The Knockoff Economy (32 page)

Databases also exhibit some degree of first-mover advantage. Like an innovative football team deploying a new formation, a successful database can remain competitive due to the need to train users in the new interface. What do we mean? As law professors, we rely heavily on legal databases such as Westlaw. These databases charge paying customers a substantial fee, and they require extensive training to learn to use well.
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That training begins in
law school, and the big database companies allow students to use their products for free as a way to get them to learn—and to become hooked. Once a law student becomes comfortable with Westlaw (or its primary competitor, Lexis-Nexis) he or she is unlikely to shift to another database. The result is that even if we create a new database tomorrow with all the legal materials contained in Westlaw—and lower prices—we will have a hard time competing with the incumbent firms, who know that lawyers who have spent years, if not decades, using one system are unlikely to start over just to save a few bucks.

Probably the most common example of first-mover advantage is software. Being first—and creating a network of users that all rely on the same program and, as a result, can easily share files and documents—can give decisive and durable advantages to the first mover’s product. And that can lead to substantial market control and lasting profits. We wrote this book using Microsoft Word, not because it is the best word processing product in existence, but because we both already had it (and it is plenty good for our purposes). There is not much competition in the word processing world, and that is partly because we all know that if we have a Word document we can send it to virtually anyone and that person too will use Word to open it. We are all part of the Word network, and that makes sharing and communicating easy—and Bill Gates rich.

Only a few industries exhibit such “positive network externalities,” as economists call them: benefits that accrue from the fact that others are using the same network. The simplest example of network externalities is a telephone: a single phone is useless, two phones on a network are nice, but hundreds of millions of connected phones are much, much better. Each additional phone on the network makes the other phones more valuable. As we have just discussed, first-mover advantages can certainly accrue in the absence of positive network externalities. But when these externalities exist, the power of first-mover advantage is much greater. The ability to lock consumers in a network that they do not want to leave makes it easier to defeat new entrants into a market, even those that mimic or improve on an existing product.

Think of (the short) history of social networks. Perhaps Facebook, so dominant today, will give way to Google +. But many people do not want to shift over to Google + because their friends are all on Facebook. It is not impossible to dislodge a leading product even when network externalities
exist—Friendster and Myspace, after all, were ultimately buried by Face-book. But it is more difficult. When products exhibit positive network externalities, first-mover advantages are very powerful.

In sum, first-mover advantage is a key concept not just in the industries we have explored but in all IP-protected industries. The fundamental purpose of copyright and patent is to create first-mover advantage: IP laws regulate second movers so the first mover has ample time to make money. Our point is simply that first-mover advantage still exists when IP law is absent or ineffective, and in some cases first-mover advantage is powerful enough to sustain a meaningful level of innovation. In others, such as fashion, it is a necessary input into a more powerful dynamic of innovation.

Brands play an important and often unappreciated creativity-inducing role in several of the industries we have explored in this book. By brands we mean familiar names and symbols such as Nike and its swoosh or Apple with its famous apple-with-a-bite-taken image.

Brands are protected by trademark law. The traditional justification for trademark protection has little to do with innovation. Instead, trademark functions to ensure that consumers can identify the source of products and thereby buy the item they want, and not an imitation. Put in economic terms, trademarks reduce the search costs associated with consumption. If you’ve had a positive experience with basketball shoes from Adidas, then marking them with the trademark-protected three-stripes helps ensure that you can quickly find their shoes the next time you are shopping. And of course it also lets everyone else know which shoes you prefer.

So brands are fundamentally a shortcut—rather than try on lots of shoes, we save time by heading straight for the Adidas rack. Brands can be extremely valuable as a result, and firms take expensive measures to develop and protect them. Legally, trademark law prevents the unauthorized use of a brand in a way that would confuse consumers about the source of products or services. But trademark law goes further. It also aims to prevent anything that would “dilute” consumers’ ability to associate a famous brand with the brand’s owner, as well as any uses of the brand that might tarnish its image.

Unlike patent and copyright, trademark law is not generally thought of as a spur to creativity. In fact, over a century ago the Supreme Court struck
down the Trademark Act of 1870 on precisely this ground. The act was created under the part of the Constitution that authorizes Congress to make patent and copyright law, which are powers given to Congress “To promote the Progress of Science and useful Arts.” Trademarks, the Court said, have “no necessary relation to invention or discovery.”
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For that reason, Congress’s power to enact a trademark law could not be grounded in the power to “promote … Progress.”
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While that view has a superficial appeal, it misses some important effects of trademarks. Trademarks can, in fact, function as an incentive mechanism, only in a different manner from that of other IP rights. And as we will describe, trademarks can interact with other creative incentives in important ways.

The power of brands is very apparent in any big drugstore. Walk into a CVS drugstore, as we did recently in Charlottesville, Virginia, and you can buy, for $20.99, 300 tablets of Advil brand ibuprofen. That is just under $0.70 per tablet. The CVS private label ibuprofen—which contains exactly the same dosage of the same medicine—costs $17.79 for 750 tablets, or about $0.24 per tablet. The Advil brand ibuprofen, in other words, is almost three times as expensive as the CVS ibuprofen, despite the fact that they are functionally indistinguishable—they will both get rid of your headache equally well. And this situation is not limited to medicines. On a recent visit to a local grocery in Charlottesville, for example, we found that a 14-ounce box of Cheerios cost $4.59. A 14-ounce box of the store-brand version—the same basic product, except for the packaging—cost $2.75. Despite this significant price differential, Cheerios are the best-selling brand of cereal in the United States.
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As this shows, brands have a strong power over price. And as a result, they wield an unexpected ability to spur innovation. The story of ibuprofen can help explain this relationship. Ibuprofen was invented in the early 1960s by the UK firm Boots, which runs a large chain of drugstores. First patented in
1961, it was introduced in the United States as a prescription drug in 1974. In 1984, the FDA approved ibuprofen for over-the-counter (OTC) sale. That same year, Pfizer reached a license agreement with Boots and introduced OTC ibuprofen under the brand name “Advil.” Boots’s US patent expired in 1986, and soon after other brands of ibuprofen entered the market.

So in all, Pfizer’s Advil brand of ibuprofen had less than two years of market exclusivity in the United States. After those two years, many competitors jumped in. And yet today, almost 25 years after the expiration of the ibuprofen patent, Advil still owns
51% of the market.
That’s more than twice the combined share of all generic ibuprofen products, despite the fact that Advil is functionally equivalent to its rivals and quite a bit more expensive.

Why are consumers willing to pay so much for certain brands? There is surprisingly little consensus among researchers about this. Part of the brand premium is surely based on perceived quality differences, and some studies suggest that beliefs about quality may account for perhaps 20% of the difference. The degree to which perceptions of quality matter, however, is likely to differ widely based on the product and the amount of information the consumer has about it. For breakfast cereal, where quality is fairly subjective, it makes sense that consumers pay more for those brands they think represent high quality. But this rationale makes less sense in the case of a basic pain reliever like ibuprofen, where the FDA certifies that the generic drug is as safe and effective as the branded pill. The brand itself seems to have some effect on the willingness of consumers to pay more.

So brands can keep prices high and give firms large and resilient market shares. That brands can have such huge effects explains why companies spend so much money promoting them and designing nifty names and symbols. This much is well known. But the power of brands also has important implications for innovation. If an innovator can link her innovation to a successful brand, she can maintain pricing power even after his innovation is copied. This is the key takeaway of the ibuprofen story. The patent on Advil gave only two years of monopoly control. Yet decades later, Advil still dominates the market for ibuprofen. This suggests that whatever the period of exclusivity, once the brand is established the innovator can continue to profit—substantially—even after the entry of copies, and even if the copies are quite literally identical products. The brand, in effect, can substitute for the protection against copies offered by patent or copyright.

Think back to the Two Pesos-Taco Cabana dispute that went to the Supreme Court, described in
Chapter 2
. In that case, the issue was whether one Mexican restaurant illegally copied the décor of another. The key to the case was the idea that décor can be a kind of trademark: its purpose is to signal that you are at Two Pesos (or Taco Cabana—they were so similar it is hard to tell them apart). The decor serves to indicate source and quality.

By protecting trade dress, as this is formally known, the law allows copies of one very important part of a restaurant experience (the food) while policing copying of another (the décor.) As long as the décor meets the legal standard—that is, as long as the public associates it with the particular restaurant—it is protected. In this way, trade dress protection partially protects innovation, permitting competitors to copy some things but not others—and allowing an originator to keep a larger share of the market than they would otherwise.

The fashion industry offers a twist on this scenario. As we have explained, neither patent nor copyright really protects new fashion designs from copying. And yet the fashion industry is stocked with very valuable brands, and the owners of those brands are often able to demand a giant premium for their products despite the fact that they compete against often very close copies. Some of this price differential is due to quality differences—the $45,000 Patek Phillipe watch is much more expensively made (though perversely, it is often less accurate) than its $45 Canal Street knockoff. But not nearly all of it. A big part of the trademark premium is the excitement, and the perception of increased social status, that comes from owning a real Patek Phillipe.
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The same can said of a Proenza Schouler dress or Prada coat.

And where does that set of feelings come from? From the meaning that brands, and the advertising associated with them, create. The process of creating this meaning is expensive and difficult. There is no foolproof recipe for it. But if the alchemy succeeds, the result can be astonishing. The monopoly theory of IP suggests that perfect copies will deprive innovators of any significant returns on their investments in creativity. But when an innovation is linked to a valuable brand, copies are never perfect. Indeed, they differ in perhaps the most important feature.

The bottom line is this: in the many contexts in which brands are significant but patent and copyright are absent or weak, market share and pricing power will not necessarily disappear. They will just flow from the power of brands, rather than from legal enforcement of a monopoly. Copies may compete with the original, but brands keep them from truly outcompeting the original based only on price. And this, in turn, preserves some of the reward that monopoly power over copying is meant to provide.

Brands have an interesting relationship to copies in another very important way. Copying may serve as
advertising for brands
—advertising that is not only free but arguably more powerful. Why? Because it stems from the authentic actions of consumers rather than the carefully orchestrated efforts of producers.

In a fascinating paper, legal scholar Jonathan Barnett explored the ways in which, in the fashion industry, brand owners benefited even when knockoff artists not only took their designs but also counterfeited their brands. Barnett argued that the presence of counterfeits may actually help brand owners by signaling to high-end consumers the desirability of the original item as part of an emerging fashion trend. Because the counterfeit copies are most often of lower quality, consumers usually can tell they’re not the real thing. At the same time, Barnett argues, their presence on the streets signals that the dress, handbag, or shoes they are aping are especially desirable. Counterfeits communicate the fact that even those who can’t afford to have the real thing still want it. That’s a free ad for the branded product.

Other studies support the power of copies as a form of advertising. A two-and-one-half year study by Renee Gosline of the Massachusetts Institute of Technology looked at people who purchase counterfeit luxury items, like handbags and sunglasses, and found that counterfeits do not hurt the sales of luxury brands so long as consumers can distinguish between them. Indeed, Gosline found that counterfeits are often used as “trial versions” of the high-end genuine branded item, with over 40% of counterfeit handbag consumers ultimately purchasing the real brand.