Monday, December 04, 2006

And about those drugs for poor nations.

Much of what I will say here is dependent on points I made in the previous post. So you really should it first. If you don’t the argument will not be as coherent and then you’ll probably blame me. But I see no need to repeat my main points merely to elaborate on aspects of them.

Something David Friedman said got me thinking about a specific aspect of the pharmaceutical industry. Ater finishing the previous post of mine and this one you can read David’s for more substance.

Previously I noted that the income from profitable drugs has to pay for all the costs associated with those drugs plus all the cost associated with unsuccessful drugs. And I argued that the marginal cost of each new pill is irrelevant since the industry must cover all the other costs as well not just marginal costs.

That brings up an issue about marginal cost. Say that pill X is needed in some very poor countries. The marginal cost of production may be 10¢. X may sell in the wealthy West for $5 for the reasons outlined below. Poor nations can’t afford $5 per tablet.

But with a marginal cost of just 10¢ the pharmaceutical company can still make a profit by selling it for 12¢. The $5 per tablet in West covers all the costs mentioned below. And the extra 2¢ per tablet is all gravy.

The choice is selling to the poor and making 2¢ per tablet or not selling to them and making nothing. So why don’t they do this? It isn’t just “greed” as the Left would say. The greedy thing would seem to be to maximize profit by selling in the poor nations at just above the marginal cost.

Let me illustrate I have 10 tablets which I sell to you for $5 each. I earn $50. They cost me $1 each. Selling to you earns me $40 profit.

But there is a customer who can’t afford the $5 price no matter how hard he tries. So I sell him the tablets at $1.50 each instead. I still make another $5 profit as a result.

Selling drugs to poor people at much lower prices can still be profitable. Now if pharmaceutical companies are greedy -- just like everyone else on the planet --- then why don’t they maximize their profit by selling to poor customers at these much lower rates?

Who stops them from doing this? Well, broadly speaking, you do. And by you I mean those of you who live in wealthy first world nations.

I have to sell X for $5 in the West in order to recoup all my costs for this drug, for unprofitable drugs and for unsuccessful drugs. If I lose money I go out of business. No one benefits from that. The more money I have for future R&D the better off everyone is. So we don’t want to destroy the profits when they exist and we need the really high profits on some drugs to pay for the failures and drugs that lose money. Not selling X for $5 would be a problem.

So off in Tagawaki, a small impoverished nation that I invented for the illustration, I am selling X for 15¢ each. The local government in Tagawaki buys the tablets for their local patients but then sell them to a distributor who markets them in the West for $2.50 each. You will, of course, buy from local outlets selling the tablets reimported from Tagawaki.

You will save $912.50 per year doing that. Now $912.50 won’t do me in. I’ll survive. But it won’t be $912.50 will it? You’ll do it and so will someone one block over and so will everyone else who knows about them. In essence I was forced to compete with myself.

In order to benefit poor people by selling them drugs at a very low price I end up having to cut my prices in the wealthy nations in order to compete with the drugs I produced for the poor nations. My income will drop significantly. And a good share of my lost income would have gone to the corrupt government officials in Tagawaki along with the reimporters.

But what happens if this drop in income means that I have a harder time covering the cost of the high risk drugs I’m investigating? I have less revenue to cover the cost of failed or unprofitable drugs. I may end up losing money if I’m not carefully. So I have some options.

I could cut back researching high risk drugs. I concentrate more on the “sure” things. I don’t want to deal with too many drugs that might lose money. I can’t afford to guess wrong so I want to make sure that I develop only profitable drugs. All in all there would be a lot fewer innovations in the pharmaceutical industry. But you are taking X at the lower price and happy.

But what if you or a loved one has another condition which can best be treated with one of the drugs I forgo producing? To sell X to you at the cheaper price I have to stop producing Y and Z since they might have been unprofitable. With less income I’m more risk aversive. But now you need Y and it isn’t there. What on the surface appeared to be a savings to you was not really a savings. In exchange for the cheaper X you have to also give up Y and any other drugs that I drop from my research as too risky.

Now it may be a good risk for you personally. Chances are that you’ll keep taking X and won’t need Y. It will be someone else who needs Y in most cases. So to get X a bit cheaper you end up denying someone else Y which they may need far more urgently. But since Y was never produced you’ll never notice that. The other person who ends up in an early grave -- well I guess they aren’t noticing it anymore either.

So the problem is reimporting the same drugs. Is there a way to cut costs for pharmaceuticals in poor nations without causing large losses in the West stifling R&D there? And face it, if the West doesn’t do the R&D it doesn’t get done.

And here is where David Friedman’s suggestion comes into play. For any condition there is the best drug available and there are second best drugs. They may do a decent job but not the same job as the newest drugs on the market.

Friedman says that once a drug is surpassed by more effective treatments its value drops significantly. So it should be possible to “buy out the patent on the second best” drug rather easily. He suggests that someone like the Gates Foundation buy some of these second level patents. They can then put the drug in the public domain allowing anyone who wishes to do so to produce it. Or they can produce it themselves and give it away.

This will dramatically increase the quality of care in poor countries. Consumers in wealthy nations would be more willing to pay a premium for the newest, best drug on the market. So few of them will downgrade their medications. :

“This proposal has one large advantage over the usual alternative of forcing drug companies to make their drugs available at a low price in poor countries, with the threat that if they do not the countries in question will simply refuse to enforce their patents. That proposal makes the development of new drugs less profitable and so buys a short run gain in availability at the long run cost of slowing the development of new drugs. It could be a very large long run cost if the practice spreads from very poor countries up to less poor countries.”