Patents - to nationalise, or otherwise

Any patent system necessarily has public and private components. Every such system rests on state intervention to do everything from defining a patentable invention to establishing the formalities of patent examination and recordation. Yet the patent system is also deeply private, for individual market actors make their own decentralised decisions over where to invest resources to create patentable inventions.

There is an undeniable downside to this mixed system, for patent owners will charge customers a price for patent use that exceeds its marginal social cost of production. Elevated prices thus preclude some socially beneficial patent uses. The standard justification for this output restriction rests on two premises. The first is that inventors will only invest in innovative technologies if they can recover their front-end costs, which requires them to abandon marginal cost pricing. The second is that the patent monopoly only covers some particular substance or device, but never an entire field. That limited patent scope fosters competition from new patented inventions that enter a market niche served by prior patents.

Neither of these justifications, however, is a complete answer to the charge that patent protection unduly restricts the use of particular products. Is it possible then to find some way to get the best of both worlds so that ample incentives to produce are married to the low prices that generate extensive use?

One ingenious proposal to square the circle is to nationalise certain key patents, especially for pharmaceuticals. The beguiling logic, advanced by, among others, Robert Guell and Marvin Fischbaum, urges the government to acquire key patents by paying their owners sums that would leave them in the same position that they would have enjoyed if allowed to exploit their patents for the reminder of their useful lives.

The lump sum payment is meant to neutralise any disincentive to invention from nationalisation. Thereafter, the government freely licenses the acquired drugs to all comers, such that competition drives prices down to the marginal cost of production, thereby allowing full public access. In some instances, this maneuver could be done by voluntary purchase. In others, perhaps by condemnation. What could be better?

Lots, it turns out. The first mistake of this proposal is its narrow frame for overall evaluation. The revenues needed to fund government patent purchases must come from somewhere. General revenues or targeted taxes of patented pharmaceuticals already in the market are the only available sources. But these taxes, however calibrated, necessarily increase the cost of other goods, thereby raising their prices above marginal costs. Any resource gains for pharmaceuticals are thus offset by losses elsewhere, which are in turn compounded by the administrative costs of programme implementation.

Worse still, the proposal runs into choppy waters even if we focus solely on the pharmaceutical industry. Outright purchases of this magnitude are unprecedented. They are a tricky business, no matter how done. The valuation of real estate, for example, requires the parties to figure out the fair market value of a piece of land whose future uses may change over time. Any real estate appraiser would be gun-shy at negotiating these complications into the pharmaceutical area, where the outright purchase of one blockbuster patent could cost the state billions.

The calculations will stumble because no one knows today how one patent will fare against new drugs, perhaps from a different class, that may shortly come on the market. Nor can any outright transfer easily deal with potential challenges to patent validity or allocate the risk of future tort liability. It is for good reason that we see virtually no outright patent sales in the private sector.

In addition, these hefty patents price tags make it impossible for any government to buy all new drugs. So, who figures out which drugs will be acquired? We can expect to see a strategic scramble as companies try to figure out whether they want to hock their drugs or steer clear of government entanglements. Once the dust settles, moreover, any selective purchase has unfortunate ripple effects for the remaining drugs within the same class, which now have to compete with a subsidised product. As no one knows in advance whose drug will be (un)fortunately acquired, the manifest uncertainty will filter back to undermine the incentive to invest, which this nationalisation proposal hoped to preserve.

We have an important general lesson to learn. No legal or social innovation should be evaluated on the cheerful assumption that deft government action can excise a single identified imperfection. The nationalisation - or regulation - that removes one imperfection is likely to create another of equal or greater magnitude. The wise approach avoids such bold initiatives without a clear warrant for changing the status quo. And none exists for this dramatic revision of the patent system.

Richard A. Epstein is the James Parker Hall Distinguished Service Professor of Law, The University of Chicago, and the Peter and Kirsten Bedford Senior Fellow, The Hoover Institution. His recent book, Overdose: How Excessive Government Regulation Stifles Pharmaceutical Innovation is available from Yale University Press.

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James Boyle: State intervention for me, but not for thee

Richard Epstein’s discussion is curious. He carefully points out both the benefits and two of the problems with the patent system. He also lays out the attraction of the government buying up patents at full market cost and making the innovations available for anyone to manufacture. The $12,000 Aids drug could be made for pennies – but investment in innovation would not be chilled. What’s not to like?

A lot, says Epstein, and this is where things become strange. His first point is that the money used to pay for the patent would have to be raised elsewhere by the state, thus “distorting” prices in that area. We should be aware of the trade-off. True. But this is not an argument against government action over patents, it is an argument against government action anywhere. All government action – including running the patent, contract and court system which Epstein holds so dear – depends on raising revenue.

All revenue raised changes the prices of the goods on which it is raised, whether labour – through an income tax, purchased goods through VAT, or what have you. So, yes, be aware there is no free lunch, and yes try and place the costs of the intervention appropriately. But there is no more reason to abandon this proposal as a result, than there is to scrap any government program – including healthcare, national defence or the extremely expensive system of government intervention called the legal system. This program actually mitigates some of the social costs of an earlier state intervention. Patenting! In fact, in most developed countries in the world, taxpayers are already paying for these drugs through national health care systems. Why not pay for them in a better and more humane way?

Next Epstein tells us that it is hard to value drug patents accurately and that there are no sales of patents. Both claims are misleading. In order for this system to work, the valuation does not have to be platonically correct. It merely needs to have two characteristics.

First, it needs to be good enough so that any losses caused by over or under valuation are less than the social gains produced – saving lives and diminishing the malign effects of monopoly. It does not have to be right, just better, provided that in addition, on aggregate it averages the annual return to drug companies of successful drugs of this class. Provided it does that, the incentive effect will be maintained. That is a much easier target to hit.

As for patent sales, drug companies buy patents from biotech firms all the time at a much earlier stage – is this easier? More strikingly, in recent years there has been a rash of sales of entire drug companies during takeovers. How does one determine the value of a drug company? By valuing its drug patents and its drug pipeline – a harder process than the one Epstein imagines, yet one the hotshots in investment banking firms are confident they can carry off. Provided this proposal provides either for voluntary transfers, or in exceptional cases where there is a public health emergency and the government “marches in” on the patent, for full compensation at average market pricing and some level of independent review, it is not an impossible one.

Epstein says argues uncertainty as to which drugs will be acquired will undermine investment. Provided the conditions above are upheld, that is not true. As an investor, I am indifferent whether my cheques are written by Aids patients, or taxpayers, so long as they average out about the same. Finally, he claims that because all drugs cannot be purchased, there will be ripple effects. This is true but several things could be done to mitigate the dangers. The state might buy all the drugs in a particular class, or it might decide that we already have too many “me too” drugs and diminishing their number is on balance positive. As a result, it might introduce the program only prospectively, and let investments proceed in full knowledge of its existence, with a review process to see if there had been a negative or positive effect on the drug pipeline.

So, is the state purchase of patents automatically a good idea? Not at all. It needs careful study and review – and attention to the points Richard Epstein points out. But contrary to the suggestion of his article, there are many reasons to believe that after such a review, we might rationally decide to go forward with it.

James Boyle is a professor of law at Duke Law School and the co-founder of the Center for the Study of the Public Domain.