Estimating allocative inefficiency in the prescription drug industry

Abstract

The economic organization of the pharmaceutical industry is profoundly affected by the patent system, which provides a temporary monopoly as an incentive for innovation. The consensus of industry observers has been that potential benefits from stimulating pharmaceutical innovation are large and very difficult to estimate, while the costs of monopoly power are relatively modest. We argue that the use of accounting profits to estimate social costs of monopoly has led to serious underestimates of those social costs. In this paper we use sales estimates for individual drugs from survey data published by IMS America Ltd to estimate dead weight loss (DWL) per dollar of sales for several prescription drugs. We estimate that for the drugs we study there is $5 billion of DWL on the $8 billion of sales.