and weak technology in their products. 86% of the companies in the Fortune 500 in 1959 are no longer there. Some of these companies disappeared because of bad management, but most companies disappeared because they did not keep up with changing technology. In other words, they did not invent.
Inventions or advances in technology are the ONLY WAY to increase real per capita incomes and the only long term business advantage. Business school theories that do not prioritize invention, are bad business and bad for our country.
Many entrepreneurs, inventors, and economists complain about the Patent System and intellectual property rights. However, when you examine their complaints they are often concerned about how the patent system is implemented as opposed to the concept of property rights for inventions – patents. For instance, an extremely successful entrepreneur and angel investor I know complained that patents increase the uncertainty when investing in a start-up company. Because of the long time that it takes patents to issue, he protested that it is difficult to know when a patent might suddenly issue, affecting the business plan of a start-up in which he has invested. Other common complaints include that the patent system is expensive, time consuming, and difficulties in determining the boundaries of a patent. Some people go so far as to suggest that this shows that patents are not a true property right. After all, they reason, it is easy to determine the boundaries of real property and obtaining title to real property (land) is a straight forward process.
Here, the complainers show that their ignorance of history. Before title insurance buyers of real property paid an attorney a lot of money to determine if they would receive “good title” to land if they bought it from the seller. This title opinion did not come with a guarantee and it was not cheap. In addition, you would have to pay a surveyor to determine the boundaries of your real property. The survey process was expensive and fraught with problems until the advent of modern technology, such as GPS. Our ancestors fought each other tooth and nail over the boundaries to their land. In fact, court battles over land are a great way to trace your ancestry, because these battles were so common.
While the critics are wrong in their comparison between real property and patents, they are correct that we need systems that reduce the cost and uncertainty of determining the boundaries of patents (inventions) and whether the owner has good title (102, 103 issues). In short, we need the equivalent of title insurance for patents. I believe that standards committees (e.g., IEEE 802.11 WiFi) are acting like title insurance companies. They determine which patents are essential to practice the invention. In effect, they determine the boundaries of patents with respect to the standard and to some extent determine if these patents have good title to an invention. I also believe that NPEs (Non-Practicing Entities) also act like title insurance companies. Of course, many of the critics of the patent system do not like NPEs either.
I, too, agree that the patent system takes too long to issue patents. However, the problem is not with the concept of a patent system but with a government that has failed to fully fund the Patent Office. In the last two decades, about billion dollars in user fees have been diverted from the Patent Office to Congressional pet projects. In the US, the Patent Office has always been funded by user fees, which are the fees that inventors pay to the Patent Office when they file for a patent. However, when an inventor writes a check to the Patent Office the money is deposited directly to the general treasury account of the federal government. Congress then appropriates these fees back to the Patent Office. When Congress diverts (steals) a billion dollars of user fees from the Patent Office, it is not surprising that the Patent Office will take longer to determine issues of patentability, increasing uncertainty for start-ups. If Congress was subject to Sarbanes Oxley, they would all be thrown in jail for this diversion of fees. In my opinion, the patent process has also become too formalistic and complicated.
These complaints that I have cataloged here are not about patents per se, but with the implementation of the patent system. I agree that the present patent system is overly cumbersome, too formalistic, too expensive, and takes too long. As an aside, I will point out that the critics of patents (IP) complain about their complexity but raise just a peep about a tax system that is over 10,000 pages and a new securities law that is over 1400 pages. There appears to be a disconnect in their thinking.
Some of the solutions to the problems with our patent system will occur if the free market is allowed to create solutions like title insurance for patents. Fully funding the Patent Office will solve many of the other problems, such as the lengthy pendency times. Patents are completely consistent with Locke’s formulation of property. Patents like real property rights are fundamental to economic progress and human rights.
AWall Street Journal article discusses how a number of European companies are delisting from US stock exchanges. The article points out that cost of complying with US law is outweighs any benefits derived by being listed on a US stock exchange. It also explains that the cost of Sarbanes Oxley is increasing, despite earlier predictions that the cost of SOX would decline over time. The new financial reform bill does nothing to address these problem. In fact the present financial reform bill, at over 1400 pages, is going to make it more difficult for start-ups to raise money and more costly to go public in the US.
A recent article in the Huffington Post suggests that the U.S. has become a third world country in terms of innovation. The article states:
A report by the Information Technology and Innovation Foundation looked at the progress made over the last decade in the area of innovation. Out of the 40 countries and regions it examined, the U.S. ranked dead last.
A study on innovation by the Boston Consulting Group concluded that America is “disadvantaged in several key areas, including work force quality and economic, immigration, and infrastructure policies.”
In 2009, patents issued to American applicants dropped by 2.3 percent. Those granted to foreign-based applicants increased by over 6 percent.
The article suggests loosening up our immigration policy for highly trained individuals and increasing the quality of our educational institutions as solutions to this problem. While there is nothing wrong with these suggestions, they fail to recognize the real changes in policy that we have made in the last decade that are killing innovation. Specifically we have passed a number of laws and regulations that are killing innovation in the US. The incredible innovation of the 90s was based on technology start-up companies built on intellectual capital, financial capital, and human capital. All three of the pillars have been under attack since 2000. Our patent laws have been weakened reducing the value of intellectual capital. Sarbanes Oxley has made it impossible to go public reducing financial capital for start-ups and the FASB rules on stock options have made it harder to attract human capital to start-ups.
An article in WSJ blogs is more evidence that Sarbanes Oxley has driven the investment banking business overseas. This has significantly hurt the financial capital to technology startups. According to the article:
A statue in the City of London of the authors of the 2002 Sarbanes-Oxley U.S. regulatory legislation?
Such a monument is worthy of consideration, joked Lord Levene, chairman of Lloyd’s of London, at a World Economic Forum panel discussion. His point was that tighter accounting and other corporate regulations delivered by the so-called SarbOx law drove business to the U.K. from the U.S. and helped London thrive before the more recent credit crisis.
Please read the full article, A SarbOx Statue in the City of London?
In one of my earlier posts, Patent Quality Non-Sense , I pointed out that the R&D (Research and Development) per patent ratio, GDP per patent ratio, and number of citations per patent have all increased over the last fifty years. These were all statistically significant changes. Based on this evidence I concluded that the quality of patents (or threshold for obtaining a patent) has increased over the last fifty years.
I was fortunate enough to have an academic economist send me a message pointing out that there were several papers by academic economists that have been debating why the R&D per patent and GDP per patent ratio have been increasing. One of these papers suggested the reason for this phenomena was that as technologies are explored they become mined out – the cost of obtaining a new invention keep increasing. Of course this issue had been explored in the 1950s by the famous economist, Jacob Schmookler, in his book “Inventions and Economic Growth.” Professor Schmookler showed that across multiple industries the amount of R&D per patent was essentially the same. See figure 2, page 46, figure 22, page 138, figure 23, page 139.
Since these industries included both new industries and mature Continue reading
For the first time in U.S. history more patents were issued to foreigners than U.S. residents, by the U.S. Patent and Trademark Office (USPTO). According to the USPTO, foreigners received 80,271 patents while U.S. inventors received 77,501 in 2008. Six of the top ten patenting companies in 2008 were foreign. Continue reading
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