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

If the market participant’s bid is higher than the true value of the innovation, then that market
participant is better off bidding zero. If the other participant’s bid is below the patent’s value to
the innovator, the innovator should raise his bid to the true value. Thus, in any equilibrium of
the subgame, the innovator receives the patent with probability e, pays 0 and retains the monopoly
profits and with probability (1 — e) loses the patent and receives a prize of 0. If the innovator chooses
not to submit the innovation to the auction, the innovator receives the monopoly profits. It follows
that not submitting the patent to the auction yields higher profits.

Other forms of manipulation lead to different equilibrium outcomes but share the property
that the auction mechanism will not help solve the problem of reducing the deadweight losses.
To see the effects of other forms of manipulation, suppose that the innovator can designate two
accomplices to the auction mechanism. Then the equilibrium outcome in the auction mechanism is
for each accomplice to bid the maximal amount permitted by the auction mechanism. The other
market participants then bid zero. These strategies are clearly best responses. Yet, the mechanism
leads to too much innovation compared to the optimum.

9. Conclusion

Our paper is a mechanism design treatment of providing incentives for innovation. We
explored how information available to the competitors of the innovator and market information can
be used by the mechanism designer to create such incentives. Our focus is on the various ways in
which information may be manipulated and on designing optimal mechanisms which are robust to
such manipulation.

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