An effective mechanism for patent buyouts would be a sealed-bid second-price auction. It would be especially effective for pharmaceuticals.

A standard way of eliciting information on the value of indivisible goods, such as patents, is through auctions. Figure I shows how an auction could be used to determine the price at which the government would offer to buy out patents. Under the mechanism, the market value of patents would be determined through a sealed-bid second-price auction,7 and the government would then offer to buy patents at this private value times some constant markup which would reflect the typical ratio of social to private value. Most of the patents that the government bought would be placed in the public domain. However, in order to give auction participants an incentive to reveal their true valuations, a small proportion of patents, chosen randomly, would be sold to the high bidder. Patent holders would have the right to accept or reject the government’s offer. Although the government might require a waiting period following either patenting or FDA approval of new drugs before it would buy out patents, patent holders would be free to postpone patent buyouts. Inventors who wished to sell their patents to the government would be responsible for paying for the administrative costs of the auction. Based on the empirical estimates of the social return to innovation discussed above, it seems likely that the government should offer to buy patents at a markup of at least twice their estimated private value. This will not match the social value of inventions, but it is likely to be a better approximation than the private value of patents, which is what inventors receive in the absence of patent buyouts. Under a sealed-bid, second-price auction, auction participants will bid their expectation of the patent’s value, given their information, conditional on their making the winning bid. It will be efficient for the government to estimate the private value using information from the entire distribution of bids, rather than only the highest bid, since there is no reason to throw away the information provided by the other bids. If the government knew the prior distribution of valuations, it would be able to aggregate the information of all bidders to estimate the private value of the patent. In practice, the government does not know the bidders’ prior distribution of valuations. Therefore, it might be best for the government to use a simple rule, such as offering the original patent holder some multiple of the third highest bid.8 The next sections consider the operation of the patent buyout mechanism in several different environments: with inventor cost or informational advantages; with complementary or substituting inventions; and with the threat of collusion. As discussed in Section VIII, this analysis suggests that pharmaceuticals may be particularly well suited to patent buyouts. However, before considering these more complicated cases, it is worth first reviewing the advantages of patent buyouts in a perfectly competitive, collusionfree environment. 1. The markup would raise private incentives for original research closer to the social benefit created by the invention. 2. Deadweight losses due to monopoly pricing would be eliminated if patents were put in the public domain. 3. Since monopoly profits would be eliminated, researchers would not have excessive incentives to invent substitutes for existing drugs to steal profits.