Drug prices, essential goods, and regulatory evasion

We see rising drug prices in the news a lot these days, from Martin Shrkeli’s infamous 4000% hike in the price of the antiparastic Daraprim (from $17.50 -> $750 per pill), to the average 250% increase in the price of insulin from the 3 major manufacturers between 2001 and 2015, a drug originally created in the 1920’s.  Overall, spending on prescription drugs in the U.S. increased 50% between 2005 and 2016, from $320 billion to $480 billion, and that’s almost entirely from price increases (utilization has not increased much, only 1% between 2011 and 2015).  These high prices naturally show up in profits, the industry’s average profit margin of around 17%, making it one of the very most profitable industries in the world.

What’s behind these high prices? Are they simply what’s necessary to incent the research needed for more new treatments? Or are these hikes the price gouging that’s enabled by very low elasticity markets?

The economics behind these questions centers on the tension between three key aspects of this industry: it is a high innovation, essential goods industry where insurance is prevalent. Essential goods industries pose a two-fold challenge. First, society has a particularly strong interest in making these goods accessible to all; for example, municipal governments generally directly provide water, another essential good, and state governments intervene with many electric utilities via price controls. Second, essential goods markets are, absent strong competitive forces, the most exploitable of markets. The “essentialness” of these goods means that their price elasticity — the reduction in quantity a vendor suffers if they raise the price of their product — is especially low, and that means that prices will be especially high without vigorous protections for consumers (researchers report elasticity values around -0.2).

Industries where insurance plays a large role pose their own challenge for market-based solutions: the fact that the consumer requesting a product or service only pays a fraction of the actual cost highly distorts the most fundamental signal a market relies on, the connection between price and the level of demand. And insurance is heavily involved in pharmaceutical payments, with private insurance and medicare together accounting for 72% of total pharma spending.

The patent protection, or “monopoly license”, we extend to inventors to encourage innovation also exacerbates the price challenge in the pharmaceutical industry, again due to the essential goods nature of the market. Patent protection is a government intervention in the market that gives the patent holder a one-firm monopoly on that invention; if there are no close substitutes, it is a de facto monopoly on an entire type of good (or treatment class, in the case of pharmaceuticals). We as society are not overly concerned with such monopolies in optional goods markets, since the goods are both non-essential and less exploitable: prices cannot be raised but so much above competitive levels, due to the higher price elasticity of non-essential goods. Unchecked monopolies in essential goods, however, can raise prices much higher above competitive levels, and inflict considerably more harm by doing so (thus the presence of price controls in other essential goods monopolies like electric utilities). Balancing this need to restrain predatory pricing with the need to encourage innovation is the key to an effective regulatory regime.

Further aggravating the patent monopoly issue, patent holders engage in numerous gaming activities to effectively lengthen their patents. The Orphan Drug Act, enacted in 1983 to encourage research and development into rare disease treatments, offers extended patent life for to reward such activites, but companies have found that they are able to claim that same protection for drugs they long ago developed if they find that it also treats a rare condition. For example, Humira, the best-selling drug in the world, is able to claim orphan drug protection because, in addition to the many other conditions it treats, it also has been found to treat a rare disease, Crohn’s disease. “Pay-for-delay” schemes are another method, where brand-name manufacturers pay generic manufacturers not to produce a generic version of their patented drug when its patent expires. Manufacturers also abuse REMS safety regulations by using them as a rationale to withhold the samples a generic producer would require to develop and get approval for a generic; just these abuses of REMS have been calculated to cost consumers $5.4 billion annually.

Patent “evergreening” or “product hopping” is another widely used strategy to delay entry of generic competition, that capitalizes on a combination of patent monopoly power, marketing and agency inefficiencies to effectively extend the life of the original patent. Before patent expiration, companies will file for patents on small changes to the drug (e.g. extended release), and then start marketing the new version heavily to physicians. Sometimes they will even stop producing the earlier version to force a switch to the new version. Potential generic entrants find themselves facing a much-reduced market for the now-replicable older version, and a physician education challenge in getting physicians to internalize the value of a generic version. The top 12 selling drugs, for example, have an average of 125 filed and 71 granted patent applications, and their prices have increased 68% since 2012.

For these reasons and others, many other countries intervene more energetically in pharmaceutical markets, with price controls (France and Italy), reimbursement limits from social insurance (Germany, Japan), and profit controls (United Kingdom). As a result, their per capita spending on pharmaceuticals is much less than in the United States; the U.S. spends between 2  and 3 times what other Western countries spend despite roughly equal drug utilization. Pharmaceutical profit margins in the U.S. average 4 times the margins of non-U.S. pharma companies.

The price issue has become important enough that even U.S. politicians, from both parties, are proposing stronger intervention in this market. Democrats in the House are working on a proposal to allow the government to match drug maker monopoly power with the buying power of Medicare, an idea very popular amongst the public, with support from 96% of Democrats, 92% of Republicans and 92% of Independents. The idea behind the proposal is similar to that behind using large insurers and pharmacy benefit managers (PBMs) to keep prices down: monopsony or buying power may be able to countervail supplier pricing power.

Direct price controls are also popular, such as limiting what companies can charge for high-priced drugs (support from 78% of Democrats, 79% of Republicans and 79% of Independents) and creating an independent group to oversee drug pricing (74% of Democrats, 71% of Republicans and 74% of Independents). Scholarly work in this area seems focused on value-based pricing.

The second most popular idea amongst the public for containing prescription drug costs is to make it easier for generic drugs to come to market (84% Democrat, 91% Republican and 91% Independent support), and as we saw with the patent extension strategies described above, this has significant potential to provide relief. Authors of this report from Brookings agree:

Over the last 10-15 years, however, industry participants have managed to disable many of these competitive mechanisms and create niches in which drugs can be sold with little to no competition. We argue in this paper that the first step toward bringing down pharmaceutical prices would simply be to fully apply the existing rules we already have.

Policies to rein in these abuses are starting to get attention, with calls like this one in the New England Journal of Medicine to reform the Orphan Drug Act, and efforts to limit “pay-for-delay” schemes and to require brand-name manufacturers to provide samples so generics can be developed.

Surprisingly, perhaps, even where there are generics available, prices are often not reduced as much as we would hope, due to industry consolidation, low numbers of competitors for a given drug, and possibly collusive behavior. Forty-four states are suing 20 large generic drug companies over an alleged price-fixing conspiracy:

“We have hard evidence that shows the generic drug industry perpetrated a multi-billion dollar fraud on the American people,” said Tong, in a prepared statement. “We have emails, text messages, telephone records, and former company insiders that we believe will prove a multi-year conspiracy to fix prices and divide market share for huge numbers of generic drugs.”

We can see some of the effects of both industry consolidation and any such market allocation schemes when we look at market concentration for specific drugs. Generic drug manufacturer market concentration measured across the industry at the national level isn’t high enough to activate special scrutiny from the DOJ, but when focusing on markets for specific molecular-dosage generic drugs, we find that 40% of them are supplied by only one manufacturer, and the median number of manufacturers is just 2. When you consider that prices don’t drop significantly until there are 3 manufacturers of the drug (a second manufacturer only brings the price down 6%), this makes numerous generic drugs considerably more expensive than what a competitive market would produce.

Returning to our original question, are these high prices, patent evergreening strategies and the like simply necessary to incent pharmaceutical research? Or do they combine with monopoly pricing power in a low elasticity market to enable price gouging and supranormal profits?  Two former pharma executives dismiss the notion that prices are set to recoup R&D costs: Hank McKinnell, a former CEO of Pfizer, says “It is the anticipated income stream, rather than repayment of sunk costs, that is the primary determinant of price”, and Raymond Gilmartin, former CEO of Merck, has commented that “The price of medicines is not determined by their research costs. Instead, it is determined by their value in preventing and treating disease.”  Inmaculada Hernandez, a professor at the University of Pittsburgh’s School of Pharmacy, notes that “usually research and development is paid for in the first years of life of a drug.”

Indeed, when we look at industry profit levels and total R&D investment, we see a wide gap between the two. The total pharmaceutical spending of about $480 billion is split 74%/36% between the branded and generic categories, and branded manufacturers receive about 76% of total branded product revenue (after insurers, PBMs, pharmacies and wholesalers take their cut).  Gross profit for branded manufacturers was 76% of their revenue, or about $205 billion, with $71B of that invested in research and development, $30B spent on marketing, and about $15B on capital equipment. Taking the 2017 industry return on capital of about 11%, and assuming that the rate of return on R&D is the same as that on marketing, we come up with a ballpark range for the industry’s return on R&D around 85%. Some argue that the industry actually spends considerably more than $30B on marketing, which might reduce the return to R&D to about 50%.  But either way, that’s a high rate of return, and they receive an equal return on their marketing investment.

All in all, rapidly climbing drug prices; the essential goods nature of the market, with it’s propensity for supra-normal prices and profits; the regulatory evasion we observe; plus a 50-85% return on R&D and an equal return on marketing, all point to there being plenty of room to more closely regulate this industry to protect consumers, while still providing healthy returns to investors.

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