Timothy Taylor quotes from a paper by historian B. Zorina Khan.

industrial prizes faltered in part because of their lack of market-orientation, and even the democratic nature of economic institutions in the United States could not overcome such drawbacks in administered prize systems.Judges had to combine technical and industry-specific knowledge with impartiality, but even the most competent personnel could not ensure consistency; decision-making among panels was complicated by differences in standards, interpretation, capture, and risk-aversion. Such difficulties tended to lead to haphazard decisions, or were often overcome by simply making the award to the person or the firm with the most established reputation. Juries were not immune to the effects of outright bias, capture, cognitive dissonance, lobbying, and “marketing.” Prizes tended to offer private benefits to both the proposer and the winner, largely because they served as valuable advertisements, with few geographical spillovers. Winners of such awards were generally unrepresentative of the most significant innovations, in part because the market value of useful inventions would typically be far greater than any prize that could be offered by private or state initiative.

Suppose that the commercial value of an idea is highly uncertain before it has become embedded in a business product or service. This leads to what we might call market-valuation errors. You can think of many examples of companies that have come out with products that they thought would be successful but failed to excite consumers.

With a prize fund, these market-valuation errors are borne by whoever puts up the prize fund. For example, if the government creates a prize fund for somebody who develops a better wind turbine, but the wind turbine still fails to penetrate the market, then the taxpayers take the hit. Instead, if the wind turbine inventor is given a reward in the form of a patent, then it’s the inventor who suffers if the turbine fails in the marketplace.

Going from patents to prizes serves to separate two functions: guessing the value of a potential invention; and coming up with the invention. Separating those two functions may not be such a good idea.

Adam Smith raised this concern. See David Henderson’s response to Taylor’s post. Henderson writes,

Essentially, the problem is a central planning problem. A government that gives prizes has to know what to give prizes for. It could give a big prize for something that matters little or a small prize for something that matters a lot. It’s hard to know in advance. Patents, as Smith points out, solve that problem.

As Henderson indicates, patents are problematic also. They are susceptible to other forms of errors by governments.