It’s no secret that the price of drugs in the United States is a touchy subject; wanting affordable drugs now versus the cost of developing presents a difficult dilemma. A lower price for drugs as soon as they’re developed could save lives, but money for expensive R&D also has to come from somewhere. Every year investors spend five times as much as government does on medical research (drugcostfacts.org, 2015), and they aren’t doing it out of the bottom of their heart. The assumption is that investors will only allocate capital to a biotech/pharmaceutical company if they believe they will be appropriately compensated for the greater risk associated with that industry.
This explains why a drug is highly priced during the life of its initial patent. It is important to point out that after the patent expires, the price drops dramatically because generic companies can produce off-brand versions of the drug. While the patent is exclusive the price does exceed the marginal cost of production, which reduces the total benefits a consumer receives. This is seen as a necessity to generate a return adequate enough to pay for the time and risks undertaken. According to Duflos in 2009, the average period of marketing under patent protection is 11.5 years. If the drug makes it to market, the drug producer has 11.5 years to generate enough profit to pay for not only the R&D, but also for the investor premium. The two benefits attributed to this model is that it allows investors to receive a return on their capital which incentivizes innovation. The time spent waiting for the patent to expire also encourages a generic market.
But still, why do drugs have to cost so much during their patent life? It starts with the fact that it takes an average of 12 years for a drug to make it from a lab into the hands of a consumer. Only 5 of 5,000 drugs that enter pre-clinical testing ever make it to market and of these 5 drugs, only 20% are ever even profitable. “The true cost of capital for a pharmaceutical company includes the costs of failures, of course. Consequently, the total cost for developing one successful drug is $5.5 billion” (Winegarden, 2014). According to the NYU Stern School’s estimate, the weighted average cost of capital (WACC) for the pharmaceutical industry is estimated to be 8.33%. This means that for a 12 year period investors expect ((5.5bil*8.33%)*12)+5.5bil= $10,997,800,000. Rounding up this is $11 billion. In order to pay for $11 billion dollars during the 11.5 year time period, a drug manufacturer must generate about 1 billion dollars of revenue each year.
If you’re looking to diversify your portfolio, the industry is worth taking a look at. Not only can it serve as a means of diversification, but according to Risk-Return Analysis of the Biopharmaceutical Industry as Compared to Other Industries, the net profit margin and return on equity for biopharma was higher than the other examined industries.
For further research: Why have investors of the biopharmaceutical industry not realized their returns if the industry has outperformed other industries
Popa, C., Holvoet, K., Van Montfort, T., Groeneveld, F., & Simoens, S. (2018). Risk-Return Analysis of the Biopharmaceutical Industry as Compared to Other Industries. Frontiers in pharmacology, 9, 1108. doi:10.3389/fphar.2018.01108
Winegarden, Wayne. (2014). The Economics of Pharmaceutical Pricing. Retrieved from https://www.pacificresearch.org/wp-content/uploads/2017/06/PhamaPricingF.pdf
What role does private sector R&D play compared to the National Institutes of Health?. (2019). Retrieved from https://www.drugcostfacts.org/public-vs-private-drug-funding