1. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 23 The Economics of Prescription Drugs

2. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Outline PROFITEERS OR BENEVOLENT SCIENTISTS MONOPOLY POWER AS IT APPLIES TO DRUGS IMPORTANT QUESTIONS

3. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Profiteers or Benevolent Scientists? Spending on drugs accounts for 9% of the more than $1 trillion health care industry The question of advertising –Ads for particular drugs These are not unexpected as new cures and remedies are invented. –Feel-good political ads These ads are seen as a means to forestall price controls or regulations.

4. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Patents A patent is a right granted by government to an inventor to be the exclusive seller on an invention for a limited period of time. Patents motivate innovation with the promise of monopoly profit for a period of time.

5. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Orphan Drugs An Orphan Drug is one that treats someone with a disease that afflicts few people. The concern is that there is insufficient potential demand to motivate innovation. For orphan drugs the patent life is extended by several years.

6. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Concern over High Prices Are prescription drug prices too high? The answer to many depends on the impact of the disease. –For “life or death” drugs price has been an ethical concern. The AIDS “cocktail” (a mix of drugs, used to fight the disease) originally cost $14,000 per patient per year. –For “quality of life” drugs it has been less of a concern. Pepcid and Zantac (heartburn medications), Seldane and then Claritan (seasonal allergy medications) cost a great deal but have not raised as much ethical concern.

7. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Impact of Monopoly Power P* Q* MRD MC Q/t P

8. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Monopoly vs Perfect Competition MR P monop Q monop D MC=Supply Q/t P P PC Q PC A F B C E Under PC CS=P PC AC PS=FP PC C Under Monopoly CS=P monop AB PS=FP monop BE DWL=EBC

9. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Deadweight Loss Deadweight Loss (DWL) is the loss in social welfare associated with production being too little or too great. In the case of monopoly, production is too little and prices are too high.

10. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Important Questions Are prescription drugs expensive necessities or relatively inexpensive godsends? –Expensive Necessities? Prescription drug prices rose twice as fast as overall prices. The prices are often more than ten times their marginal production costs. –Inexpensive godsends Drug treatments are typically much less than their surgical alternatives. (Drugs that deal with blocked arteries are less than a tenth the cost of bypass surgery.) New quality of life drugs treat ailments for which there are no surgical alternatives.

11. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Why We Should Expect Costs to be High Innovation costs –Highly trained and highly paid personnel are required to work on the therapies. –Expensive equipment is necessary to aid the invention process. Uncertainty about success –Most new therapies that make it out of the lab do not make it through clinical testing. Time delay and opportunity cost –Even when therapies are approved the revenue stream begins more than a decade after the invention costs have been incurred. –The opportunity cost in terms of lost interest must be counted as a cost as well.

12. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. The Cost Debate Consumer advocacy groups contend that ad spending now exceeds research spending. Drug firms contend that this ignores important “opportunity costs.”

13. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Are Price Controls an Answer? Price or profit controls in other countries make it such that drug prices are much higher in the U.S. than they are in other countries. If the U.S. controlled prices or profits it would eliminate the sole high profit market for drugs thereby reducing their motivation to innovate Economists are generally against price or profit limits for prescription drugs in the U.S.

14. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. FDA Approval The Process –Laboratory trials test the effectiveness of drugs “in the test-tube” and on animals. –Small scale human testing is done to determine safety. –Large scale human testing is done to determine effectiveness. This also catches some safety issues.

15. McGraw-Hill/Irwin © 2002 The McGraw-Hill Companies, Inc., All Rights Reserved. Too Lax or Too Stringent Too Lax –If drugs are approved that are later determined to be unsafe (such as the weight loss drug Fen- Phen) the concern is that screening is too lax. Too Stringent –If drugs that would have saved lives (or otherwise helped people) are delayed in their approval this is a loss as well. Economists evaluate the marginal cost of increasing stringency against its marginal benefits.