ECONOMISTS HAVE LONG APPRECIATED the importance of research and development (R&D) for economic progress. Accordingly, researchers have scrutinized the effects and desirability of stimulating various forms of research and innovative activity through such public interventions as direct R&D tax-incentives, non-profit tax exemptions for research institutions, public financing of R&D activity, and intellectual property regulations (i.e., patent, copyright, and trademark policy).
A substantial body of theoretical work has examined how much innovation intellectual property regulations induce. The analyses have generally assessed the impact of those regulations through their effect on protecting innovative returns from potential imitators who attempt to produce the same product as the innovator.
However, the loss of innovative returns because of "within-patent" competition from imitators through patent expiration is only one way in which innovative returns may be reduced by competition. The other way is through "between-patent" competition from new patents being developed by competitors. A patent only protects an innovator from others producing the same product; it does not provide protection from others producing better products under new patents. For example, in the pharmaceutical industry, within-patent competition after patent expiration stems from so-called generic manufacturers, and between-patent competition through new patents arises from so-called "brand-name" manufacturers engaging in therapeutic competition within disease and drug classes.
Between-patent competition may be as important a limit on innovative returns as within-patent competition, particularly in high-tech fields such as the telecommunications, biotechnology, and pharmaceutical industries. In those industries, which in turn contribute greatly to technological progress and growth, the demand for a given innovation is often destroyed by entry of new, superior products long before the first product's patent expires. In addition, within-patent competition occurs many years in the future and is thus less important for the present value of innovative returns. Therefore, extensive "creative destruction" through between-patent competition leaves less to be subsequently destroyed by "uncreative" within-patent competition.
Public sector stimulation The existence of creative and uncreative competition limits the ability of the public sector to stimulate R&D. Because future innovation limits the rewards to current innovation, intellectual property policies whose purpose is to stimulate R&D may have offsetting effects on innovation. Policies that stimulate R&D not only increase the current incentive to innovate, but also the incentives of producers engaging in between-patent competition. For example, an increase in an R&D tax break would make research cheaper for the innovator, but also imply that the innovator will only be able to enjoy his market advantage for a shorter duration before new patents eliminate it. Existing analyses ignore the effect of betweenpatent competition and thus give misleading implications about the effects and desirability of intellectual property regulations. in fact, because policies that reduce within-patent competition may be offset by between-patent competition, the public sector may not be able to fine-tune R&D.
Given the importance of both within-and between-patent competition, our study attempts to estimate their relative impacts on innovative returns for one of the most R&D intensive industries in the nation--pharmaceuticals. In 1997, R&D intensity (R&D expenditure as a percentage of net sales in R&D performing companies) was three times as high in the "drugs and medicines" industry as it was in the economy as a whole (10.5 percent vs. 3.4 percent). Although the pharmaceutical industry is often mentioned as one in which patents have …