Many economists of innovation are hostile to patents as they currently stand: they do not seem to be important drivers of R&D in most industries, the market power they lead to generates substantial deadweight loss, the legal costs around enforcing patents are incredible, and the effect on downstream innovation can be particularly harmful. The argument for patents seems most clear cut in industries where the invention requires large upfront fixed costs of R&D that are paid only by the first inventor, where the invention is clearly delineated, where novelty is easy to understand, and where alternative means of inducing innovation (such as market power in complementary markets, or a large first mover advantage) do not exist. The canonical example of an industry of this type is pharma.
Duncan Gilchrist points out that the market power a patentholder obtains also affects the rents of partial substitutes which might be invented later. Imagine there is a blockbuster statin on patent. If I invent a related drug, the high price of the existing patented drug means I can charge a fairly high price too. If the blockbuster drug were off patent, though, my competitors would be generics whose low price would limit how much I can charge. In other words, the “effective” patent strength in terms of the markup I can charge depends on whether alternatives to my new drug are on patent or are generic. Therefore, the profits I will earn from my drug will be lower when alternative generics exist, and hence my incentive to pay a fixed cost to create the new drug will also be lower.
What does this mean for welfare? A pure “me-too” imitation drug, which generates very little social value compared to the existing patented drug, will never enter if its class is going to see generics in a few years anyway; profits will be competed down to zero. That same drug might find it worthwhile to pay a fixed cost of invention and earn duopoly profits if the existing on patent alternative had many years of patent protection remaining. On the other hand, a drug so much better than existing drugs that even at the pure monopoly price most consumers would prefer it to the existing alternative priced at marginal cost will be developed no matter what, since it faces no de facto restriction on its markup from whether the alternatives in its drug class are generics or otherwise. Therefore, longer patent protection from existing drugs increases entry of drugs in the same class, but mainly those that are only a bit better than existing drugs. This may be better or worse for welfare: there is a wasteful costs of entering with a drug only slightly better than what exists (the private return includes the business stealing, while social welfare doesn’t), but there are also lower prices and perhaps some benefit from variety.
I should note a caveat that really should have been noted in the existing model: changes in de facto patent length for the first drug in class also affect the entry decision of that drug. Longer patent protection may actually cause shorter effective monopoly by inducing entry of imitators! This paper is mainly empirical, so no need for a full Aghion Howitt ’92 model of creative destruction, but it is at least worth noting that the welfare implications of changes in patent protection are somewhat misstated because of this omission.
Empirically, Gilchrist shows clearly that the beginning of new clinical trials for drugs falls rapidly as the first drug in their class has less time remaining on patent: fear of competition with generic partial substitutes dulls the incentive to innovate. The results are clear in straightforward scatterplots, but there is also an IV, to help confirm the causal interpretation, using the gap between the first potentially-defensive patent on the fulcrum patent of the eventual drug, and the beginning of clinical trials, a gap that is driven by randomness in things like unexpected delays in in-house laboratory progress. Using the fact that particularly promising drugs get priority FDA review, Gilchrist also shows that these priority review entrants do not seem to be worried at all about competition from generic substitutes: the “me-too” type of drugs are the ones for whom alternatives going off patent is most damaging to profits.
Final published version in AEJ: Applied 8(4) (No RePEc IDEAS version). Gilchrist is a rare example of a well published young economist working in the private sector; he has a JPE on social learning and a Management Science on behavioral labor in addition to the present paper, but works at robo-investor Wealthfront. In my now six year dataset of the economics job market (which I should discuss again at some point), roughly 2% of “job market stars” wind up outside academia. Budish, Roin and Williams used the similar idea of investigating the effect of patents of innovation by taking advantage of the differing effective patent length drugs for various maladies get as a result of differences in the length of clinical trials following the patent grant. Empirical work on the effect of patent rules is, of course, very difficult since de jure patent strength is very similar in essentially every developed country and every industry; taking advantage of differences in de facto strength is surely a trick that will be applied more broadly.