David R. Henderson  

High Profits as an Incentive to Bear High R&D Costs

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Sunk Costs Now Were Not Always Sunk

Here's a question I asked my students in the final exam last quarter:

When the drug company Burroughs-Wellcome brought out the first major anti-AIDS drug, AZT, in the late 1980s, the company priced a year's dosage at $8,000. As you can imagine, many people criticized the company for setting such a high price. Burroughs-Wellcome replied that it needed that price to offset the large R&D costs of the drug.
(a) Did Burroughs-Wellcome's justification make sense? Why or why not? (2 points)
(b) Construct a better justification for the high price, one not just in the interest of Burroughs-Wellcome but also in the interest of future consumers of future drugs who want those drugs to be invented. (2 points)

Dean Baker, had he taken my exam, would have nailed part (a). Part (b)? Not so much.

In a piece titled "Paul Krugman, Bernie Sanders, and Medicare for All," Dean writes:

In the vast majority of cases, the drugs in question are not actually expensive to manufacture. The way the drug industry justifies high prices is that they must recover their research costs. While the industry does in fact spend a considerable amount of money on research (although they likely exaggerate this figure), at the point the drug is being administered this is a sunk cost. In other words, the resources devoted to this research have already been used; the economy doesn't somehow get back the researchers' time and the capital expended if fewer people take a drug that is developed from their work.

Good answer to (a). 2 points.

He goes on to point out problems with high drug prices in the United States. I'll give the quote with my evaluation in square brackets:

Companies have incentive to engage in massive marketing efforts [DRH: true], they push their drugs for conditions for which they may not be appropriate [DRH: probably true], and they conceal evidence suggesting their drugs may be less effective than advertised, or possibly even harmful [DRH: hard to believe].

He then says something whose significance he misses. He writes:
Even research is distorted by this incentive structure, with large portions of the industry's budget being devoted to developing copycat drugs to gain a share of a competitor's patent rents.

Dean writes this in the context of a discussion of the problem with monopoly. What's the major solution to the problem of monopoly? Competition. What are copycat drugs? Competition. A Chevrolet is a copycat Ford, and we pay less for Fords because of the existence of Chevrolets.

But he never even mentions the economic analysis that I wanted my students to see (and, fortunately, that many did) in answering part (b). You can read his whole piece and not find him admitting that high profits from a monopoly on a patented drug are an incentive to bear high R&D costs. Those high R&D costs, once borne, are sunk, but, before borne, float.

By the way, if we could completely end government power over the introduction of drugs, maybe a system without patents could work, although I doubt it. But with legislation that makes drugs illegal before the FDA gives permission, and with the requirements for permission imposing costs that average over $2.5 billion per drug brought to market, there's no way.

HT2 Mark Thoma.


Comments and Sharing






COMMENTS (21 to date)
BC writes:

Agree with the analysis here. However, with the low marginal drug costs, the drug companies should still have an incentive to do price discrimination (if possible): offer drugs at high prices to people willing to pay a lot and low prices to the poor and others unwilling to pay a lot. They already do some price discrimination when they sell at low prices abroad and at high prices in the US, which is made possible when re-importation of the cheap foreign drugs is prohibited.

My question is what are the main barriers to price discrimination within the US? Is it because many drugs are covered by insurance so, in effect, every patient is willing and able to pay high prices? Are there some regulatory barriers? At the very least, it seems like drug companies ought to be able to follow the university model for price discrimination: set very high list prices but then offer the poor "financial aid" if those poor customers are willing to reveal their financial info so that the drug companies can verify that they really are poor. Would that be illegal?

David R. Henderson writes:

@BC,
Good point. The main barrier to price discrimination is the law that says Medicaid gets to pay the lowest price charged to anyone. Charley Hooper and I discuss that in this article.

Don Boudreaux writes:

Dean Baker seems as if he'd learn a lot if he were to read carefully Ronald Coase's August 1946 Economica article, "The Marginal Cost Controversy."

Zeke writes:

The average cost - marginal cost debate seems relatively well settled by Coase's writings. I wonder though if applications such as kickstarter could solve this problem, by dramatically lowering the transaction costs of ex ante price discrimination?

Thomas Nagle writes:

With regard to price discrimination, the problem is that the largest buyer for many drugs is the federal government. By law, the government is not allowed to negotiate for a better price by refusing to pay for a high priced drug (the way private payers do.) The government is, by law, entitled to the "best price" anyone gets in US. Obviously when gov't is a large buyer, companies set a high price (as for new Hep C drug) and then cannot discount to more price sensitive buyers. When they have tried schemes to do so, they have gotten sued for "overcharging" the government.

Michael Byrnes writes:

Though it's not the main topic here, I just wanted to cooemt on this quote of Dean Baker:

Companies have incentive to engage in massive marketing efforts [DRH: true], they push their drugs for conditions for which they may not be appropriate [DRH: probably true}, and they conceal evidence suggesting their drugs may be less effective than advertised, or possibly even harmful [DRH: hard to believe].

What Dean Baker may be getting at here is the file drawer problem. Many clinical trials have been conducted, including those investigating subsequently approved drugs, whose results are known to the sponsor company but are never published. It's not reasonable to conclude that all of these unpublished studies are hiding information that suggests that the drugs may be less effective than advertised, but it stechtes credibility to think that companies, while holding a lot of private information about how their drugs work, always release any negative stuff to the public.

Also, there is plenty of "spin" in how companies market their products to patients, physicians, insurers. "Me too" drugs are a great example. "Me toos" aren't generic versions of first-in-class drugs, they are different (though similar in key respects) products that were developed independently. With such drugs, there will be some "class effects" (effects that are common to the original and all of the "me toos"), but also some effects that are unique to the individual drugs. And companies with a "me too" drug will often go to great lengths to argue about why theirs is better than their competitor's, sometimes relying on arguments that are better desribed as "spin" than scientifically-founded.

john hare writes:

How many people fail to understand that failure to profit eventually prevents investment initially? Seems really simple to me and shouldn't take that much time to explain to people that don't get it. My best answer so far is that many refuse to 'get' it.

Nathan W writes:

It stuns me that you are skeptical that companies will try to claim their products are more effective than evidence warrants, or that they would try to mislead with regard to harms. Surely some people will overstate the case, but it beyond naive to suppose that it is not an issue.

Bob Murphy writes:

David,

Neat post. I think it might help EconLog readers (including me) if you spell things out for us in a future post. It sounds like you're saying, "Drug companies should only invest in R&D if they plan on charging enough to cover those costs, but once the R&D is sunk they shouldn't consider it." I.e. it sounds like the drug companies are not anticipating what their future position will be.

More generally, I remember in an NYU colloquium that someone brought up the puzzle, "Once the burgers are made and sitting on the back rack at McDonalds, isn't the marginal cost of handing it to a customer virtually zero? So if P=MC in a good equilibrium, doesn't that mean fast food restaurants should be handing out burgers for free?"

So anyway David, I think this is pretty tricky if even professional economists get tripped up applying their textbook principles to simple real-world examples.

Don Boudreaux writes:

This post, David, affords me the opportunity to plug one of my favorite articles of all time: Alchian's brilliant 1959 "Costs and Outputs." (It was formally published in a 1959 festschrift.) Not only would Dean Baker profit from reading it, so, too, would the vast majority of economists. Absorbing the insights of this article would help to frame the issue of your post - and, indeed, help to frame many other issues in economics - in a far more productive way.

This article is a top candidate for the most important article in economics that is too-little known.

JK Brown writes:

Why on earth is Apple selling iPhones for so much? I mean, it's all sunk cost and they don't cost near what is charged retail to manufacture. Or Windows? The cost to host and distribute the software after development is near nothing and all that pay and benefits to programmers are sunk costs.

Maybe if the drug companies borrowed the money they spent on R&D? Then they'd have an external note to pay to someone else that would justify their pricing instead of just paying back the retained earnings they spent of the R&D?

David R. Henderson writes:

@Bob Murphy,
Neat post.
Thanks.
I think it might help EconLog readers (including me) if you spell things out for us in a future post. It sounds like you're saying, "Drug companies should only invest in R&D if they plan on charging enough to cover those costs, but once the R&D is sunk they shouldn't consider it."
That is what I’m arguing. Sunk costs do not enter on the cost curve side and certainly don’t enter on the demand side. So if the firms are profit-maximizing, they should not consider sunk costs.
I.e. it sounds like the drug companies are not anticipating what their future position will be.
I don’t get it. Please explain.

Bob Murphy writes:

Hi David,

Sorry, I realize my last post wasn't clear. And also, I know that what you are saying makes sense. I'm trying to get you to see why it may have been confusing to a typical reader.

I realize the following isn't what you were actually saying, but I could imagine some people *thinking* you were saying something like this:

#1) When a drug company has a drug on hand that it has already developed, at that point it costs $1 per pill in MC, so the company should only charge $1 per pill. If it charged a lot higher to "make up for the R&D we spent on it" that would be bad economics.


#2) When a drug company is considering to plunk $1 billion in R&D for a drug, it will do so if it looks ahead and thinks, "I bet we can charge $1,000 per pill for this thing, once we have it developed. Given the demand curve, charging that amount--which would be way way higher than the $1 MC at that point--will let us recoup our fixed costs. Sure, let's go ahead and do that." This is perfectly rational and sound economics.


Do you see how someone might be confused by the above two statements if he thought you were making them in this fashion? It sounds like you are saying the drug company before R&D should be making decisions assuming it will engage in a sunk cost fallacy in the future.

(Again, I know that's *not* what you're saying, but I think this is a really subtle area.)

Another way of putting it, David, is that I think many people would be surprised to lose credit on your first question. Then when they heard your answer, they would be huffy and think you were just being really nitpicky about the "grammar," rather than saying their general idea was wrong.

David R. Henderson writes:

@Bob Murphy,
I know you are trying to clarify, but I think we have a big difference of opinion. If it charged a lot higher to "make up for the R&D we spent on it" that would be bad economics. The R&D is sunk. The reason to charge a high price is to maximize profits. It doesn’t matter whether R&D cost $1 or $1 billion. The only way R&D costs matter is before they are sunk.

Bob Murphy writes:

David,

Right. We agree on the analysis. Where we disagree is that (a) I think easily 75% of EconLog readers might not be able to write a 500 word essay spelling all this out and (b) you might think they would.

In my example above, I had position #1 being "When a drug company has a drug on hand that it has already developed, at that point it costs $1 per pill in MC, so the company should only charge $1 per pill." That's actually not right. But I think some readers might have thought you were saying that.

More generally, if a drug company PR person says, "If we only charged $1 per pill, then we'd stop investing in research," that sounds a lot better than, "Why would we charge $1 per pill when we can make more profit charging higher than that?"

So I agree the exact phrasing by the drug PR people was probably relying on a sunk cost fallacy, but there is a correct way to frame what they were trying to say, in a way that acknowledges the connection. I think some EconLog readers might not have understood.

LD Bottorff writes:

Since Burroughs-Wellcome was replying to critics of its pricing, it made perfect sense to say the company needed to offset the large R&D costs of the drug. The explanation may not make sense to an economist, but it makes sense to someone who might be swayed by the claim that there was something wrong with charging $8,000 for a year's dose. If the company had a staff economist prepare the response to the criticism, the response would still have gone through their public relations office. The public relations office doesn't care to explain sunk costs or profit maximization to the general public.

David R. Henderson writes:

@Bob Murphy,
Good. We agree.
In my example above, I had position #1 being "When a drug company has a drug on hand that it has already developed, at that point it costs $1 per pill in MC, so the company should only charge $1 per pill." That's actually not right. But I think some readers might have thought you were saying that.
I think that may be why it was a good question. One thing I try to teach my students, somewhat successfully, is not to read something into a statement that is not there. However, I could be wrong. If you have an alternative way of asking part (a), I would appreciate knowing.
More generally, if a drug company PR person says, "If we only charged $1 per pill, then we'd stop investing in research,"
That would be great. But notice that they said it was to recoup past R&D. Stopping investing in R&D is forward looking.
So I agree the exact phrasing by the drug PR people was probably relying on a sunk cost fallacy, but there is a correct way to frame what they were trying to say, in a way that acknowledges the connection.
Right, and that’s why I asked part (b).

David R. Henderson writes:

@LD Bottorf,
Since Burroughs-Wellcome was replying to critics of its pricing, it made perfect sense to say the company needed to offset the large R&D costs of the drug. The explanation may not make sense to an economist, but it makes sense to someone who might be swayed by the claim that there was something wrong with charging $8,000 for a year's dose.
If all the company cares about is winning, then you’re right. But remember that I asked this in an economics course and the students understood, presumably, that the question was about whether it made economic sense.
If the company had a staff economist prepare the response to the criticism, the response would still have gone through their public relations office. The public relations office doesn't care to explain sunk costs or profit maximization to the general public.
But the PR office could have done what Bob Murphy suggests above, which is to say words to the effect "If we only charged $1 per pill, then we'd stop investing in research.” Then they don’t need to get across “sunk cost” or “profit maximization.” But they do get across the part (b) answer, which is incentives to invest.

Bob Murphy writes:

Last thing and I'll drop it, David. I think it was a great question for your students, especially since (I imagine) you either went through the correct answers in class after the exam, and/or you had office hours and confused kids could come in.

All I'm saying is that some EconLog readers might not understand the big picture from this particular post. So I was encouraging you to do a future post spelling it out. This is obvious to you since you are an economist and teach this stuff for a living, but from this particular post--with the block quotes interspersed from Dean Baker etc.--I think some people might not be learning the principle, who didn't already know it.

David R. Henderson writes:

@Bob Murphy,
OK. Thanks. Since this was the final exam and I don’t get to see them after the exam, I send out an answer key.
Do you think it would make sense to have a post giving the questions and then giving my answers?

Bob Murphy writes:

David,

Yes, I think that would be great, assuming that doesn't mess up your ability to give the question in the future. (Or maybe you want to reward students who follow you on EconLog...)

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