Bad Pharma? Not quite!

Earlier this week there a Treasury Committee discussion regarding Intellectual Property took place, some of which was devoted to issues surrounding patent rights. Now, when people think of patents, they often think of pharmaceutical companies and how “evil” it is that such firms can patent and profit from products that are crucial to improving human health. Such protests can be found in publications as varied as Cracked, The Guardian, The Telegraph, The Washington Post, and The Independent, among others.

However, these protestations and complaints are unjustified. At the outset, it is important to note that patents for pharmaceutical products last, at most, twenty years, and that is to say nothing of the fact that many drugs are subject to off-patent, generic versions long before their patents expire. Hence, any potentially high profits earned by a pharmaceutical firm that owns a patent are only temporary.

Moreover, without the existence of said patent protection, a pharmaceutical firm likely would not invest in researching and developing any drugs in the first place. To see this, suppose that a pharmaceutical firm is considering investing in research and development for a new drug – its investment decision depends on whether the (expected future) revenues it can obtain from its investment exceed the (current) costs of the investment (for now let’s ignore the complications that future revenue streams are uncertain and need to be discounted). Simply put, if the revenues exceed the investment costs, then a pharmaceutical firm will invest in the R&D necessary for the new drug.

How much does it cost to research and develop a new drug for market? The BBC quotes an estimate from the Association of British Pharmaceutical Industry of £1.5bn per drug. Other, even higher, estimates also exist. Nonetheless, this means that for investment in a new drug to be worthwhile, the revenues from said drug must exceed at least £1.5bn.

If patents did not exist, then as soon as the new drug was marketed by the “originator” firm that developed it, rival manufacturers would be able to reverse-engineer their own version (usually within a few years, given the length of time it takes generic firms to produce their own version after patent expiry) without having to incur the large development costs to which the originator was subject. Hence, the rival firms would be able to undercut the price charged by the originator. In other words, without patent protection, an originator would only expect to receive minimal revenues for its investment. Under such a scenario, no rational private firm would incur the costs necessary to develop the new drug.

Under the patent system, however, rival firms are prevented from marketing their own versions for a longer time, thereby providing the originator with a longer amount of time over which it can make revenues. This means that the patent system provides the originator with a much stronger incentive to develop the drug in the first place. As such, it is clear that the existence of the patent system is essential to encouraging the development of new drugs.

However, that is not to say that the patent system is perfect. Indeed, it lacks the ability to incentivise pharmaceutical firms to develop treatments for diseases/conditions that only affect a small number of people. In such instances, the “market” is so small that the revenues obtainable under the existing patent system would not be sufficient to cover costs unless an exceedingly high price was charged (in which case health services probably would not purchase it). In these instances, drugs are not developed despite potentially being highly beneficial to those with the conditions/diseases concerned.

How can this be rectified so that drugs are developed for these “niche” conditions? One way would be for patent rights to be extended in length for drugs developed for these diseases. This would have the benefit of ensuring that the existing structure of research and development institutions is maintained, and that R&D occurs where it can be most efficiently undertaken. However, one downside would be that if a drug was to be developed, then health services would have to pay the “patented price” for that drug for a longer time (but that must be better than there not being a drug in the first place).

An alternative solution would be for a scheme that provides public funding or subsidies for the development of such drugs. If this were done via subsidies for existing pharmaceuticals, such a scheme would not have to provide the full amount of developing the drug from the public purse, but merely enough to make the investment by the private firm profitable. This seems much more feasible than a government taking on the role of a pharmaceutical firm itself – a government would have to incur substantial costs setting up and running its own pharmaceutical research and development unit, which seems needless and inefficient given the existence of such units within pharmaceutical firms already.

Obviously, a scheme to subsidise the development of treatments for niche conditions would give rise to some administrative issues. For example, would the subsidy be paid regardless of whether or not the drug being developed actually came to market? How would the amount of the subsidy be determined? What if the developed drug also had benefits for a more common condition? Nonetheless, these issues do not seem insurmountable, so there could very well be a way forward to developing drugs for niche conditions – either extend patent rights, or provide targeted subsidies to pharmaceutical firms.

Milk prices in the UK: Subsidies and their impact

There has been more than a little recent commotion regarding the prices that supermarkets and milk processing firms pay dairy farmers for supplying their milk. Indeed, the BBC has reported that some farmers have paraded cows through aisles in certain supermarkets, block-bought all the milk no a supermarket’s shelves, or simply blockaded a supermarket (see here, here, and here).

The motivation underlying these protests appears to stem from small dairy farms (such as those operated by “family farmers”) being unable to make a profit at the prices that supermarkets and milk processing firms are willing to pay for their milk. The Guardian mentions farmers’ claims that their break-even level (i.e. the level above which they start to make a profit) is 30p per litre, but that farmers are only paid about 24p per litre, resulting in a loss of 6p per litre (see here).

This has lead to protests that farmers should be paid more for their milk. However, these protests do not appear to have considered the impact of this price increase on the overall efficiency of milk production. Presumably, the larger milk farms (i.e. those run on a large scale, rather than by individual households) are able to make a reasonable profit at the prevailing price – this profit can be considered a “reward” for those farms making the best use of their resources to produce at as low a cost as possible.

On the other hand, if small dairy farms cannot produce at a cost lower than the price they receive, ordinarily they would go out of business because they are too inefficient to compete with their rivals. This is a standard economic process of obtaining “productive efficiency” – i.e. that all goods are produced at the lowest possible price.

If small dairy farms are (effectively) subsidised via the supermarkets paying a higher price, that would keep them in business, but at what cost? First, the production of milk would not be using the most efficient resources available to it. Instead, inefficient farms would be encouraged to remain in business producing milk when those resources (the people working on the farm, the equipment used, and the land itself) could be put to a more productive use. Moreover, farms that would be able to become more efficient if they had the incentive to do so (i.e. were receiving a lower price) would no longer need to make the necessary investments that would make them more efficient. In other words, subsidising small dairy farmers has the potential to harm the overall efficiency and productivity of the economy, both in the short-term and in the long-run. In other words, the reduction in efficiency and productivity would result in the UK’s GDP being lower than otherwise had the resources tied-up in the inefficient milk farms been put to other, more productive use.

Second, the fact that supermarkets are paying a higher price for their milk means that their costs have increased – it is plausible that these costs could be passed on to consumers in the form of higher milk prices. As milk is a staple product, any increase in the price of milk is likely to affect a large number of consumers, so the effective subsidising of small dairy farms has the potential to cause wide-ranging effects across the whole economy. In particular, if consumers need to pay more for their milk, they would have less disposable income to spend on other products, resulting in a decrease in demand. However, given that any increase in the price of milk is likely to be small, the magnitude of this effect may well be negligible.

Third, any increase in the price of milk paid to farms (to the extent that the price of milk is not negotiated on a bilateral basis) means that those farms that are already efficient merely serves to increase the profits of these farms. It is somewhat surprising that this aspect of an increase in milk prices has not received more attention, particularly if one has ethical qualms regarding policies that increase the profits of international firms.

Obviously, weighed against these points are any potential benefits that arise from the continued existence of small dairy farms. Perhaps benefits are derived from their impact on the countryside and/or the local communities in which they operate. I am not in a position to elucidate on these potential benefits, but the “cons” of any increase in the price of milk via an effective subsidy certainly need to be taken into account.

A nice, non-controversial topic to start off!