Dean Baker on the Inefficiencies of the Current Drug Patents Regime

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From Dean Baker of the CEPR [1]:

"The basic argument for patents and copyrights is straightforward. In a free market, without protections for intellectual property, there will be under-investment in research and creative activity like writing or recorded music or movies. As soon as an innovation is made public, others could duplicate the process and sell a comparable product, without having to bear the costs of the research that allowed for the innovation. In the case of recorded music or movies, copies can be made at minimal cost (zero cost in the Internet Age), which means that in a free market, the original producers could not sell the products at a high enough price to allow the creative workers to be compensated for their work. However, the fact that a free market will under-invest in research and creative work hardly establishes that the feudal institutions of patents and copyrights are the most efficient way to support such work in the 21st century.


The economics profession has devoted vast amount of research and textbook space to proving the inefficiency of various forms of protectionism. The basic story in this work is that protectionism causes the price to exceed the marginal cost of production. All of this work is entirely applicable to patents and copyrights, except the impact is at least an order of magnitude larger than with most instances of protectionism in international trade. While tariffs and quotas rarely raise the price of goods by more than 30 or 40 percent, patents on prescription drugs typically raise the price of protected products by 300 to 400 percent, or more, above the marginal cost. In some cases, patent protected drugs sell for hundreds or thousands of times as much as the competitive market price. In the case of copyrighted material, recorded music and video material that could be transferred at zero cost over the Internet, instead command a substantial price when sold as CDs, DVDs, or licensed downloads. Copyrighted software commands even higher prices.


The distortions resulting from these huge gaps between price and marginal cost should cause an honest neo-classical economist great pain. At the onset, the lost consumer surplus from patent and copyright protected pricing is enormous. The basic rule on this issue is that the size of the deadweight loss is proportional to the square of the gap between price and marginal cost. The United States alone is projected to spend $210 billion this year on prescription drugs. In the absence of patent protection, the same drugs would probably cost no more than $50 billion. (The savings would be equal to $500 per person for everyone in the country.) The United States will spend more than $30 billion on recorded music and videos this year, material that could be available at zero cost on the Internet. By comparison, many economists felt the need to comment on the NAFTA agreement in 1993 that reduced tariff barriers on imports from Mexico. At the time, U.S. imports from Mexico were less than $40 billion a year, and the average tariff was already less than 5 percent.


Of course the deadweight losses are just the beginning of the story. As the textbooks tell us, monopoly profits encourage all sorts of anti-social rent-seeking behavior, activities that we see in abundance in the case of both patent and copyright protection.


Starting with drug patents, the newspapers are filled with stories about concealed or distorted research findings by pharmaceutical companies who are trying to exaggerate the benefits, or minimize the risks, associated with their drugs. The corruption from companies pursuing monopoly rents permeates the research process. Medical journals routinely receive and publish ghost written articles, where prominent researchers have been paid by the industry to lend their names to company authored papers. In the same vein, the medical experts who provide guidance to the Food and Drug Administration (FDA) on drug safety are often receiving payments from the manufacturers of the drugs they are evaluating.


The sales effort to doctors is similarly corrupted by the pursuit of monopoly profits. According to the industry own data, more people are employed in sales than in research, as the industry relies on an army of salespeople to push its latest blockbuster drugs to doctors. Often this sales effort involves dinners, trips to resorts, and sometimes even outright kickbacks – all ways in which drug companies share a portion of the monopoly profit that they earn by selling drugs at patent protected prices.


Monopoly profits also distort the direction of research. According to the FDA's classification system, roughly 70 percent of new drug approvals are for drugs that do not represent qualitative improvements over existing drugs. While there is little social purpose served by developing these duplicative drugs in most instances, patent monopolies can make the development of copycat drugs very profitable. A copycat drug can allow a firm to cash in on a portion of the profits earned by a competitor on a blockbuster drug. In a world with patents, the introduction of a second drug in the market will have the beneficial effect of lowering prices to some extent (there is more competition with two drugs than one drug), however if drugs were sold in a competitive market, there would be little reason to pursue the development of most copycat drugs. The fact that most new drugs fall in this copycat category suggests that a very large share, possible a majority, of patent supported research is wasted.2


Drug patents also distort the direction of research by pushing it in the direction of patentable results. Research directed at finding cures or treatments based on diet, exercise, or environmental factors will not be pursued in a health care system that relies exclusively on patent monopolies to finance research. This neglect can be offset by government funding targeted specifically towards these areas, but the patent system will direct resources elsewhere.


Finally, the granting of patent monopolies will lead to the development of a gray market, in which unauthorized versions of patented drugs are sold. The large gap between the patent protected price and the marginal cost of production creates opportunities for profit in the same way that the high price of illegal drugs like cocaine and heroin create opportunities for profit. Since these unauthorized drugs will be sold outside of regulatory oversight (except when they are imported from countries with well-developed regulatory systems, like Canada), there will be limited quality control. Unauthorized drugs are likely to be less effective than the patented drug, and possibly even harmful. In either case, the health outcome is far from optimal.


To sum up, there are a long set of complaints against the inefficiencies associated with drug patents, all of which should jump out of any introductory textbook treatment of protectionism in international trade. Yet, the economic profession has been virtually silent on the inefficiencies associated with drug patents.


Alternatives to Drug Patents


This silence would be justified if there were no alternative mechanisms available to support the bio-medical research that leads to the development of new drugs. However, there are alternatives and they already exist. The most obvious alternative is direct government funding of drug research.3 This already occurs on a massive scale. In fact, the $30 billion that the United States federal government pays each year to support bio-medical research at its National Institutes of Health (NIH) is approximately 20 percent larger than the $25 billion that its pharmaceutical industry claims to spend on research. While this research is primarily directed towards more basic science (in order not to interfere with the efforts of the drug industry), there are many instances of new drugs being developed almost entirely through NIH support. It also requires some extraordinary claims about epistemology to argue that public funding of NIH is an efficient mechanism for supporting basic research (a contention strongly supported by the pharmaceutical industry), but somehow would prove to be a boondoggle if the agency took on the responsibility of developing new drugs and bringing them through the FDA approval process.


The basic numbers are very striking. If drug prices in the United States were to fall by 70 percent in the absence of patent protection, it would amount to savings of more than $140 billion a year, given 2005 spending levels. This is almost six times as much as the industry claims it is currently spending on research. Since half of this money may go to research copycat drugs of little social value, the savings from eliminating drug patents in the United States may be more than 10 times as large as the spending necessary to replace the useful research performed by the pharmaceutical industry.4


There are clearly better and worse ways to structure a system of government financed research. For example, the Free Market Drug Act, a bill recently introduced in the U.S. Congress, called for establishing a set of competing government corporations that would be evaluated at periodic intervals (e.g. 10 years) for the quality of their work.5 The worst performers would be put out of business with new ones created to take their place. There are other mechanisms that could be created to ensure that the funding is spent efficiently, but given the incredible waste associated with the existing system of patent financed drug research, it seems that there will be huge payoffs for both the economy and for public health by investigating alternatives.


It is also important to note that this issue has taken on enormous importance in an international context. One of the major areas of dispute in recent trade pacts has been the ability of less developed countries to purchase drugs without paying patent protected prices. If new drugs were placed in the public domain so that they could be produced as generics everywhere in the world, then this whole issue would quickly disappear.6 This would facilitate access to essential medicines for hundreds of millions of people in the developing world." (http://www.paecon.net/PAEReview/issue32/Baker32.htm)