A reward system would avoid the deadweight loss and inadequate incentive of patents

The analysis of the model may be summarized as follows. Under the patent system, the innovator's incentive to invest in research is the monopoly profits he would earn; if he produces the innovation, he then sells the innovation at the monopoly price. There are two familiar deviations from first-best behavior under the patent system. First, incentives to invest in research are inadequate because monopoly profits are less than the social surplus created by an innovation. 19 Second, if an innovation results, there is a deadweight loss in social welfare because too little is sold at the monopoly price.

Under the reward system, the innovator's incentive to invest in research is the reward he would receive. If the innovator produces an innovation, it will be available to competitors and so will sell at marginal cost (perfect competition in the product market is assumed). Because there is thus no deadweight loss from monopoly pricing, the only type of deviation from first-best behavior under the reward system involves the incentive to invest [*530] in research. This deviation could be in either direction. If the social surplus from the demand curve exceeds the reward, there will be an inadequate incentive to invest, and if the surplus from the demand curve is less than the reward, there will be an excessive incentive to invest. Either possibility may occur, as the optimal reward equals the expected surplus over the distribution of possible demand curves.

From the foregoing discussion, it is apparent that the comparison between the patent and the reward systems can be resolved into two elements. On one hand, the reward system is superior to patent in that deadweight loss due to monopoly pricing is avoided under rewards. On the other hand, the incentive to invest in research is imperfect under both systems, but in different ways. Under the patent system, the incentive to invest is always inadequate because monopoly profits are less than social surplus; but the incentive to invest is linked to actual social surplus because the innovator knows the demand for the potential innovation. 20 Under the reward system, the incentive to invest is governed by the reward and thus is not systematically inadequate; yet the incentive to invest is not linked to actual surplus but only to the reward. 21 In particular, if the innovation would be very valuable, the innovator would invest only in accordance with the reward, which will equal the expected surplus from all possible innovations.

Because patent effectively harnesses the private information of the innovator about the value of an innovation, incentives to innovate might be superior under patent to those under reward, even though the incentives under patent are always less than first best. This leads to the possibility that patent could be superior to reward, despite the deadweight loss due to monopoly pricing and the too-small incentive to innovate. Reward, however, could be superior to patent, both because of a better average incentive to innovate (as the optimal reward equals expected surplus) and because of avoidance of the deadweight loss from monopoly pricing. Analysis of patent versus reward does not lead one to think that there exists any general argument favoring the patent system over the reward system.