The Connection Between Drug Prices and Development Costs, Not What It Appears

In a nice TCS article, Economic Illiteracy Quadrifecta, Arnold Kling analyses the level and state of John Kerry's economic rhetoric. In doing so, Arnold inadvertently propagates an economic fallacy relating drug prices and development costs.

...The basic economics of drug prices is that drugs are expensive because of the high cost of developing and testing them, including the need to write off the expense of the many efforts that fail to yield a marketable medication...

While there is an element of truth to this, it appears in the form of a statistical correlation, and is the result of overall market forces, and is not the simple causal factor that it would appear to be.

The development of a drug is, at its most fundamental level, an investment decision. A for-profit-company must project its estimates of future costs and revenues of all types, and compare the expected net total return on investment with its next best investment alternative, adjusting for risk. Only in the case where the drug development is expected to produce final results which are superior to any alternative, is the development pursued.

While a part of the evaluation above would have included an estimate of what price could be charged in the future for the drug, after development the choice of a price or prices is now independent of what the historical estimate was. In the present, a particular choice of price will either maximize the profit or minimize the loss. This particular price is dependent on the price/demand schedule currently faced by the company, and its marginal production cost, but it is independent of any development costs which have already been expended, and are now sunk costs.

Thus the price that a rational profit-seeking company charges for a drug A does not depend on its historical sunk development costs. The company's overall accounting profit or loss will change in accordance with the historical development cost, but the present choice of a price will be the same no matter whether it is minimizing a net loss or maximizing a net profit.

What the development costs do control is the future supply of specific drugs and drug companies. Any drug that does not appear to be able to yield a satisfactory risk-adjusted future return will not be developed and companies which have no drugs that prospectively will be successful disappear into liquidation or possibly merger.

Although the development costs of drug A do not affect its own price, the development costs of drug B can affect the price of drug A. If the development costs of drug B are sufficiently low, in relation to projected revenues, drug B will be produced and brought to market. No matter whether drug B is a substitute for drug A, or simply a competitive alternative choice for the allocation of scarce funds available for purchases of all types, the mere existence of drug B on the market will reduce the optimum price that the company that makes drug A can charge.

Thus, increasing the development costs of drug B will at some threshold point prevent it from ever being produced and result in a higher market price for drug A.

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Patri, I took digamma's

Patri,

I took digamma's comment to be about IP rights to drugs a company develops. It seems to me you can have an operating market whether IP rights are enforced or not, but I'd expect it to be more difficult to recover development costs if other companies can produce the drugs you develop as easily as you can, thus I'd expect less drug development in the absence of enforced IP.

Drug pricing is such a

Drug pricing is such a difficult issue. The way I see it, if the government is going to grant you a temporary or permanent monopoly on making a drug, then there is no real equilibrium price - we have left the free market entirely.

Yep, excellent analysis.

Yep, excellent analysis. The current price of a drug is set by marginal cost and demand, not by past research costs. But they do affect the drug companies projection of future returns. In a regulatory environment where marginal production profits are less, drug companies will research fewer drugs.

digamma, the existance of an

digamma, the existance of an equilibrium is not contingent upon the free-ness of the market. A profit-maximizing price exists, and we will expect the drug firm to endeavor to find it. The specific rules of the game don't change this fundamental tendency.

For some reason I thought

For some reason I thought you were responding to digamma, but I see you were responding to the original piece.

Did John T. Kennedy just say

Did John T. Kennedy just say that? Nah, this must be the twilight zone.

"Thus the price that a

"Thus the price that a rational profit-seeking company charges for a drug A does not depend on its historical sunk development costs."

While this is true it is not relevant for analyzing the market as a whole. The cost of developing a drug does play a role in how other market players decide to try and enter the market. If the cost to make a competitive drug was very low, then others would readly enter the market and prices would drop.

"he basic economics of drug prices is that drugs are expensive because of the high cost of developing and testing them"

Arnold claim is not about an individual drug with no competition, but about economy wide forces.

Rob, Development decisions

Rob,

Development decisions and current pricing both must take the presence or absence of competition into account. The analysis is valid for both conditions.

The actual fundamental condition for high drug prices is the value they present to purchasers. Since drugs may well substitute for expensive surgery or long hospital stays, or intolerable living conditions, or be essential for life itself, it is hardly surprising that they may sometimes command high prices.

Regards, Don

Don, Perhaps I am

Don,

Perhaps I am misunderstanding your claim. Do you disagree with the idea that if the cost to enter the drug market was substantially lower than it is today, that drug prices would likewise go down?

Water and Food are both necessary and quite valuable, but they are also easy to produce and therefor cheap. If the drug market was as easy to enter as the food market, I argue it would see similar price levels.

Given that drugs are expensive to produce, I have no problem with them also being expensive to buy. I don't dispute the value they can bring. But I don't think that the value they bring is any more fundamental than expense to produce. At least for me supply and demand are on equal ground :)

Cheers,

Rob Sperry

Rob, Just to be sure, you

Rob,

Just to be sure, you have to consider both development cost and marginal production cost.

A sole supplier of a specific drug, whether through legal monopoly grant or by happenstance, maximizes his profit going forward by pricing at the revenue-maximizing price plus typically one half the marginal cost. The revenue-maximizing price is purely a function of the demand faced, including the effects of the level of available purchase funds and any competition of all other goods for those funds, including substitutes for the drug itself.

What an actual sunk development cost may have been does not affect the price as determined above.

Assuming that a direct competitor is legally able to enter the market, HIS development decision is NOT based on the current market price of the drug, but on the market price that will exist when and if two direct competitors exist. This price is likely to approach the marginal cost of the higher cost competitor, typically far below the single supplier profit-maximizing price.

Unless the development cost for the second supplier is much lower than for the first, possibly because he can use the results of the first supplier's development process, he will not proceed with development.

For a drug price to be high (whatever that means) a high value MUST be assigned by purchasers.

An extremely high initial development cost has no effect on drug prices because these drugs will never be produced and no price will exist.

A lower, but still high initial development cost will allow drugs to be developed if a sole supplier condition can be assured.

Only if a sufficiently low secondary development cost exists, will a direct competitor enter the market and drive prices down near marginal cost.

Regards, Don