State of Innovation

Patents and Innovation Economics

Failing of Free Market Theory

I went to an excellent talk by Professor Gary Wolfram, of Hillsdale College, at the Pikes Peak Economic Club last night.  He explained that free market capitalism is associated with the wealthiest nations in the world and centrally planned economies are associated with the poorest nations of the world.  Free markets are based on property rights and the rule of law, not the rule of man.  The freest nations economically have the longest life spans.  The poorest ten percent of the population in the freest countries have a greater share of the total wealth than in non-free countries.  A poor person in the wealthiest/freest countries is likely to live in a house they own, the house is generally a three bedroom house, and most likely has air conditioning.

Professor Wolfram explained that the way you get rich in a free society is to provide goods and services that large numbers of people want.  He stated that we should celebrate people and companies that make large profits, because they have made a large number of people happy.  A big reason why free market countries are so wealth is because they provide an incentive to innovate.  He pointed out how many products that we use today did not exist 30 or 50 years ago.

In the question period of the talk, I pointed out to Professor Wolfram that there is a strong relationship between economically free countries and those that have strong property rights for inventions or patents.  The most innovative countries in the world are those with the strongest patent systems.  Those countries that first escaped the Malthusian Trap were those with strong patent systems.  Vice versa those countries with weak patent systems or non-existent patent systems are poor, not innovative, and are often still mired in the Malthusian Trap.  I then asked why so many “free market” proponents want to weaken or eliminate property rights for inventions (patents).

He rejected my premise that many free market proponents were anti-patent.  He went on to explain that some inventions deserve patent protection that had shorter periods of time and that other inventions deserved longer periods of protection according to a perfect theoretical model of economics.  For instance, inventions that would have been discovered by someone else shortly thereafter should receive shorter terms than “truly novel” inventions.  He also suggested that patents inhibit the diffusion of new technologies.  Finally, he implied that the way we increase our wealth is by driving down the profits associated with products and services.  Reducing the profit margin in goods and services increases the availability of these goods and services.  It is common for free market proponents to see the market process of reducing the profit and cost of goods and services as the major way free markets increase wealth.

Several people pointed out that his proposal for different lengths of patent protection seemed to contradict his idea that capitalism is based on the rule of law, not the rule of man.  The implication was that someone would have to decide which inventions would receive which term length.  As a result, this would be an arbitrary rule of man decision.  In fairness, Professor Wolfram pointed out that this was not true as long as the standard was objective.  While I disagree that we should have different terms for different inventions, Professor Wolfram is clearly correct that this is not necessarily subjective.

The empirical evidence does not support the suggestion by the Professor that patents inhibit the diffusion of inventions and technology.  Those countries with the strongest patent rights also have the greatest technology diffusion.  A major goal of modern patent systems is to spread the information associated with inventions, so that other inventors can build on the work of previous inventors.  There is also no empirical evidence for the idea that inventions would occur without property rights for inventions.  Those countries without strong patent systems do not produce inventions.  The suggestion that, in a free market system, inventions will just occur is at best speculation and the evidence we have shows the opposite.  When the US has weakened its patent system, our innovation has suffered as well as our economy.  For instance, in the 1970s we weakened our patent system and the US started to technologically fall behind Japan.  For more information see Foreigners Receive More Patents Than US!

The most troubling part of Professor Wolfram’s response was the implication that wealth is created in a free market economy by driving down profits.  Professor Wolfram seemed to imply that there was a “correct” or “optimal” amount of return an inventor should receive for a patent.  Shouldn’t we celebrate inventors who create something that everyone wants?  If an inventor creates something very few people want, how does that hurt technological diffusion?  More importantly, is it really true that wealth is created in a free market by driving down the profit margins of manufacturers (or inventors)?

The idea that the real power of the free market to create wealth is in its ability to foster competition (for the same product) and therefore drive down profit margins is incorrect.  If we were able to obtain every product available in 1900 at its cost or even free, we would not be nearly as wealthy as we are today.  Wealth is mainly created, not by cost or profit reduction, but by the creation of new inventions, i.e., technology.  We do not want people/companies competing to produce me-too products, but competing based on inventions.  Shortening the length of patents will encourage competition on me-too products instead of creating new products.  While the optimal length for patents may be difficult to determine, shorter terms will discourage innovation.  There is no evidence that the present length of patents are inhibiting innovation or the economy.

The idea by free market economists that the power of free markets is there ability to reduce the cost of existing products also leads to fallacies about antitrust law (now rebranded as competition law).  This cost reduction theory suggests that we should aggressively apply antitrust law to create competition.  However, the empirical evidence shows that periods of aggressive antitrust enforcement result is low levels of invention and weak economic growth.  For more information see Foreigners Receive More Patents Than US!

Wealth in a free market is mainly created by the invention of new technologies.  It is a failing of economists to suggest that the power of a free market is its cost reduction of existing products.  This fallacy results in an anti-property right policy towards inventions and an aggressive application of antitrust laws.  The empirical evidence shows these policies do not create wealth.

November 12, 2010 Posted by dbhalling | Innovation, Patents | , , , , , , , | 19 Comments