“Inventing Prizes: A Historical Perspective on Innovation Awards and Technology Policy,” B. Z. Khan (2015)

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.

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“Inducement Prizes and Innovation,” L. Brunt, J. Lerner and T. Nicholas (2011)

Patents have many problems, deadweight loss from temporary monopoly being only one of them. There are also patent thickets where so many patents bind on any downstream investment, particularly in high tech, that patenting is only a defensive move – apparently these were less politically correctly called “Mexican standoffs” in the literature in the 1970s. There is the problem of inducing invention toward favored fields since patents treat everyone equally, and Moser’s lovely 2005 AER shows that in the era when patents were limited to fewer industries, they definitely affected the direction of innovation. These problems have led to proposals for prize systems to partially replace patents, such as the proposals of Michael Kremer, or the X Prize contests. But is there any evidence that prizes work?

Brunt, Lerner and Nicholas look at a system of prizes given by a Royal Society in the UK for agricultural improvements between 1839 and 1939. A year before each annual agricultural fair, a list of targeted invention areas was published, along with monetary prizes and “medals” which could be awarded; the McCormick Reaper won a Gold Medal, for example. Inventors were still allowed to patent. The monetary prizes were generally less than the sale price of even a single unit of a new invention, but the medals and monetary prize lists were publicized fairly widely and were thought at the time to be a valuable marketing tool. For a couple decades in the mid-1800s, the general targeted area rotated in a three year cycle and there were no major changes to the relevant patent laws. Patents in the UK were quite expensive, and required an expensive renewal after three years, so many studies have used “renewed patents” as a cutoff for signal for economically important invention; note that even this is not perfect, though, due to many inventions like the spinning jenny not being patented at all.

The monetary prizes were small, so unsurprisingly in the most convincing econometric specification, they induce little invention in the patent record of the product area targeted in any given year’s contest. But medals were valuable, and an announced possible gold medal for improvements to, say, harvesting technology caused a roughly 30 percent increase in the number of renewed patents that year (as well as, of course, a substantial increase in the number of annual fair entrants in that area). A test also checks against switching – that is, are the increases just due to displacement from the years when two previous years that no prize was offered in the targeted area? Checking patents by non-entrants only finds the positive effect of the prize announcement remains, and in an economically meaningful way. My takeaway from this paper is that it gives little evidence about the elasticity of monetary prizes to directed invention, but that it does show that high profile contests are capable many potential inventors to shift effort in a desired direction. Certainly this could be meaningful for, say, NIH or NSF driven contests and the like.

One final quibble, though. I have a pet peeve about famous papers being cited inappropriately. In the present paper, Lazear and Rosen’s 1981 tournaments result is mentioned as being relevant because it says prizes like those offered in these agricultural fairs induce higher effort among potential inventors. I don’t buy this. For one, Lazear and Rosen’s result relies on firms in a competitive labor market hiring those workers, and the existence of other firms who can make offers to the potential inventors is critical for the result. Second, these contests aren’t even tournaments in the sense of Lazear and Rosen: the number of prizes (or even whether a medal was awarded at all) varied depending on the quality of the entrants. Lazear and Rosen specifically deal with the case where the best, in the ordinal sense, worker always wins the prize.

http://www.prizecapital.net/Prize_Capital/Prizes_files/11-118_1.pdf (2011 HBS Working Paper)