Drug Advertising vs R&D

When many critics of drug companies want to contest the fact that the long term viability of drug companies requires that revenues must eventually both cover development costs and produce profits, they go to a company's annual financial report and point out that marketing and advertising costs are often a large percentage of revenue. They are quick to claim that the advertising costs can be re-assigned to development. This a superficially self-satisfying claim, but completely at odds with economic reality.

When a company has to decide how to re-deploy the revenue stream that it receives over time from the sale of its products, it has many choices, only a few of which are noted here.

First, of course, if it intends to maintain its business, it will have to buy the factors of production, including labor, that are to be directly used in the next actual production cycle. If this were to exhaust the revenue stream, the very existence of the company is likely pointless and it should be liquidated or sold.

If this is not the case, some of the other possibilities are R&D, marketing and advertising, and financial investments such as bonds or interest-bearing accounts.

How does a company allocate its funds among these (and other) opportunities? By calculating and comparing expected marginal rates of return. Every marginal dollar sequentially allocated to one of these destinations will result in a larger return than for any other alternative, given the effects of all the dollars previously allocated.

If a specific drug A is expected to have a substantial return on the dollars invested in its development, the first dollars will be invested here. However, no investment ever can absorb unlimited investment levels without having its marginal rate of return diminished, so at some point a first dollar investment in a less promising drug B will have a greater return than the n'th dollar invested in drug A.

What applies to different drugs also applies to all of the other allocation choices considered together.

In particular, every marginal dollar spent on advertising must rationally result in a larger revenue return than the best remaining possible investment in new drugs, or in interest-bearing cash balances.

When a company spends $100M in advertising, it is because it will result in at least $105M in additional revenue, for an example. It is not possible to divert the $100M spent in advertising to R&D because, in the absence of the advertising, all of the R&D that has a competitive rate of return is already being purchased given the level of revenue available. More R&D spending IS potentially enabled on drugs with still lower potential rates of return to the tune of $5M. but ONLY IF the advertising is actually purchased and achieves its expected return.

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The potential flaw in this

The potential flaw in this argument is that the return on advertising costs is related to the advertising spending of your competitors. That is, while advertising partly functions as a positive sum game in which value is created by informing consumers, it also partly functions as a zero-sum game in which companies fight for the attention of a limited number of consumers.

Hence if it was possible to get all drug companies to move money from advertising to R&D[ed], it is not clear that they would lose money, because the marginal rate of return on advertising would change.

For a highly artificial and simplified example, suppose that the first $50M of advertising is used for the highest marginal return activity, which is reaching new consumers. The second $50M is used to battle with other firms selling similar products. If all firms were forced to spend only $50M on advertising, they might achieve exactly the same benefit from advertising, because they have simply stopped the zero-sum contest.

While I agree with your analysis in general, I think its important to remember that advertising is one of those odd areas of economic activity with substantial zero-sumness. It is rent-seeking, in that all the firms who make a certain product are competing for the people who know they are going to buy that sort of product. (it is also producing value, by informing consumers, but we must not let that deceive us into forgetting about the rent-seeking aspect).

Patri, I made this same

Patri,

I made this same observation about the zero-sumness of advertizing a long, long time ago on Catallarchy. I would try to dig this post up, but it seems that our archives are not working properly.