Why Drug Pricing Has Almost Nothing To Do With Research Costs
A Few Minutes With A Calculator Reveals The Real Reason For High Drug Prices
By David Grace
http://www.DavidGraceAuthor.com
Whenever anyone asks a drug company why it charges huge amounts for patented drugs Big Pharma’s answer is always that they are forced to charge that much in order to fund their research and development efforts.
That’s not true.
Every company is in business to make as much money as possible. Every business can always find a use for more money — more R&D, more acquisitions, new facilities, profit distributions, etc. Drug companies are no different. Their prices are driven by their understandable quest to make the maximum amount of money possible. That’s expected of any business.
What is different about drug companies is:
(1) they are selling a government-granted monopoly product;
(2) unlike other consumer goods, high drug prices increase the cost of living for every insured person in the society, not just for the purchasers of that particular product;
(3) unlike other products, drugs are literally life-and-death products; and
(4) that instead of admitting that their pricing strategy is designed to maximize revenue, drug companies instead give people this BS story that they are forced to charge these huge prices in order to fund research.
Why do I say that the claim that R&D costs are the reason for astronomical drug prices is a lie?
Let’s take at look at some numbers.
There is a new Hep C drug called Solvadi. You take it for 84 to 112 days at a cost of $1,000 per day or a minimum of $84,000 for the course of treatment. Is that price based on the expense of developing the drug or is there another reason?
There are an estimated 100,000,000 Hep C patients worldwide. There are an estimated 2.7 million Hep C patients in the United States.
As an exercise let’s pretend that if Solvadi was priced at $100/dose that it might capture a bit more than 25% of the U.S. market or 700,000 patients. You can substitute other example numbers. The principle will remain the same. We don’t know what the markup is between the manufacturer’s price and the retail price but we can make a guess of 30% so a retail price of $100 would mean a manufacturer’s price of $77.
700,000 X 84 doses = 58,800,000 (or more) doses in the first year of sale.
$77/dose X 58.8M doses = gross sales of about $4.5B in the U.S. alone in the first year of the patent. If the patent expired fifteen years after FDA approval then just U.S. gross sales over the life of the patent would be about $67.5B.
If Solvadi cost $1B to develop (supposedly typical of a new drug) and if we allocated another $1B to company overhead and if we allocated another $1B to production, packaging and marketing costs that’s $3B in “costs.” That leaves us with almost $1.5B left over for profits and other research from just the first year’s sales in the U.S. alone. In the second year we would have another almost roughly $3.5B after production costs to allocate to profit, overhead and other research from U.S. sales alone.
That’s pretty good. All your R&D costs covered in the first year. All your production costs covered. All your overhead costs are covered and you have about $1.5B in the bank for other product research in the first year of sale, all from only 3% of the worldwide market. Most business people would be popping the champagne to get numbers like that on any of their non-patented products.
Anyone who tells you that $1.5B in profit over and above all R&D costs, all overhead costs, all production and distribution costs in the U.S. market alone in just the first year of a fifteen year monopoly is not enough to give their company the incentive to stay in business is absolutely, totally, lying to you.
But maybe this number is vastly wrong. What if revenues were only half that during the first year of U.S. sales, $2.25B. That would still almost cover all costs of development, overhead, production and distribution in that first year.
But the manufacturer did not price Solvadi at $100 dose. They priced it in the U.S. at $1,000 per dose. They priced it 10 times greater than what they would possibly need to cover or almost cover the total costs of all research etc. with revenues from only about 3% of the worldwide market in just the first year of sale. Why?
The answer, again, is in the numbers.
At $1,000 per dose instead of $100/dose they will get only a tiny fraction of the U.S. patients. I would speculate that they would be lucky to get about 5% of the potential 2.7M patients or about 150,000 patients.
Remember that if you have health insurance and a medication is available that is both safe and far more effective than other treatments your medical insurance company has to cover part of the cost. The drug companies essentially have the health insurance companies by the throat because the insurance companies cannot automatically just say “No.”
No matter what Big Pharma charges per dose the producers know that the insurance companies will have to pay a majority of the cost, 60%, 70%, 80% — whatever coverage your insurance company’s Tier 4 prescription drug plan provides.
The pricing questions for the drug company have nothing to do with R&D costs.
The pricing questions for the drug company are:
(1) What percentage of the U.S. patient pool for this drug has health insurance?
(2) What is the average percentage of the cost that the carriers will be required to pay?
(3) At each price point how many of the insured patients will be able to afford the co-pay, for example, at $1,000/dose, how many of the insured patients will be able to pay a $200 per day co-pay? A $100/day co-pay? A $300/day co-pay?
Once the seller calculates the answers to those questions it can calculate the monopoly price for that drug.
At $1,000/dose anywhere from 95% to 99% of the people who have the disease probably will not be treated. But drug companies are not in the business of providing treatments for sick people. They are in the business of making as much money as possible, as are all for-profit businesses.
If, for example, they treated 700,000 patients at $100/dose but their sales fell to 150,000 patients at $1,000/dose (a drop caused by the higher co-pays forcing lower asset patients out of the market) what would that do to their bottom line? Answer: Jackpot!
150,000 patients X 84 doses = 12,600,000 doses X $770/dose = $9.7 Billion dollars in the first year of their monopoly in the U.S. alone. When the price goes up by 10X the volume of product sold goes down by about 80% and the gross sales go up by 215%.
$9.7B in gross sales minus $3B in costs leaves about $6.7B to fund other research projects and profit and overhead in the first year in only one country. Higher prices and lower volumes mean vastly greater profits.
You can run the numbers at any percentages of market penetration you like but when you run them out over the entire world market for the life of the patent they are truly huge.
What’s important here is not the actual percentage of market penetration the seller would achieve at $100/dose or $1,000/dose. What’s important is the comparison of the gross sales revenues at various price points. No matter what market percentage you pick, by selling the drug at $1000/dose the manufacturer makes vastly more money than it would make by selling it at $100/dose.
The actual reason for charging $1,000/dose rather than $100/dose is purely a financial one, namely, that it’s vastly more profitable to sell 80% fewer units of anything at a price that is 10X greater.
$1,000 per dose is not the “fund R&D” price. It’s the U.S. monopoly price, namely the price at which the seller will generate the highest level of gross sales in that geographical market — the price point above which the number of units sold will fall faster than the increased income from a higher price and below which the number of units sold will increase more slowly than the income will decrease from the lower price.
Economists call it the “unit elastic price.” It’s the price where demand goes from elastic to inelastic.
It’s the price that gets the seller the maximum revenue.
It’s the monopoly price.
The monopoly price differs in different countries. The monopoly price in a poorer country like India is lower than the monopoly price in a richer country like the United States. That’s why the price of patented drugs is less in India than it is here. In other words, the price in India at which the seller will receive the maximum Indian gross sales revenue is less than the price in America where it will receive the maximum U.S. gross sales revenue.
Monopoly pricing is merely one aspect of what everyone already knows — that monopolies screw the customer. That’s why they’re illegal, except for patented products where the government grants the seller a legal monopoly.
Monopolies result in a vast decrease in the number of consumers who have access to a product and a vast increase in the cost of the product to those consumers who can afford to buy it. Additionally, when the product is a drug, monopoly pricing greatly increases the cost of health insurance for everyone in the society, including those who don’t even take that particular drug.
Is the answer to monopoly pricing to eliminate patents? I don’t think so. I think that eliminating patents would cause more problems than it would solve.
Is the answer to monopoly pricing to shorten the life of patents to five or ten years? I suspect that would cause as many problems it would solve.
There are lots of strategies that might be employed to combat monopoly pricing for drugs. Holders of drug patents could be required to license the patent to anyone who wanted it for a flat royalty of, for example, 10% of gross sales of the licensed version. If that happened price competition might arise which would force the price down from a monopoly price closer to a market price.
U.S. pharma patents could expire when a set total dollar amount of U.S. revenue was generated (e.g. $100B) or when a set amount of gross sales divided by the initial life of the patent was exceeded, for example $100B divided by a 15 year life left on the patent on the date when the drug was first offered for sale = $6.67B per year so that if the seller’s gross sales in the USA from that drug exceeded $6.67B in any one year then the U.S. patent would terminate at that time.
Another strategy would be to apply Generally Accepted Accounting Principles and sound business practices to determine what a reasonable price would be for a patented drug (the company’s actual cost plus reasonable profit and overhead) and then adding in an additional dollar amount reasonably calculated to fund new R&D for other drugs. You would then apply a sharply graduated excess profits tax to prices charged above that calculated market price so that the seller would very quickly lose the economic incentive to charge a monopoly price in the first place.
For a more detailed discussion of monopoly pricing and why an excess profits tax is a potential solution to combating monopoly pricing see my Medium post:
“A Pragmatic Look At Market Pricing”
https://medium.com/@davidgraceauth/a-pragmatic-look-at-market-pricing-8877cbaa79c8
Can you think of another a strategy for incentivizing new drug R&D while still avoiding monopoly pricing — a system that would get us new drugs that would be priced at a level where a majority of patients could actually afford to buy them without bankrupting themselves, the government and other people who pay health insurance premiums?
–David Grace
www.DavidGraceAuthor.Com
