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How Efficient is the Patent System? A General Appraisal and an Application to the Pharmaceutical Sector

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This file is to be used only for a purpose specified by Palgrave Macmillan, such as checking proofs, preparing an index, reviewing,
endorsing or planning coursework/other institutional needs. You may store and print the file and share it with others helping
you with the specified purpose, but under no circumstances may the file be distributed or otherwise made accessible to any other
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10
How Efficient is the Patent System?
A General Appraisal and an
Application to the Pharmaceutical
Sector
Paul Belleflamme
Introduction
In recent years, the legal protection of intellectual property through
patents has faced substantial criticism from several quarters. Patents
have been questioned regarding the material scope of protection (for
example, the European debate about software patentability, opposing
commercial software vendors and open-source advocates); the require-
ments for protection (patent offices, which are largely understaffed and
overworked, are accused of granting an increasing number of ‘bogus’
patents, which tend to impede innovation rather than to foster it);
or the incentives for protection (in complex industries firms accumulate
patents for purely defensive reasons and not as a way to secure returns
on their inventions). Criticisms become even harsher when it comes to
pharmaceutical patents, which are accused of restricting access to essen-
tial drugs in both developed and developing countries, and for allowing
pharmaceutical firms to make ‘outrageous’ profits.
Given the heat that the patent-based system has been feeling lately,
a sound and rigorous economic analysis of the efficiency of this insti-
tution appears to be more necessary than ever. The objective of this
chapter is to contribute to such an analysis. To this end, we start by
recalling the basic economic rationale for the protection of intellec-
tual property; we also contrast legal protection through patents with
other public interventions the aim of which is to promote innovation.
Then, we proceed to a review of different strands of the economic lit-
erature, both theoretical and empirical, in order to assess the efficiency
210
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The Patent System and the Pharmaceutical Sector 211
of patents in general. Finally, we reconsider the theoretical arguments
and empirical findings of the previous two sections in the light of the
peculiarities of the pharmaceutical sector. This allows us to discuss the
pros and cons of pharmaceutical patents, as well as alternative solutions
put forward to promote the development of drugs for neglected diseases
and to facilitate access to these drugs.
Two comments are in order before we start. First, it must be stressed
that our arguments rely on partial equilibrium analyses; that is, the mer-
its of various policy interventions are examined only in the markets
that are directly affected, ignoring any effects on other industries in
the economy. We use producer and consumer surplus to measure the
welfare effects on participants in the relevant market. Second, our anal-
ysis is ‘positive’ in that we look for the most efficient policy choices.
In that sense we are not primarily concerned with issues pertaining
to income distribution (in fact, our partial equilibrium arguments are
valid whatever the initial distribution of income). These issues are com-
monly thought of as normative and economists usually leave them to
policy-makers, government officials or philosophers to determine. How-
ever, the positive analysis remains useful to shed light on the normative
questions and to indicate the ins and outs of the policy alternatives.
Hence, we will take every opportunity to complement our efficiency
analysis by raising important issues pertaining to justice and income
distribution.
The economics of innovation: a brief reminder
What do inventions, business methods, industrial processes, novels,
songs, paintings, etc. have in common? They all result from the produc-
tion of information (or knowledge). The problem with activities generating
information or knowledge is that they suffer from the three generic
sources of market failure: indivisibility, uncertainty and externalities.
First, indivisibilities are present because the creation of new knowledge
and new information involves large, fixed, set-up costs, requires the divi-
sion of highly specialised labour and is therefore prone to economies of
scale. Second, investments in research and development (R&D) involve
two types of uncertainty: in addition to technological uncertainty (how
to make new things and how to make them work), there is commer-
cial uncertainty (how to make new things that will be adopted by the
consumers); moral hazard problems ensue as it is generally impossi-
ble to attribute the failure of a project to a lack of effort or simply to
bad luck.
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212 Paul Belleflamme
Finally, because information and knowledge are inherently public
goods, their producers generate many externalities. Public goods are
characterised by non-rivalness in consumption: the consumption of
the good by one person does not prevent (rival) its consumption by
another person; there is thus the possibility of collective consump-
tion. Another way to define non-rivalness is to say that a good is
non-rival if, for any given level of production, the marginal cost of
providing it to an additional consumer is zero. This is clearly the case
for knowledge and information. Think of a new idea or of a song
performed in public. Public goods are said to be ‘pure’ when they
are also non-excludable, in the sense that one person cannot exclude
another person from consuming that good. Whereas non-rivalness
is an attribute of the good itself, excludability depends, at least in
part, on the technology available for exclusion and the institutional
(legal) framework that permits or facilitates such technically feasible
exclusion.1
The three sources of market failure associated with investments in
information production generate the problem of appropriability,which
sets them apart from other investments made by firms or individuals.
That is, innovators and creators face a serious risk of appropriating only
incompletely the returns from their activities. As a result, there is a gen-
eral presumption that markets provide too few incentives to introduce
new innovations and that the production of IP may well be insufficient
from a social point of view. Economists therefore agree that govern-
ments ought to intervene to provide the right incentives to create and
innovate.
In short, the basic problem of innovation can be seen as an incen-
tive problem within the relationship between one principal (society)
and one agent (potential innovator) in order to produce a public good
(knowledge). Society will find it optimal to induce innovation when the
social expected value exceeds the social expected cost. If so, the objec-
tive is to create sufficient incentives for the innovator so that the private
expected compensation exceeds the private expected costs.
There are several ways to close the gap that the appropriability prob-
lem opens between social and private rates of return from innovation.
The main public responses consist either in restricting the exploitation
of knowledge (by instituting intellectual property (IP) and by protecting
it, or by allowing putative competitors to form cooperative R&D ven-
tures), or in raising the expected returns of new knowledge by lowering
its production cost (through subsidisation of research and patronage
of the arts). We focus here on the legal protection of intellectual
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The Patent System and the Pharmaceutical Sector 213
property, though we shall say something about the costs and benefits
of subsidisation as well.
The main objective of IP law is to promote innovation and aes-
thetic creativity. To solve the appropriability problem, IP law intends
to make knowledge excludable by legal means. That is, it grants exclu-
sive use of the protected knowledge or creative work to the creator. IP
law thereby provides creators with the necessary incentives to produce
new knowledge and solves the underproduction problem that would have
resulted from the non-excludability of knowledge. However, by granting
exclusive (i.e. monopoly) rights to the creator, IP law creates an under-
utilisation problem. Indeed, as the marginal cost of production is zero,
any positive price creates a welfare-reducing rationing.
In order to strike a balance between these two conflicting problems, IP
law grants exclusive rights only for a limited period of time and restricts
the scope of exclusion. That is, IP law addresses the two problems
sequentially. First, legal protection makes the good excludable: to enjoy
the services, users have to pay royalties to the producer. Second, once
the protection lapses, the good passes into the public domain, which
means that all users may access it free of charge (i.e. at marginal cost).
In other words, IP law attempts to find the best possible compromise
between dynamic efficiency considerations (how to provide the right incen-
tives to create and innovate) and static efficiency considerations (how to
promote the diffusion and use of the results of creation and innovation).
Note that dynamic efficiency calls for the broadest and longest pos-
sible protection (to maximise the flow of new knowledge creation),
whereas static efficiency calls for the absence of protection (to avoid
the deadweight loss of monopoly). Therefore, the balance struck by IP
law is necessarily imperfect as it is impossible to achieve both objectives
simultaneously. It also raises issues in terms of justice, as it is the current
consumers who finance the innovator’s efforts (by paying the monopoly
price), to the benefit of future consumers (who will enjoy the innovation
at marginal cost).
It follows that when it comes to design the appropriate way to protect
IP, the complexity is of a quantitative rather than qualitative nature:
what are the level and the structure of the rent that should be left to
the innovator? As we shall argue below when applying these princi-
ples to the pharmaceutical sector, designing the best incentive system
for innovation becomes even more complicated when other public pol-
icy objectives, such as public health and international trade facilitation,
are present. Beyond the economic issue, major issues regarding justice
are also present. For instance, as we shall see, a proposed solution for the
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214 Paul Belleflamme
efficient provision of essential drugs in developing country is differen-
tial pricing, which amounts to setting high prices for drugs in developed
countries and low prices in developing countries (and preventing paral-
lel imports). In terms of policy objectives, this solution gives an implicit
priority to public health and innovation policy over trade facilitation.
More importantly, in terms of income distribution, this solution entails
that consumers in developed countries subsidise consumers in develop-
ing countries (since R&D is financed through the high prices paid in the
developed countries). Clearly, this type of subsidisation, which seems
acceptable from a Rawlsian perspective, might be opposed in developed
countries. For instance, the Pharmaceutical Research and Manufactur-
ers Association of America argues that American consumers are unfairly
bearing the burden of financing research for the rest of the world.
It is therefore important to consider alternative public intervention
aimed at fostering innovation. The main alternative to IP rights consists
for governments in subsidising research: they pay directly for inno-
vations, which then pass immediately into the public domain. With
respect to IP protection, this subsidisation method enhances static effi-
ciency: as there is no need to grant exclusive rights to the innovator,
the innovation is in free access and no deadweight loss ensues. How-
ever, to fund R&D, governments have to raise taxes, and this introduces
distortions elsewhere in the economy and reduces static efficiency (in
contrast, the patent system assigns costs to users rather than to tax-
payers). Moreover, there is no guarantee that subsidies achieve dynamic
efficiency. Indeed, the uncertainty surrounding the social value of an
innovation might make the government over- or underestimate the
amount of subsidy and, thereby, to give too much or too little incentive
(in contrast, the patent system can be implemented without requiring
sensible economic information that is only privately known).2
We now assess the efficiency of the patent system, first in general and
then by focusing on the pharmaceutical sector.
The efficiency of patents in general
Although there is a wide agreement about the theoretical arguments
underlying the existence of the patent regime, and about the legal pro-
tection of IP in general, there is much less consensus about how effective
this institution is in practice. More than half a century ago, Penrose
(1951) declared: ‘If national patent laws did not exist, it would be dif-
ficult to make a conclusive case for introducing them; but the fact that
they do exist shifts the burden of proof and it is equally difficult to make
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The Patent System and the Pharmaceutical Sector 215
a really conclusive case for abolishing them.’ Even though a whole new
body of empirical and theoretical knowledge has emerged since then,
we are still unable to revise Penrose’s view. We are, however, able to
refine the evaluation, as recent economic analysis has brought to light
previously unsuspected costs and benefits of the patent system.
The first natural way to assess the efficiency of the patent system is
to survey innovators and ask them directly whether they see patents
as important. Several empirical studies have attempted to assess the
relative attractiveness of the different means innovators have at their
disposal to protect their inventions. In his review, Caillaud (2003)
stresses that innovating firms consider trade secrets (for process inno-
vations) and business strategies based on early-mover advantage (for
product innovations) as the main means of getting returns on R&D
investments and to appropriate the rents stemming from innovation.
Similarly, Anand and Galetovic (2004) report survey results3showing
that managers claim that ‘lead time, learning curves, and sales or service
efforts are substantially more effective in protecting IP than patents are’.
It appears thus that the appropriability problem is often better
addressed through private responses (e.g. secrecy) than through pub-
lic responses (e.g. patents). In particular, except for the chemical and
pharmaceutical sectors (which we discuss in the next section), patent
protection is generally deemed to be of little efficiency, especially for
process innovations. Caillaud (2003) advances several explanations.
Firms consider that: a patent can easily be ‘invented around’ by imi-
tators; that a patent is costly to obtain and to enforce; and that they
suffer from disclosing the information, as required by the patent.
In the light of these observations, one is tempted to ask why firms
in most sectors bother to seek patent protection for their inventions.
Several reasons can be advanced:4
(i) patents are relatively inexpensive to register (although they are
generally costly to defend);
(ii) patents can serve to measure the output of a firm’s R&D division
and, thereby, to structure compensation and incentive schemes;
(iii) venture capitalists often demand that firms patent technology, both
to block rivals and to have assets to sell in case the firm flounders;
(iv) patents can be used as a ‘trading device’. The latter reason is con-
firmed by a number of surveys, which show that it is essentially
large firms that resort to patent protection, especially in complex
industries (e.g. electronics and software) where innovations overlap
and where patents are then used as a ‘currency’ in the bargaining
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216 Paul Belleflamme
process among firms (to negotiate cross-licensing agreements, for
instance; we return to this argument below).
Although the previous surveys offer important elements in answer to
our question, their scope remains limited. It is therefore necessary to
adopt a broader perspective and examine the macroeconomic facts. The
observation of the evolution of IP protection, R&D and innovation over
the last three decades reveals the emergence of three basic trends: (i)
IP protection has been generally strengthened and broadened; (ii) the
number of patents have soared; and (iii) innovation has increased. Let
us detail these in turn.
First, on the initiative of the US and Europe, IP protection has
been strengthened, broadened and harmonised internationally.Intermsof
strengthening, in the early 1980s, legal and procedural reforms in the US
provided greater protection to holders of existing patents;5in Europe,
the European Patent Office (EPO) granted the first European patents in
1978, but a genuine European patent (superseding national patents) is
still under debate. Regarding broadening IP, new categories of inventions
have been protected, either through an extension of patent protection
(software, business methods, genetic inventions) or through the cre-
ation of sui generis rights (e.g. for semiconductors, databases).6Finally,
the Trade-Related Aspects of Intellectual Property Rights (TRIPS) Agree-
ment of 1994, negotiated within the framework of the World Trade
Organisation, represents a major advance step towards the harmonisa-
tion of IP laws. It includes a general definition of patents, which adopts
US criteria, and thereby broadens the scope of patentable inventions
internationally; furthermore, the US and the European Union have con-
cluded numerous bilateral agreements with their trading partners in
order to coerce them to significantly strengthen their own IP rights
regimes.
Second, the number of patent applications and grants has risen expo-
nentially. In the US, it more than tripled between 1980 and 2001 (it
was practically stable over the previous two decades). A comparable
trend is observed for European countries (although there it began later).
Although nearly all technology fields experienced growth in patent-
ing, two technology fields contributed substantially to the overall surge:
biotechnology and information and communication technologies.7
Third, innovation has also expanded rapidly. An important indicator is
the increase in R&D spending: in the US, R&D spending (in real terms)
multiplied by 2.5 between 1971 and 2001;8also, as reported by the
National Science Foundation, the investment in R&D by American firms
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The Patent System and the Pharmaceutical Sector 217
employing fewer than 5,000 people more than doubled between 1987
and 1997. It must be noted, however, that R&D spending is a measure
of inventive inputs (patents are measures of inventive outputs) and that
some of these inputs might be wasted or never lead to a new marketable
product or process. Nevertheless, the increase in R&D investment has
most likely led to the discovery and commercial exploitation of a greater
number of new technological leads.
This huge increase in patent counts seems to contradict what innova-
tors claim about the relative unimportance of patents to protect their IP.
The term ‘patent paradox’ has been coined to describe this contradictory
behaviour of managers who declare that patents offer weak protection,
but who nevertheless file an increasing number of them (this behaviour
has been systematically documented, for instance, in the semiconductor
industry).9The patent portfolio theory gives us a convincing explanation.
The main idea is that, in many industries, the true value of patents lies
not in their individual worth, but in their aggregation into a collection
of related patents. In other words, the more patents the merrier, because
patents are increasingly used as a ‘trading device’ or ‘bargaining chip’.
This trend is confirmed by a number of surveys, which reveal that it is
essentially large firms that resort to patent protection, especially in com-
plex industries (biotechnology, IT, telecommunications, electronics and
software).10
It is because these complex industries rely heavily on cumulative inno-
vations that firms have an incentive to build up patent portfolios. There
are two types of cumulativeness. On the one hand, in the case of sequen-
tial innovations, a particular innovation leads to many second-generation
innovations.11 The main problem with sequential innovations is that
a patent on the first-generation innovation confers on the patentee a
hold-up right over subsequent innovations. On the other hand, in the
case of complementary innovations, a second-generation product requires
the input of a number of different first-generation innovations.12 Here,
the main problem is that the prices are higher if they are set by inde-
pendent patentees rather than jointly. Indeed, if innovator A reduces
the price of licence A, then the demand for licence B increases (since the
two licences can only be used in combination), but this benefit is not
appropriated by innovator A. Hence, both innovators have insufficient
incentives to cut their prices. Moreover, the need to negotiate licences
separately with the two patentees adds to transaction costs. This prob-
lem is referred to as the ‘Tragedy of the Anticommons’.13 More generally,
it describes the fact that a scarce resource is prone to under-use when
multiple owners each have a right to exclude others from this resource
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218 Paul Belleflamme
and no one has an effective privilege of use. It is the counterpart of the
well-known ‘Tragedy of the Commons’, according to which a resource
is prone to overuse when too many owners each have a privilege to
use that resource and no one has a right to exclude another (as is the
case with fish stocks, for example).14
The previous two problems are worst in industries where hundreds if
not thousands of patents can potentially be applied to a given product.
Shapiro (2001) describes this dense web of overlapping IP rights as a
‘patent thicket’, through which firms have to hack in order to bring a
new product or technology to market.
Whatever the type of cumulativeness, the trade of patent rights
among firms might alleviate the problems: ex ante licensing addresses
the hold-up problem, while cross-licensing and patent pools can solve
the Tragedy of the Anticommons. These private arrangements are also
useful for addressing the increasing demand for interoperability and
common standards that is expressed in these sectors.15 However, this
private response might be excessive. Many firms are acquiring large
numbers of patents for purely defensive reasons (i.e. to keep the threats
stemming from other firms’ patents at bay). The global situation looks
thus like a prisoner’s dilemma, where the equilibrium is such that all
firms file a large number of patents (following a ‘balance of power’
argument), but would be better off if they could commit to fewer
patents.
The three basic trends observed over the last three decades raise
another important question: does the strengthening of IP protection
explain the huge increase in patent counts, and does this higher patent-
ing activity explain in turn the increase in innovation? In other words,
do stronger patents induce more innovation? The US position on IP rights
(and, to a large extent, the European position as well) assumes that
the answer to this is yes: it is believed that the additional innovation
induced by stronger patent systems is substantial and that strengthening
IP rights at home and abroad is to the good.
However, the empirical evidence to support these beliefs ranges from
sketchy to nonexistent. A number of empirical studies suggest that the
responsiveness to changes in patent scope is limited: stronger patents do
not seem to induce more innovative effort. Sakakibara and Branstetter
(2001) analysed the response to the 1988 Japanese patent reforms,
which expanded the scope of the patent system there. They found no
evidence of a statistically or economically significant increase in either
R&D spending or innovative output that could plausibly be attributed
to the reforms. Similarly, Lerner (2002) analysed the impact of major
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The Patent System and the Pharmaceutical Sector 219
patent policy shifts in 60 nations over the past 150 years which aug-
mented the amount of patent protection provided. An examination of
177 policy changes reveals that strengthening patent protection appears
to have few positive effects on patent applications by entities in the
country undertaking the policy change. Finally, Gallini (2002) surveyed
recent theoretical and empirical research and concluded that the case for
stronger patents as a spur to innovation is weak; however, she qualifies
this conclusion by noting that evidence that stronger patents encourage
disclosure and technology transfer is persuasive.
Other studies focus on understanding the impacts of isolated patent
policy reforms: Kortum and Lerner (1998) and Hall and Ziedonis (2001)
examined the effects of the establishment of the Court of Appeals for
the Federal Circuit in the United States, Lanjouw (1998) and Scherer
and Weisburst (1995) analysed how the strengthening of patent pro-
tection on pharmaceuticals affected, respectively, India and Italy. In
general, these studies conclude that enhancing patent protection does
not significantly spur on innovative behaviour.
Finally, empirical studies reveal that the increase in patents
(innovative output) goes along with an increase in spending on R&D
(innovative input). As a rule of thumb, it is often stated that technolog-
ical firms file on average two patents for every $1 million they spend
on R&D. Yet, in IT, the growth in the number of patents exceeds the
increase in R&D expenditure, which is indicative of the patent paradox
described above.16
The efficiency of pharmaceuticals patents
In this section, we address the topical and heavily debated question of
the suitable intellectual property protection for drugs. To this end, we
first review the previous theoretical arguments and empirical findings
in the light of the peculiarities of the pharmaceutical sector. Our main
conclusion is that the tension between dynamic and static efficiency
considerations is amplified in this sector. We then examine alternatives
to the patent-based system.
Let us first return to the economic analysis we developed above. The
first thing to note is that the three market failures we identified are par-
ticularly acute in the pharmaceutical sector: large indivisibilities result
from huge R&D fixed costs;17 the length of the R&D process18 and the
need to get public approval for new drugs cause a lot of uncertainty;19
finally, because knowledge is more science-based and more codified in
the pharmaceutical sector than in any other sector, imitation costs are
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220 Paul Belleflamme
low and hence externalities (i.e. knowledge spillovers) are important. It
must be added that successful pharmaceutical innovations create other
powerful consumption externalities as they improve public health.20 For
all theses reasons, the discrepancy between social and private returns to
innovation is particularly wide in the case of pharmaceuticals, and there
is thus a clear need for public intervention: absent appropriate inter-
vention, the level of pharmaceutical innovation would undoubtedly be
insufficient from a social point of view.
The next question that arises is whether the patent-based system
constitutes the appropriate public intervention for the pharmaceutical
sector. Some first elements of an answer come from a detailed examina-
tion of the empirical findings broadly described in the previous section.
Empirical studies indicate two reasons for concluding that the patent sys-
tem is relatively more efficient in the pharmaceutical sector than in other
industrial sectors. First, it appears that pharmaceutical companies rely
heavily on patents to appropriate the returns from their inventions.21
Second, macroeconomic analyses show that the pharmaceutical sector
plays a leading role when looking at the patent explosion (especially
in the US).22 Note that patents are relatively efficient in the phar-
maceutical sector despite the fact that the effective patent life (i.e. the
patent time remaining at the product launch) is significantly reduced
for drugs. Indeed, patents in pharmaceuticals are typically applied for
early in the development process; because of the length of the regula-
tory approval process, marketing exclusivity occurs only after a number
of years. In consequence, the US, Europe and Japan have enacted patent
term restoration laws.23 According to estimates in the US, these laws
have increased the effective exclusivity period from eight to eleven
years.24
We can conclude from this that granting patents (and extending their
effective life) appropriately contributes to alleviating the underproduc-
tion problem and thereby enhances dynamic efficiency. However, the
static inefficiency resulting from high monopoly prices is worse for
pharmaceuticals than for most other products. We argued that static
efficiency calls in general for marginal cost pricing (i.e. a price close to
zero in the case of new knowledge, meaning universal access). When
it comes to pharmaceuticals, static efficiency could even call for prices
below marginal cost, because these products generate positive consump-
tion externalities in terms of improved public health. To put it bluntly,
the abstract ‘deadweight loss of monopoly’ takes a much more con-
crete and tragic form here, which can be measured, following the World
Health Organisation, in disability-adjusted life years (DALYs) lost.25
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The Patent System and the Pharmaceutical Sector 221
It therefore, becomes apparent why, in many developed countries, the
prices of drugs are controlled and/or expenditures for drugs are cov-
ered by public or private insurance. While such interventions alleviate
the static inefficiency of patents, they also distort market incentives,
as potential demand levels condition research efforts. The latter con-
sideration stresses another shortcoming of the patent-based system: as
R&D priorities are decided on the basis of potential demand levels, the
system provides few incentives to develop products with relatively small eco-
nomic markets. What makes the matter worse is that those products are
generally of great social need. As Ridley et al. (2006) explain it, the
[t]hree diseases with the greatest burden are HIV/AIDS, malaria, and
tuberculosis. Manufacturers do invest in R&D for HIV/AIDS, because
there is a market in both developed and developing countries for
these therapies. There is less incentive to invest in R&D for malaria,
because more than 99 percent of disability-adjusted life years (DALYs)
lost to malaria are in developing countries.
Note that the ability to pay for drugs is far from being the only condi-
tion for viable economic markets to exist: pharmaceutical markets also
require ‘a system of distribution, roads for efficient transportation, ware-
house facilities to store inventory and trained personnel to dispense
the medication’ (Hammer, 2002). In many developing countries, espe-
cially in rural areas, these infrastructures are under-developed or simply
nonexistent.
Although a similar problem occurs in developed countries for pae-
diatric illnesses, preventive interventions and relatively rare diseases,
we devote the rest of this section to the lack of incentives for prod-
ucts addressing diseases endemic in developing countries. This issue
has indeed been at the centre of a widespread and bitter debate for
the past several years. This debate finds its sources in the TRIPS Agree-
ment, which requires that WTO members comply with minimum
standards for IP protection. Although developing countries accepted
TRIPS (mainly in return for concessions made by developed countries
that would expand the developing countries’ exports of agriculture and
textile products), they remained fearful that patents would put drugs
beyond the reach of the poor. To mitigate this risk, the 2001 Doha and
2003 Cancun declarations of the WTO affirmed the right of nations to
use the exceptions of TRIPS, such as compulsory licensing and parallel
imports, to meet public health concerns.26 However, as Lanjouw (2003)
rightly notes,
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222 Paul Belleflamme
[a]lthough the fight over TRIPS is proving extremely persistent and
difficult to settle, it does not stem from fundamentally conflicting
goals. The pharmaceutical industry wants above all to protect its
major markets in the developed countries. Very secondarily it would
like to see effective protection evolve in poorer countries as they
grow into more attractive markets. Making profit in the poorest coun-
tries is not an industry objective. The development community and
NGO activists, on the other hand, are primarily concerned with keep-
ing prices down in the poorest countries. In substance these are not
opposing objectives.
Yet, this does not mean that solutions are easy to find. As we now
show, the main solutions that have been proposed may correct some of
the problems of the patent-based system, but they often create problems
of their own.
A first solution that is regularly put forward is differential pricing (which
economists identify as [third-degree] price discrimination). It simply
amounts to having pharmaceutical firms set different prices for the
same drugs in different markets – high prices in developed countries
and low prices in developing countries. Economic theory establishes
the conditions under which third-degree price discrimination increases
not only consumers’ welfare but also firms’ profits. Scherer and Watal
(2002) argue that these conditions are likely to be met in the case
of pharmaceuticals. However, Hammer (2002) identifies a number of
complicated economic, legal and political challenges that constructing
an effective regime of price discrimination raises. Among these let us
just mention the necessity of preventing arbitrage,i.e.theactivityby
which the product is bought in the low-priced market and resold in the
high-priced market.27 Physical arbitrage of this sort can be prevented
through national laws regulating safety and efficacy by differentiating
products in terms of production, composition or packaging, and by
monitoring the circulation of products (via radio-labelling or other new
technology).28
Yet, as Hammer (2002) points out, there are also threats of infor-
mational and political arbitrage. Informational arbitrage refers to the
following situation: by setting low prices in developing countries, phar-
maceutical firms would reveal sensitive information about their cost
structure, which large powerful purchasers in developed countries could
use to obtain price concessions in negotiations. Political arbitrage fol-
lows from the reference pricing policies that an increasing number of
countries employ: by forcing pharmaceutical firms to give them the
June 12, 2008 19:11 MAC/INT Page-223 9780230_007093_12_cha10
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The Patent System and the Pharmaceutical Sector 223
lowest price they offer anywhere in the world, these policies may deter
a price discount in the first place.
Other proposed solutions tend to substitute reward mechanisms for
the patent-based system. For instance, ‘a buy-out pricing system gives
a cash bonus of public money to the pharmaceutical firm for the esti-
mated profits from monopoly prices. The pharmaceutical firm would
then make the drugs available to anyone in need at the marginal cost
of production’ (Barton and Emanuel, 2005). Alternatively, governments
can purchase the pharmaceutical products and cover the R&D costs.
As we indicated above, the main difficulty facing such reward meth-
ods comes from the estimation of the social value of innovation: What
are the R&D costs? What is the patent’s value? Which drugs should be
developed? An additional limitation underlined by Barton and Emanuel
(2005) is that the reduction in the number of decision-makers ‘may lead
to the ignoring of new research and product directions and to the politi-
cisation of decisions. Without market constraints this may also foster
inefficient R&D’.
A middle way between the property rights and rewards systems is to
twist the incentives associated with patents by making private returns
come closer to social returns. One such solution is the Disease Burden
Incentive System proposed by Barton and Emanuel. This approach is ‘for
the government to pay for drug development, with the price reflecting
the social value of its contribution to reducing global disease burden’.
There are two main advantages to this method: (i) because incentives
are based on disease burden rather than on market appeal, R&D efforts
are shifted from the concerns of the rich to real health improvements;
and (ii) this method lets pharmaceutical firms choose the best way to
address a disease (they could prefer to improve sanitation rather than
to develop drugs and still qualify for the reward). However, this method
shares with the buy-out and government procurement systems the same
problems in estimating the appropriate monetary rewards.
In the same vein, various mechanisms are proposed to reward research
output within the patent-based system so as to induce pharmaceutical
firms to develop therapies for neglected diseases. Kettler (2000) pro-
poses the transferable patent exclusivity right system, by which a developer
that licenses a product for a neglected disease would receive additional
patent time for a different product, and this right could be sold on.
Similarly, Ridley et al. (2006) propose a priority review voucher,which
would be awarded to developers of improved treatments for neglected
diseases, could be transferred and would entitle the bearer to prior-
ity review by the regulatory authorities for another drug. The authors
June 12, 2008 19:11 MAC/INT Page-224 9780230_007093_12_cha10
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224 Paul Belleflamme
estimate that priority review by the American Food and Drug Adminis-
tration (FDA) ‘would be worth more than $300 million for a potential
blockbuster drug, because it would shorten the time the FDA takes to
analyze data from an average eighteen months to about six months’.
This solution would have the twofold benefit of speeding up access
to blockbuster drugs in developed countries and cures for infectious
diseases in developing countries.
Conclusion
We have attempted to shed light on a debate that has become quite pas-
sionate over the last few years: the efficiency of the patent-based system
for the promotion of innovation. After presenting the basic economic
arguments underlying the protection of intellectual property, we have
extracted from the economic literature important theoretical and empir-
ical elements allowing us to understand what it takes for patents to be
socially useful and privately profitable. Finally, we have repeated the pre-
vious analysis for the special case of the pharmaceutical sector. We have
argued that designing the optimal regime for the protection of intel-
lectual property is even more complicated in this sector, because of the
particularly acute tension between dynamic and static efficiency con-
siderations, and because of the potential conflict with another, equally
fundamental, policy objective, namely public health. In this light, we
have compared the respective merits of various alternatives to and
adjustments of the patent-based system. Our conclusion is that a middle
way should be privileged, combining the positive aspects of the patent-
and subsidy-based approaches, while minimising their negative aspects.
The various solutions described point in that direction.
Naturally, the analysis carried out here is far from complete. We have
simply proposed a number of stepping-stones in order to organise our
thoughts about a complex and crucial topic. To further feed the reflec-
tion, one should discuss the relevance of public–private partnership
(PPP) schemes for the fight against endemic diseases. The important
contributions made by foundations like those set up by Bill and Melinda
Gates and Bill Clinton (the two ‘Billanthrops’, as they have been nick-
named in the press)29 to the fight against HIV/AIDS and other diseases
come to mind. With the addition of Warren Buffet’s donation, the Bill
and Melinda Gates Foundation now equals the size of multinational
companies such as Disney, Dell or Honda. Yet, whatever the sources of
funding, private foundations, pharmaceutical firms and public author-
ities all face the same pressing question: how much should be spent in
June 12, 2008 19:11 MAC/INT Page-225 9780230_007093_12_cha10
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The Patent System and the Pharmaceutical Sector 225
preventing and treating today’s diseases, and how much should be kept
to finance R&D for prevention and treatment tomorrow?
Notes
1. To understand this difference, consider TV services in most countries. A tele-
vision signal is clearly non-rival since, once it is broadcast, the marginal cost
of making the broadcast available to another user is zero. In order to watch
terrestrial TV, all you need is a TV receiving equipment. Yet, to use such
equipment, you may be required by law to pay a licence fee: those who fail
to pay are legally – but not technologically – excluded from watching terres-
trial broadcasts. On the other hand, cable TV broadcasts are made exclusive
by encrypting the signal and charging for the device that decodes it. A similar
distinction holds for knowledge: as we explain below, most countries have
adopted laws instituting intellectual property and ‘protecting’ it; that is, IP
laws allow producers of information and knowledge to prevent non-payers
from using it.
2. For a thorough analysis of the relative merits of IP rights compared to a
reward system, see Shavell and van Ypersele (2001).
3. Six hundred managers were surveyed by economists at Carnegie Mellon and
Yal e .
4. See Geroski (1995).
5. For instance, the Patent and Trademark (Bayh–Dole) Act 1980 allows univer-
sities and other non-profit organisations to patent discoveries made in their
laboratories. Also, the Court of Appeals for the Federal Circuit was estab-
lished in 1982 to harmonise patent law nationwide; this had the effect of
strengthening patent protection.
6. See L´
evˆ
eque and M´
eni`
ere (2004, pp. 47–8) for a comparative analysis of US
and European stances on the patentability of these inventions.
7. According to the OECD (2004), ‘more than 109 609 patent applications were
filed at the European Patent Office (EPO), and 179 658 patents granted by
the US Patent and Trademark Office (USPTO) in 2000, compared with 60
104 and 107 039, respectively, in 1991.... Between 1991 and 2000, biotech-
nology and ICT patent applications to the European Patent Office (EPO)
increased by 10.9% and 9.5% respectively, compared to 6.9% for all EPO
patent applications.’
8. Measured in 1996 dollars, R&D spending was just below $100,000m in 1971
and just above $250,000m in 2001 (see Scotchmer, 2005, p. 272) quoting
data from the National Science Board).
9. Hall and Ziedonis (2001) interviewed industry representatives and observed
(in the period 1979–95) that (i) firms did not rely heavily on patents to appro-
priate returns to R&D, but (ii) their propensity to patent rose dramatically
since the mid-1980s.
10. A survey published in The Economist (20 October 2005) reported the fol-
lowing: IBM now earns over $1 billion annually from its IP portfolio; HP’s
revenue from licensing has quadrupled in less than three years, to over $200
million this year; Microsoft is on course to file 3,000 patents this year, when
in 1990 it received a mere five; 54 per cent of companies saw growth in
June 12, 2008 19:11 MAC/INT Page-226 9780230_007093_12_cha10
PROOF
226 Paul Belleflamme
licensing of 10–50 per cent between 2000 and 2002; almost 75 per cent of
executives say they expect to buy as well as sell more licences over the next
two to five years, and 43 per cent expect a dramatic increase in their licensing
revenue (according to a survey by McKinsey).
11. For instance, the invention of the laser led to surgical applications, spec-
troscopy, etc.
12. Think of firms in the electronic industry (e.g. trying to produce new periph-
erals to be coupled with personal computers or video game consoles) or in
the biotech industry (e.g. combining patented genes to bioengineer a new
crop seed).
13. See Heller and Eisenberg (1998) for more.
14. See Hardin (1968) for more. Note that Aristotle, in his comments on Plato’s
Republic, stated this theory: ‘That which is common to the greatest number
has the least care bestowed upon it’.
15. A recent example of a patent pool is the MPEG-2 video compression technol-
ogy. Nine companies have pooled their patents to permit one-stop shopping
for makers of televisions, digital video disks and players, and telecommuni-
cations equipment as well as cable, satellite and broadcast television services.
Shapiro (2001) reports that broad cross-licences are the norm in markets for
the design and manufacture of microprocessors.
16. This finding could be attributed to an excessive generosity by patent offices
and courts towards patent filers and owners. Such an attitude can indeed
encourage firms to seek IP rights for the economic power they confer,
independently of their R&D efforts.
17. Grabowski (2004) reports that pharmaceutical R&D costs have been growing
significantly: ‘The average R&D cost of a new drug introduction for 1990s
approvals is $US802 million, compared with $US316 million for the 1980s
and $US138 million for the 1970s. These costs are measured in year 2000
dollars and include the costs of failed candidates and pre-clinical expen-
ditures on discovery and lead generation.’ However, Barton and Emanuel
(2005) note that ‘[i]n some cases, significant portions of these costs, partic-
ularly those incurred early in the development process, are covered through
government-supported research.’
18. According to Ceccagnoli et al. (2005), ‘in Chemical and Pharmaceutical tech-
nologies only 36% of the patents involve less up to 6 man-months for the
invention process and 9.63% of patents involve more than 48 months (the
overall EU6 shares are respectively 52.25% and 5.40%). By contrast, in Elec-
trical Engineering and Mechanical Engineering the share of patents requiring
less than 6 months is about 60% while the share of 36 patents requiring more
than 48 months are respectively 3.70% and 3.26%.’
19. Of 10,000 pharmaceutical products patented, only ten are marketed (OECD,
2000).
20. Public health is clearly a public good as it is both non-excludable (everyone
benefits from the eradication of diseases) and non-rival (no one diminishes
that good when benefiting from it).
21. Although industrial surveys show that patents are seen, on average, as a sec-
ondary or complementary instrument for protecting IP, Levin et al. (1987)
and Cohen et al. (2000) show that patents appear to be relatively more
effective in industries such as medical equipment and drugs. Other studies
June 12, 2008 19:11 MAC/INT Page-227 9780230_007093_12_cha10
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The Patent System and the Pharmaceutical Sector 227
support this finding. Arora et al. (2003) find that the additional payoff
obtained from a patented invention relative to an unpatented invention
is positive only in a few manufacturing industries, which are those where
inventors patent most: drugs, biotech, medical instruments, machinery,
computers and industrial chemicals. Similarly, Mansfield (1986) found that
the fraction of inventions US manufacturing firms would not have devel-
oped in the absence of patents between 1981 and 1983 is the highest (60 per
cent) for pharmaceuticals (compared to less than 10 per cent for firms in the
majority of other sectors).
22. However, Barton and Emanuel (2005) stress that ‘at least since the mid-
1990s, there has been a decrease in the number of fundamentally new
products, i.e., “new molecular entities”’. It is therefore not clear whether
the increase in patenting activity eventually leads to more socially useful
innovation.
23. See Grabowski (2002) for more.
24. See Barton and Emanuel (2005).
25. ‘DALYs for a disease are the sum of the years of life lost due to premature
mortality in the population and the years lost due to disability for incident
cases of the health condition. The DALY is a health gap measure that extends
the concept of potential years of life lost due to premature death to include
equivalent years of ‘healthy’ life lost in states of less than full health, broadly
termed disability. One DALY represents the loss of one year of equivalent full
health’ (WHO, www.who.int/healthinfo/boddaly/en/index.html).
26. For critical analyses of the effects of TRIPS on access to essential drugs, see,
e.g., Lanjouw (1998) and Barton (2004).
27. Kaisernetwork.org reported in 2003 one incident of smuggling $18 million
worth of antiretroviral agents from Senegal into Europe (quoted by Barton
and Emanuel, 2005).
28. However, as Sykes (2002) notes, to determine whether a patent holder has
a legal right to require nations in which it holds a valid patent to prevent
parallel imports, the unsettled ‘exhaustion’ issue (i.e., does the initial sale
by a right holder in some country ‘exhausts’ its rights in other countries?)
should first be resolved by the WTO.
29. Billanthropy. The Economist, 29 June 2006.
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