Scott Woolley

Scott Woolley

4/19/2006 @ 9:00AM

Prizes Not Patents

What is the most idiotic feature of Americas current system for patenting drugs?

A hard question, since there are so many good answers. The U.S. patent system sticks American consumers and taxpayers with eye-popping bills even as it lets foreign countries shirk their share of research costs by simply outlawing high drug prices. A mindless, one-size-fits-all incentive system, patents offer no special reward to scientists who tackle truly groundbreaking research while lavishing huge profits on easy-to-discover me-too drugs such as AstraZenecas Nexium. (see: A Heartburning Recipe). Todays system makes drugs unaffordable for many of the sickest Americans, while simultaneously convincing the not-so-sick to take more and more pills to stay healthy. (Drug ads persuade people to exercise less, smoke more and rely on pill-popping to save them, according to a new National Bureau of Economic Research study.)

But perhaps the crowning absurdity of pharmaceutical patents is also the most subtle. Americas drug patent system survives because advocates of the free market reflexively rush to its defense. They should know better.

The sole point of a drug patent is to outlaw a free market in the production of a new drug for 20 years, thus ensuring far higher drug prices than a competitive market would ever allow. This ugly bargain is well-meaningthose monopoly profits motivate inventors to discover wonderful drugs that will prolong and enrich our lives But that doesnt change what the patent system is: a blunt, market-distorting tool that the government uses to manipulate private behavior.

In the words of the Economics Encyclopedia Web site: The economics of monopoly are most easily seen by thinking of a “monopoly markup” as a privately imposed, privately collected tax. That tax inevitably leads to perverse economic outcomes (see: “A Primer On Drug Pricing“), and thus patents manage to enrage both bleeding-heart liberals obsessed with social justice and cold-hearted economists obsessed with efficient markets.

So what about the obvious alternative? Why doesnt the U.S. government simply reward drug inventors directly, with money raised from regular taxes, publicly imposed and publicly collected?

Replacing patents with cash prizes is a radical idea with an ancient pedigree. In 1714, the British government offered a £20,000 prize that led to the invention of the chronometer. In 1837, the French government bought the patent rights to Louis Daguerres early photography equipment, and then put the invention in the public domain. More recently, prizes have led to major improvements in human-powered airplanes, energy-efficient refrigerators and suborbital space craft.

Under a drug prize system, the U.S. government would simply pay cash for the rights to any drug that wins FDA approval, then put the U.S. rights in the public domain. Voilà! a free market in the manufacture and sale of new drugs. Generic drugs (generic being another way of saying the rights are in the public domain) already do a wonderful job of keeping prices down. While the price of patent-protected drugs has been rising at roughly twice the rate of inflation, the real price of generics has fallen in four of the last five years.

Prizes tap the creativity of the private sector to solve problems very effectively, points out Michael Kremer, a Harvard economist and leader in trying to popularize the prize idea. Unlike government-funded programs, [prizes] provide strong incentives. Researchers get paid only if their work succeeds.

The New Yorkers Malcolm Gladwell recently gave a pithy diagnosis of the 21st century pharmaceutical spending problem: The core problem in bringing drug spending under control, he wrote, is persuading the users and buyers and prescribers of drugs to behave rationally, and the reason were in the mess were in is that, so far, we simply havent done a very good job of that.

After getting the problem right, Gladwell gets the solution wrong. He proposes using experts to help guide consumers toward more rational drug purchases, so people wont, for instance, spend more on a patented drug if a generic is likely to be just as good. That makes sense, but trying to impose rational decisions onto a marketplace governed by irrational prices is a Sisyphean task. The only fundamental way to persuade users and buyers and prescribers of drugs to behave rationally is to charge them rational prices, prices that reflect the cost of making an additional pill for someone to buy.

Rational drug prices are anathema to the patent system, they are inherent in the prize system.

One indicator of how much money could be wrung out of the system is to look at how much drug companies actually spend on research. Pfizer, for instance, spent $7.4 billion on R&D last year, less than half the $17 billion it spent on marketing and administrative costs. Under a prize system, Pfizer would have no reason to convince people to use (or overuse) drugs it discovered. It would have already got its full payment upfront.

One easily dispensable expense: drug salespeople. Right now, 90,000 people roam the nations doctors offices, pushing brand-name drugs. Similar armies of generic drug sales reps dont exist, since pitching low-margin drug lacks a big payoff. If all drugs went generic, the brand-name sales racket could simply disappear. The annual savings from firing them all: $12 billion.

Direct to consumer advertising would vanish too. Spending on consumer ads for patented drugs hit $4 billion in 2004, up from $2.5 billion in 2000, according to IMS Health. (The increase is no surprise: The drug companies make about $4.20 in profit for every $1 they spend pitching their drugs to consumers, according to a study by researchers at Harvard and M.I.T.)

Not surprisingly, the prize idea does not sit well with the pharmaceutical industry, which is reliably one of the nations most profitable. There is nothing that shows the patent system is broken, says Mark Grayson, a spokesman for the Pharmaceutical Research and Manufacturers of America (PhRMA).

PhRMAs chief objection to a prize system seems a reasonable one: Relying on the government to decide what diseases it wants to cure and at what price is asking for trouble. It basically leads to central planning, and when weve seen central planning before, most notably the Soviet Union, says Grayson.

But some degree of central planning is a part of any government plan to compensate inventors for their discoveries, and that includes todays patent system. Faced with the thorny question of how much to reward the discovery of a particular type of drug, the current law doesnt even bother to try to get it right. It mindlessly rewards all inventors with a uniform period of patent protection and monopoly profits.

The result: Most new drugs are not really that new. Last year only a quarter of the 80 drugs that won FDA approval were new molecular entities. No surprise: Why try to develop a really novel drug if the government gives you no extra credit for your hard work?

Michael Kremer, the Harvard economist, has developed some clever ways of deducing the proper amount of a government-funded prize. One suggestion: When a new drug was discovered, he would let the government bid to buy its patent, along with private parties.

Another alternative is to set a prize budget and convene a group of economists and doctors to set the bounties on different diseases. A prize system puts the hard questions front and center. Is an AIDS vaccine worth $5 billion? Or $50 billion? Or $500 billion? How much more should a new molecular entity be worth than just another me-too drug?

PhRMA says any government bureaucracy or panel would often get the dollar too high or too low. Certainly true. But prizes at least require people to aim for rational incentives: rich prizes for major breakthroughs; meager rewards for minor improvements.

Perhaps the most viscerally appealing part of a prize is the opportunity to stick foreign consumers with their fair share of the global bill for drug development. Right now, the U.S. strategy for getting foreign countries to bear a proportional share of drug research costs is to politely ask governments to allow unregulated monopoly prices like we have here in the U.S. The foreign response, typically, is to slap price controls on the drugs, ensuring their people get the drugs cheap.

By nature, economists hate price controls. Price controls reduce the incentive to innovate, and that is absolutely deadly, says George Mason professor Alex Tabarrok, and he means it literally, since life-saving drugs go undiscovered. But he adds that the U.S. system often makes Canadians’ price controls a rational strategy for that country.

True, Canadian price controls lower global profits on future drugs, meaning companies will tend to invent fewer drugs. But whereas the Canadians get 100% of the cost savings, the whole world pays the price of making do with fewer drugs. Looked at from a purely Canadian point of view, free-riding on U.S. drug research makes plenty of economic sense.

But foreign price controls work only as for as long as the U.S. is content to play the patsy. Its easy for Canada to bully Merck or Pfizer into submitting to a price cap. When a patent-created drug monopoly faces the Canadian monopsony (a market where there is only one buyer), the monopoly loses. Drug companies could legally refuse to sell Canadian drugs at the lower price. But faced with the option of (1) making a small profit or (2) making no profit and being portrayed as an evil drug company in the press, drug companies make the obvious choice.

But say the U.S. government had set a prize of $40 billion for a diabetes cure and bought the global rights to Mercks new wonder drug. Once it owned the drug rights U.S. government could take a new negotiating tack: Your citizens pay what ours paidor they cant use the drug.

After years of playing the patsy, it would be interesting to see how playing hardball would work instead. Prizes, unlike patents, make the price America pays for an innovation absolutely clear. Insisting that other countries pay an equivalent amount is much easier politically than selling the world on the merits of monopoly prices.

There is historical precedent for unequal treatment. Back in 1837, when the French Government bought the patent rights to the Daguerrotype, its announced intention was to nobly give the whole world this discovery which could contribute so much to the progress of art and science. Then the French decided it would exclude Britain. If you wanted to use the Daguerrotype in the United Kingdom you still had to pay patent royalties. So the Brits coughed up.

While the prize system seems radical, it could be phased in incrementally, with government funding of just a few major prizes. And if the idea of a taxpayers directly footing a huge bill for drug research sticks in your craw, consider this: The bill to taxpayers for the Medicare prescription drug benefit is now expected to hit $720 billion over the next ten years. How many diseases could be cured if instead the same $720 billion poured into prize pools for new drugs?

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