Orphan Drugs, Intellectual Property, and Social Welfare

A pair of excellent articles by Geeta Anand on the front page of the* Wall Street Journal* for November 15 and 16 discusses the little-known but very costly Orphan Drug Act of 1983. The Act is designed, mainly by providing expanded intellectual-property protection (there are also tax incentives and research subsidies, but they are considered less important), to encourage the creation of drugs for the treatment of rare diseases, defined as diseases that afflict no more than 200,000 Americans at any given time. Partly because different cancers are classified as different diseases, an estimated 25 million Americans have a rare disease as defined by the Act.

A company that is first to obtain the Food and Drug Administration's approval to sell such a drug has the exclusive right to sell it for seven years. Although this is shorter than the term of a pharmaceutical patent (normally 20 years), establishing patent eligibility is a far more difficult and protracted undertaking and a patent once obtained is subject to court challenges that often succeed in invalidating it.

The expansion in intellectual-property rights brought about by the Orphan Drug Act makes the following economic sense: The incentive to create an intellectual work is a function of the size of the potential market for it. The reason is that, by definition, the principal costs of such a work are fixed costs, incurred before the first sale is made; in the case of orphan drugs, they are the cost of R & D plus (what is often greater) the cost of clinical testing, and they greatly exceed the costs of actually producing the drug. The larger the market, the lower the fixed costs per sale, and so the less the seller has to charge in order to recover those costs. If fixed costs are 100 and variable cost (the cost of producing one unit of the product) is 1, then if there are 10 customers the producer must charge each at least 11 (100 divided by 10, plus 1) to break even, but if there are 100 customers he can break even at a price of 2 (100 divided by 100 plus 1). Hence the rarer a disease, and thus the smaller the potential market for a drug to treat it, the higher the price that the producer must charge in order to break even. His ability to charge that high price will depend on his ability to exclude competition; a producer allowed to duplicate the new drug could undercut the price charged by the original producer yet make a large profit because he would not have borne any R & D costs. The higher the break-even price and therefore the greater the profit opportunity for a competitor, the likelier that competition will quickly erode the price and prevent the original producer from recovering his fixed costs. Giving the original producer more than the usual protection against competition that the law provides to creators of intellectual property is thus a method of increasing the incentive to create drugs that have only a small potential market because relatively few people suffer from the diseases that the drugs treat.

This is not just a theoretical point. The fixed costs of a new drug are indeed high, even if the industry-sponsored figure of $800 million is, as I believe, an exaggeration. This means, moreover, that even without a threat of competition, the incentive to develop a new drug that would have very few buyers would often be insufficient to induce that development. Suppose a drug cost $500 million to develop and had only 50 potential customers. Then each would have to pay (over his lifetime) $10 million (actually more, because of discounting to present value) to enable the producer to cover its fixed costs. Health insurers might be unwilling to pick up such a tab.

The success of the Orphan Drug Act in encouraging the creation of orphan drugs (more than 200 such drugs have been approved since the Act was passed, compared to only 10 in the preceding decade), which in 2003 had total worldwide sales estimated at roughly $28 billion, confirms the economic analysis and shows that intellectual-property protection can have important incentive effects. But has the Act produced a net gain in economic welfare? That is less certain. Of course many people have benefited from the drugs. But the costs per benefited person are frequently astronomical; that is implicit in the rationale for giving producers of such drugs increased protection against competition. The costs are especially high for those orphan drugs, apparently the majority, that alleviate symptoms or prolong life but do not cure the disease, so that the patient has to take them for the rest of his or her life. The* Wall Street Journal* articles give an example of a woman who suffers from Gaucher disease and spends (or rather her health insurer spends) $601,000 a year for the drug, Ceredase, and its administration. Because by definition the percentage of people who suffer from rare diseases is small, it is feasible for health insurance to cover such extraordinary expenses, provided the insurance pool is large. And Ceredase is at the high end of orphan drug expense.

Resources for medical research are finite. The Orphan Drug Act sucks large research expenditures into creating treatments for rare diseases. Without the Act, those resources would be channeled by the market into other investments that might produce a higher social return. The English economist Arnold Plant pointed out many years ago that if the law protects some monopolies, as by granting patents or equivalent intellectual-property protection, the profit opportunities that such protection creates (Ceredase generates an estimated 25 percent annual rate of return on investment for its producer, Genzyme Corp.), which are not generally available in the economy, may attract into the monopoly markets resources that would produce greater consumer welfare if invested in production in competitive markets. As a result of competition, the price of television sets is much less than the price that people would be willing to pay if the sale of television sets were monopolized; the difference is "consumer surplus" and is a measure of the net value that the industry creates. For all one knows, the consumer surplus that would be generated if the resources now devoted to developing orphan drugs were channeled into competitive markets would exceed the net benefits of those drugs, bearing in mind that there are few beneficiaries. The number of people who take orphan drugs is far fewer than the total number of people with rare diseases. Indeed, apparently only 200,000 Americans are taking such drugs. Assuming that most global expenditures on orphan drugs are for Americans (I'm just guessing--I do not have U.S. figures), this would be an average expenditure of $100,000 ($100,000 times 200,000 equals $20 billion). Few people would be willing, if only because few people would be able, to spend anywhere near this much on drugs.

As the economist Tomas Philipson points out, however, if people who do not suffer from rare diseases derive a benefit from orphan drugs--whether because they are altruistic or because they fear that they or members of their families might develop such a disease--then the total social surplus created by the Orphan Drug Act may exceed the consumer surplus. Yet if the R & D expenditures induced by the Act were channeled instead into developing drugs for equally serious but much more common diseases, this might well be preferred by most people.

An amazing number of comments, some however needlessly incivil.

A very interesting comment suggests that, if seven years of exclusivity are enough to induce substantial expenditures on developing orphan drugs despite their small market, we should reexamine the need for the 20-year patent term. An even more radical possibility would be to jettison patent protection in favor of some variant of the Orphan Drug approach, a form of intellectual property protection that is much simpler than patent protection. But I recognize the force of the criticisms of the Act in the excellent comment by "SteveSC."

Another comment asks whether the alternative uses to which resoiurces would be put if there were no Orphan Drug Act would contribute as much as or more than to social welfare; the commenter says that "it does not seem that a drug like Viagra is nearly as useful as say, one treating cancer." This proposition has great intuitive appeal, but it is (speaking of useful) useful to distinguish between the utilitarian and economic perspectives. Economists generally measure the welfare effects of a new product by willingness to pay rather than by subjective satisfaction (pleasure, happiness, freedom from pain, etc.). From that standpoint, a drug like Viagra that has a huge potential market might be more "valuable" than a drug that treated a cancer from which only a tiny number of people suffer. I am not suggesting that the economic criterion of welfare should be the only one employed by government. But I insist on the relevance of the economic perspective--and here I quote the commenter who said "It is in fact appropriate to ask--ad absurdum--whether an Act resulting in pharmaceutical companies spending billions to find a cure for a disease whose only victim were Bill Gates, instead of spending them on research that might benefit thousands of even millions of Americans, would in fact have negative benefits [for] the rest of us." No offense intended to Mr. Gates; it is nevertheless a worthwhile question.