B. Zorina Khan is an excellent and underrated historian of innovation policy. In her new working paper, she questions the shift toward prizes as an innovation inducement mechanism. The basic problem economists have been grappling with is that patents are costly in terms of litigation, largely due to their uncertainty, that patents impose deadweight loss by granting inventors market power (as noted at least as far back as Nordhaus 1969), and that patent rights can lead to an anticommons which in some cases harms follow-on innovation (see Scotchmer and Green and Bessen and Maskin for the theory, and papers like Heidi Williams’ genome paper for empirics).
There are three main alternatives to patents, as I see them. First, you can give prizes, determined ex-ante or ex-post. Second, you can fund R&D directly with government, as the NIH does for huge portions of medical research. Third, you can rely on inventors accruing rents to cover the R&D without any government action, such as by keeping their invention secret, relying on first mover advantage, or having market power in complementary goods. We have quite a bit of evidence that the second, in biotech, and the third, in almost every other field, is the primary driver of innovative activity.
Prizes, however, are becoming more and more common. There are X-Prizes for space and AI breakthroughs, advanced market commitments for new drugs with major third world benefits, Kremer’s “patent buyout” plan, and many others. Setting the prize amount right is of course a challenging project (one that Kremer’s idea partially fixes), and in this sense prizes run “less automatically” than the patent system. What Khan notes is that prizes have been used frequently in the history of innovation, and were frankly common in the late 18th and 19th century. How useful were they?
Unfortunately, prizes seem to have suffered many problems. Khan has an entire book on The Democratization of Invention in the 19th century. Foreign observers, and not just Tocqueville, frequently noted how many American inventors came from humble backgrounds, and how many “ordinary people” were dreaming up new products and improvements. This frenzy was often, at the time, credited to the uniquely low-cost and comprehensive U.S. patent system. Patents were simple enough, and inexpensive enough, to submit that credit for and rights to inventions pretty regularly flowed to people who were not politically well connected, and for inventions that were not “popular”.
Prizes, as opposed to patents, often incentivized the wrong projects and rewarded the wrong people. First, prizes were too small to be economically meaningful; when the well-named Hippolyte Mège-Mouriès made his developments in margarine and garnered the prize offered by Napoleon III, the value of that prize was far less than the value of the product itself. In order to shift effort with prizes, the prize designer needs to know both enough about the social value of the proposed invention to set the prize amount high enough, and enough about the value of alternatives that the prize doesn’t distort effort away from other inventions that would be created while relying solely on trade secrecy and first mover advantage (I discuss this point in much greater depth in my Direction of Innovation paper with Jorge Lemus). Providing prizes to only some inventions may either generate no change in behavior at all because the prize is too small compared with the other benefits of inventing, or cause inefficient distortions in behavior. Even though, say, a malaria vaccine would be very useful, an enormous prize for a malaria vaccine will distort health researcher effort away from other projects in a way that is tough to calculate ex-ante without a huge amount of prize designer knowledge.
There is a more serious problem with prizes. Because the cutoff for a prize is less clear cut, there is more room for discretion and hence a role for wasteful lobbying and personal connection to trump “democratic invention”. Khan notes that even though the French buyout of Daguerre’s camera patent is cited as a classic example of a patent buyout in the famous Kremer QJE article, it turns out that Daguerre never actually held any French patent at all! What actually happened was that Daguerre lobbied the government for a sinecure in order to make his invention public, but then patented it abroad anyway! There are many other political examples, such as the failure of the uneducated clockmaker John Harrison to be granted a prize for his work on longitude due partially to the machinations of more upper class competitors who captured the ear of the prize committee. Examining a database of great inventors on both sides of the Atlantic, Khan found that prizes were often linked to factors like overcoming hardship, having an elite education, or regional ties. That is, the subjectivity of prizes may be stronger than the subjectivity of patents.
So then, we have three problems: prize designers don’t know enough about the relative import of various ideas to set price amounts optimally, prizes in practice are often too small to have much effect, and prizes lead to more lobbying and biased rewards than patents. We shouldn’t go too far here; prizes still may be an important part of the innovation policy toolkit. But the history Khan lays out certainly makes me more sanguine that they are a panacea.
One final point. I am unconvinced that patents really help the individual or small inventor very much either. I did a bit of hunting: as far as I can tell, there is not a single billionaire who got that way primarily by selling their invention. Many people developed their invention in a firm, but non-entrepreneurial invention, for which the fact that patents create a market for knowledge is supposedly paramount, doesn’t seem to be making anyone super rich. This is even though there are surely a huge number of inventions each worth billions. A good defense of patents as our main innovation policy should really grapple better with this fact.
July 2015 NBER Working Paper (RePEc IDEAS). I’m afraid the paper is gated if you don’t have an NBER subscription, and I was unable to find an ungated copy.
A Fine Theorem 
Hi, I’m not an economist but I discovered your blog via Mark Thoma and I really enjoy it. I don’t really follow the arguments you are making in this post (and forgive me if I am attributing to you claims that are actually made by Khan, and which you are simply reporting. You seem, at least to me, to be endorsing each of these):
1. That patents are more likely than prizes to be granted to the correct party, and less likely to be swayed by cronyism.
2. Prizes suffer a distinct disadvantage in so far as a prize granter must identify a particular innovation for which a prize will be granted, which decision may be “wrong” from a social point of view (maybe in part due to information constraints).
3. The size of the prize may be off, such that a too-small prize will not elicit the desired innovation, but that a “too large” prize may carry an opportunity cost in forgone innovations whose social return would be greater than that of the targeted innovation. As in 2, this is presented as a disadvantage distinct to prizes, as opposed to patents (or the absence of either prizes or patents).
Why I don’t really follow:
1. Isn’t this really a question of the specific submission and vetting processes in place in 19th century US as opposed to 18th c UK (in the case of the denial of the longitude prize to John Harrison) rather than a generic issue of prizes vs. patents? Is there any reason to think that patent-granting processes are for some intrinsic reason really hard to corrupt, while prize granting processes are intrinsically prone to corruption? This would be a lot more persuasive if the comparison were being made between prize and patent granting institutions in the same polity in the same era, rather than different polities separated by a century or so.
2. I have always understood the argument for prizes to include the claim that, given the highly unequal distribution of endowments, innovations that are beneficial to those with large endowments are much more likely to be pursued than innovations beneficial to those with small endowments, even when the latter generate a higher social return. In so far as inequality creates a wedge between private and social returns (and of course there may be other sources of such a wedge), reliance on either patents or intrinsic private returns alone in order to incentivize innovation will leave a lot of potentially socially beneficial innovations undiscovered.
3. This really seems like a non-issue: if the offered prize is too small to excite any participation, then that seems like a problem that would be discovered quickly and could be resolved quickly through a modest increase in prize size. This could be repeated until there is satisfactory evidence that the prize is being pursued.
Maybe I’m misreading this, but it seems like either you or Khan (or both of you) are suggesting that in order to establish the correct size of the prize, the granter needs to be able to calculate the social value of the targeted innovation. But Nordhaus has shown that the vast majority of the social value of innovation has not been captured by innovators, hasn’t he? Doesn’t that suggest that the prize needs to be large enough exceed a potential innovators opportunity cost, but no larger?
As to the prize potentially being too big and distracting effort from untargeted innovations of greater social value, that seems to be to be an argument that would make most sense if we assume a background in which private and social returns are closely aligned. Given that high degree of evident inequality in endowments, to say nothing of a wide variety of other frictions and market imperfections, this does not seem to me to be a plausible background assumption. I can understand a concern that a prize might be wastefully big (much more than necessary to incentivize the desired innovation), but possible distraction from superior innovations seems like a second-order concern at best (since, against a background reflecting divergences between the social and private returns to activities, we would not expect the most socially beneficial activities to be pursued absent a prize.)
You mentioned that a driving force for innovation is “Third, you can rely on inventors accruing rents to cover the R&D without any government action, such as by keeping their invention secret, relying on first mover advantage, or having market power in complementary goods”, and there is evidence on it.
Can you elaborate more on the type of evidence you have in mind, since these values tend to be “unobservable”.