The Dual Effects of Intellectual Property Regulation

Policymakers and economists have long appreciated the importance of research and development to economic progress, and one of the most important policies affecting R&D is intellectual property regulation, in the form of patents, copyrights, and trademarks. These policies essentially protect innovation from potential imitators, and thus spur growth.

However, a patent only protects an innovator from others producing an identical product (so-called within-patent competition). It does not protect from others producing new, improved products under new patents. A patent, for example, protects a drug company from a generic equivalent; however, the same drug maker is not protected from competition stemming from an improvement on the drug.

Tomas Philipson and Frank Lichtenberg, in their Harris School working paper, “The Dual Effects of Intellectual Property Regulations: Within- and Between-Patent Competition in the U.S. Pharmaceuticals Industry,” argue that economic analysis has overlooked this “between-patent” competition (competition from those making a better version of the same product),
and in doing so has significantly overestimated the beneficial impact of patent protection on sales growth. In other words, patent protection (and other R&D stimuli) raises not only the current incentive to innovate but also the incentives for producers of better drugs that treat the same condition.

The Perils of Overlooking Between-Patent Competition
The authors use data from the pharmaceutical industry to examine the potentially offsetting effects of within-patent and between-patent competition. The authors find that throughout the first 16 years of a drug’s life, and especially in its early years, betweenpatent entry reduces innovator sales growth much more than within-patent entry. Five years after entering the market, between-patent competition has reduced innovator sales growth by 3.6%, while the within-patent competition has only reduced it by 0.4%. After 10 years on the market, the reductions are 5.9% and 1.4%, respectively. The gap begins to narrow after year 13, but in year 16, within-patent entry has still reduced sales growth less than between-patent entry—4.1% versus 8.2%.

These estimates imply that within-patent entry alone reduces sales in year 5 from a hypothetical $1,000 to $993. In year 10, sales are reduced to $943. In year 15, sales are reduced to $828. Between-patent competition, in contrast, reduces sales in year 5, 10, and 15 to $887, $686, and $476, respectively. Looking at it another way, within-patent competition reduces PDV of sales over 16 years by 4% ($11,313 vs. $11,838), while between-patent competition reduces PDV by 17% ($9,420 vs. $11,838), or four times as large as within-patent competition.

Policy Implications
The findings suggest that a fuller understanding of intellectual property regulation is warranted and any future analysis of the regulation’s effects should take account of competition by innovators who create an improved version of the same product.

An interesting case that illustrates the importance of between-patent competition is the U.S. Orphan Drug Act of 1983. This act added a seven-year exclusivity right to a class of drugs for rare diseases, in addition to tax breaks for R&D. It thereby provided a unique
reduction in between-patent competition. The act dramatically raised both R&D spending and entry of orphan drugs, facts that may be testament to the relative importance of between-patent rather than within-patent competition.

These findings are likely to be even more important in high-tech industries, where the average patent is longer, and where demand for a given innovation is often destroyed by the entry of new, superior products long before patent expiration.

Finally, extending the lives of patents, such as in the Hexler-Waxman Act, may not result in the expected returns to innovation. An extension of a patent from 17 to 20 years, or an 18% increase in the patent life, may only raise the innovative return by very little (2%–3% or less perhaps) owing to between-patent competition and standard discounting.

Tomas Philipson is a professor in the Irving B. Harris Graduate School of Public Policy Studies and a faculty member in the Department of Economics and the Law School at the University of Chicago. Frank Lichtenberg is the Courtney C. Brown Professor of Business at Columbia University.