The Patent Controversy

Today one of the most controversial issues in economic policy is that of patent law. Is a patent just an extension of property rights to the realm of ideas? Or is it an unwarranted interference by the government into the rights of individuals who have purchased goods and services to use them as they see fit? Should the Western system of patents be extended worldwide? Or should we get rid of patents entirely? Is the patent system responsible for modern miracle drugs? Or is it to blame for the millions dying of HIV in Africa? Do patents lead to greater innovation and economic growth? Or do they kill the goose that lays the golden egg?

The issue of whether patents are genuine property rights or unwarranted government interference cannot of course easily be answered by a natural experiment. We will leave that discussion to philosophers. The impact of patents on innovation does have an objective answer. In this case history instead of nature has been kind enough to provide us with a wonderful natural experiment. This experiment took place in the county of Cornwall, England, between 1772 and 1852. It was there, in the extreme southwest of England, in the wet depths of the Cornish copper and tin mines, far removed from the supply of coal in Wales, that the steam engine was pioneered.

To examine innovation in steam technology, we need a measure of how good a steam engine is. One important measure is the amount of work delivered by a given amount of fuel. This can be measured by the duty of a steam engine: the number of pounds of water that can be lifted one foot for each 94 pounds of coal consumed.

In 1772 steam engines were of the so-called Newcomen design of which the best had a duty of 10 million foot-pounds (10M). In 1777 Matthew Boulton and James Watt began selling the first steam engines with a separate condenser. These initially had a duty of 18M, rising by 1792 to a peak of 26M. There things rested until 1814 when the use of the high-pressure design of Richard Trevithick led to engines with a duty of 55M. The duty then rose relatively continuously until it reached a peak of 110M in 1852.

To summarize: During the 42 years from 1772 to 1813 duty rose 3.8 percent per year; during the 38 years from 1814 to 1852 duty rose more than twice as fast—8.5 percent per year. The evolution of the duty is charted in the figure. The state of innovation is best represented by the best engine currently being produced, but for completeness the average and minimum duty of constructed engines is reported. The decline in duty growth after 1852 reflects both the general decline of the Cornish mining industry and the more difficult conditions in which steam engines were forced to operate due to the deepening of the mines.

As it happens there is one critical difference between the earlier period and the later period. By patenting the separate condenser Boulton and Watt, from 1769 to 1800, had almost absolute control on the development of the steam engine. They were able to use the power of their patent and the legal system to frustrate the efforts of engineers such as Jonathan Hornblower to further improve the fuel efficiency of the steam engine. By way of contrast, and fortunately, Trevithick did not patent his equally innovative high-pressure design.

Ironically, not only did Watt use the patent system as a legal cudgel with which to smash competition, but his own efforts at developing a superior steam engine were hindered by the very same patent system he used to keep competitors at bay. An important limitation of the original Newcomen engine was its inability to deliver a steady rotary motion. The most convenient solution, involving the combined use of the crank and a flywheel, relied on a method patented by James Pickard, which prevented Watt from using it. Watt also made various attempts at efficiently transforming reciprocating into rotary motion, reaching, apparently, the same solution as Pickard. But the existence of a patent forced him to contrive an alternative less-efficient mechanical device, the sun and planet gear. It was only in 1794, after the expiration of Pickard’s patent, that Boulton and Watt adopted the economically and technically superior crank. The impact of the expiration of Watt’s patents on his empire may come as a surprise as well. Far from being driven out of business, Boulton and Watt for many years were able to charge a premium over the price of other steam engine manufacturers.

Here we see clearly the upside and the downside of the patent system in action. The upside is that it may be the case that the prospect of a 31-year monopoly induced Watt to spend three and a half years of his life—between late 1764, when he first was asked to repair a steam engine, and mid-1768, when he applied for patents on his improved design—working to improve steam technology.

The downsides are two. The first is that the reward to success bears no relation to the cost of invention. In what respect is it necessary, reasonable, or fair to grant a 31-year monopoly and make a man fabulously wealthy because he spent a few years working on a project that benefited his fellow man? Certainly this kind of inducement was not needed for Trevithick, whose contribution to steam technology raised the duty 110 percent as against Watt’s contribution, which raised the duty only 80 percent.

The second downside of the patent system is the devastating effect it has on incremental innovation. From 1786 to 1800 there was no increase in the duty of steam engines at all, as Boulton and Watt successfully sought to prevent competition by suppressing innovation. This should be a cautionary note for people who think that the current wave of patent litigation triggered by a system of software patents created by the courts is likely to have a beneficial impact on software innovation.

Collaborative Innovation

For the 11 years following the end of the Boulton and Watt monopoly, Cornish mining activities underwent a period of slackness, as the mine adventurers were content with the financial relief coming from the cessation of the premiums they had paid to Bolton and Watt. As a consequence they neglected the maintenance and the improvement of their engines. This situation lasted until 1811, when a group of mine captains decided to begin the publication of a monthly journal reporting the relevant technical characteristics, the operating procedures, and the performance of each engine. Their explicit intention was twofold. First, the publication of the reports permitted the rapid individuation and diffusion of best-practice techniques. Second, it introduced a climate of competition among the engineers entrusted with the different pumping engines, with favorable effects on the rate of technical progress. Joel Lean, a highly respected mine captain, was appointed as the first engine reporter. The journal would later be called Lean’s Engine Reporter. During the 31 years after 1811 this collaborative competitive effort at innovation raised duty by more than the great “breakthrough” of Watt ever did.

It is worth remarking another important feature of the process of technical change in Cornish engines during the collaborative period. Most engines were single-cylinder, high-pressure, single-acting engines, with a plunger pump of the type originally erected by Trevithick in 1812. Interestingly enough, however, alternative designs were never completely ruled out. For example, in different periods, engineers such as Arthur Woolf and James Sims continued to experiment with compound engines. Throughout this period, the development of the Cornish engine remained a fluid state and this facilitated a more thorough exploration of alternative designs.

The astute reader will no doubt notice that the collaborative innovation occurring after the expiration of the Watt patents resembles nothing so much as modern open-source software development. Like with open-source software, altruism and socialism played no role—just good old-fashioned capitalist incentives. Engineers were recruited by captains of the mine on a one-off basis to build and design an engine. Engineers were in charge of the design and they supervised the erection of the engine that was commissioned to them. They also provided directions for day-to-day working and maintenance of the engines they were entrusted with. Thus the publication of technical information concerning the design and performance of different steam engines permitted the best engineers to consolidate their reputation and improve their career prospects. Over time, this practice gave rise to a professional ethos favoring sharing and publication of previous experiences.

Much of the free/open-source-software industry operates this way today, with software engineers competing for future business through the quality of their current innovations. Sharing of information is a key part of this competition. If Linus Torvalds, creator of the Linux kernel, is not nearly so rich as Bill Gates, he is nevertheless richer than most of us. (See Michele Boldrin and David K. Levine, “Open-Source Software: Who Needs Intellectual Property?” The Freeman, January 2007.)

Even the modern controversy over the current effort of the Free Software Foundation to limit software patents through the General Public License Version 3 finds reflection in the earlier Cornwall experience. Familiar with the negative impact of the Watt patents on innovation, Cornwall mine engineers were reluctant to patent their inventions. From 1781 to 1852 Cornish residents took out a grand total of 15 patents on steam technology—against 994 patents on steam technology in all of England during that period. Will it surprise you to learn that the area with the fewest patents also was the area that contributed the most to the innovation and development of steam technology?

One may wonder why development in an obscure corner of England should draw our attention. As it happens, the design of fuel-efficient high-pressure steam engines did not only serve to improve the efficiency of pumping water out of mines in one small region. It is the fact that efficient high-pressure engines can be made light and compact and do not require much weight of fuel that made possible such modest advances as . . . the steam train, the steam boat, the steam jenny, and the steam just-about-everything-else. In short—the steam engine that we imagine as the centerpiece of the Industrial Revolution, the key link that took us from riding horses to being frequent fliers—was not the product of the inventive genius of James Watt. When the Boulton and Watt monopoly expired in 1800 steam engines were used only to pump water out of mines. The earth-shattering innovation of widely usable steam engines was the product of the efforts of Joel Lean and dozens of other equally anonymous Cornwall mining captains and engineers. It is equally a tribute to their steady innovation without making use of patents.

First, understand that the market for open-source software is a classic example of a competitive market. It is characterized by the voluntary renunciation of copyright and patent. Buyers are entitled to make their own copies, modified or not, and sell them. “Free software” in this context means “free as in freedom, not free as in beer.” There is also voluntary renunciation of trade secrecy: the original creator publishes the source code—the “blueprint” for producing the software—along with the software itself. Some open-source software has the further requirement that as a condition of use, buyers make their modification available under the same terms. The open-source movement has been called everything from a virus to socialism—so it may or may not be surprising to hear it called a model of a fully competitive market. Yet that is what it is, as much so as the market for wheat. All purchasers of software can compete with the seller and one another, and often they do.

Given that there are fixed costs of producing software and (it is commonly thought) competition drives profits to zero, how does this market function? How are the fixed costs covered? In the absence of profits from monopoly power, the source of income used to pay fixed costs is competitive returns. We will investigate three issues here. First, what is the source of the competitive returns that pay the bills of software developers? Second, is the market a real market? That is, do software producers in fact get adequate compensation for the fixed costs of their efforts? Or is open-source software, as is sometimes alleged, simply an elaborate altruistic charity? Finally, we ask how significant the open-source software market is. Is it a thriving source of innovation, or just a free-rider off the innovations of more traditional closed-source IP-protected software, making cheap imitations that never would have been produced in the first place absent monopoly power?

The evidence (and the common sense of anyone involved with open-source software) shows that the source of competitive returns that pay the bills of software developers is the complementary sale of expertise. To earn a return through the sale of something, it must be something scarce. Copies of software may be scarce, but we shall see that the actual duplication of copies is sufficiently quick and inexpensive that only small returns can be obtained through the sale of copies. However, purchasers of copies of software programs also have a demand for services—ranging from support and consulting to customization. They naturally prefer to hire the creators of the programs, who in the process of writing the software have developed specialized expertise that is not so easily matched by imitators.

To understand the sources of competitive returns in this market, it is helpful to look at an example. A leading and profitable open-source software firm is Red Hat, a company that sells the computer operating system GNU/Linux, a modified and customized version of the underlying Linux system, with many features that can be optionally installed. Although the base system is in principle obtained by Red Hat for free, in fact it pays the developers. Alan Cox, one of the main kernel developers, works for Red Hat. The firm is also a contributor to the Open Source Development Labs, which employs Linus Torvalds, the developer of Linux. In addition Torvalds benefited from a substantial “gift” of stock options from Red Hat. Beyond this, the customization and testing conducted by Red Hat is costly. So Red Hat faces a substantial fixed cost of providing its software.

Let us first consider returns earned through the sale of physical copies. In this market physical copies of software sell for greater than marginal cost. Using prices quoted on the Internet on July 10, 2002, Red Hat charged $59.95 for a package containing its system. Because it is based on Linux, competitors can legally duplicate and sell the exact same Red Hat system. In fact, at least two companies, Hcidesign and Linuxemporium, did exactly this. On July 10, 2002, Hcidesign offered for sale Red Hat Linux 7.2 for $16, about a third the price charged by Red Hat. Linuxemporium.co.uk offered a similar deal. The striking fact is that Red Hat sold many more packages at $59.95 than Hcidesign and Linuxemporium did at $16. Neither company ever represented a threat to Red Hat.

Notice that the premium charged by Red Hat was not likely due to the physical scarcity of copies. Rather, it was for the sale of expertise that came with developing the system. Anyone who uses computer software knows that it rarely functions as expected. If you buy software and have a question or problem, whom would you prefer to call? The people who wrote and developed the program? Or the people who duplicated the CD?

A Better Business Model

In fact, selling expertise by charging a premium on physical copies has not turned out to be the most successful business model. Red Hat eventually concluded that it was not selling enough $59.95 copies and switched strategies. What had previously been sold is now given away for free as Fedora Core and is used as a platform to get feedback on features that are incorporated into the commercial system called Red Hat Enterprise Linux. The latter is available only by annual subscription at a price that—depending on features—ranges from $349 to $2,499.

This blurb from the Red Hat website’s promotional material makes clear what customers are paying for: “Unlimited access to service and support: Subscriptions include ongoing service and support to guarantee your systems remain secure, reliable, and up-to-date. When you have a technical question, you’ll speak to Red Hat Certified Software Engineers. Or you can access a self-serve knowledge base of technical information and updates.”

Notice how this market works: First expertise is passed from the developers to Red Hat Certified Software Engineers. Then others acquire the expertise, the stock of expertise expands, and the price at which it can be sold drops. Of course, in the meantime innovations are created, and new expertise is generated.

The presence of profitable firms such as Red Hat—not to speak of IBM—in the open-source industry suggests that it is a viable concern and not a charitable or altruistic activity. In their 2004 paper “The Economics of Technology Sharing: Open Source and Beyond,” Josh Lerner and Jean Tirole documented some of the financial benefit to individual developers of contributing to open-source projects. For example, the team of programmers that developed the Apache web server are ranked according to the significance of their contributions and hold other jobs. Work by Il-Horn Hann et al. shows that the salaries the programmers receive in these other jobs are heavily influenced by their rank within the Apache Foundation. In other words, the “expertise” model at Apache is much like that in academia—the programmer writes software in order to receive recognition and financial payment for the expertise he demonstrates through his published product.

Examination of particular individual developers reinforces this point. Torvalds is a multimillionaire, and Bram Cohen, the developer of BitTorrent, recently received $8.75 million in venture capital for his open-source project. These figures and the success of open-source software also teach us something important about the (expected) payments needed to get smart people like Torvalds or Cohen to develop innovative software. It is unlikely that Torvalds originally wrote Linux with the aim of becoming a multimillionaire. Still, he must have hoped for some revenue stream when starting his work. His current wealth is probably higher than he expected. Still it is four orders of magnitude less than that of Bill Gates. Hence, at least in the case of Torvalds, the opportunity cost for writing innovative software is not in the tens of billion of dollars, but just in the millions. This is worth keeping in mind when someone claims that without the huge monopoly rents through IP, innovators would not be innovating.

Finally, it is possible to imagine that the open-source industry is not a real industry at all. Perhaps it exists only because it is able to free-ride off the innovations created in the proprietary part of the industry, in which the monopoly power of copyright plays a key role. It is certainly true that Linux is a knock-off of Unix and that OpenOffice Writer is a knock-off of Microsoft Word. But this means little, because practically all software, proprietary or not, is an imitation of some other software. Microsoft Windows is an imitation of the Macintosh, which is an imitation of Smalltalk. Microsoft Word is an imitation of WordPerfect, which is an imitation of WordStar. Microsoft Excel is an imitation of Lotus 1-2-3, which was an imitation of VisiCalc. And so on.

But is the free-rider argument correct?

Consider word processing. Many open-source alternatives to Microsoft Word exist, including Kword, AbiWord, and OpenOffice Writer, the latter being the most widely used. How did the cost of developing this software—financed as it was by an open-source model—compare to the cost of developing Microsoft Word? The fact is that most of the cost of writing software is not in the observation that it might be nice to have a button to justify text or in the algorithms for spacing lines—which after all were developed by Gutenberg back in 1450—but rather in the detailed implementation and debugging of computer code. As far as we know, none of these open-source projects benefited at all from the work done by Microsoft.

More Expensive to Develop

Indeed, the development of these open-source projects was probably more expensive than the development of Microsoft Word. The most difficult and expensive programming tasks faced by the developers of these projects appear to be reverse engineering of Microsoft Word documents and providing compatible formatting capability so that documents can be exchanged with Microsoft Word. Had these projects gone first, this substantial cost would have been avoided.

It is also worth noting that the competitive returns generated by these projects are significantly smaller than they would have been had they hit the market before Microsoft Word did. So it seems reasonable to conclude that the competitive market without Microsoft Word would have delivered both these programs.

Probably the most innovative program in the last few years is BitTorrent, a program that decentralizes and vastly increases the speed at which very large files can be downloaded off the Internet. It is commercially successful in the sense that 50,000 copies a day are downloaded. It is also sufficiently innovative that it is now being imitated—by Microsoft. BitTorrent, however, is open-source, and according to its website, author Bram Cohen maintains the program for a living.

The final point to emphasize here is that the market for software is not unique. Innovation and competition unprotected by patent and copyright have gone hand in hand in other industries, from financial securities to fashion. The message of open-source software is a message for all industries: IP not needed for innovation here.

Reviewed by Andrew Morriss

During the Microsoft antitrust trial a great deal of ink was spilled in the press over Microsoft’s alleged monopolization of various markets and its practices in marketing both its browser (Internet Explorer) and its operating systems (such as Windows 2000). Although Judge Thomas Penfield Jackson’s findings against Microsoft have not survived on appeal, perhaps the most interesting thing Judge Jackson got wrong was that he completely missed the most significant development in the software business since the personal computer—the rise of open-source software.

Open-source software is software that is made freely available, including its source code (the programming instructions), to anyone who wants it, subject only to the requirement that the user make any enhancements he adds equally freely available. The open-source movement grew out of the work of Richard Stallings and his Free Software Foundation, and Linus Torvalds and the operating system he created, Linux.

GNU and Linux are the results of individual efforts, but both are also the product of an amazing spontaneous order. In these and other cases an initial piece of code was created by one person. That code was then made available to others, with the promise that updates would also be freely available. Thousands of programmers from all around the world became involved in solving problems and extending the programs. The originators then incorporated the suggestions into the programs and reissued new versions. Stallings, a brilliant programmer, created GNU, a freely available set of software for Unix systems. Even more important, Stallings created the GNU “copyleft” license that ensures that any software created using GNU would itself be freely available.

Open-source software has evolved into a potent threat to closed-source software, like Microsoft’s. As the book documents, companies—including Sun, Netscape, and IBM—have embraced the open-source model for a variety of programs. Strikingly, for example, Torvalds built a barely functional Unix-like operating system from scratch as a hobby project. Through releasing the code, he evolved it into a major operating system in use around the world today—and one that remains freely available to all. Other companies have built businesses out of providing support for open-source programs—most notably Red Hat Software, one of the major suppliers of Linux.

In Rebel Code, Glyn Moody (a contributor to Wired and similar publications) has written a compelling account of the rise of the open software movement. Moody interviewed many of the most important participants, including Torvalds, Stallings, and Eric Raymond. (Raymond’s essay, “The Cathedral and the Bazaar,” available in book form or on numerous websites, is the best introduction to open-source ideas.) Moody explains the technical stuff clearly and frequently enough for a nonhacker to follow. Although at times he drifts into excessive detail on participants’ personal lives and uncritical appraisal of individuals, he successfully presents all sides of the major disputes within the open-source movement.

This is an important book for libertarians to read for three reasons. First, intellectual property (IP) presents tough issues for libertarians. Some libertarians support treating IP like other forms of property; others do not. The success of open-source programs poses an important question for those who attempt to justify IP on utilitarian and economic grounds. If GNU/Linux can succeed, then the “we must protect IP or no one will produce it” argument is significantly weakened.

Second, the programmers involved in open-source projects are a group to which we need to present our ideas. Many of the ideas behind the open-source movement are similar to ideas critical to libertarian thought—spontaneous order and freedom. As the open-source movement grows, persuading its adherents like Eric Raymond to pay attention to the works of F. A. Hayek, Ludwig von Mises, and others may bring us important allies.

Finally, there is a struggle over the future of the Internet happening now. The open-source movement is a powerful force for liberty on the Internet—Eric Raymond’s website has a link to decryption code that the motion picture industry is attempting to stifle through lawsuits. Open-source programmers occupy positions of authority at many corporations and institutions and are in a position to resist attempts by governments to seize control of the basic functions of the Internet to allow censorship and worse. We need to understand this movement so that we can call for help when we perceive a threat to liberty.

This book (together with Raymond’s essay and Neal Stephenson’s fine novel Snow Crash) provides an excellent vehicle for us to educate ourselves.

Contributing editor Andrew Morriss is Galen J. Roush Professor of Business Law and Regulation at Case Western Reserve University, Cleveland, Ohio, and a senior associate at PERC—the Center for Free Market Environmentalism.