Was Napster Right?

Falling in the emotional wake of the terrorist attacks on the World Trade Center and Pentagon, this year's Grammy awards ceremony had a solemn tone. More than a dozen moving performances recognized the mood of a nation seeking to heal its wounds. Tony Bennett crooned "New York State of Mind" in a duet with Billy Joel. Nelly Furtado soared with "I'm Like a Bird." The Rev. Al Green and CeCe Winans gave a powerful gospel finale.

The most forceful performance of the evening, however, was the speech delivered by Michael Greene. As president of the National Academy of Recording Arts & Sciences, he spoke gravely of "serious risk" and warned of worldwide threat. "Embrace this life and death issue," he implored the audience. The menace is "pervasive, out of control and oh so criminal."

But Greene was not referring to the events of Sept. 11. The sinister threat he spoke of was neither Al Qaeda nor anthrax. "The most insidious virus in our midst," said Greene, with a very stern face, "is the illegal downloading of music on the Net."

If it seems just a bit overwrought to imply that pulling a Britney Spears song off the Web is the greatest threat since international terrorism, the tenor of Greene's sermon was a clear indication of the music world's fear. New technology has loosened the industry's hold over product replication and distribution. Their profits, their business model, their very existence is under siege.

And the music business is not alone in this worry. Over the past decade, the captains of many other industries—movies, publishing, software, pharmaceuticals—have railed against "piracy" that they feel afflicts their profits. The copyright and patent protection conferred by government to protect their intellectual property has been breached by new technologies that easily and 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.

So if Greene's tirade was tone-deaf, his concern was understandable. His industry and others feel threatened because they can no longer control their product. The music industry has tried to squelch the threat, most conspicuously by suing Napster, the wildly popular Internet service that matched up patrons with the songs they wanted, allowing them to download digital music files without charge. Napster, of course, lost the lawsuit and, as this goes to press, is heading toward liquidation.

But the struggle between Napster and the music industry has given high profile to a much broader question: How does an economy best promote innovation? Do patents and copyrights stifle innovation rather than nurture it? Have we gone too far in protecting intellectual property? Is a society served better by the unfettered exchange of ideas and information than by granting creators and inventors the right to control the distribution and future uses of their products? More succinctly: Was Napster right?

In a paper that has gained wide attention—and caught serious flak—because it challenges conventional wisdom on the matter, economists Michele Boldrin and David Levine* have begun to answer that question in the affirmative. Copyrights, patents and similar government-granted rights over ideas and innovations serve only to reinforce monopoly control, with its attendant damages of inefficiently high prices, low quantities and stifled future innovation, said Boldrin and Levine in "Perfectly Competitive Innovation," a Minneapolis Fed staff report. And more to the point, they argued, 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 predictably disparate. Robert Solow, the Massachusetts Institute of Technology economist who won a Nobel in 1987 for his pioneering work on growth theory, wrote them a letter calling the paper "an eye-opener" and making suggestions for further refinements. Danny Quah, a professor of economics at the London School of Economics, called 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 University economist whose pathbreaking development of new growth theory is the focus of much of Boldrin and Levine's critique, considers their logic flawed and their assumptions implausible.

It is a measure of the depth and ambition of the paper that the authors absorb these criticisms and continue to consider their work sound and its implications far-reaching. "To avoid being humble when it is not needed," joked Boldrin in an e-mail from Madrid, where he is currently on sabbatical, "we are actually challenging IO [industrial organization] and IT [international trade] theories, beside NGT [new growth theory]." Yet he also noted in an earlier interview, "We're not claiming to have invented anything new, really. 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." But even if that's true, Boldrin and Levine are working against a well-established conventional wisdom that has sanctioned if not embraced intellectual property rights, and theirs is a decidedly uphill battle.

A long heritage

So, what is that conventional wisdom? In the 1950s, Solow showed that technological change was a primary source of economic growth, but his growth models viewed that change as exogenous, a given determined by elements beyond pure economic forces. In the 1960s, Kenneth Arrow, Karl Shell and William Nordhaus delved further into this source of economic growth, analyzing the relationship between free markets and technological change. They concluded that free markets might fail to bring about optimal levels of innovation.

"[T]hree of the classical reasons for the possible failure of perfect competition to achieve optimality in resources allocation: indivisibilities, inappropriability, and uncertainty ... all ... hold in the case of invention," wrote Arrow in a landmark 1962 article. "We expect a free enterprise economy to underinvest in invention and research (as compared with an ideal) because it is risky, because the product can be appropriated only to a limited extent, and because of increasing returns in use."

The uncertainty associated with creation and invention seems 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 examined 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 reaped by society from an invention, and the benefit reaped by the inventor. Will I try to invent the wheel if all humankind would benefit immeasurably from my invention, but I'd only get $1,000? Maybe not. Property rights, well defined, help address this issue.

And the third obstacle to innovation, indivisibility, is the concept that the act of invention involves a substantial upfront expenditure (of time or money) before a single unit of the song, the formula or the 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 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 (the cost of the latest copy), and that price simply won't cover the huge initial outlay. 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. It's a growth model, in other words, without perfect competition. The Dixit-Stiglitz model is widely used today, with the underlying assumption that economic growth requires technological change, which implies increasing returns, which means imperfect competition.

New (endogenous) growth theory

Much of this work was formalized in the 1980s and 1990s by Romer in what he called a theory of endogenous growth. It was the idea that technological change-innovation-should be modeled as part of an economy, not external to it as Solow had done. And the policy implication was that economic variables like interest and tax rates, as well as subsidies for research and technical education, could influence the rate of innovation.

Romer refined the ideas of Arrow and others, developing new terms, integrating the economics of innovation and extending the Dixit-Stiglitz growth model into what he called "new growth theory." In a parallel track, Robert Lucas, Nobel laureate at the University of Chicago, elucidated the importance of human capital to economic growth. And just prior to all this growth theory work, Paul Krugman, Elhanan Helpman and others integrated increasing returns theory with international trade economics, creating "new trade theory." Similar theories became the bedrock of industrial organization economics.

Central to Romer's theory is the idea of nonrivalry, a property he considers inherent to invention, designs and other forms of intellectual creation. "A purely nonrival good," wrote Romer, "has the property that its use by one firm or person in no way limits its use by another." A formula, for example, can be used simultaneously and equally by a hundred people, whereas a wrench cannot. The formula is a nonrival good, the wrench is rivalrous.

Nonrivalrous goods are inherently subject to increasing returns to scale, said Romer. "Developing new and better instructions is equivalent to incurring a fixed cost," he wrote. "Once the cost of creating a new set of instructions has been incurred, the instructions can be used over and over again at no additional cost." But if this is true, then "it follows directly that an equilibrium with price taking cannot be supported." In other words, economic growth—and the technological innovation that it requires—isn't possible under perfect competition; it requires some degree of monopoly power.

Undermining convention

Economists prize economic growth but distrust monopoly, and to accept the latter to obtain the former is a Faustian bargain at best. With "Perfectly Competitive Innovation," Boldrin and Levine vigorously reject the contract. "It may not be an exaggeration to assert that a meaningful treatment of endogenous innovation and growth is commonly believed to be impossible under competitive conditions," they wrote. "We aim at disproving this belief."

They point to the historical record. Innovation, they argue, has occurred in the past without substantial protection of intellectual property. "Historically, people have been inventing and writing books and music when copyright did not exist," noted Boldrin. "Mozart wrote a lot of very beautiful things without any copyright protection."

(The publishers of music and books, on the other hand, sometimes did have copyrights to the materials they bought from their creators. But as University of London economist Arnold Plant argued in a classic 1934 review of the copyright history, "The copyright monopoly, like patent monopoly" isn't necessary to remunerate authors and inventors, it restricts supply, and it doesn't produce better products than those "which [emerge] ... from the competitive bidding of the open market.")

Contemporary examples, said Boldrin and Levine, are also plentiful. The fashion world—highly competitive, with designs largely unprotected—innovates constantly and profitably. True also in modern art. The financial securities industry makes millions by developing and selling complex securities and options without benefit of intellectual property protection. Competitors are free to copy a firm's security package, but doing so takes time. The initial developer's first-mover advantage secures enough profit to justify "inventing" the security.

As for software, Boldrin refers to a Massachusetts Institute of Technology working paper by economists Eric Maskin and James Bessen. Maskin and Bessen wrote that "some of the most innovative industries today—software, computers and semiconductors—have historically had weak patent protection and have experienced rapid imitation of their products."

Moreover, U.S. court decisions in the 1980s that strengthened patent protection for software led to less innovation. "Far from unleashing a flurry of new innovative activity," wrote Maskin and Bessen, "these stronger property rights ushered in a period of stagnant, if not declining R & D among those industries and firms that patented most." Industries that depend on sequential product development, they argued, are likely to be stifled by stronger intellectual property regimes. "So examples abound," said Boldrin. "That's the empirical point: Evidence shows that innovators have enough of an incentive to innovate." But he and Levine are not, by nature or training, empiricists. They build mathematical models to describe economic theory. And in the case of intellectual property, they contend, evidence contradicts theory: Current theory says innovation won't happen unless innovators receive monopoly rights, but the evidence says otherwise. "So what we do is to develop the theoretical point to explain the evidence," said Boldrin.

Rivalry over nonrivalry

Central to their argument is a closer look at nonrivalry. A fundamental tenet of current conventional wisdom is that knowledge-based innovations are subject to increasing returns because ideas are nonrivalrous: One person's use of an idea (or song, movie, book, software, etc.) doesn't diminish anyone else's. As Thomas Jefferson put the same concept (more eloquently): "He who receives an idea from me, receives instruction himself without lessening mine; as he who lights his taper at mine, receives light without darkening me."

But Boldrin and Levine argue that in an economy, this has no relevance. While pure ideas can be shared without rivalry in theory, the economic application of ideas is inherently rivalrous because ideas "have economic value only to the extent that they are embodied into either something or someone." What is relevant in the economic realm is not an abstract concept or formula—no matter how beautiful—but its physical embodiment. Calculus is economically valuable only insofar as engineers and economists know and apply it. "Only ideas embodied in people, machines or goods have economic value," they wrote. And because of their physical embodiment, "valuable ideas ... are as rivalrous as commodities containing no ideas at all, if such exist."

A novel is valuable only to the extent that it is written down (if then). A song can be sold only if it is sung, played or written by its creator. A software program—once written—might seem costless, but "the prototype [of a program] does not sit on thin air," wrote Boldrin and Levine. "To be used by others it needs to be copied, which requires resources of various kinds, including time. To be usable it needs to reside on some portion of the memory of your computer. ... When you are using that specific copy of the software, other people cannot simultaneously do the same. ... Once again, there is no free lunch."

In each instance, development of the initial prototype is far more costly than production of all subsequent copies, admit Boldrin and Levine. But because copying takes time—a limited commodity—and materials (e.g., paper, ink, hard disk space), it is not entirely costless. "Consider the paradigmatic example of the wheel," they wrote. "Once the first wheel was produced, imitation could take place at a cost orders of magnitude smaller. But even imitation cannot generate free goods: to make a new wheel, one needs to spend some time looking at the first one and learning how to carve it."

The first wheel is far more valuable than all others, of course, but that "does not imply that the wheel, first or last that it be, is a nonrivalrous good. It only implies that, for some goods, replication costs are very small."

Economic theorists have generally assumed that the dramatic difference between development and replication costs can be modeled as a single process with increasing returns to scale: a huge fixed cost (the initial investment) followed by costless duplication.

Boldrin and Levine said this misrepresents reality: There are two distinct processes with very different technologies. Development is one production process involving long hours, gallons of coffee, sweaty genius and black, tempestuous moods. At the end of this initial process (hopefully), the prototype exists and the effort and money that produced it are a sunk cost, an expense in the past.

Thereafter, a very different production process governs replication: Replicators study the original, gather flat stones, round off corners, bore center holes and prune tree limbs into axles. Stone wheels roll off the antediluvian assembly line. In this second process, the economics of production are the same as for any other commodity, usually with constant returns to scale.

The candle's flicker

As Boldrin and Levine develop the mathematical model that describes this, they assume only that "as in reality," copying takes time and there is a limit (less than infinity) on the number of copies that can be produced per unit of time. These "twin assumptions" introduce a slim element of rivalry. After it's created, the prototype can be either consumed or used for copying in the initial time period. (Technically, it could be used for both, but not as easily as if it were used for just one or the other.)

While others have simply assumed, with Romer, that the prototype of an intellectual product is nonrivalrous, Boldrin and Levine argue that this tiny amount of cost undermines the conventional model. It's as if Jefferson's candle flickered when it was used to light another: The wax, wick and air that embody the flame are production factors, and sharing the flame actually does incur a drop of wax, a bit of wick and a wisp of oxygen. And when this is the case, find Boldrin and Levine, production is not subject to increasing returns and competitive markets can work. "Even a minuscule amount of rivalry," they wrote, "can turn standard results upside down."

Incenting invention

Still, the central question is whether innovators will have enough incentive to go through the arduous, expensive invention process. Since the 1400s, when the first patent systems emerged in Venice, governments have tried to provide incentive by granting inventors sole rights to their creations for limited periods. The U.S. Constitution, for example, gives Congress the power "to promote the Progress of Science and useful Arts, by securing for limited Times to Authors and Inventors the exclusive Right to their respective Writings and Discoveries."

Economists have long recognized that those exclusive rights give creators limited monopolies, allowing them to set prices and quantities that may not be socially optimal. But conventional thinking has said these costs are the necessary trade-off for bringing forth creative genius, for lighting the candle. "Modern economic literature reflects our reality," wrote Steven Shavell of Harvard Law School and Tanguy van Ypersele of the University of Namur, in a recent article, "and takes the general optimality of intellectual property rights largely as a given." Today, the legal realities and economic conventions have assumed the air of incontrovertible fact: If inventors can be "ripped off"—copied as soon as they create—why would they bother? We must grant them rights.

In arguing for competitive innovation, rather than the monopolistic variety, Boldrin and Levine emphasize that they are not saying creators don't have property rights. On the contrary, they stress that innovators should be given "a well defined right of first sale." (Or more technically, "we assume full appropriability of privately produced commodities.") And creators should be paid the full market value of their invention, the first unit of the new product. That value is "the net discounted value of the future stream of consumption services" generated by that first unit, which is an economist's way of saying it's worth the current value of everything it's going to earn in the future.

Britney gets her due

So, if Britney Spears records a new song, she should be able to sell the initial recording for the sum total of whatever music distributors think her fans will pay for copies of the music over the next century or so. Distributors know her songs are in demand, and she knows she can command a high price. As in any other market, the buyer and seller negotiate a deal. The same for a novelist who writes a book, a software programmer who generates code or a physicist who develops a useful formula. They get to sell the invention in a competitive market. They're paid whatever the market will bear, and if the market values copies of their song, book, code or formula, the initial prototype will be quite precious, and they'll be well paid.

In fact, said Boldrin, "in a competitive market, the very first few copies are very valuable because those are the instruments which the imitators—the other people who will publish your stuff—will use to make copies. They're more capital goods than consumption goods. So the initial copies will be sold at a very high price, but then very rapidly they will go down in price."

But what creators won't get, in Boldrin and Levine's world, is the right to "rent" their intellectual property—that is, the legal right to impose downstream licensing agreements that prevent customers from reproducing the product or modifying it or using it as a stepping stone to the next innovation. They can't, in brief, prevent their customers from competing with them.

"Britney will get her dues the same way Monteverdi, Mozart, Vivaldi and Co. did," wrote Boldrin in an e-mail. "Same for writers. All they have to do is follow in the footsteps of Homer and Shakespeare." Boldrin isn't proposing that Spears approach the King of Prussia for patronage, but he is saying that the market will take care of her; monopolies aren't necessary.

But will the market pay enough? That depends on the opportunity costs of the inventor. If the price likely to be paid for an invention's first sale exceeds the opportunity costs of the inventor, then yes, the inventor will create. If a writer spends a year on a book, and could have earned $30,000 during that year doing something else, then her opportunity cost is $30,000. Only if she guesses she can sell her book for at least that much is she likely to sit down and write.

"What we show in the technical paper is that the amount [a book publisher] gives me is positive, and in fact, it can be large," said Boldrin. "Then it's up to me to figure out if what society is paying me is enough to compensate for my year of work."

But more startling is the next implication of the Boldrin and Levine model. What happens as reproduction technologies improve, as printing presses get faster or as software and the Internet allow teenagers to share music files faster and farther—the scenario that so horrified Michael Greene at the Grammy ceremony? Won't that drive authors and musicians into utter poverty by ripping them off even more quickly?

In fact, the opposite should occur. Increasing rates of reproduction will drop marginal production costs and, therefore, prices. If demand for the good is elastic (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 the 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," said 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."

Static efficiency vs. dynamic growth

Part of the conventional wisdom about economic growth and monopoly protection for innovation is that monopoly rights do 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 toward some uses by allowing innovators to command too high a price; and they allow innovators to produce less than the societally 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. The pie grows. It is part of the Schumpeterian concept of "creative destruction," that future growth demands a sacrifice of static efficiency.

But again, Boldrin and Levine say this is a false dilemma. Monopoly rights are not only unnecessary for innovation, they 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 wrote. "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 have no incentive to find faster reproduction technologies if they won't enhance profits.

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 patent infringement battles are common functions of corporate law departments. Many observers say this kind of activity chokes off creative efforts by others, particularly small and middle-sized firms that are typically more innovative. "Rent-seeking behaviors induced through government grants of monopoly," wrote Boldrin and Levine, "are likely to hinder rather than promote innovation."

The critics

Like any radical innovation, Boldrin and Levine's argument seems to have shocked many mainstream economists, at least initially. There's "a lot of 'that can't possibly be true' followed later by 'that actually seems to make some sense,'" said Levine. "We've been presenting it in quite a few key places, and I have to admit that every time there was a riot," said 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. Klein at UCLA said the paper is "unrealistic modeling with little to do with the real world." Specifically (in a paper with Kevin Murphy of the University of Chicago and Andres Lerner of Economic Analysis LLC), Klein wrote 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 (the focus of the Klein-Murphy-Lerner paper) 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 might well be superior to copyrights and patents: government support for technology education, for example, reward systems or public funding for research and development. Nonetheless, Romer does have serious problems with the theory that Boldrin and Levine espouse.

First of all, the property rights Boldrin and Levine would assign to innovators "would truly be an empty promise," said Romer. 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" and while they argue that the inventor "can sell a few pills for millions of dollars" this conclusion 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," said 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 regarding rivalry, said Romer. 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 the slim element of rivalry that Boldrin and Levine use to overturn conventional wisdom disappears.

Romer also objects to Boldrin and Levine's contention that competition can deal well with sunk costs. "This claim is simply false," he said. And he suggests that Boldrin and Levine are wrong to object to copyright restriction of downstream use of products, since perfect competition optimally allows sellers and buyers to enter contracts that limit downstream use. "What justification is there," said Romer, "for preventing consenting adults from writing contracts that limit subsequent or downstream uses of a good?"

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

And Romer countered: "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."

What to believe?

The discussion thickens rapidly. Even a master of abstruse theory like Lucas confesses in response to an onerous Region query about the Boldrin and Levine paper, "If the questions get too abstract (as in some of your questions and some of their paper!) I get lost."

Still, says 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." The strongest examples for Boldrin and Levine, according to Lucas, 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 says, in an echo of Romer. "Here millions are spent on developing new drugs. Why do this if the good ideas can be quickly copied?"

Solow suggests that Boldrin and Levine should enrich their "very nice paper" by testing its robustness. What happens if the time interval between invention and copying is shrunk? "It would be interesting to look at the limiting behavior," he wrote. And "does anything special happen if you introduce some uncertainty about the outcome of an investment in innovation?" Solow is raising here one of the key obstacles to competitive innovation that Arrow pointed out in 1962, an obstacle Boldrin and Levine "ruled out by considering a deterministic environment."

Replicating the past

Curiously, much of this debate parallels an extensive controversy in Europe a century and a half ago. European critics of the patent system in the mid-1800s said it hindered further innovation and harmed consumers through unduly high prices. Other opponents said inventors themselves received little of the profit generated—the companies to which they sold rights made the big money—which implied that patents weren't necessary. Being first to market was often enough incentive, said other observers, as was the prestige associated with invention. "Many economists disapproved of the patent system," wrote Shavell and van Ypersele. Indeed, in 1863, the Congress of German Economists noted that "patents hinder rather than further the progress of invention, ... hamper [their] prompt general utilization ... [and] cause more harm than benefit to the inventors themselves."

The Dutch repealed their patent system in 1869. Switzerland rejected legislation to adopt a patent system in 1863. Bismarck called for its abolition in Prussia in 1868. The British established three commissions between 1850 and 1870 to investigate and reform their system and several members of Parliament proposed total abolition. But the depression of the 1870s created a backlash against the era's free-trade movement and patents again gained favor. "Europe ultimately embraced patent," wrote Shavell and van Ypersele, "but for reasons that may perhaps be regarded as more politically accidental than indicative of a substantive policy judgment favoring that system."

If the current debate repeats history, the controversy won't soon be resolved, but at least policymakers have begun again to discuss the issues. Announcing an extensive series of hearings held between February and May 2002 on antitrust policy and intellectual property rights, Timothy Muris, chairman of the Federal Trade Commission, noted that during the 1970s, antitrust lawyers tended not to appreciate the importance of intellectual property. Now, he said, the pendulum has swung, and some observers say "perhaps it is intellectual property doctrine that is not showing a proper appreciation for the innovation that competition may spur."

Refining the theory

For their part, Boldrin and Levine recognize that work remains to be done to strengthen their theory. They have begun to look at 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 self-insure against risk, whereas competitors will need to create securities that allow them, said Boldrin, "to sell away some of the risk and buy some insurance."

As for pharmaceutical research development, Boldrin and Levine contend that it's largely a straw-man argument, a misrepresentation of the industry's economics. Much of the high cost of pharmaceutical development, said Boldrin, is due to the inflated values placed on pharmaceutical researchers' time because they are employed by monopolists. Researchers are paid far less in the more competitive European drug industry.

In addition, pharmaceuticals aren't sold into a competitive market, said Levine. "They are generally purchased by large organizations such as governments and HMOs." If inflated drug prices are viewed more realistically, they argue, if pharmaceutical markets were truly competitive rather than protected by monopoly rights, 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," said 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 wrote. "This is not to argue that competition is the best mechanism in all circumstances." If indivisibility constraints bind, some socially desirable innovations may not be produced; the problem 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."

"All we have made ..."

Some economists have already begun work on the next stages. Quah at the London School of Economics has taken their basic model, confirmed it and then pushed it in a number of directions to test its robustness and applicability. In one paper, he finds their model works well if he tweaks assumptions about 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 (through innovation lotteries, contingent contracts or entrepreneur coalitions) may not actually resolve the constraint. "What is needed," he wrote, "is the capability to continuously adjust the level of an intellectual asset's instantiation quantity." Which translates roughly to coming up with half an idea, more or less. So, that might be a problem. (Boldrin and Levine are already working on it.)

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," reflected Boldrin. "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."

See also: Perfectly Competitive Superstars

* Boldrin is professor of economics at the University of Minnesota and Minneapolis Fed adviser. Levine is the Armen Alchian Professor of Economic Theory at the University of California, Los Angeles (UCLA).