Friday, December 19, 2014

Intellectual Property Regulations and Innovation (Part 3 of 3)

Another economically detrimental effect of patent and copyright laws is that they alter the incentives that firms have as far as what and how much to produce and invest. While supporters of IP regulations insist that they cause firms to innovate more than they otherwise would, there is considerable incentive for them to relax and collect profit from their protected products (Boldrin and Levine 2005). Continued innovation is expensive and risky as there is no guarantee that research and development costs of new ideas will be recouped by selling a successful new product. There is also a decrease in a firm’s incentive to improve a product that only it can sell. In a competitive market, each firm is producing something for which their competitors’ products are, at least to some degree, substitutes. IP laws make it illegal to make and sell close substitutes to one firm’s innovation.

Furthermore, intellectual property protections encourage firms to rent seek. That is, they encourage firms to use the legal framework to gain a benefit from the government, instead of focusing on innovation and creating the products protected by those laws. For example, a firm may spend time and other resources on suing other firms for allegedly violating their intellectual property or they might lobby heavily for more regulations to cover their specific interests at the expense of competitors. Such behavior results in consumption of resources without increases in productivity that would come from actual innovation. Even Acemglu and Akcigit (2012), who defend IP protection laws as beneficial in certain cases, recognize that broad protection for all firms diminishes their effectiveness. According to some of the literature, rent seeking is almost the only conduct encouraged by IP laws. Park (2010) takes a similar view, asserting that however strict intellectual property regulations are, their exact design is important so as to avoid undesirable effects. Boldrin and Levine (2004) show that since the benefit of a one form of IP regulation, patents, is to grant a monopoly on a newly invented product, firms will naturally rent seek. Boldrin’s analysis is sound, although some specific examples used may lack accuracy (Selgin and Turner, 2006). Goolsbee, Levitt, Syverson (2012) also acknowledge that, in practice, patents lead to large amounts of waste due to rent seeking. All firms would like to be free from competition, and patents give a legal way for them do so, but do not restrain the negative externalities of monopoly.

Boldrin and Levine also respond to the possibility that private rent seeking in the absence of patents may outweigh any harm done by public rent seeking with them. That is, it is possible that without patents, firms would simply keep their innovations secret forever and thus they would never be available for use by other firms as they would when a patent expired (Boldrin and Levine, 2004). The argument, from this perspective, would continue claiming that patents have the effect of getting secrets out into public by promising that they will be protected by the government for a certain duration of time. At the end of that time, they are then available to everyone as they would be if they had never been secrets at all. Boldrin and Levine (2004) correctly recognize the weakness of this argument. Firms know the duration of patents when they choose to reveal their secrets by applying for protection of them. If they expect that their secrets can be kept for longer than the term of the patent, then they will not apply for the patent. If they expect their secret will be discovered before the end of the patent term (usually because it is easily learned by examining the product), they will take the patent (Boldrin and Levine, 2004). Therefore, private rent seeking is merely incidental to and not changed by a system of IP protections.

Additional distortion in firm decision making derives from the fact that not all types of innovations are patentable or copyrightable. Since the government is offering a monopoly on some types of inventions and creations and not on others, firms are incentivized to invest in those types of products which are protected. Campbell, Huang, and Luckraz (2012) show that greater IP protection tends to change not just whether a firm innovates, but how it does so. Patent and copyright law puts the government in the driver’s seat regarding what types of innovation investment should take place rather than entrepreneurs acting in accordance with price signals.

If IP protectionism ceased, it is unlikely that total innovation would cease with it or even decline. Many inventions and innovation took place prior to the enactment of such laws. If innovation only occurs where IP is protected in the form of government granted monopolies, then we should find that past inventions only took place in the industries and locations in which such privileges were granted, but this is not the case. One must also observe that restricting access to new innovations as the effect of making many other innovations illegal because no one may improve on a design that is protected by a patent. Removing that protection would free up inventive entrepreneurs to make better and more efficient versions of previous discoveries or use those findings for a completely new technological advance.

Some, like Richard Epstein (2013), usually in favor of as little regulation as possible, have argued that some industries, such as software development, should be under some form of IP regulations. To take a different example from Epstein but still a popular one, used by Goolsbee, Levitt, and Syverson (2012), pharmaceuticals have inherently very high costs of development and very low barriers to replication so that, the argument goes, patents really are necessary to spur investment in new technologies and products. Even if there exists a situation in which the sunk costs of research and development are so large that some IP protection is the only way to get innovation to occur, there are less restrictive and anti-competitive ways to make such invention possible without granting monopolies. Boldrin (2009) points out that much of the cost of getting a new drug to market, which is born by its originator and not by imitators, is actually the product of government mandated clinical trials. Therefore, he argues, we can offset some of this cost is allow all other firms to produce generic versions of an already invented drug, but require them to pay a portion of the cost of the trials. This method would be preferable to granting monopolies in almost all cases. By requiring firms which replicate existing technologies to pay some of the high cost of R&D which allegedly make some form of IP protection necessary allows for more innovation and competition but also offsets the sunk costs of the original inventor.

Overall, patent and copyright laws have a negative impact on a firm’s decision. Rather than encouraging innovation, they, in many cases, discourage it. They distort the firms incentives and lead to public rent seeking. So called intellectual property is fundamentally different from what is normally understood as “property,” and the government monopolies that protect it are economically detrimental.

Wednesday, December 17, 2014

Intellectual Property Regulations and Innovation (Part 2 of 3)

Another type of innovation stifled by intellectual property protectionism is that of security. Without the government keeping one firms IP from being used by any others, firms would rely on concealment in order to keep their secrets safe. Even if a monopoly on a certain idea or process or other type of “intellectual property” may be beneficial, that does not entail that government imposed anti-competitive legal restriction ought to enacted and enforced as the only way to accomplish that end. The same result could be achieved through secrecy and securing proprietary information. Under IP protectionism, the government takes on the role, and bears the cost, of keeping an idea safe from competition. Beyond the issues of firms foisting the costs of doing business onto the government, this reality means that innovation in security are not realized. If firms had to protect their own secrets, then they would have an incentive to invest in inventive solutions to the prying eyes of competitors. Admittedly the type of secret being hidden determines whether this scenario is more or less probable, but it is true some cases. By strictly enforcing IP laws, innovations that would protect IP in the absence of those laws are discouraged. Daniel D’Amico uses an example involving cars. In the late 1980s and early 1990s car thefts were soaring, indicating that, while there were strong laws that made it clear that such acts were illegal, enforcement was not very effective. The laws didn’t change in the twenty first century, but car thefts fell. D’Amico argues that this trend is because it has become “really hard to steal cars now.” New technology has made it much more difficult to successfully steal a car, due to innovation like GPS tracking, and even if one could, he would have a hard time selling it or using its parts because other technological advances have made it impossible to use parts from one car in another. These are innovations in security that came about because the legal system did not effectively protect cars from being stolen. It certainly would have been better if people had never stolen cars to begin with or if, since this case involves personal property (which does and should have a different legal status than intellectual property, about which more later.), the legal system had been successful in restraining the properly illegal activity of car theft. However, the relevant principle is that a lack of effective legal restriction can and does result in additional innovation to secure “property” that the government is unable or unwilling to protect. If the government does effectively enforce IP protectionism, then such innovations will never take place.

This critique of IP protection’s alleged net benefit to innovation may seem like a form of Bastiat’s broken window fallacy. Surely we should not be pleased by the jobs created to fix broken windows or to prevent car theft per se. That is, consuming resources to keep people from violating property rights or breaking property that needs to be repaired is not a net benefit because those resources could be spent on productive activities. But intellectual “property” is not in the same realm as personal and real property and it cannot be treated as if it were, something which Fan and Gillan (2013) miss, writing as if protecting IP was comparable to protecting property as normally understood. Milton Friedman (1962) shows that, whatever one’s view on IP protection may be, we all must recognize that usual conceptions of property rights does not fit with IP. Even staunch advocates of patents and copyrights want them to be for a stated duration of time and do not want them to last indefinitely. For all other property, however, one’s right to possess it does not change with time. There is also a specificity to what kinds of things can be protected by IP laws which emphasizes that such regulations are, as Friedman puts it “matters of expediency to be determined by practical considerations” (Friedman 1962). As Kinsella (2001) points out, copyrights and patents are, in fact, restrictions on how one uses his property rather than protections of some other type of property; a firm may not arrange its property in such a way that it infringes on another firms patent or copyright. This fact makes the distinction between property, as normally understood, and intellectual property, even starker. The above discussion is merely to show that security innovations resulting from the lack of IP protection should be considered as real benefits from technological advance not as a “seen” advantage with “unseen” negative consequences.

Monday, December 15, 2014

Intellectual Property Regulations and Innovation (Part 1 of 3)

Intellectual property laws have major effects on the decision-making of firms particularly on how they choose to invest in innovation. The economic effects of these regulations is to grant monopolies which, in the long run, result in a decline in a firm’s ability and incentive to innovate.

In a free market, competition among firms is a force that drives producers to innovate to make better products at lower prices or leave the market. In many cases, however, competition is restricted by intellectual property laws. These laws, most often patents and copyrights, give the give the creator of a good a monopoly on the production and sale of that good. To evaluate the economic effects of these regulations, one must acknowledge that there is a strong presumption against anti-competitive restrictions being economically beneficial. Government granted monopolies on utilities and other areas of the economy often lead to losses in efficiency in light of a lack of competition and, in some cases, a guarantee of profit. In order to be seen as useful to a productive economy, we must find a good positive reason to enforce patent and copyright laws.

At first glance, the economic case for protection of IP seems fairly simple. To develop a new piece of “intellectual property” requires a firm to pour resources in research and development costs without the certainty of a return on the investment. If they are successful and produce a productive innovation, then other firms will be able to observe and replicate that improvement without bearing the costs of investing to create it. This fact means that the profit of the innovating firm will be greatly reduced since they have to account for the large costs and relatively smaller revenue since their products are competing with the same product from many other firms, which drives down the price. The argument advanced by many, including Tanka and Tatsuro (2014), goes that unless firms which invest in innovation have an exclusive right to their IP, then they will cease or, at least, decrease the degree to which they invest in innovation. These losses in investment would hold back innovation and, therefore, hold back economic development.

There is no question that IP laws encourage firms to innovate. They are, indeed, drawn by the possibility of monopolistic control over the production of a potentially profitable new good. It is also clear that innovation, in general, is beneficial to both firms and their customers. The question, however, is whether there is more innovation under a regime of IP protections. This question is one to which the evidence suggests a negative answer.

Initially, it must be realized that even in an open market, one without IP regulations, it is not the case that every firm can immediately copy the products of an innovating firm due to the multi-specificity of capital. There are still significant costs to adapting one firm’s production processes to accommodate a new innovation even if they are able to easily discover the innovation already made by its competitors. Capital goods are not homogeneous, and they must be altered or replaced, at a cost, to change their function. This cost will vary between industries, and those in which the multi-specificity of capital is greatest show the weakness of blanket IP protection in the name of preserving innovation.

In many cases, IP regulations, on net, reduce innovation instead of increasing it. New innovations only come about as the result of previous innovations. The invention of the wheel was only possible because someone had already invented a hammer and chisel with which to shape a rock. The invention of the automobile was only possible because someone had already invented the wheel. If the incorporation of previous innovations is delayed by patent law, then technological advancement as a whole will slow down since firms do not have the necessary prerequisites for further innovation. Henry Ford would not have been able to invent the Model T if the wheel was protected by a patent. This framework gives good reason to think that there is not a simple direct relationship between IP regulations and increased innovation.

Thursday, October 16, 2014

A Tale Of Two Cities: Why Price Gouging Is Good

Today, Antwerp is the largest city in Belgium. In July of 1584 it was part of the Dutch Imperial States; it was also under siege by the Spanish. As with all such military operations, the besieged city eventually started running out of food. As food became more and more scarce, prices of food began to rise. The leaders of the city were outraged that people would charge their fellow man such unreasonable prices for such a basic need, so they enforced a strict price ceiling forbidding anyone from selling food at too high a price. This policy was successful in keeping food prices low – until they ran out of food. Antwerp surrendered on August 17, 1585.
While the price controls were not the sole reason that Antwerp fell, they certainly contributed as they ensured that the beleaguered city would be short on food. Prior to the seemingly humanitarian regulations, food prices got quite high. This signaled to those with food outside of Antwerp that they could make a sizeable profit by smuggling food into the city past the Spanish siege, and so they decided it was worth the risk. Smugglers braved the possibility of being captured or killed because the price was so high. When the price was made lower by law, they stopped smuggling. The low prices not only resulted in a decreased supply of food, they caused consumption to be higher than it should have been, given the situation. Had prices been allowed to rise such that the people of Antwerp could only afford a bare minimum, the high prices would have rationed the food supply and they would have stood a chance of outlasting the Spanish attempt to starve them out. With prices at their pre-siege levels, however, why not consume as you did prior to the siege? After all, if you don’t buy up a lot of food now, others will, leaving you without any in the near future. Since Antwerp’s controls on so-called price gouging led to city’s defeat, the policy was, to put it mildly, quite detrimental.

In Raleigh, North Carolina in 1996 a crowd of people cheered as two men were arrested. Their crime: selling ice to the people in the area who had lost power due to Hurricane Ira. To be more specific, they were arrested for selling ice at a price that the government deemed too high and, therefore, was deemed “price gouging”. As the police impounded the supply of ice and took the men away, one cannot help but wonder why people clapped. There is no arguing that these ice sellers were charging relatively high prices for their ice, and they were most likely motivated not by selfless benevolence but by greed. The interesting thing is, though, that it doesn’t matter; they were the only ones bringing ice to the people who needed it to keep their medications and food from spoiling.

The high price, which many people willingly paid before the endeavor was shut down, sent a signal to the surrounding areas that they should bring their ice into Raleigh. In a free market, that would have happened, but North Carolina decided to “protect” its citizens from exorbitantly high prices. The result: the price was irrelevant because there was nothing to buy. The shelves were empty. It didn’t matter how much you needed ice for your medications, there was none to be had. This fact leads to a second essential function of free prices which is especially important during disasters: rationing.

There were thousands of people who wanted ice, but some of their needs were greater than others. Since prices were not allowed to rise, however, the ice went to those who got to the store first, and was not available at any price to latecomer who may have needed it for an essential purpose. If prices had been allowed to rise, and if sellers from the surrounding areas had received the signal that Raleigh needed ice and they could enrich themselves by providing it, then distribution of the ice would have reflected the subjective valuation of that ice by different people. The person who wants to keep their ice cream cold may decide to let it melt rather than pay $20 for a bag of ice, meaning that there would still be ice available for the person behind them in line who had to keep their insulin cold.

The unreasonable practice of depriving citizens of essential resources in the name of protecting them is not confined to a peculiar North Carolina law or 16th century empires. Twenty-eight states and the District of Columbia currently have “price gouging” statutes on the books. These laws should be repealed so that price signals can coordinate the flow of resources to their most valued use, especially in times of crisis.

Another version of this article was published on Rightly Wired.