Thursday, October 12, 2006

Compulsory Licensing: A Confusion of Arguments

One solution sometimes proposed for the problem of making medical drugs available in poor countries is compulsory licensing—the government of the poor country sets the price at which the patent owner must license others to produce the drug. The obvious argument against is that while it might reduce the cost of present drugs it would also reduce the supply of future drugs.

I recently heard a talk by someone who tried to test that prediction by looking at U.S. drug companies that had been required to accept compulsory licensing, usually as one of the conditions of a merger. She had a total of six cases. In only one did there seem to be a visible decrease in future patent applications. She viewed that as at least weak evidence against the "conventional wisdom" that compulsory licensing would reduce innovation.

Her sample size was tiny and the data very noisy, making a conclusion in either direction difficult. But that wasn't the interesting problem with the project.

In four of her six cases, the requirement was for compulsory licensing of a patent that already existed. When I pointed out that there was no reason to expect that to have any effect on future research by that particular drug company, she replied that that wasn't what the drug companies, arguing against compulsory licensing, claimed.

Thinking about it, I believe I know what was going on. There are two entirely different arguments for the same conclusion which look similar enough to be confused. One is the argument that I, or any economist, would make. The other is the argument she was rebutting.

Her argument takes the form "If the drug companies don't have enough money from their past research, they can't afford to finance future research to produce new drugs." That sounds plausible, but it's wrong. If future research looks to be profitable, drug companies don't need to finance it from past profits—that's what capital markets are for. If future research looks unprofitable then, however much money drug companies have from past research, they can find somewhere else to put it. That too is what capital markets are for.

The argument that makes sense to an economist is about incentives, not resources. Anything that makes future research less profitable, such as a policy of compulsory licensing expected to apply to future drugs, means that some projects go from just worth doing to not quite worth doing, reducing the amount of future research. In terms of that argument, four of her six cases are irrelevant, since they involved compulsory licensing of patents that already existed. In only two cases did the requirement apply to future patents. So her sample size was not six but two, and one of the two was the one case where she concluded that the result of the requirement was to eliminate research in the area it covered. Insofar as any conclusion could be drawn from her results, it was the opposite of the conclusion she drew.

The argument she was answering was the wrong one from the standpoint of an economist. But I can easily enough believe that it was the argument, or at least an argument, that the drug companies were making—because while it is economically wrong, it is rhetorically right.

With her argument, the drug companies are claiming that they would like to develop new drugs to save lives, but they just can't do it if compulsory licensing deprives them of the needed resources. That sounds a lot more attractive than saying that, while they could develop new drugs to save lives, they won't unless it is profitable.


At 3:12 PM, October 12, 2006, Blogger markm said...

I don't see where the future patent/existing patent distinction makes much difference to the incentives. They can't force licensing of a patent until it exists - but if a country does this to the patents currently existing, it is nearly certain that it will do the same when new patents come out for new drugs that they want to get.

OTOH, the drug companies generally just shift the entire cost of their R&D onto American patients, with high prices here and lower prices everywhere else. Since medical demand is not very price sensitive even for out-of-pocket expenses, and is usually entirely de-coupled from price by third-party-payer "insurance", it is mainly not the drug companies that lose by this, but the Americans that have to pay the cost of insurance and of any drugs they must pay for themselves.

At 3:20 PM, October 12, 2006, Blogger David Friedman said...

Markm writes:

"I don't see where the future patent/existing patent distinction makes much difference to the incentives. They can't force licensing of a patent until it exists- but if a country does this to the patents currently existing, it is nearly certain that it will do the same when new patents come out for new drugs that they want to get."

That's correct for compulsory licensing by foreign countries. But the talk I was describing attempted to test the prediction by looking at cases of compulsory licensing of American companies under special circumstances—in five of the six cases, it was a condition imposed for permitting a merger.

That's a one time event. The fact that when company A merged with company B they were required to agree to compulsory licensing of one of their patents doesn't mean that the new A+B company is any more likely than anyone else to have compulsory licensing imposed in its future patents.

At 2:48 PM, October 13, 2006, Anonymous Anonymous said...

Patents should be completely based in a single country. If foreign countries want to ignore patent law, then the loss of reputation is bourne by those governments for violating their promises. The US should not be using diplomatic pressure to force them to change their laws.

Patents would block manufacture, import and export of a patented good (without permission).

With no patent laws, companies will probably underproduce. The US then decides to implement patent law. This results in an increase of generally useful products being developed and also some US-centric products being created. This works even if no other country follows suit. Also, since the US is a major fraction of the world economy, free rider effects are diminished.

The incentive for other countries to follow suit is that they get an improvement in products that are specific to their country being produced. Also, there may be effective import/export "friction" due to the fact that companies cannot export licensed products from the US without the patent holder's permission. This may cause problems for them. Their local variants may not be quite as good as the official version.

The net result could be pretty strict patent restrictions in the US/developed world and in the 3rd world there would be compulsory licensing.

In fact, this even provides free market segmentation for the product.

For drugs, there would be an issue that going to a foreign country for treatment effectively constitutes importing the treatment. Maybe a rule that you cannot re-enter the US for 1 year after treatment or something.

My personal opinion is that patent law should work by requiring the registrant to state how much they think the patent is worth. They would then pay say 5% of that to register it. The max they can ask a person for a license fee is (value)/(number of units so far made). Also, as more units are made, licensees may be entitled to a refund. Also, if someone accidently breaks the patent, they can only be fined say double that.

This means that it would be worth actually looking at the patent database (rather than engineers being recommended to not look at it due to not being lawyers). You could see the high value patents in your area and ensure that you don't break any of those (or get a license).

This also means that submarine patents are harder to pull off. To keep it hidden, you have to set the price low, but then you get almost nothing.

At 10:38 AM, October 25, 2006, Blogger Henry Troup said...

It seems to me that if they were honest about the reasoning, there would be various avenues for various interested parties to encourage or sponsor targeted research - and it would be straightforward to compute a price tag.

Would the data indicate, for example, how big an inducement it would take to bring a new malaria drug to market?

At 9:02 AM, October 27, 2006, Anonymous Anonymous said...

A futures market can determine the required investment anyway.

The future could be something like

"will pay $0 if a malaria treatment is developed with a minimum cure rate of X% by 2015, as determined by double blind testing as judged by Y institute and $100 otherwise" Option pairs could cost $101 for a true and a false option and the $1 used to pay the institute.

If you think you can develop the treatment, then you buy up futures. If you want someone to develop the treatment, you sell the options.

The market will automatically adjust for difficulty.

If the treatment is easy, it might cost $5 to buy options that will pay $100 if the treatment is not developed. Likewise, the development company will have to pay $95 for every $5 of reward that it gets.

This however, depends on low transactional costs and people being risk averse.


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