The Wall Street Journal has a puzzling piece complaining about how the pharmaceutical companies seem to make out like bandits from the existence of the patent system. What puzzles is that the entire point and purpose of the patent system, in an economic sense, is so that inventors of things can make out like bandits. The background problem is that of public goods, something I'll explain in a moment. That problem leads us to thinking that a pure free market in things which are public goods isn't going to work as well as something a little different. So, we design something a little different. And the point and purpose of our design is so that people who innovate can make vast mountains of cash out of having done so.
It's then more than a bit odd to point out that our system enables people who innovate to make vast mountains of cash.
This point extends all the way through the patent and copyright systems of course. This is not an argument peculiar to drugs and pharmaceuticals: this is an economic problem with an economic solution, not anything to do with medicine. And yes, there are other possible solutions (Dean Baker has been arguing about this for decades now) but they all circle around the same point: how do we make sure that people who successfully innovate get vast mountains of cash?
Here's the WSJ:
Demand for a drug called Avonex has declined every year for the past 10.
Not a problem for its manufacturer. U.S. revenue from the drug has more than doubled in that time, to $2 billion last year.
The key: repeated price increases. The multiple sclerosis drug’s maker, Biogen Inc., raised its price an average of 16% a year throughout the decade—21 times in all.
It is an example of drug companies’ unusual ability to boost prices beyond the inflation rate to drive their revenue, even when demand for the drugs doesn’t cooperate.
Well, let's leave aside the most obvious point here. That a rise in the price of something is highly likely to lead to a fall in unit demand for it. We do generally think that demand curves slope downwards, don't we?
Actually, we can be more subtle than that and we will be in a moment after we've dealt with the public goods point.
A public good is not something that is good for the public, a good supplied to the public nor even something the public thinks it would be good to have. It's something which meets two specific tests, that of non-rivalry and that of non-excludability. Say, Newton's equations. Now they've been published there's no way to exclude someone from using them to calculate the route to the Moon and there's also no way that someone elses' use reduces the amount of Newton that I can use to plot my own journey to the Moon. The problem with things like this is that it's extremely hard to make money out of them. This is as true of a big budget movie as it is of a new drug. OK, the first might cost $100 million, the second $1 billion, but all of the money is being spent up front in the original development. The costs of showing it to an extra person, making an extra dose, are between trivial and nothing. And if something like that is not excludable and not rivalrous then of course anyone can just copy it. Meaning that the people who put that $100 million/$1 billion in are just out of luck as everyone pirates their innovation.
This means that we get much less of such innovation than we think we would like. So, we invent ways to make sure that these sorts of things are not launched into a free market. Copyright with artistic things, patents with drugs, but the aim is the same: to provide a way for people to make money out of having innovated. We thus think that we'll get more people innovating and we think that's a good idea.
Which brings us to the subtlety of those pricing decisions. With drugs, pharmaceuticals, close enough the cost of manufacturing a dose is zero. All of the costs go in the original research, the clinical testing (the lion's share) and getting it through the FDA. Profit is therefore determined, since marginal production costs are zero (they're not, accurately, but close enough for this comparison), by gross revenue. And we want to maximise the incentive for people to innovate, that's the very reason we've got this patent system in the first place, and thus we would rather like the pharma companies to be maximising revenue.
And thus, from this economic point of view, we should be quite happy with people raising their prices. Demand does fall as they do so, yes, but as long as gross revenue increases, the price rises more than compensating for the fall in unit demand, then we should be happy with the way the system is working. Gross revenue is being maximised, profits are being maximised, incentives to innovate are being maximised. That's what we want our system to do after all.
Far from being worried about this price gouging we should be welcoming it. Because, obviously, someone making bajillions out of having innovated a drug to cure a disease increases the incentives for many other people to go and invest bajillions of their own to cure other diseases. Far from complaining about it we should be celebrating the system working.
And don't forget, after 20 years this all comes to a screeching halt. There's no patent protection beyond that date.
So, it is confusing that the WSJ is complaining about the patent system enabling drug companies to profit. Because the very point and purpose of the patent system is to enable the drug companies to profit.
