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

does not necessarily hold. Indeed, we can show that a mechanism which induces truth telling exists.
Specifically, suppose that the planner chooses in each period a mechanism similar to the Moore
and Repullo (1998) mechanism described above. Let the planner set the Stage 2 transfers to the
competitor at T > B. By the same argument as in the section on the unique implementation in the
single period game, it follows that the competitor always tells the truth regardless of the innovator’s
strategies. Thus, manipulation in the form of implicit collusion alone does not suggest that patents
are optimal.

7. Market signals with costly manipulation

We have shown that if the innovator can manipulate market signals by bribing other partici-
pants, patents are optimal. We now examine economies in which the innovator can manipulate the
market signals in other ways. We show that if manipulation is costless, then patents are optimal.
If manipulation is very costly, prizes are optimal. For intermediate ranges, a combination of prizes
and patents is optimal. An example of how in practice such costly signal manipulation may be
arranged in practice is hidden buybacks. That is, prizes can be manipulated by the innovator (or
its accomplices such as subsidiaries or related parties) secretly purchasing the good so as to make
it seem that the market size is larger than it is.

We begin by describing a fairly abstract environment in which the planner receives the signal
s about the quality of the good innovated. The innovator can manipulate the signal by incurring
the cost. Specifically, by incurring a cost c (s — 0), c ≥ O, the innovator can ensure that the planner
receives a signal s. Note that if the innovator does not manipulate the signal, then s = 0, so the
signal reveals the quality of the good perfectly. With this formulation, the payoffs of an innovator
who has an idea of quality 0 and chooses to report the idea of quality 0 are given by

V ^m(0, 0,₇ ) = 5(0) ∣r (0>(₇0) — -h + T (0) — c[0 — 0j J .                  (19)

Incentive compatibility now becomes

V ^m(0,0,δ (0)) ≥ max V^m (0,0, δ (0)).

e∈[o,e]                  ^{v 7}

The social planner’s payoff, voluntary participation, and the no money pump constraints are
unchanged. The social planner now maximizes the social surplus subject to the incentive compati-
bility constraint (20), voluntary participation (5), and the no money pump constraints (6).

19

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