Asymmetric information in the access to pharmaceutical markets

It is frequently argued that the high costs of clinical trials prior to the
admission of new pharmaceuticals are stifling innovation. We examine this
argument and explore some of its consequences from an information economic
perspective. We construct a model in which a firm exerts an unobservable
effort towards developing a high quality drug (moral hazard) and then
announces the quality outcome to an uninformed regulator and/or consumers
(adverse selection). The product is then sold to the market with consumers'
willingness to pay, depending on their expectations about product quality.
True quality is randomly revealed over the market process. We compare the
outcomes in regard to innovation effort and expected welfare under two
regimes: (i) regulation, where products undergo a clinical trial designed to
ascertain product quality at the point of market access; and (ii)
laissez-faire with free entry, where the revelation of quality is left to
the market process. Results show that whether or not innovation is greater
in the presence of entry regulation crucially depends on the efficacy of the
trial\ in identifying (poor) quality, on the probability that unknown
qualities are revealed in the market process, and on the preference and cost
structure. The welfare ranking of the two regimes depends on the
differential effort incentive and on the net welfare gain from implementing
full information instantaneously. We show that in settings of vertical
monopoly, vertical differentiation and horizontal differentiation with no
variable cost of quality, entry regulation tends to be the preferred regime
if the effort incentive under pooling is relatively low and profits do not
count too much towards welfare. A complementary numerical analysis shows
that the outcomes vary in a non-trivial way in the presence of
quality-related production costs.