Little risk from collusion – ceiling prices and other mechanisms mitigate

Because patent sales are voluntary, the private value of the patent acts as a floor on the patent buyout price. If the mechanisms for limiting collusion discussed in the previous subsection were thought inadequate, there are several ways that governments could establish ceiling prices, and thus reduce the risk of paying vastly inflated sums for patents. 1. A waiting period of several years could be required before patents were bought by the government, and ceiling prices could be set as a multiple of annual revenues prior to the patent buyout. A waiting period would also make it easier for bidders to assess the value of patents, and would further guarantee that inventors would have incentives for marketing and development. Of course, setting ceiling prices as a multiple of prebuyout revenue would lead firms to artificially boost sales, for example by offering hospitals discounts on other drugs in exchange for purchasing the patented drug, or even by paying outright kickbacks. Tied sales would have to be prohibited. A second ceiling could be established based on the prebuyout price times postbuyout consumption. 2. The amount paid for patents could be capped by total sales of the drug following the patent buyout, times an administrative estimate of the social value of the drug per dose or per patient. International estimates of the cost in disabilityadjusted life years of various diseases are already available. These could be combined with information on drug effectiveness from FDA trials to estimate a ceiling price per dose. Setting these ceilings requires administrative discretion, but the associated rent-seeking may be limited by the fact that setting a ceiling only requires a fairly transparent decision about the social value of the drug per dose. Public interest groups could monitor attempts to set outrageous prices per dose more easily than they can monitor whether the NIH is subsidizing pure science in the guise of developing an AIDS vaccine or whether national laboratories and breeder reactors are being created for pork barrel or scientific reasons. The historical record suggests that the political economy problem in setting patent buyout prices is more that governments have an incentive to expropriate inventors ex post than that inventors wrangle huge sums for unimportant products. 3. It also might be worth considering a mechanism like that in Figure II, with a ceiling price based on the actual profits obtained from the new drug. Inventors who wished to participate would have their patents randomized. The patent would be randomized to the high bidder with some probability p, and placed in the public domain with probability 1 2 p. Inventors would be paid only if the patent was randomized to the high bidder. In this case, they would receive (M/p) min(bid,p), where M is the markup, bid is the estimated value of the patent based on the bids, and p is the realized revenue (or ideally profits) from the drug. The expected payment received by the inventor is thus M min (bid,p).16 Inventors could try to manipulate the ceiling price by bribing the high bidder to boost sales artifically through tie-ins with other products. The government would have to monitor bidders carefully to minimize such tie-ins. While tie-ins will cost the government money, they will not necessarily reduce efficiency, since by increasing sales they may counteract the static distortions created by monopoly pricing. The majority of patents would be put in the public domain so the issue would not arise, and in any case, it is likely to be difficult for firms to greatly increase demand artificially for drugs covering serious sharply defined diseases, such as cystic fibrosis. It is easy to dream up scenarios under which people could evade rules designed to discourage collusion, but it is also important to remember that many institutions which are theoretically vulnerable to collusion operate relatively well. For example, peer-review is highly vulnerable to collusion, yet the National Science Foundation and the National Institutes of Health seem relatively effective. Moreover, limited collusion is not necessarily that harmful. Collusion itself is not a problem; deadweight losses due to collusion are a problem, and there is little reason to think that these deadweight losses would exceed the deadweight losses due to insufficient original research, monopoly-price distortions, and the diversion of effort to ‘‘me too’’ research in the absence of patent buyouts. Even if collusion raises patent prices above their social value, the social value of inventions may be approximated better by the collusive price than by the existing patent system, under which private incentives for developing new inventions are likely to be less than half the social value of the inventions. Finally, if implicit collusion were expected to significantly raise patent prices, then the markup over the private value could be reduced accordingly. For example, if the optimal markup was three (as seems plausible), and if collusion were thought to raise prices by up to 50 percent, then the government could simply offer a markup of two. The auction mechanism described in this paper may be appropriate for many pharmaceuticals, but it would not be appropriate in industries where markets are too thin for auctions, or patents are not an effective means of protecting inventions. In such industries the government could simply offer to buy out patents for an amount equal to postbuyout sales times an administratively determined estimate of the average consumer surplus per unit of the good consumed.