'If I had a hedge fund, I would cure diabetes': endogenous mechanisms for creating public goods.

We consider the problem of organizing capital to produce public goods with broad societal value. We review why market corrections via government subsidies or philanthropic initiatives are inadequate, in addition to considering the paradox of patents. Our proposed mechanism (an Ever-growing Prize and a Patent Repository) directs capital towards two innovation problems routinely overlooked: (1) problems for which the reward is insufficient even with established mechanisms (e.g. patents or academic prestige), and (2) problems for which the reward is large, but the effort risk is incalculable. The proposed hedge fund mechanism facilitates crowdsourcing, addressing the challenge of determining problems with broad societal interest; the ever-growing prize allows for an emergent rather than predetermined reward; the patent repository turns private intellectual property into a public good for target problems while circumventing the inventors' threat of patent expiration. We guide this discussion by considering two problems: treating Cystic Fibrosis and curing Diabetes.

Introduction

In the musical Fiddler on the Roof, see Bock (1964), the main character Tevye (a peasant living in Imperial Russia) wonders what life would be like (and how he might influence it) as he sings “If I were a rich man.” In this paper, we explore a similar theme, with an emphasis on using private wealth to improve the welfare of the general public—especially for problems where capitalism, government action and philanthropy have yet to succeed. We postulate that a modern equivalent of “If I were a rich man,” is “If I had a hedge fund.1” As a point of illustration of how competitive market forces can be organized in a way that better aligns with the interest of the general public, we describe how the owner of a hedge fund could use this aggregation of capital to cure diabetes.

We start by reviewing the inherent challenges facing a society as it creates legal structures to facilitate optimal levels of innovation. We then review existing mechanisms for solving important, society-wide problems: competitive markets, contests, and subsidies. While successful in addressing certain problems, structural constraints of these mechanisms lead to a type of market failures,2 implicit in Marx’s critique of capitalism3 (which we frame as: the holders of excess capital are either unwilling or incapable of putting excess labor, stored as capital, to work solving problems that are of interest to a substantial portion of those who helped create the excess labor, meaning the public).

The first part of our proposed solution—an Ever-Growing Prize—provides a mechanism where an emergent price is set by society such that a sufficient amount of capital from the competitive markets will be allocated to finding a solution to a target problem (e.g. curing diabetes). The second part—a Patent Repository—provides a legal structure where the barriers for sharing Intellectual Property (for the express purpose of solving a target problem) are eliminated, while leaving traditional protections in place for other problems; it also provides a clear path for rewarding contributors if their ideas are used to solve the target problem.

The Innovator’s dilemma

Three forms of risk are inherent to innovation4: (1) effort risk—the amount of effort needed to solve a problem is unknown a priori; (2) reward risk—the amount society will pay for a solution is unknown a priori; (3) free-rider risk—the amount of (created) value captured by the innovator is small to nonexistent once a solution is in the public domain. In light of these risks, one of the primary tasks of economics is to invent mechanisms that allow a society to organize capital to create public goods5 such as knowledge, and a primary task of political systems is to implement these mechanisms (Anomaly 2015).

How can a society motivate groups of individuals to spend sustained efforts to solve important problems? How does a society determine which problems are important? The profit motive from competitive markets, provides a well-tested mechanism for prioritizing problems and rewarding inventors. The corporation is a legal structure that allows capital to be organized for problems that meet two criteria:6 (1) the expected profit is above a threshold (defining the expected profit threshold, see Fig. 1); and (2) the risk of going bankrupt before bringing a product to market is negligible (defining the innovation boundary, again see Fig. 1).

Fig. 1

Competitive markets solve problems where profit, adjusted for risk, is above a threshold (marked by the expected profit threshold) and risk of going bankrupt is negligible (marked by the innovation boundary). It is worth noting that the risk-adjusted boundary can vary by firm, as the introduction of a new solution can cannibalize, see Chandy and Tellis (1998) and Tellis (20135), an existing solution already offered by the firm

As illustrated in Fig. 1, the expected profit and risk criteria lead to two types of market failures, i.e. areas of innovation where problems important to large parts of the public remain unaddressed. A first type of market failure occurs when the expected profit falls below a threshold, making the problem unattractive in competitive markets despite the low associated risk.7 A second type of market failure arises when the effort risk is exorbitant, making the problem unattractive to firms despite high expected profits (e.g. finding a cure for diabetes). Attempts to redress market failures, using capital captured through taxation or set aside by philanthropists, can be broadly categorized as Pull mechanisms (e.g. contests) or Push mechanisms (e.g. subsidies)—see Reich (2000), Glennerster et al. (2006) and Mueller-Langer (2013), both of which have limitations.

Pull mechanisms and the ever-growing prize

Pull mechanisms require innovators to8 bear the effort risk and innovators are only compensated once a solution has been developed. A first, traditional pull mechanism is a patent regime,9 where the prize is the inventor’s ability to charge a monopoly price until the patent expiration date. The source of reward risk associated with patents is primarily competition (alternative market solutions, not dependent on the patent, may arise) and, to a lesser degree, political (a patent regime can be changed through legislation or patents become void through a lack of enforcement by governments). A second pull mechanism, developed to address problems that fall below the expected profit threshold, is the advanced market commitment. Using this mechanism removes competitive and political sources of reward risk by having a credible legal entity (e.g. the World Health Organization) guarantee a market10 (see Berndt et al. 2007; Cernuschi et al. 2011; GAVI 2017). A third mechanism, resurgent in popularity, intended to overcome constraints associated with competitive markets and government intervention, is a contest with a cash prize, such as the Ansari XPRIZE,11 in which the reward risk is essentially reduced to whether the sponsor can be compelled to pay.

The first part of our proposal is an alternative prize mechanism. Prizes12 have a long, but erratic history as a mechanism for fostering innovation and broadening the pool13 of human capital14 (Brunt et al. 2012; Clancy and Moschini 2013; Gewin 2017; Levine 2009; Murray et al. 2012; Sobel 1996; Williams 2012). A longstanding challenge with using prizes is determining the size of the prize15 (Berndt and Hurvitz 2005; Berndt et al. 2007; Grabowski 2008; Kalil 2006; Kremer and Williams 2010; Levine 2009). The optimal size can, in theory, be derived in a game-theoretic sense by finding a Nash equilibrium16—if and only if we have accurate estimates of preferences for every economically viable individual and entity within society and accurate estimates of development costs for every economically interesting problem.17 Without these, we are left with very little practical guidance from theory. Clearly if the prize is too low, then it will not generate sufficient capital as the expected profit falls below the acceptable threshold (determined by the flat expected profit threshold and, for very risky projects, the innovation boundary, see Fig. 1); if the prize is too high, then capital, which could have been used on other problems, will be wasted in duplicated efforts (Clancy and Moschini 2013; Murray et al. 2012).

Our proposed solution is to introduce a prize mechanism which is funded through different types of crowdsourcing18 and which is unbounded19 (allowed to grow over time). This mechanism solves important problems. First, it provides a legally binding structure (a nonprofit corporation with a contractual obligation—to the donors—to pay the prize to any entity satisfying the prize conditions) which is capable of aggregating large amounts of capital outside the control of governments20 (reducing political and procyclical funding risks that plague many policy initiatives). Second, it offers an alternative way for society to resolve the reward risk, by allowing interested funding parties two avenues to contribute capital toward the solution (see Fig. 2). Third, it solves the problem of how large to make the prize by, in effect, running a series of experiments over time as the prize increases—establishing (approximately) the minimum necessary reward needed to organize sufficient capital to successfully resolve the effort risk. The size of the prize thus emerges endogenously over time, rather than being determined, arbitrarily, a priori.

Fig. 2

HF Hedge Fund, which can invest in a range of assets of varying degrees of risk, like an established trust fund. Capital managed by the hedge fund comes from two sources: a Cure Fund (funded by crowdsourced donations) and a Companion Fund (which manages money for those sympathetic with finding a solution to the target problem, but who are not ready to donate directly to the Cure Fund). Profits from investments funded by the Cure Fund return to the Cure Fund, minus a (1) below-market management fee; profits from the Companion Fund return to the Companion Fund, minus a (2) standard market management fee, which is subsequently donated to the Cure Fund

Push mechanisms and the patent repository

The economist Frank Knight made an important distinction between risk and uncertainty21 (Knight 1921). Solutions to many problems are complicated but well known (e.g. running a restaurant), hence the associated risks (effort and reward) are quantifiable. Alternatively, when solutions fall outside the domain of human knowledge (e.g. curing diabetes) then the associated risks are more than exorbitant, they are unknowable. When the probability of going bankrupt, regardless of how much capital you have, is unknown, it is impossible to calculate an expected profit, and the standard economic framework of maximizing expected utility fails. A rational, disciplined investor will be unwilling to bear the effort risk for problems with Knightian uncertainty.22 Problems beyond the innovation boundary in Fig. 1 thus remain unaddressed.

Push mechanisms allow governments (and philanthropies) to bear the effort risk by providing subsidies (e.g. grants and tax credits). The challenges with subsidies are oversight and taste and can be viewed as finance problems. Good financial managers align the amount of capital invested in market segments based on their judgement of profitability. For governments, the alignment of tax revenue (capital) to a portfolio of problems should be based on the preferences of their citizens. Depending on the concentration of power within a government, the ability for citizens to affect this alignment of capital varies and is at best limited.23.24

The ever-present reality of a subsidy-driven research enterprise is that to continue to exist inventors must ensure future subsidies. Only after that condition is satisfied can they focus on research priorities. The problems of taste (who should be given a grant) and oversight (ensuring that the researcher spends the capital as promised) are exasperated by the information asymmetry between the grant-agency and the researcher25 (the researcher has better knowledge about their true ability) and, typically, the lack of objective measurements to determine the societal value of research.26

Competitive markets (and prizes) address the challenges of taste and oversight but within limits. With few exceptions (philanthropy being one), the primary mechanism for bringing Knightian problems within the innovation boundary has been government funding,27 but that leaves the choice of the problems to be addressed at the mercy of the collective judgement of the political process.28 Likewise, philanthropic funding remains at the mercy of the idiosyncratic preferences of philanthropists.29 As a society, we can do better.

To help increase the concentration of and access to ideas that can lead to a solution of a target problem, we propose creating a legal entity that we call the Patent Repository, which is affiliated with the cure fund (see Fig. 3). Firms and research organizations with patents can grant the Repository an exclusive, limited-use (limited to solving the target problem—e.g. curing diabetes) license. All remaining rights are retained by the firm or research organization. The Repository then grants an open-source, limited-use, research license for all the patents it controls to the general public (i.e. to any and all legal entities globally).

Fig. 3

The Patent Repository holds exclusive, limited-use (limited to solving the target problem—e.g. curing diabetes) licenses for patents. If a subsequent cure patent is validated (via clinical trials by the FDA which would be the responsibility of those seeking to claim the prize, but could—in special cases—be aided by the cure fund), the prize is distributed to the cure patent (and derivative patents) holders, even if the initial patent protection for the derivative patents has expired. In exchange, all intellectual property needed to solve the target problem is put into the public domain

A legal entity claims the prize by submitting a cure patent and then having the cure patent verified by a designated outside entity.30 If the cure patent uses any of the patents in the Repository (derivative patents31), then the firms or research organizations holding these derivative patents will receive a portion of the prize.32 In exchange, the Repository is allowed and required to grant a royalty-free, limited-use license for the cure patent and derivative patents to the general public.

This legal structure reduces effort risk and provides a mechanism for society to more fully resolve the free-rider risk. First to the effort risk: patents turn public goods (knowledge) into private goods, which restricts their use.33 Our proposed structure undoes this, for a narrowly defined purpose, by allowing patents within the boundaries of the Repository to become public goods once again, meaning in part that the effort needed to negotiate licenses for investigating solutions to the target problem are eliminated. In addition, the Repository acts as a collection point for ideas related to the target problem. Together these diverse ideas can become meaningful, as inventions are often based on novel combinations of preexisting knowledge.34

With regards to the free-rider risk: the value that society will pay for a solution to a problem and the reward that the innovators who solve the problem receive, should be linked. In addition, all the essential innovators should receive part of the prize, even if their patent has expired. In contrast to US and European patents, which expire 20 years after filing, patents within the Repository de facto have no expiration dates in the sense that the Repository will reward derivative patents regardless of whether the patents are still in force externally. This pushes researchers, willing to “bend their research” toward discovering a foundational part of a solution to a target problem, because a mechanism is in place to guarantee their efforts are rewarded.

Combining an ever-growing prize with a patent repository

Our proposed solution, combining an Ever-Growing Prize with a Patent Repository, provides an alternative mechanism that better aligns the public interest with the allocation of capital towards important problems. The ever-growing prize component sets an emergent price (via the increasing prize value35) for target problems, which will attract the minimum amount of capital needed to resolve both the associated effort risk and reward risk.

The Patent Repository component provides a legal structure which reduces cost of exploration, provides a reward for solutions which is not dependent on monopoly pricing, and offers an alternative mechanism to resolve the free-rider risk. While each component in isolation addresses only part of the problem (leaving inventors exposed to important, unaddressed forms of risk), in combination all three forms of risk inherent to the innovator’s dilemma are addressed—an important condition to incentivize inventors to tackle problems of Knightian uncertainty, such as finding a cure for diabetes.

An important additional advantage of the proposed solution is that it can result in the “MacGyver Effect”36 where novel but (by market standards) uneconomic solutions to problems become viable, see Vanderbilt (2019). These are the problems that fall below the expected profit threshold in Fig. 1, which we illustrate in the next section.

The MacGyver effect and cystic fibrosis

Imagine an Ever-growing Prize and associated Patent Repository with a prize that rewards a treatment, which improves the average lung capacity of Cystic Fibrosis (CF) patients by a fixed amount. Historically, two competing therapeutic approaches could have been viable contenders for this prize, but to date, only one treatment is available.

Upon the discovery of a gene mutation, the CF Foundation took the unusual and laudable risk of investing over $150 million (Pollack 2014), to develop an FDA approved treatment.37 Starting at around the same time, Political Science Professor Valerie Hudson, mother of three boys with CF, took a MacGyver approach. Her review of the literature led to a conjecture that low levels of Glutathione (GSH) in CF patient lungs (and airways) could be redressed with a regular oral (nebulized) dose of GSH, which would in turn reduce mucus and improve lung functionality (Hudson 2001; Richards 2002). The oral GSH approach is not patentable and has a marginal cost on the order of $1200 a year;38 to date, Professor Hudson and a small group of volunteers have demonstrated limited but promising clinical success (Visca et al. 2008, 2015). The CF Foundation approach was patented, sold to Vertex Pharmaceuticals for $3.4 billion39 and is available for around $300,000 a year (Pollack 2014).

The fact that the oral GSH approach (a potentially viable treatment) has no path to secure monopoly pricing nor offer academic prestige, has left it bereft of capital; this represents not only a market failure, but in our view, a philanthropic failure.

The existence of an Ever-Growing prize (e.g. starting at around $150 million) could provide an economic reward that, we conjecture, would be able to attract venture capital sufficient to pay for the FDA clinical trials40 for a variety of different approaches including the oral GSH approach.41 With the amount of capital available to the CF research community, implementing a mechanism which circumvents unrestrained profit motives, could likely bring this second MacGyver-type treatment to market, which would improve the fate of CF patients as they would be better served by having two treatments instead of one.

Curing diabetes

Even though effective treatments for Type I diabetes (measuring blood sugar and injecting needed insulin) exist, there is broad public interest in developing a cure42 (having the body produce insulin once again and properly regulate it). Currently, the capital devoted to developing a cure is limited to push subsidies. This is due primarily to the effort risk being unknowable, as a cure would require advances in basic science.43 Even if the effort risk was quantifiable, development of a cure would face the classic product cannibalization challenge, as the primary candidates for developing a cure (e.g. pharmaceutical companies) would require an expected profit premium due to the lost profits from the elimination of their existing diabetes treatments.

How would our proposed mechanism change the flow of capital directed at developing a cure? Undoubtably some push capital would be diverted to fund the prize,44 but we anticipate that a spotlight effect would increase the overall concentration of capital. Initially, push-based researchers may be incentivized to place patentable research results in the Repository. As the prize and the accumulated Intellectual Property (IP) grow, small start-up teams funded by venture capitalists45 (unhindered by the prospect of the loss of treatment profits) may emerge to test the viability of the IP in the Repository. Then, as ambiguity decreases (and is no longer “Knightian”), curing diabetes may move inside the innovation boundary, attracting even more capital46 and enticing pharmaceutical companies to invest in promising start-ups or seek a cure via their internal R&D.47

A cure would consist of having a person with Type I diabetes: (1) produce insulin; (2) regulate that insulin; (3) require no further interventions; and 4) have same health risks as a similar person who never had Type I diabetes. To be effective, the formal cure definition would have to be written in a manner such that a credible claim could be enforced in court. Given the incremental manner in which science advances, a number of prize variations might be imagined, e.g. offering a large portion of the prize if a small percent of patients were cured, then distributing the remainder of the prize in a prorated fashion as larger percentages are cured.

In addition to paying for a cure, a portion of the cure fund would be used (as noted in Fig. 2) to maintain the Patent Repository, help non-traditional groups navigate FDA clinical trials,48 and establish endowments at major medical centers with the mandate to widely promote the cure.

What could go wrong?

Utopian ideals are often based on somehow having altruism dominate human interaction—typically through a critical mass of enlightened individuals; subsequent proposed structures then crumble when they encounter the realities of self-interest. The question we explore is not whether altruism can rise to dominate, but rather, whether altruism can use legal structures to entice additional altruism as well as avert negative consequences of behavior driven purely by self-interest. We address two critical questions that may arise from the perspective of self-interest: (1) how would one get such a prize mechanism started, particularly with respect to the aggregation of IP; and (2) would not existing profit maximizing entities (e.g. pharmaceutical companies, which are making substantial profits treating diabetes) seek to circumvent or thwart the mechanism?

There is an element of altruism required for our approach to work, but the altruism is restricted to a select few—the hedge fund owners. They provide the seed money for the prize and pay for developing legally binding contracts which stop the prize from being diverted by political expediency or sudden changes in philanthropic preferences. They also facilitate altruism in a broader sense, by managing investments for those who care about the target problem but are not yet ready to be altruistic with their capital, and then donate a portion of their management fee to the prize. The existence49 of a viable legal structure and a growing prize will help entice innovators to contribute IP to the Repository, but in cases where the target problem is suitably hard (e.g. years, if not decades, away from a solution) it may be necessary, and readily implementable in the mechanism described above, to set a series of intermediate prizes (e.g. getting a person with Type I Diabetes to produce insulin again—regardless of whether it can be effectively regulated) to entice participation.

Not everyone will want to participate in the mechanism; firms that have a profitable treatment for diabetes, for example, have a perverse economic incentive to purchase promising cure IP for diabetes with the explicit purpose to halt development (a practice called “shelving”). The existence of the Repository, however, offers an alternative route for commercialization and, at a minimum, should make shelving promising technologies more expensive.50 In addition, once the proposed mechanism brings us closer to a cure, profit maximizing firms may seek to circumvent the mechanism and develop a cure outside of the Repository. If a blocking patent exists51 in the Repository, then firms would be required to participate in the mechanism. If a blocking patent does not exist, the value of the prize—compared to the net present value of the cure, at a price that the “market can bear”—may not be enough and the firm might forgo the prize and patent the cure. In that case, not only has the proposed mechanism been instrumental in bringing a cure to market, it also provides competitors a clear economic reward for developing alternative (e.g. MacGyver-like) solutions.

Conclusion

Although prizes are regularly used and large trusts aggregate capital intent on solving specific societal problems, our proposal offers a novel mechanism for organizing capital to produce public goods. One key difference to previous approaches, has to do with scale; another is the type of innovation risk our mechanism will bear; and yet another has to do with how existing patents are treated. Our prize is unbounded by time: it grows until someone satisfies the criteria.52 It is also unbounded by size, providing a mechanism where the minimum amount of capital that society needs to solve a problem can be secured. Furthermore, our mechanism addresses the free-rider risk and resolves the reward risk. Within the Patent Repository, patented ideas regain the essential feature of non-exclusion, for the target problem, facilitating an unhindered approach to cumulative innovation with a clear path for rewarding incremental contributions to a working solution. We anticipate that our approach will succeed where others have failed: such as (1) where the problem is below the expected profit threshold and potential rewards (e.g. patent, academic prestige) are not considered attractive enough to motivate an effort, or (2) where the effort risk is so ambiguous that the problem is outside the innovation boundary and the threat of bankruptcy is sufficient to deter efforts from market participants.

Finally, while the core problem addressed in this article is economic in nature, the proposed solution has direct relevance to the advance of science as this advance requires that scientists have access to capital53 commensurate to the problems society wants them to address (Gambardella 1995; Pavitt 1963; Stamp 1933; Stephan 2015). Not only will our mechanism resolve the question of how to determine the minimum reward needed as well as offer an alternative path for pooling public goods, with the intent of solving a particular problem, under one legal structure (with a clear division of the reward), it also brings a new level of public determinism for redressing Marx’s critique of capitalism. Members of the public determine which problems to solve, as the hedge fund approach can only be effective for problems which a sufficient portion of the public deems worthy of investment.54 The crowdsourcing element of our mechanism introduces a democratic element to the most challenging political part of a society’s march of progress: aligning the will of the public with the use of the excess capital it produces.