Mind Over Matter

In the information economy, intellectual property is bringing huge returns. But just how will society split up the bounty?

Wherever you turn, every medium of communication is saturated with the terms information revolution and intellectual property. The root cause of the fascination is simple: Lots of money is involved. Both individuals and business organizations have become aware that their rewards depend increasingly on mental products--in the form of education, patents, copyrights, trade secrets, databases, computer-assisted employee cooperation, and general know-how--and less on machines, buildings, and raw muscle.

The size of the stakes would itself be enough to generate an explosion of interest, but another factor also counts: a high degree of uncertainty over who, exactly, will collect this loot. Will it be the individual inventors who generate the ideas? Teams of innovators? Entrepreneurs who translate concepts into commercially viable products? Venture capitalists? Long-term stockholders? Consumers? The obvious answer is that all these groups will share in the bounty, but this answer leaves a lot of latitude about the precise details of the split--and billions of dollars hinge on the answers.

Wall Street seems to assume that a huge share will go to the stockholders. When Nervous Nellies fret that current stock price levels are extraordinary by all historic measures, and hence ripe for correction, the bulls point to the growing importance of intellectual property and information. The familiar yardsticks of companies' value, they say, are based on old industrial models in which the most important assets were plant and equipment, plus some allowance for the value of an ongoing business. But, continue the bulls, as value becomes more dependent on a firm's mental assets and less on its physical embodiments, those old measuring rods lose cogency. From this perspective, current market levels reflect the future earning power of mental assets that are not reflected in old-style balance sheets.

Take, for example, Microsoft, the flagship of the armada of new companies whose value is almost entirely mind-based. Microsoft has 2.4 billion shares of stock outstanding and, at press time, is valued by the market at about $220 billion. The company's physical existence is minimal: It has about $12 billion in cash, investments in other companies, plant, and equipment. That leaves $208 billion as the value of its patents, copyrights, trade secrets, brand name, presence on Rolodexes of customers, and the brains of its 25,000 employees. You can pare the physical component of value down even further. Microsoft's existing products are worth almost nothing in the sense that if the company announced it was freezing its designs and planning no further improvements, its products would be obsolete in a couple of years--and the company's value would drop precipitously. Clearly, no analysis based on physical assets captures the essence of this company or others like it.

So you can make a serious case that almost all of Microsoft's value lies in the new-style form of information and intellectual property, and mostly in the brains of its staff. But while Wall Street bulls may be right about that, it's far from clear that stockholders will snag those brain-based earnings in the long run. Consider that, in 1997, Microsoft produced earnings of $3.5 billion. Of this, zero dividends were paid to the stockholders--the same payout they have gotten every year since the company produced its first earnings of a penny per share back in 1982. Employees, on the other hand, not only got their salaries, they also got 96 million shares of Microsoft stock, which they were entitled to buy at bargain prices under various option plans. The company spent $2.4 billion buying shares to meet this commitment, and if this sum were added to the company's wage bill, Microsoft's 1997 earnings would drop by two-thirds.

Roger Lowenstein, a columnist for The Wall Street Journal, cited these figures as an example of a general phenomenon that companies are "transferring ever-appreciating portions of their profits to workers…motivated not by warm-hearted charity but by cold-hearted reality. Capital is in surplus; skilled geeks are at a premium. No surprise that labor is grabbing a bigger share of the capitalists' pie." Indeed, Microsoft looks a lot like a cooperative venture of its employees. At the end of 1997, the officers and directors, the people defined as "insiders" by the Securities and Exchange Commission, owned 35 percent of the company's stock. Many lower-level employees also own shares. While the company will not say how much stock is held by employees other than the "insiders," it is commonly reported that at least 6,000 of them own enough to be millionaires. In addition, it is known, again through SEC-required disclosures, that employees hold options to buy another 22 percent of the stock, at an average exercise price of $21. In sum, then, we know that the employees have a claim on at least 57 percent of Microsoft's value, plus an additional unknown percentage for the shares already owned by the lower level-employees.

The tug between stockholders and geeks within the information companies is only one dimension of the coming struggle over brain-created value. Another is even more basic: How much will the information companies themselves keep, as opposed to other players in the economic system, and consumers? To repeat the obvious, we are talking about massive gains here--very much a positive-sum game--and all the players should wind up better off. But some will be more better off than others, and the various amounts that will be paid out are up for grabs.

As a half-hour spent browsing through the new buzz-word-larded books in the business section of any local bookstore will demonstrate, discussion of information issues is often muddied by a tacit assumption that "information" is a free-standing entity that can be understood separately from any physical embodiment. This is not so. The value of most information is inextricably linked to its context. For information to be significant it must be about something, and to assess its value you must bring that about into focus.

For most information, the crucial question is how it increases the efficiency with which we use physical assets, such as capital equipment, labor, and energy. This is not a novel phenomenon. Go back 1,000 years or so to one of the great information revolutions of human history--the invention of the horse collar. The Greeks and Romans harnessed a horse by putting one strap around its belly, another around its neck, and joining them on top of the shoulders. The connection to the wagon or chariot ran to this junction. Under a load, the neck strap pulled tight and choked the horse, which cut its ability to pull by about 80 percent. All heavy loads were pulled instead at a slow pace by plodding oxen.

The horse collar, which came to Europe sometime during the Middle Ages, changed that: It still went around the neck, but two connections to the load were used, placed lower down and to the sides to take the strain on the shoulders rather than the windpipe. This adjustment multiplied a horse's pulling power by a factor of five, and, since horses are faster than oxen, also increased the speed with which goods could be hauled. The idea of the horse collar, when incorporated into a cartage system, was an extraordinarily valuable piece of intellectual property.

Much of the current information revolution is similar: Its value lies in its ability to increase the power of other factors of production. Consider the carrying capacity of telephone wire fiber. In 1989 a strand of such fiber carried 24,000 simultaneous calls. In 1997 it carried 516,000. The number will jump to 1.8 million calls this year, and to 8 million in 1999. The increased capacity is a result of changes in software--that is, in information processing--not in the nature of the fiber itself.

Another example comes from the oil industry. Improvements in processing the complicated data generated by exploration techniques has cut by a factor of three the number of wells that must be drilled to figure out the size and shape of a newly found oil field. Or take agriculture, where reliance on global positioning satellites allows farmers to micromanage the application of fertilizer down to the square yard. In all these contexts, and myriad others, information makes physical assets or energy or human labor more productive.

The horse collar was a great invention, but it is safe to say that its inventor made no royalties on it. Medieval Europe lacked a patent system, and a horse collar, once seen, was easily duplicated. Besides, it would have occurred to no one at that time and place that ideas or inventions could or should be protected. The very idea of a patent system that converts ideas into tangible, profitable, marketable property was itself a milestone invention in human history, a major contributor to the great economic ascent that began in the 18th century. It became economically rewarding for people to think systematically about innovation, and they responded with an outpouring of creativity.

The problem that has bedeviled societies ever since is how much to reward intellectual property, given that it is inextricably intertwined with other things. Suppose the inventor of the horse collar could have gotten a patent. A cartage system that was collecting $1.00 in freight charges for a particular trip can now haul five times as much and can collect $5.00. Should the patent on the horse collar entitle the inventor to the entire increase? If so, which inventor, given that few innovations appear in perfected form and an end result comes from tinkering by many minds over a period of time?

The owners of horses and wagons, not to mention the drivers, will also stake a claim, pointing out that the collar may be a fine thing, but without them it produces nothing. So why should its inventor get so much? Consumers will suggest that perhaps the freight charges should remain at $1.00 while the price of goods is dropped. After all, inventors draw heavily on the general stock of knowledge that exists in a society, so why should either they or the owners of the physical assets collect all the rewards? Sure, we need to encourage innovation, but we do not want to allow massive enclosures of the intellectual commons. Nor do we want to tie the whole economic system in knots by imposing transaction costs on all the cross-fertilizations that occur in the interaction of creative minds.

As societies become more complex, ever-more-nuanced tensions arise. The newspapers and the legal reporters are filling up with stories showing the difficulty of drawing the proper lines. Some involve lines between employers and employees. Evan Brown, who works for DSC Communications, a company that makes equipment for the telecommunications industry, and who signed a complex contract governing inventions, has an idea for updating old computer software. He says it was 80 percent complete before he went to work for DSC, and that it is unrelated to DSC's business anyway, so it is his. DSC thinks the idea belongs to the company: "If a janitor came up with a method of cleaning a hardwood floor suggested…by work in cleaning a DSC hardwood floor, technically the idea belongs to DSC," it argues. A novel element in the situation is that Brown has never put his idea on paper and has refused two court orders to do so.

Other stories look at the lines between scientists, as when a biotechnology company claims that a key idea was stolen from a scientific paper during peer review and used to obtain a patent for a rival. Among its defenses, the rival argues that the peer review process carries no obligation of confidentiality. Yet other stories turn on the lines between generators of intellectual property and consumers. A couple of years ago, the American Society of Composers, Authors, and Publishers, which collects for the use of music that has been copyrighted by its members, got into an embarrassing brawl with the Girl Scouts over the use of songs at summer camps. ASCAP claimed that the Scouts should be paying license fees, and earned headlines such as "The Birds May Sing, But Campers Can't Unless They Pay Up," "Campfire Churls," and "Legal Sour Notes." In the face of such negative publicity, ASCAP retreated.

No perfect answers to the problems of dividing the fruits of invention exist in the theory or practice of either ethics or economics, but society has evolved a series of rough-and-ready rules designed to reward and encourage invention without slighting the interests of other players on the economic system. Patents and copyrights are limited in time. You can patent only an actual device, not a general idea; if someone else invents another device that performs the same function, that's too bad for you. An inventor of a horse collar could patent his particular design, but could not patent "the idea of a collar that shifts the strain to a horse's shoulders." As the U.S. law puts it, one cannot patent an "idea, procedure, process, system, method of operation, concept, principle, or discovery." Einstein, to the regret of his heirs, could not patent the formula E = mc2. Nor could Apple Computer, to the regret of its stockholders and employees (and to the delight of Microsoft), patent the idea of a mouse and a graphical user interface, both of which originated elsewhere anyway. On the other hand--and showing the considerable confusion over the exact meaning of these formulas--a patent was issued covering a way to swing a golf club.

Other restrictions exist, such as the proviso that no one can patent familiar or obvious devices or logical extensions of current art. Because such a proviso can conceivably undercut virtually any patent, this is precisely what most patent litigation is about. We also retain our fundamental faith in the virtues of competition and impose some legal limits on the use of patents as mechanisms of monopoly. The current government investigation of Microsoft focuses on the charge that it is trying to leverage its power over the intellectual property of the Windows operating system into control of other areas.

It may seem a long way from horse collars and cartage systems to computer software and today's high-tech industries, but the distance traveled is really not so far. One of the great challenges over the next few decades will be to evolve property rights in intellectual products in a way that reconciles old concerns in these new contexts.

The task will not be simple, because the stakes are large and the conflicts are going to be fierce. Furthermore, the sides are not obvious. The interests of investors, managers, employees, consumers, and inventors are all multi-dimensional, and sometimes counterintuitive. For example, it is often assumed that large corporations favor expansive rights in intellectual property so that they can buy them up. But this is not necessarily so. Those whose power is financial might be better off with narrow definitions. That way, they can copy innovation freely and rely on marketing muscle to squeeze out the inventors. Small inventors worry about this possibility in connection with pending legislation that would make patents public 18 months after the application is filed rather than when the patent is granted, as is the present practice. Big companies, they fear, will steal the ideas and wear down inventors through litigation.

Similarly, how far should creative people go in demanding legal protection for the fruit of their labor? Creators are borrowers as well as lenders, and a requirement that they get permission for every cross-reference would be a heavy--even potentially crushing--burden. A healthy intellectual commons is to the benefit of all, but precise definitions of all the terms in that claim are elusive. Hence, in the ongoing debate over possible reform of the copyright laws, the boundaries of the concept called "fair use" is one of the most contested topics.

Corporate management will also be affected. In theory, managers are the agents of the shareholders exclusively, bound to promote their interests. But, as in the Microsoft context, "capital is in surplus; skilled geeks are at a premium." So the managers who do the best job for their shareholders in the long term will be those who are good at harnessing the mental energies of their information workers. This requires a more subtle balancing than exists at present between the interests of investors and employees, especially when, as with Microsoft, these categories have huge overlap. Since 1994, for example, Cisco Systems, a leading manufacturer of Internet hardware, has purchased 19 companies, most of them small software firms on the brink of product launch. "In short," says The Wall Street Journal, "Cisco is buying new product teams on the open market…and it is paying lofty prices--sometimes as much as $2 million an employee." When you pay that much for mental machinery, you have to figure out how to keep it in good working order, and, unlike metal machinery, you cannot do this with an occasional squirt of lubricant.

All in all, it should be an interesting time.

Contributing Editor James V. DeLong ([e-mail]) is the author of Property Matters: How Property Rights Are Under Assault-And Why You Should Care (The Free Press). His Web site, which features discussions of property and business issues, is www.regpolicy.com.