Incentives and the Innovative Environment Suzanne Scotchmer ESNIE, Carg

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Incentives and the Innovative EnvironmentSuzanne
ScotchmerESNIE, Cargèse, May 2007references
Chs 2, 8Innovation and Incentives (MIT Press,
2005)
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Innovation the problem of procuring knowledge

• Framing Questions
• Is procuring knowledge different than
  procuring infrastructure?
• Intellectual property is a procurement
  mechanism. Why do we use it in one realm, but not
  the other? (Is that true?)
• Is technological progress (growth) simply a
  matter of spending resources?
• How does imagination fit into incentive theory?

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RD How much?By whom?

• Percentages of GDP are similar, but sources of
  funds are different
• E.U. about 44 of RD spending is public
• U.S. 26 of RD spending is public
• (ratio of public/private was 21 in 1950 now
  13)
• Brazil, Chile, Costa Rica and Mexico
• substantially over half

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The Plan of this Lecture

• Frame the problem
• What is the incentive system trying to
  accomplish?
• Compare some important mechanisms
• Intellectual Property
• Prizes
• Contests
• Grants (contracts)

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The inescapable question What is primitive?How
do opportunities for innovation arise?

• In most economic models of RD and growth, the
  primitive is a production function for knowledge
• Models of RD races
• Most models of procurement
• Endogenous growth theory
• 2. The model in my own work There is no such
  thing as a production function for knowledge.
  Instead
• (1) People have ideas for investment
  (exogenously).
• (2) With investment, ideas may become
  innovations
• This is where incentives enter.

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Ideas

• . may be scarce
• The idea defines the need as well as the
  solution.
• .. or substitutes
• Examples longitude, HIV vaccine, X prize
• v
• For example, a product idea is (v,c)
• v consumers surplus at pmc pv
• c cost of developing the
• idea into an innovation

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Substitute ideasthe problem of aggregating
information

• An idea is best if (v1/r-c1) gt (v2/r-c2)
• (Not necessarily the lower-cost idea.)
• c2 v2/r
• c1 v1/r
• The incentive problem is about aggregating
  information, not about choosing the right number
  of firms in a race, or the tradeoff between
  deadweight loss and innovation.

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Intellectual Property

• In its favor A weak efficiency test (sort of).
• In its favor (maybe) Users pay
• Not in its favor
• Deadweight loss
• Payment is ex post - who funds the investment?
• Information is not aggregated
• (the best ideas or firms are not chosen)

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Prizes

• Prizes are complicated objects
• Two types blue-sky versus targeted
• Two styles first-past-post versus
  best-in-class
• In their favor
• Can give the same incentive as a patent, but
  without deadweight loss (set the prize equal to
  the patent value).
• It is always possible to make the value
  verifiable.
• Cremer and McLean 1988, Markets signals.
• Not in their favor (maybe) Users do not pay the
  costs.

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Contests (best-in-class prizes)

• Examples
• (1) Simple Commitment to Pay (Nobel Prizes)
• (2) (Vickrey Auction)
• (3) Prototype Contest
• In their favor Nothing needs verification
• Not in their favor
• (1) duplication.
• (2) Need to make contingent contracts in
  advance

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The problem of choosing the best ideaNeither
patents nor prizes aggregate information.

• What happens if we auction the right to develop?
• c1 v1/r
• c2 v2/r
• Vickrey auction works, but only if value can be
  observed. Report (vi/r ci) , Pay v1/r (v2/r
  c2)
• Prototype contest Leads to duplicated cost and
  possibly not the best

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Two Modern Grant Systems

• Peer-reviewed grants
• Not monitored future grants depend on past
  success.
• Grant is given ex ante, not withheld ex post on
  the basis of failure.
• Government Subsidies.
• Government funds research, then gives IP, often
  to firms in return for matching funds. Prevalent
  in biomedicine.
• What is the role of IP in the subsidy system?

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Grants

• NSF 99 research budget given as grants
• (NSF also supports education)
• NIH about 80 given out as grants
• Would you grant-supported RD to be different
  than in-house RD? Why? What is the point of
  grant support?
• How does NSF/NIH know whom to support?
• What constraints on abuse are there?

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A simple Model of the Grant Process

• Suppose an idea worth funding costs c.
• Suppose it is impossible to punish a grantee for
  cheating (not delivering), e.g., by getting the
  money back. The only punishment is to kick a
  researcher out of the grant system.
• Suppose that each researcher has an idiosyncratic
  idea rate, ? ideas per year
• Who does the NSF want to support? Should it
  depend on the idea rate ?? What is the
  objective?
• Let ? be the size of a grant for a given idea.
  How large should ? be? E.g., ? c? Does the
  NSF/NIH have to waste money in order to keep
  researchers from cheating?

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Keeping Grantees Honest the grant size ?

• Value of ideas in period t
• The value of staying in the system (future
  grants)
• Invest if the value of cheating, c, is less than
  value of future grants (selects the
  high-fertility researchers)

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Questions about grants

• If researchers have fertile minds (high ?),
  what does that do to the premium ?-c?
• How much surplus does a high-cost researcher
  make?
• What if you are a low-fertility (low-?)?
• Will the government have to over pay?
• Homework If the government could give different
  ? for researchers with different ?, would high
  fertility researchers get larger or smaller
  grants per idea? Would they get more or less
  money per unit time?

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Public Subsidies, Private Matching, IP

• Matching m entitles firm to IP on subsidized
  innovations
• If the cost is less than m, the surplus m-cgt0
  goes to general fund.
• (Subsidy is irrelevant.)
• If the cost is more than (ms),
• the firm pays the difference c-(ms), and
  receives IP

Space of ideas
c
v?Ts
v?T
sm
s
m
v
v
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Efficient investments A paradox(Could this
explain the dot bomb?)

• Suppose agents i1,2 have irreducibly different
  beliefs q1.4 , q2.6 , endowments 10 each.
• w1, w2 WTP in case of success
• Cost/benefit test (maybe) w1q1w2q2gtc
• What if w1w20, c1?
• Invention has intrinsic value.
• But investment can still make a Pareto
  improvement. Give19 units to agent 2 in case of
  success and to agent 1 in case of failure.
  Expected utility of each is greater than the
  value of the endowment (0.6)(19)gt10.

from Innovation and Incentives, Scotchmer 2005.
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Example Inefficient, self-reinforcing patent race

• Suppose costs are known.
• Suppose it is unprofitable for even a single firm
  to invest if signals are (L,L). Suppose each
  firm will invest, even if its own signals is L,
  if the probability is at least half that the
  other firm is H.
• Equilibrium strategies, leading to multiple
  outcomes
• Invest if and only if the other firm invests.
• If the signals are (L,L), there are two
  equilibria, with and without investment. At
  signals (L,L), the outcome with investment is not
  profit-maximizing.

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Aggregating Correlated Information

• Kremer (1998) aggregates correlated info ex post.
• Information often needs to be aggregated ex
  ante.
• Interpret v1,v2 as signals of a common value v
• Suppose v1,v2?L,H , c1,c2??,h
• The cost of innovation is minc1,c2.
• The value is E(v v1,v2).
• Information aggregation
• In general it might be optimal to ask firm 1 to
  invest on the basis of information possessed by
  firm 2!
• Firms investment strategy depends on
• firms own signal
• firms observation of the other firms investment.