Patent Protection, Transnational Corporations, and Market Structure: A Simulation Study of the Indian Pharmaceutical Industry

Author:Carsten Fink

    This chapter is adapted from an article published in 2001 in the Journal of Industry, Competition, and Trade 1(1):101-21. Helpful comments by Clive Bell, Tony Venables, Jayashree Watal, and seminar participants at the World Trade Organization and World Bank are gratefully acknowledged. Any remaining errors are the author's own responsibility.

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I Introduction

The protection of patent rights is considered to be a critical precondition for private investment in pharmaceutical research and in the development of new drugs. The importance of patent protection in this industry can be attributed to the ease with which new chemical entities can be imitated in comparison with the large research and development (R&D) outlays and long product cycles associated with research-based drugs. In economic terms, new chemical entities-unless legally protected by patents-are weakly appropriable from the viewpoint of the innovating firm.

The origins of the pharmaceutical industry go back to the commercialization of the first research-based drugs, Prontosil and penicillin, in the 1930s. Since the 1960s, the development and production of pharmaceuticals has been dominated Page 228 by a limited number of transnational corporations (TNCs) from industrial countries (mostly from France, Germany, Japan, Switzerland, the United Kingdom, and the United States). Despite the escalating costs of R&D, the declining rate of new drug development, the expiry of patents on many blockbuster drugs in the late 1980s, and the squeezing of public health budgets, the composition of the global pharmaceutical industry remained largely the same up to the early 1990s (Tarabusi 1993).1 Pharmaceutical companies have extensive international production systems. U.S. pharmaceutical TNCs, for example, have, on average, 33.8 foreign affiliates per parent firm-a larger number than in any other U.S. manufacturing industry (Maskus 1998). This pattern fits well into the ownership-locationinternalization framework (OLI) of international production: TNCs are firms with significant knowledge-based assets-patents, trademarks, and marketing expertise in the case of the pharmaceutical industry-which are internationally often most profitably exploited by taking a direct investment position in a foreign country (Dunning 1979, 1981).

This chapter examines the effect of patent protection on the behavior of pharmaceutical TNCs and market structure in India, which has traditionally been a fierce opponent of stronger intellectual property rights (IPRs). The Indian Patents Act of 1970 specifically excludes patent coverage for pharmaceutical products. To meet its obligations under the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS)-one of the outcomes of the Uruguay Round (1986-94)- India will have to amend its patent laws to allow for pharmaceutical product patents by 2005. The signing of TRIPS by the Indian government has been accompanied by forceful publicity predicting that stronger patent rights will lead to soaring prices for pharmaceuticals and to a dominance of TNCs as they "wipe out" Indian firms. This study is intended to shed some light on these issues and may also serve as a reference point for other developing countries that are introducing pharmaceutical product patents in a post-TRIPS world.

The method of analysis is the calibration of a theoretical model to actual data from the Indian pharmaceutical market and a simulation exercise to answer the hypothetical question of what the market structure would be if India allowed patents for pharmaceutical products. This technique is in the same spirit as the studies by Baldwin and Krugman (1988) on the Japanese and U.S. semiconductor industries and by Dixit (1988) on the Japanese and U.S. automobile industries, studies that focus on the simulation of alternative trade policy regimes.

The model developed for the simulation analysis explicitly accounts for the complex demand structure for pharmaceutical goods that results from the presence of therapeutic substitute drugs and from drug manufacturers' practice of differentiating their products through the use of trademarks and advertising. Consumer demand is represented by a three-level utility function, whereby preferences Page 229 for different chemical entities and brands are characterized by constant-elasticityof-substitution (CES) functions. In the absence of patent protection, firms are assumed to maximize profits, taking as constant the sales of other market participants. If patents are protected, the patent holder has a monopoly for the chemical entity but still competes with producers of therapeutic substitutes.

This model is calibrated for two therapeutic groups-quinolones and synthetic hypotensives-using 1992 brand-level data for each chemical entity sold in the two therapeutic groups that would have received patent protection in Europe (referred to as on-patent chemical entities throughout this chapter), as well as brand-level data for all off-patent chemical entities in these two groups. The simulations reveal to what extent price increases, profits, and static consumer welfare losses depend on the values of the model's parameters. They provide valuable insights with regard to the role of competition among therapeutic substances. It is important to stress that the simulation exercise presented in this chapter is hypothetical, in the sense that the drugs that are analyzed will never receive patent protection in India. The introduction of patents as spelled out in TRIPS does not extend to drugs that are already on the market; that is, there is no obligation for "pipeline" protection of pharmaceutical products.

The chapter is organized as follows. The next section describes the development of India's pharmaceutical industry and outlines the industry's main features. Accounting for these features, the following section develops a partial equilibrium model of the Indian pharmaceutical market by specifying the demand and supply behavior of consumers and producers of drugs. The brand-level data used for the empirical investigation is then described, followed by an explanation of how the partial equilibrium model is calibrated to these data. Then the simulation procedure is illustrated and the simulation results are discussed. Finally, the paper's main findings are summarized and put into perspective.

II Industry Structure

One of the stated objectives of the Indian Patents Act of 1970 was the development of an independent Indian pharmaceutical industry. The abolition of pharmaceutical product patent protection from the inherited British colonial law was seen as the key element in advancing this objective. If we look at the pure numbers, the Indian Patents Act was a success. The number of supplying firms increased from 2,237 licensed drug manufacturers in 1969-70 to an estimated 16,000 producers in 1992-93 (OPPI 1994a). The production of drug formulations grew at an average annual rate of 14.4 percent between 1980-81 and 1992-93; the negative balance of trade in bulk drugs and drug formulation that prevailed throughout the 1970s and 1980s turned into a trade surplus by 1990.2

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The period 1970-93 also saw a declining market share of TNCs in India. In 1970, Indian-owned firms held only 10 to 20 percent of the total pharmaceutical market, TNCs accounted for the remaining 80 to 90 percent. By 1980, Indian firms and TNCs had equal shares of about 50 percent; by 1993, Indian firms had raised their share to 61 percent.3 Redwood (1994) argues that the relative decline of TNCs in the Indian pharmaceutical market has been against the international trend: most other countries have seen the relative share of TNCs rise at the expense of locally owned firms.4

It is, of course, difficult to attribute the falling market share of TNCs directly to the abolition of product patent protection through the Indian Patents Act. Other factors may also have contributed to this trend. Investment and ownership restrictions under the Foreign Exchange Regulation Act may have discouraged many TNCs from investing in India. Severe price controls on segments of the pharmaceutical markets may have reduced the prospects of profitability. Moreover, it is possible that low Indian prices could have leaked to other markets, either in the form of parallel imports or through price controls in foreign markets tied to reference indices of prices in other markets (such as India). These factors may have caused some TNCs to shun the Indian market. However, given the critical role of product patent protection for the development of research-based pharmaceuticals, it seems reasonable to attribute the relative decline of TNCs at least in part to the Indian Patents Act.

This proposition is supported by the fact that the imitation and production of drugs protected by patents in other countries has indeed been a widespread activity among Indian-owned firms. Redwood (1994) estimates that 20 percent of the brands marketed by the 15 leading Indian firms in 1993 were based on chemical entities that were covered by pharmaceutical product patents in Europe, and a further 37 percent were based on chemical entities for which the patent had expired somewhere between 1972 and 1993. It is worth noting that Indian firms required no formal technical assistance from abroad to produce foreign patented drugs. The published patent titles have provided sufficient information to imitate the newly developed chemical entities. This ability has been attributed to a well-developed chemical infrastructure and the process skills of the local Indian pharmaceutical industry.

Copied brands of drugs patented in foreign countries have typically been introduced in the Indian market soon...

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