I agree that no adequate, feasible alternative to patents exists for encouraging R&D by manufacturers of pharmaceutical drugs. But my agreement should not be understood as indicating approval of the present U.S. patent system.
Patents are a source of great social costs, and only occasionally of commensurate benefits. The social cost of patents that was traditionally emphasized by economists is the wedge that a patent drives between price and marginal cost. Generally, we expect that competition will compress price to marginal cost and that this is efficient because it means that no one willing to pay the marginal cost of a good is deflected to a substitute that might cost more to produce, yet look cheaper simply because the price of the good was above marginal cost. By preventing duplication, a patent reduces competition and so may enable the producer to charge such a price. But the objection to patents that is based on the wedge is superficial because the producer may have incurred costs that do not affect his marginal cost. Suppose the cost of R&D that the producer must incur to bring a drug to market is $100 million, but the marginal cost (the cost added to total costs by each unit of output) is a constant $1 a pill. Then no matter how many pills the producer sells at $1, he will never recover his upfront investment.
The real concern about patents is the costs imposed on inventors themselves. There is the cost of searching the records of the patent office to make sure you're not going to be infringing a patent, but more important is the transaction cost involved in obtaining a license from an existing patentee. Invention is a cumulative process; a new invention is usually an incremental improvement on an existing one. So the more patents that are “out there,” the greater are the costs involved in negotiating for a license from every patentee whom the new inventor may arguably be infringing. Because a patent can be obtained without even a prototype, because patent examiners are overworked and it takes less work to approve than to reject a patent application, and because the U.S. Court of Appeals for the Federal Circuit, which reviews patent validity, is extraordinarily pro-patent, the number of issued patents has grown steadily in recent decades. There is concern that some fields are so blanketed with patents (which may be owned by firms that do no production at all—whose business plan centers on demanding license fees under threat to sue for patent infringement) that innovation is actually being impeded. Most firms don’t actually want patents; for those firms, the costs involved in obtaining licenses from patentees are not offset by the prospect of obtaining license fees on their own patents. There are many alternatives to patents for protecting one’s investment in R&D, and they are often cheaper and more effective. They include: trade secrecy; the advertising value of, and the consumer loyalty generated by, being the first to produce a popular product; the fact that marginal cost may increase steeply with output, so that a price equal to marginal cost may cover the fixed costs of invention after all; the fact that it may be costly and time-consuming for competitors to duplicate the invention exactly; and, related to the last point, the learning curve—if costs of production fall over time as the producer learns more about how to make the product at least cost, the first firm in the market will tend to have a cost advantage over competitors, who arrive later. But if other companies are busy getting patents, you may have to patent defensively, and the patent thicket thickens.
The pharmaceutical-drug industry is the industry that can make the strongest case for needing patent protection. The investment required to bring a new drug to market is very great, in part because of the many “dry holes.” And it may take years before the new drug can be sold, which shrinks the effective term of the patent (if it takes 8 years to bring the drug to market, the effective term of a 20-year patent is only 12 years). This not only reduces the revenue from the patent; but because the costs of the upfront investment are incurred years before revenues commence, those revenues must, because of the time value of money, exceed the upfront costs in order to be fully compensatory. In addition, once the drug is in production, it is easily duplicated by competitors, and the marginal cost is very low at all feasible output levels, so that with free entry the original producer would not be able to recoup his R&D investment.
That said, I am skeptical about the length of the patent term for pharmaceuticals. Congress has tacked on to the normal 20-year patent term (which until 1995 was only 17 years) an additional term of up to 5 years for the time it takes a pharmaceutical manufacturer to get a new drug approved by the Food and Drug Administration. In addition, the expiration of a pharmaceutical patent does not extinguish the patentee’s ability to obtain a higher price than the generic substitutes that come on line when his patent expires, because there may be substantial consumer and physician goodwill attached to the trademark of the patented drug—consumers, even physicians, may distrust generics and prefer the original brand even at a higher price. Indeed, there is evidence that when a patent expires the ex-patentee will actually increase price, ceding the low-price end of the market to the generics. His overall profits will be lower but may still be substantial.
Against this it may be argued that the fact that the drug companies apparently do not have excess profits show they need every bit of patent protection they have. Not necessarily. Competition for a profit opportunity may transform expected profits into costs. Suppose the drug companies believe that the invention of some new drug will yield the successful inventor a $1 billion net profit. The prospect will induce heavy expenditures on being first (the aggregate expenditures may actually exceed $1 billion). The result is that none of the companies, or the industry as a whole, may have abnormal profits. Now suppose that as a result of a shortening of the patent term, the prospect for the successful inventor is for making only an $800 million profit. Less will be spent on the patent race. Yet consumers as a whole may be better off, because the investment saved may have greater value elsewhere in the economy. The entire patent “prize” goes to the firm that crosses the finish line first, and so a firm might spend a huge amount of money to beat its nearest rival by one day even though the value to the public of having the invention one day earlier might be negligible. This danger is greater, the bigger the prize. Shortening the patent term would reduce this potential waste by reducing the revenue from a patent; it would also reduce the transaction costs of licensing, because more inventions would be in the public domain.
The pharmaceutical industry is under attack once again for its high prices, because of a belief that it pays insufficient attention to safety, and allegedly that sometimes it hides damaging information about their drugs. The industry is no paragon of virtue, but during the past 50 years it has become a major contributor to the dramatic declines in mortality and increases in the quality of life. Reforms that undervalue these contributions are likely to do far more harm than good.
Some of the industry’s important products include aspirins, antibiotics, blood pressure lowering medications, cholesterol lowering drugs, Aids cocktails, drugs that slow the progress of breast and prostate cancer and Parkinson’s disease, effective sleeping pills, and anti-depressants that enable many mentally troubled persons to live reasonably normal lives. Although the cost of producing these and other drugs is typically quite low, enormous amounts are usually spent trying to discover and develop them.
In 2003, American drug companies spend over $30 billion on research and development, which includes the very expensive clinical trials required by the FDA and government regulatory bodies in other countries. This is not very far behind the Federal government’s spending on basic and other medical research. The average number of new molecular entities approved during the past five years averaged about 50. So American drug companies are spending some $600 million (=$30 billion/ 50) per new molecular entity. This heavy R&D burden explains why stock prices of drug companies have not performed especially well during the past 5-10 years, despite very high prices for a few blockbuster drugs. Bio-tech companies as a whole probably even lost money over this period.
The low cost of producing drugs once discovered creates the impression that drug companies are gouging seriously ill cancer, Aids, and other patients. But these companies cannot recoup their huge R&D spending without charging for a number of years much more than the cost of producing their drugs. The patent system provides protection against generic competition for about 20 years from the date of first filling for a patent. However, competition from chemically similar entities usually appears years before patents expire, and the extensive testing required by the FDA considerably shortens effective patent lengths. Still, without patents or similar protection, other companies can reverse engineer most drugs to discover how they are made, and then sell them at much lower prices since they do not have the burden of heavy R&D costs.
To be sure, a patent system creates a tension between the effect that prices well above costs of production have in reducing the use of drugs by sick persons, and the effect of high prices in helping companies recoup their large R&D spending. This tension is the cause of the increasing attacks on drug companies as more blockbuster drugs have been introduced during the past couple of decades. So an important public policy question is whether we can do better than the present patent system? I believe we can improve how the system operates in many ways, but some suggestions are likely to make matters worse rather than better.
One tempting idea is to have the government buy out patent rights, and place them in the public domain available to all producers. Competition would then insure they would be sold to consumers at the cost of production. Recently, the Harvard economist, Michael Kremer (http://papers.nber.org/papers/w6304) revived this old idea in sophisticated form. Kremer suggests that the government uses auctions to decide how much patents on new drugs are worth. The value of a winning price would be paid not to the winner, but to the discoverer and patent holder-who can refuse the government’s offer and hold on to the patent. The winner of an auction only provides a measure of the drugs’ worth, and would not receive exclusive rights, even if the discoverer accepts the government’s offer, except in “a small proportion of patents”. But if this proportion is really small, the incentive to provide serious bids is greatly weakened. I also believe such a system might create a bureaucratic nightmare, but his proposal is worth more attention.
State governments and other groups are exerting great pressure to allow imports from Canada and online pharmacies, where drugs are much cheaper. But Canadian drug prices are cheap in good part because they impose price controls. In essence, Canada (and most other countries) free ride on the profits collected from the higher prices in the American market. The U.S. could also impose price controls if it wanted to do so, but these would be counterproductive because they would discourage discovery of new drugs. Moreover, if many drugs begin to be reshipped from Canada, drug companies would cut the amounts supplied to Canada, and prices there would rise. That is why Canada is beginning to crack down on online pharmacies that resell to the American market.
Perhaps patent lives should be shorter, but they were lengthened in the 1990’s because clinical trial procedures take so long due to the requirement of three clinical stages: the first to determine safety, the second to determine efficacy, and the third randomized trials to check safety and efficacy. It has been estimated that perhaps 40% of all R&D costs are spent on these trials. I have proposed elsewhere (http://home.uchicago.edu/~gbecker/Businessweek/BW/2002/09_16_2002.pdf )) that the FDA trust patients more, and allow them more freedom to use new drugs by granting approval without the efficacy and randomized stages - this was the situation prior to 1962. At the same time, the FDA can tighten up safety standards, especially by putting resources into following more closely possible side effects over long time periods. Were my suggestion implemented, R&D costs would go down considerably, patent length could be considerably reduced, and yet companies would have more incentive to invest in finding new drugs.
I do not like the hype and some other salesmanship of big pharma and bio-tech companies, but this industry has made enormous contributions to raising world health. It is likely to become even more important in the future as drugs are developed to match individual genetic differences. One does not want to kill this goose that is laying golden eggs by ill-thought out and counterproductive “reforms”.
I am impressed by the very high quality of most of the comments and by the lively exchange among the commenters. If our blog can stimulate such exchanges, it is a success already. I will limit my response to a few recurrent themes in the comments.
One, a minor point, has to do with my having said, all too cryptically, that "the essence of self-defense is striking the first blow against your assailant." Readers thought "self-defense" should be replaced by "offense." I was thinking of the defense of self-defense in criminal law: if someone is about to stab you and you could prevent him from doing so by shooting him but you decide not to do so because you would be guilty of murder, then you have misunderstood what self-defense means in the law.
A major theme in the comments is that it is impossible to assign a numerical probability to an adversary's attack, unless the attack is imminent. That is true. No one could have said in 1936 that if Hitler was allowed to reoccupy the Rhineland, there was a .__ probability that he would eventually attack France. However, we frequently have to act under conditions of profound uncertainty. It would be paralyzing to suggest that we should never act unless we can quantify the expected benefits and costs of our acts (there would be very few marriages under this approach). And readers who doubt that cost-benefit analysis can be applied to matters of life and death, such as war, should consider that lives are on both sides of the balance. If a preventive war that killed 10,000 people could prevent a nuclear attack on the United States that would kill 10 million people, such a war would in my opinion be justified. (I wonder how many readers actually disagree.) My 1936 Rhineland example was misleading in the following respect: horrible as World War II was, the 50 million killed and the untold destruction and immiseration caused might be dwarfed by what a small nation or even a terrorist gang--perhaps even a biological Unabomber--could do, if not today, then in the near future. It is the unprecedented dangers created by modern technology that require reconsideration of the traditional prejudice against preventive war.
In favor of a categorical rule against preventive war, some commenters argued that such a rule is necessary to prevent a "slippery slope" that would end with Canada and Mexico invading the U.S. out of fear that our invasion of Iraq indicated that we might be trying to conquer the world. In other words, the argument goes, the existence of such a rule reduces the likelihood of all war. But this is very unlikely. Nations will not obey rules unless it is in the national self-interest to do so. Whether or not there is a rule against preventive war, no nation will launch such a war unless it thinks it necessary for national survival or some equivalent good, and if it does, it will not be inhibited by a rule.
I thus disagree with those readers who think that "legitimacy" plays a big role in international affairs. I do think that reciprocity plays a big role. If our waging a preventive war created a risk of others' waging a preventive war against us, that would certainly be a powerful argument against preventive war.
Some readers suggest that my posting was intended to advance a hidden political agenda that includes defending the war in Iraq. Not at all; and I mentioned the failure to find weapons of mass destruction as an example of the uncertainty that plagues any decision to launch a preventive war rather than to wait for one's enemy to strike the first blow. But that uncertainty is just one of the factors that must be considered in deciding for or against a preventive war.
Although many of the comments criticize the war in Iraq, I do not recall a single criticism of the war in Kosovo. Yet that was not a defensive war. Milosevic's Serbia was not threatening other nations; Kosovo was a province of Serbia. It was not a preventive war; my reason for mentioning is that it shows that wars can be justified without being defensive. The case for preventive war must be debated on its merits rather than rejected outright on the ground that any war that is not defensive is aggressive and therefore "illegitimate."
RESPONSE TO COMMENTARY ON PREVENTIVE WAR-BECKER
I am gratified by all the responses, negative as well as positive, to my short commentary on preventive war. I do not have the time to respond to individual responses, so I will be brief and make only a few general points.
I was accused of not using economics, neglecting the costs of preventive war, and a variety of other errors and omissions. Some of the comments are well taken, but let me restate my argument in a slightly more formal way, although I will still avoid equations. When threatened by an adversary, the options are either to preemptively attack, wait to retaliate until attacked, or wait to accumulate better information before deciding whether to attack preemptively. The theory of deterrence argues that the threat of swift, powerful, and credible responses can often deter crime and other aggressive acts.
I do very much believe in the power of deterrence-indeed, I contributed to the development of the modern theory of deterrence. However, the point of my piece it that deterrence is less powerful now as a tool against certain enemies than during the cold war when the adversary was a single major state. The reason is that some of the threats now come from irresponsible nations states with powerful weapons, as well as from terrorist groups that can also acquire these weapons. These groups are not easily deterred because they are dispersed, often operate in small groups, and increasingly will get access to more and more powerful weapons. Moreover, some terrorists and their leaders do not care if they die as long as they inflict sufficient damage on their enemies, and dictators of rogue states are willing to sacrifice many of their subjects if they can obtain advantage by attacking other states and groups.
The third option- waiting for additional information-is part of what economists call the “option value” of delaying. Unfortunately, it is often difficult to know how long we should wait, and many times it is worth taking preemptive actions with very imperfect information because the risks of destructive attacks due to delay are so great. Still, as some respondents argued, we probably should have waited much longer before attacking Iraq so that we could have been much more confident about our information. I have supported the Iraqi war, but Iraq is not the main stimulus for my commentary. I mainly wanted to show why the issue of possible preventive war and preemptive attacks will arise in the future much more frequently than in the past.
I wish I had read before writing my piece the article by Eric Posner and Alan Sykes on Optimal War at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=546104. They also start from the theory of criminal deterrence and take a very similar “rational choice” approach to mine, although they develop their argument much more thoroughly.
The U.S. invasion of Iraq, the U.S. decision not to invade Afghanistan before the 9/11 attacks, and concern with the apparent efforts of Iran and North Korea to obtain nuclear weapons raise acutely the question when if ever a preemptive or preventive war is justified. If “preemptive war” is defined narrowly enough, it merges into defensive war, which is uncontroversial; if you know with certainty that you are about to be attacked, you are justified in trying to get in the first blow. Indeed, the essence of self-defense is striking the first blow against your assailant.
But what if the danger of attack is remote rather than imminent? Should imminence be an absolute condition of going to war, and preventive war thus be deemed always and everywhere wrong? Analytically, the answer is no. A rational decision to go to war should be based on a comparison of the costs and benefits (in the largest sense of these terms) to the nation. The benefits are the costs that the enemy’s attack, the attack that going to war now will thwart, will impose on the nation. The fact that the attack is not imminent is certaintly relevant to those costs. It is relevant in two respects. First, future costs may not have the same weight in our decisions as present costs. This is obvious when the costs are purely financial; if given a choice between $100 today and $100 in ten years, any rational person will take $100 now, if only because the money can be invested and through interest compounding grow to a much larger amount in ten years. But the appropriateness of thus discounting future costs is less clear when the issue is averting future costs that are largely nonpecuniary and have national or global impact.
Second, and more important, and well illustrated by the failure to find weapons of mass destruction in Iraq, if the threat of attack lies in the future it is difficult to gauge either its actual likelihood or its probable magnitude. But this is not a compelling argument against preventive war. What is true is that a defensive war is by definition waged only when the probability of an attack has become one; the attack has occurred. The probability of attack is always less than one if the putative victim wages a preventive war, because the attacker might have changed his mind before attacking.
But while the probability of a future attack is always less than one, the expected cost of the future attack—the cost that the attack will impose multiplied by the probability of the attack—may be very high, perhaps because the adversary is growing stronger and so will be able to deliver a heavier blow in the future than he could do today. It may be possible to neutralize his greater strength, but that will require a greater investment in defense. Suppose there is a probability of .5 that the adversary will attack at some future time, when he has completed a military build up, that the attack will, if resisted with only the victim’s current strength, inflict a cost on the victim of 100, so that the expected cost of the attack is 50 (100 x .5), but that the expected cost can be reduced to 20 if the victim incurs additional defense costs of 15. Suppose further that at an additional cost of only 5, the victim can by a preventive strike today eliminate all possibility of the future attack. Since 5 is less than 35 (the sum of injury and defensive costs if the future enemy attack is not prevented), the preventive war is cost-justified.
A historical example that illustrates this analysis is the Nazi reoccupation of the Rhineland area of Germany in 1936, an area that had been demilitarized by the Treaty of Versailles. Had France and Great Britain responded to this treaty violation by invading Germany, in all likelihood Hitler would have been overthrown and World War II averted. (It is unlikely that Japan would have attacked the United States and Great Britain in 1941 had it not thought that Germany would be victorious.) The benefits of preventive war would in that instance have greatly exceeded the costs.
For further discussion, see Optimal War.
Combating crime mainly relies on deterrence through punishment of criminals who recognize that there is a chance of being apprehended and convicted-the chances are greater for more serious crimes. If convicted, they can expect imprisonment or other punishments- again, punishments are generally more severe for more serious crimes. Apprehension and punishment reduce the gain from crimes; in this way, it deters others from criminal activities.
Individuals can also be punished simply for planning or intending to commit crimes. The evidence required to punish intent has to be convincing, but the standard is weaker for violent crimes, like plotting murder, since punishment after the crime does not do anything for those murdered. In addition, individuals who cannot be deterred are sometimes punished simply because it is considered likely that will commit crimes in the future. This is a major justification for forced hospitalization and psychological treatment of potentially violent and mentally unstable persons.
These arguments about intent apply much more strongly to preventive actions against terrorist organizations and rogue nations. The conventional approach to war in democratic states favors retaliation after attacks. This was the rationale for the Mutually Assured Destruction (MAD) doctrine during the height of the Cold War: the US was prepared to unleash devastating nuclear destruction against the Soviet Union if attacked with nuclear weapons, and visa versa for the Soviets. That worked, although there were several close calls, as during the Cuban crisis.
But this approach is no longer adequate to fight terrorist organizations, states that sponsor terrorism, and dictatorial states that want to destroy their enemies. For it is becoming increasingly possible for terrorist organizations and governments to unleash biological, chemical, or nuclear weapons that will cause massive destruction. Retaliation may be slow and difficult if terrorists are widely dispersed so that it is hard to generate sufficiently severe reprisals to discourage their attacks. Rogue governments also are more capable of using these weapons surreptitiously, so that it might be many obstacles to determining who was responsible if they chose not to admit their responsibility. It is already difficult to know which groups are responsible for terrorist acts except when they brag about them.
In addition, many state-sponsors of terrorism often prey on the zeal of individuals who are willing to kill themselves in promoting what they consider a higher cause. These suicide bombers clearly cannot be punished after they commit their acts (although their families could be) because they forfeit their lives while attempting to kill and injury others. One can try to raise the probability that they will fail-through barriers, walls, and other protective activities- but free societies are so vulnerable that these can never be strong enough deterrents.
The only really effective approach is to stop them before they engage in their attacks. This is accomplished by tracking them down and imprisoning or killing them based on evidence that they intend to engage in suicidal attacks. Those planning such acts can also be punished on the basis of intent.
The same argument applies to dictators who are willing to use weapons of mass destruction to attack their enemies when they do not care if many of their populations are killed and maimed by retaliation from other countries. Dictators, like Saddam Hussein, may also greatly underestimate the likelihood of massive responses because sycophants feed them bad information, or they believe that democratic victimized states will be reluctant to make swift and decisive responses.
Admittedly, the evidence is usually more imperfect when trying to prevent attacks than when responding to attacks. Mistakes will be made, and the evidence of intent must be analyzed carefully. But criminals are convicted too on less than 100% certain evidence. As Posner says in his commentary, it is necessary to consider probabilities, not certainties.
Moreover, the degree of certainty required before preventive actions are justified has been considerably reduced below what it was in the past because the destructive power of weaponry has enormously increased. Perhaps most worrisome, the power of weapons continues to grow, and to become more easily accessible. Critics of preventive wars and other preventive actions against rogue states and terrorist groups ignore these major changes in weaponry and their availability. Democratic governments have to recognize that they no longer have the luxury of waiting to respond until they are attacked.
Blogging is a major new social, political, and economic phenomenon. It is a fresh and striking exemplification of Friedrich Hayek’s thesis that knowledge is widely distributed among people and that the challenge to society is to create mechanisms for pooling that knowledge. The powerful mechanism that was the focus of Hayek’s work, as as of economists generally, is the price system (the market). The newest mechanism is the “blogosphere.” There are 4 million blogs. The internet enables the instantaneous pooling (and hence correction, refinement, and amplification) of the ideas and opinions, facts and images, reportage and scholarship, generated by bloggers.
We have decided to start a blog that will explore current issues of economics, law, and policy in a dialogic format. Initially we will be posting just once a week, on Mondays. In time we may post more frequently. The first postings will be tomorrow, December 6.
Becker is a Nobel-prize-winning economist who in addition to scholarly publications on a wide range of economic issues including education, discrimination, labor, the family, crime, addiction, and immigration, for many years wrote a monthly column for Business Week. Posner is a federal circuit judge and also a writer of books and articles in a variety of fields, including antitrust, intellectual property, and other fields in which economics is applied to law, but also topical fields such as impeachment, contested elections, and national-security issues. (The rules of judicial ethics preclude Posner from commenting publicly on pending or impending litigation or participating in politics, as by endorsing candidates.)
We wish in closing this brief introduction to our blog to thank Lawrence Lessig, Jacob Wachman, and Matthew Haughey for their valuable assistance in setting up the blog.