Diatribes of Jay

This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

11 October 2015

Lizard Brains and New Drug Pricing


One of the most astounding things about our species is how our lizard brains control our thinking on some of the most important things in life. The pricing of unique, patented life-saving medicines is one of those things.

You would think that, if we can send men to the Moon, maintain a global network of routine daily intercontinental flights, and learn (belatedly!) how to reserve our arsenal of antibiotics for deadly diseases, we might also know something real and practical about how to price new drugs. But you would be wrong.

In drug pricing, we don’t believe in science, math or pragmatism. Instead, we believe in a modern form of deity—one increasingly dominant in our commercially obsessed world and our ideologically obsessed politics. We believe in “The Market God.”

Insofar as patented drugs are concerned, this belief is best characterized as theology, or its cousin ideology. Why? Because so-called “markets” for patented pharmaceuticals are nothing remotely like what Adam Smith was thinking about when he concocted the term “invisible hand.”

Don’t take my word for it. Open up any introductory college text on basic economics. There you will find listed and explained, in great detail, the basic assumptions that govern the type of competitive, free market that Adam Smith first recognized. Depending on how you count, and on your tolerance for vital detail, there are six or seven basic assumptions. But the most important boil down to four.

First, there must be a large number of sellers of fungible products, so that no single seller, by itself, has the power to control “market” price. Second, there must similarly be a large number of buyers, each of whom can go from seller to seller seeking a better bargain. Third, transaction costs (the cost, effort and delay of buying and selling) must be minimal. And finally, buyers must have perfect information about the fungible products and prices that each seller offers.

A moment’s thought suffices to show that none—not one!—of these fundamental assumptions applies to so-called “markets” for patented new, life-saving drugs.

Because each drug is patented, only a single seller can offer it. There is no “market,” only a legally protected monopoly. If, as is often the case, the patented drug offers patients unique benefits, the monopoly is an economic one, too.

The number of buyers is limited, too, although not as much as the number of sellers. No one buys expensive pharmaceuticals for taste or fun. Buyers are limited to those with the disease or condition that the patented drug is supposed to treat. (The number of people who qualify is an important variable in calculating drug pricing, which we’ll get to later.)

Transaction costs are sky high in medicine generally, mostly because the costs of medical treatment generally, let alone patented new drugs, are usually far too high for most patients to afford personally. So the patients don’t pay for them at all; only their insurance companies do. Anyone who has spent more than an hour dealing with insurance contracts and insurance companies knows that the “transaction costs” of insurance payment are considerable, if not astronomical.

As for patients having perfect information, of course they don’t. Not even their doctors do. That’s why Big Pharma is constantly getting in trouble for influencing doctors’ decisions with freebies, travel, research support, free samples and other marketing ploys. And in any event, it’s not the doctors or their patients who determine whether to prescribe a new drug; it’s the insurance companies, with all their legal and administrative transaction costs.

So let’s take stock. So-called “markets” in patented new pharmaceuticals obey not a single one of the four most basic assumptions that free markets are supposed to follow. More than that. On all four assumptions, these products depart wildly from anything that Adam Smith would have recognized as a “market.”

So the next time you hear a representative of Big Pharma speaking of “market prices” for patented new drugs, only one response is appropriate. A big belly laugh—which (if you are a patient) might fade into hysterical laughter.

So if The Market God doesn’t set new drug prices, what does? I’m glad you asked. A few years ago, in one of my last pieces of academic research, I wrote a published paper on precisely that point. This post is the Cliff Notes version.

When a new drug is patented and has no reasonable substitutes, that patent owner has both a legal and an economic monopoly. The patent provides the legal monopoly, and the lack of practical substitutes provides the economic monopoly.

Under those circumstances, the patients who suffer the disease or condition that the drug ameliorates or cures have no choice but to buy the drug, or to suffer or die. Those circumstances, of course, are nothing like what Adam Smith contemplated when he called markets “free.”

Some patients who can’t afford the drug—or who can’t afford insurance to pay for the drug—will do exactly that. They will suffer or die, not because of their medical condition, but for lack of cash or a reasonable socioeconomic system to afford them treatment.

But for the moment, let’s bypass that inconvenient unpleasantry. Instead, lets look at drug pricing from the patentee-monopolist’s perspective.

Mathematically, the patentee-monopolist’s pricing depends almost entirely on two independent variables: (1) the number of patients who need the drug and can afford it, and (2) the rate of return on investment that the patentee-monopolist desires. That’s pretty much it. (The price itself is the dependent variable.)

Before we explore the practical consequences of this point, lets look at some numbers. Following is a table, based on pure math alone, showing the relationship between the price of an annual course of treatment (the dependent variable) and the two independent variables, the number of patients and the desired rate of return:

Cost of Annual Course of Treatment as Function of Number of Patients and Desired Rate of Return

Annual Rate of ReturnNumber of Patients N
500,0001 million5 million10 million50 million
5%$763$432$166$133$107
10%$1,782$941$268$184$117
25%$21,784$10,942$2,268$1,184$317
50%$831,414$415,757$83,231$41,666$8,413

One thing leaps out immediately from these figures. The annual cost of treatment with a patented new drug depends dramatically on the size of the patient population, N, and the desired rate of return on investment, R. But while the size of the patient population depends on evolution, genetics and medical practice, the desired rate of return depends entirely on the patent holder, in particular its top corporate managers. To put it plainly, it’s at their whim. (Pharmaceutical patent holders are nearly always corporations, mostly from Big Pharma.)

Not to put too fine a point on it, the primary determinant of a patented new drug’s pricing is individual greed. “The Market God” has absolutely nothing to do with it, because there is absolutely nothing resembling a free market.

The most important thing about this mode of analysis is that it shows only relevant variables. The new drug’s development cost is not relevant: the same proportionate figures apply no matter what that cost is.

Of course new drugs are expensive to develop. Of course innovation costs money. And yes, Virginia, there are indeed several failures (the statistics say four) for every successful new drug. But the table intrinsically includes all these costs in the development cost, i.e., investment, on which the rate of return is calculated.

So the table above includes the high cost of innovation and the cost of failed attempts to discover safe and effective new drugs. It also includes the cost of clinical trials, which is by far the biggest factor in development cost.

Yet as the table shows, the key independent variable is not the development cost, but how quickly and how dramatically the investors in development want to (at least) recoup it and then get rich. When a drug is patented and either uniquely life-saving or ameliorative of suffering, the only variables that mathematically restrict the investors’ rate of return are the number of patients whom the drug can benefit and the price the patients or their insurance companies can afford to pay.

In the extreme case, when a drug preserves life, a rational patient will pay his or her entire net worth to stay alive. So much for “free markets”—that is, if “free” actually implies entirely voluntary “take it or leave it” transactions. Few of us have a cavalier “take it or leave it” approach to life itself.

The point here is not to bash Big Pharma’s greed. All of our species is greedy. Greed is part of our human condition.

The point here is far more subtle. There is absolutely no mathematical or practical restraint on Big Pharma’s greed except: (1) the number of patients who can benefit and (2) the amounts they or their insurers can afford. Neither Adam Smith nor any putative market theology provides any other practical restraint on new drug pricing.

The ultimate conclusion is now crystal clear. The pricing of patented new drugs is inescapably and unavoidably “political” because there is no market restraint on that pricing. The Market God, in this circumstance, simply doesn’t exist.

More precisely, we have no procedure or formula—and no theory for one—to calculate how much greed is “good,” how much profit to put away for future innovation, or how many people must suffer and die for lack of the money or insurance to afford patented new medicines. Reaching for a financial theology to justify any particular pricing is nothing more than the same kind of self-interested hand behind the deity that brought us sadly through our second millennium.

Just as our species must face facts about heating our planet by burning fossil fuels, we must also face facts about new drugs and the expensive research that produces them.

Our resources are limited, both as a nation and as a species. The research that discovers new drugs is indeed expensive and risky. As a nation and as a species, we can’t research and develop everything because we don’t have infinite time, energy and money. We don’t even have infinite attention.

So someone has to set priorities.

At the moment, that “someone” is corporate executives whose primary goal is maximizing their profits and “shareholder value.” By and large, they are ignorant of medicine and epidemiology and therefore the extent to which their research dollars are likely to: (1) produce something characterizable as “success” which (2) will substantially alleviate mortality and suffering of a large number of people. If you doubt that these worthies exist and that their primary goal has nothing to do with medicine, all you have to do is read the recent news.

There’s no use in naming names because there’s so much money to be made by jacking prices up. More likely than not, the practice will spread as far and as fast as the liars’ loans packaged and sold as “mortgage-backed securities” that caused the Crash of 2008, from which we are still recovering. As we have noted, greed is part of the human condition. It’s up to the non-lizard parts of our brains, including our social evolution, to avoid its worst consequences.

So what should we do? One alternative is to move away from lizard-brain belief in false deities, such as “The Market God,” and from individual or corporate self-interest as the lodestar of medical resource prioritization, including drug pricing. Instead, we might move, as much as possible, in the direction of disinterested expertise.

After all, we tend to accept this notion in fields outside medicine. Military experts tell us where to spend our military research budgets, although some pols get bases and plants in their districts for jobs and patronage alone. Civil engineers tell us which of our increasingly dilapidated bridges are likely to fall down first. So why shouldn’t experts in medicine, namely doctors, decide—or at least help us decide—where our medical research dollars might do the most good, as distinguished from making a few privileged people the most profit?

We Yanks fought the opening battle in this war nearly a decade ago, long before so-called “Obamacare” became law. The winning campaign was hardly a triumph of reason. It was a triumph of brilliant propaganda. The insurance and drug industries won the opening engagement simply by calling our doctors, collectively, “death panels.”

Unbeknownst to the vast majority of the voting public, “death panels” were even then widely in practice. They still are. They are groups of distinguished physicians who volunteer their scarce time to write and publish—and to update annually— exhaustive compendia of current knowledge and best practices for every known human malady and condition. Panels of good doctors volunteer their time, for free, to write and update these tomes to advance their prestige and their careers and for love of science and medicine.

If you doubt this, ask your doctor about the tome on a disease or condition that you or your loved ones face. Good doctors will loan you their copies, and some are now available on line. (The summaries of current medical knowledge on the websites of the CDC, NIH, Mayo Clinic and other venerable medical institutions are just simplified and condensed versions of these tomes, with complex medical terminology removed or translated into simple English.)

These facts reflect an extraordinary thing about our American society. When something important needs doing and no immediate profit is involved, usually someone or something will step up and get it done. Our own physicians, through their medical associations, did and do so every year in writing and updating these best-practices compendia. They write the tomes on a purely voluntary basis, without compensation, although as a group they are among the hardest working and most stressed professionals in our entire society.

Similar expert panels routinely decide what fields and types of medical research receive government funding, and how much. The process is called “peer review” of grant proposals. It has been an established aspect of medical science (and other fields of science as well) for most of a century.

So what’ll it be? Who’ll set the prices for patented new drugs and determine in which research to invest? Will it be corporate executives, based on the expected rate of return, which (if the drugs are patented) they can manipulate at will? Or will it be expert doctors, based on their detailed knowledge of the extent and range of human suffering and the realistic chances of alleviating it? (Of course the doctors will have to work with accountants and other financial experts to assess costs and keep the machine of innovation running.)

I don’t know about you. But if it were my or my loved ones’ health at issue, I would go with the expert “death panels” every time.

That brilliant but utterly misleading phrase won the first battle decisively for the privileged executives. But the real war has just begun.

Footnote: The figures in this table come from formulas derived from first principles in Section II of my published paper. They assume a total development cost (investment) of $2.5 billion for each new patented drug. That number in turn assumes a per-drug development cost of half a billion dollars and five attempts, including four failures, for each successful drug.

Because the numbers in the table all scale linearly with development cost, a $ 1 billion development cost with the same five attempts per success (for example) would multiply all dollar figures in the table by two. The relative relationships among the number of patients and desired rates of return would be unchanged. In other words, under our present political-economic system, the two determinants of patented new drug pricing are (1) the size of the patient population and (2) how much profit corporate executives want to make.

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