Abstract
Pharmaceutical patents are anachronistic holdovers from an era in which modern economic understanding and tax tools were unavailable. Superior mechanisms lie somewhere between a first best pricing solution for the entire economy at one extreme and the current arrangements at the other. We discuss the economics of suggested alternatives and suggest that the intertemporal bounty is the best way to meet the multiple objectives of immediate distribution at marginal cost pricing of newly innovated patented drugs and easily administered, efficient inducement to continued innovation. The intertemporal bounty prevents the expansion of monopoly power resulting from co-pay or -insurance provisions common to modern prescription drug plans.
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Notes
Baumol and Bradford[9] provide a discussion of utility trade-offs in a tax setting where lump sum taxes are not available. The optimal tax literature goes back to the seminal work by Frank Ramsey,[10] who asked how to raise a given amount of revenue for the least loss in utility to the economic system by taxing different uses of income. The resulting system of market price plus associated tax is referred to as the ‘Ramsey pricing solution’. Modern treatments include income taxation, identifying circumstances in which public goods can be financed with small or no increase in distortion costs to the system (see footnote 9). The intervention principle asks how to induce adjustment in some action for the least loss in utility; in this article, the action is innovation of patentable drugs followed by widespread dissemination. The three questions are related because innovation has public good aspects, an intertemporal bounty of the type described here satisfies the intervention principle, and taxes are needed to finance the bounties paid.
The term ‘knowledge spillovers’ refers to the situation in which the benefits derived from one party’s creation of knowledge are used without compensation by a second party. In many cases, knowledge can be protected from unwanted dissemination, but the full protection of trade secrets is not accomplished in all cases, even with patents and other legal intellectual property protections in place.
The two-part pricing contract envisioned by Lakdawalla and Sood[20] leads to perfect innovation and utilisation, but requires accurate ex ante estimation of all future benefits
It is important to keep in mind that area B profits refer to what economists call economic profits. These are profits above and beyond the usual or standard rate of business profit. As such, economic profits could be set to zero (as they should be in a first-best world) and not harm the ability of the manufacturer in question to continue operations. Full social surplus, area A + B + C should accrue to someone in society.
There are good ways to identify (A + B + C). Kremer[15] used US Current Population Survey household income data to conclude that the social value of new pharmaceuticals, area (A + B + C), is 2.7-fold the profits that would be achieved by a monopolist, area B, and the deadweight loss, area C, is 25% of the sum of profits and consumer surplus (area A + B). Others have used information about the marginal cost of manufacturing combined with estimates of demand elasticity.
Combining estimates from Kremer (see footnote 5), profit as a fraction of industry sales of 0.18, and Centers for Medicare and Medicaid Services (CMS) information on US prescription drug expenditures in 2004 of $US189.7 billion[25] is sufficient to solve for area (A + B + C), $US92.2 billion, and area (D + E), $US323.6 billion, of which unrealised social surplus, area C, is $US18.4 billion, and industry profit, area B, is $US34.1 billion. If these numbers are representative of steady state, a bounty per sales dollar of $US0.092 would generate $US29.6 billion, equal to the current domestic R&D spending by US firms, and setting the bounty at $US0.285 per sales dollar would transfer full social surplus (area A+B+C) to innovating firms.
$US909 million in year 2000 values is $US802 million.
Implementation issues include other questions, such as how to treat the bounty paid on faulty or recalled drugs such as Vioxx® (the use of trade names is for product identification purposes only and does not imply endorsement). In the present patent system, already-earned patent profits are not rescinded. The relevant principle is that the chosen arrangements should be best suited to induce creations and dissemination of non-faulty drugs. If negligence or lack of due diligence is the cause of recalled drugs, then the bounty paid to time of recall should be returned. If recall is more often the result of error that prior effort was unlikely to have been effective in avoiding, and the recall itself was costly, then the intertemporal bounty should be implemented more along the lines of the current patent system: bounty paid to time of recall is retained by the firm. Other implementation details can be similarly evaluated.
When taxes are not an issue, rewards to innovators in the form of intertemporal bounties are unambiguously superior to intellectual property rights because government uses ex post-sales-related observations and therefore has information about demand at least as good as the ex ante information of innovators (see Shavell and van Ypersele[19]). When funds for the bounty must be raised by taxation, incentives for production, investment and innovation can be distorted, for example. However, in this case, under standard simplifying assumptions, the bounty can be financed in a manner that results in no additional distortion. The ex ante benefits from drug innovation are of equal value to everyone, so the uniform case described by Kaplow[26] is most relevant.
Patent law is subject to variability and vagaries too, based on how firmly patent rights are enforced by the courts, and how much courts change their interpretations of law.
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Grinols, E.L., Henderson, J.W. Replace Pharmaceutical Patents Now. Pharmacoeconomics 25, 355–363 (2007). https://doi.org/10.2165/00019053-200725050-00001
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DOI: https://doi.org/10.2165/00019053-200725050-00001