Prizes solve better than patents – they produce targeted innovation using the best resources for the most social impact without pricing out consumers thanks to government knowledge and ability to fine tune

A prize system of the sort sketched briefly above has three potential benefits. First, it would enable us to avoid the most serious of the drawbacks of the current patent system – namely, the social-welfare losses caused by the monopoly pricing of patented products. The patent system, as we have seen, enables the firms holding the patents to charge consumers much more for the drugs to which they pertain than the cost of producing those drugs. Indeed, that’s the point of the system. Unfortunately, pursuit of this strategy has the effect of placing the drugs out of the financial reach of some people. Economists commonly refer to the deaths or suffering of the people who are thus “priced out of the market” as forms of “deadweight loss.” In the developing world, this effect is especially grave, because so many people are both poor and uninsured and thus unable to afford the prices of patented products.

This drawback of a patent system can be mitigated in various ways. For example, as we saw in the preceding chapter, an appropriately disciplined system of price discrimination can reduce the number of persons who are “priced out of the market.” However, such devices at best can reduce the problem, not solve it.

A prize system, by contrast, is capable of eliminating this problem altogether. As indicated above, competition among manufacturers of the drugs whose development is stimulated by the prizes would keep prices low for everyone. Access to the drugs would thus be radically increased.4

Second, a prize system can take advantage of the way in which knowledge concerning actual or potential pharmaceutical products is typically distributed.5 Ordinarily, governments have (or can obtain) better information concerning the aggregate health benefits of drugs than private parties. Why? Because government agencies regularly collect and assess data concerning the incidence and impact of diseases and thus are well positioned to ascertain the welfare gains that could be reaped by developing and distributing vaccines or treatments for each ailment. By contrast, governments ordinarily have knowledge inferior to that of private firms concerning the relative merits of potential lines of innovation – which drugs aimed at particular diseases would work best, which of the possible ways of developing such drugs are most promising, and the cost of each of those routes.

The inferiority of the government’s information concerning the merits of potential lines of research gives both a prize system and a patent system a clear advantage over a system of government grants as a way of inducing innovation. In a grant system (sometimes called a “push” system), government officials must decide which projects are most likely to generate solutions to particular health problems. Too often, they make those decisions poorly.6 By contrast, in both a patent system and a prize system, private firms compete to develop solutions to health problems. In doing so, they are able to rely upon their own information concerning the costs and probability of success of alternative routes – and to respond quickly to new information on those fronts.

The superiority of the government’s information concerning the social benefits of particular innovations gives a prize system an equally clear advantage over a patent system, under which research-and-development investments are directed toward lines of innovation that private firms consider most potentially lucrative, not those that are most socially beneficial. Specifically, a government, relying on its superior knowledge, can construct and administer a prize system in ways that correct for all three of the biases (examined in detail in Chapter 4) that distort (from a social welfare standpoint) the output of new pharmaceutical products under the current patent-based system: the bias toward drugs aimed at ailments that disproportionately afflict the rich; the bias toward “me-too drugs” (the term conventionally used to describe drugs that, when introduced into the market, offer little or no health benefits over extant drugs); and the bias away from vaccines. All of these distortions could be reduced or eliminated by a prize system – most simply, by ensuring that the sizes of the prizes are adjusted to match the incremental health benefits of each innovation.

Brian Wright has suggested that the advantages of prizes over patents in correcting these biases are not so certain. In theory, he points out, a government administrator could simply adjust the duration of – or the set of rights associated with – each individual patent to reflect the social value of the specific invention at issue. A patent system that incorporated such a mechanism would be just as good as a prize or grant system in capitalizing on the government’s superior knowledge concerning the social benefits of drugs.7 In some contexts, this might be true. For instance, to address the second bias in favor of me-too drugs, the patents covering truly innovative or “pioneer” drugs might be amplified in breadth or duration, while those covering me-too drugs diminished. But conferring upon the government the capacity to make such adjustments would give rise to a patent system fundamentally different from the one we have inherited. So long as all patents (or at least all patents within a given technological field) last the same amount of time and carry with them the same set of rights, the precision that Wright proposes will be infeasible, and a prize system, which invites such fine tuning, will be superior to it.

A more fundamental response to Wright’s suggestion is as follows: in many contexts, the divergence between the social value of an innovation and its private value for a patentee cannot be overcome even if we were willing to fine tune the patent system. This is because of two significant restrictions on the way all patent regimes work. First, patent incentives are parasitic on the underlying market demand for innovations – in the sense that patent-enabled returns are simply augmentations, through price hikes, of the returns that would be available to the innovator through competitive market prices. In economic terminology, varying the breadth or duration of a patent means varying how much of the social surplus from an innovation that lies “under” the “effective demand” curve can be captured by the patentee (as opposed to the consumers of the innovation).8 Those demand curves, however, fail to capture much of the social value of many of the innovations with which we are concerned. For instance, much of the social value of a vaccine consists of “positive externalities” reaped by persons other than the recipients of the vaccine – the diminution in the likelihood that they will contract the disease resulting from the immunization of the recipient. Another example: from a social-welfare standpoint, the demand curves for many drugs aimed at tropical diseases are “depressed,” in the sense that their potential beneficiaries are too poor to have their preferences “effectively” register on the market. In such cases, no amount of fiddling with patents can enable innovators to capture the social benefits of their creations.

Yet another, contingent feature of patent systems compounds the problem: a patent system is hamstrung, in a way a prize system is not, regarding the proportion of effective social surplus that it enables innovators to capture. If the patentee is able to charge only one, uniform (supra-competitive) price for the innovation, it must give up the surplus from some consumers (those who would have purchased the good at a lower price) in order to capture more surplus from others (those paying the higher price). Again, price discrimination can mitigate this problem but not eliminate it. A prize system faces no such inherent limitation; prizes can be adjusted to achieve whatever proportion of private incentive to social value is deemed best.9 In sum: a prize system enables a government to capitalize more effectively on its superior knowledge concerning the social value of innovations than it could through adjustments of a patent system.