CBO on Pharma Profits
Note to Ec 10 students: We will study industries with these features--high fixed costs and price well above marginal cost--later in the semester under the topic "Monopolistic Competition."
By standard accounting measures, the pharmaceutical industry consistently ranks as one of the most profitable industries in the United States. Those measures, however, treat most R&D outlays as expenditures rather than as investments that add to the value of a firm. Thus, they omit from a firm’s asset base the value of its accumulated stock of knowledge. For R&D-intensive industries, such as pharmaceuticals, that omission can significantly overstate profitability. Adjusted for the value of its R&D assets, the drug industry’s actual profitability still appears to be somewhat higher than the average for all U.S. industries, but not two to three times higher, as standard measures of profitability indicate.
The notion that pharmaceutical companies enjoy extraordinary profits is reinforced by the relationship between prices and costs in the drug industry. The industry’s high R&D spending and relatively low manufacturing costs create a cost structure similar to that of, for example, the software industry. Both industries have high fixed costs (for research and development) and low variable costs (to put a software application onto a CD-ROM or to produce a bottle of prescription medication). Consequently, prices in those industries are usually much higher than the cost of providing an additional unit of the product, because revenue from sales of the product must ultimately cover those fixed costs.