Why is medicine expensive and should it be any different?

This post is a cooperation between two economics students, our guest of honor on this post, who raises the question of medicine is Bilal Abdul-Jawad, and yours truly. 

Pharmaceutical companies are profit-driven business that offers social benefits to the society (medicine) as well as private benefits for investors (profits). They operate like most other businesses by trying to exploit consumer surplus by acquiring monopolistic rights to make abnormal returns. They spend billions of dollars in research and development to make the highest quality of products, and protect their research by patenting the medicine they create, which prohibits acts of copying by competitors for products approximately 20 years. This grants pharmaceutical companies excessive market share power and monopolistic traits.

Also, the increasing role of government intervention in health care and the growth of insurance agencies have further led pharmaceutical companies to reach huge amount of profits at an even faster rate. Thus prompting medicine providers to take advantage of government and insurance companies obligations. The average patient could care less what the cost of his treatment would be if they knew they are covered. This brings us a bit off topic, nonetheless a matter to be pointed.

Pharmaceuticals research hundreds of different medicines but only a few make it to the market if not none at all and so that one product has to cover the costs, also known as fixed costs, of all failed research. Secondly, else than covering fixed costs, investors expect a specific rate of return to their investment and so revenues should cover costs and shareholder expectations (investors only goal is to maximize profit, not caring which industry it is in as long as it is legal).

An example would be if a company undertakes 10 different researches, each costing $100 million (total of $1 billion) and only one makes it to the market. This one medicine has to generate $1 billion to break-even, and then has to generate profits to invest in newer projects and to also be able to pay shareholders a decent return to not push them away. Lets say they aim to gain $2 billion in total, in 20 years time, that’s $100 million a year, say there are 1 million customers, then that’s $100 per customer regardless whether the medicine itself cost $1 to make or $50, this is how much needs to be charged.

Mon Vs Comp
Figure 1: P Competition represents operating at the price of costs with average returns. P monopolist is the price monopolies charge. (P monopolist – P competition) is the excess generated revenue they can make as they are the only providers of that product. The green box depicts the super profits a monopoly market can generate, the grey triangle is the (Dead weight loss), that the market suffers from a monopolist presence in the market.

This takes us to the big question, Why do pharmaceuticals operate this way?

Firstly, lets take a look back; economists agree that capitalistic ideals satisfy the needs of human nature, the need of greed, competition and power. Furthermore, incentives to invent are a must or else everyone would just lie around waiting for anyone else to do the hard work (free-rider effect). In our world, the most important incentive revolves around “making money”. Ask yourself this, if someone tells you go save the world, everyone would want to but just how much would you do, how much will you dedicate? Then ask yourself this, go save the world and I will give you a billion dollars; now by how much did your dedication amplify? The same goes for researching to create and help the world. Overall, we strive for a world that is rid of poverty and diseases but before we do so, selfish needs must be satisfied. In other words, philanthropy is much appreciated but is not and will never be enough to satisfy world demands; philanthropy is only achieved after selfish needs are satisfied. The only wealthy powers in an economy willing to help more than gaining returns is the government, which doesn’t have enough money to spend without generating from it and thus they are partially ruled out.

This takes us to our second big question, should these firms be run differently than firms in other sectors?

There is a growing debate over whether medicine should function like a business, guided, as businesses are, by concerns such as profits and customer satisfaction. Of course, for-profit businesses already permeate medicine, and those businesses are not confused about their priorities: providing high quality goods and services people want, at affordable prices. These companies know that they must do well in order to continue.

The pharmaceutical industry is heavily expected to not operate like any other business due to their social importance in maintaining human lives and quality. Expectations are one-sided though; people don’t realize that if these firms were not treated like those in other industries with high returns then why would investors, other than philanthropic acts, invest in them? Having high returns is also an incentive for competition to grow which causes a race to the top to become the most powerful and make the most returns. Without these factors, they would cease to exist…

Figure 2: This diagram shows the price needed for society, the price needed for fair-return pricing and the price monopolies charge. This is a theoretical approach as fair-return price is debated.
Figure 2: This diagram shows the price needed for society, the price needed for fair-return pricing and the price monopolies charge. This is a theoretical approach as fair-return price is debated.

It is true that regulating prices on a monopolist may in theory lower prices and produce at outputs seemingly more efficient. The absence of regulation or government intervention will further induce competitive barriers.

However, in the event that pharmaceutical industry would undergo any policy that would have to regulate its course of business other than first satisfying its investors we would probably see a shift of focus from quality control of products and innovation to political disputes, and cost obsessed industry, that would have negative impacts socially and privately. We would definitely see the rate of pharmaceutical innovation decline since such a field requires the brightest of minds and unprecedented patience, all the very costly indeed. Since fair return means that rate of return covers cost without having economic profits to satisfy investors, and socially optimal solution would only make government pay for the difference for operating at a loss. Governments would spend taxpayers’ money on creating medicine with high social returns but ideas and incentives would be lacking. Overall, it would reflect the cons of socialism, people would just do what they have to rather than be more efficient if no compensation is available. Also, governments cannot tackle all problems sufficiently at once as they are made of a group of people as well, whom are all imperfect. Some people might debate that some of the greatest inventions in many sectors were acts of brilliant people who did not expect large returns such as Einstein, Marie Curie and Max Planck, but then again, people like them still exist and do help the world for free but with the introduction of the private sectors, millions are added leading to overall better efficiency. The new Hepatitis-C cure names Sovaldi, cures Hep-C in 81 days and costs $81000. This is an insane amount, but looking at the world before this drug was invented, the average Hep-C patient would spend over $190,000 over the course of 35 years and never rid of it. Sovaldi, whilst momentarily expensive, yields results unavailable before at less than half the price.

 Private sector is needed but these explanations are not sufficient, so what should be done?

The biggest power there is on any firm is the government itself. Rather than providing 20-year patents that could, depending on product demand, yield profits way beyond what is deserved; governments could quantify the amount. An example would be that government force firms to lower prices to certain levels once profits reach a specific percentile. This weakens monopoly power and allows for further research in the field, increasing social rate of return.

OR?

We could think about these issues in a different spectrum or scope so to speak. This desperate search for solutions for rising health care costs concerns and all associated socioeconomic problems. Ponder on this, wouldn’t a huge portion of these problems be solved if people aren’t as sick and weak as they are now? Why can’t government invest in promoting good health,  provide healthy awareness campaigns, target future generations to aspire to be healthy and fit, and regulate food and beverages quality.