Patents or Prizes?
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Invention is the lifeblood of human progress and is supported in no small part by patents. Patents enable inventors to protect their ideas within the fuzzy realm of “intellectual property.” But patent protections come with a litany of downsides. Do these downsides mask unsung merits? Perhaps patent protection exists because all other alternatives have failed. Maybe they work better than we give them credit for and with some small tweaks, we can optimize them to spur faster innovation and human betterment.
Why Patents?
Patents have a long history. Originally, patents were not intended to promote innovation at all, but arose from a dispute between the King and Parliament of England in the 1600s. The main purpose of the Statute of Monopolies, enacted in 1624, was to prohibit the King from raising revenue by selling monopoly privileges to supporters.
The US patent system improved upon the English system, simplifying the process, lowering the cost, and explicitly designing patent law as a means to encourage innovation. The US Patent Law, first enacted in 1793, also became the basis for similar laws adopted in Germany in 1877, Japan in 1888, and ultimately much of the world.
In a competitive market, innovation carries significant expense and risk. Developing a new lifesaving drug, for example, can easily cost over $1 Billion and runs a risk of ultimately failing to be commercially viable. With such stakes at hand, a rational person would bide their time, wait for someone else to incur that cost and risk, then copy the final successful product. Having avoided the cost of development, the copier can undercut the prices of the inventor.
Therefore, absent the protection that patents confer, innovators have a strong incentive to keep their ideas secret for as long as possible, hoping to recoup their investment from first-mover advantage alone. Obviously, this is suboptimal for two reasons. First, little innovation will occur if everyone waits for someone else to act. Second, those who do take on the cost of innovating will jealousy guard their IP against competitors, thereby preventing the diffusion of new ideas for human benefit.
Patent protection attempts to strike a delicate balance. Patents provide a sovereign-created temporary monopoly on an idea, allowing the innovator to (hopefully) make a profit off of that idea before it enters the public domain for all to use. As I have written at length before, however, patents come with significant trade-offs that make them a difficult pill to swallow. There are five main criticisms of patent protection.
Criticism 1: Patents fail to fully incentivize innovation because their protections enable inventors to only recoup a very small fraction of the social value of their ideas.
Criticism 2: The monopoly rights that patents confer create deadweight loss, driving up the prices of goods and services.
Criticism 3: Patents can also exclude others from using an idea, sometimes for decades, which blocks follow-on innovation.
Criticism 4: To avoid paying royalties, patents encourage other parties to “patent around” an idea, which is seen as duplicative and wasteful.
Criticism 5: Patents encourage excessive litigation when “trolls” buy and hold IP, not in the name of innovation, but by exploiting the high cost of litigation to extract money from the innovators themselves.
These problems are indeed very real, but what alternatives do we have?
Alternatives
Some have suggested that we may be better off abolishing patents entirely. Indeed, my Georgist-leaning readers probably would support total abolition. But I remain unconvinced, for the reasons stated above, that no IP protection is better on net. There are, however, other alternatives to patenting that attempt to encourage innovation without the same drawbacks.
One such alternative is government-led direct investment. If government/taxpayer funds are used to develop new IP, conceivably, that IP would then be released directly into the public domain for the private sector to use. Direct government investment can be particularly useful for investing in areas that the private sector will not, or perhaps can not. For a discussion about this, see my article on Pasteur’s Quadrant.
Prizes, however, are the most attractive alternative. In a prize system, the government offers a cash prize for inventors to demonstrate new technology or breakthrough innovations. The key advantage of prizes, as opposed to direct investment, is that the taxpayer will not need to issue payment unless and until the specified breakthrough is achieved.
To proponents, prizes check all of the boxes that patents do not. Prizes allow innovators to be rewarded, perhaps more handsomely than patents. Once the prize is claimed, most schemes call for the idea to be released freely into the public domain, eliminating deadweight loss, ending the need to “patent around” ideas, and enabling immediate follow-on innovation.
Prizes also have successful precedent. Advocates often cite the Longitude Prize of 1714 when an award of 20,000 pounds was offered by Parliament for the first inventor who could find a precise way of measuring longitude on the ocean. At the time, a significant percentage of ships were lost at sea because, while they could calculate latitude using the stars, longitude was mostly a matter of guessing and sheer luck.
The problem was solved by John Harrison, a craftsman who developed a highly precise clock, or chronometer, that worked on the rough seas where all other devices failed. With a chronometer, it became possible to precisely know the duration spent at sea for the first time. With this new additional data point, longitude could be now calculated.
Prizes Fall Short
Ironically, the Longitude Prize example also demonstrates some of the problems with them as an incentive mechanism. Anything that is government-directed will potentially be loaded with preconceived notions as to what the innovation “should” look like. Indeed, administrators refused to award Harrison for his invention, arguing that the solution needed to be based on celestial navigation, not timekeeping. Harrison spent decades lobbying for his prize money; he never received the full award and was never formally declared the winner.
To fully address Criticism 1 of patents, a prize system requires both incredible foresight and restraint on the part of the prize issuer. The issuer must be able to foresee what innovations society needs and come up with a value for it that is sufficiently motivating to the market. It must also take care to not prescribe what the innovation “should” look like. It is unclear to me that governments are reliably capable of this.
To address Criticism 2 of patents, prizes must make new innovations cheaper and reduce deadweight loss. But The Longitude Prize highlights another problem; they often reward innovations that are not commercially viable. Harrison's chronometer was so expensive that most ships continued to take their chances navigating without them. It took decades of (patented) improvements to chronometers for them to become affordable.
More on this point of expense and deadweight loss, Benjamin N. Roin argues that, in general, the literature overstates the benefits of prizes relative to patents. While prize advocates highlight the potential of eliminating deadweight loss by effectively “buying out” an idea; that funding must still come from somewhere. Unless funded via a Land Value Tax or DBCFT, there would still be deadweight loss in the funding mechanism.
The Forgotten Merits of Patents
To further expound on the point, however, it’s not actually clear that patents enable monopoly pricing in the first place. In 2016, Alexander Galetovic, Stephen Haber, and Lew Zaretzi compiled data on licensing revenues earned by patent holders of smartphone technology, comparing the revenues to the value of the smartphones shipped that year. They concluded that patent royalties accounted for an average of just 3.4 percent of the phones’ value.
Similarly, a 2017 study by Galetovic, Haber, and Zaretzi found that if patent holders could charge royalties as predicted by pure monopoly pricing, they would constitute some 80 percent of the value of the smartphone. There is, therefore, roughly an order of magnitude gap between what patents do in theory and what they do in reality. Why is this?
Patent holders cannot charge monopoly pricing (in most cases) because alternatives exist. Yes, when companies “patent around” each other (Criticism 4) they restrain the monopoly power of IP holders by providing viable alternatives. Thus, the concept of “patenting around” could be considered a feature, not a bug, of the system.
But is this wasteful and duplicative as critics contend? Perhaps it is in some cases, but in many instances, the very act of innovating around a patent might illuminate better ideas in the process. Further, as Benjamin Roin notes, it would also be foolish to assume that this doesn’t happen in a prize system as well. Indeed, because there is usually only one winner of a prize, every other participant who expended resources without reward could be seen as equally “wasteful.”
As to Criticism 3, that patents block follow-on innovation, Stephen H. Haber and Naomi R. Lamoreaux argue that patents are fundamentally misconstrued and misunderstood. Specifically, they do not merely exclude others from an idea, but instead, actually help ensure that idea is shared so that it may diffuse into society for human benefit.
Patent holders have an incentive to share non-patented knowledge with licensees who need this technology to make the patent work. Instead of blocking the diffusion of technology, as critics contend, patents actually enable that diffusion to occur more readily. Victor Menaldo argues that patents helped advance the Spanish steel industry between 1850 and 1930 because patent holders, had to share blueprints and train steelmakers with the tacit knowledge that made their patented technology work.
Roin agrees, noting that prize advocates assume that once an idea enters the public domain it will be freely available for all to use in the marketplace. We know this is not true because patents are often accompanied by trade secrets. In a prize system, market players may no longer have access to patent protection, but they still have every incentive not to share the trade secrets and tacit knowledge that makes them work.
Thus, in a bizarre twist of poetic irony, everything that appears wrong with patents on the surface is actually what makes them uniquely effective. The purported weaknesses of patents in theory conceal hidden strengths that give them advantages over prizes in reality.
Improving Patents
None of this is to suggest that patenting is perfect. Indeed, I still view them as a kind of fly in the ointment, a necessary evil. But perhaps they can be improved so as to mitigate some of their drawbacks while preserving their core function.
As I discussed here, we could impose a small Harberger Tax on IP. This small recurring tax could discourage patent trolling by imposing a cost on squatting on patents. Furthermore, a Harberger Tax will illuminate the value of an idea, making buyouts possible, and litigation less costly and time-consuming if and when it occurs (addressing Criticism 5).
Such a tweak to the current system would preserve the function of patents as a pathway of technological diffusion whilst filing down their rough edges. Ultimately, no single silver bullet to encourage innovation likely exists, but a mix of the proper tax design, direct investment, well-defined prizes, and reformed patents, could go a long way toward accelerating progress for a better future.
Patents or Prizes?
Patents don't have to be, right to exclude, which causes a patent thicket, where no one can do anything. Why not make patents a right to license instead of a right to exclude. Anyone can now use any and all patents for a reasonable fee. As you have pointed out, investors only fund the development of tech with the greatest ROI, but innovators are more open to interesting problems. Rather than approach this as an economic problem, why not approach it as an innovation problem. Ask innovators what will produce the most innovation and for the least effort. As opposed to what will produce the most ROI.
I’m glad you are taking multiple angles to look at the structure that rewards innovation. I find the subject very interesting and complex at the same time.
Having studied economics, I appreciate the power of incentives. Knowing a bit about human nature, I also see how once the rules of the game get established, clever innovators try everything possible to play the game for the greatest advantage. Often, the work-arounds become the game.
I see the world as a complex mix of systems. The government directly funds certain R&D (or gives grants to universities to do it), some of which goes on to become privately patented for profit. Perhaps government investment followed by prizes might be an interesting combination.
I also wonder whether different market segments should have different systems or different patent rules. I specifically question the rules that apply to pharmaceutical products. My thoughts are still mostly in the form of questions at this point, rather than conclusions or suggestions.
Thank you for providing this analysis!