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!).