High Drug Prices Don’t Accelerate Innovation—Lower R&D Costs Do
Most new medicines are developed by unprofitable startups that can succeed under a wide range of pricing systems.
By Gregg Girvan and Avik Roy
Executive Summary
The United States has, by far, the highest prescription drug prices in the world. Aggressive annual price increases by drugmakers in the U.S. market are widening the price gap between America and the rest of the world.
The most common argument used to justify these high prices is that mitigating them will “harm innovation.” But all too often, this claim is advanced without any rigorous thinking about the relationship of high drug prices to innovation, and to improvements in public health. Most importantly, advocates of high prices ignore a far more important barrier to innovation: the rising cost of research and development.
48% of all drugs in phase III clinical trials in 2020 are for treatments of orphan diseases, despite the fact that orphan drugs represent 11% of U.S. drug spending and currently treat 0.5% of the U.S. population.
In this paper, we undertook a detailed review of 1,589 clinical trials, 410 FDA drug approvals, and 10 years of biopharmaceutical company financial data in order to examine trends in drug innovation. We found the following:
- Low R&D costs, not high prices, are the primary driver of pharmaceutical innovation. The U.S Food and Drug Administration and its counterparts around the world require drugmakers to undertake large, costly clinical trials if they study common diseases with tens of millions of patients, like diabetes and heart disease. By contrast, companies that study ultra-rare “orphan” diseases affecting a few thousand patients endure far lower R&D costs and upfront financial risk. As a result, companies are increasingly focusing on orphan diseases and abandoning work on large public health problems. 48% of all drugs in phase III clinical trials in 2020 are for treatments of orphan diseases, despite the fact that orphan drugs represent 11% of U.S. drug spending and currently treat 0.5% of the U.S. population.
- The majority of new drug development now takes place at startups with little to no revenue. Contrary to the claim that raising prices on old drugs drives innovation, large incumbent pharmaceutical companies are rarely the discoverers of new drugs. Large companies have bureaucratic R&D processes, in which scientists have comparatively little incentive to innovate, whereas researchers at startups share more fully in the economic rewards of successful drug development. As a result, the majority of new drugs are now discovered and brought into human clinical trials by pre-commercial-stage companies funded by venture capital and hedge funds. In 2020, 60% of new drugs approved by the FDA were first brought to the clinic by early-stage, unprofitable companies.
- The best way to spur pharmaceutical innovation is not to increase prices, but to reduce the cost of bringing drugs to market. Drugs that successfully gain FDA approval are almost always profitable, regardless of the exact price, especially when drugs treat unmet medical needs where price competition is absent. 90 percent of the cost of drug development is in phase III trials. The FDA allows drugs treating terminal diseases like AIDS and cancer to conditionally come to market after successful phase II studies. This policy should be expanded to include the largest public health challenges, like metabolic and cardiovascular disorders.
In 2020, 60% of new drugs approved by the FDA were first brought to the clinic by early-stage, unprofitable companies.
- Large pharmaceutical incumbents benefit from high R&D costs. Incumbent drugmakers with billions of dollars in revenue can afford to undertake costly phase III clinical trials, whereas unprofitable startups less frequently can. As a result, large drugmakers benefit greatly from the present system, in which startups are forced to sell the rights to their drugs to the large companies, after the smaller startups have taken the risks of successfully completing earlier-stage studies.
- Congress has a legitimate role in increasing pharmaceutical competition, and in countering exploitative drug pricing practices. Drug companies take advantage of patent law and monopoly power to charge the maximum amount they can, rather than simply seeking to gain a fair return on their R&D expenses, especially when it comes to biologic drugs where federal law restricts true competition. Congress can do more to lift restrictions against competition, and to empower private insurers and taxpayer-funded programs to push back against exploitative pricing practices.
Introduction
In the rest of the economy, the term innovation is used to describe technological advances that decrease the cost and increase the quality of goods and services.
For example, Apple launched the first iPhone in 2007. At that time, an iPhone with 8 gigabytes of memory, a 320-by-480-pixel screen, and no camera cost $599 ($790 in 2021 dollars). Today, an iPhone 13 mini costing $699 comes with 128 gigabytes of memory, a 1080-by-2340-pixel screen, and two 12-megapixel cameras. In other words, today’s iPhone 13 mini has 16 times the memory and 16.5 times the screen resolution of an iPhone 1, at a lower price than the original.
We have come to expect a different pattern in the drug industry, in which drugs launched 15 years ago—with no material improvements—cost six to ten times as much today as they did when they were first approved by the FDA.
As we detailed in 2017 in The Competition Prescription: A Market-Based Plan for Affordable Drugs, prices do not work like they do in the conventional high-tech industry, where prices go down and quality goes up over time. For example, if one compares common drugs used for multiple sclerosis, it is the oldest drugs that have experienced the highest price increases, even though those drugs have not meaningfully improved.
Accounting for the risk of failure in drug development, recent studies estimate that the average cost of developing a new drug is between $314 million and $2.8 billion. But these overall estimates obscure some important aspects of drug development:
- R&D expenditures vary widely by disease type. Clinical trial costs are largely proportionate to their size and duration. For common diseases like diabetes and high blood pressure, which affect tens of millions of Americans, the FDA requires large and lengthy trials costing billions of dollars. By contrast, clinical trials for rare diseases are generally much cheaper, because they involve fewer patients.
- Commercial drug prices are driven by market power, not R&D expenditures. As we showed in The Competition Prescription and in a 2020 follow-on paper, The Growing Power of Biotech Monopolies Threatens Affordable Care, drug companies do not price their drugs based on their past research and development costs, but rather by the degree to which they have the power to charge the highest prices possible: a power driven in large part by the existence or lack of therapeutic competition.
In this paper, we will describe four flaws in the “high prices are necessary for innovation” thesis.
- Not all drugs are equally innovative. If we define the most consequential pharmaceutical innovations as those that benefit the most people, drug companies are increasingly moving away from tackling large public health problems with their R&D expenditures, instead focusing on rare diseases where R&D costs are low.
- Most innovation occurs at unprofitable companies. While the largest pharmaceutical companies justify their double-digit annual price increases by claiming that they are necessary to fund the next generation of new treatments, most new treatments are developed at unprofitable startups based on government-funded basic science research, with clinical trials backed by venture capitalists and public investors.
- Big pharma profits drive little innovation. Large pharmaceutical companies are far less efficient than startups at turning R&D spending into drugs that help patients. Early-stage companies accounted for 72% of the total pharmaceutical R&D pipeline in 2018.
- Price increases can modestly increase R&D spending, but with little impact on innovation. Companies that rely on monopoly price increases for earnings growth argue that these increases are necessary to fund innovation in their labs. But the additional R&D spending generated through price increases is profoundly inefficient. The median R&D cost of bringing a new drug to market is $985 million, inclusive of failures. AbbVie, a large pharmaceutical company, was 45 times less efficient than the industry average, requiring $43.8 billion in price increases to develop a single new drug from in-house research.
The drug industry’s powerful incentives to abandon major public health challenges
There are a number of powerful incentives for biotechnology and pharmaceutical companies to avoid tackling common diseases, like diabetes and heart disease, and instead focus on rare disorders.
The Orphan Drug Act of 1983 grants seven-year monopolies to companies that develop drugs for diseases with fewer than 200,000 patients in the United States. Famously, Martin Shkreli of Turing Pharmaceuticals took advantage of the law to acquire Daraprim, a treatment for toxoplasmosis, and enact a 5,500 percent price increase. While Shkreli was singled out by the press for his aggressiveness, his overall strategy is widely used in the industry, as we detailed in The Competition Prescription.
Most importantly, the small clinical trials required for rare disease drug approvals are far less expensive—and far less competitive—than those for common diseases. A 2018 study by Thomas Moore, Hanzhe Zhang, and Gerard Anderson reviewed 138 pivotal clinical trials (i.e., the large-scale trials conducted in order to gain regulatory approval) from 2015 and 2016, and found that the trials cost a median of $41,117 per patient.
Case study: Sanofi’s sotaglifozin vs. Spark’s Luxturna
For example, from 2017 to 2020, Franco-German pharmaceutical company Sanofi conducted 13 phase III trials of a new oral antidiabetic drug, sotagliflozin, involving 16,965 patients. If we assume that the trials cost $41,117 per patient year, and lasted two years on average, Sanofi’s phase III clinical trial program was slated to cost $1.4 billion. Ultimately, Sanofi abandoned the program, as sotagliflozin did not prove to be superior to existing oral antidiabetic agents in the first set of phase III trial results.
Sanofi, to its credit, was trying to address a significant public health problem. Type II diabetes affects over 100 million Americans. Compare Sanofi’s strategy to that of Spark Therapeutics. Spark successfully developed a treatment for a rare disease — confirmed biallelic RPE65 mutation-associated retinal dystrophy — a form of blindness that affects approximately 1,750 people in the United States. Spark’s phase III trial for its treatment, Luxturna, enrolled a total of 31 patients and reported positive results in 2015. Spark’s entire R&D budget for 2015 was $46 million. In 2018, Spark announced that it would charge $850,000 for the drug, or $425,000 per eye.
Spark could have charged far less and still achieved a handsome return on its R&D investment. Treating 1,750 eyes would yield $744 million in revenue: an order of magnitude greater than its up-front R&D expenditure. It chose to seek the maximum possible price, and was rewarded for doing so. In 2019, Spark was acquired by Swiss pharma giant Roche for $4.8 billion: a 122% premium to the company’s stock market value.
Put simply, it is not high prices that are incentivizing the turn toward rare diseases, but rather low R&D costs. Low R&D costs for rare diseases mean that there is less up-front financial risk for investors. Few investors have $1.4 billion to spend on a new diabetes drug that may not succeed.
Nearly half of all current phase III trials are for rare diseases
In order to assess the trend of companies neglecting common diseases, we analyzed 1,589 clinical trials in the National Library of Medicine’s clinicaltrials.gov database that met three criteria: (1) trials that were currently active in the U.S. at the time of analysis (August 2020); (2) trials that were categorized as Phase III; (3) trials that were sponsored by biotechnology and pharmaceutical companies (as opposed to academic institutions).
As the chart above illustrates, 765 of these trials—48.1%—were for orphan diseases affecting fewer than 200,000 Americans. 258 (16.3%) were for diseases affecting fewer than 20,000, and 74 (4.7%) were for diseases affecting fewer than 2,000, like Spark’s Luxturna. In 2018, according to the IQVIA Institute, 51% of new drugs approved by the FDA were for orphan diseases.
All of these efforts are being devoted to a small slice of the U.S. population. In 2019, according to the IQVIA Institute for Human Data Science, orphan drugs were being used by 1.8 million patients, or 0.5% of the U.S. population, while representing 11% of U.S. invoice drug spending (i.e., prior to rebates, which generally reduce prices for drugs in competitive markets like diabetes).
Most pharmaceutical innovation occurs at early-stage, unprofitable companies
Advocates of the largest multinational pharmaceutical companies claim that without them, medical innovation would not happen. Based on our review of all new drugs approved by the FDA over the last decade, however, early-stage, pre-commercial companies with no profits now develop a majority of all new drugs. In 2020 alone, 60% of new drugs approved by the FDA were first brought into clinical trials by early stage drugmakers.
To determine how often new drugs are developed by early-stage, unprofitable companies, we examined every new molecular entity approved by the FDA from 2011 to 2020, determining which company owned the rights to manufacture and distribute the drug at the time the drug entered phase I clinical trials. After excluding drugs owned and developed by entities other than private-sector companies (i.e., academic centers), we examined the financial statements of each company to determine if they incurred a profit or a loss in the year that the Phase I trial began.
This trend is likely to continue well into the future. An analysis by the IQVIA Institute found that early-stage companies—which IQVIA defined as companies with less than $500 million in annual revenue and spending less than $200 million on R&D—accounted for 72% of the total R&D pipeline in 2018.
Most of these early-stage companies are backed by venture capital funds and other private-sector investors, such as hedge funds and mutual funds. In 2018, according to IQVIA, early-stage biotech companies attracted $23 billion in venture funding across 1,308 transactions.
The biopharmaceutical industry also benefits from basic scientific research funded by the National Institutes of Health; in 2019, taxpayers spent $39 billion through the NIH, compared to $83 billion by members of the Pharmaceutical Research and Manufacturers of America trade association (PhRMA). President Biden has proposed spending $52 billion on NIH in 2022. In addition, nearly half of all spending on prescription drugs is funded by the government, through programs like Medicare, Medicaid, and the Affordable Care Act.
Some argue that unaffordably high drug prices are necessary to attract investor interest. This is not the case. For example, in 2011, Gilead Sciences—a large, established pharmaceutical company—bought Pharmasset, a startup that had developed a cure for hepatitis C. The purchase price was $11 billion: nearly double Pharmasset’s stock price at the time. Gilead took nearly zero R&D risk in acquiring Pharmasset; Sovaldi’s key clinical trials had already been completed. Gilead then launched the hepatitis drug, branded Sovaldi, at an aggressively high price; Sovaldi has generated more than $60 billion in revenues for Gilead since 2013.
Gilead has benefited from the fact that hepatitis C patients are disproportionately poor; since government-funded Medicaid programs are obligated to pay for enrollees’ drugs with minimal cost-sharing, Gilead was able for a time to withdraw money from taxpayers at will and charge whatever it wanted for Sovaldi. This feat of financial engineering made Gilead executives — and its largest investors — rich, but if Pharmasset had remained an independent company and charged half of what Gilead did for the drug, its investors would also have been enormously successful.
How much innovation comes from large companies that grow by raising prices on older drugs?
Contrary to the prevailing narrative around drug prices and innovation, the largest price hikes usually occur for older drugs that have been on the market for a long time.
Newly launched drugs have relatively less pricing power, especially if they are geared toward adults with private insurance. Private insurers can require higher patient co-pays or explicit prior authorization from physicians for drugs whose pricing is out of line with their clinical value. In extreme cases, insurers can refuse to cover the drug altogether. (This practice is limited by federal and state coverage mandates that force insurers to pay for drugs irrespective of their price; insurers pass the higher costs onto patients in the form of higher premiums. Government programs like Medicare effectively pay for any drug that is FDA-approved, regardless of price.)
Drug companies have maximum leverage to increase prices after a majority of patients are already being treated with a drug. If patients with a chronic disease who are doing reasonably well under a specific drug therapy, physicians consider it risky to change treatments midstream. It is at this point that drug companies have maximum leverage to raise prices, because patients and doctors will blame insurers if payors refuse to cover a drug that a patient is already receiving.
Case study: AbbVie’s Humira
To illustrate this phenomenon, we examined AbbVie’s Humira, a treatment for rheumatoid arthritis and related inflammatory diseases. Humira was launched in the U.S. in 2003, and is now the largest drug in the world by annual revenue.
Over the last decade, from 2011 to 2020, AbbVie generated $263 billion in total worldwide revenues, of which $96 billion came from U.S. sales of Humira, net of rebates to pharmacy benefit managers and other market participants. The $96 billion represents 36 percent of AbbVie’s total sales over that period.
Digging deeper, we can elucidate the share of Humira’s revenue growth over the decade that came from price increases, versus the share of growth that came from higher volume (i.e., from treating more patients).
From 2011 to 2020, AbbVie generated $66.8 billion in net U.S. sales growth from Humira. Nearly two-thirds of that revenue growth—$41.7 billion—came from price increases, and only $25.1 billion from higher volume.
What would have been the impact of reducing AbbVie’s R&D spending by $6.6 billion, but returning $41.7 billion of Humira price increases back to patients and taxpayers?
In other words, from 2011 to 2020, 15.9 percent of AbbVie’s global revenues came from price increases on Humira in the United States. (In most other countries, AbbVie is unable to unilaterally impose price increases on older drugs.)
Over that time frame, AbbVie spent a total of $39.7 billion on R&D. If we assume that AbbVie’s R&D spending rises and falls in proportion to its revenues, without Humira price increases in the U.S., AbbVie’s R&D spending would have decreased by 16 percent, or $6.3 billion, over the 2011–20 time period.
What would have been the impact of reducing AbbVie’s R&D spending by $6.3 billion, but returning $41.7 billion of Humira price increases back to patients and taxpayers?
AbbVie: 45 times less R&D productivity from price increases
Advocates of unaffordably high drug prices argue that they are necessary in order to fund research and development into new cures.
Since 2011, AbbVie has developed six novel drugs that were approved by the FDA: Viekira and Mavyret for hepatitis C, Venclexta for leukemia and lymphoma, Skyrizi for psoriasis, Rinvoq for rheumatoid arthritis, and Qulipta for migraine prevention. That is a ratio of $6.6 billion in R&D spending per approved novel drug.
From 2009 to 2018, according to a study published in the Journal of the American Medical Association, the median R&D cost per new drug from 2009 to 2018 was $985 million, accounting for drug failures. In other words, AbbVie was seven times less productive than the average pharmaceutical company in its R&D efforts.
If AbbVie had not extracted price increases from Humira, and spent 16% less on R&D over the past decade, the impact on patients would have been incremental, relative to returning $41.7 billion of lost income back to patients through direct drug spending, reduced insurance premiums, and reduced taxpayer spending.
Put another way: Giving AbbVie $41.7 billion to develop a single additional novel drug is not an efficient use of patients’ and taxpayers’ money. Artificially high, bubble-like pricing leads to malinvestment in marginal, high-risk projects that are unlikely to generate competitive returns.
It is conceivably true that if U.S. drug prices were lower, incrementally less money would flow into research and development. But under that logic, we should triple the price of every drug in order to incrementally increase R&D spending. Remember that only a fraction of the revenue gained from price increases flows into research and development. AbbVie, for example, only invested 15% of its worldwide revenue into R&D from 2011–20.
As the AbbVie example shows, raising prices by $1 to generate 15 cents of additional R&D spending is not in the public interest. At a certain point, the affordability of drugs to patients and taxpayers must take precedence.
Policy recommendations
Congress and the FDA should do far more to encourage pharmaceutical innovation: not just for entirely novel treatments, but also for competitors to existing treatments. Where R&D costs are low, such as with orphan diseases, it is possible to significantly reduce drug prices without harming the incentives to develop new drugs. All of the reforms proposed below are included in the Fair Care Act of 2020, a health reform bill sponsored by Rep. Bruce Westerman (Ark.) and Sen. Mike Braun (Ind.), among others.
Apply the FDA’s conditional approval process to common chronic diseases. As we noted above, 90% of the cost of developing a drug is consumed in phase III trials. In the 1980s, after protests from AIDS activists, the FDA enabled drug companies to gain marketing authorization for anti-HIV drugs after phase II studies, provided that the phase II studies showed clear indications of effectiveness. Sponsors who gain marketing approval in this way are still required to complete phase III studies; if those trials do not replicate the phase II results, the FDA can pull the drug from the market. The FDA has since expanded the conditional approval process to drugs treating any terminal disease. This policy change turbocharged the development of drugs for cancer and rare diseases, because it greatly reduced the financial risk involved in new treatments for terminal disease. Unfortunately, the parallel effect has been to steer R&D spending away from common chronic conditions, like diabetes, coronary artery disease, and high blood pressure, which can shorten life but are not technically terminal diseases. The Promising Pathway Act, sponsored by Sens. Mike Braun (Ind.), Lisa Murkowski (Alaska), and Martha McSally (Ariz.) is one example of a bill that would expand the FDA’s conditional approval process to a broader range of chronic diseases.
Apply Congressional scrutiny to FDA regulations that increase R&D costs by greater than $100 million. Historically, the FDA has paid no attention to the costs its regulations impose on innovative pharmaceutical companies. Companies themselves are extremely reluctant to criticize the FDA, because they fear that doing so will make it harder for their drugs to gain approval. As a result, the cost of developing new drugs has skyrocketed, especially for large chronic diseases. Scientifically speaking, the cost of developing new drugs for chronic diseases should be declining, as we now have many well-characterized surrogate markers for effectiveness of these drugs, such as serum LDL cholesterol levels, that should make it easier to conditionally approve drugs at an earlier stage of development. Given the impotence of industry in this area, Congress should use its oversight authority to require a full up-or-down vote in Congress on any new FDA rules that would increase industry R&D costs by over $100 million per year: a commonly used threshold for economically major regulations.
Establish an accelerated FDA approval process for diseases where there are two or fewer effective, on-patent treatments. Competition among multiple effective therapies has proven to be a successful tool for reducing drug prices. For example, the price of Gilead’s Sovaldi started to come down after competing hepatitis C treatments were approved by the FDA. Today, the FDA enables accelerated approval for drugs that meet “unmet medical needs”; i.e., conditions with no effective treatment. The prejudice of the agency has been to look down on “me-too” drugs that compete with existing therapies. But a new drug that provides the same clinical benefits at a lower price is a legitimate and essential form of innovation, and the FDA should incentivize their development.
Eliminate mandates for public and private payers to cover cost-ineffective drugs. A broad array of federal laws and regulations, including those governing the Affordable Care Act, Medicare, and Medicaid, require insurers to cover drugs regardless of their price. These mandates enable drugmakers to charge high prices that would be unjustifiable in a freer market. For example, the Affordable Care Act requires insurers to cover at least one drug in each therapeutic class, regardless of price or clinical value. Medicare Part D plans must cover all drugs in so-called “protected classes.” While Medicare Part B physician-infused drugs are theoretically subject to a “coverage determination,” in practice Medicare Part B must pay for nearly all drugs approved by the FDA, irrespective of price or value. Congress should reform these mandates, and give both private insurers and public programs more latitude to not cover drugs whose prices are out of line with their benefit to patients. Many countries with market-based health care systems, such as Singapore, maintain a list of reimbursed drugs for their public programs, and companies that charge excessive prices risk being excluded from the reimbursed list.
Strengthen the ability of private insurers to combat drugmakers’ monopoly pricing power. Monopoly manufacturers of patented drugs are frequently able to dictate their prices, especially in disease areas where they face no competition. A number of European countries, such as Switzerland, have addressed this problem by enabling private insurers to band together within a given canton (the Swiss equivalent of a U.S. state) to jointly negotiate reimbursement rates for prescription drugs. In the U.S., former Rep. Mark Meadows introduced the State-Based, Market-Oriented, Prescription Drug Negotiations Act of 2019, which would grant an anti-trust exemption for insurers within a given state that seek to jointly negotiate prescription drug prices.
Deploy global market prices and inflation rebates in the Medicare program. In 2018, President Trump and Secretary of Health and Human Services Alex Azar proposed basing reimbursement rates for physician-infused drugs in Medicare Part B on an international pricing index based on negotiated prices in high-income countries. While there are ways to improve the Trump-Azar proposal, the basic concept is widely used outside the U.S., and is an effective method for ensuring that pharmaceutical companies cannot abuse U.S. taxpayers by raising their prices ad infinitum. In addition, in 2019, the Senate Finance Committee endorsed bipartisan legislation to require drug companies to rebate the Medicare program, and thereby seniors’ Medicare premiums, if they raised prices on older drugs at a faster rate than consumer price inflation. Both of these tools are eminently reasonable ways to ensure that market prices play a greater role in prescription drugs.
Apply greater scrutiny to biologic and orphan drug prices. Biologic drugs represent 60% of net drug spending, but less than 1 percent of U.S. drug prescriptions. Orphan drugs represent 48% of pharmaceutical R&D and 11% of spending, but are used in only 0.5% of U.S. patients. It is essential for Congress and the FDA to deploy the above tools in these drug categories, where competition is absent and, in many cases, impossible.
Supporters of the drug pricing status quo routinely claim that Moderna’s COVID-19 vaccine would never have been developed if the government negotiated drug prices. This is an ironic example to use, since the government actually did negotiate vaccine prices under Operation Warp Speed. Government-negotiated drug prices have hardly impaired Moderna; today, the company’s market capitalization exceeds $130 billion.
Rapidly rising drug prices present a significant threat to the fiscal sustainability of the U.S., and to the affordability of life-saving medications. In every other industry, innovation leads to lower prices. It is far past time for the biopharmaceutical industry to follow suit.
