By Eric Bond (Vanderbilt University) and Kamal Saggi (Vanderbilt University)

The Trade-Related Intellectual Property Rights (TRIPS) agreement of the World Trade Organization (WTO) requires that all WTO members provide a minimum level of patent protection for all types of intellectual property. This requirement has created a problem for developing countries in obtaining access to patented pharmaceuticals, because pharmaceutical companies are reluctant to sell drugs in middle and lower income countries due to the potential negative impact on prices in high income markets. The spillovers can result from the use of reference pricing in high income markets, whereby a high income country government uses an average of prices in other countries to determine the price that a patent holder can charge in its market.  Spillovers can also arise from illegal arbitrage trade.[1]

As a result of these potential spillovers, newly patented drugs may be unavailable or introduced with substantial delays in middle and low income markets.[2] TRIPS does, however, provide countries with the option of issuing a compulsory license (CL) if the market has not been served in a reasonable period of time. A country issuing a CL is required to provide adequate compensation to the patent holder. There have been a number of examples of the use of CLs to obtain access to patented pharmaceuticals by middle and low income countries since the advent of TRIPS, including drugs to treat AIDS, heart disease, and cancer.[3]

How does the requirement of patent protection under TRIPS, combined with the option of issuing a CL if the market isn’t served, affect the welfare of developing countries and patent holders? In a recent article, we address this question using a game-theoretic model to consider a patent holder’s decision of whether it should incur the fixed cost of entering a developing country market.[4] We show how the answer to this question depends on the imitative ability of the developing country to produce copies of the patented product and the level of fixed costs of entry relative to the profits from the market.

Prior to TRIPS, a developing country could obtain copies of patented products from imitators if it did not provide patent protection.  For countries where the cost of entry for the patent holder was high relative to the profits from entry, typically countries with relatively small markets, the patent holders would only enter if patent protection was provided. The country would then have to choose between providing patent protection and obtaining a high cost, high quality product, or not providing patent protection and obtaining a low quality and low cost imitation. The high entry cost countries would only provide patent protection if the quality of imitators was sufficiently low.

In contrast, for countries where the fixed costs were low relative to the profits from entry, the patent holder might still be willing to enter without patent protection if the quality of the imitators was not too high. These countries obtained a double benefit by not providing patent protection: the patented product was obtained at a low price and the copies were also available for those unwilling to pay the price for patented goods.

The absence of patent protection prior to TRIPS made CLs an unnecessary instrument for developing countries, because imitators could produce patented foreign products without requiring a license.  In fact, we show that the option of using a CL could actually make all parties worse off by reducing the incentive of developing countries to offer patent protection. The insight is that developing countries are better off under imitation relative to a CL and therefore have an incentive to preempt the possibility of the patent-holder resorting to a CL by not recognizing the patent. After all, the issuance of a CL is premised on the legal recognition of the underlying patent.

The TRIPS requirement that developing countries provide patent protection made developing countries worse off and patent-holders better off, because it raised prices of patented products by preventing imitators from providing competition for patent holders. The extent to which the option of a CL mitigates the loss to the developing countries from TRIPS depends on the country’s characteristics. For countries with markets sufficiently profitable that the patent-holder would have entered without a patent, TRIPS primarily benefitted patent-holders by eliminating competition from imitators. For countries that would have had to rely on imitators to provide the product prior to TRIPS, TRIPS provides access to the product through a CL. However, the delay required before a CL can be issued means that the country will not obtain access to a copy of the patented product as quickly as it would pre-TRIPS.

Finally, the fact that the patent holder obtains a royalty payment under the CL means that it might prefer a CL to entry if the return from entry is sufficiently low. Thus, the option of a CL could actually cause countries that provided patent protection pre-TRIPS to experience delay in obtaining access to the patented product under TRIPS. It should be noted that since developing countries do not take into account the profits of patent holders in making their decision whether to provide patent protection, the level of protection was below the socially optimal level pre-TRIPS.

We also consider the case in which the government of the developing country negotiates a price ceiling for which the patented product is to be sold in its market. The effect of the CL in this case depends on the relative bargaining power of the two parties during negotiations over the price ceiling. If the patent-holder has all of the bargaining power, then the government is able to use the threat of a CL to lower the price of the patented product. If the country has all of the bargaining power, the royalty payment required by TRIPS benefits the patent-holder by providing a minimum level of compensation that it must receive for entering the market. Thus, the ability to issue a CL primarily benefits the party whose bargaining position during price negotiations is relatively weaker.

References

Beall, R. and R. Kuhn, (2012); “Trends in Compulsory Licensing of Pharmaceuticals since the Doha Declaration: A Database Analysis.” PLos Medicine 9(1): 1-9.

Bond, E. W., and K. Saggi, (2018); “Compulsory Licensing and Patent Protection: A North-South Perspective.” Economic Journal 128 (May): 1157-79.

Cockburn, I.M., Lanjouw, J.O., and M. Schankerman, (2016). “Patents and the Global Diffusion of New Drugs.” American Economic Review 106(1): 136-164.

Danzon, P., Y. R. Wang, and L. Wang, (2005); “The Impact of Price Regulation on the Launch Delay of New Drugs,” Journal of Health Economics 14: 269-92.

Goldberg, P. K., (2010); “Intellectual Property Rights Protection in Developing Countries: The Case of Pharmaceuticals.” Journal of the European Economic Association 8: 326-53.

Endnotes

[1] See Golderg (2010).

[2] See Danzon, Wang, and Wang (2005), and Cockburn, Lanjouw, and Schankerman (2016).

[3] See Beall, R. and Kuhn, R. (2012).

[4] See Bond and Saggi (2018).