Prizes and Patents: Using Market Signals to Provide Incentives for Innovations



1. Introduction

Prosperity and economic growth depend fundamentally on innovation, that is, on the pro-
duction of new ideas, goods, techniques, and processes. In the endogenous growth models (e.g.,
Aghion and Howitt 1992, Grossman and Helpman 1991, Helpman 1993, Romer 1990) knowledge
advance and innovations are the key driver of economic growth. A widely shared belief is that
competitive markets, on their own, will produce an inadequate supply of innovation. One argument
that supports this belief is that many types of innovation have public good characteristics. The cost
of producing an idea or the first unit of a good is large. The cost of replicating an idea or producing
copies of an innovation is small, especially compared to the cost of innovating. In the absence of
intellectual property rights, competitive markets will produce duplicates and sell them at essentially
marginal cost. The producer of the first unit of the good will then be unable to recoup the costs of
innovation and will rationally choose not to innovate.

An extensive literature on innovation has discussed the efficiency of various mechanisms
intended to increase the level of innovation above that produced by the competitive markets.1 The
central question in the theory of intellectual property rights is to determine the best mechanism that
weighs the social benefits of innovation against the costs of distortions imposed by the mechanism.
One frequently used mechanism is the patent system, which grants property rights to innovators
for some period of time and prevents competitors from copying the innovation. Granting monopoly
rights of this form induces innovation by allowing inventors to recoup the costs of an innovation.
However, patents impose the usual deadweight costs of monopoly on the society. The classic analysis
of patents (see, e.g., Nordhaus 1969) weighs the costs of monopoly distortions against the benefits
of encouraging innovation. Patents are central to growth theory as the mechanism generating
innovation but at a cost of associated monopoly distortions (e.g., Romer, 1990, Grossman and
Helpman, 1991, Aghion and Howitt, 1992, O’Donoghue and Zweimuller, 2004). It is not surprising
that the issue of how to design patents plays an important role in endogenous growth theory (see,
for example, an entire chapter devoted to this issue in the textbook by Aghion and Howitt 1998).

An alternative mechanism is to award prizes.2 Prizes reward innovators while making the
fruits of the innovation public. Competitive markets then produce an efficient number of units of
the good or exploit the idea associated with the innovation as efficiently as possibly. This mechanism

1See Scotchmer (2004) for a comprehensive treatment.

2The classic analysis by Wright (1983) discusses patents and research prizes. See also Hopenhayn, Llobet, and
Mitchell (2006) for a modern mechanism design treatment of prizes, patents, and buyouts.



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