Reverse Settlements, Part 4: What Is the Baseline?

In my final post on reverse settlements I want to offer three thoughts that are more directly related to the legal question of how to treat reverse settlements under antitrust law.

First, it strikes me as odd that we scrutinize reverse settlements of Paragraph IV challenges differently than settlements of patent suits of non-drug, even non-health products.  As Einer acknowledges in his Texas Law Review piece, nearly all patent litigation affects market structure and thus both the level of competition and the amount of consumer welfare (Elhauge and Krueger 2012).  In each of those cases, because the public is not party to the litigation, settlements between patent holders and alleged infringers will – in theory and perhaps in practice – tend to hurt consumers.  (The monopoly-duopoly wedge that gives rise to the problem of reverse settlements is by no means unique to the drug market.)  Yet my patent law colleagues tell me there is no systematic review of non-drug patent settlements as is being urged of drug settlements in the FTC v. Watson case.  It seems that under the FTC view, drug patents would be treated more harshly than other patents. I am not sure why that should be the case under antitrust law.

Second, the critical question in the antitrust litigation is the baseline against which reverse settlements are judged.  Reverse settlements are only problematic under antitrust law if they extend patent duration or scope beyond some baseline.  Should that baseline be expected duration with full litigation and no settlement – as critics of reverse settlements urge – or something else?  For expected litigation to be the baseline, one has to assume that Hatch-Waxman modifies patent law and that patent duration after litigation is what is now required.  I am not sure these assumptions are appropriate.

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Reverse Settlements, Part 3: Value of a Drug Patent

In this third post on reverse settlements, I examine whether traditional legal standards for judging whether a drug patent is valid captures the social value from a drug patent.  This is important because the FTC takes the position that reverse settlements extend the expected life of a drug company’s patent as compared to litigation over patent validity under traditional legal standards for judging patent validity.  I conclude that those standards may seriously undervalue the social benefit of drug patents, even invalid ones.  First, patent validity standards do not appreciate that all drug patents – valid or not – are necessary to compensate drug companies for conducting clinical trials, which are half the cost of all R&D and are socially valuable even if the drug patent is not valid.  Second, profits from a drug patent – even if the patent is invalid – sustains research on a large number of other drug patents – which may be valid.  That cross-subsidization suggests a branded drug company ought be judged on their portfolio of patents, not on individual patents. Traditional patent validity standards fail to do that.

To be clear, I understand that patent law standards for validity are not perfect, and I do not expect them to be.  What I suggest is that there is a worse fit between patent validity standards in the pharmaceutical industry than in other industries. This is relevant for antitrust analysis because, if patent validity standards undervalue drug patents, then eliminating reverse settlements undervalues them even further since these settlements putatively extend the expected patent life of drug patents.

Let me begin with my first substantive claim: all drug patents, whether valid or not, are socially useful.  All drug patents encourage production of useful public goods, specifically information about whether a drug works.  The main reason is that, unlike patents for other products, a patent for a drug is obtained before research on the drug is completed.  Specifically, drug companies obtain patents on molecules after lab and animal testing, but before clinical test, i.e., testing on humans.[1] Yet human testing is roughly half the cost of all drug R&D (DiMasi, Hansen, & Grabowski, 2003). Moreover, the results from clinical trials, which are made public as part of the drug approval process, are a public good.  Once a drug is shown to be effective, everyone knows whether the molecule is medically valuable.  If a company did not have a patent that could prevent other companies from producing that molecule, it would never conduct the trial in the first place!

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Reverse settlements, part 2: drug company profits

In my second post, I want  continue my discussion of reverse settlements.  Recall that the basic argument against reverse settlements is that they extend the duration of a pioneer drug company’s patent beyond what it might expected to be if there were no settlement.  (Elhauge and Krueger (Texas Law Review, 2012) have a nice description of the settlement process that yields this result.  For now I will take it as given.)  In my first post I questioned whether drug patents reduce total welfare.  In this post I question whether extending drug patents raise producer welfare at the expense of consumer welfare.  I will argue that the profits pioneer drug companies make under patents overstate producer surplus.  Producer surplus depends on not competition in the drug market but rather on how competitive the market for research and development for the drug was.  But we have little evidence on how competitive that market is.  It is possible that that market is perfectly competitive, in which case, in expectation, drug companies are making no supra-competitive profits.  No such profits would mean no excessive producer surplus, and no antitrust concern, even with its consumer surplus focus.

At the risk of being repetitive (and thereby pedantic), let me restate the conventional tradeoff when setting patent duration, but from the perspective of producer versus consumer surplus as conventional antitrust analysis sees it.  An innovator – in drugs or another product – gets a patent if they come up with a valuable innovation.  This patent allows the innovator to charge a high (monopoly) price and thereby earn supra-competitive profits.  These profits are treated as producer surplus (though I will question that).  The high producer surplus comes at the cost of low consumer surplus.  This is partly because surplus is a zero sum game: total surplus is either consumer surplus or producer surplus.  This partly because the high prices that generate high producer surplus reduce total surplus by pricing consumers out of the market (ignoring my first post on reverse settlements).  When a patent ends, competition starts and the market price of the previously patented drug falls.  This increases consumer surplus, at the expense of producer surplus.  If total sales also rise, total surplus also rises, which also favors consumers.  Thus the duration of a patent determines how long producers enjoy high producer surplus and when high consumer begins.

Given this background, it is possible to see why antitrust law cares about the duration of patents.  Antitrust law and antitrust authorities – for distributional reasons it appears to me – favor consumer surplus over producer surplus; I will take this preference as given.  The more quickly a patent ends, the sooner consumers start earning higher surplus.  For this reason, antitrust law is opposed to reverse settlements if they increase the expected duration of patents.

The problem with this logic is that the producer surplus created by patents is not fully producer surplus.  The purpose of this producer surplus is to encourage innovation.  In the absence of innovation, consumers would be worse off because they would not have the innovation required to generate high consumer surplus once patents expire.  Thus, antitrust law should not judge producer surplus in the patent setting the same as it is in the non-patent setting.  It should not be judged against a baseline of zero-producer surplus.  Instead, it should be judged against a baseline of innovation with shorter patents.  If patent duration is shortened, consumers will obtain less innovation and less consumer surplus.  That reduced consumer surplus should be subtracted from producer surplus observed due to patents and credited as consumer surplus.  (If this were not the case, antitrust law would want to eliminate all patents!).

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A different perspective on reverse settlements

Before I begin my initial post, I want to thank Holly for inviting me to post on this blog.

I want to take up reverse settlements in litigation over pharmaceutical patents.  Circuits are divided on how to treat these settlements under antitrust law (Elhauge & Krueger, Texas L. Rev., 91:283, 285, 2012).  The Supreme Court has decided to take this the topic up this term; it will hear oral arguments in Federal Trade Commission v. Watson Pharmaceuticals on March 25, 2013.  However, this is a topic about which I believe the legal literature has lagged substantially behind the health economics literature.  As a result, I think the conventional (legal) views of such settlements get the economics of pharmaceutical patents and innovation wrong.  (That does not mean they are getting the law wrong. Although the law in this area is highly unsettled, the goal of the law may not coincide with economic prudence.  I am commenting primarily about economic prudence.)

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Introducing Anup Malani

We’re pleased to introduce and welcome Professor Anup Malani, who will be guest blogging with Bill of Health for the month of January.  Anup is the Lee and Brena Freeman Professor of Law at the University of Chicago. He is also a Professor at the University of Chicago Pritzker School of Medicine, a University Fellow at Resources for the Future, Washington, D.C.; a Faculty Research Fellow at the National Bureau of Economic Research; and an editor of the Journal of Law and Economics and the Forum for Health Economics and Policy.

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