PICKING A WINNER

Innovation obviously benefits society as a whole as well as the innovator. Innovators respond to incentives. Many
of the patents for agricultural inventions in nineteenth century Britain can be traced back to prizes that were offered
for a specific improvement. Even losing contestants sought patent protection for their ideas, accounting for over
13,000 inventions. In 2006 the online movie rental firm Netflix offered a $1 million prize to the individual or group
that devised the best algorithm for generating its online recommendations. By 2009 it had received entries from
over 55,000 people in 186 countries. The seven members of the winning team collaborated over the internet, and
did not meet until the day they assembled to collect the prize. NASAs recent prize for an improved astronaut glove
was awarded to an unemployed engineer, not an aerospace firm.

The development of new products and new production processes are the keys to our prosperity. To foster
such innovations, capitalist economies provide inventors and product developers with patent protection. A patent
gives the holder monopoly power for a limited period of time. This allows the patent holder to charge monopoly
prices, whereby research and development costs can be recovered. Patents deliver welfare gains because they
provide an incentive to invest in research, leading to improved products and production processes, but there is an
associated welfare cost. The monopoly price charged by the patent holder deprives some consumers of the good
those who will not buy the good because of the high price, even though the benefit that they would have derived is
high enough to cover the marginal cost of production. This is a public policy dilemma: The longer the life of the
patent the greater the incentive to innovate but the higher the welfare cost of missed consumption opportunities.
This section examines a special case of innovation. There is a sponsor perhaps the government who
wants some agent to develop a specific product or production process. Once the research bears fruit the idea will be
made available to every firm. Whats in it for the firm or individual that first develops the new idea? The sponsor
might set up a contest, with a prize going to the winning inventor. This is the approach the government took in 1992
when it offered a thirty million dollar prize to the first firm to develop a new super-efficient refrigerator. To ensure
that the new appliance would be valuable to consumers, the prize could not be collected until the winner sold
250,000 new refrigerators. Whirlpool won the contest, but couldnt collect because it sold only 200,000 units. In
1996 the charitable X Prize Foundation offered $10 million dollars for the first private firm to fly a reusable
spacecraft to a height of 100 kilometers twice within two weeks. It was awarded in 2004 to a team headed by Paul
Allen, the co-founder of Microsoft, and Burt Rutan, an aerospace engineer. The same foundation offered $30 million
to the first firm to land a robot on the moon. The offer expired at the end of 2015. In 1714 the British Parliament
offered 20,000 pounds for the first person or firm to develop a method for determining longitude on board a ship. At
that time mariners had no way of knowing how far east or west they had sailed. Accidental grounding and loss of
life sometimes resulted.
Public health provides many examples of opportunities for sponsorship: Malaria, for instance kills over a
million people each year, almost all of whom are in low- and middle-income countries. Pharmaceutical companies
obviously do not see these populations as a source of profit. There would not be enough revenue from the sale of a

malaria vaccine to pay for the research and development costs. For example, the World Health Organization could
sponsor the research, with rich countries contributing the funds.
From an overall social welfare standpoint, a contest has two drawbacks. First, a contestant will not be sure
of winning, and hence the prize has to be big enough to provide an incentive to invest in research and compensate
for the uncertainty of being rewarded. Second, because more than one firm invests in research there is duplication
of costs and hence wasted resources. (There is also waste, in the form of a lost opportunity to society, if no firm
invests due to the uncertainty of winning the prize.)
Is there a mechanism that will not only avoid the waste due to duplication of research effort but also induce
the firm with the most promise to do the research? The Vickrey Mechanism is just such a scheme.
To simplify the discussion we assume that there are only two firms capable of meeting the sponsors goal.
(It is easy to extend the analysis to the case of an arbitrary number of firms.) Let v1 denote the value to the sponsor
of firm 1's innovation, and let v2 denote the value to the sponsor of 2's innovation. The sponsor knows very little
about the inner workings of a firm, and hence does not know v1 or v2. Moreover, firm 1 knows v1 but not v2, and
firm 2 knows v2 but not v1. Because firm i will not be able to determine in advance precisely what the results of its
research will be, we can think vi as an expected value. And note that vi is the value to the sponsor, not to firm i itself.
For example, if the sponsor is a government then vi will be the value to the entire country of the new idea. We let ci
be the cost to firm of its research effort. Values and costs will be realized in the future, so we assume that they are
both discounted i.e., present expected values and present expected costs.
The net value to the sponsor of firm 1's research is v1 c1, and the net value to the sponsor of firm 2's
research is v2 c2. For convenience, we set si = vi ci, the surplus generated by firm i. The sponsor wishes to
identify the firm with the largest si and have that firm alone develop the idea. If the sponsor is the government and
the cost ci will be absorbed by a private firm, and not taxpayers, maximization of vi ci is still the appropriate goal
because ci is a measure of lost welfare as resources are shifted away from the production of other commodities in
order to develop the new idea. Maximization of vi ci is certainly appropriate when the sponsor is the government
and 1 and 2 are government agencies. In that case the cost will be borne by taxpayers. Finally, the sponsor could be
a private firm, with agents 1 and 2 being employees of that same firm. Again, maximization of vi ci is the
appropriate goal for the sponsor.
The sponsor wishes to identify the firm with the largest surplus, but the individual firm cannot be expected
to reveal its surplus truthfully, unless it has an incentive to do so. The nave mechanism has each firm reporting its
surplus, and the high surplus firm is awarded the contract. In that case each firm will be motivated to vastly
overstate its anticipated surplus. By contrast, the Vickrey mechanism provides an incentive for truthful revelation.
DEFINITION:

The Vickrey Mechanism

Each firm i is asked to report si to the sponsor. The sponsor commissions the firm h with the highest reported
surplus sh to develop the idea and pays that firm vh sj, where sj is the second highest reported surplus.

Note that we are assuming that the sponsor can verify vh after the idea has been developed. It would take time for
the value of hs product to be revealed and calculated. Moreover, the costs involved would be incurred at various
points in time. We circumvent this difficulty by supposing that vi and ci, and hence si and the payment vh sj, are
present values for each firm.
Now we prove that no firm can benefit by deviating from truthful revelation of its surplus si, regardless of
the reports of the other firms, whether or not a firm knows much or little about the reports of other firms. Suppose
initially that there are only two firms. The sponsor does not know whether s1 > s2 or s2 > s1 holds, and must rely on
the individual firms to reveal their private information truthfully.
Suppose that s1 > r2, where s1 is the true surplus of firm 1 and r2 is the reported surplus of firm 2. If 1
reports truthfully it will be given the contract and receive a payment of v1 r2. Firm 1's profit would be the payment
received minus its cost, which is v1 r2 c1 = v1 c1 r2 = s1 r2, which is positive. Firm 1 cannot profit by
misrepresenting s1 in this case because the payment v1 r2 that it receives is independent of the surplus that it
reports, given that it reports a surplus higher than r2 and that the actual value v1 can be verified by the sponsor after
firm 1 is given the contract. The only strategy available to 1 that would give it a payoff different from the payoff
under truthful revelation is reporting a surplus lower than r2. Then it would not be awarded the contract and will
forego the profit of s1 r2 arising from truthful revelation.
Suppose that r1 > s2, where r1 is the reported surplus of firm 1 and s2 is the true surplus of firm 2. If firm 2
reports truthfully it will be not be awarded the contract and will neither gain nor lose by submitting its true surplus s2
or any surplus below r1. The only strategy yielding a different payoff to 2 would be a report r2 greater than r1,
resulting in 2 getting the contract and receiving a payment of v2 r1, for a profit of v2 r1 c2 = v2 c2 r1 = s2
r1, which is negative. A firm that would not be awarded the contract cannot profit by misrepresenting its true
surplus. We formalize this argument as follows, assuming an arbitrary number of firms competing for the contract:
Theorem: The Vickrey Mechanism gives each firm an incentive to report its surplus truthfully.

Proof: Suppose that firm 1 would be the one reporting the largest surplus if it reported its true surplus s1. Then s1 >
ri for all i > 1, where ri is the surplus reported by firm i. Give the name 2 to the firm reporting the second highest
surplus. Under truthful revelation firm 1 will be selected and will be paid v1 r2 to do the research. Because firm 1
will then incur c1 in cost, firm 1's profit will be v1 r2 c1. Firm 1's profit would be v1 r2 c1 = v1 c1 r2 = s1
r2. Because s1 > r2 firm 1 will make a positive profit if it reveals its surplus truthfully. Would a different strategy
yield even more profit?
Any reported surplus higher than s2 will result in firm 1 being selected and receiving a payment of v1 r2
for a profit of v1 r2 c1 = s1 s2, the payoff arising from truthful revelation s1. Any reported surplus lower than
r2 will result in firm 1 not being selected and missing out on the profit of s1 r2 that it could have obtained by

revealing s1 truthfully. We conclude that a firm that would be the high surplus one under truthful revelation cannot
profit by deviating from truthful revelation but it can be hurt by doing so.
Suppose that firm j would not be the one reporting the largest surplus if it reported its true surplus sj. Then
r1 > sj, where 1 is the name we give to the firm reporting the highest surplus. Under truthful revelation j will not be
awarded the contract, resulting in a profit of zero. Any report rj less than r1 will give j a payoff of zero. The only
strategy that would yield a different payoff is a report rj > r1. Then 2 would get the contract and be paid v2 r1, for a
profit of v2 r1 c2 = v2 c2 r1 = s2 r1 which is negative. A firm that would not be awarded the contract under
truthful revelation cannot benefit by deviating from truthful revelation, but it can be hurt by doing so.

The proof pointed out that firm 1 would not be hurt by overstating its true surplus. But that is the case only
if 1 knows what number would be reported by the other firm. In practice, firm 1 would not have that information,
and would be hurt by over-reporting if its true surplus was below the number reported by its rival.
We continue to refer to the true high surplus firm as firm 1. Firm 1's profit is v1 s2 c1, which is less than
v1 c1. Could firm 1 develop the idea on its own and get a profit of v1 c1 instead of the lower v1 s2 c1? Recall
that v1 is the value of the invention to society as a whole, not just to firm 1's customers. Therefore, the private
development of the idea by firm 1 might yield far less revenue than v1. In fact, firm 1's revenue might be zero. The
goal of the sponsor might be knowledge, rather than some material good, and once the knowledge is developed it
might be acquired by any other firm at virtually zero cost, as in the case of the invention of a clock that keeps
accurate time at sea, making it possible to determine a ships longitude.