Patents, Prizes, and Subsidies

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.