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.

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