Creation myths: does innovation require intellectual property rights?

• Author: Clement, Douglas

THE MOST FORCEFUL performance at last year's Grammy ceremony was a speech by Michael Greene, then president of the National Academy of Recording Arts and Sciences. Speaking not long after the 9/11 attacks, Greene gravely warned of a worldwide threat--"pervasive, out of control, and oh so criminal"--and implored his audience to "embrace this life-and-death issue."

Greene was not referring to international terrorism. "The most insidious virus in our midst," he said sternly, "is the illegal downloading of music on the Net."

Greene's sermon may have been a bit overwrought, but he's not alone in his fears. During the last decade, the captains of many industries--music, movies, publishing, software, pharmaceuticals--have railed against the "piracy" of their profits. Copyright and patent protections have been breached by new technologies that quickly copy and distribute their products to mass markets. And as quickly as a producer figures a way to encrypt a DVD or software program to prevent duplication, some hacker in Seattle, Reykjavik, or Manila figures a way around it.

The music industry has tried to squelch the threat, most conspicuously by suing Napster, the wildly popular Internet service that matched patrons with the songs they wanted, allowing them to download digital music files without charge. Napster lost the lawsuit and was liquidated, while similar services survive.

But the struggle over Napster-like services has accented a much broader issue: How does an economy best promote innovation? Do patents and copyrights nurture or stifle it? Have we gone too far in protecting intellectual property?

In a paper that has gained wide attention (and caught serious flak) for challenging the conventional wisdom, economists Michele Boldrin and David K. Levine answer the final question with a resounding yes. Copyrights, patents, and similar government-granted rights serve only to reinforce monopoly control, with its attendant damages of inefficiently high prices, low quantities, and stifled future innovation, they write in "Perfectly Competitive Innovation," a report published by the Federal Reserve Bank of Minneapolis. More to the point, they argue, economic theory shows that perfectly competitive markets are entirely capable of rewarding (and thereby stimulating) innovation, making copyrights and patents superfluous and wasteful.

Reactions to the paper have been mixed. Robert Solow, the MIT economist who won a Nobel Prize in 1987 for his work on growth theory, wrote Boldrin and Levine a letter calling the paper "an eye-opener" and making suggestions for further refinements. Danny Quah of the London School of Economics calls their analysis "an important and profound development" that "seeks to overturn nearly half a century of formal economic thinking on intellectual property." But UCLA economist Benjamin Klein finds their work "unrealistic," and Paul Romer, a Stanford economist whose path-breaking development of new growth theory is the focus of much of Boldrin and Levine's critique, considers their logic flawed and their assumptions implausible.

"We're not claiming to have invented anything new, really," says Boldrin. "We're recognizing something that we think has been around ever since there has been innovation. In fact, patents and copyrights are a very recent distortion." Even so, they're working against a well-established conventional wisdom that has sanctioned if not embraced intellectual property rights, and theirs is a decidedly uphill battle.

The Conventional Wisdom

In the 1950s Solow showed that technological change was a primary source of economic growth, but his models treated that change as a given determined by elements beyond pure economic forces. In the 1960s Kenneth Arrow, Karl Shell, and William Nordhaus analyzed the relationship between markets and technological change. They concluded that free markets might fail to bring about optimal levels of innovation.

In a landmark 1962 article, Arrow gave three reasons why perfect competition might fail to allocate resources optimally in the case of invention. "We expect a free enterprise economy to underinvest in invention and research (as compared with an ideal)," he wrote, "because it is risky, because the product can be appropriated only to a limited extent, and because of increasing returns in use."

Risk does seem a clear roadblock to investment in technological change. Will all the hours and dollars spent on research and development result in a profitable product? Is the payoff worth the risk? The uncertainty of success diminishes the desire to try. Much of Arrow's article examines economic means of dealing with uncertainty, none of them completely successful.

The second problem, what economists call inappropriability, is the divergence between social and private benefit--in this case, the difference between the benefit society would reap from an invention and the benefit reaped by the inventor. Will I try to invent the wheel if all humanity would benefit immeasurably from my invention but I'd get only $1,000? Maybe not. Property rights, well-defined, help address the issue.

The third obstacle is indivisibility. The problem here is that the act of invention involves a substantial upfront expenditure (of time or money) before a single unit of the song, formula, or book exists. But thereafter, copies can be made at a fraction of the cost. Such indivisibilities result in dramatically increasing returns to scale: If a $1 million investment in research and development results in just one unit of an invention, the prototype, a $2 million expenditure could result in the prototype plus thousands or millions of duplicates.

This is a great problem to have, but perfect competition doesn't deal well with increasing returns to scale. With free markets and no barriers to entry, products are priced at their marginal cost (that is, the cost of the latest copy), and that price simply won't cover the huge initial outlay--that is, the large indivisibility that is necessary to create the prototype. Inventors will have no financial incentive for bringing their inventions to reality and society will be denied the benefits.

Increasing returns therefore seem to argue for some form of monopoly, and in the late 1970s Joseph Stiglitz and Avinash Dixit developed a growth model of monopolistic competition--that is, limited competition with increasing returns to scale. It's a model in which many firms compete in a given market but none is strictly a price taker. (In other words, each has some ability to restrict output and raise prices, like a monopolist.) It's a growth model, in other words, without perfect competition. The Dixit-Stiglitz model is widely used...