The high cost of prescription medicines and the burden it imposes on some poor households has taken center stage in the 2000 elections, at both the state and federal level. People are unhappy about medicine costs, and candidates from both parties are proposing improvements.
Many economists believe that governments should take action in economic affairs only when (a) free markets are not functioning well; and (b) one can reasonably expect that the outcome of the government action will be better than if it didn’t act. Condition (a) is frequently true—markets often fail. But just because markets fail does not mean that any government action always will result in better outcomes.
This week I will review some important economic features of prescription-drug markets, particularly ways in which the market may be failing. Next week I will evaluate the likely effects of specific proposals bandied about in the 2000 campaign.
To begin with, the pharmaceutical market is far from the economist’s ideal of perfect competition. There are hundreds of millions of buyers, but the number of sellers worldwide is small enough for the industry to be considered an oligopoly. Any major firm has some degree of market power, which may vary from country to country and from drug to drug. Such market power is seldom absolute.
If one firm raises prices unduly, other firms will offer cheaper substitutes, if they exist, or try to develop new ones. There are some barriers to entry. It takes a lot of capital to start a new drug company. But it is possible; some firms with important products today were scarcely incorporated a decade ago.
Very high profits are another sign of monopoly power. Many recent news stories have pointed to strong profits among pharmaceutical firms. But over the longer term, most studies show that these firms’ returns on equity, assets or sales are not markedly different from those in other industries.
The drug industry differs from an ideally competitive one in another way. Drugs are not a ‘homogeneous product” like No. 1 yellow corn or unleaded gasoline. Valium is not Prozac. Moreover, new drugs can be patented. In the United States, the federal government grants drug companies monopoly rights to market a new drug for 20 years. The firm can decide whether it will make more money by exclusively producing the new drug itself or by selling licenses to other firms. But for 20 years, it can capture any “monopoly rents” that the new medicine generates.
Nothing, however, guarantees that a new drug will generate a lot of cash for 20 years. A firm may spend tens or hundreds of millions of dollars developing a new drug, experience booming sales for a few years, and then see their product shot out of the water. Seldane, an allergy-relief medication, earned huge revenues, until it was discovered that it had serious side effects for some people. Seldane revenues evaporated. Previously undiscovered side effects are not the only thing that can torpedo big revenue generators.
A competitor can bring out a new, better product and kill sales of a good medicine that has been on the market only a few years. Even if Seldane had not caused side effects, Claratin would have eaten into its market share. Sometimes a firm with one good drug beats another with an equally effective alternative to market by only a few months.
The huge capital investments in research and trials necessary to bring new drugs to market are perhaps the most salient feature of the pharmaceutical industry. Research and trial administration constitute the vast bulk of a company’s cost.
The raw materials that go into most actual pills or solutions are minor by comparison. In competitive markets, the marginal cost of producing one more unit of corn or gasoline determines what producers are willing to sell it for. But if a drug company only charged the marginal cost of producing some pills, it would never amortize its huge development costs and would soon go broke.
To make things even more complicated, a company usually does not know before the fact which drug-development initiatives are going to pan out or not. The best analogy is Hollywood, where film company executives cannot predict whether a film will be a big success, such as “Dances with Wolves,” or a big bust like “Waterworld.” But they do know that they have to make enough profit on big successes to compensate for the losses on busts.
Because the marginal cost of manufacturing another pill is so far below its average cost, drug companies have unusual incentives to engage in price discrimination. That is, they can increase their revenues by charging different prices in different markets. They charge customers with high willingness to pay a higher price and those with less willingness a lower price.
© 2000 Edward Lotterman
Chanarambie Consulting, Inc.