Patent protection and market for drugs

10Several features of the pharmaceutical market imply the need for strong regulations. First, as in every innovative industry, it is characterized by high fixed costs. Indeed, developing a new drug requires huge investments in R&D with potentially no insurance that the whole process will actually yield returns. For instance, the average cost of bringing a new drug to the market has been assessed at USD 800 million (Boldrin and Levine, 2008). Second, once a new drug has been developed, the marginal cost of producing the drug is quite low, which makes the replication and production of generic drugs financially attractive. The combination of these two characteristics creates an incentive issue to invest in pharmaceuticals drugs. Without regulation, generic manufacturers can copy and compete with the firm that carried out the costly investment of R&D. Anticipating this strategy, firms will not put the financial means on R&D since they will not be able to recover them. This is particularly inefficient from a social point of view, especially in the pharmaceutical industry where the social benefits of research and development are potentially extremely high for some diseases.

11This point makes the case for patent protection in the pharmaceutical industry. The U.S. Food and Drug Administration (FDA) defines a patent as the exclusive use of an innovation for a fixed period of time. Patented drugs can therefore be sold exclusively by the patent owner, which prohibits other companies from selling the generic version of that drug. Generic drugs, however, are defined by the FDA as « medications created to be the same as an existing approved brand-name drug in dosage form, safety, strength, route of administration, quality, and performance characteristics » (2018). Generic drugs are therefore generally sold after a patent’s time-exclusivity period expires. They are identical to the original patented product and may only change in packaging, color or inactive ingredients (FDA, 2018). As of today, the exclusivity period of patented drugs in France is 10 or 11 years (Agence nationale de sécurité du médicament et des produits de santé, 2017), while in the U.S., the FDA (2015) grants different exclusivity periods depending on the drug classification, from six months (pediatric drugs exclusivity) to seven years (orphan drugs exclusivity).

12In granting patents, governments incentivize firms to invest in research, by ensuring a monopoly over the sale of the drug once it is developed. The value of a patent can be approximated by the incremental added value of the innovation at the time the patent is secured, which is also called the patent premium. Arora et al. (2008) actually measured the patent premium for 19 industries and found it to be the highest for medical instruments, biotechnology, and pharmaceutical companies, strengthening the case for the need of patent protection in the pharmaceutical industry.

13In practice, patent regulation is a bone of contention between countries. The U.S. clearly dominates the pharmaceutical market with 10,438 patents granted in 2013, while 12,060 patents were granted to all European countries put together (Akkari et al., 2016). On the contrary, India pushes policies which encourage generic manufacturers at the expense of patented drugs (Lanjouw, 1997).

The need to regulate prices

14Furthermore, patents can actually induce economic inefficiency. The pharmaceutical market is no exception to the static versus dynamic efficiency dilemma. Indeed, patents allow firms to start investing in research for drugs whose benefits will arise an average of 14 years from now (Paul et al., 2010). Therefore, patent protection increases dynamic efficiency. However, since patents grant monopoly power to a company for a given period of time, their protection leads to static inefficiency: monopolists do not sell at marginal cost, and part of the social surplus is lost. That dilemma could be a rationale for price regulation in the pharmaceutical market. However, according to Danzon (2006), this cannot be the main rationale, because patents do not prevent the entry of all the drugs that could in effect compete with the patented ones and also, the industry is structurally competitive. Another justification can be found in the widespread presence of health insurance systems in the pharmaceutical market. Indeed, because patients do not pay the medicines out of their pocket, those systems make insured patients less sensitive to prices, a situation that incentivizes pharmaceutical manufacturers to overcharge their drugs. The extra cost is then borne by insurers. Actual price regulation varies widely around the world. For instance, the U.S. does not directly regulate prices, as exemplified by the Sovaldi USD 84,000 treatment’s scandal in 2013. [3]Again, at the opposite end of the spectrum, India actually enforces a very strict price regulation, which results in low drug prices.

15Therefore, the pharmaceutical industry is characterized by the need to incentivize innovation by ensuring strong intellectual property regulation. This can lead to high drugs’prices, especially when combined with high-coverage social insurance systems. In developing countries, where social insurance systems only provide weak coverage, the burden of high drug prices is primarily borne by patients. Patent monopoly and comparatively low social insurance can consequently exacerbate access problems.

High prices

17An obvious barrier of access to pharmaceutical drugs in developing countries is the high prices that patients have to pay, especially when their country’s social security system is weak. A new medicine’s price is high until its patent expires and competition and/or generic products emerge. Yet, many countries cannot benefit from lower priced generics if their market delays their entry or if there is inefficient competition among generic producers.

18Fixing fair prices to medical drugs is a conundrum for national health systems as well as for the pharmaceutical industry. Indeed, the responsibility is often discharged from one to the other: the mere structure of drugs prices is discussed and subject to negotiations. According to figures presented in the International Federation of Pharmaceutical Manufacturers & Associations (IFPMA) 2017 report, once accounting for taxes, pharmaceutical import duties, distribution margins and drug seller charges, the net manufacturer selling price can end up representing less than one third of the final price.

19The stakes are even higher when considering the determination of a fair price across countries with different income levels. Several surveys have been conducted on the ex-manufacturer prices and retail prices of essential drugs. [4] Among them, Scherer and Watal (2002) showed that prices of many life-saving medicines for HIV/AIDS were not significantly lower in developing countries of Africa and Latin America than in the OECD countries in the late 1990s.

R&D for neglected diseases

20One concern in the global drug market is that developing countries and their small markets might present less economic interests for the pharmaceutical industry (Kremer, 2002). Developing countries have different disease environments due to geographic and social factors. More than one billion people in developing countries are facing diseases that are often qualified as « neglected diseases », including dengue, leprosy, mycetoma, or yaws, and that are less economically profitable than treating cancer or neurological conditions (Pécoul et al., 1999), which are affecting wider markets, in both developed and developing countries.

21Moreover, the problem of high fixed R&D costs and low marginal costs of production, which can result in undersupply, is worsened by the characteristics of the market in developing countries: small size of the market due to low purchasing power or low marginal willingness to pay because of credit constraint, large cost of adhering to quality standards, large investments without high expected profit for R&D on tropical disease, and lack of intellectual property protection lowering the potential revenue from product sales (Kremer, 2002).

Quality issues

22Apart from the undersupply issue, when access to medicines is possible, the quality of the product can also be an issue. This is a two-fold problem. On one hand, many developing countries are more likely to lack technical, financial or human resources required to comply with good manufacturing practices, and are more exposed to the competition of illegal markets. The lack of intellectual property rights in some developing countries led to patented-drugs being copied, without guarantee of quality. Piracy or « drug dumping » of counterfeit medicines being easier in informal markets which are often larger in developing countries. The WHO (2017) has introduced three distinctions for drugs representing quality issues: (1) substandard medical products which are authorized medical products that fail to meet either their quality standards or their specifications, or both; (2) unregistered/unlicensed medical products that have not undergone evaluation and/or approval by the National Medicines Regulatory Authority (NMRA) for the market in which they are marketed, distributed or used, and that are subject to permitted conditions under national or regional regulation and legislation ; (3) falsified medical products that deliberately/fraudulently misrepresent their identity, composition or source. WHO estimates that 10,5 % of medical products in lowand middle-income countries are either substandard or falsified (2017).Therefore, if patents and resulting high prices constitute a barrier to access in developing countries, this is not the only one, and the problem of supply and quality are also to be kept in mind.

Rationales and limitations of differential pricing

26Differential pricing has been broadly discussed as a preferred option given the structure of the market, which allows pharmaceutical manufacturers to implement price discrimination across markets. Price discrimination refers to a profit-maximizing producer selling the same product to different consumers at different prices depending on their willingness and ability to pay. It implies that the producer (1) has enough market power to control prices, (2) can identify consumers’ willingness-to-pay and (3) can prevent resale from low-priced markets to high-priced markets. In this context, an intuitive option that solves the accessibility issue is to set a higher price in low demand-elasticity markets. Yet, in practice, demand-elasticity is hard to accurately estimate. Third-degree price discrimination therefore consists in setting different prices depending on consumers’ observable wealth. It follows that a positive correlation should then be observed between drug prices and countries’ income. [5]

27This regulation system appears to be a win-win strategy: producers maximize their profits by adapting their prices to consumers’ willingness-to-pay and consumers can afford products that were out of their reach and so, increase their welfare. The theoretical case for differential pricing has been recently growing as a result of economic and demographic growth in some lowor middle-income countries, which increases the potential market size of these countries (Yadav, 2010). Other aspects that played a role in such evolution include the higher recognition of manufacturers’ social responsibilities in ensuring universal access to medicines and increasing competition from generic manufacturers in emerging markets (Yadav, 2010).

28However, beyond its theoretical appeal, differential pricing remains a limited strategy to improve access to medicines. Indeed, in his literature review, Yadav (2010) gives an assessment of the implementation of differential pricing and stresses that differential pricing has been mainly restricted to vaccines, contraceptives, and antiretroviral drugs. Moreover, he underlines the lack of significant correlation between the price of medicines and a country’s income. Recent empirical studies (Scherer and Watal, 2002; Maskus and Ganslandt, 2002; Hellerstein et al., 2004; Lai and Yadav, 2007; Waning et al., 2009) even find evidence for an inverse correlation, i.e. poor countries paying higher prices. Possible explanations for low implementation levels relate to the poor knowledge of demand and supply structures and to the risk of eroding margins in higher income markets due to external referencing. External referencing refers to the use of the price of a pharmaceutical product in several countries to derive a benchmark or reference price for the purpose of setting or negotiating the price of the product in a given country (WHO, 2013). Eventually, as highlighted by Yadav (2010), for affordability levels lower than the marginal cost of manufacturing, differential pricing is not enough to ensure access, and donors’ subsidies or government support are still required.

Parallel trade: A limit to differential pricing implementation

29Apart from limited implementation, another efficiency drawback of differential pricing is linked to its difficulty to prevent parallel trade in the context of trading economies. Maskus (2001) defined parallel trade as parallel imports of goods produced genuinely under intellectual property right (IPR) protection, placed into circulation in one market, and then imported into a second market without the authorization of the IPR owner. The only difference between exported goods and original products is that their packaging may differ and exported goods may not carry the manufacturer’s warranty. Parallel trade is a common practice in the European pharmaceutical market resulting from the free movement of goods ensured by the 1957 Treaty of Rome. In 2008, the shortages of epileptic drugs in Greece due to massive importation into the United Kingdom is a case in point of how parallel trade can undermine differential pricing and be problematic along several aspects (Morgan, 2008). However, parallel trade is also authorized under certain conditions in several developed countries such as Japan or Australia and in developing countries such as Thailand, Argentina and South Africa. [6]

30First, one needs to understand why parallel trade undermines differential pricing. The short-term process is quite straightforward: when a drug is massively bought in country A where it is cheaper in order to be exported to country B, this can result either in shortages or in an increase in price in country A. However, in country B, the price will go down as the parallel trader is selling it at a lower price. Eventually, prices should converge across countries. Second, in the medium term, the seller can anticipate that there will be parallel trade and tries to avoid competition on his market shares induced by parallel trading. Therefore, he will set similar prices across countries in order to prevent parallel trade, which should strengthen this price convergence and further undermine differential pricing.

31An abundant empirical and theoretical literature studies the impact of parallel trade on price convergence, drug supply and welfare. Many authors empirically and theoretically confirm the price convergence resulting from parallel trade (Ganslandt and Maskus, 2004 for empirical and theoretical evidence; Jelovac and Bordoy, 2005 for theoretical evidence). Another approach highlights the negative impact of parallel trade on drugs supply, as Danzon and Epstein (2012). Finally, a third approach tries to estimate the impact on welfare and finds mitigated results. Jelovac and Bordoy (2005) use a model of industrial organization in which countries differ either in their health needs or in their schemes of health insurance reimbursement. They conclude that parallel trade will have a positive impact on total welfare if countries only differ in their health needs, but a negative impact if they only differ in their copayment schemes [7] or in both dimensions.

Rationales and limitations of price regulation

32According to the OECD definition (2002), price regulation refers to the policy of setting prices (minimum and/or maximum) by a government agency, legal statute or regulatory authority. For example, price control can consist in internal benchmarking (comparing drugs from the same drug class) or external benchmarking (comparing with prices from other countries). Rémuzat et al.(2014) underline that external reference pricing (ERP) is applied in all of the 28 countries of the European Union except the United Kingdom and Sweden. Likewise, Canada uses the median price in a reference group of seven countries to determine the price of a new drug (Patented Medicine Prices Review Board, 2017).Yet, comparing drug prices between countries is difficult because products are not identical. It is necessary to take into account their origins, whether they are generic or over-the-counter products, and whether they are retail prices or manufacturer prices that might be subsidized. For this reason, Danzon and Furukawa (2003) built a composite price index measuring price per dose by molecule indication, which enables one to overcome the fact that products are different in presentation, strength, and pack size.

33Recent empirical studies find evidence of a negative impact of price regulation on investments in R&D, on the probability of launching a new product and on launch delays. Very strikingly, Golec and Vernon (2006) estimate the costs of price regulation in the European Union between 1985 and 2004 to USD 5 billion in foregone R&D spending, 1,680 fewer research jobs, and 46 foregone new medicines. Furthermore, price regulation has been shown to entail lower supply of pharmaceuticals, for both developed and developing countries. Kyle (2007) empirically highlights the lower probability of launching a new product in countries with price controls but also in other markets (spillovers effects), which results from three channels: (1) companies delay launch into price-controlled countries, (2) companies are less likely to introduce their products in additional markets after entering a country with price control, and (3) drugs that were invented by firms headquartered in countries with price control reach fewer markets than drugs that were invented by firms without price control. Danzon and Epstein (2012) complement the analysis of Kyle (2007) by identifying three mechanisms resulting in higher launch delay: (1) lower expected profits for the manufacturers, (2) strategic delays in order to influence the final price, (3) bureaucratic delays resulting from regulatory processes. Finally, external reference pricing can have negative spillovers effects (and resulting welfare losses) on launch delays in other countries in the case of lower price reference countries (Danzon and Epstein, 2012).

Theoretical impact of patent protection on availability and prices of drugs

35The theoretical effects of patent protection are threefold. First, patent protection is expected to have an impact on the level of R&D. Indeed, the prospect of high profits, given the monopoly power maintained while the patent owner exclusively sells the drug, incentivizes companies to invest in R&D. Second, patent protection is expected to have an impact on the probability and delays of launch of new products in a given market. This is also due to the higher incentive to launch new products under the prospect of monopoly power and higher expected profits. Third, patent protection is expected to have an impact on prices. Indeed, a patent creates a monopoly as no substitute for the patented drug can be sold at a lower price. Therefore, the producer can set a price that is higher than the marginal cost and generate higher profits because other firms cannot compete. This results in a wealth transfer from consumers to the monopolist and consequently in a welfare loss for the consumers.

36Accordingly, the main theoretical issue is that in a static approach, weakening intellectual property should increase access to drugs in developing countries thanks to access to cheaper generics. However, in a dynamic approach, this could be detrimental to both developing and developed countries, as it reduces incentives to invest in R&D and eventually results in the lower overall supply of drugs.

Empirical evaluation of the impact of patent protection on availability and prices of drugs

37Empirical evidence generally finds positive impact of patenting on R&D. Arora et al. (2008) analyze the effect of patenting by modeling the link between R&D effort and the decision to patent, accounting for the fact that strong patent regulation is at the same time beneficial for the firm due to higher profits under monopoly power, and detrimental because the firm cannot use the knowledge produced by the R&D of other firms. Calibrating the model with U.S. survey data, they still find that patents stimulate R&D across all manufacturing industries, including the pharmaceutical one. Kyle and McGahan (2011) also study the impact of patenting in the context of the 1994 Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS). They find that in general, R&D effort is positively associated with the protection of intellectual property. Evenson and Kanwar (2001) find similar results and conclude that intellectual property rights unambiguously constitute incentives for spurring innovation. Moreover, as Grabowski (2002) underlines, this question has also been extensively addressed from a management point of view, as in Mansfield (1986), by using declarative data from firms. Such surveys highlight the significance of patent protection for the development of innovations in the pharmaceutical industry.

38The agreement on trade-related aspects of intellectual property right (TRIPS) is a legal agreement signed by all WTO members in 1994. It aims at harmonizing and, more specifically, guaranteeing some minimum standards in terms of intellectual property rights at the international level. This agreement not only focuses on pharmaceutical drugs, but relates to any form of intellectual property regulation: patents, copyrights, trademark etc. However, its more controversial aspects deal with the harmonization of the pharmaceutical drugs patent system, which is accused of preventing access to essential medicines in developing countries. Those concerns led, after new rounds of negotiations, to the adoption in 2001 by the WTO of the Doha Declaration which, in substance, states that public health should come before intellectual property rights. More recently, in 2015, TRIPS was again made more flexible when the WTO agreed to give the least developed countries a supplementary delay (2033) to reach TRIPS’s objectives in terms of intellectual property regulation.

39However, empirical evidence is more mixed when considering the impact of patenting launching delays and the probability of launch. By analyzing the timing of launch of 642 new drugs over the 1983-2002 period in 76 countries, Cockburn et al. (2016) show that more extensive patent protection decreases delays of launch in new markets. Yet, by conducting a cross-country analysis on how patent protection affects the probability and speed of drug launches, Lanjouw (2005) finds that, in she short term, for developing countries, higher levels of protection encourage entry of innovative products. This is particularly true for countries where local technical capacity is higher and where multinationals may therefore hesitate to enter the market due to increased potential competition. Nevertheless, this domestic capacity could be an alternative source of entry and in the long term, the author argues that patent protection can have a negative impact on this local capacity. In the end, a developing country offering high patent protection could thereby lose the benefits of entry by the multinationals and have a lower probability for the launch of new products due to the weakening of the domestic capacity.

40Finally, empirical evidence demonstrates the positive impact of patents on prices. In an attempt to simulate the impact of patenting in India under the TRIPS agreement and the move from a competitive to a monopolistic market, Watal (2000) shows that prices are likely to increase and welfare to decrease due to moving to the monopoly structure. However, this work is done in a static approach, which means that Watal does not account for the fact that an increase of patent protection could also result in increased local capacity if it incentivizes domestic firms to invest more in R&D and to develop new products.

41The joint effect of higher prices, higher R&D and either higher or lower launching delays and probability of launch is difficult to estimate. Few studies try to jointly estimate the impact of patent protection on multiple outcomes (R&D, launch probability, prices and welfare). Following the TRIPS agreement, Kyle and Qian (2014) try to estimate the effects of patent protection on prices, launch probability and sold quantity in both developed and developing countries. They find that strengthened patent protection has a positive effect on prices and sold quantities but that this effect is smaller for developing countries than for OECD countries. Patent protection does provide incentives to develop pharmaceutical drugs, yet it also leads to higher prices. However, when focusing on patented drugs, they show that the patent premium is on average lower after than before the TRIPS reform. This evidence minimizes the potential detrimental effect of TRIPS – through higher prices – for developing countries. The authors are also tackling another crucial point: whether TRIPS had an effect on the pharmaceutical drug markets for notable serious and harmful diseases. Their estimation shows that the launch probability of drugs is higher under stronger patent protection, but that the effect declines with the disease burden. This result argues in favor of drugs being patented to answer specific needs, but that TRIPS weakened this relationship between the probability of dispensing a drug and the level of disease burden. This study seems to show that strengthened patent protection, through TRIPS, did not have disastrous effects in terms of drugs accessibility in developing countries. However, one of its notable limitations is not being able to account for the resistance from developing countries, which could be a significant confounding factor. Strengthened price control or an increase in the use of compulsory licenses can offset the true effects of patent protection. On one hand, taking this confounding factor into account, it could be that the positive result regarding access to drugs on patent price premium is not driven by TRIPS, but by an increase in government control over prices after TRIPS. On the other hand, the mitigating effects of TRIPS on the launch probability of drugs targeted at high burden diseases could be due to reduced economic interests for industries following price control or compulsory license use.

42Therefore, even though empirical evidence unambiguously shows that patent protection is beneficial to research and development, empirical evidence is more mixed as to whether patent protection has a positive impact on availability of drugs, especially for developing countries due to ambiguous effect on delays of launch, probability of launch, and to increased prices.