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Archive for August, 2010


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.

 
Open Question to David Kappos & Trademark Community

Why does the Trademark Office compel trademark applicants to select from the “Trademark Acceptable Identification of Goods and Services?” When I filed trademarks for my clients ten years ago there was no push to get us to select an approved statement of goods or services.  We were free to correctly define what my client thought was an accurate statement of their goods or services.  While the Trademark Office seemed to have some minor rules about how we stated what our goods (hereinafter goods should be read to mean goods or services) were, in general these rules seemed to be about form.  I will note that even these rules appeared to be poorly defined or explained, but they were not an impediment to a correct statement of the client’s goods.  Somewhere in the last ten years the Trademark Office started forcing people to select from the Acceptable Identification of Goods and Services.  The problem with this policy is that this list often does not have a correct identification of the goods that my entrepreneurial clients are offering.  By definition, these clients are providing a unique good that has not been offered in the market before.  The result of the policy is that my clients shoehorn their trademark application into one of the acceptable statements of goods.  This results in an incorrect statement of the actual goods they are providing.  This policy appears arbitrary and bureaucratic to me and my clients.  Can anyone provide me a reason for this policy?  How does this policy improve the trademark application process?  Is this policy another misguided attempt to harmonize our laws with the rest of the world?

 

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
 
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.

 
What is the Economic Impact of Start-ups?

Another excellent study by the Kauffman Foundation shows that the jobs created by new start-ups are durable.

By 25 years after firms start, only about 20 percent of them still exist, but the employment numbers appear to level off at around 68 percent of their initial values.  The fact that establishments have decreased so rapidly yet employment has more or less leveled out means surviving firms continue to grow.  Firms fail, but growth, even at these well-established firms, continues, keeping employment from dropping with the number of establishments.

Another Kauffman Foundation study showed existing firms are net job losers.  Given this information why has the Obama administration (and  Bush administration) focused on saving large established companies and consistently undermined start-up companies?

Since 2000 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 and now Financial Reform 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.  The Decline and Fall of the American Entrepreneur: How Little Known Laws and Regulations are Killing Innovation explains these problems in more detail.

 
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.

 
Another Study Shows Value of Patents

The paper, R&D, Invention and Economic Growth: An Empirical Analysis, by Professor Hulya Ulku shows that patents, per capita GDP, and spending on research and development are closely correlated.  Figure 2 of the paper shows a straight line relationship between per capita GDP and per capita patents for 20 OECD countries.  The data is based on the number of US patents issued to inventors in the 20 OECD between 1981 and 1997.

The paper discusses the endogenous/exogenous invention and growth debate and concludes:

The fact that the effect of invention on per capita output is the largest in higher income countries implies that rich countries are not constrained by stagnant output growth, as implied by exogenous growth models.  These results support endogenous growth theories which predict that countries’ R&D efforts may foster economic growth.

The paper does not support the patent thicket (tragedy of the anticommons) theory that patents inhibit research and development.  It shows that those countries with the most patents are most likely to undertake the most research and development expenditures.

 
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.

 

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