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Source link: http://archive.mises.org/9366/fallacy-run-amok/

Fallacy Run Amok

February 3, 2009 by

[This post covers chapter 7 and is part of the ongoing live blog of Boldrin/Levine; for those who love this, great; for the others who can't take this relentless barrage anymore, there are many other things to do on Mises.org or you can go to the forums and denounce me]

Fed up with the patent craze, The Economist Magazine wrote the following in a main editorial: “The granting of patents ‘inflames cupidity’, excites fraud, stimulates men to run after schemes that may enable them to levy a tax on the public, begets disputes and quarrels betwixt inventors, provokes endless lawsuits … The principle of the law from which such consequences flow cannot be just.”

It’s not in current issue. That was published in 1851, but every word of it remains true today. It was once conventional wisdom among economists that state-granted monopolies were as bad as mercantilism. But in the meantime, sometime after the middle of the 20th century, the conventional wisdom became confused.

The source of the problem was a mechanistic view of the market embodied in the idea of general equilibrium theory. It is a theoretical picture of what the macroeconomy looks like when all the dust is settled.

Demand and supply perfectly match. The prices of all things have been competitively bid down to their cost, so there are no profits. All prices are a given and all markets are cleared. There is perfect information, perfect rationality, no uncertainty no transaction costs or any other costs. Indeed, there is no activity at all. All the world is made of perfectly satisfied robots.

It’s a mathematical notion only but once it is embedded in your head as a picture of a perfect economic world, it is not a small step toward using it as a benchmark for the whole of economic theorizing. It turns out that the case for patents and copyright is bound up with this theoretical notion, and Boldrin and Levine’s 7th chapter of Against Intellectual Monopoly has the authors grappling with the problems with this idea.

Joseph Schumpeter was an advocate of patents precisely because he couldn’t shake the general equilibrium idea out of his head. He sought to account for how change happens under general equilibrium, and settled on a theory of entrepreneurship that imagines an innovation that shakes up the dust before it settles into a new pattern (Rothbard called this “Breaking Out of the Walrasian Box“).

With his benchmark, imitation would be as a costless as any other activity, so it seemed necessary for the innovator to have an exclusive for a period in which profits could be earned. Otherwise, the creative destruction necessary for social and economic advance can’t take place.

Well, the core problem here is that general equilibrium has nothing at all to do with the way an economy works, as the Austrians have pointed out for half a century. There are costs to every action, pervasive uncertainties in all aspects of life, entrepreneurship is inherent in all action, and the clearing of markets takes place over time and through a process of ceaseless trial, error, and change. It is a fascinating idea that the core reason why economists have only recently begun to look critically at the problem of IP is due to the triumph of the general equilibrium construct and the associated mathematicization of the profession that excludes the possibility of modeling central features of real-world markets. We can chalk this up as yet another cost associated with the refusal of the profession to fully absorb the ideas of Menger, Mises, and Hayek.

Thus is the core theoretical problem with those who believe that innovation cannot occur in absence of IP law: they assume a world in which all the hard stuff of life is a snap. In fact, imitation is costly and takes time. It requires effort. Even if a process or product is perfectly imitated, getting the product to market is a far more serious hurdle than simply copying something. It took a hundred years for the process of silk making to be imitated successfully. Even to this day, most of the world cannot figure out how to make a decent cup of espresso.

And even the possibility of quick and easy imitation doesn’t strip away the profits associated with being first to market. I’m pretty good at making ice cream, and I could probably replicate the Moosetracks recipe over the course of a weekend of experimenting. But it isn’t the Moosetracks trademarks, copyrights, and patents, that prevents me from doing it. It is because I have better things to do, and bringing anything to market has huge opportunity costs.

Even if competitive but nearly identical products make it to market, that doesn’t necessarily mean that the first mover cannot maintain a profit stream. The authors cite the case of TravelPro, the bad with the suitcase with the handle that has thousands of imitators. Yet even now, TravelPro does a booming business. Take a look at how: ceaseless innovation, marketing, brand recognition, and competitive pricing.

If you take the arguments of the IP advocates seriously, you would never be able to figure out how there could be a thriving market for pizzas. There are high start-up costs (buildings, employees, ovens, drivers, technique) and yet there is a very low marginal profit associated with selling each one, a product that can be imitated by anyone. Surely there must be a recipe copyright, a patent on the pizza, a monopoly of providers, in order to make sure that someone is willing to undertake this task. And yet look around: there are dozen places you can call to bring you a pizza to your desk in twenty minutes.

Another argument concerns the idea of overgrazing. If you put ideas into the commons, they will be overused and degraded the same as regular property. This is true with real property. Public schools, public roads, public lands, and the like, are all overutilized and fall into disrepair for lack of any economizing mechanism that allows rational allocation.

What about intellectual property? The Disney Corporation says that its IP in Mickey Mouse is designed to prevent overgrazing, that if he went into the public domain, he would be drawn as catfood or placed in unseemly settings. Its currency would be debased.

Of course you can make the same argument about anything, such as pizzas or all food, but there is no question that while an imaginary pizza and food monopolist would be worse off under competitive conditions, society is most certainly better off because anyone can make a pizza or make food. The authors make a further telling point in passing: when some good or service today is label as Mickey Mouse, it is certainly not intended as a compliment. So despite the monopoly, the cartoon figure has certainly been degraded.

Many pro-IP arguments boil down to beliefs that something is either going to be undersupplied or oversupplied on a competitive market. In other words, this is the same argument used for all forms of claims about “market failures.”

I can recall that there was great controversy when the first books about medical information and pharmaceutical drugs came on the market. Shouldn’t doctors and pharmacies hold the monopoly? Somehow, however, everything worked out. We buy books, look up medical information online, and still go to see the doctor.

All providers are annoyed by competition. College professors are not entirely thrilled about Idiots and Dummies Guide but sometimes a colleague breaks ranks and writes one. This is just part of the rough and tumble of life in absence of general equilibrium.

{ 22 comments }

Acai February 3, 2009 at 11:52 am

There are high start-up costs (buildings, employees, ovens, drivers, technique) and yet there is a very low marginal profit associated with selling each one, a product that can be imitated by anyone. Surely there must be a recipe copyright, a patent on the pizza, a monopoly of providers, in order to make sure that someone is willing to undertake this task. And yet look around: there are dozen places you can call to bring you a pizza to your desk in twenty minutes.

Benjamin Burkley February 3, 2009 at 3:05 pm

I am going to go to a mises conference. With my computer and my DVD burners. I am going to put up a stand next to the stand where they sell videos of confrences, audio cds and various other goods. I am going to purchase one of each. And then I am going to sit there, make copies, and sell them for 60% of the cost that the origional booth is selling them for. I will steal all of your market share, and force you to lose any monopoly profits that you had counted on to offset the sunk cost of produceing the conference. Therefore you will all lose money and the confrence will not be able to go on next year. I will reap a handsom profit, because I bore none of the cost of producing the confrence, and I will go on my merry way thanking everyone for allowing me to do that.

Please explain how, one is supposed to create a show, show a movie, produce a play, make an album, with out the expectation that they will be the only ones who are allowed to profit from their creation? I dont Understand it!!! Some one please explain it to me.

You are right when you say, ideas are not scarce goods! But the origional idea was scarce, and it took massive resources to create!

Should I then just sink my hard earned capital into projects that I do not know will work, do not know will be sucessful, and may lose money when I know that as soon as I have done all of the work of createing something good, anyone can take it for themselves?? Why would I try to create anything? It seems like communism to me! Why should I work, when I can just sit around and wait for someone else to do it, and then reap the same profit as if I had done all of the work myself!

HELP ME FIGURE THIS OUT.. Maybe I am looking at it from the worng perspective.

Benjamin Burkley February 3, 2009 at 3:05 pm

I am going to go to a mises conference. With my computer and my DVD burners. I am going to put up a stand next to the stand where they sell videos of confrences, audio cds and various other goods. I am going to purchase one of each. And then I am going to sit there, make copies, and sell them for 60% of the cost that the origional booth is selling them for. I will steal all of your market share, and force you to lose any monopoly profits that you had counted on to offset the sunk cost of produceing the conference. Therefore you will all lose money and the confrence will not be able to go on next year. I will reap a handsom profit, because I bore none of the cost of producing the confrence, and I will go on my merry way thanking everyone for allowing me to do that.

Please explain how, one is supposed to create a show, show a movie, produce a play, make an album, with out the expectation that they will be the only ones who are allowed to profit from their creation? I dont Understand it!!! Some one please explain it to me.

You are right when you say, ideas are not scarce goods! But the origional idea was scarce, and it took massive resources to create!

Should I then just sink my hard earned capital into projects that I do not know will work, do not know will be sucessful, and may lose money when I know that as soon as I have done all of the work of createing something good, anyone can take it for themselves?? Why would I try to create anything? It seems like communism to me! Why should I work, when I can just sit around and wait for someone else to do it, and then reap the same profit as if I had done all of the work myself!

HELP ME FIGURE THIS OUT.. Maybe I am looking at it from the worng perspective.

AnneMarie February 3, 2009 at 3:29 pm

Benjamin,
you are assuming that price is sole factor in determining a buyer’s decision, however a moment’s thought proves that to be mistaken. Why do people buy $500 shoes when they can purchase something similar for $20? Why do people buy books at all? Even before the internet, you could borrow them from the library and access their contents without having to buy them.
If I came across your stand, I would still buy the DVD’s, books etc from Mises Institute even though they cost more because THEY generated the ideas and if I want more, and I do, then it is in my interest to keep them generating ideas.

bob February 3, 2009 at 3:33 pm

LOL – it’s nice to see my forum post get linked to in one of these anti-IP blogs. Jeff, I hope you don’t realize that I argue against many above the valid points made here. I don’t think patents are valid. I don’t think information is “property”. I don’t think IP law should be implemented as a social, rather than individual, contract. But I still don’t think totally disregarding copyright is an efficient method to produce specifically demanded information. Read the calculation arguments in the post (which will be easy to find if you ignore MaxLiberty and Libert Student’s arguing).

What you say is true regarding production processes and designs for capital, in regards to patents. I disagree about copyrights on informational consumer products, however.

The fundamental difference is that the design IS the good, rather than simply an input. Without IP law used to exclude users, the good, being infinite, commands no market price, only showing its market demand through related finite goods that have a market price (which can be indirectly expressed, such as web ads), leading to pricing distortions about how much consumers actually favor the production of some form of information to another, or to some finite good. In the case that a producer incorrectly markets the informational good, he is unable to sell it to a more capable producer. Marketing information at all would be no different than selling it to all competitors at next to no cost – or greater than the cost of creating it.

bob February 3, 2009 at 3:51 pm

AnneMarie,
“you are assuming that price is sole factor in determining a buyer’s decision, however a moment’s thought proves that to be mistaken. Why do people buy $500 shoes when they can purchase something similar for $20? Why do people buy books at all? Even before the internet, you could borrow them from the library and access their contents without having to buy them.”

Price can be expressed in other, less seen ways. For example, $500 shoes are likely not of homogeneous quality to $20 shoes, and will occur due to different supply and demand schedules between these goods. Likewise, going to the library to renew books or facing late charges may be seen as a more costly hassle than the upfront price of a book.

“If I came across your stand, I would still buy the DVD’s, books etc from Mises Institute even though they cost more because THEY generated the ideas and if I want more, and I do, then it is in my interest to keep them generating ideas.”

Which reduces the entire information production industry into a gift economy, leaving it open to the inefficiencies of such. If Ben could sell so much as a single dvd, he has possibly made the Mises Institute’s production process less efficient. While fraud is still illegal, the cost of verifying a distributor is contributing to the original production is an additional cost imposed upon consumers.

Francisco Torres February 3, 2009 at 4:42 pm

Please explain how, one is supposed to create a show, show a movie, produce a play, make an album, without the expectation that they will be the only ones who are allowed to profit from their creation?

Answer:
With the expectation that they will NOT be the only ones allowed to profit from their creation. You get your product to the market first and get as much profit as the market allows.

I am going to go to a Mises conference. With my computer and my DVD burners. I am going to put up a stand next to the stand where they sell videos of conferences, audio CDs and various other goods. I am going to purchase one of each. And then I am going to sit there, make copies, and sell them for 60% of the cost that the original booth is selling them for.

I will be there to give them at cost, just to profit from the fact that I am spreading the good word.

Francisco Torres February 3, 2009 at 4:42 pm

Please explain how, one is supposed to create a show, show a movie, produce a play, make an album, without the expectation that they will be the only ones who are allowed to profit from their creation?

Answer:
With the expectation that they will NOT be the only ones allowed to profit from their creation. You get your product to the market first and get as much profit as the market allows.

I am going to go to a Mises conference. With my computer and my DVD burners. I am going to put up a stand next to the stand where they sell videos of conferences, audio CDs and various other goods. I am going to purchase one of each. And then I am going to sit there, make copies, and sell them for 60% of the cost that the original booth is selling them for.

I will be there to give them at cost, just to profit from the fact that I am spreading the good word.

Reason February 3, 2009 at 5:09 pm

Bob,

The conference organizers could stipulate, as part of their entrance requirements, the exclusivity and confidentiality of conference participant materials etc.

Contracts can be made to protect secrets, formulas and uniqueness. Of course, the downside to trying to be too exclusive is that your product might not find enough customers.

Reason February 3, 2009 at 5:13 pm

Sorry Bob, I meant to address Ben.

newson February 3, 2009 at 7:05 pm

b. burkely says:
“And then I am going to sit there, make copies, and sell them for 60% of the cost that the original booth is selling them for.”

sorry, sit where? mises.org owns the property, and is within its rights to eject your arse onto the street. the state owns the street and probably won’t take kindly to a hawker; getting a vendor’s licence will take time.

all this and you’re going to steal market share for what is a niche product? mises.org must be trembling in fear that you’ll act on this dastardly, yet ingenious plan

Joe B February 3, 2009 at 7:05 pm

Bob,

You’re assuming, as others have, that the price of an idea is only determined by the quantity of goods sold that it produces. You’re also assuming that the price generated by these goods would always tend to drop below development costs before a profit could be made.

The idea is not the final good, it is a capital good used to generate other goods. These do not have to be physical – a conversation could be considered as such a good – but they inevitably require some combination of scarce resources with the idea.

In cases where the marginal production costs of these scarce resources are very low, it would be difficult to fight off competition. However, although the price may be negligible it would not be zero. MP3′s take time to download and consume scarce hard drive space. So while an artist may not receive direct payment for this good, it still has a market price – buyers are still economizing it.

If I go on Limewire and see that 100,000 users are sharing my song, this indicates that I may have a viable market for other, less easily copied goods (such as live performances) leveraging this idea. So without expending any scarce goods in marginal production I have developed an auxiliary market for my capital good. Luckily for me this requires no reinvestment in the original capital good.

If I expect to make a profit on CD sales alone, I can require all of my buyers to agree to a copyright in my terms of sale. If they don’t agree, I don’t sell. I could also employ something like DRM to prevent copying. However, measures such as these would reduce the quantity of units sold and would limit the size of any auxiliary market.

If I’m a songwriter and not a performer, I can “sell” my song to a band in exchange for a royalty agreement. This is beneficial to me because I can earn a profit without expending resources in marginal production, and it is beneficial to the band because my song is better than their originals.

If another band hears this song and has more success covering it than the first band, then I may lose out. However, this means that I will probably approach that band first with my next song.

On your forum post you ask: “What business model would allow entrepreneurial investment to direct IP labor towards satisfying consumer demands, while guaranteeing as much or greater income than current business models that rely on IP law?”

The free market doesn’t guarantee anything. Sorry if you’ve built a business on this assumption. Entrepreneurial investment necessarily involves risk.

As I’ve commented on other posts, Anti-IP isn’t about forcing people to share their ideas, it is simply about eliminating state monopoly protections. Individual creators are free to protect their ideas at their own expense. They must factor in the cost of this protection when deciding whether to commit scarce resources towards developing the idea.

The challenges of how to profit from IP should be addressed by business models, not by guys with guns.

Lonnie E. Holder February 3, 2009 at 10:19 pm

Several years ago a small company called Hydro-Gear developed several products that were highly inventive and innovative. Shortly after Hydro-Gear put their products into the market, after having spent millions on development, a second company copied their products so exactly that even the engineers that designed the products had a hard time telling the products apart.

Now, if the second company had charged a price comparable to that charged by Hydro-Gear, it might not have been a big deal. However, the second company sold their products below cost, offsetting the loss by sales of an associated product (this information came to light about a year ago – it appears that the second company thought they could buy the market and expected to move Hydro-Gear out of the market in two or three years and then raised prices; they would have, had it not been for patents). Unfortunately, two large customers quickly moved to the second company, and more than half of the remaining customers advised that they were either going to move or were considering moving. Many of the remaining customers asked Hydro-Gear whether they were going to lower their price in response to the significant price reduction by the second company.

Hydro-Gear had several options. They could stop making the products in question, which meant a loss of perhaps 40% of the company’s revenue, a substantial down sizing and a loss of the millions invested in the development of the products that had yet to be recovered. The company could reduce their prices to the level of cost, but that was unfeasible because even at cost Hydro-Gear was still more expensive than the second company. Hydro-Gear decided that the copying was so blatant that suing for patent infringement was warranted.

It seems to me that this scenario is the very one that patents were designed to prevent. I have also had people tell me that this situation NEVER happens. Obviously, they are wrong.

Reason February 3, 2009 at 11:51 pm

Lonnie,

I am not convinced that the attempt at predatory pricing by the copycat would destroy the original producer or be beneficial to the copycat in the long run.

When the copycat lowers its prices in an attempt to starve out the original manufacturer it invites a larger and larger market- and incurs more and more losses for itself.

Sure, initially, the copycat can have another of its products subsidize the losses. But doesn’t the loss of revenue hurt the copycat overall, inducing investors to move away?

Even if the copycat outlasts the original manufacturer and moves to raise prices back to profitable margins, it will have to make prices that account for its war deficit. Won’t this price rise just invite competition back into the market and force prices back down? How could the copycat make up for their own losses?

Your case for patent intervention is weak in the face of economic logic. It seems that the wiser choice would have been partnership or buyout.

The real story is that the patent holder fired his weapon of privilege and shot down the copycat before the copycat’s faulty strategy could be carried out.

Might you be that patent holder, Sir?

Gil February 4, 2009 at 12:07 am

But what of pizzas? There’s no I.P. – or is there? What of trade secrets towards the ingredients? Coca Cola has a monopoly right to its recipe of its colas. Pepsi has its own monopoly rights to its colas. Domino’s must have a monopoly right to its ingredients because I can’t get a generic clone at the supermarket that tastes exactly the same. So maybe ordinary products do have I.P. protection . . .

Joe B February 4, 2009 at 1:06 am

Lonnie,

Cases like Hydro-gear are hard not to sympathize with. But without the expectation that their patented technology would be protected by Uncle Sam, would they have operated differently?

It looks like they specialize in OEM parts, meaning that they probably only have a few large buyers for a given product, and that each product is specialized for a particular buyer. I would see this as an opportunity to sign an exclusivity agreement, even if it meant discounting the product to make the exclusive sale. This could guarantee your market at least long enough to recoup your development costs. They could also take efforts to establish brand recognition (like “Intel Inside”), so that they would be adding marketing value to the customer’s final product based on their reputation for innovation.

They list about 12 pages of patents on their website, which indicates that every minute detail of each of their parts is probably somehow covered. I have to think that a non-negligible chunk of development costs goes into filing and protecting all of these patents. I also wonder whether they had to pay any licensing fees to other patent holders? Even if they don’t pay these directly, they are embedded in the costs of every tool they use.

Of course there are similar cases that go the other way – someone manages to patent a basic technology, and milks the legal system to protect their monopoly. One example is Color Kinetics (now owned by Philips), who has been sued numerous times based on prior art, but always wins by cutting a licensing deal with the company suing them.

Bose is another example – they won’t develop anything unless they can patent it. This is why it took them so long to put a CD player in the $500 piece of molded plastic called the wave radio. And they brag that 25% of their profits go back into R&D.

On a different post I made a comment that my small tech company stays ahead without patents by constantly innovating. If you can continually leverage an idea into new products and markets, you can stay ahead of the copycats while growing your customer base. If you can’t, then you should consider this fact before expending development resources.

If you rely on government protection for your business model, you may as well go door to door with a gun and cut out the middle man.

Lonnie E. Holder February 4, 2009 at 12:01 pm

Reason:

All the things you state could be true. However, Hydro-Gear would no longer be in the game. The competitor was a huge company about 40 or 50 times the size of Hydro-Gear. They had the ability to outlast Hydro-Gear long enough to assure that Hydro-Gear had eliminated those resources. Once the resources are gone, reinvesting in the market would be prohibitive.

You would think that other competitors would try to get into the market since the product that was replaced was never protected by IP and was available for anyone to produce. Yet, after the huge investment by Hydro-Gear and the inventions that came from that investment, everyone wants to copy those specific products. Fortunately for Hydro-Gear, the IP is there. Anyone can enter the market with the old technology, but the market apparently has little interest in the old technology.

Now the other problem new competitors will face is one of distribution. Hydro-Gear and the competitor that copied them had extensive distribution networks poised to take advantage of the products. Other competitors that have tried to get into the market either fail because their product is old technology, or because they do not have the distribution. So, even when the competitor that copied Hydro-Gear raises its prices, there will be no one else who has the resources to support the product. Eventually, after 10 or 15 years, there might be, but in the meantime the competitor would enjoy a de facto monopoly.

I personally think a partnership was undesirable because it significantly reduced the potential for real competition. I sometimes wondered whether the competitor had ever considered buying Hydro-Gear. It seemed like there would be a good fit with the competitor’s products.

The patent holder (I do not hold those patents) did first a disabling blow to the copier before the strategy got to the point where Hydro-Gear would have to significantly downsize. Note that what I said about the copier’s strategy is purely speculation based on observation.

I think the thing to consider here is that the competitor did to Hydro-Gear (or was doing to Hydro-Gear) what many people have claimed large companies can do (or actually do). The large company was neither inventive nor all that innovative. In fact, much of their invention is purchased (through acquisition of companies) rather than created internally. Yet, their resources are so tremendous that they can easily distort the markets they are in (and they have) and relatively easily drive competitors out of the market. They use IP and abuse IP. They have their own IP that they have used offensively and they have shown a propensity to ignore the IP of others. Good business if you can do it and get away with it.

Lonnie E. Holder February 4, 2009 at 3:01 pm

Joe B.:

You asked whether Hydro-Gear would have operated differently without protection from Uncle Sam. The answer is yes. In fact, Hydro-Gear would likely have not ever been formed, because it was specifically created to take advantage of what was considered to be a unique technology in the early 1990′s. The investment came only because of the patents. No patents, no investment (an issue that was heavily discussed during creation of the company).

You are correct that Hydro-Gear caters only to OEM’s. The technology is relatively stable, so development takes a long time and costs a lot. That also means that payback periods are long. However, those companies that do not protect their IP are punished as producers with greater penetration (surprising, to me anyway, is that low cost is typically not the primary factor, but ability to serve customers nationwide is; if you have low cost AND the ability to serve customers nationwide, you will get the market; great incentive to copy).

Hydro-Gear has used exclusivity agreements, but no one will ever sign such an agreement for more than three years. Of course, they are relatively safe since new developments get advertised about two years (sometimes more) before they are actually available in production. The reason is that suppliers are looking for feedback to be sure the product will have customers. The down side is that the early notice gives competitors a chance to copy, unless IP protection exists. Another down side is that the last three to five years you spent developing the next product was wasted because payback either gets extended to an unreasonably long period of time, or you are unable to invest in another product.

I am unable to give you precise details regarding Hydro-Gear’s patenting efforts, but the costs are relatively negligible. To the best of my knowledge, Hydro-Gear is not currently paying any other company for their IP. I am unable to answer for any IP embedded in parts they purchase or assembly lines and machine tools they use.

Continuous innovation is a good thing, and Hydro-Gear tries to do so. However, a development can take a long time, so “continuous” is a relative word. Payback can be quite long as well. Payback periods can be up to a decade (or slightly longer). Given the relative easy of copying (except when there is something that can be kept secret), it is likely that no one would have invested in this technology the way the three largest players have invested without IP protection.

The lack of investment would be unfortunate for consumers. Both Hydro-Gear and Tuff Torq (wholly owned subsidiary of Kanzaki Kokyukoki) were created to take advantage of a new patented technology that the two companies believed would reduce the price of hydrostatic transmissions substantially. That goal has been realized. The prices of hydrostatically driven mowers is less than half what it was when Tuff Torq and Hydro-Gear were formed. Consider that Eaton and Dana had hydrostatic drives in Tuff Torq and Hydro-Gear’s markets, but neither invested much in the decades they were in the market and it had effectively stagnated. No incentive to invest because no one saw how to get payback of the tremendous investment involved. Both Hydro-Gear and Tuff Torq, using two different approaches, investing tens of millions, created new technology that energized a stagnate technology. Yes, the payback period was relatively long, but now that they have established a huge market, taking hydrostatic drives from a few percent of the market to 45% of the market, the copiers are trying to move in. Of course, the copiers that are the most threat are those with huge resources that make use of existing distribution networks without investing in developing the technology. While investment by a competitor substantially lower than Tuff Torq and Hydro-Gear may ultimately stagnate the market again, it may be irrelevant because both the innovators will be marginalized by the elephant.

Laurent GUERBY February 5, 2009 at 7:35 am

Dear Loonie E. Holder

US Patent 5201692 was filed 07/09/1991 which means it will be public domain soon, even if you believe in IP it’s not surprising to see competitors by now.

Most of the important patents from Hydro-Gear were filed by two people in the two-three first years, how two people for three years are “tremendous investment” of “tens of millions” (plus it’s not heavy machinery)?

I see a “Intellectual Property Engineer ” job ad, well that’s cost too.

How much effort did it take to workaround or licence other firm patents? How much the patents did stop competitors in their tracks?

“No patents, no investment” is hard to believe … especially if we gain some of the vast amount of wasted money from the current system. Patents are not the only alternative.

Reason February 5, 2009 at 9:36 am

Lonnie Holder, more reply:

* Lonnie writes: “The competitor was a huge company about 40 or 50 times the size of Hydro-Gear. They had the ability to outlast Hydro-Gear long enough to assure that Hydro-Gear had eliminated those resources.”

Are there any other historical circumstances that match your underlying assumption? Prof. Tom DiLorenzo has researched and discussed flaws in predatory theory at length. Here is one example: http://www.cato.org/pubs/pas/pa-169.html

DiLorenzo states: “The theory of predatory pricing has always seemed to have a grain of truth to it–at least to noneconomists–but research over the past 35 years has shown that predatory pricing as a strategy for monopolizing an industry is irrational, that there has never been a single clear-cut example of a monopoly created by so-called predatory pricing, and that claims of predatory pricing are typically made by competitors who are either unwilling or unable to cut their own prices. Thus, legal restrictions on price cutting, in the name of combatting “predation,” are inevitably protectionist and anti-consumer, as Harold Demsetz noted.”

How do you know the large competitor could outlast Hydro-Gear if the scenario never played out? And even if they could, what evidence do you have that it was non-market activity? This is why DiLorenzo quotes Harold Demsetz: “The attempt to reduce or to eliminate predatory pricing is also likely to reduce or eliminate competitive pricing beneficial to consumers.”

* Prof. Tom Woods gives an excellent 7 minute synopsis w/historical example debunking predatory pricing theory here: http://vulcanhammer.blogspot.com/2008/12/thomas-e-woods-on-predatory-pricing.html

More Lonnie issues:

* Major distribution channels vs. not established underdog: Well, this kind of advantage should be considered fair until proven guilty. Did this conglomerate find massive distribution channels through market play? At any rate, technology helps small ops get world-wide distribution if they do it right.

* Re my suggestion of partnership: I proffered that from the standpoint of Hydro Gear’s possible advantage; I was not thinking of the consumer or overall efficiency.

* On large companies’ ability to swallow small orgs’ innovations and market potential: Lonnie writes, “Yet, their resources are so tremendous that they can easily distort the markets they are in (and they have) and relatively easily drive competitors out of the market.”

Again, your attempt to show proof of “predatory pricing” and even claiming that it would succeed, when DiLorenzo did not uncover any examples after looking at decades of data, does not validate or invalidate either claims. There are too many factors at play. That is why the deductive a priori of the Austrian school is a necessary element in analysis.

For example, Austrian theory deduces that companies that are large often become inefficient and less accountable to the market and acquire calculation issues so to speak. But not necessarily. A giant company could be producing for a giant market and its big size could merely reflect meeting the customer’s needs the best. Mises taught that empirical accuracy is important for identifying what a priori deduction suitably analyzes a situation. Hypothesis and testing does not work in this regard.

How should one evaluate your anecdotes? DiLorenzo applies economic logic in his analysis. One has to ask, what is the quality of your theoretical assumptions vs. DiLorenzo’s?

Lonnie E. Holder February 5, 2009 at 11:10 am

Laurent:

The competitors are not using patent 5,201,692. Indeed, Hydro-Gear has competitors in technology that is competitive to the technology covered by that patent and Hydro-Gear does well. Though I am unable to say with certainty, I do not believe anyone has infringed patent 5,201,692.

With respect to investment of “tens of millions,” note that I was referring to the creation of Hydro-Gear and Tuff Torq. Hydro-Gear and Tuff Torq were initially capitalized for tens of millions. Please see my earlier comment.

On a separate issue, the infringed patents issued between 1999 to 2007. It may well be that there are only two or three inventors on the patents that were infringed (I believe there were about a half dozen patents or so; interestingly, none of the inventors of the earlier patents were on the infringed patents). However, those two or three inventors were supported by other engineers, technicians and a large test department. If you total the analysis (a single housing analysis costs about $20k, for example), design, procurement of prototypes, and testing, I would guesstimate that the total development expenditure for the infringed products was in the range of $10 to $15 million.

Another point is that you stated that “most of the important patents” were filed in the first years. The initial patents were important because they forced Hydro-Gear’s competitors (Tuff Torq, Eaton, Dana and Tecumseh) to use a non-infringing technology, which they did. However, much more invention has occurred in the last decade, with perhaps some of the most important patents in the area of pumps, which was considered to have been essentially a stagnant technology by the “experts.”

I have no idea what your comment “it’s not heavy machinery” means. Development costs are very high for a variety of reasons. One of the most important reasons is that prototypes and testing are incredibly expensive. While some simulation can be done, these are drive products and actual testing must be conducted to minimize liability. If the drive fails, bad things can happen to the operator.

As for the “cost” of IP, I would guesstimate that it might add about 20 cents to 50 cents to the price of a unit that costs $120 to $150. As I said before, that seems trivial to me.

You also asked “how much effort did it take to workaround or licence other firm patents?” I am unable to answer either question. I do not know. However, I suggest that any workarounds to prior patented technology was beneficial to society because it expanded technology and, more importantly, it forced Hydro-Gear to generate a solution that was ultimately the most successful product in the market place.

As for how well did patents stop “competitors in their tracks,” I guess I am unsure of what you mean. Competitors had many options. They could continue to produce the previously existing products that were not patented (if there were patents, they were expired). The only thing they could not do was to copy Hydro-Gear’s technology (or Tuff Torq’s, because Tuff Torq had even more patents than Hydro-Gear).

As for your final “sneer” at my comment regarding “no patents, no investment,” and then you make some vague comment about gaining “some of the vast amount of wasted money from the current system,” I must point out first that the investors in Hydro-Gear and Tuff Torq gained no money from the current system if they did not invest, so that is not a factor.

Hydro-Gear and Tuff Torq considered first whether patent protection was possible (both companies considered patent protection essentially to recover their initial investment in this area; I would guess the two companies invested somewhere between $40 to $60 million entering this market, and IP protection was considered essential to give the companies time to establish themselves, otherwise the big players, Eaton, Dana and Tecumseh, who were already well established, could easily copy their designs) before they ever went to the next step. I can say with virtually 100% assurance that had Kanzaki or Hydro-Gear’s parent companies not had the possibility of IP protection, then Tuff Torq and Hydro-Gear would not have entered the market. There is no misunderstanding of that statement. The decision to proceed was made only after IP protection could be guaranteed. There are many other businesses for whom IP is considered a “gate” and a requirement to turn on more investment dollars, as has been well documented elsewhere.

Patents may not be the only alternative, but I find it interesting that from the first time IP protection appeared, more than two millenia ago, also at a time when technology was rapidly advancing, that every time society gets to a point where it wants technology to go faster, IP protection appears. You would think that if there were viable alternatives that were suitable for all industries that someone would have already tried the alternative system and it would still be in use (note how many Libertarian governments we have).

If you want a waste of money, consider this. Let us say that there was no IP. Let us say that approximately $50 million was invested in Tuff Torq and Hydro-Gear. Let us say that each company developed their own, unique, hydrostatic drives (so far, these statements are generally what actually happened).

Now, the market begins to take interest in these new products, but sales are low because the products are new and the turf care market is slow to react to new technology. However, huge companies like Eaton and Dana were already in this market. By the second year the products are available, they realize that the two companies already have more unit sales (at significantly lower price) than they do. So, they buy samples, using their knowledge of hydraulics (they already knew how to make pumps and motors), they realize they can reverse engineer either Tuff Torq’s or Hydro-Gear’s designs for a fraction of the $50 million invested in the two companies.

One of the big players (or maybe two) copies the designs, and using their superior distribution network and the fact that they already supply many customers that use these products, they quickly displace both companies. Hydro-Gear and Tuff Torq quickly realize that the payback period for their $50 million investment has gone from 5 to 10 years to 30 years. Both companies need more money to come up with more innovative products, but their investors see the investment as more money down a rat hole, because the big hydraulics companies can copy almost as fast as Tuff Torq and Hydro-Gear can develop. Realizing their mistake, they shut down both companies and invest in something with greater opportunity for return, like Wal-Mart stock. The hydraulics industry becomes moribund once again, now that the inventive upstarts have been put back in their place.

Lonnie E. Holder February 5, 2009 at 11:21 am

Reason:

It is possible that Hydro-Gear’s competitor was not using predatory pricing, and just plain screwed up. However, I can tell you with absolute certainty that the competitor had priced their product lower than their cost of production. Hydro-Gear’s conclusion (which still seems reasonable) was that the competitor’s intent was to force Hydro-Gear out of the market. It would not have taken long to do so at the rate customers were leaving. I would guess about three years.

Is it possible that the competitor just made a huge mistake in their pricing? Perhaps. If so, someone on their management team needs a lot of constructive criticism.

As for distribution, remember that Hydro-Gear deals directly with OEM’s. Those OEM’s EXPECT their suppliers to visit, demonstrate, and support. High technology has not hit the lawn and garden industry yet.

Suppliers who are already supplying that industry have a distinct advantage over upstarts. Hydro-Gear’s competitor was already supplying the lawn and garden market with other, non-competitive products. It is easy to see how they would easily convince an existing customer to switch to their product when they had experience with other products from the same supplier, and with a dramatically reduced price. I would have switched myself. Of course, I would have been upset several years later when Hydro-Gear was out of the market and the competitor had to raise their prices substantially because they were losing money on each sale.

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