Do patent-owners 'hold up' further innovation?

One of the standard arguments of the anti-patent crowd is that patents hinder follow-on innovation by making it risky or costly to build on other people's breakthroughs. There is some evidence for this (see this post from my colleague Charlotte).

However, a new paper challenges this general thesis by looking at whether the outcomes it predicts happen in the real world. If it is true that owners of standard-essential patents (SEPs)—those ones that set up a whole standard used across the marketplace and essential for a large number of follow-on innovators—charge over-the-odds fees and prevent follow-on innovation, then it must also be true that:

1. Industries where SEPs predominate are ones with relatively stagnant (quality-adjusted) prices, because new entrant innovators have less chance to bid them down through competition
2. Court decisions that reduce the power of SEP holders will lead to more innovation in those sectors

The paper, "An Empirical Examination of Patent Hold-Up" (pdf) finds neither of these to be true:

A large literature asserts that standard essential patents (SEPs) allow their owners to “hold up” innovation by charging fees that exceed their incremental contribution to a final product.

We evaluate two central, interrelated predictions of this SEP hold-up hypothesis: (1) SEP-reliant industries should experience more stagnant quality-adjusted prices than similar non-SEP-reliant industries; and (2) court decisions that reduce the excessive power of SEP holders should accelerate innovation in SEP-reliant industries.

We find no empirical support for either prediction. Indeed, SEP-reliant industries have the fastest quality-adjusted price declines in the U.S. economy.

The principle is nicely illustrated in this chart.

At one point there was more or less of a consensus among libertarians that intellectual property was a good kind of property rights. Nowadays you are more likely to see a proto-consensus against copyright at the very least and often patents as well. I think that emerging evidence means we should keep our minds open.

Markets are actually quite good at regulation

The ASI blog reader may not be surprised to discover that some regulations have unintended consequences that, instead of solving a given problem, make the situation worse. This isn't necessarily always true—though it might be, it's an empirical question—but it seems that regulatory fair disclosure laws, intended to make executives disclose more bad info about their firms, are another one of these. A new paper "What Induces CEOs to Provide Timely Disclosure of Bad News: Regulation or Contracting?" (pdf) by Stephen P. Baginski, John L. Campbell, Lisa A. Hinson & David S. Koo finds that regulatory fair disclosure laws lead to executives systematically guessing more pessimistically about the future. But the laws fail to stop executives delaying the release of bad news.

By contrast, they find that contracts including provisions for 'golden parachute' payments get rid of the career concerns which incentivise repressing bad news, and get around the asymmetric information problem that would exist in their absence.

Prior research finds that career concerns encourage managers to withhold bad news in the hopes that subsequent events will turn in their favor, and that government regulation (i.e., Regulation Fair Disclosure, or “Reg FD”) eliminates this problem.

In this study, we re-examine the effectiveness of government regulation at mitigating the delay of bad news, and consider the effectiveness of a contracting mechanism that accomplishes the same goal. We provide two main findings.

First, recent studies show that Reg FD changed the way managers provide forecasts in two fundamental ways: (1) managers are more likely to issue a range forecast that is pessimistically biased rather than a neutral point estimate, and (2) managers are more likely to issue forecasts at the same time as earnings announcements.

We show that when design choices do not reflect these changes in manager behavior, the extent to which regulation induces timely disclosure of bad news is overstated.

Second, we identify a compensation contract (i.e., ex-ante severance pay agreements) that firms use to explicitly reduce their CEO’s career concerns, and thus should encourage more timely disclosure of bad news. We find that if managers are promised a sufficiently large payment in the event of a dismissal, they no longer delay the disclosure of bad news relative to good news.

Overall, we find that managers continue to delay the disclosure of bad news after Reg FD, and that if firms provide compensation contracts to reduce their managers’ career concerns, this asymmetric release of information is eliminated.

Just like obscure traditions, market practices that look arbitrary, weird, or irrational are often one of the ways market institutions create a successful and rational economic order. Regulators need to be very careful before tinkering with them.

Finnish politics just got interesting

We think it's fairly obvious that over the past decade the most successful economy in the eurozone has been that of Germany. And we also think it's fairly obvious why this has been so, the so-called Hartz IV reforms. Which appears to be very much what the new Finnish likely Prime Minister believes in:

A millionaire former telecoms executive touted as a technocrat capable of rescuing Finland from economic slump won Sunday's parliamentary election, but he will likely need coalition support from a second-placed eurosceptic party critical of any more Greek bailouts.

Opposition Centre Party leader Juha Sipila, who advocates a wage freeze and spending cuts to regain Finland's competitiveness, beat pro-EU and pro-NATO Prime Minister Alexander Stubb after four years of policy stagnation and a bickering coalition.

Hartz IV looked at Germany's labour costs and concluded that they were too high for the productivity levels in the country. This therefore meant unemployment for some, low economic growth for all. The answer to this was to change the relationship between the costs of labour and the production from that labour.

It's worth nothing that this is one area of economics where there is no difference between the different schools. All will agree that involuntary unemployment is the result of wages being higher than the market clearing level. The arguments all start with why this is so (a supply or demand shock? Capitalist plutocrats screwing everyone? The banks have fallen over?) and then continue on into what should be done about it (raise demand in the economy? Increase educational levels? Lower wages?).

Dependent on the details of what is happening, something which is an empirical, not theoretical, question one of all of them could be happening, could be the right solution, at any one time. Germany then and apparently Finland now mapped it out and decided that it really was simply the general wage level that was too high. That was managed down in Germany and a decade of comparative success has followed (yes, we do have to limit ourselves to the eurozone economies in that comparison, given the burdens of the single currency). Here's hoping that the Finns have the analysis right this time and that the same solution works again.

There is no such thing as tax avoidance

You don't have to go far through the public prints to find all sorts of blood curdling tales about how the Treasury is being ripped off by varied forms of tax avoidance and even aggressive tax avoidance. And yet the truth is that as a thing tax avoidance doesn't actually exist. So it isn't as we're told in the Telegraph, that tax avoidance is actually a good thing, it's that it just doesn't happen:

Successive governments have left us with a tax regime so complex it verges on chaotic.

Which is exactly why we should be suspicious of politicians who talk imprecisely about “tax avoidance” and “tax evasion” – or who muddle the two terms, or use them interchangeably.

There is nothing wrong with tax avoidance.

Tax avoidance is what everyone does, not just the wealthy. It’s what we do when we save in Isas and pensions, or in Junior Isas for our children.

There's no doubt at all that there are attempts to avoid tax. Sticking your money in an ISA or simply not declaring millions in income are both attempts to avoid tax. But we have a system which decides which of those plans is successful in doing so. That system being HMRC in the first line, the various tax tribunals in the second and then on and up to the European Court of Justice as both Vodafone and Cadbury found out. The end result of this system of adjudicating upon attempts is that there's no room left for tax avoidance to actually happen in. For, obviously, once the courts have had their say either whatever is going on is obeying the law of the land or it isn't. And when it is decided that it isn't that's tax evasion. And when it's decided that it is according to said law that's not actually avoiding anything, is it? It's paying, in full, one's dues as Parliament has decided you ought to.

There really isn't anything called tax avoidance. There's only obeying the law and not obeying it.

So, could the public health people please shut up?

Vaping, smoking, the great question is, is one a complement to the other (complement, meaning that more of one leads to more of the other) or a substitute (more of one leads to less of the other)? Evidence:

Electronic cigarette use among U.S. middle and high school students tripled in 2014 while cigarette use fell to record lows, according to provocative new data that is likely to intensify debate over whether e-cigarettes are a boon or bane to public health.

No, that's not provocative data, that's conclusive data. A substitute not a complement.

Every public health advocate should now be pushing vaping. Anyone who claims to be such and is not is simply a Puritan.

By their actions shall ye know them.

Aren't these free market things just great?

Two little stories that caught our eye:

Morrisons is trialling a halal pick and mix counter at 10 stores, offering gelatine-free sweets to Muslim customers.

The selection of 36 sweets includes liquorice sticks, cola bottles, jelly beans, gummy bears and sugared lips - all guaranteed to be free of non-halal animal products or alcohol-based colourings and flavourings.

The lust for profits to be made by satisfying consumer desires leads to ever more product differentiation, even to sweeties that those who take their religion seriously can have.

And:

On May 12 it will be 10 years since Malcolm Glazer completed his hostile takeover of Manchester United, loading the business as he did so with the biggest debt in football history. At that moment, a group of United supporters turned their backs on the club they had long followed and decided to establish one of their own. FC United of Manchester they called it, a name now written large across the front of the main stand at Broadhurst Park, the club’s new home. As gestures go, this could not be more substantive.

When the new stadium opens officially on May 29 with a friendly game against Benfica, the 5,000‑capacity stadium, with its enormous terrace, its myriad community spaces and the area earmarked for a microbrewery to produce the club’s own ale, will surely be directing a belligerent architectural two fingers at the Glazer regime.

Don't like the capitalist plutocrats taking over "your" club? Great, start a new one, why not?

All without the intervention of a single bureaucrat.

We do not, by the way, insist that free markets solve each and every problem to perfection. Only that they work remarkably well across wide swathes of life. Which is why were so attached to them really, just because they do produce what people seem to want for the least effort.

Economic Nonsense: 50. Capitalism is unstable, subject to periodic crises, and should be replaced

Capitalism is not a fixed thing, but rather a process which develops and changes in response to changing conditions, and especially changing technology.  To say it is unstable is basically to say that it changes.  It is not by its nature stable.  The capitalism of the 21st century is very different from that which prevailed at the beginning of the 19th century.  It evolves as circumstances change, adapting itself to cope with the new realities that present themselves.

It is certainly subject to periodic crises.  The business cycle has long characterized it, with economists divided as to its ultimate causes.  Periods of growth are followed by periods of a sluggish or even contracting economy, with some observers suggesting that this is a good thing, helping to weed out underperforming businesses and redirect their capital to newer and more successful ones.

Over and above this cyclical behaviour, there are occasional crises that seem to threaten the whole basis of the capitalist economy.  The Great Depression was one such period, and the 2008 recession was another.  Critics look for some alternative that lacks these wild and damaging fluctuations.  No-one has yet produced a better system.  For all its flaws, capitalism is the best way humans have found to generate wealth and to allocate resources.  Even including its great crises, it has still produced steady average growth in developed economies for the best part of two centuries.  In less developed economies it has recently produced growth and wealth on an unprecedented scale.

Capitalism learns from these crises.  It adjusts itself.  Governments learn from the mistakes that led to them, and devise new rules to prevent the same happening again.  Capitalism develops and adjusts, renewing itself each time.

When the 2008 crisis came, critics prematurely celebrated capitalism's decline and wondered what might follow it.  The answer was capitalism, modified to prevent countries repeating the mistakes of the past.  It is certainly imperfect.  Most institutions made by humans are subject to the frailty and imperfection of humanity.  But they can improve by learning from their mistakes and adapting, and this is what capitalism does and why it endures.

Multinational taxes: what do politicians know?

This election has ratcheted up the calls for Starbucks and other multinationals to pay more taxes on their British revenues.  Politicians give no indication of how they will achieve that; one suspects their silence is based on ignorance. This blog is a brief explanation of why multinationals are fully entitled, under present laws, to push profits into lower tax regimes.  If the UK wants to change, it may need multinational legislation.

If a brand owner in one country sells to a distributor in another, they split the total profit between them.  If the companies are independent, the presumption is that the split is “arm’s length” and that is accepted by the tax authorities in both countries.  The game gets tricky when both companies are owned by the same group and the brand ownership is switched from one country to another.

The practice began with Bailey’s Irish Cream which was launched in 1972 to accept the Irish Finance Minister’s offer that any export profits for a new Irish agriculture-based brand would be free of tax for 10 years.  The brand became a huge global success and, come 1982, the ultimate brand owner, Grand Metropolitan, was about to be hit by a sharp jump in taxes.

By coincidence, the concept of “brand equity” as a marketing asset which could go on a balance sheet was also being developed in the 1980s.  Why not move the brand equity from Dublin to the Netherlands which was, then anyway, offering low taxes on Dutch earnings by foreign-owned assets? Why not indeed?

As you can imagine, the British and Irish tax authorities were less that thrilled with that and Grand Metropolitan had to justify that the Netherlands company really was marketing the brand globally.  In effect, the distributor company is renting the use of the brand equity asset from the brand owner and has to pay for that.  If the transfer price is “arm’s length” it is all perfectly legitimate so, for two companies both parts of the same group, what exactly is “arm’s length”?

The multinational can count on the support of the tax authorities in the brand owning country.  Their take decreases by the amount of profits switched to the distributor (or franchisee) country.  And if the brand owning company can show it sells, on the same terms, to (or franchises) companies which are not part of the same group, the case for “arm’s length” is strengthened.

HMRC has spent a huge amount of time and money on this issue.  Whilst it is possible they have not been tough enough, it is much more likely that the law is not on their side.  It is also likely that any unilateral action by the British government would lead to even more expensive legal costs on appeal.

With corporation tax down to 20% the UK is closing the low tax gap, but unless politicians can show they understand the game, and come up with a credible big stick, HMRC is going to have to settle for goodwill payments by the multinationals.

Some really bad ideas just keep staggering on, don't they?

One of those really bad ideas being the financial transactions tax. Never mind that it's a very bad tax, that transactions taxes themselves are a bad idea, and concentrate on the most important point of it all:

Think what Labour could do, if it chose, to revitalise public services. A 0.01% financial transaction tax would raise £25bn a year.

That's George Monbiot missing that important point. And he's quoting the IPPR who also miss that major point. That major point being that an FTT won't in fact raise any tax revenue. In fact, it will decrease the amount of tax revenue raised. At which point there's no point in thinking about all the lovely things you can go and spend the money on, it's necessary to start thinking about what of current spending you're going to cut. Which would rather temper peoples' enthusiasm for this tax one would have thought.

The mechanism is that transactions taxes are really, really, bad taxes. Their deadweight costs soar above those of other methods of taxation: that is, for each unit of revenue raised they kill off more economic activity than other taxes. And an FTT could, in theory, be so bad in this manner that it would shrink the entire economy. Shrink it so much that total tax revenues would fall, despite our being able to see this new money coming in from the FTT.

That is of course an empirical question: would those deadweight costs be sufficiently large so as to reduce the total tax take? And fortunately someone has gone and done this work for us. It was the European Union itself, reporting on the idea of an FTT implementation. And the answer is yes. The economy would shrink so much purely from the effects of the FTT that overall tax revenues would fall.

This does, of course, still leave room to argue in favour of an FTT. Maybe you want to screw the banksters, perhaps you just hate everyone and want to make them poorer, possibly even you could make a tortured argument that this will shrink the state. But you can't go around talking about all the lovely stuff you can do by spending the FTT revenues: for there won't be any.

Which isn't, when you come to think of it, all that much of a recommendation for a tax.

Economic Nonsense: 49. Government was wrong to use austerity to deal with the 2008 financial crisis

Gordon Brown as Chancellor and Prime Minister spent money profusely, believing that he could spend the British people's money more appropriately than they could spend it themselves, and by a political desire to have a large section of the populace on state largesse and thus supportive of a party that promised big spending.  The result was to make the UK hugely indebted, with an annual deficit that required borrowing to sustain that spending and increase the debt year by year.

The coalition government that followed him took action to reduce the deficit by a reduction in government spending.  This was the so-called 'austerity' package, although some critics claimed it was more talk than substance, with reductions in the increase in the debt, rather than in the debt itself.

Crucially, though, the policy was not only one of austerity.  It was accompanied by quantitative easing (QE), or increasing the money supply to reduce the more baneful effects of austerity.  Latterday Keynesians claim that government should have increased its spending to stimulate demand instead of decreasing it to tackle the deficit.  Their critics in turn suggest that it is not demand by government that sustains real economic growth, but investment by businesses in anticipation of future private demand.

The United States followed a similar policy of reduced spending combined with QE, whereas the eurozone countries led by a cautious Germany did not.  They imposed austerity on the over-extended countries of Southern Europe, but without the QE used in the UK and the US.

Britain and America experienced significant economic growth after a few flat years, whereas the eurozone countries did not.  Anti-austerity campaigners have suggested that the recovery is weak, perhaps "not even real," but the evidence does not support this.  The empirical result suggests that the combination of austerity and quantitative easing has worked, but that the eurozone policy did not.  Significantly, the QE countries did not suffer the big rise in inflation which some critics predicted.  In 2015, the eurozone countries announced their own quantitative easing, some 7 years after the UK and US did so.

The conclusion has to be that government was right to use austerity and quantitative easing to deal with the crisis.  They did not repeat the mistakes that turned a recession into the Great Depression of the 1930s.