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Morgan Rose

Patent Laws and the War on Good Drugs

Morgan Rose*

Patent laws as they apply to drug manufacturers have been challenged twice in recent weeks. In October, Senator Charles Schumer (D, New York) advocated a plan that would allow manufacturers of generic drugs to violate the patent held by the maker of Cipro, the most effective drug used to treat anthrax, so that the federal government can more quickly and cheaply increase its stockpile of the drug.1 Less than two weeks ago, at the World Trade Organization (WTO) meeting in Qatar, delegates from 142 countries signed a declaration supporting the right of poor countries to ignore drug patents in order to get cheaper generic versions of medicines used to treat diseases, like AIDS, that threaten public health within their borders.2 These seem like worthy goals, but if patent laws get in the way of curing or preventing disease, why do we have them in the first place?
Patents and Monopolies
 

For a classic treatment of monopoly theory, see Book V, Chapter XIV of Alfred Marshall's 1920 textbook, Principles of Economics.

Before we answer that, let's start with a few basics. A patent grants a company the exclusive right to sell a new good that it has invented. Companies can also hold patents on new ways to produce already-existing goods. Patents are temporary, expiring after anywhere from five to seventeen years (depending on the country and industry), but while they last they allow their holders to be monopoly producers of the goods they invent. Standard economic analysis tells us that from society's point of view, a monopolist seeking to maximize his revenue will produce too little of a good and charge too high a price for it. Jean-Baptiste Say, in Book I, Chapter XVII, paragraph 113 of A Treatise on Political Economy (1803), described patent systems in this way:

The individual inventor of a new product or of a new process may obtain the exclusive right to it, by obtaining what is called a patent. While the patent remains in force, the absence of competitors enables him to raise his price far above the ordinary return of his outlay with interest, and the wages of his own industry. Thus he receives a premium from the government, charged upon the consumers of the new article; and this premium is often very large.

For drug companies, the premium is often very large indeed, because once a new drug is invented and tested, the cost of manufacturing one additional pill is very low. Because of the monopoly created by patents, some drugs, including Cipro, can sell for much more than they would if produced generically.

Those advocating setting aside patent protections on some drugs therefore have a point—patent laws do impose costs in the form of higher prices and lower availability for consumers. Their grievances are even sharper, because it is not the case that drug companies have acquired these monopolies for themselves, with governments just sitting idly by. By enacting and maintaining patent laws, governments have actively created the conditions in which monopolies over drugs and other products can come about. This is at the heart of one of Ludwig von Mises's criticisms of government action in economic affairs, and of the people who suggest that the repairing of the damage caused by government interference be done through further government interference. These criticisms were the subject of paragraph 57 of the Epilogue of Socialism (1981, first pub. 1922):

In the eyes of these people all the undesired and undesirable effects of government interference with business are caused by capitalism. The very fact that a governmental measure has brought about a state of affairs which they dislike is for them a justification of further measures. They fail, for instance, to realize that the role monopolistic schemes play in our time is the effect of government interference such as tariffs and patents.

These valid criticisms about patent laws bring us back to the question asked earlier. Why do countries persist in having patent laws, when we know that they create monopolies where they otherwise would not exist, and when in the case of new medicines they prevent those medicines from getting cheaply into the hands of those who need them? Why should government interfere to make markets, especially important markets, less competitive?

Incentives to Innovate

The simple answer to that question is that for patent laws to be economically viable, governments must perceive sufficient benefits arising from patent laws to outweigh the costs just described. Only a bit trickier is identifying what those benefits are. The economic argument for the benefits of patent laws goes something like this:

Let's take each step in the argument in turn.

Innovation is a good thing for society

That innovation is a good thing for society is a fairly straightforward proposition. Innovation that leads to new products expand the range of choices available to consumers and producers alike. Innovations that lead to better ways of making existing products can reduce production costs, the amount of resources needed to make things, or both. This usually translates into lower prices and greater availability for consumers. Innovation then generates a wider variety of goods and lower prices for them, both benefits to society.

If you increase the expected return from any given activity, more resources will be devoted to that activity

The proposition that increasing the return on an activity, all other things being equal, leads to more of that activity does not need much explanation. A higher return makes an activity more attractive, so on the margin more people will be willing to incur more costs or more risk in order to engage in that activity. This certainly holds true for innovative activity. Innovation is not free of risk or costs, and this is especially true in the case of drug companies. It may take thousands of research hours and millions of dollars to discover a potentially effective new drug, and that comes before the expensive and years-long process of testing it first on animals, then on humans. Throughout all of this, one unsuccessful test can potentially result in all of that time, effort, and investment being discarded and a whole new line of research started. Alfred Marshall captured this idea in Book IV, Chapter XI, paragraph 6 of Principles of Economics (1920): "Each new departure is an experiment which may fail; those which succeed must pay for themselves and for the failure of others; and though a small manufacturer may think he sees his way to an improvement, he must reckon on having to work it out tentatively, at considerable risk and expense and with much interruption to his other work." Given that this is the lot of those engaged in innovation, anything that increases the return on their efforts will increase the amount of that effort.

Patent laws increase the expected return from innovation

The key proposition in the economic argument for patent laws is the third one, that patent laws increase the return on innovation, so we will address it at some length. The return on innovation is similar to the return on most investments in the world of production, namely a stream of future income payments. The satisfaction of creating something new and useful for one's fellow man is also valuable to many innovators, but certainly the major portion of the return is the money that will come in, either by directly selling the new product or selling information about a new production technique to others who will in turn sell the product.

Importantly, though, the return that an innovator expects to receive is not measured solely in the amount of money he expects his innovation to generate. He also must consider how likely it is that he, and not someone else, will get that money. If he is the only one able to produce the new good, he will take in all of the proceeds from its sale. If, however, other people can copy his innovation and produce the good themselves, our innovator becomes just one of many sellers in a competitive market, and he may get only a tiny fraction of the future revenues. Here is how Frank Knight put it in Part III, Chapter XI, paragraph 46 of Risk, Uncertainty and, Profit (1921):

The matter is indeed frequently, if not usually, complicated by the very low cost of indefinitely multiplying an idea when it is once secured. As a consequence of this fact the inventor or discoverer usually has to make some special provision to limit the use of his results to his own business operations. In certain fields this can be done through legal protection granted by the State in recognition of the value to society of the service. In others artificial measures for secrecy must be taken. In many cases no direct safeguards are available and the economic profitableness of the idea is limited to the period of time required for competitors to copy the new method. Regular commercial research in these fields is doubtless rare. Even legal protection is valid only for a limited period of time and secrecy cannot often be permanently maintained. When the idea becomes common property it is like any other superabundant element in production, a free good and no longer a productive factor in the effective economic sense.

So the security of our innovator's hold on the future revenues from his creation play a big role in his return on innovation. It won't matter to him that his innovation may generate billions upon billions of dollars in sales unless he has some confidence that he is going to see some of that money. The more confident he is that the money will be his and not his competitors', that is, the higher his expected return will be.

Here is an example to make this a bit clearer. Suppose I have an idea for a new spray that will prevent household pets from shedding hair all over your nice clothes and furniture. Let's also say that I'm sure that this innovation will generate one million dollars in sales over the next five years. If at first I think that, once I develop the spray, I am going to be the only one able to sell it, I expect that I will get that one million dollars. However, suppose that upon reflection I realize that there are plenty of talented chemists out there who probably can analyze my pet spray, figure out how I make it, copy it, and sell it themselves. To put a figure on it, let's say that I think there's a 95% chance that people will be able to figure out my secret pet spray formula immediately, and if they do, so many people will enter the pet spray market that the revenues I get will be so low as to call it zero. Then I only have a 5% chance of getting that million dollars. My expected return then equals (5% × $1,000,000) + (95% × $0) = $50,000.

This is where patent laws come into play. If I can take out a patent that lasts five years on my pet spray, then even if those sneaky chemists do figure out how to copy my spray, they are still legally prohibited from selling it, and I can be confident that I'll be getting that million dollars. My expected return is therefore $1,000,000. The patent laws have made me confident that I will receive more of the proceeds from my own innovative activity, so my expected return from innovation has risen.

Under patent laws, more innovation will occur, which as stated above is a good thing for society

This last proposition just puts together the results from the previous three. Continuing with the example, without patent laws, my expected return was just $50,000. In the situation, I would only be willing to devote $50,000 worth of money, time, and effort into developing my pet spray. If I think I will be unable to successfully complete its development with that much innovative activity, the pet spray will not be created, and society will lose out on an idea from which it would have derived $1,000,000 worth of benefit.

 

The above argument holds not just for patent laws, but for any system that encourages innovative activity by increasing its return. Other possible systems, public and private, could be used for the same function in the place of patent laws. Knight argued for some different system to be put in place in Part III, Chapter XII, paragraph 43 of Risk, Uncertainty, and Profit. John Stuart Mill came to the defense of patent laws in Book V, Chapter X, paragraph 25 of Principles of Political Economy (1909, first pub. 1848). There are also those who argue that in the absence of government intervention, private arrangements for securing intellectual property rights would develop. A discussion of their arguments is beyond the scope of this essay.

With patent laws, suddenly I've gone from being willing to invest only $50,000 worth of innovative activity to being willing to invest twenty times that amount. The amount of innovation in which I'm willing to engage has skyrocketed, not because I think the value of my idea has changed, but all because I'm now confident about the security of my claim to that value. Assuming that I can perfect my pet spray with that much innovative activity, then the innovation will occur. Because of the patent laws, pet owners are better off, I am better off, and society's sweaters and plush couches are better off.

That is the economic argument in favor of patents. Benefits are gained from patents, but they still must be traded off for the costs described in the previous section, the higher prices and lower availability caused by government-created monopolies. Whether the benefits outweigh the costs under any particular patent system is an empirical matter. It comes down to the length of time of a patent, the increase in expected returns they cause for innovators, and the costs of monopolies. In the case of Cipro and HIV medications, there are obviously people who reach different conclusions about the relative magnitudes of the costs and benefits associated with patents.

But There's More at Stake

Having been through all that, there is still one more important issue to address concerning the potential breaking of the drug companies' patents, and it has consequences that extend well beyond just that one industry. Regardless of whether or not you believe that the costs of patent laws actually outweigh the benefits, patent laws are still laws, laws on which drug companies as well as innovators of every size and shape relied when making past decisions over how much innovative activity in which they should engage. Economically justified or not, through patent laws governments have allowed for the creation of property in the form of ideas and information, part of what is commonly called intellectual property. Concerning the fundamental relationship between property and law, Frédéric Bastiat had this to say in his essay "Property and Law," first published in 1848 (Chapter 3, paragraph 19 in Selected Essays on Political Economy):

As the desire for life and self-development can induce the strong man to despoil the weak, and thus to violate his right to the fruits of his labor, it has been agreed that the combined force of all members of society should be devoted to preventing and repressing violence. The function of the law, then, is to safeguard the right to property. It is not property that is a matter of agreement, but law.

To rescind ex post the protections they have previously guaranteed for the security of that property and allow that property to become commonly held, the government would in a very real sense be expropriating the property of innovators, violating that most basic legal agreement. Such behavior not only harms those innovators, such as the drug companies, who would be directly affected, it also does great damage to innovative activity, and indeed all types of capital formation. Even if patent laws generally remain in force, but a select handful are revoked, it still sets the precedent that at some point in the future, any patent, even my pet spray one, may also suddenly be snatched away. Turning to Bastiat again, from paragraphs 55-59, he described the effect of the law being used to modify or remove property rather than secure it in terms of "the uncertainty that it always holds suspended, like the sword of Damacles, over labor, capital, commerce, and industry." He continued:

Where the right to property is placed above the law, where the sole function of the public police force is to safeguard this natural right, each person can in full confidence dedicate his capital and his labor to production. He does not have to fear that his plans and calculations will be upset from one instant to another by the legislature.

But when, on the contrary... we permit the makers of utopias to impose their schemes on us in a general way and by decree, who does not see that all the foresight and prudence that Nature has implanted in the heart of man is turned against industrial progress?

Where, at such a time, is the bold speculator who would dare set up a factory or engage in an enterprise? Yesterday it was decreed that he will be permitted to work only for a fixed number of hours. Today it is decreed that the wages of a certain type of labor will be fixed. Who can foresee tomorrow's decree, that of the day after tomorrow, or those of the days following? Once the legislator is placed at this incommensurable distance from other men, and believes, in all conscience, that he can dispose of their time, their labor, and their transactions, all of which are their property, what man in the whole country has the least knowledge of the position in which the law will forcibly place him and his line of work tomorrow? And, under such conditions, who can or will undertake anything?

I certainly do not deny that among the innumerable systems that this false principle gives rise to, a great number, the greater number even, originate from benevolent and generous intentions. But what is vicious is the principle itself.

This idea, that the security of property really is not so secure, would be the most chilling effect of the arbitrary breaking of patents—on a fundamental level, property rights would be less secure than they were before, for drug companies considering how much innovative activity to devote to the next generation of anti-anthrax medicines or HIV therapy treatments, and for any innovator deciding how hard to work at expanding society's potential choices.


Footnotes
1.

"Schumer: New Cipro Source Could Dramatically Increase Supply," October 16, 2001, posting on Senator Schumer's official website.

2.

Paul Blustein, "Getting WTO's Attention: Activists, Developing Nations Make Gains," Washington Post, 16 November 2001, page E01. Online, see WashingtonPost.com.


*Morgan Rose is a Ph.D. candidate in economics at Washington University in St. Louis, with research interests in industrial organization, corporate governance and economic history.

For more articles by Morgan Rose see the Archive.
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