Tuesday, February 24, 2015

Innovate or Die

Clear to blue. Breakthrough!




Over time, a firm competing in an industry that is competitive will tend towards zero economic profits. Over the long term, that means there will be exit from firms that have higher marginal costs, as they will lose money as a price taker.
If a firm wants to remain a going concern and they are not just a commodity producer, they should ideally become a monopoly, so that they can set their price and quantity. That task is too easily said but is difficult to accomplish. Any monopoly at a large scale will face regulation and excessive attention from the state in terms of prices and quantities produced.
Instead, what a firm needs to do is to be constantly innovative. By being constantly innovative, they can use first mover advantage to gain a temporary monopoly on their new concepts. Even better is if a firm can use state protections like patents, which grant a temporary monopoly on a product. One example is Viagra. Viagra was the first drug that was popularly used to treat erectile dysfunction in the United States. Its introduction was unlike any other drug in recent memory, and it led to jokes and magazine covers. It also led to sales. Though there are now competing drugs, Viagra is not just a chemical compound; it is a brand in itself. It still controls almost 50% of its market, and in 2012 brought in over two billion dollars for Pfizer (“Viagra”).
The problem is that those temporary monopolies lapse. Drug companies have to keep drugs in their research and development pipeline because Viagras are few and far between. Many promising compounds flame out somehwhere between the lab and human testing. Therefore, to maintain its market position, drug companies have to innovate. Alternately, they buy smaller companies working on promising compounds. The reality is that the monopoly granted by a patent is temporary. The patent for Viagra will run out in 2019 (“Viagra”), and Pfizer will have to replace that two billion dollars with something else. Other companies will be able to make the chemical equivalent of Viagra and the profit on Viagra will be lowered. There are other strategies that drug companies use to extend their monopoly on drugs: they will reformulate the delivery system and then rebrand it as something like “Viagra Extended Release”. Moves like this stem the fall of economic rents from the patent protection and the fading brand, but they are no substitute for new innovation and differentiation.
A final thing to consider is the pricing on your temporary monopoly. If a drug company has created some potentially life-saving compound, the price of that compound would perhaps have a perfectly inelastic demand curve. No matter what price the company charged, the demand would be everyone who had the disease. Something close to this has happened recently. Gilead released Sovaldi. It is a twelve-week regime that has a much higher cure rate for Hepatitis with few side effects than current treatments. Gilead used its monopoly to set the price high: 84,000 for the twelve-week-course. That comes out to about a thousand dollars a pill when the marginal cost of the making those pills is much less. This pricing has brought out extra-market forces to bring pressure on the company. (“Who Deserves to Get Them?”). A quirk of the pharmaceutical industry is that many of its products are not paid for by the end user, instead it is government agencies and insurance companies. Around the world, they are imposing various forms of political pressure and price controls on the drug. In spite of this pressure, Gilead realized over ten billion dollars in revenue on Sovaldi alone (“Sales of Sovaldi”). Even though there was much clamor, the company made the profits by their innovation. In addition, they are not done. Gilead has more drugs in the pipeline for when Sovaldi is tapped dry.

References
Appleby, J. (2014, May 2). New hepatitis C Drugs’ Price Prompts an Ethical Debate: Who Deserves to Get Them? Washington Post. Retrieved from http://www.washingtonpost.com/business/new-hepatitis-c-drugs-price-prompts-an-ethical-debate-who-deserves-to-get-them/2014/05/01/73582abc-cfac-11e3-937f-d3026234b51c_story.html
Pollack, A. (2015, Feb 3). Sales of Sovaldi, New Gilead Hepatitis C Drug, Soar to $10.3 Billion. The New York Times. Retrieved from http://www.nytimes.com/2015/02/04/business/sales-of-sovaldi-new-gilead-hepatitis-c-drug-soar-to-10-3-billion.html
Wilson, J. (2013, March 27). Viagra: The Little Blue Pill That Could. CNN. Retrieved from http://www.cnn.com/2013/03/27/health/viagra-anniversary-timeline/index.html