November 16, 2018

When people think of monopolies, they usually think of something like Google with its 90% market share in search, Microsoft with its 90% share in operating systems, or Comcast with its dominance of US cable. But monopolies in markets often come from patents and intellectual property – and in the case of pharmaceuticals, they often cover an individual drug.

Patents give drug makers a period of time with no competition where they can be rewarded for their innovations, encouraging drug companies to invest in costly research and development that might take years to pay off. The logic behind patents is sound, and drug companies devote billions of dollars to find extraordinary cures that extend our lives.

But intellectual property, once an unremarkable area of law, has exploded since the 1980s. From 1900 to 1982, the number of patents increased by around 138%. After 1982, the number of patents extended increased by an astounding 416% by 2014. Not only did the number of patents explode, the areas they cover has expanded in ways the Founding Fathers never intended.

Over the past few decades, copyright protection has been extended to unpublished works, the requirement to register one’s copyright has been dropped, and copyright terms have grown from 28 years to the life of the author plus 70 years. This is the dark side of patents, when they are often used as a tool to gouge customers. In the case of drug companies, patents allow them to rip off patients. The longer the drug lacks competition, the longer companies can charge extortionate prices.

The cost to society is immense. The United States spends over $3 trillion annually on health care, and 10% is spent on drugs. The average American spends more than $1,000 a year on prescription medications, 40% more than the next highest country, Canada, and double what Germany spends.

The broadest study done on the reasons for the increase in costs appeared in the Journal of the American Medical Association: “The most important factor that allows manufacturers to set high drug prices is market exclusivity, protected by monopoly rights awarded upon Food and Drug Administration (FDA) approval and by patents.” Generic drugs are the main reason why drug prices have fallen, but access to them is generally delayed by numerous business and legal strategies.

When patents are about to expire, for example, the pharmaceutical industry seeks endless extensions through ‘reformulation’ of their drugs or minor modifications to the methods of delivery. Reformulation involves changing the drug just enough to obtain additional patent protection, while keeping enough characteristics the same, so that previous clinical testing results can be relied on to obtain FDA approval. There is no new innovation, no new discoveries or any greater benefit to patients, yet companies can continue to charge high prices.

For example, the Orphan Drug Act of 1983 regulated the approval of drugs for rare diseases and gave a drug companies even greater exclusivity. In theory, this would encourage drug companies to find cures for diseases that might not have a big market. The problem is that Orphan Drugs are not in fact rare. They make up 20% of all global prescription drug sales. Incredibly, 44% of new drugs approved in 2014 had orphan status, and due to pricing they are almost all the most expensive drugs. Now pharmaceutical companies are taking advantage of these incentives to gouge patients, insurers and the government.

Even once patents expire, regulations and bureaucracy provide another even greater barrier to entry for challengers who might want to bring new medicines to market. All new drugs are approved by the FDA to make sure that they work and are not harmful. This is an essential job. Generic drugs, though, are not new or unknown. They are identical to a brand name drug that is off patent in dosage form, safety, strength, route of administration, quality, performance characteristics and intended use. Yet the current FDA approval process for generics is extremely onerous.

Drug makers can charge what the market will bear because the magic of competition is missing. On average, a generic takes between three and four years to be approved. Given how long this process takes, it is no surprise the FDA’s backlog of generic drugs stands at an all-time high. In 2014, nearly 1,600 applications for generic drugs were submitted to the FDA. By the end of the year, not a single drug was approved due to a backlog of over 4,700 generics from previous years. Fast-forward to July of 2016, and 4,036 generic drugs awaited FDA approval, yet very few were even processed.

The bipartisan Creating and Restoring Equal Access to Equivalent Samples Act (CREATES), which has been submitted to Congress, should remove roadblocks to the approval of lower-cost generic drugs. However, lobbying – the industry spends millions of dollars a year – means it has almost no chance of passing and has failed every time it has been introduced.

The ugly truth about regulation is that while big businesses often complain about regulation, they tend to benefit from it. Regulations that are burdensome enough kill small companies but not enough to kill large ones are, in fact, ideal. To big companies, startups are like a horrible cancer attacking them, and they are willing to put up with anything painful that will kill them.

You can compare its effect with cancer treatment. Chemotherapy has the capacity to kill nearly every cell—tumor or normal. The most common way it does so is to damage DNA, the genetic blueprint of the cell. The damaged cells do not die right away—only when they try to replicate with the damaged DNA do the cells die. Sometimes replicating with damaged DNA triggers cell suicide, called apoptosis.

Normal tissues can repair damage because they have the resources and DNA blueprint to repair damage, even if it means slowing growth. Cancers, on the other hand, grow at the expense of any DNA repair. When they try to grow with damaged DNA, they then undergo cell death, through apoptosis or necrosis. Hence, the basis of selectivity of chemotherapy.

Bigger companies favour regulation because, like the normal tissues, they can divert energy to repair and maintenance (lawyers, compliance officers, lobbyists, etc). Big companies are not in the exponential phases of growth like many startups are. (Interestingly, most toxicity in normal tissues come from tissues that grow rapidly: intestines, skin, hair, bone marrow.) These smaller companies need to grow and do not have the budgets to hire an army of lawyers and compliance officers. These fixed costs are a bigger drag on the profitability of small firms than large firms. Hence excessive regulation selectively kills off the small startups attacking big corporations. It is a formidable barrier to entry for any industry.

Today, small businesses are feeling the scorching heat from the chemotherapy of regulation. US companies in 2016 were subject to 104.6 million words of regulation. (The King James Bible comes in around 783,137 words.)

Researchers have found that a 10% increase in the regulatory restrictions on a particular industry is associated with a decrease of about 0.5 % of the total number of small firms within that industry, with large firms mostly unaffected. The correlation between regulation and higher profits holds across countries. The economist Fabio Schiantarelli looked at OECD countries, and found that high barriers to entry contributed to higher markups. It also explains the loss of dynamism in the economy with fewer startups.This is exactly what has been happening in the US, as industries have concentrated.

If you doubt that regulations can effectively kill any new entrants, consider what has happened to the banking industry. The extensive new regulations introduced with the Dodd-Frank Act have created a protected class of financial firms, with only seven new banks formed between 2009 and 2013. Jamie Dimon, the CEO of JP Morgan has said that Dodd-Frank creates a “moat” around the big banks, while doing nothing to break up America’s largest banks or end the status of banks that are too big to fail. Instead, it has simply kept lawyers, accountants, and consultants busy while choking off competition.

For big businesses across many industires, it’s exactly as one Goldman Sachs lobbyist told Politico in 2010: “We are not against regulation. We’re for regulation. We partner with regulators.”

This is the third of three extracts from “The Myth of Capitalism: Monopolies and the Death of Competition” a new book co-authored by Jonathan Tepper and Denise Hearn.