Economics

Raise the Wage: The Minimum Wage’s Effect on the Restaurant Industry

Overview

The popular myth is that the typical minimum wage worker is a young high school student who is looking to earn pocket money in lieu of living expenses. This could not be further from the truth. According to the Department of Labor, “89 percent of those who would benefit from a federal minimum wage increase to $12 per hour are age 20 or older, and 56 percent are women” [9]. Within the past year the US has seen a number of fast food workers strike for a $15 an hour minimum wage. Would this increase be too high too fast? Back in 2007 when the minimum wage was looking to increase from $5.85 to $7.25 per hour, there was much wailing and gnashing of teeth from the restaurant industry. In 2007 I also wrote a small post which examined the possible effect of a minimum wage increase on the restaurant industry. Research studies have exhibited that an increase in the minimum wage would not be such a bad deal for the restaurant industry.

Labor and Prices  

One effect that the minimum wage increase will have on the industry is that labor costs will increase. Understandably, businesses have a strong desire to keep their costs low so they do not impact profit margins. Typically, labor accounts for about 30 percent of a restaurant’s overhead. This number is slightly below what is spent on food so it represents a significant portion of restaurant operating costs. For Darden Restaurants Inc labor makes up about 43 percent of its cost of sales [2]. Over the course of two years the federal minimum wage will increase by 40 percent. Margins in the casual dining restaurant are very slim, so any increases in costs will cut into the restaurants’ bottom line. As a result of the increases in labor costs, restaurants will be forced to raise prices on their goods. For example, Darden Restaurants Inc has adjusted prices in the past in response to state minimum wage increases. These increases were enacted so that Darden can maintain its profit margins.

Economists Daniel Aaronson and Eric French examined government-collected price data to determine the impact of minimum wage increases on prices. They found that “a 10 percent hike in the minimum wage increased restaurant prices on the whole by 0.7 percent, and prices at limited service establishments by 1.6 percent [1].”

The fast food sector of the restaurant industry provides a number of low skilled minimum wage earning jobs. Aaronson and French’s research shows that prices in this sector can expect to increase by 1.5 percent per every 10 percent increase [1]. With the minimum wage expected to increase by 40 percent over the next two years, if Aaronson and French’s model holds then prices will increase 6 percent in some states. Most likely this would occur in states that follow the federal minimum standard rates and those that do not have their own specific state minimums. Fast food chains that do a significant amount of business in states such as Georgia, Texas, Louisiana and Tennessee amongst others, could potentially feel the full impact of price increases. For states that are already above the federal minimum wage the impact could be less severe as these states may choose to not enact any further increases to their minimum wages.

Another consequence of price increases in the fast food sector would be its disproportional effect on the poor since poorer families spend a relatively large fraction of their incomes on such goods [4].

Employment

Aaronson and French in their research have constructed a model that attempts to determine the impact of minimum wage increases on employment. “In a perfectly competitive labor market, the authors find that a 10 percent increase in the minimum wage will result in a 2.5 to 3.5 percent decrease in employment. [1]”

While conventional theory dictates that minimum wage increases lead to higher unemployment levels, a study by David Card and Alan Krueger, two economic professors at the University of Princeton challenged this notion. They believe that the U.S. is far below the point where wage increases will begin to start costing jobs. Card and Kruegar conducted a study on minimum wage hikes and focused specifically on the New Jersey minimum wage hike in 1990 and its effect on the fast food industry. Unemployment rates and wages were compared in New Jersey and in Pennsylvania. What they found was that “employment actually expanded in New Jersey relative to Pennsylvania, where the minimum wage was constant. [4]”

Card and Krueger repeated this study and focused on the 1996 federal minimum wage increase with respect to New Jersey and Pennsylvania. In this instance the situations were reversed as New Jersey was already above the $4.75 mandated wage and Pennsylvania was increasing its wage from $4.25. They found that greater employment growth occurred in Pennsylvania than in New Jersey. Although they doubted that Pennsylvania’s strong employment growth was caused by the minimum wage increase they believed that the wage increase at worst, did not lead to unemployment as would be expected. “There is certainly no evidence in these data to suggest that the hike in the federal minimum wage caused Pennsylvania restaurants to lower their employment relative to what it otherwise would have been in the absence of the minimum-wage increase. [5]”

 Potential Benefits of Increased Minimum Wage

An increase in the minimum wage will produce some detrimental effects for that industry but there are some benefits to be had as well. I believe that there are employee benefits as well as employer benefits. The employee benefits are those that focus on the pluses experienced by minimum wage workers while the employer benefits are those that actually benefit the restaurants. An employee benefit would be that corporate restaurant chains would be forced to share some of their vast wealth with the people who helped create that wealth. In an economic outlook report issued by the National Restaurant Association they stated that “The industry is heading into 2007 as an economic powerhouse. [6]” The same association has also estimated nationwide industry sales of $536.9 billion next year, up 5 percent over 2006 [6]. With sales of this magnitude it may be feasible to require that more profit be passed on to employees especially since workers need a minimum amount of income to survive and pay bills. At the current rate of $5.15 and hour, “today’s minimum wage workers have less buying power than minimum wage workers had half a century ago. [7]”

Restaurant employers could benefit from the minimum wage increases as well. Card and Krueger studied restaurants in Texas after the federal minimum wage was raised from $3.80 to $4.25. They concluded that job growth was faster at those restaurants which were affected by the increase [9]. Some restaurants were not affected by the increase because they already paid at or over $4.25.

A higher minimum wage could help businesses like Applebee’s and Darden reduce their worker turnover which could increase the level of worker experience and reduce overall training costs. “High employee turnover is destructive to a company because it means that the company workforce lacks experience and continuity; it means that experienced workers have to spend much of their time training new hires; it means that managers have to spend both time and money finding replacements [8]”.

Conclusion

An increase in the minimum wage will mean that restaurants will most likely be forced to increase prices on their offerings in order to compensate for the higher labor costs. But as the article mentions, if prices increase and sales are not affected then fast food restaurant franchisers could reap the benefits of higher royalties. While conventional economics hint that higher wages will lead to higher unemployment, studies by Card and Krueger show that wage increases (at least as they apply to restaurants that rely on minimum wage workers) will not necessarily lead to higher unemployment. Their studies have shown that unemployment rates have fallen in states when the minimum wage was increased. An increase in the minimum wage could also pave the way for increases in restaurant productivity and a lowering of employee turnover.

References

[1] http://www.epionline.org/studies/aaronson_06-2006.pdf

[2] “Darden sees little impact from a minimum wage hike” Reuters News. (20 Dec. 2006) Factiva.

[3] Becker, Gary and Posner, Richard “How to Make the Poor PoorerThe Wall Street Journal (26 Jan. 2007): pg A11. Factiva

[4] http://www.uvm.edu/~vlrs/doc/min_wage.htm

[5] http://www.irs.princeton.edu/pubs/pdfs/90051397.pdf

[6] “UPDATE 1-US restaurants see 2007 sales up, oppose wage hikeReuters News. (12 Dec 2006) Factiva

[7] http://www.businessforafairminimumwage.org/

[8] http://www.huppi.com/kangaroo/41More.htm

[9] http://www.dol.gov/featured/minimum-wage/mythbuster

How Timken Manages the Business Cycle

Capital Expenditures

In Peter Navarro’s book entitled “The Well Timed Strategy: Managing the Business Cycle for Competitive Advantage”, the professor of business at the University of California-Irvine defines the master cyclist as “A business executive who skillfully deploys a set of well-timed strategies and tactics to manage the business cycle for competitive advantage”[1]. With respect to capital expenditures, firms headed by master cyclists will increase capital expenditures during recession in order to develop new and innovative products and be better positioned to satisfy pent up demand once a recovery takes place. These firms will also modernize existing facilities during economic slowdowns [10].

The overall financial performance of the Timken Company was disappointing in 1998. Although the company was able to set a new sales record at that time, earnings as compared to 1997 dropped 33% [2]. A combination of difficult market conditions and unusual occurrences such as a prolonged strike at General Motors contributed to the decline. “A nearly global economic slow down — which started last year in Thailand, spread to Japan, then to most of the rest of Asia, South America and Russia — has squashed demand for many U.S. products”[3]. The modernization of existing capacity in many countries along with volatile currencies and a strong dollar placed substantial downward pricing pressures with respect to bearings worldwide [1]. Competitors in Asia found the U.S. market appealing since demand was drying up in their home markets. Consequently, the amount of imports into the United States for the products Timken manufactured increased, while exports decreased during this time period.

In this global economic slowdown for players in the steel and ball bearings industry, conventional wisdom would dictate that a company would need to decrease their capital expenditures to better position themselves. Timken during this period of time executed some strategies that were contrarian to conventional wisdom in an attempt to manage the business cycle. From their 1998 annual report Timken states, “We made record capital investments to prepare for the future and lower costs”[4]. During the third quarter of 1998, Timken dedicated a $55 million dollar (~$69 million in constant dollars) rolling mill and bar processing investment at its Harrison Steel Plant in Canton, Ohio [11]. Modernization expenditures were also announced for Timken’s Asheboro plant which opened in 1994 and produces bearings used in industrial markets. “The expansion will increase the size range of bearings the Asheboro plant is able to produce, hike plant capacity and add options available to Timken’s industrial customers” [5].

Timken has a record of increasing its capital expenditures in the face of economic slowdown or recessions in keeping with the strategies and tactics of a master cyclist. Their last new steel making plant prior to 1998 was the Faircrest Steel Plant in Perry Township, Ohio [6]. The plant was announced in the middle of the early 1980’s recession and opened in 1985 [12]. Timken took a huge gamble and invested $450 million (~1.1 billion in constant dollars), which was two-thirds of Timken’s net worth at the time — to build the only completely new alloy steel plant in the U.S. since World War II” [7]. At the time, the so-called experts said the U.S. steel industry was dead and companies didn’t need to build any new plants ” [12]. Similarly during the recession year of 1991, Timken boosted capital expenditures to $144.7 million up from $120 million in 1990 [12].

In order to differentiate its products from pure commodities Timken invested in research and development during this period of economic uncertainty for its products. This strategy is also in keeping with the master cyclist philosophy of increasing capital expenditures to develop innovative products and new capacity in time for a recovery. While Timken’s largest research and development center is in Canton Ohio, it added another large facility in Bangalore India to focus on new product development. Timken Research has four centers located in the US, Europe, Japan, Romania and India. The Timken Engineering and Research India Pvt Ltd is part of the company’s “work with the sun” concept where it is day time in at least one of the company’s centers [8].

Risk Management

 Firms that geographically diversify into new countries and regions can reap the benefits that this hedging strategy provides against business cycle risk. “The effectiveness of geographical diversification as a hedge is rooted in the fact that the business cycles and political conditions of various countries are not perfectly correlated ” [5]. The privatization of Brazil’s steel mill industry in 2001 opened up the door for North American companies to do business there [9]. Timken responded by forming a joint venture with Bardella S.A. Industrias Mechanicas (Bardella) to provide industrial services to the steel and aluminum industries in Brazil. In 2001 the company also acquired Bamarec which operated two component manufacturing facilities in France. The presence of French facilities allowed Timken to expand their precision steel components business unit. Timken CEO James Griffith believed that there was an opportunity to grow this business in Europe and entering the French market provided a base from which to launch their European strategy [10]. Both of the moves during a recession provided Timken an opportunity to hedge against the business cycle risks they faced in the United States.

 

[1] Navarro, Peter. The Well-Timed Strategy: Managing the Business Cycle for Competitive Advantage. New Jersey: Wharton School   Publishing 2006.

[2] The Timken Company 10K Report. 1999.

[3] Adams, David. “Canton, Ohio Steel Executive Favors Federal Reserve Rate Cut.” Akron Beacon Journal, Ohio. 13 November 1998. KRTBN Knight-Ridder Tribune Business News: Akron (Ohio) Beacon Journal.

[4] The Timken Company Annual Report. 1998.

[5] “Timken plans $20M boost for bearings. 16 July 1997.” American Metal Market. Vol. 105, No. 136, ISSN: 0002-9998

[6] Adams, David. “Steel Bearings Maker Timken Co. Opens New Canton, Ohio Mill.” 11 August 1998.

[7] Industry Insider. “How Timken Turns Survival into Growth.” http://www.businessweek.com/magazine/content/03_14/b3827027_mz009.htm 7 April 2003.

[8] Business Line (The Hindu). “Timken Company R&D base in India.” 11 February 1999.

[9] Robertson, Scott. “Timken expects to benefit from Brazil steel privatization.” 9 April 2001. AMM.

[10] “The Curse of a Strong Dollar; Timken CEO James Griffith says his outfit could sell a lot more bearings if the greenback wasn’t ‘overvalued…on the order of 30%.’” Business Week Online. 28 November 2001.

[11] “Continuity and Change in the Growth of a Family Controlled U.S. Manufacturing Firm.” Humanities and Social Sciences Online.   16 April 2007. <http://www.h-net.org/reviews/showrev.cgi?path=16914932502209&gt;

[12] Excerpt from Bear Stearns Industrial Internet Special. “The Wall Street Transcript – Questioning Market Leaders for Long Term Investors.” May 2001.

 

Macroeconomic Assessment: First Quarter 2007

Here is a May 1st, 2007 throwback submission for a macroeconomics graduate class taught by a great professor, Dr. Matthew J. Higgins. The assignment was to assess the current macroeconomic environment and compare the current environment with the previous year. Per the syllabus, one of the aims of the assignment was to teach students how to “cultivate the ability to process the vast amount of macroeconomic data that is put out and shape it into an assessment.”

Looking back on the assignment, I highlighted some ominous trends in housing that obviously affected the course of the economy quite negatively (to use an understatement). I wish I had the foresight of the guys in “The Big Short“. As an aside, Merry Christmas.


Overview

Gross Domestic Product for the first quarter of 2007 increased from the fourth quarter of 2006. In billions, gross domestic product rose from 13458.2 to 13632.6 [5]. In nominal terms, the economy expanded 5.3% but 4% inflation sapped most of that growth [1]. In real terms the increase was more modest at about 1.3% well below an already low projection of 1.8% [4]. Considering previous growth percentages of 5.6%, 2.6%, 2% and 2.5% for the four quarters of 2006, 1st quarter growth was lackluster. In fact, first quarter 2007 results were the weakest growth numbers since before the 2003 tax cuts [3] and well below many economists’ expectations [2]. However, some economists believe that the economy has hit its low point and is ready to rebound.

“The first-quarter GDP report was “probably the low point in the cycle,” said Nariman Behravesh, chief economist at consulting firm Global Insight. “It suggests that in fact we may be setting the stage for a very slight rebound this quarter.” Mr. Behravesh believes the economy will be growing at a rate of close to 3% by the end of the year” [2].

 Housing

Residential Investment, which is a proxy for the housing market, was the biggest drag on 1st Quarter results. Residential Investment decreased from about 717 billion in the 4th quarter of 2006 to 687 billion, a slide of about 4.2% [5]. This aforementioned decrease shaved about one percentage point off of overall GDP.

In the 4th Quarter of 2006 residential investment lowered overall GDP by 1.21%. This slide in investment has been ongoing and falling for six consecutive quarters. The downside to the destabilization of the housing sector is that it could force consumers and businesses to cut back sharply in spending. Former Federal Reserve Chairman Alan Greenspan estimated that the cash homeowners extract from their homes accounted for almost 3% of all consumer spending as of the third quarter of 2006 [2]. Similarly, studies have shown that a 1$ increase in housing wealth increases consumption by seven cents [6]. The main driver of the U.S. economy is personal consumption. A significant drop in consumption most likely would have an adverse effect on GDP. Falling home prices and fewer home equity extractions could potentially curb personal consumption as well.

Interestingly, the slowing U.S. housing market is also having an effect on Latin American countries. Home construction is the main gateway industry for immigrants entering the United States [7]. These immigrants contribute a significant portion of the estimated 50 billion in cash sent from the U.S. to family members in their home countries [7]. “In a recent study of 15 Latin American economies tracked by BCP Securities of Greenwich, Conn., all but three showed better than a 90% correlation between the ebb and flow of U.S. housing starts and the swelling and shrinkage of remittances as recorded by the nations’ central banks” [7].

Trade and the Dollar

For the first quarter of 2007 exports fell 1.2%, the biggest decline in nearly four years. Imports on the other hand increased 2.3%. Net exports subtracted 0.5 of a percentage point from growth. The decline in exports was puzzling considering a rise of 10.6% in the fourth quarter of 2006.

A weakened dollar and European and Asian growth have allowed exports to be a driver of the U.S. economy in recent years. “The Federal Reserve’s Trade-Weighted Dollar Index, which measures the dollar’s performance against seven currencies, fell to its lowest level this past week since the index’s inception in 1973.” [8]. The dollar recently traded at $1.3647 per euro after touching $1.3679 April 29th, near the record low of $1.3681 set April 27 [7]. The dollar dropped 2.22 percent to $1.3651 in April for its biggest monthly drop since November [7]. The weakening dollar will begin to alter the flow of trade by making domestic products cheaper in foreign markets and imported products more expensive. As consumers begin to buy less imported products the economy will be positioned to experience more gains from consumer spending as more money will stay with domestic business.

Another benefit of the weakening dollar is the strong boost it provides domestic companies that do significant business in foreign markets. Companies such as Caterpillar, McDonalds and General Electric reported first quarter 2007 earnings that surprised Wall Street Analysts [9]. PepsiCo Inc. for example reported a 16% increase in first-quarter profit, more than half of which it attributed to sales outside North America. U.S. based businesses with foreign operations will be able to increase their profits when those profits are converted back to dollars. Companies in the S&P 500 derive about 30% of their revenue from abroad, up from 22% five years ago [2]. The current weak dollar will allow companies to gain market share simply by holding their prices steady in dollar terms.

Personal Consumption and CPI

Personal consumption expenditures increased by an annualized 3.8% in the first quarter of 2007. While this was better than the overall 2006 number of 3.2% growth, it lagged behind the fourth quarter 2006 4.2% growth. The Reuters/ University of Michigan Consumer Sentiment index was down from 88.4 in March of 2007 to 87.1 in late April [10]. The drop in consumption was attributed to an increase in certain areas. Medical-care services are up at a 5.9% annual rate over the past six months [11]. Fuels and utilities increased at 1.2% and household energy increased 1.4% as well [11].

Interestingly the CPI exhibited a major price increase in fruits and vegetables. For February of 2007 fruits and vegetables increased 4.7% as a result of the government’s efforts to develop a market for ethanol fuel. An increase in the price of corn has ramifications for the prices of many products.

A major freeze in California in winter 2006 had an impact on the price of fruit and led to drastically lower crop yields. All California crops sustained about 1.3 billion dollars in damage and losses for citrus crops were estimated at 800 million [12].

Rising gasoline prices have also contributed to a decrease in consumer confidence. Gasoline prices as of April 30, 2007 were at $3.02 a gallon and up 80 cents, or 36% since bottoming out in late January at $2.21 a gallon [13].

All of the aforementioned price increases have had an adverse effect on consumer confidence and have been a drag on personal consumption.

Government Consumption Expenditures and Gross Investment

Government consumption expenditures and gross investment lagged in the first quarter of 2007. Overall this area grew at about 1% in annualized terms as compared with a 3.4% increase in the fourth quarter of 2006. National defense was down 6.6% as opposed to a 12.3% increase in the fourth quarter [5]. In a role reversal, Nondefense spending increased as opposed to a decrease in the previous quarter. State and local government expenditures were at 1.672 trillion dollars and grew at a 3.3% annualized rate from the previous quarter [5].

Conclusion

Overall GDP growth was disappointing with respect to the previous quarter and year. Exports which had been a strong component of GDP in the previous year due to the weakening dollar, fell drastically. The weak dollar and a strong global economy have provided a boon to U.S. companies with foreign operations. This situation has been conducive towards the Dow Jones Industrial Index reaching record levels. Although personal consumption is still the engine that powers the U.S. economy, it has weakened somewhat with respect to 4th quarter 2006 levels. The Reuters/ University of Michigan Consumer Sentiment index has experienced a third-consecutive monthly decline and reached its lowest level in seven months [2]. An increase in food, utilities, medical-care services and gasoline have caused consumer sentiment to wane recently. Residential Investment has continued to be a drag on the economy and hobble expansion. This housing downturn has the potential to affect consumer purchases as homeowners experience a drop in home prices. Federal government expenditures were below 2006 levels although buoyed by strong state and local expenditures. This continued weakness in the economy combined with rising prices could be the recipe for stagflation in the near future.

References:

[1] Nutting, Rex “ECONOMIC REPORT: U.S. Economic Growth Slows To 1.3% Pace In First Quarter” Dow Jones Business News (7 April 2007): Factiva

[2] Dougherty, Conor and Whitehouse “Mark Economy Slows But May Hold Seeds of Growth — Weak First Quarter May Signal a Bottom; Consumers Keep Buying” The Wall Street Journal (28 April 2007): Factiva

[3] “Hot Topic: Economic Ups and Downs “ The Wall Street Journal (28 April 2007): Factiva

[4] “ECONOMIC REPORT: Capital Spending Bounces Back In March” Dow Jones Business News (25 April 2007) : Factiva

[5] http://www.bea.gov/national/pdf/dpga.pdf

[6] “Hot Topic: Finding Meaning in Dow 13000” The Wall Street Journal (28 April 2007): Factiva

[7] http://www.bloomberg.com/apps/news?pid=20601085&sid=akQspI2qj7dM&refer=europe

[8] Karmin, Craig “Dollar Touches a New Low Against Euro — U.S. Currency’s Slump Is Likely to Aid Profits, But Add Inflation Risk” The Wall Street Journal (28 April 2007)

[9] Bruno, Joe “U.S. firms benefiting in sales from weak dollar” Associated Press (29 April 2007)

[10] “US: Roundup of Economic Indicators through April 30” Market News International (30 April 2007) :Factiva

[11] Dougherty, Conor “Inflation jumps in U.S. as manufacturing gains” The Wall Street Journal Asia (19 March 2007): Factiva

[12] Raine, George “ECONOMIC DEEP FREEZE / January cold spell inflicts hardship on the state’s citrus workers “ The San Francisco Chronicle (7 March 2007): Factiva

[13] “ECONOMIC REPORT: Gas Prices Jump 10 Cents To $3.02 “ Dow Jones Business News (30 April 2007): Factiva

 

 

An Analysis of the Pharmaceutical Industry

Innovation

Innovation in the pharmaceutical industry is driven by the protections provided by intellectual patents. In theory, these patents temporarily grant innovative pharmaceutical companies a monopoly over their new product or innovation. This monopoly in turn allows pharmaceutical companies to recoup their research and development costs. Companies are able to reap high margins on their products and thus obtain a competitive advantage in the industry. Pharmaceutical companies that participate in the innovation sector are always under intense pressure to find and develop their next “blockbuster drug” quickly, cheaply and effectively. Those companies who are not able to innovate and bring a successful new product to market will experience financial difficulties. For example, pharmaceutical giant Pfizer Inc. has not produced a blockbuster drug since its introduction of the erectile dysfunction drug Viagra in 1998. As a consequence of not successfully innovating a new product since that time, the company will have a diminishing revenue stream in the future. Generic competitors will begin to steal market share from Pfizer as it loses its exclusive monopoly on highly profitable drugs.

While intellectual property protection can encourage innovation in the pharmaceutical industry it can also hamper innovation. Pharmaceutical companies can easily obtain new patents by making minor changes to existing products regardless of whether the drugs offer significant new therapeutic advantages [1]. Typically, minor changes are made to blockbuster drugs before their patent expiration date in order to increase the lifespan of the monopoly. In essence it is much faster and cheaper to receive new patent protections on these “me-too” products than to innovate and bring “new molecular entity” drugs to the marketplace.

Alternatives to the current monopolistic patent protection have been proposed to help foster more meaningful innovation. A drug prize system has been bandied about in intellectual discussions for some time. Under a prize system, the U.S. government would pay out a cash prize for any new drugs that successfully pass FDA regulations. The drugs would then be put into the public domain thus creating a free market system for drugs. “Generic drugs (‘generic’ being another way of saying the rights are in the public domain) already do a wonderful job of keeping prices down. While the price of patent-protected drugs has been rising at roughly twice the rate of inflation, the real price of generics has fallen in four of the last five years.” [2] The prize system has its benefits in the fact that marketing costs would be significantly reduced as companies would have already been paid an upfront prize for their efforts. Large awards could be provided to the pharmaceutical innovator who produces breakthrough results while smaller rewards would be paid for incremental “me-too” innovations.

A prize system could also help increase the number of innovations concerning critical diseases that affect the third world. Government intervention can help direct R&D resources to areas where the private market has failed to concentrate. Breakthroughs are badly needed in the fight against AIDS or the search to develop a malaria vaccine. Advanced industrialized nations could pool their resources together and decide to create a large bounty for any drug that provides a real breakthrough in this area. The desired end result would be enhanced access to better medicines for the third world. Obviously the prize system would have some drawbacks. One major drawback would be the duplication of efforts encountered by firms that would compete for the biggest prizes. It is possible that R&D resources concentrated on the highest prizes would encourage a majority of companies to compete to be the winner in these races even more so than in the current patent system.

Research and Development

Pharmaceutical companies are heavily dependant upon acquiring patents and innovating in order to compete in the industry. As a consequence, massive amounts of funding are needed for research and development in order to keep product pipelines full. The Tufts center for the study of drug development estimated the average costs of developing a prescription drug to be 802 million in 2001, up from 231 million in 1987 [3]. This estimation includes the costs of failures as well as the opportunity costs of incurring R&D expenditures before earning any returns.

A price/R&D tradeoff exists in the pharmaceutical industry. If pharmaceutical companies lower prices for drugs in the marketplace it is feasible to believe that profits will fall for these drug manufacturers. As profits fall, R&D is affected which in turn lowers the amount of new drugs coming into the marketplace. Fewer drugs in the marketplace could potentially lead to future generations of less healthy people.

The pharmaceutical industry is one of the most profitable industries in our nation’s economy, thus the companies that develop new drugs are quite content with the current structure in which R&D costs are high. Of course this means that prices for consumers will continue to remain high. Consumers on the other hand need access to new drug products for illness prevention or treatment purposes. Consumers would prefer that prices fall for new drugs while innovations increase. Given the current nature of the pharmaceutical industry this outcome will remain a paradox.

EndNotes:

[1] http://oversight.house.gov/Documents/20061219094529-73424.pdf

[2] http://www.forbes.com/2006/04/15/drug-patents-prizes_cx_sw_06slate_0418drugpatents.html

[3] http://csdd.tufts.edu/NewsEvents/RecentNews.asp?newsid=6

Image courtesy of amenic181 at FreeDigitalPhotos.net