Drug Company Profits

Everyone hates them--even a free-market think tank

Gregg Girvan writes,

In our new analysis, we find that the savings to the public from constant unit drug prices would have been substantial: $139.2 billion from 2012–2021, or 36.7 percent of U.S. sales on the drugs sampled. We estimated that such a price freeze would have reduced R&D spending by $25 billion over the same timeframe. But that reduction in R&D spending, we estimate, would have had a minimal impact on the development of innovative new medicines. Under the counterfactual scenario, the number of drugs approved by the U.S. Food & Drug Administration would have only declined by one percent.

As I understand it, the “analysis” says, “Look at all the money the big pharma companies spent on R&D without producing many new drugs. If we took away their profits by imposing price controls, we could give that money to smaller companies and get more new drugs.” This does not strike me as the right way to think about profits and research.

I don’t think of drug profits as being “used” to develop new drugs. High profits on drugs function as a signal to develop more drugs that will be profitable. The question is whether the signaling mechanism works well or is broken.

Suppose that company A earns a lot of profits on its past drugs, sending a signal that drug research pays. The successful drug research that this incentive creates could just as easily be undertaken by company B as by company A. The effect of price controls on company A is simply to reduce the incentive of both company A and company B to pursue further research. If company B is more efficient at research than company A, then sooner or later the market will figure this out and give more resources to company B.

If you asked me to improve productivity in pharma research, I would focus on the incentive system, not on trying to pick winners and losers. I would try to shift away from using patents as an incentive and instead go in the direction of using prizes as an incentive. Patents provide too much incentive to game the system by trying to maximize the value of the patent relative to the actual innovation involved. With a patent, your incentive is to get more people to pay more money for the drug. Under a patent system, developing a drug that is only slightly better than an existing drug for treating a mild ailment may be more profitable than a drug that would treat an otherwise incurable severe ailment.

With a prize system, prize money would come from private foundations, such as the American Cancer Society, as well as government. It would be easier to calibrate the reward to the amount by which the drug improves treatment relative to existing treatments. Prize money would have to be allocated both to the people or companies who come up with the treatment and those who take it through the testing process.

Pharmaceuticals are an extreme case of a business with high fixed costs and low marginal costs. The fixed cost of finding and testing a new drug are high. The marginal cost of producing a dose is often low. Under our current system, the fixed costs are recovered by awarding the company a monopoly patent that allows it to charge prices far above marginal cost. Under a prize system, the fixed costs would be covered by awarding the prize, and no monopoly would be granted for producing the drug. With no monopoly patent, the price for a dose would be driven by competition closer to marginal cost.

Under the patent system, it is tempting for government to take back some of the monopoly rent by imposing price controls. That is not the best approach. It is disappointing to see a think tank that supposedly is market oriented advocate for what I see as inferior policy using what looks to me like shoddy economic “analysis.”