Surprisingly absent from the healthcare debates surrounding ObamaCare is the “high” cost of prescription drugs. I’m not sure exactly why this issue has not received as much discussion. Sadly it is probably not because the population at large is realizing current drug prices compensate investors for the risk of drug development and fund current drug research for the next generation of drugs.
Setting drug prices is difficult and I do not know the exact formula pharmaceutical companies use to price different medications. I sympathize with individuals facing large monthly costs for prescription drugs. I do not, however, believe the government should negotiate drug prices or set price limits on prescription drugs. Here I’ve laid several key issues and arguments on the issue and tried to constructively add to the discussion.
The Cost of Drug Development
The cost of developing a drug is enormous. Estimates I’ve seen are between $800 million and $1 billion. This includes costs of the many, many compounds that never make it through clinical testing for FDA approval.
Drug companies receive typically a 17-year patent on new drugs, but those patents start when the compound is first registered. Pharmaceutical companies are incentivized to register a compound early to protect its intellectual property. However, that also has the detrimental side effect of limiting the number of years a drug can be sold under patent protection. Drugs typically take 5-12 years to make it through the approval process, so potentially a drug could only have five years to recoup the investment in its development.
Price Controls in Other Countries
Many countries have price controls on prescription drugs. Even with the price controls, pharmaceutical companies still sell drugs into those countries. This is often used as argument that it proves drug companies can still make money selling drugs for substantially less than they are sold in U.S. However, this is simply proof of the low marginal cost of producing most chemical based drugs.
In many respects the U.S. consumer is subsidizing the cost of prescription drugs for consumers in countries with strict price controls. When a pharmaceutical determines to move forward with a drug project, it looks at total cost of production and eventual total revenue from the product. It needs to justify investing the money into research and development by the potential profit if the drug is approved. Companies know they won’t be allowed to receive a fair price in many countries, so American consumers are forced to pay more to justify the initial investment.
Low Marginal Cost of Production
Drugs are typically broken into either chemical-based or biologic-based drugs. Chemical-based drugs are typically the pills we take, like Lipitor. Once the clinical testing is completed, FDA approval received and manufacturing process perfected, the cost of producing the next individual pill is very small. This argument is used repeatedly in the media to “prove” we are being over-charged for prescription drugs. While it is true that the marginal cost of producing the next pill is often very low, the total fixed cost of the drug’s development is significantly larger. To earn an acceptable return on investment, the pricing of the pills needs to reflect the full cost of drug development, not simply the marginal cost of producing the next pill.
Capital Investment and Risk/Return
Drug development is extremely risky. Only a tiny fraction of researched compounds ever make it to market as a prescription drug. Hundreds of millions of dollar are spent annually by the pharmaceutical and biotechnology industry researching drugs that will never generate one dollar of sales. For all the failure, these companies hope to find one or two that will help patients and make it through the approval process.
Given this risk, investors will demand a significant return on their money. U.S. treasury bonds pay a very low return but the probability of getting your money back is very high. Pharmaceutical and biotech ventures are just the opposite. If the return on the winners (drug that get approved) was not sufficiently high, investors wouldn’t be willing to finance all the research on drugs that ultimate end up being worthless.
As a society, we all benefit from the availability of ever improving drugs. Drugs being used today were funded with research that started 10-20 years ago. Drug research being funded today will benefit those needing care 5-20 years in the future. This is why I say, ‘I don’t want to be taking Lipitor when I’m 60.’ Lipitor is a great drug that has improved the health of numerous individuals worldwide. However, when I get to point of needing a cholesterol lowering drug, I want to take the caliber of pill that will be available only through significant investments in drug research today. And that drug research does not pay for itself.
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