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Posts Tagged ‘Jacob Schmookler’


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.

 
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.

 

It is quite common to hear that only 2% of all patents every make money.[1]  Apparently this myth has been around for a long time, because Jacob Schmookler in his 1966 book Invention and Economic Growth, he investigates this myth.  His survey show that over 50% of patents are commercialized.[2]  He states that “prevailing opinion has proved to be in serious error.”  He found similar results in Europe, based on the percentage of five year maintenance fees paid.  He states that even “many corporate officers who doubted the accuracy of the (commercialization rates) later found that their own companies’ experience confirmed the findings.”  He notes that most people are only able to perceive giant steps in an area of technology.  As a result, most people not skilled in the art deny the novelty encompassed by the average invention.  A recent survey in China finds that 70% of patents are commercialized in China.[3]


[1] http://www.howtomakemoney4life.com/learn-how-to-make-money-off-patent-royalties/http://www.inventionstatistics.com/Innovation_Risk_Taking_Inventors.htmlhttp://www.canosoarus.com/16InventorTips/Tips02.htm

[2] Schmookler, Jacob, Invention and Economic Growth, Harvard University Press, Cambridge, Massachusetts, 1966, p. 49. 

[3] http://news.e-to-china.com/industry/Patent/Patent_Information/2009/0601/54163.html (12/16/09).

 

Jacob Schmookler, who conducted the most extensive econometric study of patents, estimated the mean value of a patent as $80,000.00 in 1966.[1]  Adjusting for inflation this would place the mean value of an issued patent at $506,000.00.  This estimate seems reasonable based on other data points.  For instance, Intel’s venture capital arm around 2000 would increase the valuation of any start-up they invested in by $1 million for each issued patent.  Of course, not all patents are created equal and the very illiquid market for patents means that the value of any particular patent will vary significantly.  If there were a strong secondary market for patents, we would not only have a better understanding of the value of an issued patent but also less variation.  For more on how to create a strong secondary market for patents see Jump Starting a Secondary Market for Patents. (http://hallingblog.com/2009/11/16/jump-starting-a-secondary-market-for-patents/)


[1] Schmookler, Jacob, Invention and Economic Growth, Harvard University Press, Cambridge Massachusetts, p. 55, 1966.

 

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