Drug Pricing Made Easy

 

President Trump was both lucky and smart this week in his approach to the thorny issue prescription drug pricing. Lucky, because a district court threw out on First Amendment grounds his executive order that drug companies supply list prices for all the drugs that they produce. Smart, because at the eleventh hour he decided against issuing an executive order that would have required pharmaceutical companies to offer a system of “most-favored-nation” pricing, which would cap the prices that drug companies could charge in the United States to the lowest price charged for that drug in any country outside the United States. Eliminating poor price signals is a modest benefit. But the implementation of the executive order would have slashed revenues, putting pharmaceutical companies at serious financial risk and perhaps ruin.

The basic flaw behind both proposals is that they assume that there is a unique “price” at which pharmaceutical drugs sell. That assumption often works in competitive markets in which the costs of development are low relative to the marginal (i.e. additional) cost of production for each unit. But so-called marginal cost pricing does not work for new pharmaceutical drugs whose development costs are already high and getting ever higher. Companies are constantly researching and trying to develop new drugs with strong therapeutic properties and tolerable side effects. They also face huge costs in shepherding promising drugs through three stages of clinical trials, each one more complicated than the last. Many promising new drugs wash out in these clinical trials, which means that a pharmaceutical company can remain solvent only if its blockbuster drugs yield enough revenue to offset the costs of its duds. And finally, companies incur huge financing costs as they bring drugs to market. Development and clinical trials take years to complete, and drug companies have to find ways to finance expenditures made in year one with revenues that will only start, typically, some eight to 10 years later.

So how are these costs best recovered over the relatively short period during which the drugs receive patent protection, which today works out to around 11 years, give or take, for a major blockbuster drug? The common suggestion is that each purchaser should only be required to pay for the marginal cost of producing the drug that he or she consumes. This was the idea behind Trump’s aborted executive order. In a market that is characterized by high fixed costs of development, that strategy offers favorable prospects for all customers but one—the first. So if a drug takes one billion dollars to research and develop, but only $10 to produce each unit, the marginal cost formula says that the first consumer has to pay the billion dollars so that the other consumers can get the favorable deal. That formula guarantees that no drug will ever make it to market.

The only way in which the drug can be sold is to distribute the cost of the first drug sale on all subsequent sales. But there is no single way in which this can be done, and hence no single price at which these drugs should be sold, which is one reason why the effort to require companies to disclose “the” price is misleading. It also follows that an intense competition will arise as various consumers—or, more accurately, their buying agents—compete to ensure that as much of that front-end cost is loaded onto the shoulders of other buyers. In this struggle, all potential buyers are not created equal.

At the simplest level, consider the split between two classes of providers: Retail pharmacies have to carry the full array of drugs in any given class—there is a long list of statins used to control cholesterol, for example—while individual health plans with their own subscribers need not stock all drugs in a given class, and hence can play rival producers against another. At this point, price discrimination will always emerge. Each drug company knows that it wants to make the sale so long as it can cover as much of its fixed costs of production as possible. So the providers pressure the company to reduce prices toward marginal cost.

A drug company will reluctantly do that, but not if it has to disclose its rebate publicly, which would put it in a helpless position to negotiate with the next health plan. So the rebates are kept secret to improve the prospects for the company of recovering those front-end costs. The situation is even more complicated than this brief description, because consumers are often enrolled in a variety of different kinds of health care insurance plans, each of which pick up a different fraction of the cost, leaving a different residual co-pay cost to their clients. Medicare and Medicaid are subject to their own pricing constraints.

The critics of the current drug cost system do not offer evidence showing that these complex market adaptations are inefficient. Indeed, President Trump would have courted a major pharmaceutical crisis if he had acted on his proposal to tie American prices to the lowest prices charged anywhere in the world market. In many other nations, the government is the sole purchaser of goods for its own health care system. It will, therefore, behave like any monopoly buyer. It will push hard to lower costs, and the wise drug company will service that market so long as it covers the variable costs for those additional sales, and some portion of the fixed costs of development. Even where there is no sole government buyer, many of these countries are sufficiently poor that even competitive drug companies can charge only limited prices given those sharp constraints on local demand.

The effect of imposing a most-favored-nation clause would bring all production to a screeching halt, for once the United States plays hardball on drug companies, no one else will, or could, pick up the fixed costs that cannot be charged back to the American market. Those new drugs are on average better than the drugs that they replace, which is why, in the United States, many of them are purchased as soon as they hit the market. The high price is justified in light of the demand. Many European countries hang back from purchasing new drugs until their efficacy is demonstrated to their satisfaction, which is little comfort to their citizens who die before the drug is made more generally available.

So what then can be done to ease the log jam? The world is full of bad proposals, many of which are briefly discussed in a New York Times editorial, “Sound, Fury and Prescription Drugs.” One possibility is to tax any price increases, which would only impose yet an additional cost on drug development. A second proposal the Times mentions is the “parallel” importation of drugs from Canada into the United States. But these solutions will run into serious problems if FDA and customs officials don’t cooperate. The new imports could infringe American patents, and counterfeit drugs could be slipped into porous drug supply chains. Still, a third proposal is for compulsory purchases by the government of government patents, which would allow patients to obtain the patented drugs at a fraction of their previous cost. But the huge budgetary demands are large, and this proposal will roil the market if only one drug is purchased, and its competitors have to sell at market prices.

Characteristically, the Times overlooks three market-based proposals that should improve the situation by encouraging more entry into the drug market. One is to ease the restrictions on the production of generic drugs. Another is to license for sale in America any drug that has been used successfully overseas, without having to go through the lengthy and costly American drug approval process. The last is to ease up on the cost restrictions that make it so hard to bring new drugs to market, especially for niche drugs for rare conditions.

Any reforms to the FDA’s cumbersome approval process that speeds drugs to market will have the desired effect of lowering overall drug costs. Lower costs allow for lower prices for new drugs. And the higher rate of new drug approval should exert a downward pressure on the prices of existing drugs in the market.

It is always important to recall that there are two kinds of error in drug regulation: letting bad drugs into the market and keeping good drugs out. But the costs are not equal. If a drug comes on the market, it is still subject to all sorts of scrutiny on both its safety and effectiveness by health care groups, hospitals, physicians, and patients. But if a drug is kept off the market by fiat, these protections cannot take hold. It is no accident that so many drugs are commonly prescribed for off-label uses to great success. The FDA is getting better at its approval process. But it has a long way to go.

© 2019 by the Board of Trustees of Leland Stanford Junior University

Published in Healthcare
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There are 11 comments.

  1. CarolJoy, Above Top Secret Coolidge

    Since 1992, The FDA has supported itself with revenue from its users.Who happen to be the Big pharmaceutical companies.Congress needs to intervene and stipulate that The FDA is supported by tax payer monies only.Two needed results would then take place: The FDA would no longer rush through the approval process such that, as occurred a little over a decade ago, babies die because a roto virus vaccine is released before adequate testing is done.Secondly there might also evolve a real way to stipulate that since tax payer money is often offered up front to the drug companies to help with their research and development, that the government then gets to “help” them with a pricing schedule. However, as long as it is Big Pharma itself funding the FDA, we won’t see either of those things happening.

    • #1
    • July 16, 2019, at 1:25 PM PDT
    • 2 likes
  2. Guruforhire Member

    See the problem is that the drug companies international price discrimination strategies are driven in part or in whole by local regulations to keep drug prices down.Like any hydraulic system, when a country creates regulations to lower the cost of drugs in their local country, it raises them in the US. So high drug prices in the US becomes a subsidy for other countries with governmental price controls. So those countries are exporting the dead weight losses that their consumers would experience on to us here in the US.Lets not be naive here.

    • #2
    • July 16, 2019, at 2:01 PM PDT
    • 5 likes
  3. CarolJoy, Above Top Secret Coolidge

    Richard, you ask the following regarding just how companies can mitigate the funding for their R &D and the long years of waiting for approval: So how are these costs best recovered over the relatively short period during which the drugs receive patent protection, which today works out to around 11 years, give or take, for a major blockbuster drug? 

    The following article details how Pharma companies are no longer bringing forth new products. Instead they tweak already existing products that are about to, or already have, lost the protections of the original patent.

    So for example: I just bought myself 25 baby aspirins for $ 3.89. At Walmart, I could have gotten 60 for the same price, but I didn’t have time to travel there.

    There is probably nothing to stop the major players inside the drug industry from colluding to insist that only specially buffered aspirin are safe to use. Since tremendous amounts of ad revenue the Pharma mafia uses to hold our news media hostage wouldn’t allow for a sane discourse on a new prohibition, then Americans might be paying $ 26 for 25 aspirin.

    This tweak on an old remedy would count as “new products developed by We, The Pharmaceutical Companies who provide you with good health.”

    The following article details what goes on inside the industry:

    https://www.statnews.com/2019/04/24/pfizer-shareholder-meeting-pharmaceutical-industry/

    from the article: But the company’s internal records paint a different picture. Pfizer is not lacking for resources & could lower its products’ costs. In 2017, the company spent almost 60% of its net profits on payments to shareholders through dividends and buybacks. Following… Trump’s corporate tax cuts, Pfizer’s spent 180% of its net income in 2018 to pay shareholders in the form of dividends & buybacks, which means the company used a combination of cash reserves or debt to pay shareholders. Other companies do the same: Between 2006 & ’15, 18 pharmaceutical cos in S&P 500 spent 11% more on payments to shareholders than on R & D.

    Research by economists Öner Tulum and William Lazonick shows that Pfizer generated most of its revenue by acquiring companies that already had drugs on the market; relatively little revenue came from new drug development. Since 2001, only four internally generated products have created significant revenue for the company.

    In 2017, as Pfizer jacked up the price… of its prescription products, it did the same with then-CEO (and now chairman of the board) Ian Read’s salary: a 61% pay raise with annual compensation… of $27 million. That salary doesn’t come close to topping the list of pharmaceutical CEO pay.

    Pfizer, like other pharmaceutical firms, has invested… in peddling the myth of expensive drugs driven by research costs, whether at a Feb hearing on Capitol Hill or through a multimillion dollar ad campaign convincing 69% of us that this fable is true; or through $11.4 million in lobbying in 2018 alone.

    End of Part One

     

    • #3
    • July 16, 2019, at 2:32 PM PDT
    • Like
  4. CarolJoy, Above Top Secret Coolidge

    Part two from same article:

    SNIP We can reform and enforce antitrust laws to break up monopoly power in the pharmaceutical industry, which undermines the free market. We can curb or outlaw stock buybacks, which Pfizer uses extensively, to pay shareholders and executives at the expense of delivering affordable and quality pharmaceuticals for the American people.

    SNIP

    George Goehl author is director of the nonprofit People’s Action. Felicia Wong is the president and CEO of the Roosevelt Institute.

    Comments:

    M.E. Singer
    April 28, 2019 at 1:28 pm

    Despite prior Harvard research evidencing how Big Pharma’s claim of the high cost of R&D is actually depicts the excessive cost of marketing and lobbying wrapped up into R&D, nothing changes.

    Nothing will change until both sides of the aisle in Congress no longer are funded by Big Pharma. Congress knows and has taken no action to regulate and stop the strangulation of competition, including:
    1) Manipulating ingredients on branded drugs to extend the life of the patent.
    2) Harassing generics with needless, costly litigation, to delay introduction.
    3) Violating the basic tenets of anti-trust by paying generics to withhold product from market and splitting the profits of the extended brand life.
    4) Creating coupons directed at consumers to extend life of brand, at higher cost to insurance; later, to patient.
    5) Since 1997, the FDA allowed advertising of prescriptions to the public to push product demand.

    SNIP

    CW
    April 24, 2019 at 8:01 pm

    As someone working in R&D, it was never R&D costs. I could only wish. The Marketing budgets are massive and senior executive pay packages are interesting. Why are the prices so high? Companies set ever higher prices because they can and, according to current business philosophy, any dollar “left on the table” makes the company a ship of fools and attacked for not maximizing shareholder value. Martin Shkreli is not the only pharma bro, just the loudest. There are also many people with strong ethics, moral principles and a sense of responsibility towards people with medical needs. Their voices need to be heard and they need to be in leadership.
    Reply
    Joe 2

    Pharma has no interest in lowering prices. Only goal is profit, profit and profit. They have hardly invented any therapy. Acquisitions has been their religion and only religion. Once in a while they have stumbled on a therapy but then they sell it at the highest price. When do they care about patients, they die anyway.

    • #4
    • July 16, 2019, at 2:35 PM PDT
    • Like
  5. Chris B Member

    Richard Epstein: The effect of imposing a most-favored-nation clause would bring all production to a screeching halt, for once the United States plays hardball on drug companies, no one else will, or could, pick up the fixed costs that cannot be charged back to the American market. Those new drugs are on average better than the drugs that they replace, which is why, in the United States, many of them are purchased as soon as they hit the market. The high price is justified in light of the demand. Many European countries hang back from purchasing new drugs until their efficacy is demonstrated to their satisfaction, which is little comfort to their citizens who die before the drug is made more generally available.

    The reality is that other countries will and can pick up the costs of R&D, they simply haven’t had to. There’s no reason that a drug should cost 200 times as much in the US as it does in the UK, Japan, India, or Australia. None.

    We literally have drugs being manufactured in China and India that are sold in the US for dozens or hundreds of times more than those exact same drugs made in those same factories cost in the local market.

    Something as simple as requiring the drugs to carry the average world wide price at the time of manufacture stamped on the bottle would solve this problem.

    Give an American consumer the information that he and his insurance paid $2,700 for this bottle of pills, but the average global price is $40, and the problem will quickly take care of itself.

    • #5
    • July 16, 2019, at 4:37 PM PDT
    • 1 like
  6. CarolJoy, Above Top Secret Coolidge

    Chris B (View Comment):

    Richard Epstein: The effect of imposing a most-favored-nation clause would bring all production to a screeching halt, for once the United States plays hardball on drug companies, no one else will, or could, pick up the fixed costs that cannot be charged back to the American market. Those new drugs are on average better than the drugs that they replace, which is why, in the United States, many of them are purchased as soon as they hit the market. The high price is justified in light of the demand. Many European countries hang back from purchasing new drugs until their efficacy is demonstrated to their satisfaction, which is little comfort to their citizens who die before the drug is made more generally available.

    The reality is that other countries will and can pick up the costs of R&D, they simply haven’t had to. There’s no reason that a drug should cost 200 times as much in the US as it does in the UK, Japan, India, or Australia. None.

    We literally have drugs being manufactured in China and India that are sold in the US for dozens or hundreds of times more than those exact same drugs made in those same factories cost in the local market.

    Something as simple as requiring the drugs to carry the average world wide price at the time of manufacture stamped on the bottle would solve this problem.

    Give an American consumer the information that he and his insurance paid $2,700 for this bottle of pills, but the average global price is $40, and the problem will quickly take care of itself.

    Thumbs up on your post.

    A lot of people don’t see any real problem with paying $ 2,700 for some pills until they themselves are suffering with cancer and need to spend 18K a month to stay alive. (And insurance only helps so much, as after a while, you reach your limit.)

    • #6
    • July 16, 2019, at 4:51 PM PDT
    • Like
  7. Bryan G. Stephens Thatcher

    We should bully other nations into respecting our drug companies patents, and not let foreign governments steal the drugs, or force drug companies to sell at lower prices on threat of theft.

     

    • #7
    • July 16, 2019, at 5:19 PM PDT
    • 3 likes
  8. RushBabe49 Thatcher

    In order for pharma companies to better recoup the cost of development, when the drug is off-patent, instead of keeping the price artificially high, they could assess the average generic cost of the drug, and lower their price to say 10% higher than the average generic cost. That way, they would still be making money, and there would be less incentive for PBMs to delete the brand-name drug from their formularies. Consumers would be able to get the brand-name medicine for not 10X the cost of the generic, but only 10% more. Many brand-name drugs actually work differently than generics, and some people actually need the original medicine to treat their condition.

    President Trump might benefit from some education about how overseas governments dominate drug pricing, so he wouldn’t think big American drug companies are fleecing the American public. Hey, he got Europeans to pay more of the cost of NATO by using his bully pulpit; maybe he could do the same for Pharma!

    • #8
    • July 16, 2019, at 6:19 PM PDT
    • Like
  9. Bryan G. Stephens Thatcher

    I think the patent time could be extended, which would allow more time to recoup costs. 

    I agree it is way too expensive to bring drugs to market.

    • #9
    • July 17, 2019, at 6:11 AM PDT
    • Like
  10. CarolJoy, Above Top Secret Coolidge

    RushBabe49 (View Comment):

    In order for pharma companies to better recoup the cost of development, when the drug is off-patent, instead of keeping the price artificially high, they could assess the average generic cost of the drug, and lower their price to say 10% higher than the average generic cost. That way, they would still be making money, and there would be less incentive for PBMs to delete the brand-name drug from their formularies. Consumers would be able to get the brand-name medicine for not 10X the cost of the generic, but only 10% more. Many brand-name drugs actually work differently than generics, and some people actually need the original medicine to treat their condition.

    President Trump might benefit from some education about how overseas governments dominate drug pricing, so he wouldn’t think big American drug companies are fleecing the American public. Hey, he got Europeans to pay more of the cost of NATO by using his bully pulpit; maybe he could do the same for Pharma!

    I like your comments in your first paragraph, but drug companies are too greedy to follow your wise suggestions.

    As far as your 2nd paragraph, I think that Trump often gets a great deal of information from people he knows who are experts in some field he is getting involved in. The fake news media implies continually he shoots from the hip without checking to see of the gun is loaded, and without taking proper aim.

    This is not what he does at all. Time and time again, he proves he asks questions about situations he is getting involved in. He would never have made it to the Oval Office without doing this. His recent decision to ground the Boeing Max airliners was informed by airline pilots he respected.

    I am on the same page as the President – the big drug companies are fleecing us. And often for products that are inadequately tested, and that actually kill Americans. Merck’s FDA approved fast track of Vioxx, a pain killer where there were early indications heart attacks would result from its use, actually ended up killing 33,000 people. (Some say the number is twice as high.) But the court settlements to grieving families are just a cost of doing business.

    One other objection is to the double standard. To wit, that while stockholders in drug companies together with the company execs absolutely loathe the idea of government intervening in drug pricing of the products, they do not at all object to having the government hand over tens millions of dollars to assist the Big pHamra companies in doing their research. Either despise government handouts and regulations or else approve of them, I don’t care. But if someone approves of our government giving these greedy merchants of crappy products tons of money, then there should be regulations to protect the very tax payers who actually helped fund the products!

    • #10
    • July 17, 2019, at 5:57 PM PDT
    • Like
  11. Jerry Giordano (Arizona Patrio… Member

    Prof. Epstein’s argument does not make sense to me.

    One of the basic assumptions of microeconomic theory is perfect information. In theory, the free market produces the best allocation of resources assuming perfect information. But Prof. Epstein’s argument is that the drug companies should be permitted to sell at different prices to different customers, which they can only do because they keep their price negotiations secret.

    In this circumstance, there is not a free market. There is a strange, rigged market, which would have been undermined by the President’s order requiring price disclosure.

    I don’t have a great answer to this problem. I simply find that Prof. Epstein’s argument is unconvincing.

    • #11
    • July 18, 2019, at 8:00 AM PDT
    • 1 like