Patently broken

The patent system was designed to incentivise innovation, right? With patent applications for grilled cheese sandwiches, as well as toast itself, there is no shortage of evidence suggesting the system is no longer fit for purpose. But what alternatives will lead to productive new ideas?

OVER THE PAST few decades, the number of people employed in research and development in the world’s leading economies has been rising dramatically, but productivity growth has been flat. Yes, there are more patents filed – but the number of patents produced per researcher, or per research dollar, has been falling. We may have booming universities and armies of knowledge workers, but when it comes to producing new ideas, we are running to stand still.

This is particularly worrying because we are hoping that new technology will solve so many of our problems. The obvious place to turn for solutions is to the market, where countless companies compete to bring new ideas into profitable shape, from start-ups to giant innovation factories such as Intel, General Electric and GlaxoSmithKline. As we’ve seen, the market is tremendously innovative – as long as the basic setting is fierce competition to develop super-cheap ideas, such as new software.

But when it comes to the more substantial, expensive innovations – the kind of innovations that are becoming ever more important – the market tends to rely on a long-established piece of government support: the patent. And it’s far from clear that patents will encourage the innovations we really need. The basic concept is sound: patents entice inventors by awarding them a monopoly on the use of their idea, in the hope that the cost of this monopoly is offset by the benefits of encouraging innovation in the first place. Whether patents actually get this balance right is an open question.

They have been discredited by the appearance of absurdities such as US patent 6,004,596, for a “sealed crustless sandwich”, or patent 6,368,227, “a method of swinging on a swing”, which has been granted to a five-year-old boy from Minnesota. These frivolous patents do little harm in their own right, but they exemplify a system where patents are awarded for ideas that are either not novel, or require little or no research effort.

Consider IBM’s patent for a “smooth-finish auction”, where the auction is halted at an unpredictable moment – unlike an eBay auction, which is vulnerable to opportunistic last-second bids. The patent office’s decision to grant the patent is puzzling, because the idea is not new.

In fact, it is very old indeed: the auction expert Paul Klemperer points out that Samuel Pepys, London’s most famous diarist, recorded the use of such auctions in the 17th century. (A pin was pushed into a melting candle. When it dropped, the auction ended.) Such mistakes happen, but there is no simple way to correct them: to do so requires going into direct competition with IBM, hiring an army of lawyers, and taking your chances. A cheaper way of fixing errors is essential.

Or take the idea of using a smartphone to scan barcodes in stores, and immediately reading reviews and checking whether the product is available more cheaply nearby. The concept of the scanner-phone popped into the head of a young Canadian economist called Alex Tabarrok while he was taking a shower one morning, at the height of the dot-com boom. Alas for Tabarrok, it had popped into other people’s heads too, and he soon discovered that patent 6,134,548 had been awarded for the same proposal just a few months earlier. That might seem like a misfortune for Tabarrok alone, but in fact we all suffer: a patent given out as a reward for random moments of inspiration delivers all the costs of intellectual monopoly without any of the benefits.

Worse, patents also fail to encourage some of the really important innovations. Too strong in the case of the scanner phone and the smooth-finish auction, they are too weak to inspire a vaccine for HIV or important breakthroughs in clean energy. Part of the problem is the timescale: many important patents in, say, solar power, are likely to have expired by the time solar energy becomes competitive with fossil fuels, a technology which has been accumulating a head start since the industrial revolution began.

A second, ironic, problem is that companies fear that if they produce a truly vital technology, governments will lean on them to relinquish their patent rights or slash prices. This was the fate of Bayer, the manufacturer of the anthrax treatment Cipro, when an unknown terrorist began mailing anthrax spores in late 2001, killing five people.

Four years later, as anxiety grew about an epidemic of bird flu in humans, the owner of the patent on Tamiflu, Roche, agreed to license production of the drug after very similar pressure from governments across the world. It is quite obvious why governments have scant respect for patents in true emergencies. Still, if everybody knows that governments will ignore patents when innovations are most vital, it is not clear why anyone expects the patent system to encourage vital innovations.

The patent problem could be fixed with some simple administrative improvements, but questions remain about whether any reform to the patent system can encourage companies to focus on truly large-scale, long-term projects. The innovation slowdown is likely to continue.

If patents can’t encourage the market alone to unleash the scale of innovations we need, the obvious alternative is governments. Governments, after all, are supposed to have the long time horizons, and the interest in solving our collective problems.

But so far, government grants have failed to deliver their full potential. Suppose for a moment that you and I sat down with a blank sheet of paper and tried to design a system for doling out huge amounts of public money – taxpayers’ money – to scientific researchers. That’s quite a responsibility.

We would want to see a clear project description, of course. We would want some expert opinion to check that each project was scientifically sound, that it wasn’t a wild goose chase. We would want to know that either the applicant or another respected researcher had taken the first steps along this particular investigative journey and obtained some preliminary results. And we would want to check in on progress every few years.

But it is exactly the wrong way to fund projects that offer a small probability of a revolutionary breakthrough. It is a funding system designed to avoid risks – one that puts more emphasis on forestalling failure than achieving success. Such an attitude to funding is understandable in any organisation, especially one funded by taxpayers. But it takes too few risks.

Fortunately, the governmental model isn’t the only approach. The Howard Hughes Medical Institute (HHMI), a large charitable medical research organisation set up by the eccentric billionaire, has an “investigator” programme which explicitly urges “researchers to take risks, to explore unproven avenues, to embrace the unknown – even if it means uncertainty or the chance of failure”.

The HHMI does ask for results, eventually, but allows much more flexibility about what “results” actually are – after all, there was no specific project in the first place. But is the HHMI system really superior? Maybe it leads to too many costly failures. Maybe it allows researchers to relax too much, safe in the knowledge that funding is all but assured.

Here’s the thing about failure in innovation: it’s a price worth paying. We don’t expect every lottery ticket to pay a prize, but if we want any chance of winning that prize then we buy a ticket. In the statistical jargon, the pattern of innovative returns is heavily skewed to the upside; that means a lot of small failures and a few gigantic successes.

Yet the problem of encouraging expensive, world-changing innovations remains daunting. Government officials will always tend to avoid risks when spending large sums of public money, while the patent system will rarely inspire costly, long-term research efforts from private firms.

Neither approach is likely to combine the two elements essential to encourage significant innovation in a complex world: a true openness to risky new ideas, and a willingness to put millions or even billions of dollars at risk. These two elements are fundamental to 21st-century innovation, yet they seem mutually incompatible. They are not.

Netflix is a mail-order film rental company which recommends films to its customers based on what they’ve previously rented or reviewed on the company website. The better the recommendations, the happier the customer, so in March 2006 the founder and chief executive of Netflix, Reed Hastings, met some colleagues to discuss how they might improve the software that made the recommendations. Hastings suggested offering a prize of $1 million to anyone who could do better than Netflix’s in-house algorithm, Cinematch.

The Netflix prize, announced in October 2006, struck a chord with the Web 2.0 generation. Within days of the prize announcement, some of the best minds in the relevant fields of computer science were on the case. Within a year, the leading entries had reduced Cinematch’s recommendation errors by more than 8 per cent – close to the million-dollar hurdle of 10 per cent. Over 2,500 teams from 161 countries and comprising 27,000 competitors entered the contest. The prize was eventually awarded in September 2009 to a team of researchers from ATT.

The use of prizes is catching on again, and quickly. Five national governments and the Bill and Melinda Gates Foundation have put $1.5 billion into a prize called an “advanced market commitment” to reward the developers and suppliers of a more effective vaccine against pneumococcal diseases such as pneumonia, meningitis and bronchitis.

The reason a prize is needed is because even with a patent, no pharmaceutical company could expect to reap much reward from a product that will largely benefit the very poor. Pneumococcal infections kill nearly a million young children a year, almost all of them in poor countries.

The problem with an innovation prize is determining when the innovator has done enough to claim his reward. One pneumococcal vaccine might be cheap and fastest to market; another might be more reliable and have fewer side effects. Who is to decide who wins the prize? Or have both won, or neither?

For this reason the vaccine prize takes the form of an agreement to subsidise heavily the first big orders of a successful vaccine. The developers do not reap their rewards unless they can persuade governments or citizens of poor countries to buy the vaccine – albeit at a bargain price – and they will receive their money slowly or quickly, in part or in full, depending on how the market responds. The prize also partly replaces the pricing-power that comes with any patent, because if the drug company wants to collect the prize it has to agree to offer the drug cheaply.

Given that only the very largest pharmaceutical companies spend more than $5 billion per year on research and development, a $1.5 billion prize should be taken seriously on hard-nosed commercial grounds alone. And it has worked: at the end of 2010, children in Nicaragua received the first prize-funded vaccines for pneumococcal disease.

There is more to come. The next target is a vaccine for malaria, which might require a prize of $5 billion to generate commercial interest. Prize enthusiasts think that even an HIV vaccine may be possible, and speculate about a fund of $10 billion to $20 billion, three times the total annual research spending of the largest drugs companies.

This is serious money. But the wonderful thing about prizes is that they don’t cost a penny until success is achieved. This allows the ultimate combination: a completely open field, where failures are tolerated and the boldest, riskiest idea could succeed, alongside huge sums of money that are spent only when the problem has been solved.

This is an edited extract from Tim Harford's new book, Adapt, published by Little & Brown. Harford is a member of the Financial Timeseditorial board.