Forum on Economic Reform In recent decades the alliance of neoclassical economics and neoliberalism has hijacked the term �economic reform�.� By presenting political choices as market necessities, they have subverted public debate about what economic policy changes are possible and are or are not desirable.� This venue promotes discussion of economic reform that is not limited to the one ideological point of view. The Reform of Intellectual Property Dean Baker�� (Center for Economic and Policy Research, USA)

Introduction It is remarkable that economists, who usually view themselves as advocates of free market transactions, unquestioningly embrace various forms of intellectual property rights, especially copyrights and patents. Copyrights and patents are government granted monopolies. They have their origins in the feudal guild system, not the free market economics of Smith and Ricardo. In fact, at the end of the 19th century, Switzerland and the Netherlands actually eliminated patent and copyright protection, with the intent of promoting free market competition. In spite of their feudal legacy, and their obvious status as forms of protectionism, few economists ever question the merits of the patent and copyright systems. This paper details the ways in which patents in prescription drugs and medical equipment and copyrights lead to economic inefficiencies.1 It points out that the efficiency losses from these forms of protectionism are likely several orders of magnitude larger than the barriers to international trade that receive so much attention from economists. The paper also outlines alternative systems for providing incentives for innovation and creative artistic work. In the absence of deliberate government policy, there probably would be under-investment in innovation and creative work, but that is not the relevant question. The relevant question is whether the existing patent and copyright systems are the most efficient mechanisms for supporting innovation and creative work. That would be the question that any honest economist would pose. The Inefficiency of Drug Patents and Copyrights The basic argument for patents and copyrights is straightforward. In a free market, without protections for intellectual property, there will be under-investment in research and creative activity like writing or recorded music or movies. As soon as an innovation is made public, others could duplicate the process and sell a comparable product, without having to bear the costs of the research that allowed for the innovation. In the case of recorded music or movies, copies can be made at minimal cost (zero cost in the Internet Age), which means that in a free market, the original producers could not sell the products at a high enough price to allow the creative workers to be compensated for their work. However, the fact that a free market will under-invest in research and creative work hardly establishes that the feudal institutions of patents and copyrights are the most efficient way to support such work in the 21st century. The economics profession has devoted vast amount of research and textbook space to proving the inefficiency of various forms of protectionism. The basic story in this work is that protectionism causes the price to exceed the marginal cost of production. All of this work is entirely applicable to patents and copyrights, except the impact is at least an order of magnitude larger than with most instances of protectionism in international trade. While tariffs and quotas rarely raise the price of goods by more than 30 or 40 percent, patents on prescription drugs typically raise the price of protected products by 300 to 400 percent, or more, above the marginal cost. In some cases, patent protected drugs sell for hundreds or thousands of times as much as the competitive market price. In the case of copyrighted material, recorded music and video material that could be transferred at zero cost over the Internet, instead command a substantial price when sold as CDs, DVDs, or licensed downloads. Copyrighted software commands even higher prices. The distortions resulting from these huge gaps between price and marginal cost should cause an honest neo-classical economist great pain. At the onset, the lost consumer surplus from patent and copyright protected pricing is enormous. The basic rule on this issue is that the size of the deadweight loss is proportional to the square of the gap between price and marginal cost. The United States alone is projected to spend $210 billion this year on prescription drugs. In the absence of patent protection, the same drugs would probably cost no more than $50 billion. (The savings would be equal to $500 per person for everyone in the country.) The United States will spend more than $30 billion on recorded music and videos this year, material that could be available at zero cost on the Internet. By comparison, many economists felt the need to comment on the NAFTA agreement in 1993 that reduced tariff barriers on imports from Mexico. At the time, U.S. imports from Mexico were less than $40 billion a year, and the average tariff was already less than 5 percent. Of course the deadweight losses are just the beginning of the story. As the textbooks tell us, monopoly profits encourage all sorts of anti-social rent-seeking behavior, activities that we see in abundance in the case of both patent and copyright protection. Starting with drug patents, the newspapers are filled with stories about concealed or distorted research findings by pharmaceutical companies who are trying to exaggerate the benefits, or minimize the risks, associated with their drugs. The corruption from companies pursuing monopoly rents permeates the research process. Medical journals routinely receive and publish ghost written articles, where prominent researchers have been paid by the industry to lend their names to company authored papers. In the same vein, the medical experts who provide guidance to the Food and Drug Administration (FDA) on drug safety are often receiving payments from the manufacturers of the drugs they are evaluating. The sales effort to doctors is similarly corrupted by the pursuit of monopoly profits. According to the industry own data, more people are employed in sales than in research, as the industry relies on an army of salespeople to push its latest blockbuster drugs to doctors. Often this sales effort involves dinners, trips to resorts, and sometimes even outright kickbacks � all ways in which drug companies share a portion of the monopoly profit that they earn by selling drugs at patent protected prices. Monopoly profits also distort the direction of research. According to the FDA's classification system, roughly 70 percent of new drug approvals are for drugs that do not represent qualitative improvements over existing drugs. While there is little social purpose served by developing these duplicative drugs in most instances, patent monopolies can make the development of copycat drugs very profitable. A copycat drug can allow a firm to cash in on a portion of the profits earned by a competitor on a blockbuster drug. In a world with patents, the introduction of a second drug in the market will have the beneficial effect of lowering prices to some extent (there is more competition with two drugs than one drug), however if drugs were sold in a competitive market, there would be little reason to pursue the development of most copycat drugs. The fact that most new drugs fall in this copycat category suggests that a very large share, possible a majority, of patent supported research is wasted.2 � Drug patents also distort the direction of research by pushing it in the direction of patentable results. Research directed at finding cures or treatments based on diet, exercise, or environmental factors will not be pursued in a health care system that relies exclusively on patent monopolies to finance research. This neglect can be offset by government funding targeted specifically towards these areas, but the patent system will direct resources elsewhere. Finally, the granting of patent monopolies will lead to the development of a gray market, in which unauthorized versions of patented drugs are sold. The large gap between the patent protected price and the marginal cost of production creates opportunities for profit in the same way that the high price of illegal drugs like cocaine and heroin create opportunities for profit. Since these unauthorized drugs will be sold outside of regulatory oversight (except when they are imported from countries with well-developed regulatory systems, like Canada), there will be limited quality control. Unauthorized drugs are likely to be less effective than the patented drug, and possibly even harmful. In either case, the health outcome is far from optimal. To sum up, there are a long set of complaints against the inefficiencies associated with drug patents, all of which should jump out of any introductory textbook treatment of protectionism in international trade. Yet, the economic profession has been virtually silent on the inefficiencies associated with drug patents.

Alternatives to Drug Patents This silence would be justified if there were no alternative mechanisms available to support the bio-medical research that leads to the development of new drugs. However, there are alternatives and they already exist. The most obvious alternative is direct government funding of drug research.3 This already occurs on a massive scale. In fact, the $30 billion that the United States federal government pays each year to support bio-medical research at its National Institutes of Health (NIH) is approximately 20 percent larger than the $25 billion that its pharmaceutical industry claims to spend on research. While this research is primarily directed towards more basic science (in order not to interfere with the efforts of the drug industry), there are many instances of new drugs being developed almost entirely through NIH support. It also requires some extraordinary claims about epistemology to argue that public funding of NIH is an efficient mechanism for supporting basic research (a contention strongly supported by the pharmaceutical industry), but somehow would prove to be a boondoggle if the agency took on the responsibility of developing new drugs and bringing them through the FDA approval process. The basic numbers are very striking. If drug prices in the United States were to fall by 70 percent in the absence of patent protection, it would amount to savings of more than $140 billion a year, given 2005 spending levels. This is almost six times as much as the industry claims it is currently spending on research. Since half of this money may go to research copycat drugs of little social value, the savings from eliminating drug patents in the United States may be more than 10 times as large as the spending necessary to replace the useful research performed by the pharmaceutical industry.4 There are clearly better and worse ways to structure a system of government financed research. For example, the Free Market Drug Act, a bill recently introduced in the U.S. Congress, called for establishing a set of competing government corporations that would be evaluated at periodic intervals (e.g. 10 years) for the quality of their work.5 The worst performers would be put out of business with new ones created to take their place. There are other mechanisms that could be created to ensure that the funding is spent efficiently, but given the incredible waste associated with the existing system of patent financed drug research, it seems that there will be huge payoffs for both the economy and for public health by investigating alternatives. It is also important to note that this issue has taken on enormous importance in an international context. One of the major areas of dispute in recent trade pacts has been the ability of less developed countries to purchase drugs without paying patent protected prices. If new drugs were placed in the public domain so that they could be produced as generics everywhere in the world, then this whole issue would quickly disappear.6 This would facilitate access to essential medicines for hundreds of millions of people in the developing world. Copyrights While copyright enforcement may not raise the sort of life and death issues as do drug patents, it also leads to enormous economic inefficiency. Furthermore, the extent of this inefficiency will grow through time, as technology makes it ever easier to transfer recorded audio and visual material, as well as software. The standard economic texts tell us that there are large losses of consumer surplus associated with the government monopolies created by copyright protection. In the case of items like recorded music, movies, and software, material that could generally be transferred at zero cost, instead carries a high marginal cost. In addition, the difficulties of protecting copyrights in an era of digital technology have led to enormous enforcement costs. These enforcement costs include not only the costs directly associated with policing against unauthorized uses of copyrighted material, but also efforts to restrict the development of hardware and software in ways that could facilitate unauthorized reproductions of copyrighted material.�� There is an additional, less widely noted, cost of copyright -- it impinges on artistic freedom. In the absence of government intervention, any writer, musician, movie producer or other creative worker could take any existing artistic work and modify it in any way that they chose. This could be done for parody or as a creative extension of an existing work. (Imagine, for example, writers choosing to write dozens of different endings for a popular novel or to develop new works building off its fictional characters.) Copyright largely prohibits this practice, unless the creative worker has the copyright holders� approval. It is possible to design a system that compensates creative workers, while still leaving the choice of material to individuals (rather than some government commission), and eliminates the economic distortions associated with copyright. The basic point of such a system would be to compensate the creative worker at the point where they do their work, rather than compensating them after then fact for the work. If the creative worker is compensated at the point where he or she produces the material, then there is no need for copyright, the work can be transferred as quickly and freely as technology will allow. One mechanism for this sort of compensation is a system of individual vouchers, where each adult can be given a fixed sum (e.g. 50 to 100 dollars a year), which can only be used to support creative or artistic work. These �artistic freedom vouchers� (AFV) could be paid out through the tax filing system, so that individuals could make their payments each year directly through their tax return.7 The system of charitable contributions in the United States provides an excellent model for such a system. Under the United States tax code, a wide variety of organizations engaged in charitable work (this includes religious activity, aid to the poor, and even publicly oriented think tanks) can register for tax exempt status. This registration allows individuals to make contributions to these organizations and to deduct the contribution from their taxable income. The role of the government in this process is to simply record that an organization engages in some specific activity that qualifies for tax exempt status. The government makes no attempt to evaluate the quality or appropriateness of this activity. The only monitoring involved (in principle) is to ensure that no fraud is being committed, specifically that financial records by the tax exempt organizations are being properly kept, and that it is fact engaging in the activities in which it claims to be engaged. The role of the government in the AFV system would be very similar to its role in monitoring the system of tax exempt organization. Under the AFV system, anyone wishing to receive money through the system would be required to register as a creative worker, indicating what sort of creative work they do. Intermediaries could similarly register to receive funds by indicating that they support specific types of creative work (e.g. producing jazz music, writing mystery novels, etc.). This registration entitles the individual or intermediary to receive money through the system. (An individual would have to be registered with the system to receive money through an intermediary.) The one other requirement for any individual or intermediary registered with the AFV system is that they would not be eligible for copyright protection. The logic here is simple, the creative worker is entitled to be compensated once for their work, not twice. If the worker has received money through the AFV system, then he or she has been compensated in advance for the work they produce. There is no reason that the government should then also act to provide this worker or their agent with a monopoly over the distribution of their product.8 Even a very modest sized AFV could support a vast amount of creative work. For example, a $50 voucher would make approximately $10 billion a year available in the United States to support creative workers. If these workers received average compensation of $40,000 a year through the AFV system, this money would be sufficient to support 250,000 workers. While there is no apriori way to know for certain whether the money distributed to creative workers through the AFV system would be more or less concentrated than the distribution of earnings under copyrights, there is good reason to believe that it would be less concentrated. The copyright system encourages entertainment companies to select a relatively small group of creative workers and to promote them as stars. The rationale is that it is costly to promote a singer, musician, or writer to the point where they have a mass following. Therefore, once they have succeeded in developing a star to this point, it is far less risky to continue to promote the star than to take a chance with a new prospect. As a result, the vast majority of promotional money gets spent promoting a very small group of creative workers. Under the AFV system, there is likely to be less profit in promoting specific creative workers. Presumably intermediaries will attract support by demonstrating their efficiency, which is likely to mean minimizing the money spent on promotions rather than actually supporting creative workers. However, the most important distinction between the AFV system and the copyright system is that all the creative material produced through the AFV system can be transferred at zero cost. Creative workers would promote the development of technologies that would allow their work to be spread as easily as possible, instead of insisting that hardware and software manufacturers find mechanisms to lock it up, so that those who do not pay cannot get it. There is also no reason that copyrights could not co-exist with the AFV system. Creative workers who remain outside of the AFV system would have the option of getting copyright protection, just as is the case at present. The only difference is that the copyrighted material would be forced to compete against a large amount of creative work that is available at no cost. But copyright only provides a monopoly on the copyright holder�s work, it doesn�t protect the copyright holder from competition from free work. Another desirable feature about the AFV system is that it requires minimal enforcement by the government. If a creative worker takes AFV funds, and then obtains a copyright for his or her work, in violation of the rules of the system, the copyright simply becomes unenforceable. Any person can freely distribute this person�s work as though the copyright did not exist, since it would not in fact be a valid copyright. In this case, enforcement of the rules simply requires inaction on the part of the government. This is an enormous contrast with the current efforts to enforce copyright protection, which have included F.B.I. raids on college dorm rooms, prohibitions on the development of technology, and government propaganda efforts on the evils of copyright infringement. Reforming Intellectual Property: Getting Away from the Middle Ages The alternatives to patent and copyrights described above may not be the best ways to promote innovation in biomedical research or creative and artistic work.9 However, it is probably even more certain that the current patent and copyright systems fail this test. Given the large and growing costs associated with patent and copyright enforcement it is imperative that alternative incentive mechanisms be explored. Clearly there are very powerful interests that stand to lose from reform of intellectual property rules, specifically the pharmaceutical industry, the medical equipment industry, the software industry, and the media and entertainment industries. These sectors include many of the biggest and most powerful corporations in the world. But the strength of the resistance to reform does not affect the intellectual argument for reform. It would be difficult to identify more harmful economic policies than the current system of patent and copyright rules. They are few cases where the application of standard neo-classical economics could have such beneficial effects.��� Endnotes 1. There is a distinct set of issues that arises in a case where a patent is issued for a product sold directly to consumers and accounts for the bulk of the product�s price (as is the case with prescription drugs and medical equipment), compared with a patent on an industrial process. In the case of patents on industrial processes, the expected outcome is that patent holder will sell the patent to the user, who will then be able to use it at zero marginal cost, thereby eliminating the distortions associated with patent protection. 2. A study commissioned by the PhRMA, the industry's lobbying group, found that on average, copycat drugs cost almost as much to develop as breakthrough drugs (see Ernst & Young LLP. 2001. Pharmaceutical Industry R&D Costs: Key Findings about the Public Citizen Report. Pharmaceutical Research and Manufacturers of America. [http://www.phrma.org/press/newsreleases/2001-08-11.277.pdf]). 3. A fuller account of the economics of this sort of alternative to patent supported drug research can be found in Baker and Chatani (2002), (see �Promoting Good Ideas on Drugs: Are Patents the Best Way? �[http://www.cepr.net/promoting_good_ideas_on_drugs.htm]). 4. The industry estimates that approximately 8 percent of its research goes to studying production and safety issues. This research would be carried through even if all drugs were sold as generics, and therefore would not have to be replaced by the government. 5. A full description of this bill is available on the website of its lead sponsor, Representative Dennis Kucinich �[http://www.house.gov/kucinich/issues/freemarketdrugact.htm]. 6. It would be desirable to have some sort of international system that ensured that countries paid their fair share toward supporting biomedical research. Hubbard and Love (2004) provides an example of such an agreement (see "A New Trade Framework for Global Healthcare R&D." Plos Biology, V2, #2. [http://www.plosbiology.org/plosonline/?request=get- document&doi=10.1371%2Fjournal.pbio.0020052]). 7. The AFV system is described in more detail in Baker 2003 (see �The Artistic Freedom Voucher: An Internet Age Alternative to Copyright� [http://www.cepr.net/publications/AFV.htm]). 8. It would be important that this ban on access to copyright protection extend for a substantial period (e.g. five years) after receiving AFV funds. The point of the AFV system is to establish a competitor to the copyright system, not a farm system for the entertainment industry. If the most successful people in the AFV system could simply leave and immediately become eligible for copyright protection, then the system would end up just providing a subsidy to the copyright protected entertainment sector, since it would screen out less popular artists for it. 9. It is likely that some sort of direct funding mechanism would be the most efficient way to support software development, another area in which patents have led to massive waste, although a decentralized AFV mechanism may be appropriate for some types of software, such as video games.� baker@cepr.net ___________________________

SUGGESTED CITATION:

Dean Baker, �The Reform of Intellectual Property�,� post-autistic economics review, issue no. 32, 5 July 2005, article 1, http://www.paecon.net/PAEReview/issue32/Baker32.htm