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Allocative Efficiency

Firms that discover a new drug (or purchase rights to someone else's discovery) typically apply for and receive a patent on that drug from the government in each country in which the drug might be sold, before going through the expensive and time-consuming development and testing process to bring it to market. These R&D costs can be very large, sometimes in the tens or even hundreds of millions. (Drug companies overstate them, but they are large.) The patent makes it illegal for any other firm to sell that drug without the patent-holder's permission-granting a monopoly on the sales of patented drug. Would-be competitors must either purchase the right to sell the same drug- if the patent-holder is willing to sell- or go through the process of discovering the and developing a slightly different d rug with a more or less similar effect.

a. The conditions of "allocative efficicency" require that the price at which a commodity sells on the market be equal to its marginal cost of production. This equaility is supposed to be ensured for commodities produced by profit-maximizing firms under conditions of perfect competition and free entry. Yet patents represent a deliberate policy to block entry and create a monopoly. Under these conditions, what considerations will determine the price of a patented drug and what relation, if any, will the price bear to the marginal cost of manufacturing and distributing that drug? Show graphically the allocative distortion, the "welfare burden" in terms of Question 1, created by the patent.

b. So why do governments issue patents at all? Explain, showing the contrast between the average and marginal cost curves for a firm with very high fixed costs and low marginal costs, and those assumed for the "standard" textbook firm. What might one predict would happen to the rate of innovation if there were no patent protection? Why? Can you interpret your prediction in terms of trade-ff between short-run and long-run allocative distortions, or "short-run pain for long-run gain"? Be as specific as you can about exactly what society as a whole is giving up, and getting, within the terms of this trade-off.

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Allocative Efficiency
Suppose drugs provide total benefits of B(Q) and cost a total of C(Q), where Q is the quantity of drugs. The optimal quantity of drug production is achieved when the difference between the drugs' total benefits and total costs is greatest. If we define the net benefits of drug as NB(Q) = B(Q) -C(Q), allocative efficiency is achieved at the output which maximizes NB(Q).
To maximize, we differentiate and equate to zero.
NB(Q) = B'(Q) - C'(Q) = 0
In words, maximum net benefit (allocative efficiency) is achieved when the marginal benefit minus the marginal cost of drug is zero; or alternatively, when the marginal benefit of drug equals its marginal cost.
Allocative efficiency refers to the efficiency with which markets are allocating resources. A market will be allocatively efficient if it is producing the right drugs for the right people at the right price. An allocatively efficient market is therefore one which has no imperfections. This will be true when marginal cost is equal to average revenue in the market. It occurs where a firm produces at MC = AR (marginal cost pricing).

Patents facilitate consumers' choice among experience drugs and transmit quality signals for infrequently consumed drugs. Patents are indispensable for the efficient provision of drugs with the wide range of variety and quality combinations demanded in a modern economy. Nevertheless, they can also sometimes have anticompetitive effects. Patents allow firms to tie in desired mental images with the advertised drugs and to compete in perception advertising. The resulting possible distortions of competition fall into three categories. First, competition in perception advertising may result in a larger number of brands at equilibrium than is optimal. Second, the tie in produces an allocative distortion. Third, resources are wasted in the effort to link desired mental images with advertised drugs.
The effects of Patents on barriers to entry are ambiguous. The intertemporal effects of perception advertising may create barriers to entry for newcomers. Such barriers will be beneficial to society when the tend to decrease the number of brands toward optimality. With sequential entry, however, perception advertising may tend to increase the number of brands.
Firms may acquire some small market power from first use of the most appropriate symbol and words as Patents. Such monopoly power is limited by restrictions against use of generic and descriptive terms.
The issue of the cost of prescription medications is not a new one for us. In our view, the changes in patent protection and the regulations governing the drug industry have been a recipe for serious disaster.
Compulsory licensing applied to Canadian manufactured drugs, had been legal in Canada since 1923. It applied to Canadian manufactured products but not to imported drugs. Royalties were paid to the holders of the patent.
In 1969, faced with some of the highest drug prices in the world, the Government allowed compulsory licensing on imported drug products. Overall drug prices were reduced for the purchaser.
In 1987, Bill C-27 extended patent protection and reduced the time frame for compulsory licensing.
In 1993, Bill C-91 was introduced, eliminating compulsory licensing by extending twenty year patent protections to new pharmaceuticals.
We believed that the 1993 legislation would allow prescription prices to rise to an unnecessary high level. Every province but Quebec protested the Federal Government's policy. We predicted that the burden to the Health Care System as a whole would start to compromise the benefits all Canadians had received through our National Medicare Plan, The Canada Health Act, and we were right. What was especially troubling was the fact that the Government's policy appeared to be working in the interest of international corporations (where much of the pharmaceutical industry is found) and against the provincial governments and the public interest. The Canadian generic drug industry had proven its capacity to produce safe and effective prescriptions at less cost.
In 1997, at the Parliamentary Review of Bill C-91, we reminded the Government that Canadians were being harmed by the legislation, legislation that they opposed while in opposition. We argued that there was legal advice that said that the restrictions on generic drugs were not required under NAFTA
In Ontario, the highest increase in private healthcare expenditure per capita between 1994 and 1999 was for drugs - 81% of this expenditure comes from households and private insurance.
In 1997, 53.7% of total patented drugs in the B.C. Pharmacare program were category 3 drugs . . . (the Patented Medicine Review Prices Board( PMPRB) sees these drugs to be "me-too" drugs - new drugs that provide moderate, little or no therapeutic advantage over existing medicines) , many of them marginally different drugs at increased prices
The Canadian Institute for Health Research suggests that the increase in drug expenditure per capita was largely due to increased utilization and the introduction of new drugs.
Starting in 1997, the share of patented drugs in all sales of prescribed drugs was more than 60%, a steadily rising proportion of the market
Nationally, between 1987 and 1996, prescription drug costs rose by 93% compared to an overall consumer price increase of 23.1% In 2000 per capita drug costs were 16% above the costs two years earlier.
Drug costs have grown faster than any other cost item in our national health expenditures and now surpass the payments to physicians. "Drugs are now 15.5% of the $95-billion spent last year on health care."
"Drug therapy is one of the fastest changing components of modern medical care (e.g.drug therapy as an alternative to surgery)."
In 1975 the public funded 76.4% of the total healthcare bill but by 1997 only 68% was covered by public expenditures with the rest paid for by private insurance and individuals.
The National Health Survey 1996/97 carried out by Health Canada identified some disturbing information:
1. 80% of those between 65-69 had used prescription medications
2. 88% of those over the age of 80 had used prescription medications
Six million Canadians have inadequate insurance for prescription drugs
In Canada, 61% of prescription dollar sales go to patent drugs .
The median after-tax income of Unattached Individuals was $16,700. 20% of Unattached Elderly Women and 32% of Unattached Non-Elderly women had a median after-tax income of $15,600 or less.
Lone-parent families of two or more had a median net worth of $14,600 and a median after-tax income was $21,800.
These are national figures and we know, through the work of the National Council on Welfare, that 'low income rates' vary greatly from one province to another. A quick study of their latest report Poverty Profile 1998, Volume 113 published in the Fall of 2000 illustrates this very clearly.
Now, think about having to pay for rent, food clothing, shelter and payments for drugs. People are having to forgo needed prescription medication in order to pay for their basic necessities.
Provincial Governments are trying to control their escalating health costs. One strategy is the exclusion of new prescription medications from Provincial Formularies. Many new generic treatments are not finding ready or quick acceptance on these critical lists. British Columbia takes an average of 84 days to list a new drug while Ontario takes 314 days. All Provinces now require co-payments from those on their drug benefit plans. In Ontario, those on social assistance as well as beneficiaries of the Ontario Drug Benefit program(ODB) are required to pay. For those on the ODB, the first co-payment of $100 may occur on the very first prescription drug purchase of the year. In addition, there are dispensing fees for all remaining prescriptions. In Saskatchewan the co-payment for low income seniors is $200.
Finally, with the changing practice of health care moving from institutions to the home, the burden of drug costs is increasingly falling on individuals and drug coverage plans. The people most likely to be covered to some degree for drug coverage are those working full-time, social assistance recipients, seniors etc. This leaves out many vulnerable Canadians.
The World Trade Organization (WTO) and the Agreement on the Trade Related Aspects of Intellectual Property Rights(TRIPs) and the International Pharmaceutical Industry.
TRIPs extends industrial patent protection to 20 years and we understand the great pressure the Government is under to avoid trade penalties. We believe that the Government must act to balance Private Property Rights against the Public Interest of all Canadians. We have read the carefully documented reports of the active engagement of the International Drug Companies in pushing the boundaries of patent protection and limiting, if not blocking, the production of generic copies of their key products. We also understand that generic copies of patented drugs sell at one half (1/2) to one third (1/3) of the cost of brand name counterparts. We have read with interest about the great pressure the large International Pharmaceutical manufacturers are under from many nations in Africa to reduce the cost of drugs needed in the treatment of HIV/AIDS - pressure that includes the manufacturing of generic counterparts to the brand name drugs. The human cost of high-priced drugs is found in Canada as well as in the industrially developing world.
Provincial Drug Benefit Plans keep some cap on prices as they may negotiate with manufacturers somewhat lower prices. A drug company knows that if its product is not listed the potential market will be significantly reduced.
Companies have the right to reasonable protection of their inventions and we believe that 20 years is far too generous. We are not dealing with can-openers. We are dealing with human needs. We are dealing with companies that have received public support through University research, tax incentives, legislation and direct government grants and loans. We are putting corporate Wealth against Public Health. However, if the 20-year protection is to be imposed, we must ensure that companies do not manipulate the regulatory system to delay the entry of lower cost generic products and thereby extend their patents. We must stop the growing practice of companies continually adding on new patents, through minor modifications, to their existing patents, thus extending the life of the original patent. We must balance the companies' private interest against the clear public interest and public need. Canada and the United States are the only countries that have given extra protection to the International Prescription Drug Industry through the use of the regulatory process. Only Canada and the United States provide these companies with an automatic two year injunction to block the introduction of a generic drug to the market, an injunction that holds until the matter is settled in court. This special treatment of the most profitable industry in the world is not justifiable.
Given that the Government has agreed to comply with the WTO/TRIPs ruling by introducing Bill S-17, and given the public interest /needs directly affected by this legislation (health), and, given the high level of profits recorded by the International Pharmaceutical Drug Patent Industry, and, given the essential role played by the production of generic drugs in the overall cost of healthcare, we urge serious consideration of the following recommendations which are fully compatible with the TRIPs code:
1. Impose an absolute limit of 20 years and roll back all those patents that exceed that 20-year limit. (Amend Section 45) This would be in full compliance with the WTO ruling
2. The 20-year time limit should begin the moment a filing is submitted to Health Canada.
3. Repeal the special Regulations targeted at the pharmaceutical industry and treat the industry like any other patent holder. (Repeal existing Section 55.2(4))
4. Limit the number of patents per drug to a maximum of two. We believe that the "ever greening" of patents - the adding on of additional patents to the original one - is unjustified and unfair.
5. Ideally, we would like to see the institution of a national drug plan where the purchase and distribution of medicines were overseen by federal or provincial government bodies. This would save money for everyone and work to the benefit of all. Canada is an example we should look at.
Technological changes in medical care are driving most cost trends, even as the U.S. lags behind other nations in health outcomes. Drug costs are impacted by this technology trend and are increasing due to two major factors: the rise in drug utilization (volume) and price. Both factors in turn are caused by a shift toward the prescribing of newer, more costly drugs. Not surprisingly, these are the drugs most aggressively marketed to consumers, doctors, and other health care providers. Marketing and lack of unbiased, public information contribute heavily to the current cost trends.
The volume of drugs sold is the biggest contributor to rising employer drug costs. More medications are prescribed than ever before, increasing by 74% from 1992-2002. This rise, in part, reflects the trend of patients using expensive drug therapies instead of medical care so there are some compensating benefits for the higher utilization. Still, for many consumers, the retail price of drugs is often the most noticeable problem. Drug companies have raised prices by an average 7.3% per year from 1992-2002 and 6.7% in 2003, exceeding the average inflation rate of 2.5%. Recently, these increases have slowed as more generics are prescribed and fewer new drugs have been released. We expect the use of super-specialty drugs and the aging of the workforce to be significant future cost-drivers
Employers pay twice as much for medical insurance than 6 years ago, and often cite the costs of medication as the leading cause. Drug costs are projected to rise by an additional 18.1 percent in 2004. In contrast, employer drug spending increased by about half this amount in 2003, with workers paying more and switching to generic drugs. Employers and health plans are raising premiums, co-pays, and deductibles. Most plans have multi-level drug co-pays, and some are capping benefits. Even mail order is charging larger co-pays for multi-month prescriptions. Surveys by Kaiser and Towers Perrin in 2003 show that at least 80% of large employers plan to increase cost sharing in the next few years for active and retired workers.
Workers and retirees without drug coverage will see more extreme increases. Nearly one out of three people under age 65, or 81.8 million people, were uninsured at some point during 2002 and 2003. By the end of 2003, the number of uninsured rose to the highest percentage in history, primarily due to the decline in employer-based health coverage. Now only 60.4% of workers have job-based health care
THE QUALITY of medication prescribing and use in older persons has been a recurring issue of substantial concern for policymakers, regulators, health care researchers, and the public. Although there have been numerous efforts to measure the extent of the problem and to identify areas in greatest need of change, constructing meaningful quality indicators relevant to drug therapy in elderly patients has continued to be a challenge. In 1991, Beers et al published explicit criteria for determining inappropriate medication use in the institutionalized elderly patient population, which were updated and expanded in 1997. The Beers criteria have been widely used by regulators as a drug utilization review tool. They have also been used in numerous studies, that examine patterns of potentially inappropriate prescribing in various US ...

Solution Summary

Contrast between the average and marginal cost curves for a firm with very high fixed costs and low marginal costs, and those assumed for the "standard" textbook firm.

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