The present patent system is uniquely non-functional for pharmaceutical markets – inverting reward and value

It is well known that monopoly exploitation of innovations under the patent system can reduce the benefits or “surplus” available to society from an innovation. This inefficiency is tolerated because the monopoly profits create an incentive to innovate, and in the absence of innovation, even less social surplus is created. Underlying this trade-off between high prices and innovation is the understanding that willingness to pay a high price for a good indicates high value. The greater the value to consumers, the higher the price the innovator can charge, and the greater the profits. This means, in turn, that the incentive for innovators is to undertake research that is valuable to society, since such innovations will earn high rewards. If rewards are not proportional to the social value, then the patent system cannot work well: it will lead firms to invest in innovations which have little social value, while ignoring avenues of investigation which could be of immense social value. Unfortunately, pharmaceutical markets are among the least well functioning of all markets, undermining the connection between value and reward. Doctors prescribe medications based on their beliefs as to the best medicine, somewhat influenced, presumably, by the extensive detailing and advertising focused on them. Since doctors do not pay for the medicines they prescribe, price is not an important component of their decision-making process. Consumers are typically ignorant of possible choices, and of the differences between various therapies and medicines and how these would relate to their own physiology, and may be paying only a fraction of the price of any medicine, or may pay nothing at all. The other part will be paid for by an insurer – possibly government or a private company – which has limited influence over the medicine prescribed.6 In these circumstances, price is a relatively unimportant strategic variable for competition between drugs – detailing of doctors may be more important. In addition, prices in many countries are regulated by government. The result is that prices may be either too high or too low compared to the ideal market (one in which consumers are informed about the choices they make and then bear the full cost of those choices). Since prices in pharmaceutical markets do not necessarily reflect value to consumers, profits are not likely to be proportional to the social value of an innovation. There are four types of problems which arise here, which I will discuss in turn. First, the pricing of pioneer drugs may bear no particular relationship to value. Second, “me-too” drugs may be able to generate large profits even though they offer little or no therapeutic advantage over prior therapies. Third, firms may find it very profitable to develop minor modifications to their own existing drugs, as a sort of evergreening strategy. Fourth, profits from developing and showing new uses for non-patented compounds will be small and may not support investing in clinical trials to demonstrate efficacy.