Pharmaceutical patents: incentives for research and development or marketing?

Author:Brekke, Kurt R.
 
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  1. Introduction

    A patent protects the patent-holder from firms copying its product for a given period. In other words, patents restrict entry of homogeneous (identical) products during the patent period. However, patents rarely lead to a complete monopolization of a market. In most cases, a patent just requires that new products must be sufficiently differentiated, implying some degree of competition in the market.

    The rationale behind patents is to stimulate firms to undertake research and development (R&D) to discover new products by granting market power and thus returns on their investments. A generous patent system is likely to stimulate innovation strongly. However, a generous patent system may also induce patent-holding firms to exhibit market power in a potentially detrimental way. This is the basic idea explored in this article. In a model framework designed to fit the pharmaceutical industry, we analyze how a patent-holding firm may strategically use advertising ex ante to affect the R&D investments in new products, thereby reducing the probability of increased future competition.

    The relationship between innovation and marketing is of special interest for the pharmaceutical industry. This industry is highly R&D-intensive and patents of chemical compounds play a crucial role in terms of stimulating developments of new drugs. The pharmaceutical industry is also one of the most advertising-intensive industries (Scherer and Ross 1990). Marketing expenditures typically amount to 2040% of sales revenues, often exceeding R&D expenditures. According to Schweitzer (1997), the marketing expenses for three of the largest U.S. pharmaceutical companies--Merck, Pfizer, and Eli Lilly--ranged from 21-40% of annual sales revenues, while the R&D expenses varied between 11 15%. (1)

    The basic structure of our model is as follows. We consider a therapeutic market with potentially two (horizontally) differentiated drugs, where one of the drugs is already discovered--the breakthrough drug--and under patent protection. The incumbent is thus a monopolist and advertises the drug, taking into account the possibility of future entry of new competing products. A new competing product may or may not be discovered, depending on the amount of R&D investments incurred by the incumbent and a potential entrant. If the incumbent is successful, he becomes multi-product monopolist, a situation often referred to as brand proliferation. On the other hand, if the new drug is discovered by the potential entrant, there is a duopoly, where the incumbent and the entrant advertise accordingly to capture market shares. Finally, if none of the firms are successful, the incumbent remains a single-product monopolist in the market.

    This modeling setup builds on two empirical observations: (2) First, the vast majority of pharmaceutical innovations are follow-on drugs rather than completely new medical treatments. Lu and Comanor (1998) find that all but 13 of 148 new branded chemical entities introduced in the United States between 1978-1987 had at least one fairly close substitute; the average number of substitutes being 1.86. Scherer (2000) reports that the number of drugs per symptom group ranged from 1 to 50, with a median of five drugs and a mean of 6.04. Second, there is a large variation in the degree of competition across therapeutic markets. Some therapeutic fields are monopolized by a dominant pharmaceutical company, often having several related drugs on the market, while other therapeutic fields are highly competitive, with several pharmaceutical firms offering different products that can cure the same disease (Scherer 2000). Thus, our setup applies to a wide set of therapeutic markets and offers explanations for market structure variation across therapeutic markets.

    In line with the specific features of pharmaceutical markets, we restrict attention to non-price strategies innovation and marketing by assuming that firms face exogenous (regulated) drug prices. (3) The importance of non-price strategies in the pharmaceutical market can be explained by the fact that most countries exert some sort of price control either directly by regulating the prices or indirectly via the reimbursement system. (4) In addition, the demand for pharmaceuticals is highly price inelastic, mainly due to health insurance and/or physicians' ignorance of price in the prescription choice. (5)

    In a fairly general framework, we obtain two main results. First, we show that advertising and R&D are substitute strategies for the incumbent firm--implying that more advertising will, all else equal, induce the incumbent to spend less on R&D--if the following two conditions are met, in equilibrium (i) the second-order cross-derivatives of demand with respect to advertising expenditures are negative (implying that advertising expenditures are strategic substitutes), and (ii) the second-order cross-derivatives of the innovation success functions are sufficiently small in absolute value. (6)

    Second, under these general conditions, we show that the incumbent has an incentive to strategically overinvest in advertising in order to negatively affect R&D investments and thereby protect its existing patent rent. The key mechanism in the relationship between advertising and R&D incentives is the incumbent's ability to influence ex post payoffs of the potential entrant through ex ante advertising of the existing product. (7) If drug marketing has a business-stealing effect, advertising may serve as a rent-shifting device, reducing the R&D incentives of the potential entrant. (8)

    We also derive a general condition for identifying under which circumstances the incumbent has incentives to invest too much in advertising from a social welfare perspective. We conclude that, under reasonable assumptions, socially excessive advertising is more likely to occur if there is a stronger persuasive element to advertising, and/or if the patent rent is higher (due to either longer patent periods or a higher regulated drug price). Naturally, a divergence between private and social advertising incentives opens for a discussion of relevant policy measures, like restrictions on drug marketing and the generosity of the patent system. These issues are especially relevant for the pharmaceutical industry, since most countries impose regulations on both marketing and prices of prescription drugs. Our analysis suggests that strict regulation of advertising and strict price regulation (or, equivalently, a less generous patent system) are policy substitutes, implying that a generous patent (or price regulation) system should be matched with strict regulation on advertising, and vice versa.

    Applying the general framework to a standard informative advertising model (see Butters 1977; Grossman and Shapiro 1984), we show that advertising and R&D are substitute strategies and that the incumbent always has an incentive to strategically overinvest in advertising in order to reduce the probability for a new product being developed by the potential entrant. Using numerical simulations, we also demonstrate that a generous patent system (equivalently, generous drug prices) tends to stimulate marketing incentives relative to R&D incentives, and finally, that our conclusions from the general welfare analysis about the relationship between patent rent and advertising incentives are strongly confirmed, even in a setting where advertising is purely informative.

    We find these results interesting for several reasons: First, the potentially negative impact of a more generous patent protection on R&D incentives runs counter to the general presumption in most theoretical papers on optimal patent design (see Denicolo 1996). On the other hand, the results seem to be in line with the recent, though scarce, empirical studies on this topic. For instance, Sakakibara and Branstetter (2001) find no evidence of an increase in either R&D spending or innovative output due to the Japanese patent law reform, strengthening the patent protection in Japan. In addition, Jaffe (2000) documents several studies from the United States, which offer indirect evidence that calls the value of stronger patents into question. Our article provides one possible answer to this puzzle, namely that a patent enables the patent-holder to exploit market power--in our case by means of marketing--to reduce incentives for R&D innovations of new, competing products. The market power effect can be viewed as a negative, indirect effect counteracting any positive, direct effects of patents on innovation.

    The general insight that advertising can strategically preempt R&D is of course not entirely novel. Although there are, to our knowledge, no previous studies of the strategic link between advertising and R&D, (9) our article is clearly related to the literature on advertising and entry (see Schmalensee 1983; Fudenberg and Tirole 1984; Ishigaki 2000). A striking conclusion from this literature is that the incumbent can deter entry by strategically underinvesting in advertising, a result that runs counter to the related literature on production capacities. (10) Advertising is assumed to be a durable investment, but the incumbent can always increase the advertising stock ex post if this is profitable. This raises a concern whether the incumbent can credibly commit to underinvest in advertising. Schmalensee (1983) observes this problem, but avoids it by making restrictions on the incumbent's advertising choices, (11) Fudenberg and Tirole (1984) also avoid this problem simply by making second-period advertising exogenous.

    In our model, entry only occurs with a certain probability, depending on the amount of R&D incurred by the contestants. By focusing on non-price competition, we establish incentives for overinvestment in advertising by the incumbent firm, which contrasts with results for entry deterrence under price or quantity competition, as previously discussed...

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