How to Promote Innovation: The Economics of Incentives

businessman-dollar-gearsOver the past several years the U.S. Supreme Court has slowly, but consistently, eroded what is considered patent-eligible, most recently with decisions on software[1] and gene[2] patents. In essence, the universe of patentable innovations has been diminished. And with it, the country’s economic potential.

Innovation is a powerful economic force and driver of both development and prosperity. Yet the Supreme Court’s recent decisions undermine the incentives to innovate in areas critical to future U.S. economic growth. Reducing the patent-eligible landscape in this way essentially eliminates any future U.S. contribution in these areas. Fundamentally it is an issue of incentives and their power to shape behavior.

Incentives are essential to innovation due to the expense of research and development activities, and the public-goods nature of the resulting knowledge. As described by Belleflamme (2006), intellectual property (IP) generating activities suffer from three generic sources of market failure: externalities, indivisibilities and uncertainty.[3] The externalities arise from the public-goods nature of information, which makes imitation is easier than invention. Information and knowledge are public good in the sense that they are non-rival in consumption[4] and non-excludable[5]. In addition, intellectual property markets are characterized by indivisibility since knowledge and information are inherently discrete. Finally, knowledge creation involves tremendous uncertainty and risk.

Innovators face appropriability problems due to these three market failures. That is, investors are unable to fully capture the returns on their investment and the social benefits usually exceed the private benefits. Empirical studies suggest that investors capture at most half of the returns on their investments.[6] As a result, many potentially beneficial investments in innovative pursuits are foregone because the private returns available are inadequate to warrant investment. In essence, the market provides insufficient incentives for innovation and knowledge and information are underprovided.   In answer to this, intellectual property rights solve the under provision problem and provide innovators with the needed incentives to invest.

For all these reasons, we know that innovations must be incentivized. Historically, societies have incentivized and rewarded research in a variety of ways, including patents, prizes, and direct government funding and grants. The primary mechanisms utilized today are patents and government grants. As Suzanne Scotchmer (2006) wrote, “All forms of funding are implicitly incentive schemes, since they set the direction of research and encourage people to do it. Some funding is given ex ante, such as grants, whereas other funding is given ex post, such as patents and prizes. . . The only fundamentally new incentive scheme of the past 400 years is intellectual property. Whereas wealthy benefactors and governments can indulge in basic science and curiosity-driven research, a research agenda driven by patents is hostage to the market and to consumer sovereignty. The consumers who are sovereign are those with resources.”[7]

The patent system serves two primary functions: it provides an incentive for research and development and promotes the diffusion of ideas and information. As described by Clancy and Moschini (2013), the incentive potential of patents stems from their private value which is a function of their length, scope and breadth. “The length of the patent is codified by law (twenty years from filing the application), although the effective economic life of the patent can be considerably shorter, and influences how long competitors can be excluded from a particular market. The scope of a patent is more subtle and concerns the breadth of its applications, which relates to the range of products or processes that can be excluded by a patent’s right (by the so-called doctrine of equivalents, a product might be found to infringe on a patented product even if it is not an exact replica). Unlike length, the breadth of a patent cannot be explicitly codified, and it is left to be determined by the patent’s claims, as approved by the patent examiners and ultimately adjudicated by the courts.”[8]

Empirical evidence from economic studies confirms that patents provide the incentives that promote innovation and the impact is particularly pronounced in some sectors.  Incentives matter. This claim is bolstered by tens of thousands of empirical economic studies, and not one that convincingly refutes it.

In a study of 60 countries over the period 1960-1990, Park and Ginarte (1997) find that the strength of intellectual property rights was positively associated with research and development (R&D) investments.[9],[10] Hall (2007) and Hall and Marhoff (2012) confirm the value of patents as important incentives for R&D in several sectors, including pharmaceuticals, biotechnology and medical instruments.[11],[12] In the context of product innovations, a recent study by Duguet and Lelarge (2012) concludes that “overall, patents do increase the private incentives to innovate, but through a specific, unbalanced, channel. Indeed, at the firm level, the direct incentive effect of patents is restricted to the firms’ R&D effort, which affects significatively their product innovations.”[13] The importance of patents to incentivizing innovation stems, in part, from their reliance on market forces, arguably moreso than any other incentive mechanism. Patents leave all technical, developmental, and economic deicisions in the hands of innovators and consumers. They work due to the wisdom of Adam Smith’s so-called invisible hand.

Steven Landsburg summed it up succinctly, “Most of economics can be summarized in four words: ‘People respond to incentives.’ The rest is commentary.”[14]

In the context of patentability, consider the importance of the 1980 Supreme Court decision in Diamond v. Chakrabarty, 447 U.S. 303, 206 USPQ 193 (1980), and the consequences. While the United Kingdom was once the world leader in biotechnology, this changed drastically with the 1980 decision in which the Court “held that microorganisms produced by genetic engineering are not excluded from patent protection by 35 U.S.C. 101.”[15] The importance of this decision to the emergence of the U.S. biotechnology industry cannot be overestimated. In the words of Biotechnology Industry Organization (BIO) President and CEO Jim Greenwood, “By finding that subject matter derived from nature is eligible for patenting if it is modified by man into something new, useful and unobvious, the Court provided assurance to biotech companies and their investors that emerging technologies are protected by the patent system even if they could not have been foreseen when the system was created 200 years earlier.”[16] The result has been transformative for the biotechnology industry. Now dynamic and flourishing, the industry enhances and extends human life through innovations in medicine, agricultural crop productivity, and renewable fuel. These benefits span the globe, incentivized by effective patent protection.

Finally, consider the thoughts of Dr. Peter H. Diamandis, the Founder and Chairman of the X Prize Foundation:

You get what you incentivize. If something in your life is not working, it’s because you incentivize that behavior. Of course the opposite is true as well. In the United States, our tax code is so complicated that it creates an entire accounting and legal industry. Why is it so complex? Because we incentivize the lawyers who run this nation to keep it as such. You get what you incentivize. Along those lines, I’m a big proponent of incentive competitions, the idea that you can put up a cash prize with a very clear goal and ask people around the world to solve it for you. Incentives are a powerful way to get the smartest people in the planet to help solve your problems.[17]

Incentives, when thoughtfully designed, have the potential to motivate great innovations and generate tremendous economic growth. When misused, or incorrectly applied, they also have the power to undermine progress and erode prosperity. For a country built on ideas and inspiration, the importance of the correct incentives cannot be overstated.  As noted by Bronwyn Hall in 2007, “Unfortunately (from the perspective of optimal policy), many of the changes in patent policy in the United States during the past two decades have been as a result of court decisions, especially those of the Court of Appeals of the Federal Circuit (CAFC), and to a lesser extent by the Supreme Court. Addressed as they are to the features of individual cases, these decisions do not always consider the broader policy implications as they set precedents.”[18] This trend continues. An examination of recent Supreme Court decisions suggests that more attention and meticulous consideration needs to be given to the role of incentives and their consequences. The future of U.S. innovation is in the balance.



[1] Alice Corp. v. CLS Bank

[2] Association for Molecular Pathology v. Myriad Genetics, Inc.

[3] Belleflamme, Paul. “Patents and Incentives to Innovate: Some Theoretical and Empirical Economic Evidence,” Ethical Perspectives: Journal of the European Ethics Network, vol.13, no.2, 2006, pp.267-288.

[4] Non-rival in consumption means that the consumption by one individual does not preclude consumption by another individual. For example, the security one individual is provided by national defense system does not prevent that system from protecting another (all other) citizens.

[5] Non-excludable means that an individual cannot be excluded from consuming the good in question. For example, the clean air provided by a community cannot be withheld from an individual.

[6] Glennerster, Rachel & Michael Kremer. “A Better Way to Spur Medical Research and Development,” Regulation, vol.23, no.2, 2000, pp.34-39.

[7] Scotchmer, Suzanne. Innovation and Incentives, MIT Press, 2006, p.2.

[8] Clancy, Matthew S. & GianCarlo Moschini. “Incentives for Innovations: Patents, Prizes, and Research Contracts,” Applied Economic Perspectives and Policy, vol.35, no.2, 2013, pp. 206–241. (quote from page 209)

[9] Park, W.G., and J. C. Ginarte. “Intellectual Property Rights and Economic Growth,” Contemporary Economic Policy,XV, 1997, pp.51-61.

[10] This finding holds true for countries with above median incomes (like the United States), but not for the less-developed countries.

[11] Hall, Bronwyn H. “Patents and Patent Policy,” Oxford Review of Economic Policy, vol.23, no.4, 2007, pp.568-587.

[12] Hall, Bronwyn H., and Dietmar Harhoff. 2012. Recent Research on the Economics of Patents. Annual Review of Economics 4: 541–565.

[13] Duguet, Emmanuel & Claire Lelarge. “Does Patenting Increase the Private Incentives to Innovate? A Microeconomic Analysis,” Annals of Economics and Statistics, No. 107/108, July/December 2012, pp.1-38. (quote at p.21) .

[14] Landsburg, Steven E. The Armchair Economist, Simon & Schuster, May 2012, p.8.

[15] U.S. Patent and Trademark Office.

[16] Greenwood, Jim. “BIO Celebrates 30th Anniversary of Diamond v. Chakrabarty Decision,” web posting, June 16, 2010.

[17] Diamandis, Peter H. “Peter’s Laws: Supercharging Your Attitude,” May 23, 2013.

[18] Hall, Bronwyn H. “Patents and Patent Policy,” Oxford Review of Economic Policy, vol.23, no.4, 2007, pp.568-587. (quote at p.579)


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Join the Discussion

2 comments so far.

  • [Avatar for NWPA]
    July 22, 2014 07:34 am

    Good comment step back, but I guess you could roll fairness into incentive as one thing we want is to live in a fair world (those of us that have any morals left, which does not include the top .01 percent of income earners.)

    Good article. One thing that shocks me about people like Mark Lemley and Richard Stern is that they are so disconnected from reality. In my practice, I work with real tech companies start-ups and big tech companies. I see the in-house counsel trying to make the applications as concise as possible and as closely tied to real innovation as possible. Management uses the application as a measurement of the accomplishment of the engineers and as a way to incentivize them to innovate. Is what you did this year worthy of a patent application? We the attorneys often are in the positive of saying yes or no.

    People like Lemley take the few outliers that are gaming the system and try to characterize all of us as if we are one of the few outliers. The more objective real data is used to evaluate the patent system, more people like Lemley are seen as the charlatan clowns that they are. (I also wonder why no one has filed an ethics complaint against Lemley at Stanford. His papers often misrepresent the truth and citation. One of his papers said that software has no structure, and he didn’t even bother to cite to counter arguments, which he was aware of.) Moreover, if you look at what Lemley is doing with his company, he will not publicly tell us how he is protecting the IP. It appears what he is doing is tying his employees down with draconian contracts to prevent them from competing with his company or getting any other work related to what they do for him. So, the Lemley world is one of slave labor and hidden information in practice and a utopian in his theoretical papers that intentionally misrepresent facts and citations. And, remember that law journal articles are a vanity press. There is no peer review so they should not be called a journal, but a vanity press.

    Moreover, the likes of Richard Stern intentionally misrepresents information processing. Just consider that he and others try to say that information processing methods are laws of nature. Anyone that has been schooled in the last 50 years in cognitive science would find such a statement abhorrent to science and an act of aggression against our reason.

    One must ask oneself why these people take these positions. I think the answer is not simple. In Lemley case, I think he has made himself very rich and very well-known by burning the system down and there is no one to stand against him and lots of big corporate money to feed him. In Stern’s case, I think he thinks he is protecting us against information processing patents that the USPTO cannot examine.

  • [Avatar for step back]
    step back
    July 22, 2014 06:45 am

    Economics is not the one and only way to understand human behavior.

    Consider instead the psychology of “fairness”:

    (In posting the above link, I am not endorsing it as being a full or accurate descriptor.)

    Chimpanzee “A” does all the hard work of finding (discovering) the hidden fruit tree in the jungle, climbing up to grab a bunch of bananas and carrying them all the way down. By the time he gets back to ground (as “first mover”), he is exhausted. Then the rest of the troupe (Chimpanzees B, C, D, etc.) pours in on top of him, grab and devour all the bananas, leaving him with nothing but humiliation for all his hard work. Fair? Will he do it again? Or will he develop a different attitude about being a pioneer in a crowd full of grubby ingrates?

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