Patents, Prizes, and Subsidies

Course Outline

Patents, Prizes, and Subsidies

Growth on the cutting edge is all about the creation of new ideas.

So, we want institutions that incentivize such creation. How do we do this? The answer is somewhat tricky.

The first goal for good ideas is for them to spread as freely as possible. The further the reach, the greater the gains. The problem is, if just anyone can use ideas, then why would we ever pay for them? And without the right incentives, why would innovators create new ideas at all?

Imagine yourself as the creator of a new drug. Typically, it costs about a billion dollars to do this, not counting the time and effort needed, to get the drug FDA-approved.

Now, if there were no protections in place, then theoretically, once the formula’s known, everyone could just copy the make-up of your new drug. See, the thing about pharmaceuticals is, once the formula’s known, production is relatively cheap. Given that, let’s assume imitations start flooding the market.

Predictably, the price of your new drug will plummet.

Once prices hit rock-bottom, you’ll have no way to recoup the $1 billion you spent on R&D.

Given that kind of result, we reckon you probably won’t want to develop more good ideas.

The US founding fathers anticipated this problem. Knowing that innovators needed incentives to have good ideas, the founders wrote a protection mechanism into the Constitution.

They gave Congress the ability to grant exclusive rights to inventors—rights to use and sell their inventions, for a limited period of time. This exclusive right, is what we call a patent. Patents grant inventors a temporary monopoly over the use and sale of their intellectual property.

Now, as nice as this is, patents are a thorny subject.

For one, how long should patents last? Also, how much innovation is considered enough to merit a patent grant? Not to mention, are patents the only way to reward good ideas?

The answer is no.

There are two more incentive options here: prizes, and subsidies.

Let’s start with subsidies. University and research subsidies are particularly effective in the basic sciences. Since innovations in this space are rather abstract, subsidies incentivize research without requiring the applications of the research to be explicitly named. The problem is, when we’re incentivizing just research, then researchers might pick directions that are interesting, but not particularly useful.

This is why the third incentive option—prizes—exists.

Prizes reward the output of solving a certain problem. Another plus, is that prizes leave solutions unspecified. They provide a problem to work on, but give quite a lot of leeway as to how the problem is solved.

Now, knowing the complexity inherent in patents, you might think that prizes and subsidies are good enough alternatives. But none of these incentives for ideas, are inherently better than any of the others. Patents, prizes, and subsidies all involve their own tradeoffs and questions.

For example, who decides what gets subsidized? Who decides which goals merit a prize?

It’s hard to determine what mix of institutions, will best incentivize the production of good ideas. Patents, prizes, and subsidies all navigate these conflicting goals, in their own way.

And yes, all this talk of incentives and conflicting goals and tradeoffs might be like walking a tightrope. But, it’s a tightrope we can’t opt out of. Certainly not if we want the economy to keep growing.

In our next release, you’ll watch a TED talk from a certain economist that elaborates further on ideas. And then, we’ll wrap up this course segment with the Idea Equation. Stay tuned!


Growth on the cutting edge is all about the creation of new ideas. So, we want institutions that create incentives to produce new ideas. Ideas, however -- they've got some odd properties and it makes this kind of tricky. Two people can't use the same shovel at the same time. If one person's using the shovel, the other person can't. That's pretty obvious. Two people, however, can use the same idea at the same time. In fact, the same idea can be used by millions of people and then millions more. In the language of economics, ideas are nonrivalrous. Or we might say that ideas are made to be shared. We want to spread good ideas as far and as wide as possible because the more people who use a good idea, the greater the gains.


But, there's a problem. If no one is ever excluded from using a new idea, who will pay for new ideas? And if no one pays for new ideas, then what incentive will there be to create new ideas? Let me give an example. It takes about a billion dollars and years of research and investment to come up with a new drug and to get it through the FDA approval process. But once the formula is known, pharmaceuticals are typically cheap to produce. The first pill costs a billion dollars, the second pill costs 50 cents. Imitation is much cheaper than innovation. But if anyone can copy the new drug, the price for the new drug will quickly be pushed down to its production cost: 50 cents. Now that sounds great!



But, that would leave the innovator with no way to recoup the billion dollars of research and development. So, we might be worried that if we let ideas spread as far and as wide as possible -- that ideas are going to be under-supplied. The US founders understood this problem, and so they created a special institution to incentivize idea creation and they wrote it right into the U.S. Constitution. In order to promote the progress of science and the useful arts, the Constitution empowers Congress to give to inventors an exclusive right to use and sell their invention for a limited period of time. In other words, a patent. Patents give innovators a temporary monopoly, and thus a way to profit from their idea before the imitators can jump in and push prices down. This gives the innovators more incentives to innovate.



But it also means that good ideas -- they don't spread as far and as wide and as quickly as possible. Patents can prevent other innovators from building on top of good ideas. Check out my other video on patents that talks more about this. So, we have a great dilemma. We want lots of ideas, but we also want to spread new ideas, and these two goals are in conflict. Navigating this tension is complicated. A patent is one solution, but how long should the patent last? Ten years? Twenty? Fifty? And how broad should the patent be? And how much of an innovation counts as enough to get a patent? Should we allow patents on new business methods like online auctions? Should Amazon be able to patent one-click buying? How about on genes, like the breast cancer gene? And how about patents on new methods for teaching yoga? There are no simple answers to these questions.


It's all about balancing incentives for new ideas and letting ideas free in the world so that other innovators can build and improve upon them. And here's another problem. Fundamental discoveries in mathematics, physics, and molecular biology -- they're really important. But often, the more fundamental the idea, the more difficult it is to profit from . . . precisely because the idea's just got so many applications. If it weren't for Einstein's theory of relativity, for example, the GPS navigators in our cars would send us way off course. Yet Einstein was never paid for this application of his idea. In our Principles of Microeconomics course, we learned that goods that create spillovers or positive externalities -- that they're undersupplied.



But we also learned that we might be able to increase the production of these goods with subsidies. Government funding of universities and government research grants subsidize the production and sharing of new ideas. This argument for subsidies is strongest where the spillovers are largest, namely for research in basic science. Subsidizing universities or government labs, however, doesn't give researchers much skin in the game. Researchers might work on problems that they find interesting, rather than on the problems that consumers actually want solved. So instead of paying for the input of research, another idea is to offer a large prize for the output of solving a problem.



Instead of pharmaceutical patents, it might be possible, for example, to offer pharmaceutical prizes. You win a large prize by creating a drug that successfully cures a disease and then you give the solution to everyone so the idea is spread as far and as wide as possible. One advantage of prizes is that they leave it open how a goal is to be accomplished. Prizes are often won with radical new ideas that no one was expecting. Prizes and subsidies, however -- they've got problems of their own.



Who decides what gets subsidized? Who decides what goals get prizes? Patents are profitable only when consumers value the new idea. Subsidies and prizes -- they don't have to pass this same market test. Now that doesn't mean that we shouldn't have subsidies and prizes. It's just another demonstration of how tricky it is to create the best institutions for producing good ideas. When it comes to ideas, just as with goods, institutions create incentives. We want incentives to create valuable new ideas, but also to allow ideas to spread as far and as wide as possible. Patents, subsidies, and prizes -- they're three types of institutions that navigate these trade-offs in different ways. And each may be best at different times or for different types of ideas. Finally, there are other factors that determine the volume of ideas. More people, for example, means more ideas.



Next up is a TED talk by a handsome and brilliant economist who will explore some of these additional factors. Don't miss it. After that, we'll finish this section with the Idea Equation. And that's going to help us predict the future of ideas and the future of economic growth.



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