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]

Interesting point about reducing patent terms helping the consumer--as R&D money could, perhaps, be better spent elsewhere.

I have a question about IP more broadly, inspired by your discussion on Lessig's blog. The terms on patents seem at least defensible, whereas the lengthy terms on copyrights seems to me indefensible. Books, movies, and music are not written and produced by the consideration of garnering profit 30,40, or 50 years later. What movie studio, when deciding on whether to green light a project or not, asks what possible profit will they make in 40 years?

What economic arguments are there for having copyright terms of 100 years or more? Can they be defended or are they purely a result of special interest lobbying?

[Andrew Boysen]

Purely the result of lobbying. Assuming an expected rate of return of 10% per year (which is much lower than record companies expect), it would not be worth investing $74 for a certain profit of $1,000,000 in 100 years. A certain profit of a million dollars 50 years from now is worth $8,519 (but if you do a more accurate expected return rate of 20%, that value drops to only $110).

Any finance student (even a freshman) could tell you that the value of extending the copyright of something produced now is virtually worthless compared to the value of extending the copyright of something already produced (even more so when you realize that there is no cost to extend copyrights to previously produced works, other than lobbying cost)!

[Ron Wright]

So right yu are that companies may race to the finish line to claim the prize.

Unfortunately we consumers/patient lack the knowledge to be informed consumers. Everyone has some knowledge of what a car is.

In the field of medicine the consumer has to put their trust in the doctor, the drug companies, and the regulatory system.

However when ethics lapse there can be significant consequences.

See this breaking story on our site:

Subject: BREAKING - HOT UPDATE ON "VACCINE-A" TO THE BLOGOSPHERE

ANTHRAX VACCINE - Had additive agent that may be injurious to the health of
those service people inoculated.

Several days ago I posted and linked to a book review on our site,
"Vaccine-A." We've since transferred this piece from the HSPIG Forum Site,
"Book Reviews" to the new HSPIG blog site:

http://www.hspig.org/MT/weblogs-hspig/archives/2004/11/anthrax_vaccine_1.html

HSPIG has a keen interest in things related to bioterrorism and bio-chem
weapons both in their use and our response and counter-measures.

The book, Vaccine-A, has far reaching ramifications from the manufacture of
such weapons to mounting creditable defenses against their use.

This is something to watch. This story is continuing to evolve.

This is still under the radar of the MSM. The MSM is probably wary of
Uncle Sam I suppose. The MSM has been burned badly lately on not
objectively reporting the news. One can argue almost that they have markedly
been rooting for the enemy.

Mr. Matsumato doesn't appear to be an alarmist and has considerable
credentials with a strong research/investigative background. Mr. Matsumoto
is a well respected and experienced investigative journalist both in print
and the TV media. Mr. Matsumoto was the Chief Investigative Correspondent
for the FOX News Channel and a foreign and national correspondent for the
NBC Nightly News. For his other distinctions and awards see his bio at:

http://www.hspig.org/hspig-board-bios-gmatsumoto.htm

This story has the potential to dwarf the Rathergate scandal and could even
rival Watergate. This Country is at war and those who would allow this to
happen to our brave men and women need to be held accountable for their
actions.

Since the original post Tom Barnes, Co-Founder of HSPIG and Persian Gulf War
vet - military intel, has talked many times with the author, Mr. Matsumoto.

Mr. Matsumto has agreed to come on the Board of HSPIG. Mr. Matsumoto is
staking his professional reputation on his book. As he says,"I took a page
from my old employer's play book at Fox News Channel - 'We Report. You
Decide.' I reported; now you decide." Mr. Matsumoto backs up his book with
exhaustive research he has done over the last several years.

Mr. Matsumoto has answered several comments from concerned vets in posts
subsequent to the initial article.

In a response on the HSPIG blog, Mr. Matsumoto says:

Dear GulfVet2: I obviously didn't think it was purely coincidental either.
The trail of evidence is too complicated for TV, and almost too complicated
for newspapers; hence the book. The DOD/FDA stonewalling on this issue -
which has been documented by the GAO, Congressman Jack Metcalf, and the
House Government Reform Committee - has been so formidable that I felt it
necessary to write a book to lay it all out. Even pressure from Congress
couldn't pry loose the facts that you've read in VACCINE A.

I took a page from my old employer's play book at Fox News Channel - "We
Report. You Decide." I reported; now you decide.

What I reported in VACCINE A, you won't hear from the Department of Defense
or the FDA. I think officials from DOD/FDA/NIH - the three federal agencies
working in concert to "fast track" the second generation anthrax vaccine
with squalene - will continue to stonewall, obfuscate and lie about squalene
and its injurious effects until they are forced to testify about it under
oath. With the help of veterans like yourself - the people who arguably need
the most protection from unethical human experimentation - that could
happen.

Mr. Matsumoto

Ron Wright, Moderator
HSPIG Forums Site
www.hspig.org

[Paul Gowder]

It absolutely astonishes me to see something from Richard Posner that I can completely agree with.

What do you think about curtailing trademark protection as one part of the solution to this problem, especially to the effect of consumer loyalty after a drug goes out of patent? For example, it might be useful to have the trademark to a patented product go generic by statute at the same time the patent expires. ??

[Paul Rubin]

Patents serve an additional function besides providing an incentive for invention. They also provide an incentive for developing a product. For example, a patent holder might invest in additional trials to find additional uses for a medicine. If the drug were generic or not patented, then there would be no incentive for this investment. Also, a patent holder would invest in promotional activities.

As to promotion, two points:
1. Promotion is not so different from research. Both are information activities. Research finds information about the functioning of some chemical as a drug. Promotion then distributes this information to users – physicians and patients. Without the promotional expenditures, users would have more difficulty in learning about the results of research, and some would not learn at all.
2. Critics complain that some patented drugs are not much if any more effective then generics, but that promotion and advertising lead consumers to spend more on the patented drugs. But that assumes that consumers would learn of the existence of the generics. No one will spend resources promoting generics, so the choice is often one between use of the patented drug and no drug at all. If the drug is useful, then there may be no better alternative than promotion and use of the more expensive drug.

[Brian Slesinsky]

I don't find Paul Rubin's theoretical arguments in favor of advertising to be all that persuasive when compared to seeing actual drug commercials on TV. Anyone who's seen these ads knows that they have little information content and appeal primarily to our emotions. If you want to defend them, you need to show how particular drug advertisements have proven to be valuable, not just defend the category in the abstract.

Between the media, the Internet, and of course the advice of doctors, not to mention other forms of advertising, I find it hard to believe that any consumer would be at all inconvenienced if television ads for drugs were banned. Banning the most expensive and least informative form of advertising doesn't seem like a serious barrier to finding out about these drugs.

Furthermore, if drug companies weren't able to make emotional appeals in favor of more expensive drugs, maybe consumers would be less likely to want them just because they have vague feelings that they're somehow better than generics.

[Johnnie]

Would it reduce social costs of the patents to require a prototype? The effective life of the patent would be lengthened if it was measured from the time of presentation of the prototype. On the other hand, the costs incurred by the inventor in developing the prototype (and hiding it, if it is big) must be added to cost exposure before protection begins. And there also are increased costs on the patent office of viewing the prototype. Suppose that Noah had wanted to patent his 300-cubit x 50-cubit x 30-cubit ark. He would have had to conceal it in a 301-cubit by 51-cubit x 31-cubit tent until the patent office inspector had come to view it.

What would be the change of social costs, in balance?

[Patrick R. Sullivan]

There's currently a very well told series running in the Seattle Times by reporter Alwyn Scott that illustrated the issues being discussed here. Inventor Harry Rassmussen made a fortune, lost it, and is now about to garner a second fortune. This link gets one to a discussion about the first two articles in the series, and there are links there to those pieces:

http://seattletimes.nwsource.com/html/shiftingfortunes/2002116859_qa_investor12.html

[Paul Rubin]

Brian Slesinsky says that "Between the media, the Internet, and of course the advice of doctors, not to mention other forms of advertising, I find it hard to believe that any consumer would be at all inconvenienced if television ads for drugs were banned. Banning the most expensive and least informative form of advertising doesn't seem like a serious barrier to finding out about these drugs." He is probably correct for anyone reading this blog. But many people do not have access to the internet (or do not search it for drug information.) A doctor is useful for information only if a patient knows to see one and ask; but for many of the drugs advertised on television, without the ad, the consumer would not have the information needed to ask or might be embarrassed to ask (think of the early Viagra ads). Information is expensive, and ads are one of the cheapest ways to effectively communicate with many consumers.

[Corey]

The interesting thing about Posner's last paragraph is it sounds a lot like Marx's argument about how competition can/will lead to an overproduction crisis. I would read that last paragraph as a strong argument for government regulation/assignment of new technology research (perhaps on the current Chinese model).

If long term patents (or long term equipment supply contracts at telecommunications service providers) lead to 25 companies getting into a race only one can win, then there is going to be a great deal of economic waste. However, at the other extreme if patent terms are negligible (or equipment supplied to a market becomes fungible/commodifiable) then incentive for innovation stops. The necessity of striking a balance somewhere in between is a great case for either direct government intervention or closely regulated industry consortiums. No one could expect the market to decide for itself what the ideal length of a patent term should be. (Well, I'm sure some L&E type will try to say it.)

[JennyD]

There is a motivation by big drug companies to sell more, and thus doctors are taken golfing and rolfing, and who knows what. Perhaps this cost is small compared to R&D, but it is important to consider.

What if the marginal improvement on a drug is, frankly, not worth the social cost? That we'd all be better off with an older, cheaper, nearly as effective drug. Then the drug company doesn't have to fete the docs, or whatever.

That's the problem. The market is not always perfect. It allows for waste with good marketing.

I would also request that you put up a contact site. I'd like to suggest that you consider the idea of school choice and vouchers as an imperfect market because of poor information to consumers. Not because of all the reasons.

http://drcookie.blogspot.com/2004/12/voucher-schools-become-accountable.html

[Brian Slesinsky]

Paul Ruben writes: "But many people do not have access to the internet (or do not search it for drug information.) A doctor is useful for information only if a patient knows to see one and ask"

If someone isn't taking any steps to solve a medical problem, not even asking their doctor about it, it's unclear to me why the rest of us should have to pay to inform them. Few would be in favor of a special tax to advertise prescription drugs on television. Why should we feel any better about it when these costs come from our insurance premiums?

[Max Lybbert]

I wonder what effect on prices we would see if people actually paid for their own prescription drugs. Since the price of a drug is currently set at what insurance companies are willing to pay (and then pass on to the consumer), high prices are the norm. I wonder if prices would drop in a freer marketplace.

Yes, I recognize that patents are meant to prop up prices by limiting how efficient the market can run. However, I also recognize that having a third party buy the drugs makes the market even less efficient. Somebody has to decide what price to charge for a patented drug, and that decision is partly based on how much the consumer is willing to pay.

[Sami]

George,

The problem I see with getting rid of patents and using exclusivity terms that are awarded after the drug passes clinical trials is that one company can spend years on phase I and II (with trial and error) and have another company with more resources come in and follow their example and and finish phase III before the first company. The first company is out millions with no way to recoup.

Patents protect the company that develops the technology from the beginning. If you take away that protection, there will be a higher risk to that company and subsequently much less technology. Companies need protection if they are going to invest millions into something that is already inherently very risky. Otherwise they won't invest.

With exclusivity alone only the big companies with the resources would develop anything. Plus you may get a race with several companies trying to beat each other to the punch for one blockbuster drug with only one winner and several out of millions that could be spent on other drugs. This would also take away from the amount of new drugs on the market, and the amount of small biotech companies developing drugs. Which can't be good for the market or the patients.

[Ashish Hanwadikar]

I don't understand the reason why patent needs to be awarded to the first one to cross the "finish" line. If other individuals (or organizations) had put efforts/investments before patent application was filed they have right to make free use of that knowledge without restriction of patent filed by competitor.

Only when a successful patent application is filed and made public then can it be argued that any subsequent work by others is influenced by the knowledge of that public patent.

Why only concern ourselves with recovery of investment of first R&D investment to successful file patent? What about others who might have invested heavily and were almost near the "finish" line? Doesn't their investment count for something?

[Eric Davis]

Dear Judge Posner,

I'm not a patent attorney, and I don't play one on TV, either, but I thought you and your audience might find this interesting:

http://www.spectrum.ieee.org/careers/careerstemplate.jsp?ArticleId=i120204

From the IEEE (electrical engineers) with some interesting proposals about patents. Refered to me via Slashdot.

Just a Fan Here in Oak Park

[Alex Bryan]

I agree with the last comment pertaining to rewarding R&D done by other companies. By only rewarding the first to cross the finish line you create incentive to skip a few steps to get the patent first, possibly sacrificing safety. Constantly drugs are put on the market before enough research is done on there side-effects. Recently, Vioxx and the AIDS drug to Africa. By rewarding all parties involved in R&D companies would be less inclined to patent or place a drug on the market without fully testing it.

It becomes a fine line dealing with such matters. Creativity and discovery are born out of competition and with a lack of incentives science can be slowed, but it also becomes an issue of safety.

I realize that being first still has it's advantages, but playing with numbers here and there may allow for some change towards the positive.

[Sami]

Ashish,

But when are talking about recovery for R&D investments we are talking about recovery for the costs after the patent was filed (in drug development this is millions of dollars). Most will not invest much before filing the patent therefore any company that lost in the "patent race" would have lost a negligible amount of both time and money compared to the whole process of drug development. Patents are filed at the very early stage in drug development, before animal toxicity tests and likely a couple years before Phase I starts.

Investors are not going to want to invest the money if there are other companies developing the product(not when your talking about 10 years and millions of dollars). The company/individual that "almost" filed the patent isn't going to want to spend the time on the drug either if they know someone else is developing it and is already farther along in development.

[Sami]

Rakesh -
As a scientist, I agree that in general science is enhanced greatly by making their discoveries public. But as someone who now works for one of the small biotech companies (we do license from universities), I see that there is a point in drug development where it is not possible to move forward without privatization.

The original inventor can still publish his data (after the patent is filed) and still continue his studies. After filing the patent the information is in the public domain and other researchers can still many times use the drug for non-commercial purposes (many times the researcher can buy it from a vendor who then pays a royalty to either the university or the company). The university and the inventors (and the PIs lab) get some money from out-licensing which can be spent on more research. But the inventor and university cannot enter clinical trials. Unless you want the government to fully subsidize clinical trials you need the companies, and the companies need to assurance profitability.

Actually, out-licensing from universities has been growing rapidly), and it is a great way for universities to bring in some money and for researchers to see their ideas get turned into products. I am not sure that this really slows down scientific knowledge.

[Andrew Boysen]

In response to Ashish Hanwadikar's thought on insurance companies investing in new drugs -

That is a very good thought. This would essentially be vertical integration of the health care industry, reducing the number of steps to the consumer, and increasing insurance company’s awareness of drug effectiveness to cost. I think the reason this business model hasn’t developed goes to anti-trust reasons.

The cost of R&D only returns of profit if you sell it to make lots of money – simply developing it with cost saving goals would not work for insurance companies. If there is a disease with no cure or treatment, the cost to the insurance company is zero. If the insurance company develops a treatment, not matter how cheap, it will still cost money to provide it to customers.

The problem comes in selling the product to other users. If the pricing structure is different enough that other insurance companies or patients can’t afford it (essentially forcing patients who need the treatment to go with the insurance company who also happens to own the patent), this is binding, and is illegal. Selling the drug and selling insurance are separate business, and the company’s pricing power is limited by laws regarding selling a product that a customer doesn’t want (insurance) in order for the customer to buy the product they do want. Even when given away free (Internet Explorer with Windows), the courts have found that this is an illegal barrier to trade.

[James Wetterau]

If we're taking options such as eliminating patents off the table, what about altering the way patents work from a "one-size-fits-all" model to a variable term? The length of the patent term could be in some way calibrated to the expense. This would no doubt require a tremendous amount of accounting, but we're not afraid of that in our tax system, which impacts everyone, so why should we be afraid of it in patents, which affect few?

Another alternative, in order to address the competitive overlap, is that patent winners could be required to document the specific innovative leaps that add up to the patent, and assign weights to each. If other companies got part way to the solution and could document their success, they could then be entitled to share in the patent proportionately to the part of the solution they had. This could be used to administer a revenue sharing scheme among the patent holder and other parties who have a provable claim of nearly reaching the same result, while still protecting them against other free riders.

[Ian Samuel]

Here's what I want to hear about: software patents. With drug patents, I can understand the argument that patents are necessary, because they help create incentives to do millions of dollars in R&D work that wouldn't happen if someone could just steal your idea.

But listen, I'm an engineer by training; I can tell you that the Amazon "one-click" buying system didn't take millions of dollars and thousands of person-hours to develop. It was some dude sitting around, probably in the bathroom, who then realized it would be neat if you could just have all your information saved and buy stuff faster. I would imagine the first prototype was whipped up in about fifteen minutes.

Yet Amazon, because they've patented it, enjoys exclusive license to use something that is so common-sense and obvious that it's hard to believe no one had thought of it already. Is this really good for the industry? Probably not.

[Corey]

Patents are not necessary for software, or for drugs, or for music. Because as you say, software is written by college kids and bored engineers just to see if they can do it. The government and universities fund drug research and would do so even more if every venture capitalist was to suddenly catch plague from their caviar. Medicine incents itself. As for music and arts, when was the last time you heard or saw anything that was produced purely for money that wasn't horrid.
Art works just as well under a patronage system as under patents. We still listen to Bach and we already laugh at Britney Spears.

The biggest falsehood in American business culture is the idea that things get done because of Senior Management compensation plans. I say innovation happens despite the CEO and that is no small miracle. Fact is, you could run Microsoft or Pfizer as a non-profit and the actual people doing the work wouldn't be able to tell the difference. They might actually make more.

Property rights exist to perpetuate aristocracy.
Intellectual property rights are NOT designed to incent innovation. That is the mythology that prevents us from thinking about how patents function in the real world. They limit competition, perpetuate monopolies, hold down supply, stabilize prices at high levels, and channel those higher profits into individual pockets.

Don't forget that Bill Gates and company wrote MSDOS before they got rich, and only got the IBM deal because the other guys were playing golf. Newton invented calculus for fun. The internet was created by the government, popularized by university students, and the first real web browser came from CERN. Taxol was developed from tax dollars, Napster was written by a high school kid, and the most innovative new music of the last decade came from a band nobody has heard of from Iceland. (Sigur Ros)

[Palooka]

While I find some level of agreement, surprisingly, with the misguided Corey--such as that art and music would still be produced, though I suspect it would definitely impact the market--I cannot sign on to the ridiculous notion that all that IP does is bad.

To dispel Corey's fallacious conception that medical research would go on unabated in the absence of IP law, all one has to do is look at what drug companies spend their money on--common diseases. They are clearly developing products for which they believe they can make a profit. Take away IP, and you have all but killed private medical R&D.

Just because government is capable of subsizdizing private and university research in the absence of IP does not mean that system would be equally efficient as our current one.

I have little doubt that private companies invest in medical research which shows the highest expected value. I am less certain unversity and government research is as efficient. And in a world of scarce resources (finite scientists), it is an imperative that we use those resources efficiently.

Moreoever, though it is sure that some resources (most notably the scientists and research staffs themselves) could be redirected to university R&D, losing most, if not all, of private research would be of course a detriment. To suggest otherwise is, I am afraid, pure insanity.

Corey's misguided beliefs are familiar. It took a long time to prove to the world to any degree of satisfaction that collectivist, socialist, and centralized economies were bad for the people who lived under them. Now Corey believes he can strip away incentives and abolish market solutions to all intellectual endeavors without consequence. He's living in that familiar illusion the 20th century has already proven false.

[Scott Scheule]

"Just because government is capable of subsizdizing private and university research in the absence of IP does not mean that system would be equally efficient as our current one."

Of course, just because intellectual property laws are the status quo doesn't mean that they would be more efficient than a change.