Question

Think about the idea of patents and how they essentially create a monopoly for the patent holder. However, patents only provide the right to be the exclusive seller, but the patent holder does not have to sell their product. In particular, a patent holder can set the profit-maximizing price, but they may still lose money if the demand for the product is limited. For example, a pharmaceutical company may develop a drug that cures a life-threatening disease, but the seller may lose money if the disease is relatively rare (e.g., uncommon strains of flu, unusual forms of cancer, etc.). Given that it costs about $350 million to $500 million to gain FDA approval for a drug, the company may not market the medicine if it will not generate enough revenue to pay for these costs.

Congress tried to resolve the problem by passing laws like the Orphan Drug Act, which provides federal grants and tax credits to encourage pharmaceutical companies to bring drugs for rare diseases to market. The act also protects the product from competition for a number of years so the drug company can make some money. Due to these financial incentives, the pharmaceutical companies have earned money from taxpayers and from people who develop rare diseases, but the companies have introduced over 600 drugs for rare diseases that have helped over 10 million people in the US.

Alternatively, the government could resolve the problem by dropping the financial incentives and simply requiring all new pharmaceutical products for rare diseases to be sold at some reasonable price set by FDA. However, this may reduce the amount of research dedicated to new drug products because firms may be forced to take a loss on some of their products.

There are pros and cons to each approach to this problem. How do you think we should resolve this issue?

Answer 1

Provision of patents comes with its own advantages and disadvantages. On one hand, patents protect the seller from competition and gives them exclusive rights to sell their produce, on the other it may not be beneficial if the demand in the market is limited. As per the example provided in the above text:

For example, a pharmaceutical company may develop a drug that cures a life-threatening disease, but the seller may lose money if the disease is relatively rare (e.g., uncommon strains of flu, unusual forms of cancer, etc.). Given that it costs about $350 million to $500 million to gain FDA approval for a drug, the company may not market the medicine if it will not generate enough revenue to pay for these costs.

Each approach to the problem has pros and cons.

1. If the government could resolve the problem by dropping the financial incentives and simply requiring all new pharmaceutical products for rare diseases to be sold at some reasonable price set by FDA, then this will have a spillover effect. It will affect the R&D sector since the firms will reduce the amount spent on researching new products. This will be a result of knowledge transfer or spillover. Knowledge created by one firm will be transferred to other firms over time when the financial incentives are absent. The firms which under-researched or did not put efforts in developing new drugs for rare diseases will benefit or learn from the other firms' discoveries, given they have the technological intellect for knowledge transfer. If this happens, there will be two effects:

• Other firms will be able to produce those drugs at a lower cost ( since due to knowledge transfer, they do not incur the additional R&D cost which was incurred by the original firm) and the original firm will face competition from such firms. It will eventually drive down the prices and the original firm will not benefit enough from its production of new drug. Its profit will eventually fall , whereas the cost incurred by it remains large.
• The firms will spend less in research and discovery of new drugs in the hope of benefiting from knowledge transfers from other firms . This can lead to a free rider problem threat and on the whole, nobody will put their full effort to produce new drugs for rare diseases.

Benefit of this approach can be taken only when there is enough demand, which is not in control of the producer.

Hence, this alternative has more cons than pros, also the probability of benefiting is quite low. Hence, it is better not to resort to such a solution.

2. Congress' effort to resolve the problem by passing laws like the Orphan Drug Act, which provides federal grants and tax credits to encourage pharmaceutical companies to bring drugs for rare diseases to market is beneficial.  The act also protects the product from competition for a number of years so the drug company can make some money. Due to these financial incentives, the pharmaceutical companies have earned money from taxpayers and from people who develop rare diseases. Providing such financial incentives helps protect the firms from competition so that they remain the exclusive seller of the drugs and can make enough profits to cover their costs including R&D costs. They no longer have to fear competition from other firms nor any knowledge spillovers which encourage them to invest more in research for such drugs.

Also they enjoy exclusive rights for some years, this will help in enhancing the quality of their products so as to create trust and reputation among consumers. Also they will benefit if enough demand is created by those firms for their new drugs. Hence, this approach is feasible and should be followed to resolve the issue of patents.