San José State University
Department of Economics
Thayer Watkins
Silicon Valley
& Tornado Alley

The Prices of Pharmaceuticals and their
Relation to Costs, Risks, Patent Policy

The subject of pharmaceutical prices is fraught with some very emotional issues. Pharmaceutical companies have developed some effective drugs for various maladies. Some of the buyers of those drugs have the notion that it is unfair for their prices to be anything above the costs of production. Other more enlightedned buyers feel the companies should be able to recover their research costs as well as their production costs but not any advertising expenditures. Even more enlightened buyers recognize that the pharmaceutical companies need a risk premium on their profit rate to compensate for the great risk that a large research investment may yield nothing. None of these perceptions corresponds to the system that actually exists.

Pharmaceutical companies undertake research with the objective of receiving a patent on their products. During the patent period of 17 years the companies have a monopoly and can charge whatever price they choose. The price that maximizes profit for a monpolist is determined by the value of the product to consumers and the cost of production. The price chosen by the monopolist is to only a limited degree affected by costs, either production or research. There are no reasons to expect the price of a product provided by a protected monopolist will be driven down to the level of costs. Prices are driven down to costs only by competition, actual or potential. During the patent period the company has a protected monopoly and hence does not face competition.

The more profitable the drugs are during the patent period the more incentives have for investing in risky research to find new effective drugs. The policy question is then how long should the patent period be for the good of the public. Is 17 years too long, or is it perhaps too short? The more incentives there are for research the sooner will be found effective remedies for ailments.

In the case of some ailments there may be different pharmaceuticals that are effective. For these if different companies secure patents for these different pharmaceuticals there would be oligopolistic competition which would bring down the prices to a degree. But for some ailments there may not be alternative medication. As a matter of public policy the same pharmaceutical company should not be granted or allowed to purchase patents on alternative medications for the same ailment. This notion is of course easier to say than to implement.

Advertising Costs

For the special case when demand function is linear and marginal costs are constant, it can be shown that an increase in customers without an increase in the perception of the consumers of the value of the product to them will increase the company's profit but not increase price. Advertising increases price only to the extent that it increases the perception of value of the medication on the part of the of the patients or their doctors.

Price Discrimination

If a company has a monopoly on a certain product it may be in the interest of the patent holder to charge different prices in different markets. That would include charging different prices in different countries. It may be in the interest to charge different countries; this is just the effect of having a monopoly. Generally the profit-maximizing price will be lower in countries with lower incomes.

Price Controls in Other Countries

Most of the new pharmaceuticals are developed because of their developers' access to the lucrative U.S. market. Companies can accept price controls in Canada if they have access to the U.S. market. If the U.S. takes away the unrestricted profit opportunities very likely there will be few or no new drugs developed. Consider how many effective new drugs came out of the socialist world of the 20th century.

Pharmaceutical companies characterize price controls in Canada as free riding. These price controls are free riding only in a special sense. They do not result in higher prices in the U.S. because those prices are not cost-driven. The Canadian price controls are only free-riding in that they reduce the bonanaza that pharmaceutical companies are pursuing to get the patent, and hence reduce the the resources pharmaceutical companies are willing to devote to the research and thus could slow the development of new remedies to the world's ailments.

(To be continued.)

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