Creation Myths

Does innovation require intellectual property rights?

Douglas Clement from the March 2003 issue

(Page 4 of 4)

But what happens as reproduction technologies im-prove: as printing presses get quicker, or as the Internet lets teenagers share music files faster and farther? Won't that drive authors and musicians into utter poverty?

In fact, Boldrin and Levine argue, the opposite should occur. Increasing rates of reproduction will drop marginal production costs and, therefore, prices. If demand for the good is elastic -- that is, if demand rises disproportionately when prices drop -- then total revenue will increase.

And since creators with strong rights of first sale are paid the current value of future revenue, their pay will climb. "The point we're making is the invention of things like Napster or electronic publishing and so on are actually creating more opportunities for writers, musicians, for people in general to produce intellectual value, to sell their stuff and actually make money," says Boldrin. "The costs I suffer to write down one of my books or songs have not changed, so overall we actually have a bigger incentive, not smaller incentive."

Conventional wisdom admits that monopoly rights impose short-term costs on an economy. They give an undue share of the economic pie to those who own copyrights and patents; they misallocate resources by allowing innovators to command too high a price; they allow innovators to produce less than the socially optimal level of the new invention. But these costs are all considered reasonable because innovation creates economic growth: The static costs are eclipsed by dynamic development.

Boldrin and Levine say this is a false dilemma. Monopoly rights are not only unnecessary for innovation but may stifle it, particularly when an innovation reduces the cost of expanding production. "Monopolists as a rule do not like to produce much output," they write. "Insofar as the benefit of an innovation is that it reduces the cost of producing additional units of output but not the cost of producing at the current level, it is not of great use to a monopolist." Monopolists, after all, can set prices and quantities to maximize their profits; they may have no incentive to find faster reproduction technologies.

More broadly, producers are likely to engage in what economists call "rent-seeking behavior" -- efforts to protect or expand turf (and profits) by fighting for government-granted monopoly protection -- and that behavior is likely to stifle innovation. Expensive patent races, defensive patenting (in which firms create a wall of patents to prevent competitors from coming up with anything remotely resembling their product), and costly infringement battles are common functions of corporate law departments. Such activity chokes off creative efforts by others, particularly the small and middle-sized firms that are typically more innovative.

The Critics

Like any radical innovation, Boldrin and Levine's argument has its critics. "We've been presenting it in quite a few key places, and I have to admit that every time there was a riot," says Boldrin. "There was a riot at Stanford last Thursday. It was a huge riot at Chicago two weeks ago. I know it was a riot at Toulouse when David presented it."

A "riot" among economists might not call for crowd control, but the paper does evoke strong reactions. UCLA's Klein says the paper is "unrealistic modeling with little to do with the real world." In a paper with Kevin Murphy of the University of Chicago and Andres Lerner of Economic Analysis LLC, Klein writes that Boldrin and Levine's model works only under the "arbitrary demand assumption" that demand for copies is elastic, so that as price falls over time output increases more than proportionately and profit rises. In the case of Napster and the music industry, this "clearly conflicts with record company pricing. That is, if Boldrin and Levine were correct, why are record companies not pricing CDs as low as possible?"

Romer has a broader set of objections. As a co-author and graduate school classmate of Levine's and a former teacher of Boldrin's at the University of Rochester, Romer has no desire to brawl with his respected colleagues. Moreover, he agrees that property rights for intellectual goods are sometimes too strong; in some cases, society might benefit from weaker restrictions. Music file sharing, for example, might increase social welfare even if it hurts the current music industry. And he stresses that alternative mechanisms for bringing forth innovation -- government support for technology education, for example -- might well be superior to copyrights and patents. Nonetheless, Romer does have serious problems with the new theory.

First of all, the first-sale rights Boldrin and Levine would assign to innovators "would truly be an empty promise." In their model, if a pharmaceutical firm discovers a new compound, it can sell the first pills but not restrict their downstream use. A generic drug manufacturer could then buy one pill, analyze it, and start stamping out copies.

"So what Boldrin and Levine call 'no downstream licensing' is instant generic status for drugs," Romer complains. And while they argue that the inventor "can sell a few pills for millions of dollars," this is unrealistic if everyone who buys a pill can copy it. "You can make a set of mathematical assumptions so that this is all logically consistent," says Romer, "but those assumptions are wildly at odds with the underlying facts in the pharmaceutical industry."

If Boldrin and Levine are unrealistic about appropriability, they are even more at sea re-garding rivalry, Romer adds. While it's true that ideas must be embodied to be economically useful, it's false to say that there is no distinction between the idea and its physical instantiation. A formula must be written down, but the formula is far more valuable than the piece of paper on which it's written. In a large market, the formula could be so valuable that "the cost of the extra paper is trivial -- so small that it is a reasonable approximation to neglect it entirely." If Romer's approximation is right -- if it truly is reasonable to neglect that "trivial" cost -- then out goes the slim element of rivalry on which the Boldrin/Levine argument rests.

Romer also objects to the contention that competition can deal well with sunk costs. And he suggests that Boldrin and Levine are wrong to object to copyright restriction of downstream use, since perfect competition allows sellers and buyers to enter contracts that impose such restrictions. "What justification is there," says Romer, "for preventing consenting adults from writing contracts that limit subsequent or downstream uses of a good?"

Boldrin's quick e-mail re-sponse: "We never say anything like that!! Patents and copyrights are NOT private contracts; they are monopoly rights given by governments."

Romer counters: "The legal system creates an opportunity for an owner to write contracts that limit how a valuable good can be used....The proposal from Boldrin and Levine would deprive a pharmaceutical company or the owner of a song of the chance to write this kind of contract with a buyer."

According to University of Chicago's Lucas, "There is no question that Boldrin and Levine have their theory worked out correctly. The issue is where it applies and where it doesn't." Their strongest examples, Lucas argues, are Napster and the music industry. "If we do not enforce copyrights to music, will people stop writing and recording songs?" he asks rhetorically. "Not likely, I agree. If so, then protection against musical 'piracy' just comes down to protecting monopoly positions: something economists usually oppose, and with reason."

But Lucas cautions that their theory may not apply everywhere. "What about pharmaceuticals?" he asks, echoing Romer. "Here millions are spent on developing new drugs. Why do this if the good ideas can be quickly copied?"

Refining the Theory

Solow suggests that Boldrin and Levine should enrich their "very nice paper" by testing its robustness. What happens, for example, if the time interval between invention and copying is shrunk? And -- echoing Arrow -- "does anything special happen if you introduce some uncertainty about the outcome of an investment in innovation?"

Boldrin and Levine recognize that work remains to be done to strengthen their theory. They have begun to examine the effect of uncertainty on their model, as Solow suggests, and they say the results still broadly obtain. The difference is that a large monopolist may be able to insure himself against risk, whereas competitors will need to create securities that allow them to sell away some of the risk and buy some insurance.

As for pharmaceutical research and development, Boldrin and Levine contend that their critics are misrepresenting the industry's economics. Much of the high cost of pharmaceutical R&D, Boldrin argues, is due to the inflated values placed on drug researchers' time because they are employed by monopolists. Researchers are paid far less in the more competitive European drug industry.

In addition, Levine says, pharmaceuticals aren't sold into a competitive market: "They are generally purchased by large organizations such as governments and HMOs." If inflated drug prices are viewed more realistically, these economists argue, the development costs of new drugs would not be nearly as insurmountable as commonly believed.

Moreover, copying a drug takes time and money, providing the innovative drug company with a substantial first-mover advantage. "It's not obvious that the other guys can imitate me overnight," says Boldrin. "The fact that you are the first and know how to do it better than the other people -- it may be a huge protection."

Still, they admit, there are cases of indivisibility where the initial investment may simply be too large for a perfectly competitive market. "We have argued that the competitive mechanism is a viable one, capable of producing sustained innovation," they write. "This is not to argue that competition is the best mechanism in all circumstances." Indivisibility constraints may keep some socially desirable innovations from being produced; the situation is similar to a public goods problem. The authors suggest that contingent contracts and lotteries could be used in such cases, but "a theory of general equilibrium with production indivisibility remains to be fully worked out."

Some economists have already begun work on the next stages. Quah at the London School of Economics has pushed Boldrin and Levine's model in a number of directions to test its robustness and applicability. In one paper, he finds it works well if he tweaks assumptions about the consumption and production of the intellectual assets, but it falters if he changes time constraints.

In another paper, Quah contends that Boldrin and Levine's potential solutions to indivisibility constraints may not actually resolve the problem. "What is needed," he writes, "is the capability to continuously adjust the level of an intellectual asset's instantiation quantity." Roughly translated: We need the ability to come up with half an idea. That might be a problem.

More studies like Quah's will be needed to poke, prod, refine, refute, and extend Boldrin and Levine's theory. And empirical work will be needed to see whether it is indeed a more apt description of innovation. The theory is part of an intellectual thicket, and economists who work that thicket tend to render it impenetrable by adopting different terms or defining identical terms differently.

What is clear, though, is that Boldrin and Levine have mounted a formidable assault on the conventional wisdom about innovation and the need to protect intellectual property. That it has met with opposition or incredulity is to be expected. What matters are the next steps.

"The reaction for now is surprise and disbelief," Boldrin says. "We'll see. In these kinds of things, the relevance is always if people find the suggestion interesting enough that it's worth pushing farther the research. All we have made is a simple theoretical point."