Question 4 a In most of the developed countries, when a pharmaceutical firm deve

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Question 4

a In most of the developed countries, when a pharmaceutical firm develops a new drug, the patent laws give the firm a monopoly on the sale of the drug for a period of time (e.g. 10 to 15 years). Though a monopoly is generally inefficient, why does the government grant the firm a patent on its new drug?

b When the patent runs out after about 20 years, what will happen to the price of the drug? Briefly explain your answer.

c Most pharmaceutical firms are facing decreasing average costs and are always accused of creating deadweight loss because they charge prices higher than marginal cost. Is it feasible for governments to regulate these firms by asking them to charge prices equal to marginal cost (i.e. marginal-cost pricing)?

Explanation / Answer

(a) A monopoly power creates inefficiency by causing social deadweight loss, because firm charges higher price and supplies lower output. Despite this, government grants patent for the new drug because, new drugs fill-in a gap between existing medicinal requirement for healthcare and the required medicinal requirement for healthcare. Medicine being a life-saving good, a firm that develops a product to enhance the power of life-saving is granted the power to control the market using its monopoly power. However, due to this issue of inefficiency, a patent is timed - it expires after specified patent period.

(b) After the patent expires, drug price significantly falls. This is because other pharmaceutical firms develop the equivalent composition of the same drug by reverse engineering the patented drug, and introduces their lwer-cost "Generic" version of the patented drug in the market, therefore leading to rapid increase in sales.

(c) A marginal-cost pricing for pharma firms will result in a financial disaster for them. Majority (close to 80-90%) of the cost of developing and selling a new drug comes from the fixed costs of research and development that goes in developing the new drug. The difference between price and marginal cost is an apportionment of this fixed cost. If this portion of price is eliminated by a marginal-cost pricing, firms cannot recover their fixed cost and will result in huge losses.

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