Broken Symmetry

What SUVs and Cost Accounting have in common

The design of both was predicated on an unlimited supply of cheap fuel.

When SUVs were designed, the costs of fuel were low relative to the joy that people got from driving them relative to other kinds of cars.  Nobody cared about miles per gallon.  What they wanted to know was how big and how fast it could go.  Don't get me wrong.  I love cars that growl and shake when you start them.  But that growl and shake come literally at the expense of fuel efficiency.  The design loses its appeal when the price of fuel starts to cut into my enjoyment of other things.

Similarly, cost accounting was designed to measure and report activities within a firm at a time when "fuel" (i.e., capital, labor, and raw materials) were very cheap relative to the demand for its products.  Globalization supercharged that trend, and kept the flawed model of cost accounting on life support.  When labor got expensive, we simply moved to another part of the world where it was still cheap.  Capital got cheaper!  Only raw materials were getting more expensive.

And here we are in 2008, with the number of places in the world where labor is significantly cheaper than it is in the United States shrinking by the day, with capital getting more expensive thanks to inflationary monetary policy, and with raw materials more expensive than ever thanks to an oil shortage.

Time to rethink our theory of accounting folks.  It's not how big or how fast you are anymore.  It's your miles per gallon that matter.

The Ensemble of Parametric Oscillators Model of the Economy

Markets can be modeled as ensembles of parametric oscillators.  The parametric oscillator model is the simplest model that is useful in understanding dynamic market prices.  For non-physicist readers, you've made a parametric oscillator whenever you've pumped your legs on a swing to change your frequency of oscillation.  If you've ever had somebody push you, then you've made an amplified parametric oscillator, which is equivalent to a market hooked up to a time-varying external money supply.

Supply can be modeled as an ensemble of oscillators, one for each person.  The cumulative frequency distribution of the supply ensemble is equivalent to the aggregate supply available to a market within a window of time.  Demand can be modeled as an ensemble of oscillators, one for each person.  The cumulative frequency distribution of the demand ensemble is equivalent to the aggregate demand available to a market within a window of time.  See here.  Elasticity is a function of the fatness of the frequency distributions at the half-maximum to their peaks.  The distributions will be poissonian in shape.

Both cumulative distribution functions can be parametrized in terms of the opportunity cost of any scarce resource within an economy, or in terms of a currency that does not vary fast with respect to other currencies within the size of the time window.  (Doesn't that explain why we use currency rather than bartering?)

The "temperature" of these ensembles (i.e., the shape of the distribution for a given amount of capital when scarcity and size of the ensemble are fixed) will be a function of the capital available.  Similarly, other changes in the cumulative frequency distributions of supply and demand will be a function of capital (energy), scarcity (volume), and the size of the ensemble (pressure).  If the changes are made slowly with respect to the time windows within which the distributions are measured, then convexities in the function of frequency with respect to increasing capital, decreasing scarcity, and increasing ensemble size may be observed.  Certain ranges of capital, scarcity, and size of the population will be characterized by certain types of structures.  In other words, as capital, scarcity, and size of population are tuned through different ranges, spontaneously ordered structures for the allocation of capital and resources throughout the ensembles will emerge.  Thus, the parametric oscillator model is consistent with a thermodynamics of institutional design.

Thermodynamics gives us no insight into how and when change will occur.  But the parametric amplifier model also permits an insight into market dynamics.  According to this model, the ensemble of supply oscillators  couples nonlinearly to the ensemble of demand oscillators.  Mathematically, the mechanism for coupling is analogous to a damping force on each ensemble that is, in part, a function of the frequency distribution for the other ensemble.  In other words, the oscillations of the two ensembles don't simply add or subtract from one-another.  They can multiply or divide one-another.

In practice, the coupling mechanism might be provided by anything that causes the frequencies of the ensembles to multiply rather than add, such as transactions costs or liquidity constraints that do not vary linearly with the quantity of goods exchanged.  Study of models of the coupling mechanism will be one of the most fruitful areas of research for econometricians.  For the coupling mechanism is not simply a function of the frequency of the supply and demand ensembles of the market in question.  Rather, it is a function of the frequency distribution for any supply or demand ensemble with non-trivial cross-elasticity with the supply and demand ensembles for the market in question.  The coupling mechanism, including the phenomenon of cross-elasticity, is the dynamic mechanism that describes how and when phase transitions will occur.

Note that variations in external money supply would be a source of capital to the supply or demand ensembles that should be considered separate from the coupling mechanism.  Thus, an increase in external money supply might give rise to parametric amplification.  Variations in external money supply add many complications to understanding the dynamics of parametric oscillators.  Having a Taylor rule that describes how the external money supply varies in time makes the model easier to solve.

Parametric oscillators exhibit many interesting dynamics.  One is the phenomenon of parametric resonance, whereby the ensembles may become synchronized in phase.  Phase synchronization is an implicit or explicit characteristic observable in all markets.  Another is the phenomenon of parametric instability.  Price bubbles can form when the resonance peak (or peaks) are too high-frequency to be sustainable.

For the Hayekians out there, given constant resources and population, as capital is removed from the system, spontaneous symmetry breaking will result in new spontaneous ordering of capital, resources, and population within the market.  In other words, holding two out of three of capital, resources, or population fixed, and minimizing the other variable will lead to more spontaneous order within society.

As an end note, the wave equation necessary to the parametic oscillator model will not apply over longer time scales.  Wave equations are second-order in time.  For very large time windows, dissipative forces will have more noticeable effects, and a heat equation (like the Schrodinger equation) will provide a better approximation of dynamics.  The difference in observable dynamics at different time-scales is part of why microeconomics and macroeconomics are not readily joined in econometric theory.

Why don't VC funds employ in-house lawyers to do work for portfolio companies?

A while back, Jason Mendelson wrote a great post about his frustration with "startup lawyers," by which he means outside counsel who work on transactions relating to portfolio companies.  Like many consumers of legal services, Jason is frustrated with a trend toward lower quality and higher cost.

I don't want to get into the discussion of what trends have emerged and why here.  Rather, I want to ask the question of why more VC funds haven't hired outside counsel to come work in-house doing work for portfolio companies.

Benefits:

• Lower fees from outside counsel, probably more than offsetting the salary cost
• Better quality services from outside counsel (higher bandwidth communication, especially when it's with a former colleague)
• Less worry about the billable hour clock by the in-house lawyer, which means more efficient allocation of time to various legal problems
• Lower cost to lawyer spending time on-site with portfolio companies to proactively avoid legal problems
• Lawyer also available for consulting on fund-related issues when not needed at portfolio companies

Disadvantages

• Requires outlay of cash-flow from management fees to cover salary
• Agency costs that could result from soft kickbacks between in-house lawyer and outside counsel (relatively easy to reduce with monitoring)
• Misalignment of incentives between lawyer and portfolio companies because salary is paid by VC fund (but this one is shared with the VCs!)

Note that nobody could eliminate outside counsel because of the superior access to information about new case law, unusual market scenarios, the database of internal legal documents built up over years for use in a variety of client matters, lower cost ability to generate stock ledgers, etc.

Often, VCs invest millions of dollars into a new round of financing, only to demand that the startup company turnaround and pay outside counsel for the tens of thousands of dollars in costs of advising on the transaction.  I understand why this is done from an accounting perspective.  But it is not so cost efficient.

Inventors are Customers

Have you ever wondered why startups are better at innovating than larger corporations?

Some people say that it's because of the culture, which promotes teamwork.  Others say it's the focus on a constrained set of resources.  Both are true to some extent.  But I don't see either as the root cause.

Startups are often founded by people who are frustrated because their own needs have not been met by existing products or services.  In other words, unmet needs are the source of inspiration to inventors.

Inventors are simply frustrated customers.

And if you think about it, this might explain why so many venture capital funds, investment banks, and large corporations have failed at promoting innovation.  Innovation needs to be driven by customer needs.

Do venture capitalists know customer needs?  Some do.  But their incentives are driven by large corporations (on the M&A side) and investment banks (on the IPO side).

Do investment banks know customer needs?  Some do.  But their incentives are driven by whatever will sell at a given moment.

Do large corporations know customer needs? Some do.  But their incentives to do M&A may also be driven by (misguided) attempts to increase ROI regardless of whether that will help them sell more at lower cost.

From whence in the cycle of innovation does the knowledge of customer needs arise?  It's at the point in the cycle where the beginning and the end meet.  Customers are the end, inventors the beginning. 

Inventors are customers.

A New Kind of Firm for the R&D Market

Having articulated an improved theory for the firm, one which makes explicit the value of matching supply and demand cycles, I can now say why, in accordance with that theory, a new kind of firm would be beneficial to the market for R&D.

For at least three reasons, market price signals have failed as a means for coordinating the supply cycles with the demand cycles for R&D.

1. Most basic science is now funded by the government.  R&D therefore tends to be supplied much earlier than the demand for it by large firms.  Thus, there is a funding gap between research and venture-capital backed startups.  This funding gap is part of the cause for the observation by many R&D buyers that "ideas are cheap."
2. Even when supply and demand can be matched in time, sensitive ownership and trade secret issues raise the transactions costs for transferring technology from one large entity to another
3. There is a shortage of service professionals (especially patent lawyers) who understand R&D and can assist in negotiating technology transfers.  This shortage has hit the inventors the hardest.

Some inventors have given up on finding proof-of-concept financing for their work, only later to watch a venture-capital backed startup make millions or billions, with very little (if any) flowing back to the pioneering inventors.  Some large firms have gotten tired of paying millions or billions for startup companies, only later to layoff the employees who do similar work to what is already done by top-quality teams within the large firm.

Since the Bayh-Dole Act was passed in 1980, our best scientists and engineers have been less concerned with industrial R&D needs, instead being content to turn their published papers in to the technology transfer office so that a patent application can be churned out.  Every once in a while, a graduate student drops out to start a new company with a new idea.  In technology corridors like Silicon Valley and Boston, that every once in a while has been often enough to make a few professors rich.  But the rest of the time and at most universities, if an idea turns out to be valuable enough for industry to commercialize, the university ends up negotiating a license for patent rights alone.  Often and at an increasing rate, that negotiation comes at the end of a long litigation.

Venetian Capital Management provides a new way to meet the R&D needs of large firms with the best R&D teams available for those needs.  Inventors or large firms interested in learning more about Venetian Capital Management services should contact me by email.

The End of the Golden Age?

Over at PE Hub, Michael Butler analyzes the decline of investment banks, and wonders about the future.

"One could easily argue that the industry’s quiet unraveling and the resulting drift toward consolidation started back to the late 1970’s or early 1980’s.  A look at tombstone ads from 25 to 30 years ago reveals a lot of now-extinct names like Dillon Read, White Weld and LF Rothschild. These once-powerful investment banks have either disappeared or been merged into other firms."

He points to the repeal of the Glass Steagall Act as the cause for consolidation in the industry.  That repeal came very late in the game.

Another possible cause, which I found in a paper by Prof. Richard A. Booth, is the NYSE abolition of fixed commissions for institutional investors that came on May Day 1974.  Overnight, the relative costs of assembling a diversified portfolio dropped below the costs of assembling a diversified conglomerate through M&A.  The emergence of mutual funds resulted.

But the emergence of private equity buyout funds required leverage.  Thus, the bond market that resulted after the Federal Reserve floated interest rates in October 1979 was also necessary to the emergence of private equity buyout funds in the 1980s.

In fact, the repeal of Glass Steagall Act in 1999 effectively only permitted investment banks to mimic what it had been profitable for the private equity funds to do alone for the two decades before.  And we know how that turned out.  I guess the early bird gets the worm.

Market prices synchronize the phase of supply and demand cycles.

Market price signals permit dispersed people to synchronize production and consumption activities.*

Broken Symmetry readers know that the aggregate supply and demand curves are cumulative distribution functions that can be derived from the frequency distributions that describe the rhythms of consumption or production for a given good or service.  Specifically, the frequency distributions show the patterns of consumption or production for a population of people within a window of time.  Within different time windows, the peaks of these frequency distributions may slide left or right, and narrow or fatten.  For example, we can observe the supply cycle sliding right to some maximum mean frequency and then sliding left again.  As another example, we can observe the demand cycle sliding right to a higher maximum mean frequency when the good consumed is certain kinds of information (such as books or music).

Often, the frequency distributions in supply and demand will take a poissonian shape because the decision by each person within the population to consume or produce will often be uncorrelated with the decisions of other members of the population.  Other distribution shapes may arise, especially within smaller populations and shorter time windows.

Both frequency distributions (i.e., both the frequency distribution for supply and the frequency distribution for demand) correspond to a set (or "ensemble") of time-varying functions.  These two ensembles of time-varying functions (in supply and demand, respectively) together provide the the information needed to calculate the time-varying function of price.  What follows is a plain-English explanation of the dynamics.

Static Theory and the Cobweb Model

To visualize what is happening in time, it helps to start with an easier case, which has already been solved.  What I will here call "static theory" obtains at the limit where, for a given population within selected successive time windows, the frequency distributions (and hence supply and demand curves) do not change.  More specifically, they vary less from time window to time window than would be required to increase or decrease equilibrium price more than the transactions costs for exchange within that market.  In other words, if the supply or demand curves don't shift enough from window to window to increase or decrease equilibrium price more than transactions costs, we're at a "static" limit.

From the cobweb model, we know that when the static limit obtains, price will evolve as a damped, driven oscillation around the equilibrium price.  In other words, regardless of where the aggregate quantity of supply or demand begins, the suppliers and producers will eventually (over a succession of time windows) end up exchanging goods at the equilibrium price.  This is equivalent to saying that regardless of how many people are producing or consuming within the first time window, price will eventually (after a succession of later time windows) reflect the level corresponding to the point at which the aggregate supply and demand.  (Technically, within a price range of that point proportional to the transactions costs.)

The period of time required to reach equilibrium is a function of the frequency of supply, the frequency of demand, and the transactions costs.  Higher frequencies and lower transactions costs means faster return to equilibrium.

Non-equilibrium Price as a Phase Synchronization Device

With the static limit picture of a damped, driven oscillation in price in mind, we have our insight into what is causing non-equilibrium dynamics in price.  Specifically, it must be a mismatch in phase between supply and demand because, by definition, at the static limit the frequency distributions of supply and demand are not varying in time.

At any given moment, there are some people within the population that have to decide whether to undertake another cycle of supply or demand.  To a good approximation, each person within the population decides whether or when to undertake another cycle of supply or demand by asking whether, at the current market price, an additional cycle of supply or demand would be increase wealth.  When the current market price is below equilibrium, suppliers will not undertake a new supply cycle.  When the current market price is above equilibrium, consumers will not undertake a new consumption cycle.**

In other words, market price is a mechanism for synchronizing the cycles of supply and demand.

At any given moment in time, market price is a combination of the (positive or negative) phase difference (caused by the asynchronicity in supply and demand) plus the equilibrium price.

Beyond Static Theory: Dynamic Market Price

Having seen how market price is a mechanism for synchronizing supply and demand cycles in the static limit, I now ask whether removing the static limiting conditions should have an effect on price.

Not on the synchronization mechanism.  Although the "equilibrium" component of price will no longer be fixed in time (because the supply and demand curves may slide left or right or fatten or narrow with time), the phase difference component is calculated the same way by looking at the aggregate lead phase difference between supply and demand cycles.

Conclusions

Price at a moment in time is a function of both the relative aggregate quantity of supply and demand (which are a function of the frequency of supply and demand cycles) and the aggregate difference in phase between supply and demand cycles.

Although the phase of supply and demand cycles may be randomly distributed at an earlier point in time, as time evolves, a population of people will tend to synchronize supply and demand cycles so as to eliminate the phase difference component of price.  In the equilibrium limit, this component vanishes as supply and demand become perfectly synchronized.

* In electrical engineering terms, I am toying around with the model of markets as voltage-controlled oscillators, with the voltage being the phase difference signal.  VCOs are very useful devices in control theory.  When used in conjunction with negative feedback, VCOs can be used to build phase-locked loops.

** Note that the ability to store and use inventory or money will have important effects on the phase synchronization of the supply and demand cycles.  I'm going to ignore these for now, although I will assert that these effects probably dominated the price dynamics within the subprime mortgage market.

How the Quanta decision is good for patent owners

The Supreme Court handed down its decision in Quanta v. LG Electronics today.  Already some commentators have concluded that the decision was harmful to patent owners.  Not so fast.

There were two issues before the Court in Quanta:

• Whether exhaustion doctrine should apply to method claims
• Whether on the facts of this case, the patent owner (LGE) had exhausted its enforceable patent rights against Quanta by Intel's sale to Quanta of goods covered by LGE's patents

On my view, on both counts the Supreme Court has helped patent owners by clarifying both the scope of the rights of patent owners and of the obligations of patent licensees.

First, by unifying the exhaustion rules for product and process claims, the Supreme Court is saving everybody time and money.  The procedural posture of the case only highlights the problem with having different rules.  Recall that the holding by the district court that gave rise to the appellate jurisdiction over the first issue arose only after the district court issued a second order clarifying that its summary judgment of exhaustion was based on the product claims of the patents-in-suit.  The reason that a second order was necessary is because the parties were still bickering over whether the distinction between product and process claims might provide some loophole in the summary judgment.  It's not so hard to imagine patent owners and prospective licensees bickering over the same thing in the future had the Supreme Court not unified the exhaustion rules so that they applied, unambiguously, to both product and process claims.  Not to mention the prosecution games that would result.  As the Court was acutely aware in writing this opinion, such distinctions exalt form over substance.

Second, even though Quanta effectively got a free pass in this case, patent licensees like Intel are NOT off the hook because of this opinion.  One thing that's unusual about this opinion is that the activities of Intel, a third-party, feature more prominently in the recitation of facts than do the activities of Quanta, a named party.  The reason there are so many facts about Intel is that the Court knows that this lawsuit (and others like it) could have been avoided had the patent owner (LGE) and licensee (Intel) sorted things out without dragging downstream firms (like Quanta) into their fight.  The lawsuit against Quanta resulted only after Intel refused to play ball with LGE.  At the end of its opinion, the Supreme Court practically begs LGE is to sue Intel for breach of contract.  And they should!  If the understanding between LGE and Intel was that Intel's customers were going to pay part of the royalties due LGE, and those customers didn't come through, then Intel absolutely should be required to make good for the shortfall.

Under Quanta, the Supreme Court did nothing to hurt (and probably helped) patent owners' ability to contract for a fair royalty.  But Quanta does give patent owners a strong argument for demanding higher royalties from their licensees.  Specifically, patent licensees can no longer tell patent owners, "Go and get  the rest of the royalties you want from each of our customers."  Patent owners have a definite answer to that one now: "I can't."

Thus, on my view, this is a modest victory for norms of cooperation.

Surowiecki on M&A

In an earlier post, I blogged about how Microsoft's antitrust liability should arguably have been limited to fair value for the inventing, R&D, and early-stage proof-of-concept commercialization done by smaller competitors (such as Netscape).

The other side of the same coin is that far less M&A would be necessary if more large corporations simply transferred new technology in rather than buying smaller firms in order to get it.  Here's James Surowiecki making the point in the most recent New Yorker:

"Merger mania also rests on what you might call the fallacy of ownership—the assumption that you have to own a company to make money from its properties. In fact, much of what mergers are supposed to accomplish can be achieved through partnerships and alliances. Google has made deals to handle searches and advertising for companies like A.O.L. and I.A.C., giving it access to their customers without the hassle of an acquisition. And I.B.M. has, in recent years, marketed the products of its competitors Sun Microsystems and Novell, enabling it to expand its offerings and its potential customer base. If CBS and CNET had simply agreed to cross-promote each other’s brands and distribute each other’s content, CBS would have had many of the benefits of merging without the costs."

There's no need for ownership if all you're looking to do is get from point A to point B.  Leases and rentals often will get you the same benefits -- without the costs of maintenance.

Germany Leads the Way

Today on the IAM blog, Broken Symmetry's favorite IP investment management journalist Joff Wild blogs about new IP-focussed investment funds in Germany.

IP Bewertungs AG (a/k/a IPB) stands out from the pack.  According to an executive at IPB, IPB doesn't merely aggregate patent rights.  IPB is actually spending time and money after acquiring IP rights on pre-commercialization development.

Without hearing more, it's difficult to know exactly what kind of development they're doing.  But it's easy enough to imagine that they've got a team of scientists or engineers assigned to each portfolio of IP that they've acquired, working to further refine the inventions patented into product or service concepts that are more susceptible to early-stage commercial development.  Without the know-how of these scientists and engineers mixed in, naked IP is far less valuable to prospective transferees.

Coupled with the earlier article on IPB published by IAM magazine, which laid out some facts about the comprehensive diligence process that IPB goes through prior to acquiring a patent portfolio, IPB is beginning to emerge as a thought leader in this market.

Schumpeterian Competition

Two weeks ago I read about University of Chicago professor Lee Fennell's work on rebundling real property, and noticed that her theory sort of implies a cycle in the housing market.  This is obviously true post-subprime bubble.  But what has slowly dawned on me since then is that economists do not yet have any simple models to describe bubbles.  Reading in the Wall Street Journal about Bernanke's team, I went to their Princeton home pages and discovered that at least some of the models used in their papers require a theory of psychology.  Psychology is of course important for investors and regulators to understand; but I believe that a theory of psychology is not required for modeling market cycles.

Fluctuations in the market price for a particular good or service can be modeled in time as a relatively simple function of scarcity in an older good and its newer substitute.  (Think of how IBM PCs were replaced by Macs in the 1980s.)  The simplest mathematical model to associate with Schumpeterian creative destruction of price as a function of time and demand for the older good is the simple harmonic oscillator.

The most useful observation about market cycles that can be drawn from Schumpeter's work is that creative destruction will reverse increases in price over time -- even as supply remains steady or decreases.  When a new substitute for an existing good becomes available, the price of the old substitute will decay over time as consumers switch from old to new.  The result is growth, then decay in price, even as supply remains stable. 

To add some phenomenological richness to the simple oscillator model, one can model in variables for transactions costs, liquidity, and external money supply.  These additional variables change the simple harmonic oscillation predicted by Schumpeter into a damped, driven harmonic oscillation.  RLC circuits and tuning forks are other systems that can be modeled as damped, driven harmonic oscillators.  In my analogy to the RLC circuit, price is a voltage signal that varies in time, which is in turn a function of the aggregate demand for the older good.

A time varying price signal will behave considerably differently after taking the effects of liquidity, external money supply, and transactions costs into account.  For example, when demand (and hence price) swing rapidly, a resonance response (i.e., bubble) may occur when transactions costs are not too large and liquidity and external money are not too small.  These were the conditions that obtained in the subprime mortgage market recently.  A corollary is that the period of the cycle could have been estimated by looking only at the magnitude of liquidity and external money supply (this is the "resonant frequency" for the bubble).  Another corollary is that the "quality factor," which is equivalent to the liquidity divided by the transactions costs, tells us how big a bubble effect we might see.  And indeed the subprime market could fairly be characterized as having very strong liquidity and very low transactions costs as it approached its peak.  (We sort of blew the circuit at that point.)

Yet another useful observation that can be drawn from the model is that bundling supply without including a proportional bundling of demand or other negative price effect will lead to an unsustainable exponential growth in price.  Actually, there are many such lessons that could be drawn from Control Theory, which physicists now routinely use to design and monitor dynamic equilibriums in other systems.

Finally, I note that no physicist would attempt to design or monitor such a system without first getting comfortable with the accuracy of her tools of measurement.  In the case of markets, our tools are not working too well for the moment because the accounting rules do not make any sense in view of the actual relationship between price and value, which is a function (ultimately) of the value that everybody in a market places on a particular good, not simply the value placed on a good by the two parties to a transaction at a moment in time (which is what most people think of when we talk about "price").  Increasing transparency into what company managers see is useful and important in preventing fraud on shareholders.  But adopting rules that are consistent with reality in terms of how economic growth and decay occurs is equally important.

It's also worth mentioning that in some sense, all of these price cycles are coupled, either weakly or strongly.  Hence the entire economy could be modeled as a chain of coupled damped, driven oscillators.  This is actually a theoretical model from which quantum field theory and non-equilibrium statistical mechanics depart.  Among other useful results, these theories have permitted physicists and chemists insights into how and when to expect phase transitions in what would otherwise be considered unstable thermodynamic states.  This in turn suggests another insight into the problems economists and accountants have been having dealing with bubbles.  Like the static models of supply and demand, thermodynamics is successful in making forward-looking predictions about how a physical system will behave in response to changes in temperature, volume, and pressure.  But it still took a mathematical model of molecular dynamics to understand exactly how and when transitions would occur: thermodynamics, like static economics, provides little insight into how long unstable equilibriums will persist.

Summing Up: Feathering the Nest for Inventors

Sensible patent reform should focus on feathering the nest for inventors in the United States.  There is nothing more important to our long-term prospects within the global economy.  To summarize the posts made this week:

IP is a limited exclusive right to an inventor's time, not a limited exclusive right to a thing.  I.e., IP is Not an Asset.  Lawyers, business people, and politicians should consider how the patent law will affect the activities of inventors.  A plugged R&D pipeline can lead to Stranded R&D and an exodus of inventors from the United States.  We would promote the progress of arts and sciences better by building legal and financial institutions that recognized the benefit of a division of labor between inventing ideas and building things.  This is What Adam Smith taught the Founding Fathers.

The Most Important Role of Public and Private Regulators?

Libertarians struggle with the question of how and when any government or private regulation is proper.  In the wake of the subprime mortgage market collapse and in view of the existing problems with the patent system in the United States, I have come to a few more general conclusions.

The most useful role for regulators is to ensure that the consumers whose transactions constitute the smallest units of demand within a market are required to internalize at least part of both the positive and the negative externalities (i.e., social costs and benefits not otherwise priced into the bilateral transaction) of subsequent comparable transactions.  This will require at least the cooperation of the individual or firm that is counterparty to the smallest unit of demand.

In the housing market, a bubble developed because at each stage in the cycle from homebuyer to bank, to larger institutional investors, and back to buyer, no accounting was made for how an increase in home prices was going to increase the price and decrease the volume of transactions in other goods.  In other words, the opportunity costs of increasing prices in homes was not sufficiently internalized by homebuyers in the subprime mortgage market.  This problem could have been avoided by requiring homebuyers to buy insurance covering the risk of declines in home price due to off-site factors.  (Thanks, Lee Fennell.)

Taxes are probably the most impactful way that government regulators have ensured that the negative externalities of an individual engaging in particular activities are internalized by the same individuals in some measure.  (Thanks, Pigou.)  In the sense I'm thinking about them, taxes are like an insurance premium we pay to the government to ensure that somebody is worrying about (and will bail us out from) major catastrophes that are too large in scale or too long in time horizon for the market to accurately price into transactions with consumers.  Please note that this does not mean that I am in favor of raising taxes!  A corollary is that the role of government may be rationally more limited in places and times when private institutions are able to more accurately price low-probability and long-time horizon (i.e., major) catastrophes.  Requiring insurance and reinsurance against catastrophes is probably healthier for everyone than building labyrinthine bureaucracies (like FEMA) that aren't going to do much work on preventing disasters, and won't be much help when they inevitably occur.

Here's one piece of evidence to support this theory.  Warren Buffett and Charlie Munger have almost made a religion out of including negative feedback in every financial statement, probably even in every transaction.  The result?  Longer time horizons and more accurate pricing (through negative feedback) have permitted them to run what is perhaps the most efficient conglomerate in the history of humanity.

"How is it organized? I don’t think in history of world has anything Berkshire’s size organized in so decentralized a fashion. Net amount of bureaucracy is tiny, costs are low, autonomy in subsidiaries is vast, no common culture shuffling people around. How far can this go? This system has gone farther than any other system. Low cost, not a lot of envy effects – where everyone compares everything. People in subsidiaries have a feeling – whereby there is less fealty to headquarters. If you want an imperial headquarters which exacts a big overhead charge on the provinces – they will resent it. Net number of intra-subsidiary transfers is tiny. It has worked well. It can go a lot farther. No one else has been here before."

Berkshire-Hathaway is one of the first private regulators to make negative feedback a priority, and look at what they have accomplished.  What would the world look like if we redesigned legal and social norms to encourage negative feedback (i.e., accountability).  And Berkshire-Hathaway did it without any government telling them that they had to.  They were seed crystals in this sense.

Update: The characteristic slope of the Taylor Rule for monetary policy (which requires that the magnitude of changes in target rates always exceed the magnitude of changes measured in inflation) could be viewed as an embodiment of the negative feedback principle.  A control theorist might say that the Taylor Rule leads to more stable economic cycles by requiring a decrease in money supply in response to increases in inflation.  Assuming the measurements were accurate, in the limit in which the lag in time between the decrease in money supply and the increase in inflation approches zero (i.e., assuming adjustments could be made instantaneously) the money supply rate and the rate of inflation should be equal.

Thus, the best known approach to matching the money supply rate to the real rate of inflation is not unlike the approach followed by Buffett and Munger in their attempts to match the price of Berkshire-Hathaway stock to their estimates of its intrinsic value: negative feedback works.

IP is not an Asset: Patents and Inventors Need to Stick Close

Earlier this week, Peter J. Wallison argued that conventions in fair value accounting may in part be the cause for the recent bubble markets.  Specifically, Wallison pointed to the convention (implemented under FASB 157) that requires assets to be carried at "market" values, even when those assets are not being held for trading purposes.

Almost any scientist or engineer would immediately have recognized the truth of this argument.  Our understanding of any system -- chemical, electrical, mechanical, or financial -- will be limited in part by the accuracy of our tools of measurement.  When one considers how FASB 157 required banks to report the values of MBSs, CDOs, and CDO^2s on their balance sheets far above what the banks would themselves have been willing to give away for the same assets, one understands how the financial markets quickly lost track of the intrinsic value backing the securities traded.

This wisdom has direct relevance to the secondary markets for IP.  Most of the firms now in the secondary markets for IP have taken the view -- and are conducting their businesses -- as if IP were an asset.  This is because IP does bear some characteristics of an asset.  Namely, like real and personal property, IP can be protected through exclusive rights.  The analogy to property has thus come to dominate our understanding of the nature of IP.

Although accountants often treat IP as an asset, IP is not a commodity.  IP is more like equity, although it is not like other equity.  IP is a limited exclusive right to human capital (namely, to inventors' time solving a technological problem).

Maybe part of the reason that Abraham Lincoln understood the importance of patent law is because he understood that human capital cannot be owned.  The photograph shows the Emancipation Proclamation, whereby Lincoln did more for the cause of freeing human capital than many other men together have done in the course of human history.  Lincoln loved the patent system because he understood that it too could lead to more freedom.  Scientists and engineers work best free from the immediate demands of business people and customers.  The idea of a patent system carries within itself the promise of more innovation and more freedom.

POSTSCRIPT: Please note that I do not believe that inventors are literally enslaved right now.  There are obviously huge differences between the enslavement of millions of black Americans and the metaphorical enslavement of inventors who are now forced to do work other than inventing because of the broken patent system.  I do, however, believe that making people more free leads always to a multiplicity of unanticipated social benefits.

Slicing and Dicing Insurance and Property Risks

I see that Charlie Munger has come out against slicing and dicing insurance risk.

I'm going to make a simple observation based on a couple of posts from earlier this week.  The problem with slicing and dicing insurance or property is not the slicing and dicing -- which respectively serve only to amplify the positive or negative externalities of ownership.  The problem is that the source of price signals -- i.e., the individuals who decide whether to buy property or insurance -- are not generally forced to buy both.

Each individual within our society should be required to accept some measure of both the positive and negative consequences of her actions.

Charlie, if you're out there, don't you agree?

What the Founding Fathers knew about R&D that we have forgotten

As evidenced by his lecture on discoveries and inventions, Abraham Lincoln had a deep understanding of the patent system.  It is amazing how his lecture, which is now well over 150 years old, can seem so fresh today.  He and Charlie Munger have inspired me to undertake a historical review of other important lessons of the imminent dead.  Today the lesson is from Scottish enlightenment thinker Adam Smith, famous for his authorship of The Wealth of Nations. I must shamefully admit that I have thus far been unable to make it through the entirety of his treatise.  I have nonetheless been the beneficiary of the wisdom of Adam Smith through the help of editors, from whom we have the following excerpt:

To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business . . . nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them.

Adam Smith goes on and on from here about the many benefits of the "division of labour."  Although controversial in his day, the benefits of "the division of labour" are in our day a fact so well-accepted by the majority that many people seem unaware of the history of this idea.  We seem to assume it a logical consequence of any business. That it is not.  In each case in which a division of labor is successfully implemented in business, there was first an entrepreneur who saw the benefit of separating one task into two.  Henry Ford brought the magic of divisions of labor to the production of cars through the assembly line.   Most people can't imagine this, but before him others probably scoffed at the idea that something as complex as a car could ever be assembled without a single person overseeing the entire process.

Are we not still scoffers?  In the United States, we now live in an age in which most lawyers, business people, and researchers believe that R&D and early-stage product development are incapable of being done by two teams.  The fact remains, however, that the best inventors and the best startup CEOs are not often the same person.  And the best R&D and the best product development tend to occur in different environments.  We have strained for the past twenty-years in the United States to force inventors into the role of entrepreneurs, and entrepreneurs into the role of inventors.  Being a hardworking nation, we have not been entirely unsuccessful.  But how much more successful might we be were we to accept once and for all that there is an efficient division of labor between R&D and commercialization (yes, even the "commercialization" done by startups)?

The patent system is the most sophisticated and efficient means for implementing a division of labor between R&D and commercialization ever conceived by humans.  It is by cutting back at patent rights in the United States that we have inadvertently forced inventors to become entrepreneurs and entrepreneurs to become inventors.  Let us not further disintegrate the division of labor between R&D and commercialization by weakening our patent laws in 2008.  Let us recognize that good inventors and good startup CEOs are not always (or often!) the same person.  Let us "promote the progress of science and the useful arts" in the ways our Founding Fathers intended, by a division of labour between R&D and industry.

Stable Market Design with Control Theory

Earlier this week, I had a vision of how analog circuit design theory could have provided some useful insights into how to avoid bubble markets.  I haven't found too much on this from googling, although this paper looks pretty close from the abstract (I don't have a subscription so can't verify whether they're actually thinking the same way).

The field that physicists and applied mathematicians call Control and Dynamical Systems has basically developed to aid engineers in building systems that use feedback to stabilize the state of any system that goes through cycles.  There are lots of things that machines (like the stealth fighter) do that humans would not be able to do because of the magic of feedback-stabilized oscillation.

The implications that this has for business cycles in public and private markets is so obvious that I'm quite certain that somebody already knows how to do this.   Alas, they're probably making boat loads of money on it as we speak.  Another problem worth solving is how to give incentives to such people to share their insights through something other than bidding or asking price.  (Actually, granting patents on financial engineering innovations isn't a bad way to do this.  But a two-decade term would be overkill in most cases.)

In the interest of aiding translation between physicists and economists (and hopefully help avoid yet another major bubble in our financial markets), I'm going to identify the simplifying assumptions that I think are most useful in modeling markets with control theory, and then offer a few extremely crude observations about the potential benefits of applying this theory.  I'll use electrical engineering terminology to show the relationship between the variables.

* Price can be modeled as a two-dimensional current signal in time and demand P = P(t, d)
* Price changes will be amplified by bundling supply and demand (e.g., through securitisation) so that P = A*P where A is either less than 1 (supply bundling) or greater than 1 (demand bundling) depending on whether buyers or sellers are being aggregated by a particular security.
* Transactions cost can be modeled as resistance (and Price * Transactions Cost will approximate Demand)
* External money supply can be modeled as capacitance (which will introduce a phase lag into price)
* Liquidity can be modeled as inductance (which also introduces a phase lag into the price)
* Demand can be modeled as voltage

For purposes of this model, I'm assuming that the external money supply obeys some predictable rules (like Taylor's Rules).  The system is going to be extremely indeterminate if the external money supply doesn't behave in predictable ways.  (There's a useful result right there!  Let's implement Taylor's Rules.)

From my very crude understanding of theory, this kind of model would permit the following predictions to be worked out from the nonlinear differential equations that govern such a system:

* Systems that include both inductance and capacitance (i.e., external money supplies and liquidity) are going to oscillate at a characteristic frequency.  That frequency is the "resonance peak," and it's amplitude will vary depending on the amplifiers.  If they're too strong, the circuit blows up.

* Systems that include large inductance but low capacitance (i.e., liquidity but no external money supply) are going to decay exponentially to zero price

* Systems that include mostly positive feedback (i.e., amplify demand without inverting or phase shifting the input signal) are going to increase exponentially (until they blow up).  (This was Monday's insight.)

* Systems that are tuned to include just the right amount of positive and negative feedback are going to oscillate stably within a limit cycle for long-periods of time.  In fact, such systems will "magically" self-correct price to demand.   Actually, this is most markets, most of the time.  We just haven't been paying enough attention to the bigger picture.

Somebody out there must have done some graduate school research on this topic.  We should send them to Bernanke and hope for the best.

UPDATE: Thanks Google.  Here's Steve Fairfax of MTechnology making a similar point.  And here's Donald D. Hester and D.L. Brito making a similar point... in 1974!  Do we ever learn?  (Don't answer that.)

UPDATE2: Here's a book on "Economic Dynamics" with a whole section working out a version of control theory applied to a more complicated model.

UPDATE3: I've worked out a numerical example with estimates for the subprime mortgage market here.

Fermi and Founders

"There are two possible outcomes: if the result confirms the hypothesis, then you've made a measurement. If the result is contrary to the hypothesis, then you've made a discovery."

- Enrico Fermi

Around Silicon Valley, early-stage venture capitalists tend to agree: invest in teams and markets, not business plans.  Why not business plans?  Because plans have to change, and sometimes drastically, in order for a new business to succeed.

In this sense, the character of a company's founders is much more important than a particular business plan.  The process of thinking through, writing out, and pitching a business plan causes founders to become more committed to their ideas psychologically.  It takes founders of extraordinary character to have both the courage to ignore criticism that is not well-founded, and the humility to listen and learn from criticism that is.  Not coincidentally, it is the same characteristics that make for the best businesses.  Good businesses have the courage to ignore the customers who will never find value in their product or service, but listen and adapt to the needs of the customers who do and will.

Enrico Fermi was one of the last great physicists to do both theory and experiment.  There's pretty much a division of labor between these in physics now.  According to legend, Fermi would wake very early in the morning and work out on paper the expected results of his experiments.  Then he'd go into the lab and produce data until he'd satisfied himself that he had done his calculations correctly.

Is it any wonder that he seemed to have more insights?

Stranded R&D

In 1980, Congress passed the Bayh-Dole Act.  Overnight with its passage, universities and government-funded R&D labs gained a comparative advantage in funding R&D.  Universities and government labs have a cost advantage in that many had already spent tens of billions of dollars setting up research labs for non-commercial purposes, including teaching and curious exploration.  Many scientists and engineers found the prestige of academia, and the increase in professional freedom it promises, a compelling offer.  The result has been a gradual shutting down of corporate R&D labs, and an expansion of industry collaboration with scientists and engineers now employed by universities and government labs.

Many people think of the Bayh-Dole Act as an unmitigated success story.  Several multi-billion dollar technology companies that are now household names (such as Genentech and Google) started in graduate school research labs.  Many inventors are happier in the more collaborative environment that academia offers.  Collaboration is an under-appreciated driver of innovation.

Unfortunately, so far universities have underperformed private benchmarks for the successful transfer of technology.  Despite spending almost an order of magnitude more on R&D (about $50 billion), the AUTM reports only about a factor of two more revenue from R&D (about $2 billion) than does IBM (about $1 billion on about $5 billion in R&D) over an overlapping period from the mid-nineties to the mid-zeroes of the present decade.  Although it is tempting to attribute the difference in returns entirely to the diversion of R&D funding into pure science (an attribution that ought to silence the Bayh-Dole critics who favor pure science), it is important to remember that there was a net inflow of the most productive researchers from industry into academia over the same period of time.  This concentration of the brightest minds of science and engineering within academia would probably have led to a faster increase in returns from R&D if there weren't something else going on.

And there is something else going on.  The costs of licensing and litigation of patents has skyrocketed over the same period of time.  The biggest reason for increasing costs has been the inelastic supply of patent lawyers relative to the exploding demand for their services.  Unlike patent prosecution, which can be done by non-lawyer patent agents and examiners, patent licensing and litigation are services that require a state bar license (and the three years of ABA-accredited law school that this usually requires).  Law firms are struggling to meet demand by increasing starting associate salaries (patent boutiques started the chain reaction in both instances over the past ten years), but the corresponding increase in associate to partner ratios at most law firms (necessary to keep profits-per-partner high and retain top partners) has led to a decline in the quality of services overall.

It is worth noting that many technology transfer offices are staffed by non-lawyer scientists and engineers with formal or informal business training.  Many of these employees are probably undervalued by the legal services market because of their lack of state bar credentials.  Seeing the value, university tech-transfer offices and other government and private firms not constrained by state bar requirements are scooping these types of employees up.  Non-lawyers will probably play a growing role in R&D funding and technology-transfer going forward, even in providing "legal" services.  The investment banks (such as Altitude Capital) and venture capital funds (such as Intellectual Ventures) that have recently entered the secondary market for patents are early signs of this trend.

The result of these macroeconomic trends in R&D is a market in which many startups and smaller companies are realizing only a fraction of the intrinsic value of their R&D.  Technology is stranded in later-stage startups and other small private companies that are not eligible for further venture capital financing, acquisition, or IPO.  Problems in the credit markets and the passage of the Sarbanes-Oxley Act have further exacerbated the problem for these companies in the acquisition and IPO arena.  In effect, the United States is piling up a vast, invisible junkyard of stranded R&D that could be socially valuable if placed into the hands of the right owners.

As the returns to investment in R&D decline, so too do the number of jobs available for researchers outside academia.  This is a problem that is vital to the health of the U.S. economy within its global environment.  If current trends continue, there will be more Ph.D. engineers living in China than in the U.S. by 2010.  The number of U.S. patents issuing to foreign entities is already nearly equal to the number of patents issuing to the U.S.  If the U.S. were to strengthen its patent system, we would be far better positioned than any other nation in the world to bring the power of market-based incentives to bear on the problem of attracting the most talented human capital -- the single most important problem we face in our long-term prospects for economic growth.

People are starting to recognize these problems.  Recently, the Brookings Institute has called for the government to setup a National Innovation Foundation.  But aren't the market-based incentives of a strong patent system a better way for the government to encourage R&D funding?  Although a handful of firms, including Intellectual Ventures, Ocean Tomo, and other new entrants are struggling to meet immediate needs, the inventors and startups most in need cannot afford to hire anyone to answer the lobbyists hired by the large corporations that are net payers of patent licenses (when forced to pay at the end of protracted litigation).

Although the big picture of innovation is so large and complex that it is difficult for most people to understand, the solutions are actually simpler and easier than most would imagine.  First, the patent laws should be reformed in ways that would promote private settlements of disputes over patent infringement rather than litigation.  Some recent changes to the patent law have been beneficial in this regard, and some detrimental.  Unfortunately, the Supreme Court's recent holding in Medimmune makes it harder than ever for inventors to get to the table with large corporations without ending up in litigation.  And after Mercexchange, startups and independent inventors do not have the threat of an injunction to keep licensees at the bargaining table when those startups and inventors have failed to find funding to themselves commercialize the technology.  Neither of these by themselves is fatal.  The threat of injunction was no doubt abused by opportunistic speculators from time to time over the past few decades.  But not in decades has it been more difficult for investors in R&D to see a return through patent licensing.

Second, if the government is going to provide funding to solve these problems, that funding might best be used to lower the barriers to entry for the practice of patent law.  For scientists and engineers, especially those who understand business, the opportunity costs of wages are probably much higher than the costs of a law school education.  Public funding of scholarships for scientists and engineers who intend to study law would over time decrease the transactions costs associated with patent licensing, and gradually decrease the amount spent on litigation as it becomes easier and easier for opposite parties to reach agreement on differing valuations of a technology.

Third, institutional investors should consider allocating a larger share of their funding to hiring more employees for their technology transfer offices now, and later for investing in private equity funds that specialize in R&D investment.  The technology transfer offices are now overwhelmed by the demands on their time in many cases.  As a result, they tend to focus on the biotech and pharmaceutical inventions that are likely to provide the largest payouts, ignoring the many other areas of R&D that could nevertheless have a transformative impact on our society.  In terms of private equity investments, over the short-term the lack of licensing revenue is going to impede the returns for these funds.  But restarting the R&D engine of economic growth is going to require the public and private sectors to work together.

These are complex problems that it will take teamwork to solve.

Update: Silicon Valley never fails to disappoint in its farsightedness.  Jaisen Mathai, Michael Arrington, and Stu Phillips are all groping around the edges of the problem.

Update 2: I was recently asked whether the figures for IBM and AUTM include capital gains from equity.  The answer is no, neither do.  I have seen no evidence and have no reason to believe, however, that the AUTM should be seeing larger returns from equity on its R&D than IBM.  So the larger point about relative efficiency in technology transfer seems still to be sound.

Every Patent Affects Two Different Markets

There are two different markets relevant to every valuable patent. First, there is the market for the R&D work that results in the patent.  Prices in this market are set by the opportunity costs for the time of scientists and engineers who are capable of theorizing about and experimenting with the technology.  Second, there is the market for the claimed products or services that the R&D work opened up.  The second market is the one that everyone naturally thinks about.  In fact, our whole nation has had a blind spot for the first market for a long time because corporate R&D divisions were serving that market very well until the Bayh-Dole Act was passed in 1980.  Most universities have not been able to consistently match pre-product funding with the flow of R&D produced by their faculty.  One former R&D employee from Apple and Microsoft blames Silicon Valley, saying "Silicon Valley forgot how to do R&D."

Within the law of antitrust, one can observe how this blind spot is affecting the outcome of litigation.  The essential facilities doctrine of antitrust law has been applied in an inconsistent way because most judges don't see that there are two different markets.  R&D work almost always has natural monopoly characteristics.  But patents covering valuable R&D should not therefore trigger the essential facilities doctrine.  Lots of R&D work needs the barrier to entry that only legal exclusivity can provide in order to recover even a reasonable profit.  Yet if the same patented R&D is valuable because the claims cover a product, the production and distribution of which have natural monopoly characteristics, then applying the essential facilities doctrine to require the patent owner to make licenses available on a non-exclusive basis might make sense.

Consider two concrete examples.  Example 1:  I patent R&D claiming a new type of telephone.  The essential facilities doctrine should not be invoked to require me to license others to sell the patented telephone.  Producing telephones is not a natural monopoly because the total average costs are not always declining.  Note that this is true even though the telephone demonstrates network effects.  Example 2:  I patent R&D claiming a new type of telephone network.  The essential facilities doctrine probably should be invoked to require me to license others on a non-exclusive basis who need to use the telephone network for their own products or services to be valuable.  Building telephone networks is a natural monopoly because the total average costs are always declining.  In both cases, the crucial question is whether the second market has natural monopoly characteristics.  The first market almost always will.

In some cases in the past, when the essential facilities doctrine has been invoked against patent owners, judges have decided either to let the patent owner maintain full exclusivity or to deny any compensation.  Better would be for judges to let most patent owners do whatever they want, but require compulsory licenses in the subset of cases in which the actual product or service sold has natural monopoly characteristics.

Those with an extraordinary interest in reading more can wade through this paper.  But know that I am no longer enthralled with the idea of applying the reverse doctrine of equivalents in patent law or the Feist originality doctrine from copyright law to the same effect.  Too much potential for mischief.

How did the United States get stuck on the peak of a Sombrero?

Consider a ball resting at the center of the sombrero pictured at right.  Poised at the very center of the sombrero and at rest, the ball will not move.  It is in an (unstable) equilibrium.  Nonetheless, if nudged, the ball will roll down into the ring of the sombrero.  The lowest ring around the peak of the sombrero is a stable equilibrium.  Any further nudges will push the ball around the ring a bit; but the ball will end up rolling around the ring from then on.

In this example, physicists would call the direction in which the ball gets nudged an "order parameter."  And here's what makes the order parameter interesting: Starting from the peak of the sombrero, the ball will roll in any direction easily.  But starting from the ring of the sombrero, the ball will tend to roll only along tangents to the ring.  The symmetry of the order parameter is broken as it moves into a new equilibrium.  Thus, broken symmetry signals a new equilibrium.

People, firms, and even whole markets can persist in unstable equilibriums, like the peak of the sombrero.  If it's a big enough sombrero, even relatively big nudges won't move us off the peak.  In addition, from the peak of the sombrero, every direction looks about the same.  So for a long time we might get nudged one way and then nudged back again without ever leaving the peak.

Look at what happens, however, when a group of people start seeing the sombrero rather than its peak alone. That group will start rolling the ball in the same direction.  And note that it doesn't much matter what direction that is.  Any direction will do in getting us off the peak of the sombrero (so long as there isn't another group just as big trying to roll it back the other way).  Once off the peak, things will look very different to everyone, not just the people who can see the whole sombrero.  We might even be able to reach a new consensus: "We'll either go left or right around the ring.  But any other direction doesn't make sense."

When it comes to patent law in the United States, we're at the peak of a sombrero right now.  Here's what I see: We're spending tens of billions of dollars every year on new R&D.  But some of that money is spent redundantly (in ignorance of the prior art), and some of it is completely lost (to patent infringement) because ideas, once disclosed, are impossible to take back.  Trade secret torts and contracts just aren't as good a way to solve these problems.  Turning a blind-eye to patent infringement is bad long-term policy for the United States.  There are already a few other countries that are watching and hoping that we'll drop the ball on this one.  (Or I guess not push the ball far enough in the right direction.)

With the big sombrero in mind, it shouldn't be so hard for everyone to see how strong patent rights are a smart way "to promote the progress of science and the useful arts" through market-based incentives.  Both the Venetians in the 15th Century and our Founding Fathers in 1787 saw the value of patents.  Where did we go astray?

I also gave a brief explanation for the name "Broken Symmetry" in my first post to this blog, but I wanted to revisit the metaphor because it has been so fruitful for me in understanding the organic evolution of markets and firms.

The more things change...

Thousands of years ago Plato (top left) wrote that "Until philosophers are kings, or the kings and princes of this world have the spirit and power of philosophy, and political greatness and wisdom meet in one, and those commoner natures who pursue either to the exclusion of the other are compelled to stand aside, cities will never have rest from their evils, -- nor the human race, as I believe, -- and then only will this our
State have a possibility of life and behold the light of day."

Plato's student Aristotle (bottom left) understood government differently: "When several villages are united in a single complete community, large enough to be nearly or quite self-sufficing, the state comes into existence, originating in the bare needs of life, and continuing in existence for the sake of a good life. And therefore, if the earlier forms of society are natural, so is the state, for it is the end of them, and the nature of a thing is its end. ... Hence it is evident that the state is a creation of nature, and that man is by nature a political animal. And he who by nature and not by mere accident is without a state, is either a bad man or above humanity; he is like the 'Tribeless, lawless, hearthless one, ' whom Homer denounces- the natural outcast is forthwith a lover of war; he may be compared to an isolated piece at draughts."

This week, Judge Posner (top right) made the following remarks on problems in the current credit-market: "This would be fine if zero regulation were the social desideratum, but it is not. The correct approach is to carve down regulation to the optimal level but then finance and staff and enforce the remaining regulatory duties competently and in good faith. Judging by the number of scandals in recent years involving the regulation of health, safety, and the environment, this is not being done. And to these examples should probably be added the weak regulation of questionable mortgage practices and of rating agencies' conflicts of interest and, more basically, a failure to appreciate the gravity of the moral hazard problem in the financial industry."

As Aristotle saw things differently from Plato, so Becker (bottom right) sees the purpose for regulation differently from Posner: "It would run counter to human nature for regulators to take a skeptical attitude toward the riskiness of various assets when the market is indicating that these assets are not so risky, and when originating and holding these assets has been quite profitable. One can expect regulators to mainly follow rather than lead the market in assessing riskiness and other asset characteristics."

Rebundling Ownership and Control of Patents

On Friday I attended a panel on the "State of the Legal Profession" held at Stanford Law School.  The panel was well-designed, with a variety of perspectives from lawyers in-house, at law firms, in academia, or in public interest.  It's hard to get six lawyers to agree on anything, but it seems that everyone more or less agreed that the traditional law firm business model is not holding up well in the 21st century.

There are many reasons for this, one of which -- the inaccuracy of the billable hour as a metric for the value of legal services -- I've discussed in a previous entry.  Another reason that was obvious after hearing the panelists is the relatively inelastic supply of talent graduating from law schools every year.  That pool of talent hasn't grown much in decades, even as the demand for legal services has exploded.  Public interest advocates are seeing more and more people opt for pro se representation in court or no representation in transactions (see, e.g., subprime mortgage lending).  Law firms are raising salaries higher and higher to attract talented associates, but also increasing leverage (i.e., the ratio of associates to partners) in order to continue attracting talented partners (profits-per-partner being a key metric for partners in deciding where to work).  Meanwhile in-house counsel is facing increasing pressures from company management to keep down the costs of legal bills as global competition narrows the margins on products and services.  Another time I may elaborate on how some big law firms are beginning to resemble a Ponzi scheme in this regard.  And anyone keeping tabs on the credit market knows how ugly deleveraging can get.

So what can be done?  There's no choice for now but to get more efficient with the supply of talent that we've got.  My earlier post gave a suggestion for how more efficient incentives could reduce costs for certain kinds of transactional work.  But it didn't elaborate on how rebundling of ownership and control is capable of solving a whole class of principal-agent problems in legal services.  A similar solution could be used by many companies to reduce the costs of procuring and enforcing patents.

The basic contractual framework for accomplishing this is simple, although the practical execution is difficult, requiring human capital with a high-level of expertise in three different, (now) weakly-overlapping professional disciplines.  Instead of paying a law firm by the hour (or paying a high fixed-rate) to prosecute patents, clients could pay a much lower (or zero, or negative) fixed-rate for their work, and then give them a slice of any future royalties earned on the portfolio.  Lawyers who (a) believe in the value of their services, (b) understand the technology patented, and (c) believe in the prospective value of the market that the patents are meant to cover should be willing to accept lower rates in exchange for a slice of future profits.  The trouble is that there just aren't that many lawyers who understand law, technology, and venture capital investing.  And the ones that do (think of senior partners at big law firms) generally are too comfortable with the status quo.

Not every company is going to feel comfortable with doing things differently, especially if the current system is meeting their needs.  Nonetheless the potential is there for forward-looking clients and entrepreneurial patent lawyers to innovate on the traditional business model, and maybe even lead the way into a better model for legal services in every market.

UPDATE: Thanks to IPKat I have learned that the French bar is in the middle of a protracted struggle to keep scientists and engineers out.  Not surprising, but comforting to know that we're not the only ones with this problem given the implications that our excessive domestic regulations have for the United States in competing in a global economy.