The economic and moral case against patents

One of the most conventional of conventional wisdoms today is the idea that the development of new ideas will at least be highly jeopardized in the absence of intellectual property, especially of patents which this essay is dealing with for the sake of brevity.

There are two apparently sound basic arguments for it, one moral and one economic. The moral argument is based on the notion of desert. By analogy with the Lockean idea that an individual has a right to the physical objects which are products of her labor, it is claimed that the results of intellectual labor must also belong to their creators.

The economic case for patents rests on the belief that certain ideas can be very difficult (costly) to come up with but easy to understand and utilize once they are made public in order to achieve material gains. The latter may lead to the inability of the would-be developers of certain ideas to receive adequate compensation of their costs, thus leading to low incentives for discovery and innovation.

However, despite the apparent strength of those arguments, there are both empirical and theoretical reasons for doubting that patents are necessary for scientific and technological progress. Of course, it is far beyond the scope of this essay to even list all those arguments, but it is possible to sketch the most important ones.

Now let us turn to the economic counter-arguments. On the fundamental level, there is something odd about the notion that there can be certain ideas that:

1) require a lot of effort, and (or) resources, and (or) thinking to arrive at;

2) can be immediately understood and put into application once made public;

3) can bring its user substantial profit.

It is tempting to believe that it is at least very unlikely that an idea may satisfy all those conditions simultaneously. For instance, there are a lot of ideas that satisfy (1) and (3). A good example of such ideas is the TEA laser technology. As Michael Polanyi rightly noted in his classic book Personal Knowledge,

So in 1971, when Harry Collins studied the spread of a technology called the TEA laser, he discovered that the only scientists who succeeded in copying it were those who had visited laboratories where TEA lasers were already up and running: “no-one to whom I have spoken has succeeded in building a TEA laser using written sources (including blueprints and written reports) as the sole source of information.[1]

Many ideas also meet criteria (2) and (3). They usually fall into the category of entrepreneurial discoveries, the term coined by I. Kirzner (1973). It often only takes a substantial degree of alertness and chance for an entrepreneur to notice an opportunity to receive profit. At the same time, no significant effort, amount of thinking or allocation of resources may be required.

Finally, there is a probably much smaller set of discoveries that satisfy (1) and (2). Those are some discoveries made by fundamental science. Their key feature is that they do not have an immediate commercial application.

In addition to this line of reasoning, even if there is a very small set of ideas that satisfy all the three conditions in question, it is still impossible to predict the future discoveries, otherwise we would have already made them. The mostly abysmal performance of futurologists of all kinds is a testament to that.

Therefore, someone who would wish to derive profit from appropriating the discoveries made by others would have to maintain a heterogeneous set of resources in order to be able to cling to the opportunity of copying as soon as it arises. This means that such an entrepreneur will have to bid away resources most of which will stay idle for considerable periods of time.

The empirical evidence generally seems to confirm the idea that patents are not exactly very useful for innovation. First, Hall et al. (2013) document that only 4% of UK innovating firms actually obtain patents for their products. Balasubramanian and Sivadasan (2011) find a similar figure (about 5.5%) for US manufacturing companies.

At the same time there is an obvious direction of influence of patents which is troubling for economic progress. Patents are one of the pure cases of monopoly. Their existence stifles competition and limits the dissemination and sharing of knowledge. Thus, it would seem from the viewpoint of economic theory that patents do not contribute to and probably impede the achievement of their goal.

However, perhaps there are certain special cases where the use of patents is warranted. Let us now return to the issue of pharmaceutical drugs which was mentioned in the beginning of this essay. The pharmaceutical industry is considered to be a prime example of a field where patents are essential for innovation. The popular explanation for this is that huge up-front investment needs to be made into developing, testing and obtaining the regulatory approval of new drugs whereas it is very easy to copy them once they are made public.

In reality, original drugs are not exactly copied. Instead, they are reverse-engineered into generics. Reverse engineering requires sophisticated technological processes and usually takes around six months. But this is not the end of the process. The producer of a generic drug must make sure that it is bioequivalent to the original drug. Finally, the generic drug must be approved for entry into the market by the regulator, although the requirements for obtaining such approval are less stringent than for original drugs. According to Appelt (2010, 12), generic drug producers in the EU usually start the preparation for market entry of the new generic drug three years before such entry. In countries with more lax regulatory frameworks, like India (Rai 2003), this process may take less time but is still a matter of years.

Thus, it would seem that the economic rationale for patents fails even when applied to the apparently most promising case, in addition to being dubious from the theoretical standpoint. But perhaps patents are ethically justified even if they are an economic non-starter?

As was mentioned in the beginning the main ethical argument for patents is grounded in the notion of desert. According to this logic, someone who originated an idea must be able to get an adequate reward for it, just as the creator of a valuable material object is. Perhaps, rewarding the desert is an integral part of prosperity in the broad sense of societies being virtuous.

There are at least three issues that cast serious doubt on this idea. First, it is unclear whether the notion of desert has any determinate meaning. Who and on the basis of what criteria should decide what remuneration the originator of an idea is entitled to? There does not seem to be a plausible answer to those questions. This arbitrariness is perhaps best reflected in the question of the duration of the term of patent protection. Should it be 20 years, 50, 70? The question seems to be rhetorical.

Another problem arises from the fact that, as was shown above, it is implausible that the originator of an idea may not derive certain remuneration for it in the market. The originator of a new basic scientific discovery may, if she so wishes, switch from doing basic science to creating marketable products on the basis of her discovery. The commercial success the discoverer of the properties of the DNA James Watson is a good example of this. And if an idea has an immediate commercial application, its creator will, as a rule, have a certain advantage before her potential competitors in exploiting it commercially, even, as it turns out, in the pharmaceutical sector.

Finally, perhaps the most important ethical objection to patents (and intellectual property in general) is that the idea of intellectual property is in a certain sense an oxymoron. The main rationale behind property rights is that they bolster personal autonomy of individuals by allowing them to predictably use in their projects certain material objects or parts of certain objects. But property rights are only necessary because the relevant objects are scarce in one way or another, or, in other words, because they cannot be simultaneously used without certain limitation. But there is no such scarcity with respect to ideas. No objective features of ideas are changed by their use, no matter how many people use them.

As a consequence, what intellectual property rights do is create artificial scarcity where there is none which leads to actually restricting by force legitimate property rights and liberties. Quite a problematic way to promote virtue.

Bibliography

Appelt, S. 2010. “Entry and Competition in the Pharmaceutical Market following Patent Expiry: Evidence from Macro and Micro Data.” Inaugural-Dissertation zur Erlangung des Grades Doctor oeconomiae publicae (Dr. oec. publ.) an der Ludwig-Maximilians-Universitat Munchen.

Balasubramanian, N. and Sivadasan, J. 2011. “What happens when firms patent? New evidence from US economic census data.” Review of Economics and Statistics 93: 26-46.

Hall, B., Helmersy, C., Rogers, M. and V. Sena. 2013. “The importance (or not) of patents to UK firms.” Oxford Economic Papers 65 (3): 603-29.

Kealey, T. 2013. “The Case against Public Science.” CATO Unbound. August 5.

Kirzner, I. 1973. Competition and Entrepreneurship. The University of Chicago Press.

Rai, S. 2003. “INTERNATIONAL BUSINESS; Generic Drugs From India Prompting Turf Battles.” The New York Times. December 26. http://www.nytimes.com/2003/12/26/business/international-business-generic-drugs-from-india-prompting-turf-battles.html.

[1]Quoted in Kealey (2013).

The Problem with Logical Possibility

Modern philosophy makes much of the notion of logical possibility. In particular, this notion lies at the heart of the tendency of modern philosophers to use obviously unrealistic thought experiments. It also underlies the popularity of the possible worlds logic. But is the notion of logical possibility as uncontroversial as it is taken to be?

Philosopher Roderick Long was, in my view, on target when he wrote.

Thus I essentially agree with Fraçois’s answer: “Just because we can imagine the gravitational constant being, not 6.674×10^-11 m^3 kg^-1 s^-2, but rather 6.252×10^-11 m^3 kg^-1 s^-2, does not mean that it can actually be 6.252×10^-11 m^3 kg^-1 s^-2. Just because we can write it down and make calculations based on it doesn’t mean it’s actually possible.”

The source of the problem with logical possibility is that it is necessarily relative to our knowledge about a particular phenomenon. Thus, for instance, until it was discovered that the Earth is moving through space, it had been logically possible that it stays stationary. But after it it has become logically impossible.

It may be countered that in some cases the human mind is just capable of seeing that something must be so, but not in others. For instance, we are just capable of seeing that the Pythagoras theorem is true. But we cannot see that, say, the gravitational constant must have the observed value. However, the question is what can make us sure that we can never see that claims like the latter are necessarily true. There does not seem to be an obvious reason for that.

In other words, there is no good reason to believe that certain facts about the world are merely contingent. Any attempt to prove the contrary must rely on implicit claims to access to some kind of Platonic realm of certainty only in certain supposedly purely mental spheres (e.g. mathematics), which borders on religion.

Piketty’s capital/income ratio decline puzzle for the UK, France and Germany

One of the most important purported empirical contributions of Piketty’s Capital in the 21st century is the U-shaped evolution of the world capital/income ratio in the 20th century where, after, this indicator starts falling dramatically in 1910, hits the trough in 1950 and then starts growing again.

As we now know thanks to Phil Magness, a substantial part of this U-shape is due to the strange decision by Piketty to include into the calculation the capital/income ratios for the socialist countries which are a priori set equal to 100%. However, another part of the decline between 1910 and 1950 arises from the performance of three large European countries – the UK, France and Germany.

If one looks carefully at the declines of the capital/income ratio in those countries, as calculated by Piketty (pp. 116, 117 and 141 of Piketty’s book), one may notice that the lion’s share of this decline in the two former and a large part of the decline in Germany took place just within the 1910s. This involved a dramatic decline in the total value of capital in the narrow sense. In the UK it grew a little between 1920 and 1950 but not even remotely sufficiently to reach the pre-1910 level.

The question that arises here is why such a decline took place in that decade, especially why it started in 1910. While the answer to the latter question may lie in Piketty’s beloved averaging techniques, if it does not, then the causes of such dramatic decline become even more mysterious than they are if it really hit in full force with WW1.

But even WW1 does not seem to explain why the decline was so dramatic. After all, WW1 was followed by the Great Depression and WW2 but, even taken together, they did not produce a comparable decline in the capital/income ratio.

Thinking that something is amiss here, I decided to focus for the sake of brevity on the British case and look for comparison for the British stock market data for the 20th century to see if they match the decline between 1910 and 1950. The results are not very good for Piketty’s calculations.

 

If you click at the graph above (de Long 1996), you will see that the evolution of the British stock market value was quite different from the evolution of the capital/income ratio calculated by Piketty. While there is a sharp drop that starts during WW1, the stock market value recovers and reaches its pre-WW2 peak around 1937 at a level which is far higher than at the start of the WW1-related decline..

This seems to cast an even bigger doubt on Piketty’s calculations of the capital-income ratio for the UK for 1910-1950 because it is unclear how the evolution of the stock market value could diverge so much and for such a long period of time from that of the capital/income ratio in the absence of an especially rapid growth in the national income.

Sources:

De Long, J. B., Grossman, R. 1996. The British Stock Market and British Economic Growth, 1870-1914. Available at: 

Let’s reject the notion of marginal product

Lately, I’ve been thinking about the inadequacy of the notion of marginal product for economic analysis.

Consider a shop with only one employee which would be unprofitable if the selling process were automatized. What is the marginal product of the employee? Or, more exactly, what will be the product of the shop without that employee? Zero. This example demonstrates that it’s impossible in this case to mathematically strictly separate the contribution of various factors of production the way it is usually done.

But suppose the question is about the productivity of the addition of another employee to an enterprise that can function without her. Can we say that her marginal product will be reflected in the change in revenue which will happen after her hiring absent other changes? No, because the change in the revenue will be not just because of the net impact of the worker but because of the changed productivity of capital or even other workers.

In other words, productivity isn’t a mathematical function of several variables like, say, the height of a mountain (even if you consider everything in strictly monetary terms). It is with regard to the latter that you can strictly mathematically separate the impact of movement in a particular direction on the height. But you can’t calculate even in principle the marginal contribution of small factor units.

If this is correct then a big question arises about how factor prices are determined in the market. The current theory has it that they tend to be paid the monetary equivalent of their discounted marginal product. What can we say if we abandon the notion of marginal product?

I think we can build a market process theory of factor price determination. We can say that factor prices reflect the extent to which the opportunities of using the relevant factors profitably are discovered by entrepreneurs.

To illustrate what I’m saying consider an employee in a certain business who gets, say $1000 per month. From this fact we can say that entrepreneurs have not yet discovered the opportunity to employ her in a way which would be profitable enough to allow to pay her a higher salary.

This approach has the big advantage that it doesn’t require the postulation of the superhuman ability of entrepreneurs to somehow calculate the exact contribution of each factor to the product of their enterprises but at the same time leaves completely intact the logic of economic calculation.

The Central Contradiction of Capitalism That Isn’t

Capital in the Twenty-First Century, by Thomas Piketty, Belknap/Harvard, 685 pages, $39.95.

 

The book on how capitalism supposedly necessarily causes increasing inequality, which French economist Thomas Piketty initially wrote in French a year ago, has recently been published in English and became an immediate success with readers reaching No. 1 in the book bestseller list on Amazon. It also received a lot of praise from the commentators on the left of the ideological spectrum.

It is beyond the scope of this review to analyze all or even most of the arguments Piketty makes in the book. I will also not deal with the potential adverse consequences of implementing Piketty’s recommendations which have been addressed fairly well in other reviews (see, for example, Tyler Cowen’s take). Instead, I will focus on the soundness of Piketty’s main argument from the perspective of the dynamic market process theory mainly developed by the Austrian School of Economics.

Piketty’s main point, and what he calls the “central contradiction of capitalism” in a nutshell is that in the conditions when the economic activity is not significantly depressed (as it was the case in the period between 1929 and 1945), capitalism tends to result in ever increasing inequality, as measured by the ratio between the total value of capital (in which Piketty curiously includes housing) and the national income (which is calculated as GDP minus the depreciation of capital plus net income received from abroad). Another way to put the same idea is in terms of the ostensibly fundamental inequality r > g meaning that the rate of return on capital is higher than the rate of economic growth. The mechanism which is postulated to underlie this phenomenon is that in a relatively low-economic growth conditions the rate of savings will tend to be higher than the rate of economic growth.

But do the calculations cited by Piketty measure the dynamics of inequality, and even to the extent that they do, are those increases inherent in capitalism?

The national income is calculated on the basis of the actual purchase and sale transactions where all the monetary amounts that go into the total figure actually change hands during the year. Thus, all the products purchased in those transactions are (however, imperfectly) evaluated by their buyers. At the same time, capital is defined by Piketty as “the total market value of everything owned by the residents and government of a given country at a given point in time, provided that it can be traded on some market” (p. 48). With regard to the calculation of such market value, the technical appendix to Piketty’s book refers to the data appendix to his 2013 study co-authored with Gabriel Zucman according to which the part of capital which is constituted by capital in the narrow sense (or the goods used in the production of consumer goods to be sold in the market) is measured based on the market value of the firms’ equities. However, the method of calculation Piketty chooses does not seem to be crucial because the data that he provides on the ratio between the market value of corporations and their book value does not suggest that stocks of the developed countries’ companies have been systematically overvalued compared to the actual assets (p. 189).

There is a big puzzle related to Piketty’s calculations which arises from the question why the total value of wealth has been growing much faster than the national income. Let us set aside the issue of housing for a moment and focus on capital in the narrow sense.

From the standpoint of the market process theory, the fact that the total value of capital has been increasing translates into the conclusion that the prices of certain capital goods have been increasing. These capital goods are those that have actually been purchased and sold, and the increase in their prices, in the absence of capital destruction, means that there has been increased competition for those capital goods and that much of them have been reallocated. And, what is more important, the fact that the increases of the prices of those goods have been systematically outpacing the growth of the national income suggests that a lot of the reallocated capital has been malinvested.

But the crucial question that this reasoning leads to is how this substantial malinvestment could be compatible with the economic growth that has been observed. This is the most important question that needs to be answered and it can only be answered with the help of dynamic market process reasoning.

Consider the phenomenon of smartphones. They represent an important innovation which within a relatively short period of time has made essentially or nearly obsolete a lot of other consumer goods and their components. It is sufficient to mention the obvious examples fixed phones, portable music players, alarm clocks, point-and-shoot cameras, most video cameras, and GPS navigators. It is fairly plausible to assume that through this process they have freed up substantial amounts of capital for other uses.

However, the resources that are thus freed up do not get automatically reallocated to the new uses. Instead, innovators and entrepreneurs must come up with the ideas about such new uses. The process of innovation may take considerable amounts of time, especially with the increasing government regulation that discourages entrepreneurship and innovation.

At the same time the initial innovation – in this case, smartphones has freed up the money that the consumers would have spent on the things that smartphones have made obsolete. Thus, there will be a big incentive for entrepreneurs to try to discover such processes, even if it may be not easy to do that. At the same time, since the freed up money will tend to be channeled into the capital goods that have become cheaper as a result of the initial innovation, the malinvestments that arise will tend not to extinguish economic growth completely. This will of course only be the case if the process of intertemporal coordination is not distorted by the monetary policy which is often the case according to the Austrian Business Cycle Theory and based on the recurrent economic crises.

The idea that the excess increase of the total value of capital as calculated by Piketty actually represents malinvestment of resources freed up by successful innovation, if correct, casts doubt on Piketty’s thesis that this excess increase suggests growing inequality. Malinvestments do not make people wealthier, after all. It might suggest, though, that the existing government-created barriers to innovation must be minimized.

Finally, we may return to the issue of housing which is a major category of capital under Piketty’s definition the total value of which has become even higher than the total value of the national capital in some developed countries. According to Piketty’s data, it constitutes almost three fifths of the total value of capital of Great Britain, for example, and its ratio to the national income has grown rapidly since the 1970s, and especially since 1990. In France the ratio of the total value of housing to the total value of other capital is even higher – almost 2:1. In the US the total value of capital in the narrow sense slightly exceeds that of housing.

To start with, from the economic theory standpoint, housing is not part of capital. Capital goods are those goods which are produced and maintained to be used in the production of either other capital goods or final consumer goods. Residential houses, on the other hand, are for the most part durable consumer goods. I wrote for the most part because some people do use their living space for work or business, thus making such space partly a capital good. But it is doubtful that such uses generate a large part of the value of housing.

But the most important problem with housing is the assumption that the excessively fast growth of their total value is the result of endemic market forces whereas there are serious reasons to believe that this growth, especially in the European countries like the UK and France has been largely caused by supply-restricting regulations, especially zoning rules. As an illustration, recent research by Paul Cheshire in the South-Eastern England has demonstrated that more land in the Surrey County is devoted to golf courses than to housing. Add to this the regulations about the maximum height of the buildings and many others.

The mechanism of how the growth in housing prices may have been caused by regulation is not very complex. Although in countries like the UK and France population growth since 1950s has not been very dramatic, there has been a significant increase in welfare. It is very plausible to assume that welfare increases lead to an increased demand for housing space, and if the supply of housing is artificially restricted, it is no wonder that significant price increases would follow and persist. The rise of housing prices, although it does point to increasing inequality in this case, is probably not a symptom of an inherent contradiction of capitalism but of something that is opposite to it.

UPD: In his several criticisms of Piketty (see e.g. here) Robert Murphy correctly criticizes Piketty for confusing the return on capital with the rental price paid to the owners of capital goods. In my review I decided to use Piketty’s terms because my line of critique seems legit regardless of them.

 

Non-Equilibrium Price Theory – the Case of Price Ceilings

A couple of weeks ago when I was presenting my version of the Austrian Business Cycle Theory at the Prague Conference on Political Economy, one of the conference participants asked me the question whether I am myself actually tacitly using an equilibrium-based price theory in my theorizing. I told him that such a theory is not necessary for ABCT but I did not have time to go any further into the matter.

In this post I will try to demonstrate the possibility of such a theory on the example of price ceilings.

1)      Suppose that there is an ongoing market process where, among other goods, consumers buy good X for money.

2)      Suppose that a celling is imposed on the price per unit of good X that is below at least some prices that would have been paid in the market for certain quantities of good X without the price ceiling (default scenario).

3)      Suppose that the preferences of the buyers and sellers with respect to money and good X are not affected by the imposition of the price ceiling compared to the default scenario.

4)      An opportunity for trade in relation to good X is a state of affairs in which at least one seller and one buyer will exchange a certain quantity of good X if they are not physically prevented from doing it.

5)      There will tend to be more foregone opportunities for trade with the price ceiling than without it (from 1-4).

One of the reasons why the conclusion is only about the tendency is because it is conceivable that the prices which would have been established in the default scenario would have sufficiently exceeded the reserve prices of the sellers to make them still willing to enter into transactions over the same amounts of good X even in presence of the price ceiling.

Notice that in order to make this argument I did not need to assume the clearing of the market in the default scenario, let alone the clearing of the market at a single price per unit of good X. The assumption that the preferences of the buyers and sellers with respect to money and good X will not be affected by the imposition of the price ceiling looks quite realistic.

A Concise Formulation of the Socialist Calculation Problem

Recently, I was asked by a commenter in one Internet discussion to clearly explain the essence of the calculation problem. Later, I got thankful for the opportunity to do that because it was actually not so easy but in the end I managed to come up with what I think is an adequate formulation.

1) There is no such thing as a social welfare function. There is no way for any agent to spell out the structure of preferences of all the society among various combinations of consumer goods.

2) Because of (1) the only thing even a socialist government can do to even try to respond to the needs of consumers is to retain the market for consumer goods. However, because we are talking about the calculation problem for socialism, there can be no markets and thus prices for producer goods.

3) Suppose that the government in the beginning of the first socialist production period distributes a certain amount of coupons among the population that are valid for the period for buying consumer goods. In parallel it implements a certain production plan for the period. What it gets in the end of the period is a set of quantities of various consumer goods and prices paid for them. In the next period it can distribute the same amount of coupons and make adjustments to the production plan for the period. In the end of the period it will get some other set of quantities and prices but the crucial thing is that there will be no basis for a rational comparison between those two sets to tell which of them is associated with better satisfaction of consumers’ wants. Thus, economic calculation is literally impossible even under market socialism.

4) In contrast, in the presence of markets for producer goods, the adjustment of the production structure towards better satisfaction of consumers’ wants happens through the process of arbitrage between the prices of consumer goods and producer goods. If an entrepreneur finds a way to use certain producer goods to create more value for consumers she will receive profit. If profit is high it will attract other producers. Also, if consumers still want the consumer goods produced with the relevant producer goods strongly enough, the prices for the relevant producer goods will tend to rise and push producers of the producer goods which are inputs into the production of the former into producing more of those. There will also be incentives over the whole chain to innovate in order to lower the costs of production. Thus, resources will tend to be continuously reallocated towards more productive uses over the whole production structure.