The Standard Argument

Standard theory, see e.g. Danzon (1997a), argues that countries tend to free-ride on the huge sunk innovation costs of pharmaceutical firms. By setting the drug ceiling as low as possible, they can minimise their health expenses. This seems to be rational, but this regulation has severe impacts on the pharmaceutical firm’s incentive to invest in further pharmaceutical innovations. Ex ante, there are huge investments necessary to finally bring a new drug on

the market, and these investments are already sunk at the time when the national regulators decide on the price ceiling. In order to recover these R&D costs, a sufficiently high mark-up on the price must be granted.

In a static perspective, a classical free-rider problem arises, because the innovation costs are sunk. As long as the price covers at least the marginal costs of production, the firm pro- vides the drug. Hence, all individually regulating countries have an incentive to implement marginal cost pricing. They hope that the foreign price regulations allow for a sufficiently high profit such that the sunk innovation costs are covered and further innovations can be expected despite their own strict price regulation.6 _{In the long run, this is a problem, be-} cause the development of new drugs increases social welfare by allowing to treat illnesses more effectively or by providing new treatments. But the pharmaceutical firms anticipate the problem and expect losses, since the sunk innovation costs cannot be recovered with marginal cost pricing. In the extreme, there will be no investments in R&D.

This general argument can be shown in the framework of a two-countries model without arbitrage possibilities, where governments regulate prices sequentially. A pharmaceutical firm produces a drug q in country H. It faces large sunk innovation costs I and marginal costs c. The drug can be sold in the firm’s home country (H) and a foreign country (F). Demand is qi(pi), with qi′(pi) = dq_dpi(pi)

i < 0 and i = H, F. Demand depends on the price which eventually prevails in the market.

The structure of the model is as follows: In the first stage, the firm decides whether to innovate. The decision rule is to innovate, if the profits resulting from innovation are at least as high as the expected innovation costs. If the profits are lower, the firm does not invest. In the second stage, the H government sets a price ceiling which determines the maximal price allowed in H. The optimal price ceiling maximises welfare in H. Welfare consists of the consumer surplus

CSH(pH) =

Z q−1₍₀₎

pH

qH(p)dp (4.1)

6_{Precisely, the firm does not compare expected profits, but rather expected returns with the innovation}

costs. Since the innovation costs are sunk at the time of the profit respectively return realisation, this chapter talks about the profit π.

and the firm’s profits7

πi(pi) = (pi−c)qi(pi), i=H, F (4.2)

Hence, H maximises the welfare function defined in (4.3) by choosing an appropriate price ceiling pH.

max CSH(pH) +πH(pH) +πF(pF) (4.3)

The game is solved by backward induction.

In the third stage, F sets its optimal price ceiling. F’s welfare consists only of the con- sumer surplus, because the pharmaceutical firm’s profits accrue solely to the home country. F maximises its welfare function subject to the firm’s participation constraint. The firm provides the country F only with the drug, if it earns non-negative profits.

maxCSF(pF) s.t. πF(pF)≥0 (4.4)

It can easily be seen that F indeed sets its price ceiling equal to marginal costs, i.e. as low as possible, and therefore free-rides on innovation costs. The lowest price ceiling is the price level pF at which the participation constraint is binding:

dCSF(pF) dpF =−qF(pF)≤0, πF ≥0, πF dCSF dpF = 0 ⇒ p∗ F =c

In the second stage, H anticipates F’s behaviour. Since the home country’s price ceiling has no impact on F’s price regulation, H maximises welfare by considering only the consumer rent and the firm’s profit in H. Welfare is thus maximised with marginal cost pricing.

d[CSH(pH)+πH(pH)+πF(pF)] dpH =−qH(pH) +qH(pH) + (pH −c) dqH(pH) dpH = 0 ⇒ p∗ H =c

In stage 1, the pharmaceutical firm anticipates that the prices will be regulated too low, and that the innovation costs will not be recovered. Therefore, it will not innovate.

The only way to solve the free-rider problem is for the national regulators to commit ex ante credibly to a sufficiently high price mark-up. One possibility is, e.g., to build up 7_{In the trade literature, it is generally assumed that the welfare function includes the firm’s profit both}

in the domestic and the foreign country. See e.g. Spencer and Brander (1983) or Krugman (1984). They explicitly use the idea that national governments wish to help domestic firms expanding market shares in profitable areas.

reputation. This can be done in a dynamic framework which is not further analysed in this chapter. The present model analyses the possibility to discipline national regulators in their price-setting behaviour by allowing for parallel imports.