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Four Reasons Drugs are Expensive, of Which Two are False - An Opinion

Scannell, J

October 2015

Innogen working paper no. 114

Open / download (PDF, 267KB)

If I offered to buy your shoes you would think I was strange, but we could probably haggle a price. If I offered to buy your children, we would not get to the haggling stage. The difference between trading shoes and children is not merely legal. It is also moral. People find it unpalatable, even taboo, to put prices on things that we treat as absolutes; life, liberty, or health. People have moral qualms about the cost of medicines for the sick or dying, but not about the cost of Botox or liposuction.

Yet life-saving medicines do not exist in a parallel moral universe, free from economics. Taxes are paid, as are health insurance premiums; healthcare budgets are set; doctors earn money, often in direct proportion to the quantity of treatment they provide; professors seek riches as biotech entrepreneurs; venture capitalists gamble other people’s money on the professors’ ideas; drug companies pay wages to employees and dividends to shareholders; and former hedge fund managers set up firms to play pharmaceutical arbitrage, buying drugs low then selling them high.

A recent uptick in commercial drug discovery in diseases such as cancer, hepatitis C, and multiple sclerosis means that the price of drugs is firmly a First World Problem; not merely something that troubles poor people in faraway countries. This article focuses on the economics of the problem. The aim is to explain why many drugs are so expensive that even First World health systems struggle to pay for them.

After all, to the uninitiated, drug pricing does not make obvious sense. For around the price of a cappuccino, UNICEF can buy vaccine to immunize a child against polio. In the 4 years before her death from metastatic breast cancer, an American woman might consume drugs that cost more than $200,000 yet offer little prospect of cure. Life-saving insulin for type 1 diabetics can cost only a few dollars a day. Five years ago, drugs priced at $50,000 in the US cured just over 1 out of 3 patients with a hepatitis C infection, at a “cost per cure” near $140,000. Two years ago, a new drug, Sovaldi, was launched at a price around $85,000. It cured 95% of patients, at a cost per cure near $90,000. The price of Sovaldi has caused intercontinental apoplexy, but the cost per cure has fallen, and Sovaldi is cheaper than many drugs that never cure anyone.

It is not only prices that are a puzzle. The drug industry has higher profit margins and higher R&D intensity than any other industry . But some stock market analysts (me, for example) spent the last decade believing that much drug R&D was a waste of shareholders’ money, and if drug companies put their shareholders first, they would be shutting labs, firing scientists, and paying bigger dividends.

So what is going on? “Cost”, “value”, “power” and “prizes” are four ways that people think, talk or write about the mechanism by which drugs are priced. “Cost” refers to cost-based pricing; the idea that the price of goods is based on how much it costs to produce them. “Value” refers to value-based pricing; the idea that the price of goods reflects their value to the buyer. “Power” is the exercise of intellectual property rights, to create scarcity and to find the maximum price that the market will bear. “Prizes” are the incentives provided by profit tomorrow, made credible by profit today, for investors gambling on the R&D that might create tomorrow’s drugs. In the paper, I start with more familiar but less truthful explanations of drug pricing, cost and value, before moving to more truthful but less palatable ones; power and prizes.

An on-line version of this paper was published on the 13th October 2013 by Forbes: http://www.forbes.com/sites/matthewherper/2015/10/13/four-reasons-drugs-are-expensive-of-which-two-are-false/