The Patent System Is Seriously Screwed Up: Here’s the Solution

The patent system results in prices that are too high and innovation that is too low. But there is another way endorsed by a Nobel prize-winning economist

I’ve previously written about the existence of low-hanging fruit when it comes to many areas of life. Most people do lots of things relatively poorly, including in domains in which there are well-understood ways to succeed, and so there are lots of domains in which it’s easy to do better than 99.9% of people. But I intentionally didn’t include politics as an example of one of those domains—and this is for a simple reason: politics is very complicated. But despite this, there are still some areas that provide genuinely low-hanging fruit—some policies where the answer is obvious.

That no one has picked the low-hanging fruit sometimes arises from the fact that voters are apathetic. For example, the wrongness of arms sales to Saudi Arabia is a pretty easy issue—but only because our policy is utterly barbaric as a result of U.S. voters and politicians caring very little about the lives of people overseas. But some issues are low-hanging fruit just because no one cares that much about them, so people don’t optimize the search space.

The patent system allows the creators of a product to maintain a monopoly on it for 20 years—though this includes the time it takes to get approval, so it’s usually shorter than that. The rationale is fairly straightforward: if people can get a monopoly on some product, then it’s more profitable to invent the product. Thus, innovation becomes more valuable, and innovation is good! It’s why we have toilets, running water, and the movie Sharknado. Innovation is the cause of improving quality of life over time, and so it’s basically the most important thing to promote. As Robin Hanson says “We owe pretty much everything that we are and have to innovation.”

What we want out of a system like the patent system is two-fold: First, we want efficiently priced products, second, we want to adequately incentivize innovation. Unfortunately, the patent system does both poorly.

First, it limits innovation. Ideally, we want the profits that one gets from innovating to be equal to the societal benefits of the innovation, so that people will innovate only if the benefits outweigh the costs. But the current system results in innovators being paid much less than this. If one is only paid an amount equal to the monopolistic profits of the first 15 or so years of their product, then they will not be paid equal to the value of the product they produced. Life-saving drugs produce millions of dollars in consumer surplus, meaning that the benefits consumers get from the product minus the price is often worth millions of dollars, but only a small fraction of that can be captured in profits. This is especially true because patents expire so quickly—so there’s no incentive to innovate to solve problems that will be far in the future. This has resulted in much too little funding for solutions to antibiotic-resistant microbes, which have killed millions, and will kill 10 million a year by 2050 according to the world health organization. New antibiotics are stagnating because they are not sufficiently profitable, and by the time they are, the patent will have expired. If there are two drugs, one of which will be obsolete in 20 years, the other of which will save a billion lives in 21 years, right now pharmaceutical companies have equal incentives to invest equally in those two drugs, because they’d both produce the same profits over 20 years. This is clearly a deeply misaligned system that totally neglects consumer surplus.

Nobel prize winner Michael Kremer also notes that patents do not reward researchers for creating products that are useful to future researchers. One innovation might inspire dozens of other innovations, but the innovator would not be rewarded for that. The computer, for example, has been used by other researchers, and so only a small portion of the benefit came from the direct research. This is particularly significant because, as Kremer claims, summarizing an extensive empirical literature, social rates of return to R&D average close to 50 percent.

Kremer also notes that patents create incentives for people to make new products that are similar to old products because the new products can still make a profit. So, if there is already a drug that cures lung cancer, there’s still an incentive to make a new one that is just as effective, instead of another drug for a problem that there is not a solution to, because one can capture 50% of the market share. This is especially significant when about 80% of new drugs are mostly just tweaks of previous drugs.

The second thing we want out of a patent system is efficiently priced products, and the current patent system fails to provide those too. Those possessing a cursory familiarity with economic theory will understand that monopolies are inefficient because they sell things above the competitive price, generating deadweight loss. Deadweight loss occurs when an interaction that could have benefitted all parties fails to occur because of some feature of a system. Suppose that some product costs 10 dollars to produce (taking into account labor costs) and would produce 15 dollars worth of benefits for someone. Ideally, we’d like for them to gain access to that product—it would, after all, produce more benefit to them than it would cost. But it’s very likely that monopolists would charge more than that, because they don’t face competition, meaning that they would not get the product, even when their getting it would be optimal. Michael Kremer notes

Static distortions arise as people who value the good above the marginal cost of production do not consume it at the monopoly price. To take a particularly dramatic example, monopoly pricing of AZT makes it impossible for HIV-positive pregnant women in developing countries to prevent transmission to their children, leading to hundreds of thousands, if not millions, of cases of pediatric AIDS. To see that financing research with monopoly profits not only is not first best, but is generically less efficient than financing research through tax revenue, consider the problem of a social planner choosing a tax to finance research. The principles of Ramsey taxation should clearly guide the planner’s decision, and it is highly unlikely that the optimal tax will be a several thousand percent tax on the patented good. Yet financing research by giving monopoly rights to inventors is equivalent to such a tax.

So the patent system is out. It is the mehest of both worlds—it charges way above the optimal price and results in profits way below the optimal level. Fortunately, there is a solution, and the solution is patent buyouts.

The way patent buyouts would work is that when someone creates a new invention, the person would not get access to the patent. Instead, people would bid on the patent. The patent would be sold to the highest bidder in 20% of cases, with the money spent on bidding being given to the inventor. However, in 80% of cases, instead the government would buy the patent from the inventor for perhaps 300% of the top price (or perhaps third or fourth price, for a reason we’ll come to later) and then destroy it. Thus, because the bidders would figure out the market price, inventors would, in 20% of cases, get an amount of money equal to the value of their inventions, and in 80% of cases, get much more than that. In 80% of cases, because the patent would be destroyed, it would always be sold at market price, and in the other 20% of cases, it would work basically the way patents do now. Gulati gives an illustration of how the process would work

This means that the patent system would both give more profits to innovators and charge consumers less, resulting in less deadweight loss. It would thus be the best of both worlds—producers would get much greater incentives to innovate, getting, in 80% of cases many times more profits than they currently do, and in 80% of cases, all deadweight loss would be eliminated.

One might worry about corruption—inventors could collude with bidders to charge high prices. This would allow them to get exorbitant amounts of money from the government for minimal innovations. However, the system could be designed so that the patent is sold to the highest bidder, but the government markup applies to the amount charged by the fourth-highest bidder. Thus, the inventor would need to collude with four other significant companies, who would do the bidding. This would require an impressive level of corruption especially given anti-trust laws, and while it might still be a risk, is still an improvement on our current patent system.

The patent system has been around for a long time. But there’s no reason to keep it around if it’s not working. And when the patent buyout system is demonstrably better, it’s about time we replaced it.