WIIW The Vienna Institute for International Economic Studies - Wiener Institut für Internationale Wirtschaftsvergleiche

By Roman Stöllinger
Image: iStock.com/solarseven

• Incentives for R&D will not vanish if strict international patent protection is rescinded
• Innovating firms will remain profitable even without patent protection as large global markets provide an incentive for engaging in R&D
• If need be, governments can strengthen incentives for business R&D of products of public interest. Such support should be guided by the public interest, not firm profitability
• International trade laws should put tariff protection and patent protection on an equal footing instead of applying double standards

Pessimists say that the worst fall-out from the COVID-19-pandemic is yet to come in the form of people’s economic, social and psychological stress. Optimists argue that despite all the agony the pandemic has caused, it may also hold the seeds of direly needed changes in how economies are run. Siding with the optimists, one could see the recent US proposal to suspend the generous patent protection that international trade law grants innovating firms as an important symbolic step toward changes.

Rules are not immutable and there is always an alternative

All too often existing regulations (or the lack therefore) that are vital for the functioning of the economy are portrayed as immutable, almost as natural law. Think of carbon subsidies, tax havens, the seemingly impossible agreement on a financial transaction tax or the need to make labour markets more flexible. Until very recently, the 20-year patent protection for innovations, enshrined in the WTO’s Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS), was also such an axiomatic economic truth. Firms need patent protection, so the story goes, because it creates and maintains incentives for firms to engage in costly research activities. Without temporary protection from competition, innovators cannot recoup the massive investment costs associated with R&D.

While this argument cannot be entirely dismissed, it is questionable for a number of reasons. First, economists like to stress that innovators ‘stand on the shoulders of giants’ which means that typically, and even in the case of radical innovations, new products and processes always build upon previous knowledge generated by others. More often than not these processes of earlier knowledge generation have been supported by public money. Second, it is interesting to note that economists put less emphasis on the dynamic implications of temporary limitations of competition outside the realm of intellectual property protection. Third, there are alternative ways to create incentives for firms to come up with new innovations - true innovations, that is.

Giants, entrepreneurs, governments, profit

Multinational firms account for the bulk of innovation. According to the EU’s Industrial R&D Investment Scoreboard (2020 edition) 2500 companies account for an estimated 90% of global R&D funded by business. There are growing indications, if not evidence, that multinational companies are among the big winners in the current wave of globalisation (for one such view see Kaplinsky, 2019). One of the reasons why multinational firms benefit strongly from the current global trade and economic architecture is that they earn high profits. The profits of multinational firms have grown proportionally with the size of the global market and are further increased and prolonged by temporary protection, that is, by patent protection. This is why economists refer to these profits as a mixture of innovation rents and policy rents: innovation rents because profits are the result of innovation efforts, and policy rents, because these profits are magnified by patent protection (as well as public purchases at the national and international level).

Among these 2500 firms in the above-mentioned R&D Scoreboard there are 436 firms from the pharmaceutical and biotechnology industries. The question now is whether in such an environment, business R&D would really take a strong hit if the policy rent component were to be reduced. Policy rents would in any case remain, as ‘big pharma’ still benefits from sizeable R&D subsidies and knowledge spillovers from basic research in public institutions and universities, as has been repeatedly argued by Marianna Mazzucato (see here for a discussion in the COVID-19 context).

Related to this is also the fact that path-breaking innovations in many cases do not originate with big pharma. Rather, these companies co-operate with universities (AstraZeneca and the University of Oxford) or with successful start-ups (see the cooperation between Pfizer and BioNTech) which actually do most of the research. If we go one step further, one may also ask whether the merits of innovations should not go, at least to some extent, to the ‘giants’ who developed the underlying technology. As is by now well-known, messenger-RNA technology was to a substantial extent developed by Hungarian biochemist Katalin Karikó, thanks to a lot of personal effort and supported by public funds.

Against this background, suspending patent protection for the benefit of private firms therefore seems to be no loss. This is all the more true, if the elimination of patent protection for the mRNA COVID vaccines would not ease the supply shortage anyway, as has recently been argued by EU leaders. While remaining anxious about big pharma’s incentives to engage in R&D, lifting patent protection in their view would not lead to an acceleration of vaccine production because the production of these new vaccines is skill-intensive and technologically demanding. But if patents do not matter anyway, one wonders why they are needed in the first place. Therefore, the conclusion remains the same:  suspending patent protection for life-saving medical products is unlikely to threaten the profitability of pharmaceutical and biotech firms, including profitability from vaccines.

On a bad TRIP(S)?

Another inconsistency regarding patent protection is revealed by comparing patent protection with tariff protection. Trade theory suggests that tariff protection is harmful for both firms and consumers because it hampers competition, leading to efficiency losses and higher prices. This conclusion is based on static efficiency arguments which compare two states in the economy without paying much attention to adjustment processes or developments over time. Therefore, leaving aside the optimal tariff argument for large economies, the conclusion is unambiguously that governments should not mess with tariffs.

A different perspective is given by the arguments for patent protection from innovation economics. It is widely acknowledged that patents stifle competition and provide temporary protection for innovating firms. For this reason, patents hamper competition leading to efficiency losses and higher prices. Sounds oddly familiar but the conclusions drawn by mainstream economics is very different. Patents, according to the argument, are necessary to ensure incentives for firms to invest in R&D and technological progress. Hence, the argument in favour of patent protection rests on dynamic efficiency arguments.

Without any intention to provide additional ammunition to anti-globalisation agitators, this just looks very much like a blatant use of different yardsticks with the intention of ensuring economic backing for trade rules that are tilted in favour of multinational firms. Note that this is not an argument in favour of raising tariffs or any other trade barriers. The point is a different one. As has been argued by structural economists (see e.g. Botta, 2009 for a modern formulation), economic dynamics are complex, full of ‘path-dependencies’, and therefore rarely unambiguous in their outcomes (by now also acknowledged by endogenous growth theory proponents). This means that outcomes depend on the specific circumstances so that, for example, the use of temporary tariffs as well as domestic content requirements or joint venture obligations in FDI relations could be extremely useful from a dynamic efficiency perspective. Again, this article is not calling for more tariffs but for less patent protection and a more equal treatment of the two policy instruments.

Incentivising regulations as an alternative to patent protection

Assuming that patent protection is suspended, starting with the pharmaceutical and biotech sector, governments can use regulations to ensure policy rents for firms if they wish to do so, without resorting to patents. Take the contracts that the public sector signs with pharmaceutical firms. It is probably fair to say that there are many instances in which public negotiators (for whatever reasons) allow for generous profit margins. As argued in the literature, governments could and should use the leverage arising in public procurement contracts strategically. This can be done simply by granting higher profit margins for truly innovative medical products and those that help fight fatal diseases. Second, governments can continue to use R&D subsidies (ideally not in the form of general tax breaks) to provide additional incentives for research in priority areas where these priority areas are not determined by prospective profits but by public health considerations.

Conclusion

There is absolutely no need to be worried about a lack of R&D incentives or the profitability of pharmaceutical firms in a world without patent protection. The Alphabets, Microsofts, and Volkswagens of this world will continue to earn high innovation rents due to their superior skill and technology base as well as their advantages from scale-effects and their global market presence. These advantages should suffice to keep them highly profitable, even if they are not perpetuated and magnified by policy rents in the form of patent protection.

This is particularly true for ‘big pharma’. Firms such as Johnson & Johnson, Novartis or Pfizer, all of which figure among the top 20 R&D investors worldwide, benefit not only from globalisation but from lucrative contracts with public health institutions around the world. This public demand leverage can be used to keep high incentives for R&D in areas of public interest by granting price premia for the development of new drugs, depending on the severity of the illness they are intended to cure (or provide protection against). Strategic public procurement operations can easily be supplemented by classic supply-side industrial policy in the form of R&D subsidies.

Trade policy guided by the public interest does not legitimise excessive patent protection, in just the same manner as it does not, in general, legitimise excessive tariff protection. The suspension of patents for COVID vaccines would therefore be an important first step towards a more balanced international trade architecture. The World Health Organisation’s director general, Tedros Ghebreyesus, even called it a “monumental moment” for addressing global health challenges. Whether there will really be a monumental moment is yet to be seen. But the fact that the US administration made this suggestion is a silver lining for a change for the better.