Sunk Costs Now Were Not Always Sunk

Here’s a question I asked my students in the final exam last quarter:

When the drug company Burroughs-Wellcome brought out the first major anti-AIDS drug, AZT, in the late 1980s, the company priced a year’s dosage at $8,000. As you can imagine, many people criticized the company for setting such a high price. Burroughs-Wellcome replied that it needed that price to offset the large R&D costs of the drug.
(a) Did Burroughs-Wellcome’s justification make sense? Why or why not? (2 points)
(b) Construct a better justification for the high price, one not just in the interest of Burroughs-Wellcome but also in the interest of future consumers of future drugs who want those drugs to be invented. (2 points)

Dean Baker, had he taken my exam, would have nailed part (a). Part (b)? Not so much.

In a piece titled “Paul Krugman, Bernie Sanders, and Medicare for All,” Dean writes:

In the vast majority of cases, the drugs in question are not actually expensive to manufacture. The way the drug industry justifies high prices is that they must recover their research costs. While the industry does in fact spend a considerable amount of money on research (although they likely exaggerate this figure), at the point the drug is being administered this is a sunk cost. In other words, the resources devoted to this research have already been used; the economy doesn’t somehow get back the researchers’ time and the capital expended if fewer people take a drug that is developed from their work.

Good answer to (a). 2 points.

He goes on to point out problems with high drug prices in the United States. I’ll give the quote with my evaluation in square brackets:

Companies have incentive to engage in massive marketing efforts [DRH: true], they push their drugs for conditions for which they may not be appropriate [DRH: probably true], and they conceal evidence suggesting their drugs may be less effective than advertised, or possibly even harmful [DRH: hard to believe].

He then says something whose significance he misses. He writes:

Even research is distorted by this incentive structure, with large portions of the industry’s budget being devoted to developing copycat drugs to gain a share of a competitor’s patent rents.

Dean writes this in the context of a discussion of the problem with monopoly. What’s the major solution to the problem of monopoly? Competition. What are copycat drugs? Competition. A Chevrolet is a copycat Ford, and we pay less for Fords because of the existence of Chevrolets.

But he never even mentions the economic analysis that I wanted my students to see (and, fortunately, that many did) in answering part (b). You can read his whole piece and not find him admitting that high profits from a monopoly on a patented drug are an incentive to bear high R&D costs. Those high R&D costs, once borne, are sunk, but, before borne, float.

By the way, if we could completely end government power over the introduction of drugs, maybe a system without patents could work, although I doubt it. But with legislation that makes drugs illegal before the FDA gives permission, and with the requirements for permission imposing costs that average over $2.5 billion per drug brought to market, there’s no way.

HT2 Mark Thoma.