Pharmaceutical Patents--Posner

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.

Comments

[Palooka]

Scott,

Corey is advocating abolish all IP, and that such abolition will not negatively impact innovation. That is what I meant by less efficient. I didn't mean to imply it is perfect or that reform in some form is not justified.

[Corey]

Oh yes, I forgot that the 20th century taught us all that any step towards collectivation is a step towards doom and economic collapse. How misguided of me. I guess I should be building a little shrine to Hayek instead of posting. Oh,
and someone should tell those crazy Chinese that the U of Chicago debunked their system eh?

Lets keep the revisionism to a minimum here, and lets remember why everyone loved the New Deal.
Save that "20th century has proven socialism is bad" ideology for people who aren't collecting any of the bad socialist benefits in this country like social security, welfare, medicaid, Stafford Loans, electricity from the Hoover dam, freeways... Oh, and don't forget the 400 billion dollar a year defense budget without which entire industries would not exist. That's a great example of the machinations of the free market eh?

If you read my post carefully you will see that I am not advocating the loss of incentives. I am pointing out that awarding the CEO of Pfizer enough stock options so that he can buy a 400 foot boat and a second house in Aspen does NOT incent innovation in the drug market. It incents profit taking. As someone who used to work as an engineer and who invented patentable stuff, you would think that the market would have incentivized me after the fact. But NO... I was laid off to make the quarterly revenue prediction so the CEO could keep his job. I guess you could say the market incentivized me to be a neo-marxist.

In your massively efficient market, three times as many real dollars are going to marketing as are going to R&D. How wonderfully efficient. More money goes to executive compensation at many of these companies than to R&D. Oooooh, what a great solution the market has arrived at.

I bow before the god Mahkut! Please oh Mahkut, bless us with a solution for the rising homelessness in our cities! The cost of real goods like gas and milk has risen for 5 years with no corresponding real wage increase! Why hast thou forsaken us oh Mahkut! Can I have a job for Christmas? Please?

[Palooka]

"If you read my post carefully you will see that I am not advocating the loss of incentives."

That is EXACTLY what you advocated, because you operate under the mistaken assumption that people's desire to help their fellow man is all the "incentive" anybody needs.

I never took any issue with specific socialistic policies, I took issue that the premise that incentives and markets don't matter. That is your position, Corey. Remember the whole "IP isn't necessary" line?

It's clear I'm dealing with someone with very little regard for reasoned debate. I'm sorry you were imbittered by your experience in private enterprise, and I hope you find comfort in your neo-Marxist delusions.

[James Wetterau]

Re: "LessBureaucracyNotMore"'s comment:

I am not a fan of our patent system, but if it is likely to be preserved, it seems to me that we should consider how best to reform it. Just because an alternative form might require more bookkeeping doesn't mean it won't have offsetting beneficial economic effects. The problem here is not entirely one of bureaucracy -- it's a problem stemming from monopoly rights and the costs they impose.

Your suggestion that this would cause progress to grind to a halt since anyone could file for "also ran" status is a strawman argument: if that were so, the same problem would apply to prior art with our current system.

[Corey]

"It's clear I'm dealing with someone with very little regard for reasoned debate."

Reasoned debate... is that the kind where one side defines the terms in advance in order to make sure the discussion does not escape the bounds of permissible thought?

I don't know, people here seem to like economics, and my posts have even more numbers in them than Posner's! Of course my numbers aren't hypothetical, maybe that is the problem. Maybe I should have said: "Assume excess profits in the drug industry of 25%." That sounds pretty
econominical eh? Posner forgot to put the "assume" in when he said the drug industry does NOT have excess profits, but he is understandably busy so we will remember to fill it in for him.

[Sami]

Corey,

Since you asked several times. Here is where Bristol Meyers Squibb's money went for the 2003 according to their annual report readily available on their website.

1. Cost of Product Sold - 7.592 B (46%)
2. Marketing, Selling Admin - 4.660 B (29%)
3. Advertising and Product promotion - 1.416 B (8.7%)
4. R&D 2.279 B (14%)
5. Litigation 0.199 B (1.2%)

Total expenses are 16.2 B (I left out some minor expenses)

Cost of the product and R&D together are about 60% of the expenses, while advertising and promotion was only 8.7%. Litigation was very little. The total revenue for BMS for 2003 was about 20.8 B.

You can check it out yourself here: http://www.bms.com/static/annual/2003ar/annual_report/data/2003bmsar.pdf

[Sami]

Sorry for the complete link after the "2003bms" type "ar.pdf"

[Corey]

The 12% R&D figure I used was off a Pfizer annual report.

What do you think the difference is between "marketing and selling admininistration" and "advertising and product promotion"...
together they add up to 38%, which is pretty much exactly what I said. Except not really, because those are percentages of expenses, not percentages of earnings.

But anyway, with 4.6B in profits, why fight over one or two percent. Lets give them some more corporate welfare, 25% profits is pathetic, those seniors can pay more, they are going to die soon anyway!

Merry Christmas to all.

[GW IP JD]

As for the Federal Circuit being "extraordinarily pro-patent:"

It behooves the Prince indeed to keep the laws by which he himself if empowered.

Perhaps if the Fed. Cir.'s jurisdiction were broadened to less-beholden IP areas (trademarks?), we would see fewer self-interested policies enunciated by that Court. Or, perhaps sister circuits, on the off chance that they receive a patent appeal a la Vornado Air v. Holmes Group, should should fashion anti-patent opinions, if anything for the sake of showing the effect of contrasting policy. The Federal Ciruit isn't the last word on patents because it is infallible; it is infallible because it has been the last word on patents for the last 25 years (notwithstanding tepid attempts by SCOTUS to try to reassert their ability to understand and decide patent policy).

[GW IP JD]

*is*

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