I wrote about antibiotics before. So far, this was a success story. Since the 1940s, the price for antibiotic drugs fell extremely, transforming a once unaffordable drug into an “everyday product”. Unfortunately, however, there is more and more evidence that we might fall behind in the evolutionary battle against drug-resistant bacteria. Recently, I read an article in the NYT on the topic. The problem is essentially that developing new antibiotic drugs is not profitable anymore. They are usually given only for a short period of time and have small profit margins. In addition, newly developed drugs would probably kept away from the mass market in order to serve as a back-up drug when the standard medicaments fail to take effect. Of course, this lowers the incentives for pharma companies to invest in expensive research on new compounds. Development of drugs against heart attacks, cancer, or Alzheimer’s is much more promising from a financial point of view.
This is a classic case in the economics of innovation. Private companies do not have sufficient incentives to innovate in certain technology areas because they cannot be sure to appropriate enough profits of an innovation which would allow them to recoup their investment costs. On the other hand, the (future) value for society of R&D in antibiotics might be substantial. The NYT article proposes to organize an inducement prize competition to overcome this incentive problem.
Inducement prizes aren’t a new idea. Brunt, Lerner, and Nicholas (2012) study awards for technological developments offered by the Royal Agricultural Society of England between 1839 and 1939. During that time, the society organized annual shows at which it granted prizes for innovative agricultural equipment and machinery in the form of monetary prizes as well as prestigious gold and silver medals. These prizes were usually announced one year in advance and for specific technology areas. The researchers are able to investigate whether these prize incentives were effective in (1) increasing the number of inventions in a technology area and (2) spurring the patenting of ideas.
Results are positive. A prize announcement both increased the number of participants in an annual show as well as it was accompanied with a significant increase in the number of patents within the respective technology area. The latter result is reinforced by the fact that the researchers consider patents for which the applicants paid a renewal fee after three years. This usually is associated with a higher economic value compared to patents that were not renewed.
During 1856 and 1872, the Society applied a rotating prize schedule in which the choice of technology area for a prize competition was following a rotating sequence. Since the results for this subperiod are very similar, we can be less concerned about the fact that prizes might have been organized in particularly booming technology areas in which invention activities were high anyways. In addition, the researchers look at repeat inventors participating in the competitions and find no evidence that a prize announcement induced them to switch to certain technology sectors. This gives an indication that the increased participation due to prize announcements was driven by real entry and not just by substitution of inventive effort.
Inducement prizes as an incentive to innovation, in comparison to granting patent rights, have the advantage that society does not need to grant monopoly rights to the inventors which are associated with a deadweight loss in welfare. However, when development costs are high the prize money should be as well. For the competitions organized by Royal Agricultural Society of England it was actually not so much about the direct monetary incentive itself, as the paid sums were usually quite small and were not suitable to cover investment costs.
The shows attracted many interested people from all over Britain. Winning a prize was thus equivalent to a certification of quality to potential customers. This explains why Blunt et al. find that most of the positive effects stem from the award of a gold medal compared to the actual amount of prize money. Inventors could then patent their ideas and sell them at attractive rates to interested clients.
Thus, the prize competitions by the Royal Agricultural Society effectively established a market for ideas. This won’t work in the case of antibiotics. As I mentioned earlier, it’s not so much about customers being not aware of the quality of new drugs but about the low profit rates attainable in the antibiotics market. Therefore, prize money needs to be sufficiently high to cover investment costs and to compensate for these low earnings prospects should the prize competition be effective in spurring innovation in antibiotic drugs .
But what amount are we talking about? Are $2 billion enough, as the NYT article derives from expert knowledge on development costs in the pharma industry? Chari, Golosov and Tsyvinski (2012) have an interesting paper on that. A prize granting authority that doesn’t know the value of an invention ideally wants to rely on market signals. You could, for example, offer the good to potential customers on a test market and extrapolate the inferred information to the size of the entire market*. But this is problematic when the inventor can manipulate these market signals by, e.g., artificially increasing demand in the test market. The might justify a post on its own. So I’ll go into more detail at a later point in time. Bear with me.
Anyway, the idea of prize competitions for innovations of high social value, as it is the case for antibiotics, is not bad. However, I’m still skeptical about the appropriate amount of prize money which needs to be promised. Furthermore, I’m unsure which entity would be willing to do so. Do the U.S., like it’s proposed in the NYT article, really want to spend $2 billion on an invention which other countries might then copy nearly costlessly? Again, the usual problems in innovation economics…
* I’m not saying that this example would be the best mechanism for the specific case of antibiotics though. It’s an example given in the paper.
Brunt, L., Lerner J., and T. Nicholas (2012): “Inducement prizes and innovation,” The Journal of Industrial Economics, 60(4), 657– 696.
Chari, V.V., Golosov, M., and A. Tsyvinski (2012): “Prizes and patents: Using market signals to provide incentives for innovations,” Journal of Economic Theory, 147, 781–801.