The role of patents: a business view

Karl Marx once wrote: “The philosophers have only interpreted the world; the point is to change it”. This statement is particularly true of science. The first goal of science is knowledge for its own sake, the purest of motivations; other goals are secondary. Nevertheless, these secondary goals have their own importance — particularly for society at large.

The practical application of scientific knowledge is of enormous benefit to society, and is a principal reason that society supports and funds scientific research. But knowing in principle how to do something is not sufficient to ensure that it is done.

The first goal of commerce is to make money. Although not a high motivation, it is both reasonable and practical. Commerce provides a livelihood for those who engage in it; much more importantly, in general, it benefits society in addition to its practitioners.

This is as true for developing countries as it is for the advanced industrialised nations. Competitive markets make available to customers things they need or want. Commercial enterprises, in pursuing their own interests, do much useful work that benefits society, whatever its level of development.

But the first law of commerce is that it is impossible to obtain a continuing supply of useful work from an enterprise unless, over time, the income of the enterprise exceeds its outgoings. Without profits a business is not sustainable. If money invested in a business cannot be recovered — and eventually increased — the business will fail, as it will lose the support of its investors.

One useful thing that commercial enterprises do is to bring the fruits of new scientific knowledge to the public, usually in the form of new products. For example, pharmaceutical companies produce the new drugs needed to combat life-threatening diseases, both in the developed and developing worlds.

But, like biological mutations, most commercial innovations are unsuccessful — whether for technical or commercial reasons — and lose money. Innovation is commercially risky; in the pharmaceutical industry, only a very small proportion of promising ideas for new drugs eventually make their way into the market. It is much more prudent to allow someone else to establish, by experiment, whether a new product can be introduced successfully and profitably into the marketplace.

Without protection, the minority of new products that are successful can then be imitated: the imitators can invest with confidence, knowing there is a market, and profiting from the innovator’s experience. Such imitation is socially valuable, since it rapidly drives the price of useful innovations down to their marginal cost, with early benefit to consumers.

But imitation is also dangerous, as it penalises innovators, preventing them from recovering the cost of their failures from the profits of successful innovations. And if no one is willing to go first, there can be no imitators. Some counterbalance is needed to encourage entrepreneurs to innovate.

One such counterbalance is provided by the patent system. Under the patent system, the state grants to an inventor an exclusive right to exploit commercially a new invention for a limited period, typically 20 years. In return the inventor must describe how to carry out the invention so that others can make use of the knowledge for other purposes or in other jurisdictions.

Two main justifications put forward for the patent system. Firstly, it rewards inventors, who are seen as having natural rights in their intellectual creations — Article 27 of the Universal Declaration of Human Rights states that “Everyone has the right to the protection of the moral and material interests resulting from any scientific, literary or artistic production of which he is the author”. Secondly, the patent system encourages the publication of new technical information and ideas.

For business, however, the justification of patents is that they make it possible to sell new products that otherwise would inevitably lose money. Some new products can be produced relatively cheaply and quickly, so that start-up costs are small, and can be recovered in selling costs over a period of months, before competition starts affecting prices. Others require heavy investments over several years, which take several more years of sales to recoup.

Pharmaceuticals are the typical case. Here the start-up costs of research and development (R&D) are massive, while the variable costs of manufacturing are typically small in comparison. The main output of the R&D is information — on clinical effectiveness and safety — which for the most part has to be published. Without sole rights of commercial exploitation, a pharmaceutical company would have no hope of profitably producing new drugs.

The diagram below illustrates this:



This diagram represents cumulative cash flow for a successful new drug. For a typical development, the time t at the bottom of the curve might be 10 years from the origin (invention date), while the money invested at that time could be $300m. With strong patent protection, the cumulative cash flow follows the solid line of the graph, and turns positive before the patent expires (at the inflexion in the curve above the x axis).

Without patent protection, however, once it is clear that the new drug is a success, imitators start to come in: as a result, competition forces the selling price down, eventually to the marginal cost of production. At this point the cumulative cash flow curve is horizontal, and the start-up costs will never be recovered: the company has made a massive loss. This shows how patent protection is essential to a drug company, so that it can make profits and stay in business.

Patent rights are vital to all innovating businesses (even if most are less dependent on them than the pharmaceutical companies). This is still true where patented products are the most effective way of controlling life-threatening diseases, such as AIDS. Would such products exist without patents? Will similar products be developed in the future, if patent rights are now ignored? Of course, pharmaceutical companies must work to ensure that their products reach those who need them most. But they do not bear this responsibility alone.

Patents do not so much provide an incentive to innovate (as is often said) as limit a powerful disincentive: that of being unable to recover the costs of successful innovation.

The author is Vice-President of the UK Chartered Institute of Patent Agents.

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