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Posts Tagged ‘economic growth’


The Most Powerful Idea in the World: A Story of Steam, Industry, and Invention

This book has an extremely intriguing title.  The book’s goal is to explain why the Industrial Revolution happened and how it happened.  The book explains that there are over two hundred theories for why the Industrial Revolution occurred.  The author points out that most of these theories miss the most obvious point, “which is that the Industrial Revolution was, first and foremost, a revolution in invention.” (Italics in the original)  It further explains, “For a thousand centuries, the equation that represented humanity’s rate of invention could be plotted on an X-Y graph as a pretty straight line.  . . .  Then during a few decades of the eighteenth and nineteenth centuries, in an island nation with no special geographic resources” it changed.  Ultimately, the Industrial Revolution was a perpetual innovation machine.

The author explains that England’s patent laws democratized invention and this combined with the advent of limited liability companies and the new capital markets resulted in an explosion of new inventions that created unimaginable wealth.

“The best explanation for the preeminence of English speakers in lifting humanity out of its ten-thousand-year-long Malthusian trap is that the Anglophone world democratized the nature of invention.

In England, a unique combination of law and circumstances gave artisans the incentive to invent.  . . .  Human character (or at least behavior) was changed, and changed forever, by seventeenth-century Britain’s insistence that ideas were a kind of propertyThis notion is as consequential as any idea in history.” (emphasis added)

The United States went on to create the first modern (non-archaic) patent system that was considerably more democratic (this is small d democrat) than England’s.  This was a major reason why the U.S. became a world economic power in less than 100 years.  Unfortunately, the U.S. is presently considering legislation, the America Invents Act (aka Patent Reform), that will again make inventing undemocratic and the province of the wealthy.

The book explains the history of patent law, the history of the science of steam (thermodynamics) as well as the history of the technology and economics of steam engines.  The writing style is easy to read and very informative.  Despite the bold initial statements in the book, it really focuses on the story of the Industrial Revolution instead of supporting its thesis.

The Most Powerful Idea in the World: A Story of Steam, Industry, and Invention, by William Rosen.

 
America Invents Act Will Increase Patent Application Backlog and Will Not Encourage Innovation or Job Creation!

This is a Press Release from American Innovators for Patent Reform and Eight Other Organizations Send Letter to Congress Stating Objections to House Version of America Invents Act:

 

New York, N.Y. − April 1, 2011American Innovators for Patent Reform (AIPR) joined eight other national organizations in a letter sent to all members of the House of Representatives and the staff of the House Judiciary Committee on March 29. The letter details the organizations’ objections to the House’s version of Senate bill S. 23, the America Invents Act, H.R. 1249. The letter explains why this proposed legislation will increase the cost of securing a patent, reduce access to the patent system for inventors and small businesses, increase the current 700,000 patent application backlog at the Patent Office, and decrease the ability of patent holders with limited resources to enforce their patents.

The organizations object to a weakening of the grace period as proposed by the Senate bill and the House’s version of the bill.  As stated in the letter, a weakening of the grace period granted to inventors under current law − during which they can refine and improve their inventions, build working prototypes, or secure financing or manufacturing for their inventions − would put inventors and small businesses at a distinct disadvantage as they might not be prepared to bear the costs of filing a patent application while large corporations can file their patent applications sooner and more frequently.

The letter recognizes that some of its signatories are opposed to the establishment of a post-grant review provision that creates yet a third process by which the infringer of a patent can challenge the validity of a patent and force patent owners to abandon their patents rather than enforce them.

The letter strongly recommends that Congress take a more targeted approach and shift its attention away from the broad and technically difficult America Invents Act, and instead pass a streamlined, targeted bill that focuses only on long-term funding for the Patent Office.

“We hope the House will seriously consider our objections to this legislation,” says Alexander Poltorak, founder and President of AIPR. “We need legislation that truly promotes innovation and investment in new technologies. Such a system will create new industries and new jobs. The America Invents Act, as now proposed, will likely have the opposite effect.”

Joining AIPR in co-signing of this letter were:

  • CONNECT, an organization entrepreneurs and investors dedicated to innovative technology and life sciences
  • IEEE-USA (Institute of Electrical and Electronic Engineers) in the U.S., the largest organization of technical professionals in the world
  • IP Advocate, a group that represents and assists the academic research community
  • NAPP (National Association of Patent Practitioners), the trade association for patent attorneys and patent agents
  • National Congress of Inventor Organizations representing independent inventors and entrepreneurs
  • National Small Business Association, an organization reaching 150,000 small businesses
  • Professional Inventors Alliance USA, a group that promotes the interests of inventors and entrepreneurs
  • U.S. Business and Industry Council, an association representing small to mid-size businesses

“The fact of the matter is the America Invents Act is an infringer’s dream-come-true,” claims Alec Schibanoff, Executive Director of AIPR. “It was pushed by lobbyists for the large corporations that are the most notorious infringers of patents. If enacted, this bill would tilt the U.S. patent system in favor of the large corporations and put inventors, small businesses and universities at a distinct disadvantage.”

 

About American Innovators for Patent Reform

American Innovators for Patent Reform (AIPR) represents a broad constituency of American innovators and innovation stakeholders, including inventors, engineers, researchers, entrepreneurs, patent owners, investors, small businesses, and intellectual property professionals such as patent attorneys, technology transfer managers and licensing executives.
AIPR opposes any patent reform that weakens the U.S. patent system, which is a driving force behind American innovation. AIPR advocates a multi-tier patent system, automation of the patent application process and synchronization of patent and copyright laws.

For more information about AIPR, please visit www.aminn.org.

 

 
Manzullo on American Invents Act

The America Invents Act is bad for the US economy and I will be posting principled statements explaining its flaws.  Rep. Don Manzullo has shown the courage to be an independent thinker and not to blindly follow the lead (money) from large corporations that want a system that makes it easier for them to steal other people’s technology.

U.S. Rep. Don Manzullo (R-IL) released the following statement expressing his concerns with patent reform legislation that was introduced today in the U.S. House of Representatives.

STATEMENT

“I am deeply concerned that ‘The America Invents Act,’ which was introduced today as H.R. 1249, will stall American innovation and send more of our jobs overseas. This legislation reflects an approach to patent reform that stalled previously, in 2007, in the face of massive opposition from American innovators.

“Like its Senate counterpart (S. 23), the House bill includes an unfortunate provision that would shift America’s current patent system – where the first person to conceive of an invention is granted a patent – to a ‘first to file’ system that would turn our system into a foot race to the Patent Office.

“The U.S. has always awarded a patent to the first inventor to come up with an idea, even if somebody else beat them to the Patent Office. The Constitution, in fact, mandates that inventors have exclusive right to their discoveries. This is a system that produced game-changing inventions from people like Samuel Morse, Alexander Graham Bell and Dr. Ray Damadian. Despite that track record, some people are now insisting that the U.S. should ‘harmonize’ with the rest of the world. With all due respect to our friends and allies abroad, I would not trade America’s record of innovation for that of any of those first-to-file countries.

“The bill would also devastate small inventors by effectively eliminating the one-year ‘grace period’ that U.S. inventors currently have. This grace period is critical to small inventors, who can use that year to develop their invention, seek investors and raise funds to begin the expensive patent application process.

“The House bill also fails to provide appropriate safeguards, like those included in S.23, for the controversial new administrative post-grant review process it proposes. Current law already provides two separate administrative tracks to challenge a patent within the PTO, and this bill proposes to add a third ‘post-grant review’ process. Any additional layers of administrative review must be accompanied by safeguards that will diminish the potential for abuse, particularly by infringers with deep pockets and other third parties.

“Moreover, the bill also establishes a transitional review proceeding at the PTO that would affect certain financial service business method patents. Subjecting patent holders who have proven the validity of their patents, both administratively within the PTO and at trial, to a new type of retroactive challenge seems like unnecessary harassment.

“Many of America’s inventors and innovators are alarmed over these fundamental changes to our patent system, and we must hear them out and address their concerns. I urge the House Judiciary Committee to listen to stakeholders of all sizes and perspectives and to find a truly consensus approach to modernizing our patent system.  I look forward to working with my colleagues on and off the Committee to craft legislation that will support and encourage all of our American innovators.”

 
Fundamentals of Economic Science: An Objectivist Approach

Ayn Rand stated in, Capitalism: The Unknown Ideal, that

Political economy was, in effect, a science starting in midstream‘

 

Economics has ignored the unique features of its principle resource – Man.[1] We are going to avoid that problem, by first examining the unique nature of homo sapiens.  But before we look into the unique nature of man, let’s examine what it means to be a science.  It is my premise that economics is objective and therefore can be a hard science[2], based on empirical observation, logic, and reason.  There are some who would say that economics cannot be a hard science because we cannot setup isolated experiments to test hypotheses.  However, the same can be said of geology and astronomy, both of which are considered hard sciences.

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 person’s 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[3]

Ayn Rand would state this fundamental observation as:

 

Reality exists as an objective absolute—facts are facts, independent of man’s feelings, wishes, hopes or fears.[4]

 

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) satellites will run at a different rate than clocks on earth.[5] This appears counterintuitive, but empirical evidence shows that this is true and failure to account for this difference will result in meaningful navigational errors.

 

Fundamental Observation: Reality is understandable or discoverable using observation, logic, and reason

 

Ayn Rand would state this fundamental observation as:

 

Reason (the faculty which identifies and integrates the material provided by man’s senses) is man’s only means of perceiving reality, his only source of knowledge, his only guide to action, and his basic means of survival.[6]

 

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.  All logical systems are based on either observations or assumptions.  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 use observations.

 

Definition: Economics is the study of how man transforms things to meet their needs.

 

Keeping Rand’s admonishment about the state of economics in mind, we now turn our attention the unique nature of man.  Aristotle and Rand define man as a rational animal.  The genus is animal.  The unique nature of animals and all life is that it thrives on negative entropy.[7] The species in the definition of man is that he is rational.  In the context of economics, the important part of being rational is that man invents.  No other animal invents.  In Atlas Shrugged invention plays a major role in the story.  The major character John Galt is an inventor as is Hank Reardon.

 

Man’s unique reward, however, is that while animals survive by adjusting themselves to their background, man survives by adjusting his background to himself.[8]

 

The first need of every person is to stay alive.  This means that 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 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.  Edwin Schrödinger, Nobel Prize winning physicists, proposed this idea in his 1944 book, What is Life.[9]

 

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 that 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.[10] 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.[11] 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.[12] 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, and 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 (energy) 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.  Or stated in the laws of physics, the 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.  Evolution is life’s way of determining which species is best at overcoming entropy.

Homo sapiens also consume food and create shelter to overcome the effects of entropy.  Unlike other living organisms, homo sapiens 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 be surprising, since the distinguishing characteristic of homo sapiens is their ability to reason.  Man is a rational animal according to Aristotle’s classical definition.[13] 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 increase order (wealth) is his ability to invent.

 

Ayn Rand’s way of explaining this is:

 

Nothing can raise a country’s productivity except technology[14]

 

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 exceeded the rate of growth in population and man escaped the Malthusian Trap at least in the West.[15] 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 and end up wealthier.  David Ricardo 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 wine 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.[16]

 

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.[17] 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 its 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.[18] 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.

In summary, life is a fight against entropy.  Economics is the study of how man transforms things to meet their needs.  The unique way in which humans meet their needs is to invent.  Only by inventing can humans increase their level of wealth.

 


[1] Rand, Ayn, Capitalism: The Unknown Ideal, Kindle Edition, location 126-128, 2011.

[2] Hard sciences include physics, chemistry, and biology, as opposed to “soft science”, such as psychology, sociology, and political science.

[3] Even the bizarre results of quantum mechanics are repeatable and independent of the observer’s hopes, desires, faith, opinion.

[4] The Ayn Rand Institute, Introducing Objectivism, http://www.aynrand.org/site/PageServer?pagename=objectivism_intro, 2/0/11.

[5] Real-World Relativity: The GPS Navigation System, http://www.astronomy.ohio-state.edu/~pogge/Ast162/Unit5/gps.html, October 3, 2010.

[6] The Ayn Rand Institute, Introducing Objectivism, http://www.aynrand.org/site/PageServer?pagename=objectivism_intro, 2/0/11.

[7] Wikipedia, What is Life?, http://en.wikipedia.org/wiki/What_is_Life%3F_(Schrödinger), Edwin Schrödinger, 10/6/10

[8] Rand, Ayn, For the New Intellectual, p. 15.

[10] There are few exotic life forms that do not need oxygen, but all require energy to overcome entropy.

[11] 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.

[12] 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.

[13] The Philosophy of Aristotle, Adventures in Philosophy  http://radicalacademy.com/philaristotle4.htm, 10/7/10.

[14] “The Moratorium on Brains” The Ayn Rand Letter, I, 3, 5.

[15] This should more accurately be stated that the rate of growth in productivity due to the introduction of new technologies exceeded the rate of growth in population.

[16] Ridley, Matt, The Rational Optimist: How Prosperity Evolves, Harper Collins, New York, 2010, p. 75.

[17] This example ignores the cost of transport the wine and cloth, but it illustrates the general concept.

[18] Ridley, Matt, The Rational Optimist: How Prosperity Evolves, Harper Collins, New York, 2010, p. 56.

 

 
Obama: Make Regulation Efficient

President Obama in a Wall Street Journal op-ed piece said that he has directed federal agencies to eliminate job killing regulations.  According to Obama the Executive order requires “a government-wide review of the rules already on the books to remove outdated regulations that stifle job creation and make our economy less competitive.”  As an example he points out:

For instance, the FDA has long considered saccharin, the artificial sweetener, safe for people to consume. Yet for years, the EPA made companies treat saccharin like other dangerous chemicals. Well, if it goes in your coffee, it is not hazardous waste. The EPA wisely eliminated this rule last month.

The fact that it has taken a severe economic recession and the lagging poll numbers of a president to make this changes shows how heavy handed our government has become and how Bzyantine our regulatory environment is.  I have suggested that the US needs a Regulatory Bill of Rights to provide citizens protections from excessive and contradictory regulations.  The Bill of Rights (first ten amendments) do not protect citizens from regulatory rules.  With just a few exceptions, if the governmental designates something a regulatory law or civil penalty then it can completely ignore the Bill of Rights.  I doubt that this is what the Founding Fathers intended when they passed the Bill of Rights.

 

If President Obama really wants to get rid of job killing regulations here is a list in order of importance:

1) Repeal Sarbanes Oxley

Sarbanes Oxley has effectively killed the IPO market and the better part of the equity market in the US.  See Sarbane Oxley Obstructing Innovation

2) Fully Fund the US Patent Office

Congress has stolen about $2B in user fees from the US Patent Office over the last two decades.  This has hurt innovation, job growth, and the economy.  See Restore Patent Funding to Create Jobs.

3) Repeal all Securities Laws

Every econometric study of our securities laws shows that they provide no benefit for investors.  See Liu, Tung, Santoni, Gary J., Stone, Courtenay C.,   Federal Securities Regulations and Stock Market Returns. This paper surveys several papers that have studied the effects of securities laws all of which show no meaningful change in investor outcomes.

4) Pass a Regulatory Bill of Rights

This would provide ordinary citizens the tools necessary to require the federal government to only implement regulations that achieve their purpose in a cost efficient manner.  See Regulatory Bill of Rights.

 

5) Eliminate the Income Tax

The income tax is not designed to generate revenue for the federal government.  It is designed to punish certain people who have committed no crime (violation of the due process clause of the 5th Amendment) and to allow Senators, Congressmen and the President to sell tax favors to the wealthy.  The income tax system should be replaced with a system with the sole goal of providing the federal government the revenue it needs.  A flat tax or a national sale tax would both work.

 

6) Repeal ObamaCare

This is a job killing piece of legislation that we cannot afford.

 

7) Reform Social Security and Medicare

The best reform is to make them defined contribution programs instead of defined benefit programs.

 

If President Obama were to implement these five simple changes, the U.S. would see above 7% growth for the next two decades.

 

 
George Will: US Suffering From Innovation Dearth

In a January 2, 2011 column (Needed: A science stimulus) in the Washington Post, George Will points out that the US is suffering from a lack of innovation.  He makes a token node to the patent system in the article and then he focuses on government spending on science and engineering and does not mention the patent office is underfunded.  George reflects Washingtons and the elitists attitude that government spending is what drives the economy.  He just believes government spending should be directed to science.  In addition, he repeats the elitist comment that most of the science is done by the elite and us peasants don’t really contribute much.

The late Nobel laureate Julius Axelrod said, “Ninety-nine percent of the discoveries are made by 1 percent of the scientists.”

This elitist attitude contradicts all the available evidence.  As the book, The Most Powerful Idea in the World, discussed in Georges’ article points out, sustained economic growth does not happen until property rights for ideas (patents) are enacted.  This releases a flood of inventions, not by the elite, but by ordinary citizens.  It was the democratization of the inventing process that lifted the masses out of the Malthusian Trap.

 

 
Long Term Economic Predictions

Background

It has been a year since I published my book The Decline and Fall of the American Entrepreneur: How Little Know Laws and Regulations are Killing Innovation.   The book explains that the only way to increase real per capita income is by increasing our level of technology.  This can be accomplished by capital equipment purchases, which upgrade plant and equipment with newer technologies or by creation of inventions.  Since the United States is a leader in technology, we do not have the choice of just upgrading to new technologies produced in another country.  So we must create new technologies if we want our economy to grow.  There are two ways to encourage the creation of new technologies; government funding or private investment in inventions.  Government spending on research and development is not nearly as effective as private spending for all the same reasons that government spending is always wasteful.  A study by the Small Business Administration shows that most emerging technologies are invented by small entrepreneurial start-ups.  Unfortunately, since 2000 the U.S. has undermined the three foundations on which technology start-ups are based.  Those three foundations are intellectual capital, financial capital, and human capital.  We weakened the intellectual capital foundation by weakening our patent system, we weakened the financial capital foundation with the passage of Sarbanes Oxley, and the human capital foundation was weakened by the accounting rules that required the expensing of stock options.

Since my book was published the financial capital foundation has been further undermined by the passage of the financial reform bill.  There has been no change on the human capital front.  There is mixed news on the intellectual capital front.  The good news is that David Kappos replaced the incompetent and traitorous Jon Dudas as the head of the Patent Office.  The bad news is that Supreme Court again illustrated their utter incompetence in the Bilski decision.  For more information, see The US Economy and the State of Innovation.

These problems are being exacerbated by the budgetary issues associated with aging baby boomers.  The Obama and Bush administrations compounded these problems by expanding Medicare to prescription drugs and the passage of Obama Care.  Presently, Medicare/Medicaid and the Children’s Health Insurance Program (CHIP) represent 21 percent of the federal budget.  Social Security represents about 20 percent of the federal budget and interest payments represent about 8 percent of the federal budget.  It is estimated that about 10,000 baby boomers will go on Medicare per day for the next twenty years.  However, about 5000 seniors are dying per day.  Each Medicare recipient costs about $10,500, so Medicare costs will expand by $185 billion dollars (today’s dollars) or another 5% of the federal budget.  Roughly, the same calculation applies to social security.  So Medicare and Social Security will consume approximately 50% of the U.S. federal budget by 2020.  In addition, the interest payments are likely to consume around 30% of the U.S. federal budget.  This means that 80% of the federal budget will be spoken for.  This does not include any additional costs for Obama Care.  It is unlikely that the federal budget as a percentage of the economy can grow, since the U.S. had to borrow one third of the federal budget in 2010.

Here are my predictions for the next decade based on this background.  I provide an optimistic, most likely, and pessimistic scenarios.  Note these scenarios are based on what I believe is most likely to occur, not what I believe is the best that could be done or the worst that could be done to the U.S. economy.

Predictions Common to all Scenarios

Properties rights of all kinds will continue to be weakened.  It appears that you can get a PhD. in economics (or even win the Nobel Prize) without understanding even the most basic ideas of property rights and how they affect a free economy.  Even so called free market economists forget that Reagan not only cut tax rates, he strengthened property rights.  Particularly he strengthened patent rights – for more information click here.  He also strengthened property rights by weakening regulations and weakening the power of unions.  A number of so-called free market economists do not understand that property rights are based on productive activity.  As a result, they have joined in an all attack on property rights for inventions – patents.  For more information see Scarcity Does it Prove Intellectual Property is Unjustified.

There does not appear to be any meaningful ground swell against Sarbanes Oxley[1] and the Financial Reform Bill.  As a result, entrepreneurial companies will be starved for financial capital.  Because it appears very unlikely we will strengthen property rights for inventions or property rights generally or strengthen our capital markets so they work for start-up companies, the most optimist scenario is limited to subpar growth.

The growth of the Internet will result in a continued decline in commercial real estate values under all scenarios.  Commodity prices are likely to increase, inflation adjusted, under all circumstance.  Growth in China and inflation will drive this increase in commodity prices.

Optimistic Scenario

This scenario assumes that the U.S. faces up to its budgetary problems, repeals Obama Care, and rationalizes it tax structure.  This scenario assumes that Obama is not elected for a second term.  Government spending will grow slightly as a percentage of GDP.  Supply Side economists would probably consider this enough to create vigorous economic growth.  However, it does nothing to really encourage investment in new technologies.  As a result, real inflation adjusted GDP growth over the decade will probably be around 2%.  Median household family income after taxes will be stagnant.  This will be two decades during which median household income has not grown in the U.S.  I believe that will be the first time in the history of the U.S. this has occurred.

The housing market is likely to be stagnant since family incomes will be stagnant.  Inflation is likely to run 4-6%, but this will not be enough to cause appreciation in housing prices.  In fact, inflation adjusted housing prices will likely decline.

The best economic opportunities will be in government related jobs or businesses.  Commodity based business will also prosper.  Technology entrepreneurs will be few and far between.  Unemployment numbers will hover between 7-9% throughout the whole decade – this will be the new normal.  The U.S. will no longer be the largest economy in the world and based on per capita income among large countries the U.S. may fall below the top ten in the world.  The U.S. will also be one among many equals in technological and scientific leadership.  All social ills will increase slowly including crime, number of welfare dependents, and black market transactions.

Most Likely Scenario

This scenario assumes that the U.S. will not face up to its budgetary problems and Obama Care will not be repealed completely.  Under this scenario, the U.S. will go from financial crisis to financial crisis.  Each financial crisis will be meet with a short term band-aid solutions.  Federal government spending will grow to at least 30% of GDP and total government spending will be 50-60% of GDP.  Inflation will grow to 10-14% by the end of the decade.  Despite this, housing prices will not keep up with inflation.  Median household family income after taxes will decline by 2-7%.  Official GDP numbers will show slightly negative growth, but this will over state the actual growth rate.

The best economic opportunities will be in government related jobs or businesses.  Commodity based business will also prosper.  The financial differences between those who are in the government’s favor and those who are not will be huge.  Technology entrepreneurs will be almost nonexistent.  The brain drain from the U.S. will be apparent and a cause for anxiety.  Unemployment numbers will hover between 9-15% throughout the whole decade.  The U.S. will no longer be the largest economy in the world and based on per capita income among large countries the U.S. will fall well below the top ten in the world.  The U.S. will also be a declining power in technology and science.  All social ills will increase moderately including crime, number of welfare dependents, and black market transactions.  The chance of a major war in the world will be moderate.

Pessimistic Scenario

The U.S. will not face up to its budgetary issues even to get through a crisis.  The U.S. will either literally default on its debt or inflation will be over 20% or both.  Multiple states will go bankrupt and be bailed out by the federal government.  Tax burdens will skyrocket as will the black market.  Housing prices will decrease significantly except in extremely exclusively neighborhoods.  Social order will collapse.  The pretense that the U.S. is a nation of laws or that the Constitution has any meaning will be completely destroyed.  There is a possibility (15%) that there will be a military coup.  Alternatively or in combination there is a possibility that the U.S. will break up into a number of separate countries.  Many parts of the U.S. will decide that it no longer makes sense to support Washington, Wall Street and parts of California that have become use to crony capitalism and government handouts.  The brain drain from the U.S. will be well known and huge.  This may be the driver for politicians and voters to demand real reform.  China and India will dominate the world economy.  Unfortunately, neither will likely fill the U.S.’s shoes and become a technological and scientific leader.  Singapore will likely be the richest country in the world on a per capita basis by a large margin.  They will be the major center of technological and scientific research.  The chance of a major war in the world will be probably.

Caveats

The best reason to be more optimistic is that the U.S. has never had two bad decades in a row.  In the late 1930s and late 1970s there was no reason to suppose that the U.S. would right itself economically.  We pulled out the 1930s because Roosevelt realized that he had to adopt pro-business policies if the U.S. was to have any chance of winning World War II and so did the voters.  In the 70s, there was little hope that the U.S., let alone England, would pull out of the inflationary spiral, increase unionization, increased regulation, increasing government spending and entitlements.  However, there was the glimmer of Ronald Reagan and a surge of free market economists such as Milton Friedman, who still understood property rights.  Unfortunately, I do not see a Ronald Reagan on the horizon and many of today’s free market economists are overly focused on the detrimental effects of Federal Reserve and high marginal tax rates.  Very few seem to understand the importance of strengthening property rights, particularly for inventions or the need to free up our capital markets from regulation.  I hope I am wrong and there is a politician who understands property rights, particularly for inventions, and the need to free up our capital markets, while having the strength to stand up to government unions and special interests.

I cannot decide if we are seeing the collapse of Western Civilization under the weight of the welfare state (socialism) or if we are seeing the last hurrah of the welfare state.


[1] Ron Paul and Newt Gingrich have advocated eliminating SOX.

 
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.

 
More Evidence that Stealing Inventions is a Business Strategy

I was reading a post on the myth of the first mover advantage, which intrigued me because I have argued essentially this point in my post, Invention – A Financial Analysis .   One of the responses suggested the book, Copycats: How Smart Companies Use Imitation to Gain a Strategic Edge.  The description of the book on Amazon states:

In the business world, imitation gets a bad rap. We see imitating firms as me too players, forced to copy because they have nothing original to offer. We pity their fate: a life of picking up crumbs discarded by innovators striding a path paved with fame and profit.

In Copycats, Oded Shenkar challenges this viewpoint. He reveals how imitation the exact or broad-brushed copying of an innovation is as critical to prosperity as innovation.

Shenkar shows how savvy imitators generate huge profits. They save not only on R&D costs but also on marketing and advertising investments made by first movers. And they avoid costly errors by observing and learning from others trials. (Emphasis Added)

I show in my post that without intellectual property rights that copycats will “save on R&D costs” and “marketing and advertising costs” compared to inventing firms.  This book clearly argues for stealing the inventions and marketing efforts of inventors.  There is nothing wrong with being a copycat firm, if you pay the inventor for their intellectual property.  However, this is not what the author is suggesting.  He is suggesting stealing the inventing and marketing efforts of innovators.  According to the description of the book, the author suggests that copying is as critical to prosperity as innovation.  Since you cannot copy an invention until it has been created, invention always proceeds copying.  It is impossible for the effect, copying, to be as important as the cause, invention.  This book may be providing good business advice in the present environment of weak patent rights, but it is dead wrong that imitation is as important invention for the economy.  The only way to increase real per capita income is by increases in our level of technology.  Only by properly protecting the rights of inventors can we encourage (private) invention and therefore increase our real per capita income.  This book is sad statement on the US economy and its willingness to protect property rights.

 

 
$30 Billion for Small Business Lending

President Obama’s latest proposal to stimulate the economy is to subsidize community banks so that they lend to small businesses.  Gary Townsend has a great article on this at Seeking Alpha.  He suggests the program is flawed because of poor execution issues.  In his more cynical mood (honest mood), he suggests that it is payback to the banks for supporting financial reform.

More important than poor execution is that Obama’s proposal is fundamentally flawed.  It is another case of the government stealing money from one group to give it to another group.  It will not create jobs.  Banks lead to established businesses that have assets and cash flow.  The Kauffman Foundation has shown that all net new jobs over any decade are created by new businesses not small businesses.  High quality jobs are created by new business that are creating new technologies.  President Obama could get 300 times the impact with 1/30th the spending by fully funding the Patent Office and repealing Sarbanes Oxley and the new financial reform bill.  New companies (start-ups) that create high quality jobs are funded by equity investments.  These equity investments are backed by intellectual capital – patents.   The best return on these equity investments occurs when these companies go public.  Sarbanes Oxley has made this almost impossible.

This proposal by President Obama is not about creating jobs, but about political payback.

 
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.

 
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.

 
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.

 
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.

 

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