(by Jonathan and Stian)
How should a business make the most of its intangible investments? Here’s an interesting lesson from history.
i. Good fences make…
Let’s step back to the American West in 1870, a place of cowboys, rugged homesteads and…fences. The humble fence was a big deal. Fencing represented a big chunk of the total capital stock of the Western states, as Richard Hornbeck, whose superb 2007 paper this example derives from, pointed out.
Why fencing? Imagine you’re a farmer in the Old West. You’ve got a big farm growing alfalfa. One thing you really don’t want to happen is for a large number of someone else’s cows to show up before harvest time and eat your alfalfa.
If you were back in the old country, you’d have some comeback: various European laws entitled landowners to compensation from the owner of marauding livestock. But American law didn’t. In the land of the free, it was your responsibility to keep the cows off your crops.
So if you didn’t want your alfalfa to fatten someone else’s cows, you needed to build a fence. And a lot of people did. In 1870, the US had over 2.3m miles of fences.
That was all well and good where fencing was cheap. In wooded areas a fence could be had with an axe, a saw and a few days’ work. But the American West isn’t known for its forests (indeed, so scarce were trees that the US government would make land grants to people who planted them). So to fence off your huge farm would be incredibly expensive. Chances are you couldn’t afford it. So you’d accept the risk that cattle might eat your crops, and manage your expectations accordingly – including not betting the farm (ho ho) on big investments in the next harvest, like clearing land, or buying better tools, seedstock or fertilisers.
But then two wonderful things happened. A man in Illinois invented barbed wire, which is very good at keeping cows out. Even better, the increase use of the Bessemer Process made steel very, very cheap.
In just 10 years, between 1880 and 1890 the price of barbed wire fell by more than 50%, and it fell by another 50% in the next 10 years. It was, in a way, the Moore’s Law of its time. People who hadn’t been able to afford fences now could.
The effect of this new source of fencing is, well, electric. Hornbeck’s research shows that it caused farmers to invest in their lands, causing productivity to increase between 1880 and 1890, when barbed wire was widely deployed.
The particularly clever thing about the research is it distinguishes between farms in wooded areas (where it was already cheap to fence in land) with less wooded areas, where the barbed wire made a real difference. And tellingly, it’s in the non-wooded areas where we see the productivity increases – of around 23% over the period.
From an economic point of view, two things were going on on these farms in the Old West.
- First of all, farmers who couldn’t appropriate the benefits of their investments in their farmland (because cattle might eat or trample the crops) invested less than they otherwise would have.
- Secondly, an exogenous shock that makes it easier to appropriate the benefits of investment (the invention of cheap barbed wire) increases investment and productivity.
We might also speculate a third phenomenon. Innovation Studies teaches us that demand is important to innovation. It wouldn’t be surprising if the invention and commercialization of barbed wire didn’t depend, at least a little bit, on the existence of lots of people for whom it would be very valuable.
ii. Investment, spillovers and appropriability in 2016
Now let’s forget about farms and the Wild West for a moment and think about the modern economy.
One of the foundational facts of the book we are working on is that the nature of investment has changed. A large body of research suggests that intangible investment has grown significantly and that in countries like the US and the UK, businesses invest more each year in intangibles (like R&D, organizational development, software or brands) than in tangible assets.
These intangibles have various interesting properties. One of them is that, on the whole, it is harder for a company to be sure it will get the benefits of intangible investments than tangible ones or that its competitors won’t. So EMI invents the CT scanner, but GE builds a rival scanning business and EMI is left with nothing. Apple undertakes breathtakingly original design work, backed up with good R&D and intense development of supply chains to transform the smartphone market with the iPhone, but within a year Samsung, HTC, Google and others have competitive (and superficially similar) products.
Investing in lots of intangibles and seeing another firm get the commercial benefits is a bit like clearing and planting a new field of alfalfa and seeing it disappear into the bellies of a cattle baron’s herd just before harvest time.
So if the economy has changed, in a long-term structural way so that a greater proportion of investment is intangible, and if intangible investment is on the whole inherently harder to appropriate, it’s a bit like what would happen if, hypothetically, one were to go back to 1890 and un-invent barbed wire. Appropriability of investment would go down, and, presumably, investment itself would fall as well.
We could expect tangible investment to fall too, to the extent that it is complementary to intangibles. If EMI had decided not to invent the CT scanner because it was worried a competitor would end up with the lion’s share of the business, it would also have not invested in the factories to produce the scanners or the offices to house the sales force.
iii. The dilemma of appropriability
If all that was going on was that the benefits of intangible investment were hard to appropriate, there’d be a fairly straightforward solution.
Just strengthen intangible property rights, and investment would pick up. If patent laws were wide-ranging and courts strongly favoured patent-holders, Apple could be confident that they could sue Google over Android and receive a crushing settlement. EMI could demand generous royalty payments from GE, easily repaying their outlay on R&D and business development. You’d allow all sorts of things to be patented or otherwise protected – software, business processes, organizational structure, you name it. The law would allow draconian non-compete clauses so companies could prevent employees taking their know-how to competitors. It’d intellectual property law as envisioned by the legal department of the Walt Disney Company or Intellectual Ventures.
But of course there is a problem with this solution.
The spillovers from intangible investment are not just a bug; they are also a feature. Cavity magnetrons were invented by a defence contractor to improve radar, but they turned out to cook food rapidly, and thus was born the microwave oven. When lasers were invented, it wasn’t clear what they would be used for (precision cutting? nuclear ignition?); its now-ubiquitous use in fibre optic cables, for example, was not obvious.
We know one of the properties of ideas is that they’re good when you bring them from one domain to another, and when you mix them together and build on them. Brian Arthur’s The Nature of Technology is to a great extent about the “combinatorial” nature of ideas and technologies. Science writer Matt Ridley enthuses about the wonders that arise “when ideas have sex”.
A more formal way of putting this is that intangible investments become more valuable when they’re merged with other intangible investments, but that working out the right combinations is a very difficult task. Indeed we could go as far as to say it is resistant to analysis – serendipity and trial and error are essential. Fostering these things is the point of open innovation and one of the reasons we see scientific knowledge as a public good.
If you lock down property rights over intangibles, you make serendipity and exaptation harder.
So there is a dilemma. Lock down ownership of intangibles and you solve the appropriability problem. It’s the equivalent of providing the Wild West farmer with a roll of barbed wire to fence off her farm. All other things being equal, firms will invest more and productivity will increase.
But there’s a serious side-effect. If you lock down the ownership of intangibles, you create a problem that doesn’t apply in the Wild West example: you make it harder to bring together unexpected combinations of intangibles, and so productivity goes down.
iv. So what? Some questions
It seems there is something of a tragic dilemma for businesses and governments when it comes to investing in intangibles.
Protecting intangible assets with laws and litigation makes it more likely that investors will get the benefits of their own intangible investments. This makes firms more likely to invest in intangibles. But too many laws makes it harder to realise the synergies between your own intangible investments and those of the rest of the world, which reduces the return on intangibles, and the incentives to invest.
Managing this trade-off strikes us as an important goal for managers, economic policy-makers and regulators, and it’s something we’re working on in the book.