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Clarke & Dempsey's 'Info Indy Innovation'

The Economics of Innovation
in the Information Industries

Roger Clarke and Gillian Dempsey *

Version of 30 April 2004

© Xamax Consultancy Pty Ltd, 2004

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for Education licence

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Innovation in the information industries is being seriously constrained by the concessions that large corporations have wrung out of governments in the form of extensions to intellectual property laws. These extensions run counter to economic theory, and counter to the interests of economies and societies.



The digital era arrived very suddenly during the closing decades of the twentieth century. This paper considers the nature of innovation in the 'information industries' in this new context. The term 'information industries' is used here to encompass both information technology providers (in particular of software, but to some extent also of hardware, communications artefacts and services), and content providers (including content in the form of text, images, sound including music, video and multi-media).

It is only natural that institutions whose existence is founded on an old set of assumptions should endeavour to slow down the pace of change.

One institution that is still trying to ignore contemporary realities is economics, where conventional analyses predicated on scarcity continue to be pursued, even though a much more appropriate economics is already available which leads to quite different conclusions.

Another category of conservative institutions is resisting change much more emphatically, and with much more harmful impact. 'Old' information-industry corporations, particularly in the music and software sectors, have recognised that the explosion of the digital era during the last 10-15 years has threatened their longstanding business models and market dominance. They have used their power over the U.S. and other governments to achieve substantially extended copyright and patent laws.

The extended laws are delaying innovation by new and vigorous competitors, and enabling the established corporations to ignore the new context and defer adapting to it. This artificial slowing-down of progress may be to the short-term benefit of the shareholders in large information-industry corporations, but it is to the serious detriment of the economy because it is retarding technological development and hence economic activity.

This paper examines the nature of innovation in the information industries, and contrasts the analyses of conventional economics and information economics. It argues that copyright and patent expansionism must be halted and reversed, in order to remove the impediments to innovation.

Invention and Innovation

Invention is the conception of a 'new idea'. This may be expressed in textual language, or in a formalised language such as mathematics or precise drawings. Alternatively, the idea may be embodied in some kind of artefact or process.

Innovation is a step beyond invention, and is concerned with the deployment of one or more ideas in the real world. This may involve the articulation of an invention, that is to say, its integration into an existing category of artefacts or processes, including adjustments to them to accommodate the new idea. Other ways of describing innovation include the application of knowledge to the manufacture or deployment of a new kind of artefact or process; and the adoption of a new product or process.

Innovators may have to overcome some major hurdles in order to achieve success. In particular:

The significance of these impediments varies a great deal, however. It is not appropriate to merely assume that innovations of particular kinds are subject to them. Rather, each case needs to be assessed on its merits.


Parliaments have intervened into free-market activities by creating monopolies of various kinds, both generic (e.g. patent and copyright), and specific-purpose (e.g. chip circuit layout protections, and plant breeders' rights).

The basis for these laws needs to be carefully considered. The moral worth of innovators ('they deserve it') is not a sufficient justification for such major interventions into free market processes. Nor is the micro-economic argument that 'protection enables innovative enterprises to earn revenue, make profits, and achieve advantages over their competitors'. Competition policy declares emphatically that it is not the role of governments to 'pick winners', but merely to ensure that an appropriate climate exists. Nor is it appropriate for individual nations to manipulate intellectual property laws in order to gain competitive advantage over other countries.

The argument is properly assessed on macro-economic grounds, i.e. 'the economy as a whole will work better, because there will be more innovation'. Hence, for a protective measure to be justified, its proponents need to demonstrate that:

The argument for protections is based on a raft of assumptions that need to be examined in each particular case. In particular, it assumes that innovation requires a high level of investment over an extended period, that innovation involves substantial risk, and that competitors' cost-profiles will be lower (e.g. because they have not been burdened with investment in discovery and experimentation).

Large corporations active in the information industries have sought substantial extensions to the monopolies that they already enjoy through copyright and patent laws. Considerable expansions of privileges have already been granted; and more are being sought.

The monopoly powers for copyright- and patent-owners are justified on the basis that they need a sufficient 'window of opportunity' to financially exploit their innovation; otherwise they will not invest in innovation in the first place, and the economy and society will suffer from insufficient innovation. As was argued in the preceding section, however, the claim that impediments to innovation exist needs to be subjected to careful analysis, and not merely accepted at face value.

This paper's purpose is to examine the extent to which claims for special treatment by the information industries are justifiable. Each particular information industry sector then requires further consideration. One particular sector, open source software, is briefly examined.

The Nature of Innovation in the Information Industries

There are instances in which innovations in the information industries require very substantial investment prior to revenue being earned. The vast majority of innovations, however, require much more modest investment than, say, new large-scale chemical plants, and involve much shorter time-frames than, say, pharmaceuticals development.

There are also instances in which major breakthroughs occur in the information industries. Examples include the transistor, and xerography. The huge majority of innovations are, on the other hand, incremental and progressive, involving step-wise refinements.

In order to analyse the nature of innovation, a distinction needs to be drawn between two forms of knowledge:

An omelette recipe is codified knowledge. The expertise to interpret the recipe, to apply known techniques and tools to the activity, to recognise omissions and exceptions, to deliver a superb omelette every time, to sense which variants will work and which won't, and to deliver with style, are all examples of tacit knowledge.

The information flows that typically occur within an innovative organisation are depicted in Figure 1. Individuals use tacit knowledge that they already possess, draw on their observations of and experiments with known artefacts and processes (or 'prior art', as it is often described in the context of patents law), and on codified knowledge expressed in available documents. They devise new artefacts and processes, and convert some of their tacit knowledge into codified knowledge and express it in specifications and handbooks. In the process, they generate new tacit knowledge.

Figure 1: Information Flows Within the Innovative Organisation

But innovative organisations in the information industries are anything but independent islands. Figure 2 depicts the information flows that occur within an industry sector. The innovators draw, often heavily, on the ideas of their customers, and feedback from their customers. They also take note of feedforward from their suppliers about new capabilities and opportunities arising in relation to the innovator's raw materials. The customer feedback and supplier feedforward are not based solely on their experiences with the innovator, but also on their experiences with the innovator's competitors. Moreover, there are many ways in which ideas cross-fertilise around a sector, including through consultants, academic researchers, professional bodies, educational institutions, and labour mobility.

Figure 2: Information Flows Within the Innovative Sector

Innovation is therefore heavily dependent upon freedom of movement of ideas and information among many individuals and organisations. Monopoly powers such as copyright and patent constrain that freedom. Extensions to such monopoly powers, such as preclusion of reverse-engineering, criminalisation and onerous discovery procedures, add to the barriers against innovation.

One important way to test whether such monopoly powers are justified is to examine the sources of 'first-mover' advantage in the information industries. The following are key factors that determine whether an innovation will earn revenue and establish market-share:

During the pre-launch period, there are measures available to innovators to protect their interests. These include:

Moreover, marketing strategy text-books identify and advise on many ways in which what might be termed 'business acumen' can be applied in order to extend the innovator's 'window', and to increase the revenue and market-share potentials within that window. These include:

Intellectual property laws appear in those lists of factors supportive of innovation. But they also appear in the lists of impediments that innovators must overcome. Other parties, which perceive the innovator as a threat, are able to use their own copyrights and patents as devices whereby the innovator's speed of development can be slowed to a crawl. This may be achieved by precluding the innovator using common components and well-established techniques, by forcing the innovator to discover novel ways to articulate and integrate the primary new invention, and by deflecting the attention of key staff-members within the innovator's team away from the project. This is most commonly achieved by launching complex, multi-faceted and multi-phased legal threats ('nasty-grams'), negotiations, and court actions.

An analysis of innovation processes in the information industries shows that there are many factors at work, and the ease with which competitors can catch up with the first-mover is only one of them. There are many circumstances in which the monopoly protections afforded by copyright and patent laws are not at all important to the success of innovations; and there are also many circumstances in which copyright and patent laws are actively anti-innovation, because they can be, and are, much-used as a means of slowing down innovation by competitors.

The Conventional Economic Perspective

The main body of economic theory has been developed in the context of real estate and physical goods and services. Various terms are used to refer to that body of knowledge, such as 'rationalist' and 'neo-classical'. The term 'conventional' is used here.

Conventional economic theory assumes scarcity, in the senses that there are limits to the quantity of the tradable item, and one party's possession and use of a tradable item deprives other parties of the possibility of possessing and using it.

The assumption of scarcity is carried over when conventional economics is applied to the information industries. It is combined with the further assumptions that:

Conventional economic analysis results in the following interpretation of innovation:

The conclusions the theory reaches are that:

This provides the justification on which copyright-expansionists and patent-expansionists rest their case.

The 'Information Economics' Perspective

But information is not scarce. And the digital era has seen all aspects of information production and reticulation greatly changed, with much more rapid and less expensive access to information.

An alternative, more recent, body of economic theory removes the assumptions that tradable items are scarce, and that one party's possession or use of them deprives others of possession and use.

The information economics analysis makes assumptions very different from conventional economics:

The perspective on innovation is also quite different from conventional economics:

The conclusions are accordingly very different as well:

The analysis, and these conclusions, are fundamentally at odds with conventional economic analysis, and with the justifications used for copyright and patent extensions to advantage existing, large information-industry corporations.

Application of the Analysis to Open Source Software

The information economics perspective on innovation can be applied to any and all information industries, across hardware, software, communications and content.

One especially active, and to date very poorly understood, segment of the new economy is open source software. Open source involves the assertion of copyright in software, but the provision of licences under liberal terms.

The open source approach is distinguished from hitherto conventional 'proprietary' or 'closed' source ideas. Under the old philosophy, owners decline to make source-code available, and apply very restrictive licensing terms to the executable code. Closed-source approaches represent the active exercise of copyright law by the owner in an endeavour to maximise financial returns, and as a direct weapon against both competitors and customers.

The rationale underlying open source software is that the source is exposed to the view of many people's eyes, and hence the discovery and fixing of quality and security defects is facilitated, and cumulative enhancements are made possible.

Some software providers reject the idea that closed-source is harmful, and that open-source is beneficial. Microsoft goes so far as to oppose open source software on ideological grounds, arguing that it is socialist, precludes profit being made, and therefore undermines investment and innovation.

Microsoft's arguments are self-serving, and clearly not in tune with contemporary realities. Open source is consistent with the information economics perspective on innovation. Moreover, open source does not in any way preclude conventional markets; it merely shifts the nature of the tradable item. Users, rather than being restricted to purchasing a mysterious object that can be executed on a computer, are able to inspect, understand and enhance what they have bought.

Active open source markets have emerged in systems software, utilities, application components, and entire applications. It is very important to innovation, and to an active economy, that the open source software sector be given free rein.

Moreover, a flourishing open source marketplace does not necessarily mean the death of Microsoft, nor of the closed approach more generally. Closed-source providers will compete successfully against open-source providers where their customers are tightly locked-in, and where the closed-source provider has a product that is genuinely better fitted to customers' needs than the products offered by their open-source competitors.


Analyses based on conventional economics are of no use in the information industries, because conventional economics assumes scarcity, whereas information, especially digital information, is anything but scarce. The appropriate form of economics to apply is information economics.

Information economics shows that innovators can achieve returns even if they only have quite limited monopoly rights.

The prevention of distribution of mere imitations without enhancement is justified; but that requires at most some minor refinements to longstanding copyright law, and none at all to longstanding patent law and practice.

The substantial extensions to copyright law, and to patent law and practice, that have already been granted in response to the lobbying of large, entrenched corporations are seriously harmful to innovation in the information industries. The further extensions and powers that these corporations are seeking would compound the problem.

It is essential that the current round of demands from powerful information industry corporations be rejected, and that the excessive extensions that they have already been granted be wound back.


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Clarke R. (2003b) 'Open Source Licensing' Xamax Consultancy Pty Ltd, 25 September 2003, at

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The Authors

Roger Clarke is Principal, Xamax Consultancy Pty Ltd, Canberra. He has Honours and Masters degrees in Commerce, and a doctorate in information systems. He is also a Visiting Professor in the Baker & McKenzie Cyberspace Law & Policy Centre at the University of N.S.W., and in the E-Commerce Programme at the University of Hong Kong, and a Visiting Fellow in the Department of Computer Science, Australian National University.

Gillian Dempsey is a barrister, in Carlill Chambers, Level 31/239 George St, Brisbane. She has a law degree and a doctorate in the economics of information law, and was admitted to the Queensland Bar in 2000. She has held posts at the Australian National University and the University of Queensland, and as a Distinguished Visiting Professor at the University of Toronto Law School in Canada.

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