Are Patents and Intellectual Property Necessary Components of an Economy?

I apologize for my hiatus. I have been extremely busy on a project for work that has consumed about 75% or more of my time lately. I appreciate you, my faithful readers, sticking with me.

If you’re a fan of economics, you won’t be disappointed today. In response to the news of Martin Shkreli buying the patent to produce the AIDS medication, Daraprim and promptly jacking up the price, I was asked by a friend on Facebook to comment from a Libertarian perspective.

I immediately identified the problem as being the patent. The fact that the government allows this guy to operate a monopoly is what allows him to get away with this.

If there was no patent and the price rose this high naturally, then that would be an indication that there was a shortage of supply in the market. This would signal producers to create more supply. In this particular case, some other pharmaceutical company would create their own version of the drug and compete with this guy, thus eating his lunch if he tries to stubbornly keep his prices higher. Even then, the price might still stay naturally high if demand continues to outweigh supply until more and more companies produce more of the drug and the price eventually comes down.

Of course that cannot happen in this case, because the government has created artificial barriers to enter this market in the form of the patent which makes actually it illegal to produce more of the same thing and FDA screening which requires a lengthy and expensive red tape process to get your product approved by the government before it can be deployed to the market.

So the true bad actor here is the government. Shkreli himself may indeed be a bad actor, but he’s only able to succeed at acting badly because of the environment that the government created, much the same way that Al Capone was only able to succeed at his bad acting because of prohibition.

The funny thing is, when I posted this analysis, my friend objected. His objection?

Don’t get me wrong- intellectual property (and especially copyright) policy in the U.S. is obscene as is… But it also exists for a reason.

Without it… Joe spends years of his life and millions of dollars researching the production and effects of a chemical that solves a particular problem.

I then, nearly overnight, buy a single quantity of this chemical, analyze and replicate it. My costs being significantly lower, I sell it at a fraction of the price, forcing him out of business (in order to compete, he has to eat his development costs, and may never be able to turn a profit at all).

The overhead in creating something is ALWAYS higher than the overhead in copying it…

The irony here is that his objection to my analysis that the government causes this problem by outlawing the practice of poaching products (I’m not sure if that’s a real economic term or not, but I will use it for this article and define it to mean the act of reverse engineering a product for the purpose of bringing an alternate to the market as competition) – which clearly needs to happen in this case – is that without patents, products would be poached!

Despite several attempts to explain that this is a good thing by going over sound economic praxeological analysis of this issue including what prices actually are (in which I tried to dispel the notion that prices are determined by production cost and argue that patents shield innovators from risk causing them to make bad investments in things that may not actually be viable products) he remained firm in his faith that

Price may be set by the market, but if the price is lower than the cost, the product won’t ever get made in the first place.

The cost, in the case of drugs, is cost of development PLUS cost of manufacture. Cost of development is MASSIVE, but only has to be paid by whoever does it first.

With patents, the developer has a massive advantage, because he doesn’t have to worry about competition for a year or few.
Without them, that advantage moves from the developer to EVERYONE BUT the developer…

Without patents, the price will always be lower than the cost, thus, successful businessmen will NEVER innovate, because it’s NEVER worth it, in the cost-benefit analysis.

Thus, your free market stagnates.

[…]

Patents exist to provide an extra benefit that might temporarily outweigh that cost. Stripping them away doesn’t free up entrepreneurs to innovate at will… it takes away one of the few reasons to invest (unless they can afford to throw money away on a guaranteed loser, and are doing it for feel-good reasons).

So what do I say to this? Is he right? Would poor old Hypothetical Joe be at the mercy of the sharks in the market if he didn’t have a patent to protect him?

Well there’s a lot that could be said. I’ll start by simply shaking my head at the fact that in my friend’s imagination of what a world without patents would be like, big businesses – who, by the way, are the ones who actually have the resources to invest in pioneering R&D – are just going to sit around and wait for the little guy who doesn’t really have the resources to produce something just so they can copy it and undercut him. Is this really how the market would work?

No! That’s patently absurd! (forgive the pun). All we need to do is to apply a little bit of praxeological analysis. What’s praxeological analysis? That sounds like an expensive procedure. Does my insurance cover it?

Relax! Praxeology is nothing more than exploring what would happen in a given hypothetical economy by starting with the first principle that humans act in their own self-interest in response to incentives. Whatever the environment, whatever the incentives, humans will act and make choices in such a a way as to maximize their own profit. In short, everbody is greedy. This might seem bad, but it’s undeniably true. So assuming that’s the case, what would the world look like in our hypothetical scenario if everyone operated with maximum greed? All we have to do to figure out how a patent free marketplace would handle Joe’s problem is to put ourselves in the shoes of someone in the marketplace and ask ourselves, “What would I do if I was Greedy CEO of Giant Company A”?

So, yeah, let’s imagine that. You’re the CEO of Giant Company A and you’re a miser. You want to make the most profit you can for yourself. So what are you going to do when you hear about a small independent developer, Joe, working on his new product? Would you camp out at the first public release so you can buy a unit that you can then reverse engineer?

Probably not, but why not? Well first of all you don’t really know if his product is going to be any good. He might have developed a lemon. That risk is especially high if he’s a particularly small operation. Maybe he doesn’t have the resources required to actually produce a good product, so what he ends up selling is really heap of garbage. Why would you want to copy that? But there’s a second reason. Even, and especially, if his product is any good, you can’t guarantee that you’ll be the only Giant Company in line for the product. What’s to stop Giant Company B from doing the same thing you’re trying to do? Nothing at all! In fact, they might even be ahead of you in line! So there goes all of your competitive advantage.

If you’re the CEO of Giant Company A, you’re probably going to want a better strategy. You’re going to want something that will guarantee you a leg up on selling this product. After all, even without patents, being the first to the market is still a huge advantage – especially if you have a genuinely good product. People will associate your name with the product and will forever consider others to be rip offs (Don’t believe me? Can I have a Kleenex? No? Well I just cut myself, how about a Band-Aid? Now I’m hungry, can I have some Jell-O?). So you’re really going to want to get your version of the product on the market before Giant Company B’s version, and it’d be extra nice (from your perspective as Giant Company A) if it hit the market more or less at the same time as Joe’s, if not before.

Well what’s the best way to ensure that? Hire Joe! Don’t wait for him to develop the product on his own and then try to beat Giant Company B to poaching it off of him. Make him an offer he can’t refuse and hire him to develop it for you! Make your version and Joe’s version the same thing! Then you will have an enormous leg up on Giant Company B. Since you have the resources to enable Joe to do R&D well enough to produce a really good product, to market and distribute it really well, and to back that with good customer service, you will be able to claim that prized first to market spot.

And what if Joe does beat you to the market. What if you only hear about this after he produces something. What’s easier and less risky, trying to reverse engineer Joe’s product or simply buying him out to make his product yours? If his product is any good, why reinvent the wheel if you don’t have to? You can back his product with your good distribution, marketing, and customer service and not have to even do the work to poach it! Sure you could poach it, but you’re taking a big risk. You don’t really know for sure just how easy it truly would be to reverse engineer, but even bigger, you have no guarantee that your scheme to force Joe out of business will actually succeed. He might just stick around despite your efforts to drive him out! And even if you do drive him out of business, there’s always Giant Company B who you can bet is trying to do the same thing. Then where’s the advantage of your evil nasty scheme? It’s a much wiser policy for you to buy the product off of Joe.

But how does all this work out for Joe? He’s the victim here, right? He’s the one who slaved away for years of his life, spending millions he didn’t really have, and going into enormous debt to produce this product only to have it snatched away from him as soon as he finished it. Well, actually it works tremendously well! He makes millions! How so? Well, in reality he doesn’t actually have to slave away. Instead, he gets a salary and, if he’s a savvy negotiator, a stake in the profits from future sales of the product. And he doesn’t have to take on enormous debt because he will get to use Giant Company A’s resources and won’t have to try to come up with his own. And even if he’s not discovered until he’s about to bring his product to market, then all the hard work will immediately pay off when he sells out, and his debt will be paid off in short order. And that’s assuming that only Giant Company A is involved. Of course the fact that there is also Giant Company B means that they will have to bid against each other, giving Joe the luxury of going to the highest bidder. So Joe’s no victim here. He’s in the catbird seat!

What about the consumers, though? Aren’t they the odd-man out? Regardless of how Giant Company A becomes the sole producer of the product, either by poaching, hiring, or buying out Joe’s product, they are still the sole producer, right? They can still charge exorbitant prices and screw customers, right?

Well, no… They can’t! Because there’s still nothing to prevent Giant Company B from poaching the product from Giant Company A. And you can bet that they will if the price is so high.

Remember what prices are? No? Ok, a brief primer:

Prices are signals to producers that resources are urgently needed. If prices are high it is because demand is too high for the supply to meet. My friend tried to make a point about inelastic demand. Speaking of the Daraprim situation, he said:

Most people can afford [Daraprim] though, because they have insurance, and their insurance can afford it. He could charge whatever he wants, really, and it wouldn’t affect demand OR sales, because it’s a necessary item (so demand is fixed) and covered by insurance (so the end-user’s income doesn’t affect their ability to afford it).

By making this argument, he has only revealed his ignorance of supply and demand theory. Supply and Demand theory assumes inelastic demand. Prices go high when demand outweighs supply causing a temporary shortage. Thes adjustment comes on the supply side, not the demand side. In response to the incentive created in the form of a higher price, suppliers will bring more supply to the market, thereby reducing the price.

Just think about it. Let’s say you’re a baker, and one day there’s suddenly a shortage of bagels. You go out into the market and observe people buying bagels for $500 each and fruitcake for $1 each. What are you going to make the next day? Certainly not fruitcake! You’re going to make bagels – probably exclusively! – because they provide the best return on your investment. And how many bagels are you going to make? As many as you can! One bagel nets you $500. Two nets you $1000. Duh. The high market price of bagels has caused you, the greedy business man, to produce what the consumers in the marketplace desperately demand. Your greed has been automatically counterbalanced by theirs.

The new supply puts downward pressure on prices because of the economic law of diminishing marginal returns. As each new unit comes to market, it works to alleviate the supply shortage, meaning that each bagel new bagel is less urgently needed than the previous one, causing a gradual lowering of the price. You might think this would cause producers to only make a small quantity, but you’d be wrong. Even with this downward pressure on prices, you will still make more money by selling more bagels.

Suppose one bagel is $500, but each additional bagel reduces the market price by $1. So two bagels would be $500 for the first and $499 for the second, with an average market price of $499.50. Even though you make less for each bagel, you still make more for two than you do for one. So you make a third for $498, resulting in a market price of $499 and a net income of $1,497. Extrapolate this out, and you could actually reduce the price of each bagel to $2 by making 499 and you would still make more money than you would by only making one bagel – a lot more, actually. The broader result for the market as a whole is more affordable bagels made abundantly available for everyone!

Obviously my numbers are made up and the math is contrived. Real economic analysis is more complicated than this, and there are a lot more variables in the real world than what can adequately be encapsulated in a hypothetical example, but the point is an illustrative one, and I think you get the idea. When supply runs short, the price goes up. This tempts suppliers to add as much supply as they can to the market so they can make the maximum profit off of the high price. The result is a lowering of the price of each unit until a stable equilibrium price can be reached.

Want a real world example? They abound, and the very best one is your local grocery store. Can’t find one in your neighborhood? That’s probably because there are five or six or twenty! And what’s in them? A huge array of products catering to every imaginable taste and dietary restriction (or at least the ones represented in the local population). This is among the freest markets we know (which is saying something given corn subsidies and food labeling laws…), and it is also the most robust. But how in the world could this be? I mean what demand is more inelastic than the need to eat? You see, it is only when government central planners get involved and monkey with the economy that you get empty bread shelves, like you did in the Soviet Union. Leave the markets alone and resources will be spontaneously allocated to where they are needed most.

So if demand is so inelastic that people are actually buying Giant Company A’s product at the exorbitant rates that they charge, then the market actually NEEDS Giant Company B to poach the product. If the demand isn’t that high, then nobody will buy at the price Giant Company A wants to charge. Nobody’s getting ripped off and there’s no incentive for Giant Company B to poach the product.

Is this ever a bad thing? No! But what about piddly little Joe here? You might be thinking that maybe the market doesn’t need Giant Company A to poach his product, but they do it anyway because they are just evil and greedy. What then?

See, that’s where you’ve gotten off track of praxeology. You haven’t put yourself in the CEO’s shoes. Even as a CEO of a Giant Company, you still have to be smart with your money. If not, you won’t be CEO very long. Even though you could invest in a knock off of Joe’s product, you want to make sure that your investments will actually pay returns. If nobody is buying Joe’s product, then why in the world would you want to poach it?

Pretend you’re a Chinese manufacturer of knock off electronic goods. You have to choose whether you are going to knock off an Apple iPod or a Microsoft Zune (Apparently it’s 2008 in my example universe). Which are you going to knock off? The iPod, of course! It’s what people want! So companies aren’t just going to go around poaching products all willy nilly just because of irrational greed. Why not? Because that very same greed will cause them to go where there’s the highest return on their investment. They are going to survey the landscape of the marketplace and choose which products to poach based on which ones have high prices as a result of high demand and low supply. Sure, they MIGHT make a profit poaching Joe’s product. But the DEFINITELY would make a profit poaching Daraprim. See what I mean? The poachers are naturally going to gravitate to where they have the highest opportunity to succeed. They’re going to make bagels, not fruitcake. And when this happens, they will be doing exactly what the market needs them to do!

So there is absolutely no problem with poaching on a free market. My friend’s scenario simply does not match the reality of a market as it would exist organically in the natural state – the natural state being what emerges through voluntary spontaneous order absent the coercion of government. Probably the only thing that would need to be said about my analysis is to clarify what is meant by “Giant Company”. You’re probably thinking Apple or Microsoft. That’s probably too big, actually. Those companies are unnaturally large because of government support through things like patents. They are shielded from genuine competition. In a free market, alternatives would arise as smaller competitors would poach their products and the result would be a much more robust and affordable market for their products. But that doesn’t mean there won’t be big companies with lots of resources. They will simply have to get and stay big by making wise investments, serving customers really well, and playing fairly in the market. And, as I’ve demonstrated, poaching products is actually not foul play.

But why do so many people have these irrational views about things like this? Why the paranoia? Why the inability and unwillingness to do praxeological analysis to think things through and understand the true nature of reality and see that these imagined and theoretical problems are simply not real?

Mostly it’s because their entire education on the subject has been what they were taught by the government in school and the portrayal of Mr. Slugworth in Willy Wonka. That’s really all it is. They have never been exposed to the works of Ludwig von Mises at even a cursory level, and if they did it was probably for about five minutes which, after 12+ years of propaganda, is only about enough time to think, “wow this guy’s crazy.” Of course, you only think that because he cuts across the grain of the pre-conceived notions that were force fed you by the government when you were too young to really understand them. It is not because you have tested what he says to see if it stands up to reason and adequately predicts the world around us that you reject his economic analysis. But good grief, even I have never actually read Mises. His books are enormous and very nerdy, even for me! I’ve only read about him, read summaries of him, and heard those like the incomparable Tom Woods explain him. And because I actually thought through what they were saying, I have come to recognize that his ideas absolutely match reality.

So after having explained all of this, I know there will still be objectors. They will simply never be happy because there was at least a brief period of time when a “bad actor” “got away with it” by “price gouging.” That definitely can’t be allowed, right?

Here’s the thing though. People who complain about this are like my daughter who, when I ask her whether she liked the movie we just watched, almost always says no because she didn’t like the villain. What’s so silly about that?

It’s silly because my daughter (she’s 6 btw) is complaining about the middle of the story. She’s not considering that the middle is not the final state of affairs. Yeah, there’s a while in any good story where the bad guy looks like he’s going to win and all the heroes are going to die. But no good story ends there! The middle crisis of the story gives rise to the hero who defeats the villain and sets everything right again. In fact, the end is often better because without the villain and the middle, we wouldn’t know the hero. Often the hero wouldn’t know himself. In the end, everything usually ends up better than it started at the. (At least…. In the kinds of movies we’re watching with our six year old…) The ends don’t justify the means. The middle is still bad. The villain still evil, and his villainous actions are still inexcusable. But we can’t evaluate the story as a whole based solely on the middle.

What in the world does this have to do with markets, patents, and intellectual property? The proponents of patent law are not considering the end of the story. They throw out some hypothetical issue and say, “so there! This is bad.” But they invariably describe the middle of the story when the problem has been caused by some market phenomenon or some bad actor, but they never once look forward to the end. They simply ignore the fact that the market won’t stay in this state. This problem will give rise to a hero – or a group of heroes, who will take the incentives as an opportunity and will fix the problem. Prices are too high? No problem. Somebody will produce more.

Why this short circuit in our theorectical analysis? I suggest that it’s because it doesn’t match reality. And I don’t mean that to say that my theory is wrong. I mean that to say that our reality does not match up with the free market that would exist in the hypothetical. We live in a market that is controlled and centrally managed by a government. Despite their noblest intentions and best efforts, this invariably serves to tie one hand around the hero’s back and hinder his efforts to solve the problem.

Just take the example of Daraprim. What NEEDS to happen here is for someone to poach this product. But that won’t happen. Why? Because of the government. They have created barriers to entering this market. They claim that by doing this they are trying to prevent the villain from arising in the first place, but that clearly didn’t happen in this case. This is yet another example of the thing the government is supposed to prevent happening on the government’s watch with the same response of all the Statists trying to use it as an argument for why we need government! It’s not an argument for why we need government. It’s proof the government has failed!

The government has actually created the environment that made it is possible for this guy to do this. They have tied the heroes’ hands behind their backs. The government has been the villain!

Every single problem attributed by politicians, media, hack economists, or popular opinion to markets and capitalism is always either a description of the middle of the story with no consideration of the end, or is a problem of the government tying the hands of the hero so that there problem in the middle can’t be solved.