Tuesday, October 16, 2012

Patents Tipping Too Far: Three Examples

The basic economics of patents as taught in every intro econ class is a balancing act: On one side, patents provide an incentive for innovation, by giving innovators a temporary monopoly over the use of their invention. This temporary monopoly rewards innovation by allowing the inventor to charge higher prices, and thus the tradeoff is that consumers temporarily pay more--although consumers of course also benefit from the existence of the innovation. Like any balancing act, patents can tip too far in one direction or the other. On one side, patents can fail to provide providing sufficient incentive (that is, large enough profits) for inventors. But on the other side, patent protection that is too long or too rigid can lock profits for early innovators for an extended period, both at the long-term expense of consumers and also in a way that can cut off possibilities for future innovators.

There's is some concern that the balance of patent law has tipped in a way that is overly favorable to earlier innovators. Without trying to make the case in any detail, here are three straws in the wind of this argument that recently crossed my desk.

1) Has the specialized federal appeals court for patent cases run amok?  

Back in the 1970s, it seemed clear that the enforcement by patents was wildly uneven. Thus, in 1982 a United States Court of Appeals for the Federal Circuit, one step below the U.S. Supreme Court was created to hear all appeals of patent decisions from around the country. The difficulties are described by Timothy B. Lee under the (perhaps slightly overstated) title, "How a rogue appeals court wrecked the patent system," appearing in ArsTechnica.

Lee tells the stories of the whacky 1970s, when companies that got patents literally raced to file infringement suits in jurisdictions that they thought would be favorable, while competitors raced to file infringement suits in jurisdictions that they thought would be favorable--because who filed first would often determine where the cases would be consolidated, the jurisdiction where the case was heard would largely determine the outcome. Here's what happened in the 1970s: "Every Tuesday at noon, a crowd would gather at the patent office awaiting the week's list of issued patents.
As soon as a patent was issued, a representative for its owner would rush to the telephone and order a lawyer stationed in a patent-friendly jurisdiction such as Kansas City to file an infringement lawsuit against the company's competitors. Meanwhile, representatives for the competitors would rush to the telephone as well. They would call their own lawyers in patent-skeptical jurisdictions like San Francisco and urge them to file a lawsuit seeking to invalidate the patent. Time was of the essence because the two cases would eventually be consolidated, and the court that ultimately heard the case usually depended on which filing had an earlier timestamp."

But unsurprisingly to any student of political economy, the new court ended up being staffed by lawyers who believed in very strong patent enforcement. The share of patents that were found to be infringed went from 20-30% in most of the 1960s and 1970s up to more like 50-80% for most years of the 1980s. Lee tells the story in more detail, but the new court eventually allowed software to be patented, and "business methods" to be patented. "Microsoft received just five patents during the 1980s and 1,116 patents during the 1990s, for instance. Between 2000 and 2009? The company received 12,330 patents ..." Since 2006, the U.S. Supreme Court has overruled at least four major decisions from this lower court.

Lee argues: "Either way, breaking the Federal Circuit's monopoly on patent appeals may be the single most important step we can take to fix the patent system. The Federal Circuit looks likely to undermine other reforms undertaken by Congress, just as it has resisted the Supreme Court's efforts to bring balance to patent law. Only by extending jurisdiction over patent appeals to other appeals courts that are less biased toward patent holders can Congress return common sense to our patent system."

2)  Why are patent cases being decided in the International Trade Commission?

In May 2012, the International Trade Commission affirmed an earlier decision to ban imports of a number of Motorola Android-based smartphones and other mobile devices because they infringed a Microsoft patent that involves software for scheduling meetings--software that is rarely used and by one estimate is worth 33 cents per phone. The case raises standard difficult issues about how innovation can flourish in an industry like high-tech electronics where products use dozens of overlapping patents, and thus every new product is susceptible to claims that it is infringing on some patent, somewhere.

But for me, the eye-opening part of the case was the decision-maker: Why was the International Trade Commission deciding what was essentially a patent infringement case? K. William Watson tells some of this story in "Still a Protectionist Trade Remedy: The Case for Repealing Section 337," which was published as Cato Policy Analysis #708. It turns out that under Section 337 of the Tariff Act of 1930, the ITC has power to block imports of any products that involve "unfair means of competition." The ITC process is faster than the courts, and has often proven quite friendly to existing patent-holders. The ITC remedy of shutting off imports is very costly. Watson summarizes the argument this way:

"The current state of the global “patent wars” in the mobile device industry aptly demonstrates the risks posed by Section 337. Courts have been perfectly capable of imposing strong remedies to deal with patent infringement, which sometimes include banning a product from the market. Most of
these disputes, however, are merely part of a business model where competitors must collaborate
to pool together the many patented technologies that make up cutting-edge consumer products such as smartphones and tablet computers. While companies would love to have their competitors’ products forced off the shelf, the truth is that many of the disputes involve patents that are worth
only a tiny fraction of the product’s total value, meaning that injunctive relief is not always appropriate. ... There is only one simple and effective solution: repeal the law. The ITC has no business imitating a court of law and is not equipped to do so. The foreign origin of a product does not make it necessary to subject its producer to a separate regime that more quickly and forcefully
settles intellectual property disputes. The existence of two distinct patent enforcement mechanisms disrupts the balance of U.S. patent law and, because one mechanism is only available to challenge imports, violates U.S. trade obligations."

 3) When brand-name drug companies compensate generic drug companies to delay in entering the market.  

Brand-name drug companies typically have a patent, and when that patent expires, it then becomes possible for manufacturers of generic drugs to enter that market. But this process isn't necessarily smooth, as the Federal Trade Commission explains in a recent amicus brief in U.S. District Court.

When a brand-name firm is expecting the potential entry of a generic producer, a standard strategy for the brand-name firm is that, when its patent expires, it can start selling a generic equivalent of its own drug. The FTC finds that this strategy can cut the cut the profits for the new generic producer by 40-50%. For example, when the brand drug Paxil went off-patent, a company called Apotex was the first to be allowed to sell a generic equivalent, and the first generic company to enter gets a 180-day period of exclusivity as an encouragement to enter. Apotex was expecting sales of about $550 million in that 180 day window, but then the maker of Paxil put out its own generic version, and Apotex generates only $150-200 million in sales during that period.

This scenario creates the possibility for an anti-competitive deal: the original drug seller agrees not to produce its own generic equivalent, and the new generic producer agrees to delay entry into the market. The result is that new competition from the generic is delayed, and as the FTC explains: "Both effects are harmful to consumers, who face higher drug prices over a longer period." The FTC argues in its brief that brand-name pharma firms should not be allowed to compensate generic producers for delay in entering the market--whether that compensation takes the form of a direct payment or the form of an agreement not to start its own line of generics. The FTC also points out that such payments are fairly rare--and thus presumably not necessary in finalizing the switch from a patented product to one that can be sold in generic version.

In short, even what might seem like a simple transition--the act of a patent expiring--can be fraught with practical difficulties and ways for the incumbent firm to extract just a little more in profit. The practical world of patents is vastly more complex and ambiguous than the standard textbook tradeoff.