The unintended effect of compulsory licenses

In view of the coronavirus pandemic,  many countries and NGOs have suggested the use of compulsory licensing to increase the supply of coronavirus vaccines. Although such suggestions are no doubt well-intended, it is questionable whether such an approach is the right one. In this post, I will briefly discuss the international legal framework that is already in place regarding compulsory licensing. I will subsequently address the potential pitfalls of using compulsory licensing to obtain such policy objectives.

Legal Framework

The idea of compulsory licensing of patents is not new, and many countries’ legal systems already incorporate possibilities of granting compulsory licenses. This practice is explicitly allowed for in international treaties.

Most countries (currently 177) are a party to the Paris Convention for the Protection of Industrial Property Article 5A(2) of the Paris Convention prescribes that each country has the

“right to take legislative measures provided for the grant of compulsory licenses to prevent the abuses which might result from the exercise of the exclusive rights conferred by the patent, for example, failure to work.”

In cases in which the grant of compulsory licenses would be insufficient to prevent such abuses, the Paris Convention even provides for the possibility of forfeiture of the patent (Article 5A(3) Paris Convention). The Paris Convention does provide the patent proprietor with a timeframe to work the invention (four years from the application date or three years from grant). A compulsory license is to be refused when the patentee has legitimate reasons for being inactive (Article 5A(5) Paris Convention).

Many of the parties to the Paris Convention are also members of the WTO. For WTO countries, the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS) provides more detailed rules on the use of an invention without the patentee’s authorization in Article 31 (e.g., use by the government or use on the basis of a compulsory license). For example, Article 31 prescribes that:

  • each case should be considered on its specific merits;
  • an attempt should be made to obtain authorization (except in case of national emergencies, extreme urgency, or public prior use);
  • the use should be predominantly limited to the domestic market of the WTO country that authorizes such use;
  • the patentee should receive adequate remuneration

Article 31bis TRIPS provides specific import/export-related exceptions to the requirement that the use is predominantly limited to the domestic market. This provision is aimed at addressing health problems in least-developed WTO countries. At the EU level, Article 31bis TRIPS was implemented in Regulation (EC) 816/2006 on compulsory licensing of patents relating to the manufacture of pharmaceutical products for export to countries with public health problems.

Most European countries have implemented national provisions to enable the grant of compulsory licenses. However, an overview of the EPO from 2018 shows that case law is relatively scarce and that compulsory licenses are rarely granted.

Economic analysis

As mentioned, many countries and NGOs suggest that this instrument should be used to increase the supply of coronavirus vaccines. Whether this is a sensible suggestion should also be evaluated from an economic perspective, since the existence of patents is ultimately economically motivated.

The following figure is a diagram that shows the influence of price on supply and demand as can be found in many textbooks on economics. Price (P) is on the vertical axis, while Quantity (Q) is on the horizontal axis.

When the price is low, demand (orange) is high, but supply (blue) is low. When the price goes up, demand goes down, but supply goes up.

The supply-demand diagram makes perfect sense. When the price of a product is too low, supply will dry up, as no one is willing to supply a product without making a profit, let alone at a loss. However, at low prices, there will be strong demand. When the price goes up, it becomes commercially interesting to supply the product, however, there will naturally be less demand.

Where the two lines intersect, supply and demand are in equilibrium. At this price, there is still significant demand, but it also leads to sufficient supply to actually meet that demand.
Now let’s consider the situation in which the price is not allowed to move above a specific price ceiling lower than the equilibrium point.

It immediately becomes apparent that due to this price ceiling, it is no longer possible to reach the equilibrium point. If the price could rise, supply would go up to satisfy the potential extra demand. Setting a ceiling on the price effectively results in a shortage of products on the market.

The drug market is a highly regulated market, but that does not mean basic economics no longer apply. For example, research performed on the effects of preference policies from insurers on the Dutch market suggests that such policies lead to shortages of the drugs for which they apply. This makes sense because, under such a preference policy, an insurer will only reimburse a preferred product, which is typically the cheapest generic version of a specific drug that is available on the market. Effectively, a preference policy sets a price ceiling, which in turn results in a shortage.

This example concerns generic medicines. By their nature, compulsory licenses only apply to patented drugs, but also a compulsory license effectively sets a price ceiling. After all, the royalties that the patentee receives for use of its patents under a compulsory license will be lower than the royalties the patentee would receive for the use of its patent under a voluntary license.

Royalties are essentially the price paid for the licensed use of an invention. The patented invention is the result of costly research and development. The effect of a compulsory license can therefore be illustrated with the following supply-demand diagram.

What this shows is that a compulsory license will result in a lower supply of R&D than what is required to satisfy the market demand for innovative drugs. This makes perfect sense. Under a compulsory license, the patentee will receive a lower license fee for the use of its patented invention. Any pharmaceutical company has a limited pool of resources, so it will use these resources as effectively as possible. When deciding on budgets for R&D projects, a pharmaceutical company will set a higher budget for those projects that are more likely to provide a good return on investment (ROI).

If there is a significant risk that the ROI of a specific R&D project will be diminished due to a future compulsory license, then the pharmaceutical company will set a lower budget for such a project. The logical conclusion is that an increase in the use of compulsory licenses would lead to less R&D for the development of drugs that are more likely targets in compulsory license proceedings. If compulsory licenses would be granted more frequently, this would logically reduce development efforts related to especially those drugs that are most needed during a health crisis. Any short-term gain would be negated by a long-term loss.

Conclusion

The conclusion from the above is clear. The fact that compulsory licenses are rarely granted is not a problem for society, but a blessing. It is the lack of compulsory licenses that is essential for the development of exactly those drugs that are needed most during a health crisis.

Robin van Kleeff, Hoyng Rokh Monegier

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