has the advantage that it avoids the monopoly distortions associated with patents. The disadvantage
of this mechanism is that it requires the entity awarding prizes to have a great deal of information
about the social value of the innovation. This social value is often not directly available to the prize
giver. Thus, an important question is, how can the prize giver use information from competitors in
the industry or, more generally, from the market to elicit the social value of the innovation?
This question is particularly interesting in the context of the theory of innovation because
those who argue that innovation has public good characteristics explicitly assume that copies of
innovated goods can be produced at little more than production costs. In other words, once the
good is invented, competitors in the marketplace have a great deal of information on how to produce
the good in question. The social value of the good depends crucially on the number of units of the
good that will be sold in the competitive marketplace. Any theory of patents as a form of intellectual
property must ask why mechanisms cannot be devised which exploit information that will become
available in the marketplace after the good has been innovated.
In this paper, we ask whether market signals can be used to reward innovation appropriately
while avoiding the deadweight costs of monopoly. We answer this question by setting up a general
mechanism design framework. In this framework, a planner can use information from innovators,
competitors, and the marketplace to reward the innovator. We first consider an environment in
which the innovator cannot manipulate the information about the value of the innovation. We show
that a prize-like mechanism can induce socially efficient levels of innovation and completely avoid
the deadweight losses of monopoly. We then show how to construct a mechanism that yields a
socially efficient outcome as a unique equilibrium. In terms of implementation, such mechanisms
may take a variety of forms. For example, a mechanism that makes the prize for the innovation a
function of total sales in competitive markets can implement socially efficient levels of innovation.
We then analyze several classes of environments where the innovator can manipulate market
signals. Two forms of market manipulation are of particular interest: bribes and costly signal
manipulation. In terms of bribes, we assume that the innovator can make binding commitments to
make payments to market participants. For example, if the mechanism involves the use of prizes
which are functions of aggregate sales, we allow innovators to bribe other producers to induce them
to misrepresent sales. We show that bribes of this kind can be used by the innovator to subvert
market signals completely. Indeed, we show that the best mechanism necessarily resembles patents.
Society must then necessarily incur the deadweight costs of monopoly to induce innovations.
In terms of other forms of market manipulation, we show that prize-like mechanisms are