profit. The presence of monopoly means that prices will be inefficiently high and out-
put will be too low. (After the fact, social benefits are maximized if new drugs are priced
at marginal cost.)
A third type of market failure stems from imperfect information. On their own, con-
sumers have no means to assess the benefits and risks of new drugs. Thus, before any new
drug is commercialized, laboratory and clinical studies are required to confirm its bene-
fits and to identify potential side effects and risks. The medical research community, in
conjunction with drug companies, carries out these tests. The FDA evaluates the test
results and decides whether or not to approve the drug. The FDA approval process relies
on two basic benefit-cost rules: (1) approve the drug if and only if its expected benefits
exceed its costs, and (2) design the tests, so that the expected benefit of additional infor-
mation just matches the extra dollar costs of the tests. The need to acquire extensive infor-
mation about any new drug results in tough test requirements that account for the lengthy
approval process (seven or more years).
Given these multiple market failures, how should the government set its trade-offs
in regulating new drugs? The answers are simpler in principle than in practice. Ideally,
the government should grant the developer the right to sell a new drug at a price that
offers the firm a normal rate of return given the risks of the development process. Thus,
this prescription parallels the rule of average-cost pricing, discussed earlier in the context
of natural monopoly (Chapter 8). This rate of return, however, must average in the costs
of unsuccessful research efforts. After all, only a small fraction of the drugs on which R&D
efforts are devoted are brought to market.
Because of the difficulty in measuring average costs in such a risky environment,
the majority of health analysts are reluctant to move toward formal price regulations for
new drugs.^23 Research studies provide some evidence of above-normal returns earned
by pharmaceutical companies. But price regulations designed to eliminate excess prof-
its could go too far, leaving drug companies with below-normal returns and severely
retarding new drug development. More modest government strategies aimed at increas-
ing the availability of new drugs include (1) increasing government subsidies to needy
individuals to pay for the costs of drugs, (2) disseminating information about generic
drug substitutes, and (3) using managed-care purchasing arrangements to negotiate
lower drug prices.
The government does have a significant role to play on other fronts. Given the
enormous external benefits of new drug development, the government should con-
tinue to sponsor and subsidize scientific studies by universities, private firms, and its
own research groups. Finally, for many new drugs, such as AZT, the FDA should accel-
erate its approval process (notwithstanding the high costs of doing so). For the most
promising drugs, the considerable benefits of early introduction and dissemination jus-
tify these additional costs.484 Chapter 11 Regulation, Public Goods, and Benefit-Cost Analysis(^23) For economic assessments of drug development and policy recommendations, see E. Porter, “Do
New Drugs Always Have to Cost So Much?” The New York Times, November 14, 2004, p. BU5, and
F. M. Scherer, “Pricing, Profits, and Technological Progress in the Pharmaceutical Industry,’’
Journal of Economic Perspectives(Summer 1993): 97–116.
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