Does Big Pharma make unusually high profits from their high prices for patented drugs? If so, why hasn’t competition whittled them down?

Does Big Pharma make unusually high profits…

Yes.

According to this article from Forbes. The U.S. industry with the highest profit margins is “Health Technology” with a projected average profit margin of 21%.  I’m not sure exactly which companies are included in “Health Technology” but it certainly includes Pfizer, Merck, and Johnson and Johnson.

Does Big Pharma make unusually high profits from their high prices for patented drugs?

They certainly make up a big chunk of revenue. In 2014 the Global Innovating Pharmaceutical Operating Segment, the bit of Pfizer that contains new and innovative drugs, make around $14B in revenue, or about 30% of Pfizer’s total revenue from Biopharmaceuticals, which make up the vast majority of the company’s revenue.

Revenue is not profit, but seeing how fervently Pharmaceutical companies protect their patents and look for ways to extend them, it is pretty obvious that they are an important part of their profits. For example, when Pfizer lost the patent to Lipitor in 2011, their total profit dropped by 19%.

If so, why hasn’t competition whittled them down?

The whole point of patents is to give companies a monopoly on certain products as an incentive to invent more of these products. So there is no direct competition on patented drugs. Once patents expire, the introduction of generics can cause massive price drops.

The other way for competition to eat away at profits, would be if market forces drove large drug companies to spend most of their income on investment, as opposed to taking profits.  I am not familiar with what drives these decisions: It could be that executives are looking to maximize short term share price via profits. It could be that there are diminishing marginal returns to investments in new drugs. Just because a drug company has a bunch of money to spend on developing new drugs, doesn’t mean that there are a bunch of profitable new drugs to develop. This might be especially true given how long it takes to develop a new drug.

Another possible hypothesis is that there isn’t that much competition among the major drug companies. In 2008 15 companies made about half the total global revenue for the industry[1]. Combine that with drug monopolies and high barriers to entry and you end up with something that is far from a situation of perfect competition.

In the long run, in a competitive industry profits should fall. The fact that they haven’t for the pharmaceutical industry is evidence that the competitive forces are not powerful enough.

[1] http://triplehelixblog.com/2014/07/the-patent-cliff-implications-for-the-pharmaceutical-industry/