Market Power Screens Willingness-to-Pay∗

What is the best way to reward innovation? While prizes avoid deadweight loss, intellectual property screens out projects generating low consumer surplus per unit sold. We propose a stretch parameterization of demand under which innovations differ in both the size of the market they create and consumers’ average willingness-to-pay for them. We solve the resulting multidimensional screening problem by decomposing the analysis into a separate choice of the level and structure of rewards for innovations. Optimal policy generally calls for some market power but never full monopoly pricing. The appropriate degree of market power is determined by a value-weighted average of the innovation supply elasticity multiplied by the log-variance of the ratio of the monopoly prices to quantities, opening our analysis to empirical calibration. Our results also shed light on the pricing of platforms, incentives within firms for product development and public infrastructure. ∗Weyl acknowledges the support of the Milton Fund and Nokia. Tirole acknowledges the support of Microsoft and Nokia to the Institute for Industrial Economics (IDEI). The research leading to these results has received funding from the European Research Council under the European Community’s Seventh Framework Programme (FP7/2007-2013) Grant Agreement no. 249429. We are grateful to many people for the helpful comments they provided on this paper, but we especially thank Roland Benabou, Joshua Gans, Scott Duke Kominers, José Scheinkman, Josh Schwartzstein, Yossi Spiegel, Scott Stern, Michael Whinston and Pai-Ling Yin. Most of all, we appreciate the excellent research assistance of Stephanie Lo, Vladimir Mukharlyamov, David Smalling, William Weingarten and especially Andre Veiga and Rui Wang. All errors are our own. †Harvard Society of Fellows and TSE: 78 Mount Auburn Street, Cambridge, MA 02138, USA: [email protected]. The order of authors has been chosen to conform to the scientific convention of priority of contribution rather than the social convention of alphabetic precedence. ‡TSE, 21, allée de Brienne, Toulouse 31000, France: [email protected].