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.
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.