Drug Companies Don't Get Enough Money …

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… for the life-saving benefits that they provide us, according to an intriguing article in current issue of The Milken Institute Review (registration required). In their article, "Dividing the Benefits from Medical Breakthroughs," two University of Chicago scholars, Tomas Philipson and Anupam Jena, look at the case of HIV/AIDS drugs and figure out how much value patients get from the drugs versus how much value pharmaceutical companies get from the same drugs.

HIV/AIDS drugs increase an infected person's life expectancy by 15 years on average, which Philipson and Jena (using standard econometric techniques for figuring out the value of life years) calculate as being worth a total of $740,000 per infected person. They then sum up the total value over the number of people in the United States who have been infected and, assuming a steady annual infection rate of 20,000 per year, they conclude: "The aggregate value of the HIV/AIDS drugs for those infected and those who will be infected is nearly $1.4 trillion!"

How much do the drug companies get? They estimate that the lifetime sales revenues of HIV/AIDS drugs will equal $74 billion. Which means, according to Philipson and Jena, that "almost 95 percent ($1.33 trillion out of $1.4 trillion) of the economic surplus generated by the drugs went to consumers." That's right, consumers get 95 percent and drug companies get 5 percent!

Philipson and Jena cite other calculations that find that the value of the changes in life expectancy between 1970 and 1990 was $2.8 trillion owing to the development of other life-extending medical advances against infectious diseases and coronary artery disease.

Considering how valuable drugs are, Philipson and Jena then wonder if we could get more of them with better incentives to innovators. To wit:

The value to be had from life-extending and life-enhancing medical innovation is enormous. But, generalizing from the case of HIV/ AIDS drugs, the portion of the surplus ending up in the pockets of innovators is often modest—so modest that the division may be seriously retarding the pace of innovation. The big question, then, is whether politically acceptable ways can be devised to sustain high levels of private investment in high-risk medical projects that have the potential of huge payoffs for patients. The promise of modern medicine is vast. But the mechanisms for insuring that medicine delivers on that promise are not always up to the task.

Something to think about the next time you hear a politician demagoguing against "Big Pharma."

Disclosure: Yes, I do have some small stock holdings in various biomedical companies. I certainly hope to make a profit off of them, but I also believe in the good that they are doing. If you choose to invest in some random biomedical stocks because of what you read here, may God (or other deity of your choice) help you.

NEXT: Save Me From Myself Redux

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  1. The federal government also pays for a significant portion that may have led to the drug’s discovery that does not seem to be taken into account from the quoted parts of the article.

  2. Ron, I think this is a misguided way to look at the issue. Many products generate massive “consumer surplus”–benfit to their purchasers vastly in excess of their cost–because competition among suppliers drives the cost down to near the cost of production, rather than up to the level of benefit to the purchasers. That’s one of the beauties of capitalism. Innovative drugs evade some of this downward pressure for a time through government patent laws. At least some patent protection is certainly warranted to spur innovation, but comparing the return to suppliers with the surplus to purchasers tells you little about whether there are sufficient incentives for the suppliers. The real issue is how much above a “normal rate of return” the suppliers make, and for how long, and whether that is enough to recoup the costs and risks of development. The amount of “consumer surplus” seems to me to have nothing to do with it. Or is a shot of penicillin worth $1 million? In some circumstances, after all, that shot could save your life.

  3. Cal Ulmann: Government does pay for a lot of basic research but at the risk of quoting from another of my articles:

    “Government-supported research gets you to the 20-yard line,” explains Duke’s Grabowski. “Biotech companies get you to the 50-yard line and [the big pharmaceutical companies] take you the rest of the way to the goal line. By and large, government labs don’t do any drug development. The real originator of 90 percent of prescription drugs is private industry. It has never been demonstrated that government labs can take the initiative all the way” to drug-store shelves.

    George Whitesides, a distinguished professor of biochemistry at Harvard University, similarly appreciates the role of often-government-funded research labs at universities in the early stages of drug development. But he stresses that “pure” research rarely translates into usable products. “The U.S. is the only country in the world that has a system for transmitting science efficiently into new technologies,” he argues. That system includes research universities that produce a lot of basic science and get a lot of government money. In turn, startup companies take that lab science and develop it further. “Startups take 50 percent of the risk out of a product by taking it up to clinical trials,” explains Whitesides. “Industry has an acute sense of what the problems are that need addressing.” Without private industry to mine the insights of university researchers, taxpayers would have paid for a lot of top-notch scientific papers, but few if any medicines.

    Cal: It might well also be the case, that government is significantly underinvesting in drug research.

  4. jbd: I hear you. Driving down costs due to competition is one of the great beauties of capitalism.

    But I believe that the authors do have a point when they argue:

    “Is 95 percent too much or too little? In the simplest theoretical models of markets, one virtue of competition is to drive prices down to producers? marginal cost ? thereby ensuring that all of the economic surplus goes to consumers. So, from that perspective, a market in which 95 percent of the surplus goes to consumers looks pretty good. But in markets in which fixed costs are very large ? and that is certainly the case on the frontiers of pharmaceuticals, where R&D swallows hundreds of millions of dollars before the first pill can be sold ? the expectation that only a small portion of the surplus from a breakthrough will go to the owners of the intellectual property may well retard innovation.”

    I really recommend reading the whole article.

  5. While it’s true that some drugs are lifesavers and have benefited society there are also a lot of myths that surround the pharmaceutical industry in this country. The first is that the drug companies are being so incredibly innovative in bringing new drugs to market, they aren’t. Most of the so-called “breakthrough” drugs they release are actually just variations on pre-existing drugs.
    The second is that the poor, poor, drug industry is running on a tight margin because they lose so much money bringing “new” drugs to market. This is just PR, in fact the drug industry is one of the most consistently profitable in the nation. So if you are looking for a good investment go with pharmaceuticals, especially those developed for kids because it’s becoming increasingly common to drug kids into oblivion for so called “disorders” that used to be known as childhood.

  6. Philipson and Jena then wonder if we could get more of them with better incentives to innovators

    Naw, that’ll never work.

    Lets cut off the flow of money to everyone involved in innovation via price controls and weakened IP protection for drugs. While we’re at it, lets increase the regulatory barriers to bringing new drugs to market, under the precautionary principle enforced via the trial lawyers.

    There’s your surefire recipe for increased innovation!

  7. Ron,

    Do you think it is the actual R&D that costs too much? Or more regulatory compliance costs to bring the drug to market?

    The NDA process often eats into the patent term of the product. Further chipping away at the developers piece of the economic surplus.

  8. Wow, what saints those drug companies are! They give AIDs victims a few additional years of life, and even allow them to keep a good portion of the money they earn in that period. It’s probably because of charity like this that they are forced to have their 90,000 person sales force buying off doctors, and lobbyists buying tax breaks and government handouts.

  9. Libertylover:
    At the risk of being tedious I really have debunked many of the “concerns” you raise such as “me-too drugs” and implied “excessive profits” in my earlier article, “Goddamn The Pusher Man.” For example, quoting myself again:

    Central to virtually all “reform” agendas is reining in those drug company profits. Will that contain health care costs? “Suppose we seize all pharmaceutical profit,” suggested Sidney Taurel, CEO of Eli Lilly & Co., in a speech last October. “Drugs are just 8 percent of total health care. To simplify the arithmetic, let’s stretch and say [profits are] 20 percent of sales. Twenty percent of 8 percent equals just 1.6 percent of total health care costs. Does that sound like a solution to you?” Despite its political appeal, it’s not much of one. In fact, that sort of thing would almost certainly retard the development of new drugs by destroying the incentive for research. (It’s not called the profit motive for nothing.)

  10. Pharmacutical companies also get a great deal of economic benefit from patent protection, for which they pay nothing. Maybe we should start charging them for the privilege?

  11. Dean Baker and John Quiggin make some convincing arguments that the incentives provided by patents are extremely inefficient.

    No time to read the article at this point, but I am convinced that the current system is not working very well for all sides (except perhaps patent lawyers). Prizes for helpful discoveries seems the most promising.

  12. Dakota: You’re right that the drug approval process is a huge part of what drives up costs for new drugs. Basically we need to reform the drug approval process to essentially eliminate Phase III trials.

    However, you must keep in mind that the government granted monopoly of patent protection also increases costs to patients.

    What libertylover and other critics of “me-too” drugs miss is that their introduction dramatically reduces the costs to patients of all drugs in given treatment category, e.g., price of Prozac dropped a lot when Zoloft and Paxil were introduced. More “me-too” drugs would come onto the market faster if Phase III trials were eliminated, thus driving down prices even faster.

  13. Alan: Abraham Lincoln once described patents as “adding the fuel of interest to the fire of genius.” What many people forget about patents is that they are a disclosure mechanism. The monopoly is granted on the grounds that the inventor tell us exactly how he makes his product. This disclosure mechanism removes us from the old economically stagnant world of trade secrets in which inventors could only make money if they told no one how they did something. This allows other people to use those insights to invent other products. Patents are not perfect, but they have worked pretty well.

  14. Whatever nonsense you are spouting in this, it isn’t capitalism. Yes, people are expected to receive value from products. It’s why there’s an economy. No, the producer is not expected to gain financially proportionally to the value received. It’s not supposed to be a zero sum game. The producer is expected to make a modest profit, but there’s certainly no expectation of fabulous wealth in return.

  15. In response to Ron’s post I would like to make a few points. Far be it from me to prevent the drug industry from making a profit from their work, good for them. I do remain unconvinced however to how truly “free-market” the drug industry really is in truth. I’m not talking about the costs of regulation here just the fact that as a rule I have always found that if you dig deep enough you will find the pork and cronyism in there somewhere. If you would to find out more read “The Truth About the Drug Comapanies: How They Deceive Us and What to do About It” by Marcia Angell. Another excellent book is “On the Take: How Medicine’s Complicity with Big Business Can Endanger Your health” by Jerome P. Kassirer.

  16. Drug companies set their prices to maximize their profits. If they could make higher profits by claiming a higher % of the value they provide, they would do so. That they do not demonstrates that there isn’t much of a market for higher priced drugs.

    This system of price setting seems to be good enough for libertarians in most other settings. Why is it inadequate here?

  17. Mac: Capitalism doesn’t set profit margins–markets do and some entrepreneurs do get fabulously wealthy as a result,i.e., Sam Walton & Bill Gates.

    libertylover: Not an excuse, but as an explanation–as the most highly regulated industry on the planet, do you really expect pharmaceutical companies to ignore their overlords on Capitol Hill and the Executive Branch? Modernize the new drug approval process and a lot of lobbying funds will dry up. Of course, politicians, as the beneficiaries of lobbying largesse, have no incentive make such reforms.

    Regarding Marcia Angell’s book–it’s economically ignorant. I haven’t read Kassirer’s book, but the extent of monetary relationships between pharmaceutical companies and physicians does need scrutiny.

  18. joe: Right on. When I was doing research for an article on drug companies a while back, I was talking with an economist about how they set prices. Did they base on their research costs, their manufacturing costs, and so forth? He looked at me, sighed, and said: “Ron, they charge what the market will bear.” I blushed.

  19. Why, by this absurd math, your median household earns enough in a year to justify about 6 man-month of life expectancy. So we can only conclude that most people don’t deserve to live, as obviously they can’t afford to! And Libertarianism would not want them to have a free ride, would it?

  20. trollumination:

    Actually if you do the math at 5% of economic surplus, the average person in this case is paying $37,000 for 15 years of life that they would otherwise not have.

  21. Ron: Of course I don’t expect drug companies to ignore their overlords on Capitol Hill or any other Statehouse. The crux of the issue, as I see it, seems to be that on the one hand red tape and political meddling can interfere with the development of potentially useful drugs and harm consumers and frustrate producers. On the other hand, what mechanisms should be in place to protect consumers from dangerous/poorly researched/over marketed drugs? It seems like both sides could trade horror stories all day.
    I am unconvinced that the average consumer will have the proper available research or training to make an informed choice about the drugs they consume. Unlike other common consumer products there may be potentially health-threatening or even life-threatening consequences to making a poor choice. This problem seems to have no ideal solution government or otherwise.
    I also don’t believe for a second that the drug companies have any interest in true competition with other alternatives such as herbal medicines, homeopathy, or vitamins/nutraceuticals. They are all too happy to have to have big brother step in to protect their interests if say a product like Red Rice Yeast comes along and provides a safe, effective alternative to Statin Drugs for the management of cholesterol. I offer as an example of this a proposal in CA, Prop (56?) I believe which aims to do just that.

  22. And my patent-protected, government safety inspected engine keeps boeing’s planes from dropping out ofthe sky. I think I’m entitled to way over 5% of Boeing’s profits.

    Ron,

  23. Correction: Prop 56 is incorrect. I will have to check again for the right bit of legislation. I first learned of this when one of my suppliers, Lifelink, told me this product may not available for much longer due to a pending proposal in CA.

  24. Mr. Bailey,

    What is your source for the statement that AIDS drugs extend life expectancy by 15 years?

    The latency period stated by AIDS experts between HIV infection (untreated) and sickness began at 2 years, (in 1984,) increased steadily in subsequent years, and is now said to be between ten and fifteen years, but possibly “up to 30 years.”(Gallo.)

  25. Libertylover: You write: “I also don’t believe for a second that the drug companies have any interest in true competition….” Actually, no company has any interest in “true competition.”

    Regarding herbal supplements and so forth, of course, pharmaceutical companies and FDA bureaucrats share an interest in keeping out competition. Ironically, they deploy the same argument you do in opposition to them, to wit: “Unlike other common consumer products there may be potentially health-threatening or even life-threatening consequences to making a poor choice [of herbal supplements.]

    I lived in Latin America and drugs were dispensed quite safely in consultation with pharmacists, no doctors’ prescriptions needed. I believe that we should move toward this system.

  26. Hamlet: The estimate is taken directly from The Milken Institute Review article I’m referencing. Thanks for the updated info.

  27. Actually if you do the math at 5% of economic surplus, the average person in this case is paying $37,000 for 15 years of life that they would otherwise not have.

    And doesn’t that seem like a ridiculously low figure from what actual AIDS patients are spending for their 15 years of the treatment of their condition?

  28. I’ll begin to buy this blather once anyone can provide me with any empirical or methodlogical evidence that patents (one of the methods used by activists who claim we need more incentive to innovate) actually increase innovation. Otherwise it’s just another call for subsidizing someone else’s profit at my expense.

    Nothing I’ve seen provides support for the proposition – even Judge Posner admits there is no empirical support for the proposition in “Economic Basis of Intellectual Property Law”. And there’s quite a bit of dead on logical deductive work by Kinsella that refutes a logical basis for the proposition.

    And, having worked in the industry, specifically in that wonderful place where NDAs, ANDAs, and patents meet, I can tell you that rent-seeking is the norm, not the exception, in the industry. As you would expect…

  29. Ron: Good point about supplements. I guess it comes down ultimately to who should be the gatekeeper, the FDA, Doctors, or consumers. I have been frustrated many times by government clampdowns on supplements after some hysteria over a product, usually taken out of context. I guess my concern is over what I perceive to be the unscrupulous ways drug companies market many of their products and MD’s to play ball with themm while both attempt to belittle and or crush the supplements market. But maybe your solution is the best of all worlds let pharmacists/herbalists/nutritionists etc. advise consumers and leave the choice up to them. People will continue to be harmed by some drugs or supplements but maybe not any more so than now but at least they will be in the driver’s seat.

  30. Ron: Good point about supplements. I guess it comes down ultimately to who should be the gatekeeper, the FDA, Doctors, or consumers. I have been frustrated many times by government clampdowns on supplements after some hysteria over a product, usually taken out of context. I guess my concern is over what I perceive to be the unscrupulous ways drug companies market many of their products and MD’s to play ball with themm while both attempt to belittle and or crush the supplements market. But maybe your solution is the best of all worlds let pharmacists/herbalists/nutritionists etc. advise consumers and leave the choice up to them. People will continue to be harmed by some drugs or supplements but maybe not any more so than now but at least they will be in the driver’s seat.

  31. Re: Herbs, Homeopathy, and Black Magic

    If fraudulent claims law were rigorously enforced, there would be next to no supplements market. The only measure of efficacy is the controlled double blind study. If you take any drug, herb, or for heaven’s sake homeopathic dilution that hasn’t passed such a study, you are gambling against incalculably long odds that you are actually helping your condition.

    People can do what they want, and I have no patience for regulations to keep players out, but personal experience tells me that 90% or better of the alternative medicine business is populated with ghouls.

    “Everyone knows you can cure cancer with $10,000 oxygen chamber treatments, right? If not, there’s always $100 shark cartiledge pills. Remember, drug companies are here to take your money! Always ask yourself who benefits from people being sick? But that doesn’t apply to us! We’re here to tell you the truth!”

    They lie to sick and dying people to take their money, giving them in return all the healing that self satisfied conspiracy theory gets you.

  32. quasibill:

    What replaces the incentive to invest in patentable medicine? Are you criticizing the idea that return on investment provides incentive to invest or are you criticizing the idea that investment translates to innovation?

  33. quasibill,

    “I’ll begin to buy this blather once anyone can provide me with any empirical or methodlogical evidence that patents (one of the methods used by activists who claim we need more incentive to innovate) actually increase innovation. Otherwise it’s just another call for subsidizing someone else’s profit at my expense.”

    Not to quible but the USPTO is the only government agency completly funded by user fees. Actually the USPTO profit funds other agencies in the commerce department. No one is subsidizing another’s profit, through the USPTO.

  34. “What replaces the incentive to invest in patentable medicine?”

    Well, there are several very sophisticated analyses provided by a couple of economists, one of which is Stephen Kinsella (a patent attorney himself) – which are generally beyond a cursory discussion. (I’m not even sure I totally understand the finer points myself at this point). You can look up Kinsella’s stuff on his website, and he has a good set of references listed there, also.

    As far as supplying a Cliff Notes version, it’s the same thing that drives innovation in general – competition and the advantages that early knowledge gains in the market (not only in sales and branding, but also in investment – it is in investment that the analyses get really sophisticated).

    As an aside, it is really easy to see, when you look into the industry, to see how patents and regulation have altered the R&D investment behavior significantly – directing funds to projects that are less desired by the market, but easier to patent and/or sheperd through the FDA, or, in the moves that make patent attornies buttloads of money, the combining the two schemes to ensure monopolies that extend well beyond the nominal length while actually taking useful products off the market!

    “No one is subsidizing another’s profit, through the USPTO.”

    You’re mistaking the nature of the subsidization. It has nothing to do with the funding of the USPTO, and everything to do with the governmentally created monopoly (which are the only way a ‘bad’ monopoly can endure). In the absence of this monopoly, competition would enter the market and end the rent-seeking behaviors that are common.

    In the end, it is a simple matter of logic. If you argue that profits aren’t enough to justify an investment, if you want to increase the profits to make investment worthwhile you are looking to subsidize the industry at the expense of someone else, whether it be consumers or taxpayers. Patents are just another form of licensing.

  35. And what kind of a life would most people have if they paid $37,500 a year for 15 years?

    There’s lots of things that save lives. Quantifying it like this makes no sense whatsoever.

  36. jb: It’s $37,000 for 15 years, not 1 year of life. And if for some reason they don’t like the kind of life they’re living, they can stop taking the medicines, just like any patient can.

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