Are High Prices Necessary for Innovation?

Writing in Bloomberg, Megan McArdle says:

America’s high pharmaceutical prices are what compensates pharmaceutical firms for the risk of developing drugs. If we drive them lower, we’ll get fewer new drugs….After a few years of obscene profits, most of these innovations will be pretty cheap and widely available. Every useful weapon we decide not to try to produce for that arsenal comes at a cost to future people’s health.

Megan’s argument is a common one, and is often used to justify government-granted monopolies through patients. Although it pains me to do so, I must disagree with her here.

Drug research certainly is expensive, but as David Henderson and Charles Hooper point out, regulatory burden is also a major cost for firms:

Economists have shown that the cost to get one drug to market successfully is now more than $2.8 billion. Most of this cost is due to FDA regulation. Some potentially helpful drugs don’t ever make it to market because the cost the company must bear is too high. Drug companies reguarly “kill” drugs that could be effective because the potential profits, multiplied by the probability of collecting them, are less than the anticipated costs.

In other words, firms make a simple probabilistic Net Present Value calculation and the cost of regulation tends to be the deciding factor to cancel a project.  The high prices firms receive are a reflection of both the cost of innovation, but primarily the cost of regulation.  As Henderson and Hooper discuss, drug prices could be lowered (by changing the regulatory regime) and have it not affect innovation.

In a more general sense, high prices/profits are not necessary to spur innovation.  Competition can do the same thing.  In competitive markets, firms must always be on the look out for competitors cutting into their profits.  They look to gain any edge they can, which includes innovation.  Innovation can mean improving the current mousetrap or building a better one.  This is why we continue to see innovation even in highly competitive markets like retail/wholesale even though they do not earn extra-normal profits.

An easy way to test this theory would be, as Henderson and Hooper suggest, reduce regulation.  Standard monopoly theory says that a firm would develop into a monopoly if (among other reasons) there are significant technological barriers preventing entry into the market (in other words, if innovation is so expensive only one firm can efficiently conduct it). If the regulations are lifted and prices remain high and drug companies meld into a monopoly, then we can conclude Megan’s hypothesis is correct.  If, however, drug prices fall (as I suspect they will), we can conclude Henderson & Hooper’s hypothesis correct.

3 thoughts on “Are High Prices Necessary for Innovation?

  1. Yep. Government-granted monopolies allow companies to charge much higher than necessary prices. Megan McArdle is simply wrong on this issue.

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  2. In addition the potential market for a new drug can play a part in whether that drug is even a candidate for development. Treatment for a relatively rare condition may not even be considered.

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