Chapter 2: The policy context for action on innovation and access

C. Economics of Innovation and Access to Medical Technologies

The past decade has seen more systematic efforts to use the tools of economic analysis to support discussions on health policy, particularly in developing economies. The WHO Commission on Macroeconomics and Health (WHO, 2001a) was a major milestone along this road. The present study does not attempt to advance economic analysis and the theoretical  understanding  of  the  economics of technology innovation and access issues. Rather, it recognizes the growing importance of economic concepts in policy debate, and it briefly reviews the main economic concepts and the current body of literature dealing with the IP aspects of these issues.

In the economics of innovation and IP,  knowledge  or new, useful information has been considered to have, to some extent, the classical characteristics of a public good: non-excludability and non-rivalry. Non-excludability means that it is not possible to exclude others from using the knowledge once it is made public. Non-rivalry means that one person’s use of the knowledge does not restrict or diminish the amount of it available or its value for use by others. Its non-rivalrous character means that knowledge can be easily shared and replicated. In the absence of some kind of protection against unauthorized sharing or replication, it is difficult to see how private entities would invest in the creation of knowledge, since others could benefit for free from their efforts once the knowledge is public. Therefore, for the original private investors, generating a reasonable level of return on their investments might prove difficult. Consequently, no protection at all would lead to chronic underinvestment in the creation of knowledge, or in other words, markets would fail to produce knowledge in socially optimal quantities.

Economists wrestle with the question of how best to finance the creation of new knowledge, particularly when private investment is involved. Special challenges arise in the area of medical technologies in general and medicines in particular, given the long product development times, the necessarily stringent regulatory burden, and the relatively high risk of failure (such as when pharmaceuticals fail tests on safety and efficacy at a late stage in their development) and the comparatively low marginal costs of production.

While patents may increase costs to society in the short term by restricting competition, they should generate greater and more dynamic benefits as a result of encouraging more innovation in the long term. The requirement to disclose the invention fully in patent applications helps to disseminate scientific and technical information that could otherwise be kept secret. Society therefore benefits from research conducted by those “standing on the shoulders of giants” to create additional new and useful inventions. Patents can also be useful instruments for obtaining finance (venture capital).

Costs associated with research in the pharmaceutical sector are high, but production costs often are very low and thus it is relatively easy for other companies to enter the market with generic versions of a new medicine at much lower prices, as these companies do not bear any of the R&D costs. Several studies have shown that when an array of different choices are examined – patents, trade secrets, lead times and other business strategies – the pharmaceutical sector stands out as the one that depends most on patents as a means of capturing returns on R&D investments. This finding has also been borne out by large-scale, multi-sector industry surveys conducted in the United Kingdom (Taylor and Silberston, 1973), the United States (Mansfield, 1986; Levin et al., 1987; Cohen et al., 2000) and in many other countries (WIPO, 2009).

Even where patent protection is in place, the actual period of effective market exclusivity is typically much shorter than the patent term. It has been estimated that the effective patent term of a new chemical entity (NCE), which is the balance remaining in the patent term after obtaining the relevant regulatory approvals, is an average of 8 to 12 years in the US market (Office of Technology Assessment, 1993; Grabowski and Kyle, 2007).

Despite this, the pharmaceutical sector also stands out for its high accounting rate of profit, which is between two and three times higher than the average rate for Fortune 500 companies. However, it should also be borne in mind that the pharmaceutical sector’s profit growth rate corresponds with the growth rate of R&D in this sector (Scherer, 2001). Indeed, US pharmaceutical companies invest as much as five times more in R&D, relative to their sales, than the average US manufacturing firm. However, despite the steeply rising costs of R&D in recent decades, the number of NCEs introduced worldwide, particularly those that deliver a significant therapeutic advance, has not increased proportionately. Factors such as increasingly complex disease targets and growing technological complexity may play a role in this decrease (USCBO, 2006). OECD (2011) observes that “rising patenting activity has been accompanied by an average 20% decline in patent quality over the past two decades” with the quality of pharmaceutical patents rating below than average and below that of other less mature areas of technology.

In order to understand the effect of pharmaceutical product patents, several attempts have been made by economists to simulate the effect on prices and welfare of the introduction of pharmaceutical patents.¹ One such study concludes that the introduction of product patents on pharmaceuticals in just one therapeutic subsegment in India would lead to significantly higher prices and welfare losses which are estimated to range from US$ 145 million to US$ 450 million per year (Chaudhuri et al., 2006). Most of this loss would be borne by consumers, in terms of lower consumer surplus. This outcome in reality would of course depend on the way policies were implemented, the extent of price regulation and the degree to which foreign multinationals responded to patent protection. These companies could either maintain exclusivity in marketing or use licensing more extensively.

Medical innovation benefits  patients  around  the world, whereas R&D into medical technologies is only undertaken in  a few  countries.  This  raises  the  issue of equitable sharing of the burden of R&D in this sector. Several solutions are advocated, and have been attempted, to attenuate the effects of high prices of patented medicines. Among these solutions are price controls, parallel imports and compulsory licensing. Price regulation, whether in terms of direct cost-plus or indirect price reimbursement models, including those based on reference pricing, can be efficient means to lower prices, but they have to be worked out carefully in order not to result in medicine shortages in the market.² Compulsory licences have also been reported as having resulted in substantially reduced prices of patented medicines during the patent term (see Chapter IV, Section C.3(a)(iii)). However,  compulsory  licences are not an easy solution for more complex technologies, as they do not oblige the patent owners to cooperate in transferring the additional know-how that might be required. In addition,  while  compulsory  licensing  can be effective at reducing prices, if used widely, it can undermine the equitable burden sharing of R&D costs. There is, however, not much empirical evidence so far on this question.

In addition to compulsory licensing, parallel imports of medicines may allow poorer countries to benefit from lower prices elsewhere.³ However, it has been demonstrated that while parallel imports result in a reduction in prices, they deliver considerably higher benefits for traders involved in such imports than they do for consumers (Ganslandt and Maskus, 2004). Furthermore, it needs to be borne in mind that the possibility of parallel importing is not determined solely by the IP regime chosen by a country. Rather, it also depends on the conditions in the individual contract between the  manufacturer  and  the wholesaler, as well as on the differences in the market authorization granted, including, for example, the trade name of the product, which may vary from one jurisdiction to another.

Another potential solution is differential or tiered pricing, under which lower prices are applied in poorer countries (see Chapter IV, Section B.2). In order to maximize profits, a monopolist selling under different  market  conditions could use a form of price discrimination based on differing willingness and ability to pay for the product. The counterfactual to differential pricing is uniform pricing, whereby the seller sets one price, adjusted for transport, distribution and other costs, for all consumers in all countries. It should be noted that in such circumstances there would be no scope for parallel importation.

A medicine protected by patents should, in  principle, lend itself to differential pricing. In such circumstances, both consumers in poorer countries and patent-owning companies would be better off. It would also seem that, in these circumstances, the market itself could move closer to solving the problem of equitable sharing of R&D costs. In order for differential pricing to occur, three conditions would need to be fulfilled (WTO, 2001):

• The seller must have some control over price, such as some degree of market power.
• The seller must be able to identify and segregate consumers according to varying price sensitivities.
• The seller must be able to limit resale from low-priced markets to high-priced markets or, in other words, must be able to segment the market.⁴

In addition to concerns about the price or affordability of patented medicines, concerns have been raised about delays in the availability of these medicines in other countries from the date of first approval in the first country. One study (Lanjouw, 2005) found that while for high-income countries, patents unambiguously encourage the introduction of new drugs, price regulation deters such entry. The picture is mixed for the other countries. For low- and middle-income countries (LMICs) with a high capability to imitate new drugs, introducing strong IP protection may mean having fewer new drugs on the market, as patent owners may delay entry due to expectations of low prices, and generic producers cannot enter due to patent protection. On the other hand, while price regulation makes it less likely that new drugs will be available quickly in LMICs, such regulation does not appear to prevent new products from being launched eventually.

This research has been taken further by others including, more recently, by Berndt et al. (2011), who demonstrate that key developing countries have been shown to have slower diffusion of new drugs, even in a post-TRIPS era. While the data in this study are new and interesting, the researchers’ conclusion that slower diffusion of new drugs is due to lack of IP enforcement is more controversial. Some countries provide incentives to originator companies to introduce their products soon after first marketing anywhere in the world by counting the term of test data exclusivity from the date of first approval globally, as opposed to from the date of first approval in that country. For example, Chile has implemented such a system following the US–Chile FTA (Fink, 2011).⁵ For countries with a weak regulatory framework, somewhat delayed introductions, on the other hand, have the advantage of avoiding adverse events associated with withdrawals for safety reasons.

Finally, it is important to note that patents  and  other IPRs are meant to be market-based instruments. They play a limited role in providing incentives to develop new medicines for “neglected diseases” or “diseases of the poor” in regions where there are small markets. Thus, the ongoing debate on access to medicines, has generated a debate on alternative non-price linked mechanisms for incentivizing innovations such as prizes or advance market commitments, and it has spawned new business models such as private–public partnerships.⁶

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1. Economics teaches us that, under certain assumptions, static social welfare is maximized when consumers and producers are able to achieve the maximum surplus possible in a given market, such as a market for a specific medicine. Consumer surplus is the difference between the price a consumer pays for this medicine and the price he would be willing to pay rather than do without it. Producer surplus is the difference between the amount that a producer of the medicine receives and the minimum amount that he or she would be willing to accept for the medicine (or marginal cost).  back to text

2. For examples of these kinds of measures, see Chapter IV, Section B.1.  back to text

3. Exhaustion and parallel imports are discussed in Chapter IV, Section C.3(b).  back to text

4. For further details, see Chapter IV, Section B.2.  back to text

5. For other examples on the national implementation of test data, see Chapter II, Section B.1(c)(iii).  back to text

6. See Chapter III, Section C.4.  back to text