Patents are a Tax

Elsewhere and under different circumstances we might identify the ability to compel another person to action, against their will, as slavery – or at least coercion.  I see no reason to regard the prohibition of action any differently.  Whether ownership of another’s labor is a moral problem is not the question which this post seeks to address.  We will explore the effects of a specific distribution of property rights known as the patent system.  It is those effects which we may analyze outside of the moral purview.  We should be able to agree on the derived effects of patent enforcement.  Judgments regarding the economic trade-offs are always normative.

Patents are, first and foremost, a specific allocation of property rights.  To some extent, they are emergent.  To a greater extent, they are enforced by state violence.  Certainly, some people may abstain from copying a product or method, which another person conceived, as a moral imperative.  But the reason that the government attempts to enforce patent exclusion is that people naturally attempt to gain the largest product per investment of effort.  This includes copying methods and products which others conceive.  When governments enforce patents, they are effectively giving title to a patent holder over the labor of another.  The government gives the patent holder a monopoly by enforcing the holder’s right to prevent certain actions by others.  The patent holder, de facto, has a claim on the labor of all people who may be affected by the state sanctioned allocation of property (This is a classic example of dispersed cost and concentrated benefit in public choice literature.  When benefits are disbursed as under laissez faire, it is no surprise that collective action would concentrate these benefits).

Patents provide rents to patent holders.  These are amplified schumpeterian rents.  A schumpeterian rent is the profit which an innovating firm or individual garners by selling a good which is above  the market rate of marginal revenue, below the market  rate of marginal marginal costs, or an entirely new product .  These  rents, in the form of pecuniary profits, are both the incentive and result of innovation.  They fall over time as other firms innovate and imitate the  new method of production.  Once other firms have adopted the new method [or equimarginal revenue and cost equivalents], the market is again in temporary competitive equilibrium with zero real profits for firms.  The idea which theoretically supports patent systems lies in the relative price of innovation.  Firms may choose whether to innovate.  More firms will choose to innovate more often if the relative price of innovation is low and the price of complacency is high.  Providing a patent holder with a monopoly increases his returns to innovation by preventing the would-be competitors from competing away his profits in a like manner.  The profits to the innovator are increased which therefore increases expected value, and therefore the effective relative price, of innovation.

The argument is that the new relative prices incentivize innovation.  This is true.  Since we are analyzing the effects of patents, we should also identify the same effect of having no patents.  If we removed patents, and people were free to imitate and invest their labor however they deemed most effective, then I contend that we would observe the same effect on relative prices.  Without patents, rather than increasing the absolute rents to innovators, we are increasing the relative cost of non-innovation.  Without patents, firms would adjust, imitate, and adopt new ideas more quickly and drive the normalized profits down to zero.  Since profits for non-innovating firms would be zero or negative, the relative price of innovation is lower – just as in the case of government enforced monopoly.  Therefore, it is not logically conclusive to say that the effect of patent law, on relative prices, is any different from an absence of patents.  The effects are in the same direction.  The magnitudes of relative prices effects  would be an empirical question (And it may not be answerable).  The theory, in regard to relative prices, is identical between patents and the lack thereof.  There is a substitution effect in either case.

Maybe someone, for whatever reason, is not convinced of the real application of the above theory and insists that patents increase innovation.  As with any good, 100% investment, or 100% avoidance in the case of a bad, is almost never preferable.  The reason is the opportunity cost.  So what are the opportunity costs of patents?

One might argue that patents are good because they are a way for individuals to contribute to the variety future consumer goods which would otherwise not exist.  Patents exist now and expire in the future.  We can imagine that innovation happens at time zero and that the patent exists only in this first period.  The 2nd period, after the rents have been extracted by the patent holder, is when the patent expires and consumers can enjoy the benefits of innovation at the lower, now competitive, price.  We can use, as a representative, a consumer who lives during both periods in order to ignore the effects of dying before enjoyment of the innovation (living may be a real opportunity cost in application.  It will be implied by the following deduction).

Because a patent works by decreasing the supply of a good,  it is necessarily the case that a patented good exchanges at a higher price during period one than the price at which same good would exchange in the absence of monopoly.  The price of the good would be determined competitively.  That is, consumers would purchase greater quantities and pay a lower price.  This is the same as saying that consumers’ real income is higher.  This is also the same as saying that the standard of living is higher (People afford to do more of what they prefer).  So in the first period, it follows that patents decrease period one utility.

OK.  Fine.  But since we’ve given patents the benefit of the doubt, and assumed that they increase innovation, then we have increased the standard of living in the second period by providing goods which,  otherwise, would not have existed at all!   Can we then be said to have increased the relative consumption in the second period?  Absolutely.  Patents change the intertemporal relative prices (second period, patent-expired goods can be normalized into a lower price of the old goods set in order to reflect their increased marginal utility).  We must be careful, however, not to equate greater future consumption with greater welfare across time.

We can use the intertemporal consumption preference of the representative consumer in order to see how a patent affects total welfare.  We can imagine that the agent prefers to consume in both periods (consumption of zero in either period would mean death) and that he only earns income in the first period (This doesn’t determine the logic – it does make illustration easier).  In order to consume in period two, the agent has to save in the present by consuming less than his total income.  And since the the agent is marginally less able to accurately empathize with his future self, the utility of  future consumption is discounted from the time of the decision to consume in period one.  With no innovation at all, future consumption is no different in content than present consumption.  The two consumptions only differ insofar as the agent values one at a discounted rate. The interaction between the relative prices of present, and future, consumption and the valuations of the agent are what determine total welfare.

Anyone who is familiar with indifference curves will recognize the following graph:

The slope of the budget curves are the ratio of prices between present and future goods.  The no patent budget shows, appropriately, period one goods to be relatively cheaper than period one goods for the budget with patents.  We can’t say for certain what the income or wealth effect is, of a relative price change,  with this very basic model.  What we can say is that the preferences of our representative agent are what determine the set of prices and, therefore, the mix of consumption which maximizes utility.  If person B is the representative agent, then he would prefer future consumption to be relatively cheaper.  The opposite is the case for person A ( It might be helpful to conceive of the price sets as effective interest rates).   It turns out that the logic also works if we include depreciation, interest, overlapping generations, and death.  Therefore, enforcing patent law is not unambiguously welfare increasing.  Some people may benefit and some may suffer.  Effectively, the patent forces all people to accept an interest rate, regardless of their time preference, and to change their mix of consumption toward the future.  Patents prohibit people from choosing whether they shall save and, therefore, limit the choices for all agents who could otherwise increase their total satisfaction.

The point is that innovation has an opportunity cost.  We can’t contribute 100% of resources to innovation – nor would most people want to come close.  We don’t know whether technological innovation has constant returns to scale.  But we do know that the foregone consumption to innovation is the consumption of  goods which have decreasingly positive marginal utility.  This means that the marginal utility of each dollar spent on innovation becomes increasingly expensive in terms of the goods which people forego consuming.

Finally, if we really do care about the happiness and satisfaction of people, then we should disregard the level of innovation and focus on the extent to which the intertemporal consumption mix contributes to happiness.  It is certainly the case that new technologies, if chosen for use, contribute more to our desires than do the previous level of technologies.  But the cost of investment, through foregone consumption, and a temporary decrease of the standard of living may outweigh the future benefits.  The choice to invest in future consumption is one thing.  It is another thing altogether to be forced into a lower standard of living now, in exchange for a marginally higher standard of living in the future, without any opportunity to discover, through the process of decision, whether revealed preferences justify such investment.

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