Economist on intellectual property

The Economist has a nice survey on patents and IP. As I mentioned in an earlier post, the US patent system (esp. for software) is pretty broken right now. The Economist looks forward to a day when ideas themselves can be bought and sold like any other product. In such a world, some firms might specialize solely in innovation, leaving other tasks like manufacturing, marketing and distribution to others. Of course, this assumes a smoothly functioning IP system, which seems very far off. At the moment, the legal costs of resolving a patent dispute are sufficiently high that startups (which produce a disproportionate amount of innovation) often cannot afford any confrontation with a public company. Given that many big companies are aggressively pursuing a patent-hoarding strategy (hiring more patent attorneys, but perhaps not more scientists!), this may have a negative effect on innovation. See here for leading patent recipients in 2004.

It can take years of hard work, and millions of dollars, for VCs, inventors and entrepreneurs (all of whom have "skin in the game") to determine the worth of an idea. (In this process, the original idea is almost always revised in important ways.) Thus, even if a liquid market for patented ideas existed, valuation would be a very difficult problem. It is true that large companies often sign bulk cross-licensing agreements (for example, Sony and Samsung have cross-licensed a huge number of patents), but I have a hard time imagining a future where I can list a clever idea on EBay and sit back to consider bids from around the world.

The new predominance of intellectual property in technology industries is fed by a number of broader industry trends. First, IT and telecoms have become so complex that there is a greater willingness to accept the innovations of others. Gone are the days when vertically integrated firms handled every step of a product, from initial design to final sale. Now, a small army of specialist firms focus on narrow portions of technology, using intellectual-property rights to protect their inventions when they are licensed out.

Second, as many new technologies quickly turn into commodities, firms increasingly rely on innovation to remain competitive. Yet the return on investment in R&D is short-lived because more people innovate at a far faster pace than before. That means margins have shrivelled, explains Ragu Gurumurthy of Adventis, an IT and telecoms consultancy. “How to recoup the cost of innovation? By licensing the technology,” he says.

Third, customers are demanding “interoperability” and common standards rather than proprietary systems, which means different firms' technologies must work together smoothly. This often requires pooling patents or cross-licensing agreements.

Fourth, generating intellectual property is less capital-intensive than other aspects of the IT businesses because it relies mainly on people rather than bricks, mortar and machinery. That makes it attractive to many start-up firms. Venture capitalists often demand that firms patent technology, both to block rivals and to have assets to sell in case the firm flounders. This was particularly apparent during the internet boom in 2000. “In addition to the dotcom bubble, we had a patent bubble,” says Mark Webbink of Red Hat, a firm that sells Linux, an open-source operating system.

Companies cannot simply turn their back on what is happening in intellectual property. Even if they refuse to play the game, they may be unwittingly infringing someone else's patents because there are so many more of them around. Unless firms have patents of their own to assert so they can reach a cross-licensing agreement (often with money changing hands too), they will be in trouble. Thus many companies are acquiring large numbers of patents for purely defensive reasons, for use only to keep others' patent threats at bay.

...But when talking to executives in the technology firms themselves, the language you hear most often is that of “the arms race” and “mutually assured destruction”. Companies amass patents as much to defend themselves against attacks by their competitors as to protect their inventions. Many technology companies have recently championed reform of the patent system to deal with spuriously awarded patents, licensing extortion and massive lawsuits. “There is a broad recognition in the US that the patent system, if not reformed, will...begin to impede American competitiveness around the world,” says Bruce Sewell, general counsel of Intel, the world's biggest chipmaker.

This survey will argue that, despite such adjustment problems, the huge changes in intellectual property currently taking place in the IT sector will in time produce more efficient markets. But what do the IT firms themselves make of it all?

See also this article in the survey on IP in China and India.

The rise of China and India has mainly been underwritten by foreign companies, not indigenous ones, though this is starting to change. Both countries have been good at persuading firms setting up operations there to invest in training locals. Today, nearly all the large IT firms have big research centres in both countries, and local companies understand the need to develop their own intellectual property. Local people who went to Silicon Valley to find fortune are now starting up their own businesses in their home countries. Foreign venture capital is pouring in.

Without home-grown technology, India and China have to depend on foreign firms, and they do not like it. China, in particular, has seen a surge in the royalties it is paying to foreign firms, and is trying to stem the flow. When Qualcomm's boss went to China in 2001 to negotiate royalty payments for his company's third-generation mobile-phone standard, he agreed to accept less than what he charges others. Within a year, China was working on developing its own 3G wireless standard. If it succeeds, Qualcomm will see its royalties shrink further.

China and India have more to offer than just low costs, although these are clearly important. They are also able to deploy huge numbers of people to work on a project. Being able to throw bodies at a problem is vital in IT. It allows firms to do things such as speed up development cycles or explore alternative approaches that would not be possible with a smaller labour force.

In short, China and India are not simply taking over western IT jobs, they are changing the very process of IT development. It is not about doing the same thing cheaper, but about doing things that simply could not be done before. In that endeavour, intellectual property is becoming increasingly important.

There are limits to the optimism about India and China. Both countries have a culture of keeping technology to themselves. The western concept of patents is fairly new to them, and has proved controversial for countries at their stage of development. Also, both nations have huge institutional and infrastructure obstacles to overcome. Capital markets are embryonic. Big companies are coddled by the state. India's government bureaucracy is stifling; China's is opaque and corrupt. The legal system is uneven in India and consistently inadequate in China. Both countries badly need more experienced managers.

American technology executives with some experience of India and China are worried that the two are about to eat the rich world's lunch, but locals with deep knowledge of both countries think it will take at least a decade. Still, the overall trend is clear: the rise of China and India as centres of innovation will radically shake up the technology industry that is today based mainly in rich countries.

...Take Huawei Technologies, a big vendor of communications equipment, with revenues of $5.6 billion in 2004. This year, revenue from abroad is expected to surpass that from domestic customers for the first time. Around half of its 34,000 employees do R&D work, claims the company. Its patent filings almost doubled each year during the 1990s, though they have recently started to slow somewhat: the number this year will be around 2,400, and from next year it is expected to settle at around 3,000 a year. In 1995 the company created a special department to work on patents, which currently has 100 people on the payroll but will expand to twice that number next year.

“If you didn't have patents, you would be in a very disadvantaged position relative to your competitors,” explains Liuping Song, the head of Huawei's intellectual-property department, at the firm's headquarters in Shenzen. “Other companies approach you and charge you for using their patents.” So is the firm chasing after patents simply because other companies are doing the same thing? Mr Song laughs and says, “That is a difficult question to answer.” Then he adds: “We have to play by the rules of the game.”