Search the archive.

The AIDS crisis has brought to public notice what has always been generally true—that the existing business model for drug development leads to high prices and unequal access. There is now widespread dissatisfaction with drug prices in both the developed (Families USA 2003) and developing world (Correa 2000). Governments and health insurers are finding ways to deny access to the newest and priciest products. In the United States and other countries without a universal public health system, the uninsured simply cannot afford the newest medicines. In developing countries, life-saving medicines are priced beyond the reach of most people, a morally offensive outcome (TrueVisionTV 2003). Huge publicity surrounds negotiated price reductions for specific drugs in specific developing countries, yet the effect on the overall access problem is tiny.

Today's high drug prices are a direct consequence of a business model that uses a single payment to cover both the cost of manufacture of a drug and the cost of the research and development (R&D) carried out by manufacturers to discover it. A 20-year patent-based marketing monopoly is then granted to the drug's developers to prevent their prices being undercut by ‘generic’ copies produced by manufacturers who do not have R&D costs to recover. Preventing such ‘free riding’ on R&D has become a global trade issue at the World Trade Organisation (WTO) (Drahos and Braithwaite 2002). The implementation of the TRIPS (Trade-Related Aspects of Intellectual Property Rights) agreement and a growing number of regional and bilateral agreements on intellectual property require most countries to implement tough patent systems that discourage or eliminate competition from manufacturers of generic medicines (Box 1).

Innovation can be a driving force for improving public welfare. Nowhere is this more stark than in the creation of drugs to treat fatal diseases. If you have the drug you live; without it you die. Whether you have the drug depends on two issues: has it been developed, and if so, do you have access to it? The conflict between these issues revolves around how to stimulate innovation and how to pay for it. It is exemplified by the issue of access to Aids drugs and is one of the most contentious issues of international economic policy and law.

Drugs are cheap to manufacture, but expensive to develop. Much of the underlying research comes out of academic institutions funded by government grants. Much of the development work is by pharmaceutical companies, which will not invest in research and development without incentives: in this case the patent system, which rewards a company that develops a successful drug with a 20-year marketing monopoly.

On May 5 the Biden administration announced that it would support waiving intellectual property protections for COVID-19 vaccines under the World Trade Organization’s Agreement on Trade-Related Intellectual Property Rights (TRIPS). Predictably, the move drew fiery condemnation from drug companies. In addition, many disinterested observers criticized the support for a TRIPS waiver as empty symbolism, arguing that vaccine patents are not the major obstacle hindering the currently flagging drive to make vaccines available around the world.

Waiving patent protections is certainly no panacea. What is needed most urgently is a massive drive of technology transfer, capacity expansion, and supply line coordination to bring vaccine supply in line with global demand. Dispensing with patents in no way obviates the need for governments to fund and oversee this effort.

Earlier this week, Ezra Klein published a column at the Times pegged to the very intriguing announcement from the Biden administration about a new government agency called Advanced Research Projects Agency-Health or ARPA-H, modeled after the legendary DARPA that helped bring the age of networked digital computers into being. The launch of ARPA-H alone was an interesting development, and certainly one worth tracking over the coming years. But it was another, almost parenthetical, reference in Klein’s piece that caught my eye. In talking about potential approaches that the government could take to support risk-taking and innovation, he mentioned an initiative that I have long been fascinated by:

Bernie Sanders used to promote an idea for creating a system of prizes to run parallel to the patents we normally use to make drug development profitable. The government could identify, say, 12 conditions that it wants to see a drug developed for. The first group to develop and prove out such a drug would get a princely sum — $100 million, or $500 million, or a billion dollars, depending on the condition and the efficacy. In return, that drug would be immediately off-patent, available for any generic drug producer to manufacture for a pittance (and available for other countries, particularly poor countries, to produce immediately).

THE ENTIRE U.S. patent system needs serious repair, but the most broken thing about it is the way we patent prescription drugs. Federal and state governments spend billions of dollars on basic medical research, and the resulting science winds up informing (at least indirectly) the development of blockbuster pharmaceuticals. But our patent system then grants drug companies the exclusive right to sell their innovations without "generic" competition for years. Big Pharma points out that such patents are necessary because without them it can't recoup the massive costs of creating new products. Meanwhile, there are some classes of drugs that the world desperately needs—new lines of antibiotics, for example, or treatments for tropical, emerging, and rare diseases—but that the current system, dependent on blockbusters, doesn't readily produce. The incentives are out of whack.

There's another solution to this problem—a way to directly fund the drugs we're not getting and avoid the high cost of artificial monopolies. Let's take a page from some of our deep-pocketed philanthropists, who have used competitions to rejuvenate space technology (the X Prizes), mathematics (the Millennium Prize), and more. Instead of granting patents, the government should offer lump-sum payouts.

Currently, we rely almost entirely on the patent system to stimulate and channel drug research.108 What adjustments should we make in the patent system if a prize system were introduced?

There are three possible answers to this question. This first is: none. Neither the content nor the coverage of the patent system should be altered at all. The prize system would thus be cumulative, offering drug developers rewards in addition to those they could receive by patenting their creations.

Race to Be First. The optimal magnitude of the reward would be affected in practice by a consideration that we did not study in our model: the race among potential innovators to be the first to innovate. As is emphasized in the literature on patent, this race leads to the possibility of overinvestment in research because the private return to being first may exceed its social value. 39 Likewise, under a reward system, there would be a race to be first, and it might lead to excessive investment in research, lowering the optimal [*543] reward. Because the race to be first is a factor that afflicts both systems, and because the information needed to address it under either seems to be of the same character, consideration of the race to be first does not seem to bear on the comparison between reward and patent. 40

As we stressed in the analysis, the government’s knowledge about the social value of innovations, embodied in its probability distribution over demand curves, is important to the performance of the reward system and to that of the optional reward system (even though the latter dominates patent no matter how poor the government’s knowledge). In fact, one supposes that the government could obtain significant information about demand. Most obviously, the government can base its rewards on sales data, which should be relatively easy to obtain; thus, the version of rewards discussed in Section IIH is the most relevant one to consider. (Note that if rewards are based on sales, the government should not fear that it would be flooded by claimants for rewards with inferior or meaningless innovations—they would not generate products that would pass the market test.) The government could also attempt to measure more about the demand curve than sales at the market price; it could estimate demand elasticities and undertake surveys to determine the character and frequency of use of, for example, computer software musical recordings, and cinematic and television productions. As events unfold and information flows to the government, it could appropriately supplement rewards, perhaps on an annual basis. In past proposals for reward systems, payments based on sales and other information that the government receives have sometimes been discussed.37 It would be a gross mistake to envision the reward as having to be premised on the government’s estimate of valuation at the time an innovation is registered.

Subsequent Innovations. We did not discuss the issue of subsequent innovations, that is, improvements to innovations or new innovations depending on past ones. In this regard, two points are of interest. First, under the intellectual property rights system, subsequent innovations may be stymied by the refusal of holders of property rights to allow improvements; there may be breakdowns in bargaining between the holders and innovators due to asymmetry of information. 41 A famous example of this occurred when James Watt, holder of an early steam engine patent, denied licenses to improve it to Jonathan Hornblower and Richard Trevithick, who had to wait for Watt's patent to expire in 1800 before they could develop their high-pressure engine. 42 Under a reward system, this would not have been the case, for Watt's steam engine would have been in the public domain, and Hornblower and Trevithick would have been free to improve it immediately. (Indeed, as noted in Section I, this was one of the arguments in favor of the reward system emphasized in the nineteenth-century debates.) 43 The second point of note is that the government's problem of determining rewards is made more difficult when the value of an innovation is in part that it leads to subsequent innovations. However, the government's problem in administering the patent system is also made more difficult by the possibility of subsequent innovations (notably, in determining issues of patent scope--which subsequent innovations will be considered infringing) and for closely related informational reasons. Hence, it is not clear the extent to which, or whether, the added informational difficulty presented by subsequent innovations favors patent over reward.

Alternatively, we can side‐​step these difficulties by moving to a prize system to reward pharmaceutical innovation. The competition spurred by a prize regime would also make it much harder for drug companies to set inflated prices. Under a prize regime, drug companies could only charge the marginal cost of production and payers could even run an auction to determine which manufacturer would have the right to supply any given drug to their beneficiaries.

Substituting prizes for patents would also make it possible to rationalize the financial incentives for developing new drugs. Currently, expected prices and sales volumes determine the strength of these incentives. This arrangement encourages pharmaceutical companies to create new cancer treatments that retail for hundreds of thousands or even millions of dollars despite extending patients’ lives only briefly. By contrast, it gives the drug makers little reason to develop new antibiotics with the potential to save lives because doctors will use the new antibiotics only when all previously existing medications fail. By linking financial rewards to delivered benefits, prizes will focus researchers on drugs that are needed.

Administrative Costs. Under a reward system, administrative costs would be incurred by the government in deciding upon rewards, and these costs [*544] presumably would exceed those associated with deciding on the granting of patents. There would also be litigation costs borne in relation to disputes about rewards between innovators and the government, as well as between different innovators. However, under a reward system, there would be a savings in administrative costs relative to under the patent or copyright systems: under these systems, intellectual property rights have to be protected by the state, parties often make efforts to determine if their rights have been violated and also to ascertain if they are violating someone's else's rights, and litigation costs are expended in disputes over rights; but under the reward system, there are no intellectual property rights to generate such costs. On a priori grounds, one cannot say whether these administrative cost savings of the reward system would outweigh the added administrative costs that the reward system would entail. 44

The analysis of the model may be summarized as follows. Under the patent system, the innovator's incentive to invest in research is the monopoly profits he would earn; if he produces the innovation, he then sells the innovation at the monopoly price. There are two familiar deviations from first-best behavior under the patent system. First, incentives to invest in research are inadequate because monopoly profits are less than the social surplus created by an innovation. 19 Second, if an innovation results, there is a deadweight loss in social welfare because too little is sold at the monopoly price.

Under the reward system, the innovator's incentive to invest in research is the reward he would receive. If the innovator produces an innovation, it will be available to competitors and so will sell at marginal cost (perfect competition in the product market is assumed). Because there is thus no deadweight loss from monopoly pricing, the only type of deviation from first-best behavior under the reward system involves the incentive to invest [*530] in research. This deviation could be in either direction. If the social surplus from the demand curve exceeds the reward, there will be an inadequate incentive to invest, and if the surplus from the demand curve is less than the reward, there will be an excessive incentive to invest. Either possibility may occur, as the optimal reward equals the expected surplus over the distribution of possible demand curves.

We did not discuss the issue of subsequent innovations, that is, improvements to innovations or new innovations depending on past ones. In this regard, two points are of interest. First, under the intellectual property rights system, subsequent innovations may be stymied by the refusal of holders of property rights to allow improvements; there may be breakdowns in bargaining between the holders and innovators due to asymmetry of information.41 A famous example of this occurred when James Watt, holder of an early steam engine patent, denied licenses to improve it to Jonathan Hornblower and Richard Trevithick, who had to wait for Watt’s patent to expire in 1800 before they could develop their high-pressure engine.42 Under a reward system, this would not have been the case, for Watt’s steam engine would have been in the public domain, and Hornblower and Trevithick would have been free to improve it immediately. (Indeed, as noted in Section I, this was one of the arguments in favor of the reward system emphasized in the nineteenth-century debates.)43 The second point of note is that the government’s problem of determining rewards is made more difficult when the value of an innovation is in part that it leads to subsequent innovations. However, the government’s problem in administering the patent system is also made more difficult by the possibility of subsequent innovations (notably, in determining issues of patent scope—which subsequent innovations will be considered infringing) and for closely related informational reasons. Hence, it is not clear the extent to which, or whether, the added informational difficulty presented by subsequent innovations favors patent over reward.

The most serious problem for government contracts is likewise the most serious problem for prizes: The government must determine what to pay for and how much to pay.57 Too small a reward relative to social value will lead to too little invention; too large a reward, in turn, will lead to wasted inventive effort. On the other hand, patents only clearly have benefits over the other two systems if innovators have important information about the value of the desired invention or creation.58 This advantage may be substantial if we assume that governments often will be less likely than private investors to know of the existence of possible creations or inventions, much less of their value.

Recent work on prize design, however, shows that the informational advantage of patents may be less substantial than once thought. The key insight is that the size of a prize need not be established ex ante. It can also be determined ex post—when there is better and more widely distributed information about value. For example, Michael Kremer has suggested an ex post patent buyout mechanism that uses an auction to elicit private information about the value of the invention.59 Steven Shavell and Tanguy Van Ypersele subsequently brought attention to the possibility that prize amounts could be set on the basis of market sales.60 The latter model has been the subject of important recent proposals for innovative incentive mechanisms, most prominently in the areas of pharmaceutical research and music. These incentive mechanisms would reward creators according to a measure of the uptake of their creations, and at the same time, would address deadweight loss by suspending price in lieu of a prize.61 While these models would require funding, presumably through taxation (which also generates deadweight loss), price is equivalent to a tax on a single market, “which is generally thought to impose greater deadweight loss than the broad-based taxation that generates general revenue.”

What lead the US Patent Office to interpret, essentially, the words “not obvious” as meaning “obvious”? The Patent Office is constantly under pressure from applicants and their lawyers to be more generous in issuing patents—that is, to adopt lower standards of obviousness and steeper standards for what is considered “prior art.” The following statement by David Kappos (2010), director of the US Patent Office concerning the allowance rate—what fraction of patents are accepted—is revealing: “Overall in FY 2010, the allowance rate increased to 45.6%, compared to an allowance rate of 41.3% in FY 2009 . . . So, while we still have a lot of work to do, I think we are on the right path.” Apparently, accepting a higher fraction of patents applications is defined as “the right path.” Talk about “regulatory capture”!

Patent lawyers play a large role in the political economy of patents. According to Quinn (2011), who is a patent attorney, legal fees for filing a patent run upwards of $7,000 and roughly half are rejected. In 2010, according to the US Patent Office, 244,341 patents were issued, which would imply roughly $3 billion in legal fees per year. Obviously, patent attorneys as a group have a tremendous incentive to see that more patents are issued. This insight helps us understand better the role of the courts and their relatively recent reform. In 1982—lobbied by patent lawyers— Congress passed the Federal Courts Improvement Act, which moved federal patent appeals out of the regular court system to a special court system for dealing with patents. Naturally, many of the judges for this new court were chosen from the ranks of patent attorneys. For example, when a court voted, in a 1994 decision, to expand the scope of patents to software (In re Kuriappan P. Alappat, Edward E. Averill and James G. Larsen 33 F.3d 1526 [ July 29, 1994]), of the six judges who voted in favor, half had previously been patent attorneys, while of the two that voted against, neither had been. The referee of the patent game is biased both materially and ideologically. As Landes and Posner (2004, p. 26) write in their discussion of the political economy of patents: “That has been the experience with the Federal Circuit; it has defined its mission as promoting technological progress by enlarging patent rights.”

The main drawback with such models is likely the expense of administration, which increases with prize complexity.63 But IP, prizes, and government contracts all have costs of implementation, so the matter is really one of comparative cost. Commentators have also emphasized the potential problem of capture when innovation is induced through prizes and contracts.64 But insofar as IP systems generate rents, they also attract rent seeking—as they clearly have in recent years.65 Commentators have additionally worried that prizes carry a risk that the government may renege on its promise to pay after costs have been sunk.66 This problem is minimized with contracts because contracts pay up front. But IP mechanisms may have their own problems of uncertainty because, for example, the value of investments may be subject to stochastic, black-swan events.67 IP systems, like prize systems, are also subject to ex post changes that can diminish the benefits that were expected ex ante, such as compulsory licensing schemes or even simple shifts to doctrinal rules about the scope of protection or remedies.

Another pull incentive that can be used to stimulate innovation is giving cash rewards for the achievement of specified objectives. Prizes can be designed in many ways – they are most commonly set up as “end prizes” once the final target product is developed or “milestone prizes”, in which interim results are rewarded. Prizes are results-based: they are only paid if the objectives set by the prize sponsor are met, thereby rewarding only successful innovations. A 2011 assessment of prizes for development of health technologies concluded that milestone prizes were better at attracting different actors to the early stages of development – especially smaller companies or non-industry actors (148). It also noted, however, that it was important to include mechanisms to ensure that candidates are taken all the way to market.

As a pull incentive, prizes require organizations to make investments up front. Milestone prizes reduce the amount of investment necessary before any payment can be received, as opposed to end prizes, in which the investment has to be made all the way through the end of development to obtain a reward. Wilson & Palriwala (148) also suggested that the prize design should take accessibility into account, including conditions such as the licensing of IP to all interested manufacturers or including requirements about the final price of the product. Prizes are a way of delinking R&D investments from prices, as the investments are recouped through the prize and not through sales of the end-product (149).

Government's Ability to Obtain Information about the Value of Innovations. As we stressed in the analysis, the government's knowledge about the social value of innovations, embodied in its probability distribution over demand curves, is important to the performance of the reward system and to that of the optional reward system (even though the latter dominates patent no matter how poor the government's knowledge). In fact, one supposes that the government could obtain significant information about demand. Most obviously, the government can base its rewards on sales data, which should be relatively easy to obtain; thus, the version of rewards discussed in Section IIH is the most relevant one to consider. (Note that if rewards are based on sales, the government should not fear that it would be flooded by claimants for rewards with inferior or meaningless innovations--they would not generate products that would pass the market test.) The government could also attempt to measure more about the demand curve than sales at the market price; it could estimate demand elasticities and undertake surveys to determine the character and frequency of use of, for example, computer software, [*542] musical recordings, and cinematic and television productions. As events unfold and information flows to the government, it could appropriately supplement rewards, perhaps on an annual basis. In past proposals for reward systems, payments based on sales and other information that the government receives have sometimes been discussed. 37 It would be a gross mistake to envision the reward as having to be premised on the government's estimate of valuation at the time an innovation is registered.

Government's Information versus Innovators'. We have just mentioned the ability of the government to obtain information about demand, but we have not considered how good innovators' information is and its relation to the government's. In this regard, two comments should be made, which together suggest that the factor of innovators' superiority of information may be less important than it initially appears to be. First, innovators' information will often be substantially imperfect ex ante, at the time when they are deciding on research investment--the crucial period for assessment of innovators' information. Second, the government's information will often be reasonably good ex post, which is the pertinent period for assessment of government information when rewards are based on sales and other indicia of worth. Thus, when rewards are based on ex post data, the informational comparison that bears on the choice between rewards and intellectual property rights is that between innovators' ex ante information and the government's ex post information. (That innovators' ex ante information may be superior to the government's ex ante information would be irrelevant to the choice between rewards and property rights.) This point can be put more sharply. Suppose, as is not implausible, that the government's ex post, sales-related information about demand is as good as innovators' ex ante information, when they are deciding on research investment. Then innovators enjoy no informational advantage that favors intellectual property rights, and mandatory rewards (not just optional rewards) are unambiguously superior to intellectual property rights. 38

The case against patents can be summarized briefly: there is no empirical evidence that they serve to increase innovation and productivity, unless productivity is identified with the number of patents awarded—which, as evidence shows, has no correlation with measured productivity. This disconnect is at the root of what is called the “patent puzzle”: in spite of the enormous increase in the number of patents and in the strength of their legal protection, the US economy has seen neither a dramatic acceleration in the rate of technological progress nor a major increase in the levels of research and development expenditure.

Both theory and evidence suggest that while patents can have a partial equilibrium effect of improving incentives to invent, the general equilibrium effect on innovation can be negative. The historical and international evidence suggests that while weak patent systems may mildly increase innovation with limited side effects, strong patent systems retard innovation with many negative side effects. More generally, the initial eruption of innovations leading to the creation of a new industry—from chemicals to cars, from radio and television to personal computers and investment banking—is seldom, if ever, born out of patent protection and is instead the fruit of a competitive environment. It is only after the initial stage of rampant growth ends that mature industries turn toward the legal protection of patents, usually because their internal growth potential diminishes, and they become more concentrated. These observations, supported by a steadily increasing body of evidence, are consistent with theories of innovation emphasizing competition and first-mover advantage as the main drivers of innovation, and they directly contradict “Schumpeterian” theories postulating that government-granted monopolies are crucial to provide incentives for innovation. A properly designed patent system might serve to increase innovation at a certain time and place — and some patent systems, such as the late-nineteenth century German system allowing only process but not final product patents, have been associated with rapid innovation. Unfortunately, the political economy of government-operated patent systems indicates that such systems are susceptible to pressures that cause the ill effects of patents to grow over time. The political economy pressures tend to benefit those who own patents and are in a good position to lobby for stronger patent protection, but disadvantage current and future innovators as well as ultimate consumers. This explains why the political demand for stronger patent protection comes from old and stagnant industries and firms, not from new and innovative ones. Our preferred policy solution is to abolish patents entirely and to find other legislative instruments, less open to lobbying and rent seeking, to foster innovation when there is clear evidence that laissez-faire undersupplies it. However, if that policy change seems too large to swallow, we discuss in the conclusion a set of partial reforms that could be implemented as part of an incremental strategy of reducing the harm done by the patent system.

Over the last year, there has been a renewed focus on improving American competitiveness in key fields of science and technology. Numerous bills and executive initiatives have been implemented or proposed to dramatically increase investment into science and technology. Recent examples, including the Endless Frontiers and the Clean Futures Act, use a wide variety of policy tools to advance research and development (R&D) along multiple axis. Here we consider the free market portion of these tools, in which the private sector plays a key role in determining topic and direction, while the public sector supports these activities through high-level directives, conditional contracts, and other mechanisms. While other approaches such as public purpose consortia and R&D tax credits have been considered elsewhere, here we focus on Advance Market Commitments.

Advance Market Commitments (AMCs)are a powerful policy tools that can be used to ensure that America can retains leadership in technology fields such as climate change, computing, and medicine. In an AMC, a U.S. agency commits to buying some specified new technology before that technology exists. This provides a price, specification, and framework for evaluation that can streamline decision making and funding approaches in the private sector and accelerate progress towards well defined technical outcomes without being directed about the underlying solution and steps along the path. As such, AMCs represent a powerful option for ground-up technological building where private investment replaces the role of more traditional, blue sky government funding, and the larger market for the resulting product is jump-started by an initial government market.