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PHARMA: Drug Prices here and there

There’s no question that in the US big pharma and its employees colleagues at USTR are on the attack over "low drug prices" in other countries, with the assumption that the US consumer is subsidizing R&D here and therefore allowing foreigners to get the benefit of new drugs without paying their fair share. Late last year I spent some futile time (aided by Derek Lowe who writes the excellent In the Pipeline blog) trying to get at the issue of whether this is true, and whether drug profit margins abroad are so low that they wouldn’t support said R&D. Of course the alternative is that drug prices are too high in the US (or at least higher than they need to be to attract investment in pharma R&D). It’s a common estimate that pharma companies make about 60-70% of their profits in the US. It’s also well known that net margins in the pharma industry are the highest of any major sector at roughly 17%, compared to the next highest, financial services at 14% and way above any other manufacturing industry, including software.

You don’t see software companies complaining about their need for government to ensure high prices to promote R&D, although monopolies by technology standards work equally well for one well known company. Pharma companies will argue the they only have limited time to make money, as patent expiration takes away their monopoly position and essentially forces them to start again from scratch, but in any other business, competitors will also come into the market using lower prices as their wedge in. (And to be fair to big Pharma they are by no means alone in looking to regulation or tariffs to protect them–which is why American car companies concentrate on minivans and SUVs, as there’s a 25% tax on foreign "light trucks"). Pharma companies also must essentially give away the fruit of their research to generic companies. So the whole issue is very complex.

Although my own effort to get original data was futile, I’ve recently seen two contradictory articles about the pharma R&D spend. One is a Bain report extensively quoted in The Trouble With Cheap Drugs in The Economist of January 31, 2004 and the other is an article called Will Lower Drug Prices Jeopardize Drug Research? by Donald Light of Univ of medicine and Dentistry of New Jersey and Joel Lexchin from York Univ in Toronto (yes he’s one of those naughty cheap old Canucks). These two papers take very different tacks. Given that Bain makes much of its living selling consulting to the pharma companies and Lexchin gets his salary from the Canadian government, you get no prizes for guessing which side of the issue they respectively fall on.

According to The Economist Europe is now spending 60% less per head on drugs than the US did compared to 30% less in 1992. That translates into $160 billion in annual "savings" compared to what the Europeans would have spent if their drug spending had gone up at the US’ rate of increase–which of course was very high over that time. Bain’s argument is that back in 1992 Europe and the US both spent $10bn a year on drug research but now whereas the US spends $30bn, Europe only spends $20bn. In consequence new drug development in terms of NCEs (new chemical entities) has gone down by half in Europe while it’s doubled in the US. While globally pharma profits are up from $60bn in 1992 to $121bn in 2002, the share of those profits made in the US has gone from less than 50% to 60%. The core of Bain’s argument is that new R&D goes where profits are made and that the loss of the high wage jobs in the drug business and the consolidation of pharma power in the US has hurt the European drug giants (especially the Germans like Bayer and Hoescht). So far so good, although in these days of everyone being headquartered in Bermuda, it’s pushing it to claim that any drug company is "national", given the success of GlaxoSmithKline in the US.

But Bain then goes on to argue that Germans get worse care and access to drugs than Americans because of spending constraints, and quotes some ridiculous numbers about cancer care mortality rates, which according to the OECD are virtually identical in both countries, and higher in both cases than in Switzerland, to back it up (and ignore plenty that would refute it such as relative life expectancy and child mortality rates). And then they claim that while Germany "saved" $19 billion on comparative drug costs, the cost of not having the R&D jobs, associated patents, and the cost of "worse health care" actually came to $22bn. This calculation, which is pretty hypothetical, appears not to reckon with the fact that not all the extra pharma spending would stay in Germany, but I guess that’s by the by. (For those of you remembering your Econ 101, the article also quotes the fact that there would be a "multiplier" effect from all that R&D spending, which is the first time that I can recall the monetarist Economist spouting long disparaged Keynesian theory).

So if the argument can be made that price controls — or more accurately as it happens in most of Europe relatively fixed global budgets for drugs — hurt the economy. Can you not argue the inverse–that expensive drugs hurt it too? Light and Lexchin certainly give that a good go. They have several arguments, some of which I’ll summarize here, but the whole document is short and worth reading.

They start by using British and Canadian government reports to demolish the "myth" of low profits hurting R&D.

    On the contrary, audited financial reports of major drug firms in the UK, show that all research costs are paid, with substantial profits left over, based solely on domestic sales at British prices (Pharmaceutical Price Regulation Scheme 2002). Likewise, 79 research drug companies in Canada submitted reports showing their R&D expenditures have risen more than 50% since 1995, all paid for by domestic sales at Canadian prices (Patented Medicine Prices Review Board 2002). Sales to the U.S. and elsewhere are in addition to the positive, domestic balance sheets.

The next allegation they refute is that price controls cause less R&D hence fewer new products, in fact their answer is that:

    R&D expenditures have been growing rapidly, though it is becoming more and more difficult to discover breakthrough drugs on targets not already hit (Harris 2003).

And claim that we don’t need all that many new products anyway

    The truth kept from Americans is that first-line treatment for 96% of all medical problems requires only 320 drugs (Laing et al. 2003).

As for the price gap that the Economist/Bain article points out

    The widening gap between prices for patented drugs in the U.S. and other countries is due to drug companies raising U.S. prices, not other countries lowering theirs (Sager and Socolar 2003; Families USA 2003).

In addition to all this, Licht and Lexchin claim that we spend more on R&D in the US because we’re not that good at it. Only about 18% goes on breakthrough research, the rest goes on me-too drugs and refinements of existing drugs to extend patent life:

    But while the U.S. accounts for 51% of world sales, it took 58% of global R&D expenditures invested in the US to discover only 43% of the more important new drugs (NCEs) (European Federation of Pharmaceutical Industries and Associations 2003). This means that other countries are helping to pay for the large, inefficient U.S. R&D enterprise, the opposite of what the editors of Business Week claimed (Business Week editors 2003).

They then, correctly in my opinion (and that of some of my other contributors) attack the often quoted $800 million sum that a new drug "costs"

    About half of the $800 million figure consists of "opportunity costs", the money that would have been made if the R&D funds had been invested in equities, in effect a presumed profit built in and compounded every year and then called a "cost." Drug companies then expect to make a profit on this compounded profit, as well as on their actual costs. Minus the built-in profits, R&D costs would average about $108 million 93% of the time and $400 million 7% of the time.

And they also claim that much of that money comes from taxpayer-funded research at the NIH, which again is true although the exact value in the marketplace of the NIH contribution is unclear, as Derek Lowe discusses here. Then they come to the rub of their argument, and this is the gist of the whole thing

    If American prices were cut in half, research budgets would not have to suffer unless executives decided to cut them in favor of marketing, luxurious managerial allowances or high profits. They probably would not, because R&D gets such favorable tax treatment compared to other expenses. Lower prices would save other Fortune 500 companies billions in drug benefit costs, and drug company profits could come into line with the profits of the companies who pay for their drugs.

To me this is the most compelling part of the argument. If drug prices were cut there would indeed be a lowering of costs within the drug industry. To this time, the highest ROI within big pharma has been in its marketing and sales function. The reason Pfizer became such a big player is that it had the marketing capacity to make a big success of not only its own drugs but others it licensed in or purchased outright, notably Lipitor. Merck’s story as the big Kahuna in the 1980s is roughly similar with many of its products licensed in. There’s even a whole industry doing just R&D called biotech, with an exit strategy of feeding the big pharmas’ marketing machines. So if prices go down, my first expectation would be for marketing efforts to increase (in order to make it up on volume!).

But there will inevitably be a drop-off in R&D. The question is how much? Given that overall margins are so high in the drug business, and given that prices pretty much equate directly to gross margins as production costs are so small, an R&D effort rewarded by even net margins of 12% is still better than a dollar invested in virtually any other industry.

So we have two anomalous situations in which neither system figures out the true "market" value of drugs. In Europe they have strict defined budgets or price controls which force a limit on the price or volume or both of all drugs and limit access to some drugs as a consequence. On the other hand in the US, as with the rest of health care, we have a supplier-induced patent-protected oligopoly market, with no effective market discipline due to our free-flowing third party payment system which can’t say no, (despite the attempts of managed care, CDHPs, etc, etc to bring rational choice "market" discipline to bear in medical care consumption decisions).

My guess is that the US will eventually end up somewhere in the middle, but that the pharma industry will remain the most profitable segment of the economy. In the end American’s love medical technology and will want their government to pay for it. But with the government slowly moving into the business of being a purchaser of drugs, the free-ride that the pharmas have enjoyed for so long won’t last forever.

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