Here is my third and final post on Boldrin and Levine’s book. I cover here the final two chapters and the pharma industry (chapter 9) and their conclusions (chapter 10). As lazy as usual, it is mostly some copy-pastes. As a reminder you can find here part 1 and part 2.

The Pharmaceutical Industry

The traditional model predicts that there should be many potential producers of a medicine, that the industry should be dynamically competitive, and therefore highly innovative with newcomers frequently challenging incumbents by means of innovative superior drugs. […] Some people esteem the pharmaceutical industry and some people despise it: there is little middle ground. The pharmaceutical industry is the poster-child of every intellectual monopoly supporter. It is the vivid example that, without the sheltering patents provide inventors with, the outpouring of new wonder drugs we have grown accustomed to would have not materialized, our life expectancies would be a lot shorter, and millions of people would have died of the diseases Big Pharma has instead managed to cure. In the opposite camp, Big Pharma is the scourge of humanity: a club of oligopolistic white men that, by controlling medicine around the globe and refusing to sell drugs at their marginal cost, are letting millions of poor people die. […] This sounds utterly complicated, so let us handle it with care and, for once, play the role of the wise fellows: in media stat virtus, et sanitas. […] How strong is the case for patents in pharmaceuticals? While Big Pharma is not necessarily the monster some depict, the case for patents in pharmaceuticals is a lot weaker than most people think. [Pages 242-243]

The authors make a long and interesting analysis of the history of the chemical industry with France and the UK blocking while Germany and Switzerland could innovate.

[Page 249] Here is how Murmann summarizes the main findings from his historical study of the European synthetic-dye industries during the 1857-1914 period. British and French synthetic dye firms that initially dominated the synthetic dye industry because of their patent positions but later lost their leadership positions are important cases in point. It appears that these firms failed to develop superior capabilities in production, marketing and management precisely because patents initially sheltered them from competition. German and Swiss firms, on the other hand, could not file for patents in their home markets and only those firms that developed superior capabilities survived the competitive home market. When the initial French and British patents expired, the leading German and Swiss firms entered the British and French market, capturing large portions of sales at the expense of the former leaders.

The authors also analyze Italy and India, which did not have until recently strong IP policies. “Interestingly though, we have not been able to find a single independent analyst claiming that the additional amount of pharmaceutical innovation patents may stimulate in the Indian industry, will be substantial and large enough to compensate for the other social costs. More to the point, the positive consequence of patent adoption in countries like India is, according to most analysts, a consequence of beneficial price discrimination. The argument goes as follows: monopoly power allows price discrimination – that is, the selling the same good for a high price to people valuing it a lot (usually people richer than average) and for a low price to people valuing it little (usually people poorer than average). Due to the absence of patent protection, there are very many new drugs that are not marketed in poor countries by their original producer, as the latter is not protected by reliable patents in that country.” [Page 253]

[Another] doubt comes from the following observation: if it were really true that imitating and “pirating” new drugs is that easy, absent patent protection local firms would be already producing and marketing such drugs in the country in question. [Page 254]

Pharma today
A few additional facts : the top 30 firms spend about twice as much in promotion and advertising as they do in R&D; and the top 30 are where private R&D expenditure is carried out, in the industry. Next we note that no more than 1/3 – more likely 1/4 – of new drug approvals are considered by the FDA to have therapeutic benefit over existing treatments, implying that, under the most generous hypotheses, only 25-30% of the total R&D expenditure goes toward new drugs. [Page 255]

Summing up and moving forward, here are the symptoms of the malaise we should investigate further.
– There is innovation, but not as much as one might think there is, given what we spend.
– Pharmaceutical innovation seems to cost a lot and marketing new drugs even more, which makes the final price for consumers very high and increasing.
– Some consumers are hurt more than others, even after the worldwide extension of patent protection. [Page 256]

Where do drugs come from? [Pages 257-260]
Useful new drugs seem to come in a growing percentage from small firms, startups and university laboratories. […]Next there is the not so small detail that most of those university laboratories are actually financed by public money, mostly federal money flowing through the NIH. The pharmaceutical industry is much less essential to medical research than their lobbyists might have you believe. In 1995, […] about $11.5 billion came from the government, with another $3.6 billion of academic research not funded by the feds. Industry spent about $10 billion. However, industry R&D is eligible for a tax credit of about 20%, so the government also picked up about $2 billion of the cost of “industry” research. […] In 2006, total was $57 billion while the NIH budget in the same year (the largest but by no means the only source of public funding for biomedical research) reached $28.5 bn.[…] it is wise to remember that the modern “cocktail” that is used to treat HIV was not invented by a large pharmaceutical company. It was invented by an academic researcher: Dr. David Ho.

It is a fact that, without the strong incentive the prospect of a successful patent induces, those researchers would not be working as hard as they do. That is true, so let us think the issue through once again. We observe that, while the incentive to patent and commercialize their findings should have been increased by the Bayh-Dole act allowing patentability of such research results, there is no evidence whatsoever that, since 1980 when the act was passed, major medical scientific discoveries have been pouring out of American universities’ laboratories.

It therefore remains an open question: did patentability of basic biomedical innovations create an incentive for engaging in more socially valuable research projects and investigations? Which medical and pharmaceutical discoveries are truly fundamental and where do they come from?

Here are the selected fifteen most important medical milestones: Penicillin, x rays, tissue culture, ether (anaesthetic), chlorpromazine, public sanitation, germ theory, evidence based medicine, vaccines, the pill, computers, oral rehydration therapy, DNA structure, monoclonal antibody technology, smoking health risk. How many entries in this list were patented, or were due to some previous patent, or were obtained during a research project motivated by the desire to obtain a patent? Two: chlorpromazine and the pill. […] Now the “list of Top Pharmaceuticals”, these are the current pharmaceutical products selling the most worldwide, and there are 46 of them. Patents had pretty much nothing to do with the development of 20 among the 46 top selling drugs. […] Notice though that of these 26, 4 were discovered completely by chance and then, 2 were discovered in university labs before the Bayh-Dole Act was even conceived. Further, a few were simultaneously discovered by more than one company leading to long and expensive legal battles, however, the details are not relevant to our argument. The bootom line is more than half of the top selling medicines around the world do not owe their existence to pharmaceutical patents.

Rent-seeking and redundancy. [Pages 260-263]
The next question then is, if not in fundamental new medical discoveries, where does all that pharmaceutical R&D money go? […] 54% of FDA-approved drug applications involved drugs that contained active ingredients already in the market. […] 35% were products with new active ingredients, but only a portion of these drugs were judged to have sufficient clinical improvements over existing treatments to be granted priority status. In fact, only 238 out of 1035 drugs approved by the FDA contained new active ingredients and were given priority ratings on the base of their clinical performances. In other words, about 77% of what the FDA approves is “redundant” from the strictly medical point of view. […] Sad but ironically true, me-too or copycat drugs are largely the only available tool capable of inducing some kind of competition in an otherwise monopolized market. ..] The ironic aspect of me-too drugs, obviously, is that they are very expensive because of patent protection, and this cost we have brought upon ourselves for no good reason. […] Insofar as new drugs are replacements for drugs that already exist, they have little or no economic value in a world without patents – yet cost on the order of $800 million to bring to market because the existence of patents forces the producers to “invent something” the USPTO can pretend to be sufficiently different from the original, patented, drug.

Libraries have been written on the obvious connection between marketing and the lack of competition. The pharmaceutical industry is no exception to this rule, and the evidence Professor Sager, and many others, point to has a simple and clear explanation: because of generalized and ever extended patenting, large pharmaceutical companies have grown accustomed to operating like monopolies. Monopolies innovate as little as possible and only when forced to; in general they would rather spend time seeking rents via political protection while trying to sell at a high price their old refurbished products to the powerless consumers, via massive doses of advertising.

The authors finish with an economic analysis of the social cost and benefit of patents and without patents, and propose solution in the final chapter.

Conclusion: The bad, the Good, and the Ugly

Edith Penrose, concluded that “If we did not have a patent system, it would be irresponsible, on the basis of our present knowledge of its economic consequences, to recommend instituting one. But since we have had a patent system for a long time, it would be irresponsible, on the basis of our present knowledge, to recommend abolishing it

But the authors claim: “On the basis of the present knowledge” progressively but effectively abolishing intellectual property protection is the only socially responsible thing to do. […] A realistic view of intellectual monopoly is that it is a disease rather than a cure. It arises not from a principled effort to increase innovation, but from a noxious combination of medieval institutions – guilds, royal licenses, trade restrictions, religious and political censorship – and the rent-seeking behavior of would be monopolists seeking to fatten their purse at the expense of public prosperity. [Pages 277-78]

A myriad of other legal and informal institutions, business practices and professional skills have grown up around them and in symbiosis with them. Consequently, a sudden elimination of intellectual property laws may bring about collateral damages of an intolerable magnitude. Take for example the case of pharmaceuticals. Drugs are not only patented, they are also regulated by the government in a myriad of ways. Under the current system, to achieve FDA approval in the United States requires costly clinical trials – and the results of those trials must be made freely available to competitors. Certainly, abolishing patents and simultaneously requiring firms that conduct expensive clinical trials to make their results freely available to competitors, cannot be a good reform. Here patents can only be sensibly eliminated by simultaneously changing also the process by which the results of clinical trials are obtained, first, and, then, made available to the public and to competitors in particular. [Page 278]

The authors look at many intermediate solutions including deregulation, private contracts, subsidies, social norms but they are clearly convinced (and convincing) that an evolution is needed, even if they are pessimistic:

Where, today, is a software innovator to find safe haven from Microsoft’s lawyers? Where, tomorrow, will be the pharmaceutical companies that will challenge the patents of “big pharma” and produce drugs and vaccines for the millions dying in Africa and elsewhere? Where, today, are courageous publishers, committed to the idea that accumulated knowledge should be widely available, defending the Google Book Search initiative? Nowhere, as far as we can tell, and this is a bad omen for the times to come. The legal and political war between the innovators and the monopolists is a real one, and the innovators may not win as the forces of “Stay the Course” and “Do Nothing” are powerful, and on the rise. [Page 299]

Certainly the basic threat to prosperity and liberty can be resolved through sensible reform. But intellectual property is a cancer. The goal must be not merely to make the cancer more benign, but ultimately to get rid of it entirely. So, while we are skeptical of the idea of immediately and permanently eliminating intellectual monopoly – the long-term goal should be no less than a complete elimination. A phased reduction in the length of terms of both patents and copyrights would be the right place to start. By gradually reducing terms, it becomes possible to make the necessary adjustments – for example to FDA regulations, publishing techniques and practices, software development and distribution methods – while at the same time making a commitment to eventual elimination. [Page 300]

I promised a continuation to my post Against Intellectual Monopoly and here it is. The book is really a must-read for anyone interested in innovation. But maybe you want to begin with an direct explanation by the authors. Check the following audio interview.

So, as a follow-on, here are some very interesting elements about:
– Does IP increase innovation?
– Non-compete labor contract clauses inhibit innovation.

This is something I have been particularly sensitive to, as you will see below through past links. But before this, let us follow the book from where I had stopped.

Criticism of the Schumpeterian Theory
“Although originally not a mainstream view in economics, the Schumpeterian view is now close to becoming an orthodoxy in most circles. Schumpeter celebrates monopoly as the ultimate accomplishment of capitalism. He argues that in a world in which intellectual property holders are monopolists, competition is a dynamic process that is implemented via the process of creative destruction. […] How many industries can [one] mention where the mechanism described in the Schumpeterian model has been at work, with innovators frequently supplanting the incumbent monopolist, becoming a monopolist in turn to be ousted shortly after by yet another innovator?” [Pages 189- 190]

About secrecy and disclosure through patents/copyrights
“A common argument in favor of patent law is that in order to get a patent you must reveal the secret of your invention. […] Suppose that each innovation can be kept secret for some period of time, with the actual length varying from innovation to innovation, and that the length of legal patent protection is 20 years. Then the innovator will choose secrecy in those cases where it is possible to keep the secret for longer than 20 years, and choose patent protection in those cases where the secret can be kept only for less than 20 years. In this case, patent protection has a socially damaging effect. Secrets that can be kept for more than 20 years are still kept for the maximum length of time, while those that without patent would have been monopolized for a shorter time, are now monopolized for 20 years. Indeed, it is important to realize that outside the pharmaceutical industry, where the regulatory system effectively forces revelation, trade-secrecy is considerably more important than patent. Repeatedly, in surveys of R&D lab and company managers only 23%-35% indicate that patents are effective as a means of appropriating returns. By way of contrast, 51% argue that trade-secrecy is effective.” [Page 186]

“If instead there is a race for a patent, the incentive is to keep intermediate results secret so as to keep competitors from winning the race. In fact there is much evidence that secrecy and legal monopoly are complementary rather than alternatives. Despite copyright, producers of books, music and movies have aggressively attempted to encrypt their work with Digital Rights Management (DRM).” [Page 187]

Worse, [for Amazon 1-click purchase patent], “as can be seen, the “secret” that is revealed is, if anything, less informative than the simple observation that the purchaser buys something by means of a single click.” [Page 189]

“In the case of copyrightable creations, it can be argued that technological change – computers and the Internet – are greatly lowering the cost of reproduction, and so the conventional model in which ideas trade instantly at zero price is relevant. However, it is cost relative to the amount of competitive rent that matters. If indeed the Internet is reducing competitive rents, bear in mind that the same computer technology is reducing the cost of producing copyrightable creations. Take music, for example. Music editing capabilities that required millions of dollars of studio equipment ten years ago now require an investment in computer equipment of thousands of dollars. And long before the Internet swamps the markets with music and movies, authors will be able to create movies on their home computers with no greater difficulty than writing a book – and entirely without the assistance of actors, cinematographers, and all the other people that contribute to the high cost of movie making. […]Whether price falling to zero implies revenue falling to zero depends on the elasticity of demand, the mathematics of infinity times zero is complicated at times and this is one of them. If, in fact, demand is elastic, then price falling to zero implies (because so many more units are sold) revenue increasing to infinity. [Pages 193-194]

About the global economy
One often finds the argument that the increasingly freer trade, the growth of many Asian economies, and the lowering of transportation costs are creating a dangerous mix for our economic stability. In particular, it is argued, our ideas and products are increasingly being “unrightfully copied”, and this requires some kind of serious intervention by our governments. In other words, globalization is risky for our innovators, and we need to strengthen intellectual property protection and force emerging countries to do the same we do. [Page 194]

There is a […] perhaps more subtle but certainly not less relevant argument. As market size increases, two things happen. More consumers are added for all those ideas you are already producing or you would have produced in any case. Let us call these “good” ideas since they were good enough to be profitable even when the market was small. Also, additional ideas from new guys getting into the game become available. Let us call these “marginal” ideas, since if they had been good ideas they would have been introduced even when the market was small. Now, lowering intellectual property protection decreases the monopoly distortions for all consumers of the “good” ideas. With a larger market, many more consumers benefit from the greater usefulness and availability of all these “good” ideas. Second, lowering intellectual property protection makes it harder for “marginal” ideas to make it into the market. But in a larger market, more of these “marginal” ideas are going to be produced anyway, as there are more consumers to pay for the cost of inventing them. So the bottom line is that as the size of the market increases, by lowering intellectual property protection, you can get a lot more use out of “good” ideas at the cost of not getting quite as many “marginal” ideas as you would have.

“This simple rule of thumb would be that if the size of market grows by 4%, the length of protection should be cut by 1%. […]Unfortunately, in the case of copyright, terms have been moving in the wrong direction; they have grown by a factor of about four, while world GDP has grown by nearly two orders of magnitude. Hence, if the copyright term of 28 years at the beginning of the 20th century was socially optimal, the current term should be about a year, rather than the current term of approximately 100 years!” [Page 196]

And the authors add regularly that only already successful ideas are copied, not all of them, so yes there is less revenue and profit. Again how much is enough…?

Does IP increase innovation? [Chapter 8]
“A number of economic historians, Douglass North and his followers foremost among them, have argued that the great acceleration in innovation and productivity we associate with the Industrial Revolution was caused by the development of ways to protect the right of inventors, allowing them to profit from their innovations. Central among such ways was the attribution of patents to inventors, and their upholding either by Parliament or by the courts. Relative to the very poorly defined contractual rights of pre-seventeen century Europe, plagued by royal and aristocratic abuses of property and contracts, there is no doubt that allowing individuals a temporary but well defined monopoly over the fruits of their inventive effort was a major step forward. Even monopolistic property is much better than a system that allows arbitrary seizure by the rich and powerful. This does not, however, contradict our claim that widespread and ever growing monopolistic rights are not as socially beneficial as well defined competitive property rights.” [Page 209] “The issue, then, is the one we posed at the outset: does monopoly really lead to more innovation, on average, than competition? Theory gives an ambiguous answer, so let us look at evidence, supported by a bit of statistical common sense.” [page 210]

After an interesting analysis of music composition before and after copyrights [pages 211-213], the authors analyze patenting. “A number of scientific studies have attempted to examine whether introducing or strengthening patent protection leads to greater innovation using data from post WWII advanced economies. We have identified twenty three economic studies that have examined this issue empirically. The executive summary: these studies find weak or no evidence that strengthening patent regimes increases innovation; they find evidence that strengthening the patent regime increases … patenting! They also find evidence that, in countries with initially weak IP regimes, strengthening IP increases the flow of foreign investment in sectors where patents are frequently used.” [Page 216]

Innovation may lead to more patenting but more patents and stronger patent protection do not lead to more innovation. [Page 219]

About labor contract clauses: [Pages 224-227]
(Route 128 and Silicon Valley and restrictive “non-compete” labor contract clauses)

Legally preventing workers from spreading the knowledge they acquired in previous occupations is an inefficient way to internalize knowledge spillovers.

In 1965 both Silicon Valley and Route 128 were centers of technology employment of equal importance, and with similar potentials and aspirations for further growth. … By 1990, Silicon Valley exported twice the amount of electronic products as Route 128, a comparison that excludes fields like software and multimedia, in which Silicon Valley’s growth has been strongest.

What explains this radical difference in growth of the two areas? […] The only significant difference between the two areas lay in a small but significant difference between Massachusetts and California labor laws: A postemployment covenant not to compete prevents knowledge spillover of an employer’s proprietary knowledge not, as does trade secret law, by prohibiting its disclosure or use, but by blocking the mechanism by which the spillover occurs: employees leaving to take up employment with a competitor or to form a competing start-up. Massachusetts law is generally representative of the approach taken toward postemployment covenants not to compete by the great majority of states. California law governing covenants not to compete is both unusual and radically different from that of Massachusetts. “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.”

The paradox of Silicon Valley was that competition demanded continuous innovation, which in turn required cooperation among firms. [Quoted from Saxenian. This is as you know one of my favorite topics as you might read from Silicon Valley – more of the same? or The spin-off virtuous circle].

The (not so) famous Wagon Wheel Bar, incarnation of knowledge spillover.

We know that there are good economic reasons why it must be so: competition is the mechanism that breeds innovation, and sustained competitive innovation, paradoxical as that may sound to those that do not understand it, often is best implemented via cooperation among competing firms.

While Route 128 companies spent resources to keep knowledge secret – inhibiting and preventing the growth of the high tech industry – in California this was not possible. And so, Silicon Valley – freed of the milestone of monopolization – grew by leaps and bounds as employees left to start new firms, rejoined old firms and generally spread socially useful knowledge far and wide.

About simultaneous inventions [Pages 229-235]
The authors add interesting examples when simultaneous discoveries were made, including the sad story of tesla vs. Marconi. “So, why did N. Tesla Broadcasting Co. not hold a complete monopoly over radio communications in the U.S. until late in the 1920s? Why did Nikola Tesla die poor while Marconi enriched himself, on his way to a Nobel prize? Because now like then, the game of patenting and intellectual monopoly is not all that democratic and open to the little guys as Ms. Khan’s recent and altogether interesting book would have us to believe. So it is the case that Marconi, supported by the likes of Edison and Carnegie, kept hammering the U.S. Patent Office until, in 1904, they reversed course and gave Marconi a patent for the invention of radio. We read that “The reasons for this have never been fully explained, but the powerful financial backing for Marconi in the United States suggests one possible explanation.”[…] The story of injustice to Nikola Tesla has a tragicomic ending: in 1943 the U.S. Supreme Court upheld Tesla’s radio patent reversing the earlier decision of the U.S. Patent Office. Of course, Tesla was dead by this time – and indeed that is why he was awarded the patent. The United States Government had been sued by the Marconi Company for use of its patents during the First World War. By awarding the patent to Tesla, they eliminated the claim by Marconi – and faced no similar claim from Tesla, who, being dead, was unable to sue. [Pages 232-33]

For reference Khan, Z. [2005], The Democratization of Invention. Patents and Copyrights in American Development, 1790-1920. Cambridge University Press.

More in part 3, soon…