The Knockoff Economy

by Kal Raustiala

  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.* 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.

  Gosline’s study suggests that fake luxury goods are a very effective form of advertising: people who buy them and live with them have a significant probability of being converted to the brand and buying the real thing once they can afford to do so. Copies, in short, are a kind of “gateway drug” that leads to consumption of the harder (or at least, more expensive) stuff. What’s more, every time consumers go out with their fake item, they’re publicly displaying the desirability of the brand, sparking trend-driven consumption that spills over—or up—to the original version.

  Gosline’s and Barnett’s findings are broadly reinforced by other recent research. A 2011 study by economist Yi Qian for the National Bureau of Economic Research looked at data from 31 branded shoe companies, as well as a number of counterfeiters, operating in China in 1993-2004. The study likewise found that counterfeiting had a surprisingly positive effect on the sales of high-end branded items. The tendency of counterfeits to advertise the desirability of the branded product—what we will call the “advertising effect”—outweighed any su
bstitution effect, by which we mean the effect of consumers purchasing the counterfeit instead of the original. The substitution effect is harmful for creators, and the advertising effect is helpful. And only for low-end branded products did the substitution effect outweigh the advertising effect.

  These results lead to two key points. First, trademark can actually provide some of the value to innovators that patent and copyright are designed to offer. Owners of well-known brands can often maintain a stable market share and demand a significant price premium for their products—even when cheap copies are widely available. Pfizer can charge high prices for Advil to those who prefer the brand name; CVS can sell generic ibuprofen to everyone else. Second, copies of branded goods—counterfeits—can have a counterintuitive effect on originals. While these copies can steal away some would-be buyers of the original, they also can help create new buyers through the advertising effect. Some counterfeit buyers “graduate” to the real thing, whereas others who never buy a counterfeit become buyers of the original because the counterfeits serve as advertising.

  And importantly, this second point is not limited to formal brands—that is, to the kinds of brands protected by trademark law. The basic dynamic of the advertising effect can also be seen in individual creators, who can build a very valuable name for themselves as innovators.

  Los Angeles-based chef Ludovic Lefebvre, for instance, is not a brand in the formal sense. But his name and personality draw big crowds, providing him with several ways, besides actually getting behind the stove, to gain value from his skill as an innovative chef: cookbook author, consulting chef, Top Chef: Masters contestant, and so forth. In 2011, he even debuted his own television show, Ludo Bites America, on the Sundance Channel. And it is enough to know that a new restaurant is run by Lefebvre—or by any of a number of other famous chefs—for legions of fans to show up.* Like shoppers in the shoe store seeking the Adidas rack, they know what the Ludo Lefebvre brand entails.

  Unauthorized copies, in turn, can serve as unintended advertisements in the same way we have described. In some cases the unauthorized copy is a noteworthy dish that soon appears in competitor restaurants and sparks interest in the original. Being copied in this way can reinforce a reputation as an innovator and elevate a chef’s standing in the public eye. In other cases, as with Pearl Oyster Bar and Ed’s Lobster Bar, what is copied is not a dish (or two) but an entire restaurant or culinary approach. As described in Chapter 2, Pearl Oyster Bar and Ed’s Lobster Bar, both located in downtown Manhattan, are pretty similar in look, feel, and menu, though whether Ed’s is a direct copy of Pearl’s—or simply a co-equal variant of the basic idea of a New England shellfish shack—is a more difficult question that divides the food cognoscenti.

  But whatever the true answer—and the dispute settled before going to trial, so no legal ruling on the question emerged—assume for a moment that Ed’s is indeed a deliberate copy. It is far from clear that Ed’s copying harmed Pearl Oyster Bar, or for that matter that the arrival of Mary’s Fish Camp, an earlier offshoot of Pearl Oyster Bar, did any harm either. Despite being within a mile or so of each other, all three restaurants do a brisk business. (Ed’s even recently opened a satellite a few blocks away.) And on several recent visits, we found that Pearl Oyster Bar seemed to have far more business than it could handle—a result that, at least according to the 2011 Zagat restaurant guide, is the norm for Pearl. Having competitor shellfish/seafood bars that appear to be knockoffs may simply serve to trigger the advertising effect: to make customers want to try the original, and putatively best, version—or at a minimum to try all three spots and compare.* And maybe the copies have fueled a trend of oyster bar-hopping, spurring the growth of all competitors.

  Advertising via copying is perhaps the most powerful endorsement a brand can hope for. Few people believe that the celebrities in glossy product ads really consume (or are actually willing to pay for) the product they are shilling: we are too jaded for that, even if the halo effect of a celebrity somehow renders the item in question more desirable. In this sense, conventional advertisements are inherently limited because they rarely convey authentic endorsement. A copy, by contrast, is as sincere an endorsement of quality and desirability as any creator could hope for.

  Brands, first-mover advantage, norms, the power of performance, trends and fads, and open-source innovation: all are important elements in the many creative industries we have explored in this book. And to varying degrees, they provide new ideas and new approaches to the many creative and often copy-plagued industries we have not discussed. To be sure, we are not offering a guaranteed tool kit of anti-copying strategies. Nor are we Pollyannas who believe that all copying is harmless. But a clear-eyed and realistic look across the many and diverse innovative industries in the world shows that there is substantial reason for optimism, even in a world in which copying is becoming ever easier and more prevalent.

  This coming world is sometimes depicted as either a technology-driven utopia in which information finally gets to be free, or a looming cultural wasteland in which “digital parasites” destroy first one, then another, creative enterprise.34 Both of these positions are overheated and hyperbolic. Rules against copying are essential to our economy; as we have repeatedly emphasized, we do not want to abolish IP.35 At the same time, the already-existing creative fields that we have explored make plain that ever-freer and easier copying is not an inevitable death sentence for creativity and innovation. And as we will describe in the Epilogue to this book, even in an arena such as music, commonly considered the paradigmatic example of a creative industry plagued by pirates and parasites, the reality is different from the rhetoric. Music is thriving, though the major music labels are not.

  In short, creative output is a more complicated process than many assume. Our legal structure of innovation—the IP system—is but one part of that process. We will wrap up this concluding chapter by briefly considering some of the broader factors at work in innovation. These broad factors, such as the tendency, which appears endemic to human nature, to make rosy-eyed predictions about our future success, provide further support for the idea that creativity is more resilient to copying than conventional wisdom suggests.

  COSTS, BENEFITS, AND CREATIVITY

  If we step back from the particular stories we have told and consider what generally drives people to create and innovate, two basic, even obvious, factors are paramount. How much does it cost to create? And, what is the expected return on that creation? In other words, the rate of innovation broadly reflects the costs and benefits of investing time and money in creative work. Many creators, to be sure, create for the love of it. But in the end, sustained innovation requires adequate incentives. This premise is a foundation of the monopoly theory of innovation. But it is equally central to our account of innovation; in this book we have simply illustrated the many more complex creative incentives that exist, incentives that—as the sustained success of fashion, food, and the like demonstrate—keep creativity alive despite copying.

  In this final section, we want to extend the analysis with two points, both of which make us more optimistic about the future of innovation. First, the benefits of innovation are often overestimated by the innovator, which serves to induce more innovation than otherwise and may also make innovation more resilient in the face of losses from copying. Second, the costs of creation are dropping in many fields, which has a similar effect on innovation: lower cost generally means more output than otherwise. Together, these two phenomena provide more reason to think that a world of easy copying is not necessarily a world of little creativity.

  Consider first the benefit side of the equation. Copyright and patent are fundamentally about ensuring sufficient benefit to creators. Their primary justification is that they raise the expected return on innovation by ensuring that copyists cannot undercut the market for creations after they are made. Discouraging copying allows innovators to reap more of the benefits of their innovations. This much is conventional wisdom
, and we agree that IP law generally has this positive effect. But what this underscores is that the key is return on innovation, not restrictions on copying. As long as the return is high enough, we will see innovation.

  This leads to an obvious, but too often overlooked, point: legal rights are not the only way to raise that return. Innovation can be induced by other things—ranging from social norms to tax credits to prizes.* And some of the forces incentivizing innovation are even more fundamental than these—they arise not from external prods, but from basic human psychology. Consider again the cost-benefit calculation of creating something new. It is not actual return but perceived or expected return that most powerfully shapes decisions to create. And because there is good reason to think that we all are prone to overestimate the benefits that will flow from our creativity, we are likely to overinvest in it. This “optimism bias” is one more reason to think that creativity and innovation are more resilient in the face of copying than conventional wisdom would suggest.

  Optimism Bias

  Conventional thinking about innovation and IP relies on the concept of a rational innovator. It assumes that innovators calculate, either explicitly or implicitly, the cost of creation versus the size of the return they will likely enjoy. A writer might anticipate a certain advance from her publisher; a musician might estimate the sales of a new song. This expected return shapes how much effort they pour into creation and what kinds of creation they pursue. Abundant research in economics and psychology, however, suggest that their judgments are often likely to be wrong—and systematically so.