Question

In Pharmaceuticals & Medicine industry it is very common to observe two phenomenon, patent and price regulation. Simultaneous existence of these two phenomenon is puzzling for normal consumer. It seems that idea of patent is to allow a company to earn more profit whereas price regulation is to curb on company's greed for profit. Please explain why these two economic phenomenon exist at the same time and what will happen if government eliminates one or both. Only use economic reasoning to explain.

Answer 1

Yes, a patent does allow a company to accrue more profit, but that is not the main reason why patents are offered. A patent offers inventors the exclusive right to benefit from their innnovations for a limited period of time. In the absence of a patent, it is likely that a firm is unwilling to invest in research and development(R&D). Firstly because, if there is no patent, then there is no profit, as it will be the case of a competitive market (where price=marginal cost) with equal information to all firms, and thus no money to invest in research. And secondly, even if the firm has some capital from its inception into the market that can be used for research, then the benefit of the innovation cannot be limited to the innovator. This will make it easier for the other firms to copy the same innovation at no cost, and benefit from it as well.

But, a patent also offers a kind of limited monopoly. And a monopoly produces where marginal cost= marginal revenue, i.e. it maximizes its profit, and charges a price that the consumers are willing to pay at that output.

This generates a deadweight loss as is shown in the above diagram. The deadweight loss measures the value of the lost output by valuing each unit of output at the price that people are willing to pay for that unit. In other words, it is a measure of how much worse off people are paying the monopoly price than paying the competitive price. It is the loss in 'social welfare' that could've been gained had it not been a monopoly.

Therefore, there comes a need for prices to be regulated, otherwise there is a tendency for companies with patents to extract maximum profit, and causing social loss. This becomes especially important when companies get together and form cartels. Because then they can coordinate production and push up prices illegally.

So, the government would want firms to innovate, but at the same time try to minimize the loss of social welfare. In this case, patents and price regulations would coexist.

If the government eliminates a price regulation, then firms with patents can choose whatever price they want, and exploit the people causing a social welfare loss.
And if the goverment eliminates patents, but regulates prices, then it can restrict output if necessary, but that would not benefit society, since in a competitive market social welfare is maximum. But if a cartel exists, then the government might need to intervene through regulating prices.

If the government eliminates both, then there won't be any incentive to innovate among firms. But if there is cartel formation, then the government won't be able to regulate it either. Examples of cartels which face no price regulation include the Organization of Petroleum Exporting Countries(OPEC), and the United Potato Growers of America.