Pharmaceuticals is the industry sector where a strong patent system, promising substantial returns to successful innovation, is of paramount importance. A large proportion of R&D in pharmaceuticals fails to yield new approved drugs, so pharmaceutical companies must earn substantial profits on the drugs that are successful to support their continuing drug development efforts. Legal rules that ratchet down on such profits, in the name of limiting “profiteering,” are counterproductive. Whatever static short term price reductions they may achieve are swamped by the harm they create in softening incentives to invest in R&D – a result which reduces pharma innovation, harming future patients and undermining the long-term vitality of a critically important industry.

Nevertheless, legislators and antitrust theorists continue to peddle dubious “solutions” to the “problem” of “overly high-priced” branded and patented drugs, seemingly oblivious to the harm to dynamic competition and innovation that their nostrums entail. Writing in Truth on the Market, Emory University Law Professor Joanna Shepherd recently highlighted two recent troublesome examples that nicely illustrate this point.

First (see here), bills proposed in various states would require drug manufacturers to disclose detailed and sensitive information about the production and materials costs, profits, and history of pricing changes for drugs whose prices are above a certain level. As Professor Shepherd points out, technical cost data for drugs on the market fail to account for the enormous costs involved in developing the 90 percent or so of drugs that fail to make it through government clinical trials (costs which must be covered to some degree if a firm is to remain in business as part of a “risk-return tradeoff”). Furthermore, the allocation of high joint research and regulatory expenditures that may be aimed at developing a large potential portfolio of drugs (an issue at the heart of pharmaceutical development efforts) is not addressed by legislative technical cost reporting requirements. Moreover, a legislative focus on narrow technical production costs totally ignores a wide variety of other factors that are key to the setting of pharmaceutical prices, including conditions of demand, therapeutic value, substitute drugs, market size, and patent life. (I would add miscellaneous government regulatory constraints, found in Medicare and other statutes, that constrain private sector price-related decision-making.) What’s worse, this legislative approach threatens to raise the cost of pharmaceutical production, to the detriment of producers and consumers. In short, as Professor Shepherd aptly puts it:

[Such legislative proposals] will impose extensive legal and regulatory costs on businesses. The additional disclosure directly increases costs for manufacturers as they collect, prepare, and present the required data. Manufacturers will also incur significant costs as they consult with lawyers and regulators to ensure that they are meeting the disclosure requirements. These costs will ultimately be passed on to consumers in the form of higher drug prices.

Second (see here), Professor Shepherd ably critiques the new-found enthusiasm (by both private U.S. plaintiffs and the U.S. Government) for bringing antitrust suits that challenge “product hopping” – a term used to describe the process by which brand name pharmaceutical companies shift their marketing efforts from an older version of a drug to a new, substitute drug in order to stave off competition from cheaper generic drug producers. As stated by Professor Shepherd:

This business strategy is the predictable business response to the incentives created by the arduous FDA approval process, patent law, and state automatic substitution laws. It costs brand companies an average of $2.6 billion to bring a new drug to market, but only 20 percent of marketed brand drugs ever earn enough to recoup these costs. Moreover, once their patent exclusivity period is over, brand companies face the likely loss of 80-90 percent of their sales to generic versions of the drug under state substitution laws that allow or require pharmacists to automatically substitute a generic-equivalent drug when a patient presents a prescription for a brand drug. Because generics are automatically substituted for brand prescriptions, generic companies typically spend very little on advertising, instead choosing to free ride on the marketing efforts of brand companies. Rather than hand over a large chunk of their sales to generic competitors, brand companies often decide to shift their marketing efforts from an existing drug to a new drug with no generic substitutes.

Pharmaceutical product hopping often involves the introduction of new and valuable product features (for example, an extended release feature) that benefits consumers. Thus antitrust courts risk undermining incentives for improving medications if they readily allow product hopping lawsuits, premised on theories of harm to competition, to proceed. As Professor Shepherd further explains:

Product redesign is not per se anticompetitive. Retiring an older branded version of a drug does not block generics from competing; they are still able to launch and market their own products. Product redesign only makes competition tougher because generics can no longer free ride on automatic substitution laws; instead they must either engage in their own marketing efforts or redesign their product to match the brand drug’s changes. Moreover, product redesign does not affect a primary source of generics’ customers—beneficiaries that are channeled to cheaper generic drugs by drug plans and pharmacy benefit managers. . . . Product redesign should only give rise to anticompetitive claims if combined with some other wrongful conduct, or if the new product is clearly a “sham” innovation.

Unfortunately, product hopping as a theory is very much alive in the real world. In July 2015 the Second Circuit upheld an injunction requiring the continued production of an older obsolete drug in New York v. Actavis, while the Third Circuit currently is considering an appeal of a district court’s grant of summary judgment in favor of a brand name product hopper in Mylan Pharmaceuticals v. Warner Chilcott. In the event of a circuit split, the Supreme Court should intervene to clarify that the introduction of an improved drug product, in and of itself, cannot give rise to antitrust liability – even if it involves the withdrawal of an earlier version of the medication.

Regrettably, the weakening of pharmaceutical patent rights through legislative means and antitrust lawsuits is symptomatic of a broader and more general policy attack that antitrust enforcers have directed against patents in recent years (see, for example, my article here). Antitrust enforcers and legislators clearly need a few remedial lessons in the economics of innovation before their myopic meddling cripples the (up-to-now) highly successful American pharmaceutical sector and other key U.S. industries, which have stood as a testament to the value of strong patent rights. Stay tuned.