Patents versus Markets

Long ago Jack Hirshleifer pointed out that markets can reward innovative activity even in the absence of patents (H.'s point was actually that markets could over-reward such activity but the point was clear).  If an inventor discovers a new source of energy that requires the use of palladium, for example, he can buy palladium futures, announce his discovery and wait for the price of palladium to increase.  Of course, this only works if the discovery is credible so betting (contra Tyler) is an important way to test the credibility of a theory (e.g. here and here and of course Hanson's key paper Could Gambling Save Science).

All this is by way of introduction to a new paper in Science, Promoting Intellectual Discovery: Patents Versus Markets (press release here).  Bossaerts et al. compare a patent system with a market reward system in an interesting experimental setting.  The innovation is the solution to a combinatorial problem called the knapsack problem.  In the knapsack problem there are Z items each with a certain value.  You must choose which items to put into the knapsack in order to maximize it's value but each item also has a weight and you cannot go over a fixed weight which is set such that you can't carry all the items.  The solution to a knapsack problem is not obvious since it's not always best to include the most valuable items.  The authors argue that solving the knapsack problem is like combining ideas to create a new innovation.  The authors, of course, know the optimal solution to each knapsack problem.

Rewards for creating the innovation are offered in two ways, in the patent method the first person to produce the optimal solution gets the entire reward.  In the market system each participant is initially given an equal number of shares in each item.  The item-shares trade on a market. After the markets close a $1 dividend is paid to each item-share if the item is in the optimal solution, other shares expire worthless.  Thus, the price of the item-shares can be thought of as the probability that the item is in the optimal solution.  (i.e. is palladium in the optimal solution to the energy problem?  If so, it will have a high price.)  Dividends are set such that the total reward is about the same in the two treatments.  Proposed solutions were also collected in the market setting although the solutions per se were not the basis of any reward.

Important findings are that the problem was solved just as often in the market setting as in the patent setting.  Indeed, in the market setting more people solved the problem on average.  There are two possible explanations.  First, the winner-take-all nature of the patent system may have deterred some of the weaker participants from exerting effort.  Second, and more interesting, is that the prices in the market system did in fact incorporate information about the optimal solution - thus market prices may have given people hints about the optimal solution, much like seeing a partial solution to a jigsaw puzzle.

Problems are that the market system can work only if there are rents to be had from market prices.  A new computer chip design, for example, won't change the price of silicon (although even here side-bets may be possible, the inventor knows the manufacturer to whom he sells the invention for example).  Also, the price of an input, like palladium, can be influenced by many things other than the innovation so the market system will typically often involve more risk.  Still this is an interesting experimental approach to a deep problem.

Thanks to Monique van Hoek for the pointer.