Profiting From The Pharmacy

Last month, the company Turning Pharmaceuticals purchased the rights to the drug Daraprim, used to help babies born with parasitic infections, AIDS patients, and some cancer patients. The company then raised the price of one pill from $13.50 to $750, an increase of 5555 percent. The Infectious Diseases Society of America and the HIV Medicine Association, who condemned the decision, estimated that the annual treatment cost would be either $336,000 or $634,500, depending on the patient’s weight. The CEO of Turing Pharmaceuticals, Martin Shkreli, defended the decision as one neccesary for business, adding “This is still one of the smallest pharmaceutical products in the world… It really doesn’t make sense to get any criticism for this.” It was later revealed that Shkreli did something similar earlier in his career, raising the price of the drug Thiola from $1.50 a pill to $30 a pill, a 2000 percent increase. This controversy, combined with Shkreli’s arrogant personality, stirred up extreme anger at the company. Last week, just days after the controversy broke, he bowed to pressure and announced “We’ve agreed to lower the price on Daraprim to a point that is more affordable and is able to allow the company to make a profit, but a very small profit.”

But, as a number of commentators have pointed out, Shkreli’s company is far from the only company to engage in such “price gouging” of medication. Indeed, at the exact same time that this controversy was occurring, another company agreed to reverse its 2,160 percent price increase of a tuberculosis drug it had recently purchased and return it to the non-profit who had previously owned it, likely out of fear that it could be next in line for bad publicity. Just this Summer, a company released a new Hepatitis C drug called Sovaldi for $1,000 a pill. It’s estimated that the cost of making a Sovaldi pill costs no more than $136. The cost of research and development for the drug were probably very expensive, but its believed that those costs were made up within several weeks of sales. The Economist lists some more examples:

Valeant of Canada sharply raised the cost of two heart drugs after acquiring them this year. Horizon Pharma increased the price of a pain-relief tablet, Vimovo, by 597% after buying the rights from AstraZeneca in 2013. Since 2008 the price of all branded drugs (including both patent-protected ones and those whose patents have expired) has risen by 127% in America, compared with an 11% rise in the consumer-price index, reckons Express Scripts, which manages medicines’ costs on behalf of employers and health insurers.

This type of practice is very common in America, and is a large contributor to the fact that America has the world’s third highest total healthcare spending per capita. But what’s bad for the American people is good for corporate America: from Spring 2011 to the middle of last week, the stock value of pharmaceutical companies has risen at more than three times the rate of the S&P 500 index (the industry has since seen a sharp decline due to the sudden flood of criticism). The pharmaceutical drug industry has a net profit margin more than double that of the market average. This injustice is why the two most popular Democratic presidential candidates have been focusing on the issue recently.

Earlier this month, Senator Bernie Sanders helped introduce a bill that does four things: it permits negotiating down the cost of drugs for Medicare, introduces stronger penalties for fraud, bans “pay-for-delay” agreements that brand-name drug companies use to delay the release of competing generic drugs, and makes it easier to import cheap drugs from Canada. On his campaign website, he also proposes stronger transparency measures and lower drug costs for poor elderly people on Medicare and Medicaid.

Last Tuesday, Former Secretary of State Hillary Clinton proposed a comprehensive plan that proposes everything that Bernie did, minus the fraud penalties and with a weaker proposal for lowering costs for the poor elderly, but plus a number of additional policies: restricting direct-to-customer advertising, expanding the Research & Experimentation Tax Credit, requiring a certain level of private R&D in order for a drug company to receive government support, capping out-of pocket prescription drug costs in insurance plans, and making the introduction of new drugs into the market easier. Additionally, she also mentions making it easier to import drugs from places like Europe, not just Canada.

But before we begin to understand how we should fix this problem, or what the effects of any of the above policies would be, we first have to understand how this problem is possible in the first place. To put it simply: companies can get away with doing things like this because there’s nothing stopping them.

In economics terms, the demand for specific medications among those who require them for health reasons is often highly inelastic, meaning that price changes have little impact on how much consumers decide to buy. Because medication is often something necessary for survival and living a healthy life, it is a top priority for consumers. However, unlike other goods necessary for survival, such as food, water, and housing, prescription drugs often don’t have many available substitutes. When you’re shopping for potato chips, you have an entire grocery store aisle to chose from. That type of consumer choice rarely exists with prescription drugs. As Dr. Judith Aberg of New York’s Icahn School of Medicine at Mount Sinai said, one of the only alternatives to using an expensive drug like Daraprim is to use “alternative therapies that may not have the same efficacy”.

So, then, why don’t other companies try to introduce competing substitutes to existing drugs? That’s where the problem lies: due to current U.S. policy, the pharmaceutical industry today is extremely noncompetitive.

The root problem is that the results of research- knowledge and information- are what are called “public goods”. Public goods are goods that are very difficult to prevent others from stealing, and having one person use them does not reduce anyone else’s ability to use them at the same time. Private companies rarely produce public goods because of how easy it is for “free riders” to take advantage of them without paying anything. It could even be possible for a company to produce a public good and have it benefit a competitor more than it benefits them. However, we need these public goods to be produced: we can’t produce new goods if no one is willing to do the research and information-finding necessary to make them.

In order to encourage companies to take the risk of investing large sums of money in researching and developing new drugs, the government has provided enormous benefits to drug producers through patent law. In this way, the “free rider problem” is eliminated by legally preventing anyone except the person holding the patent from producing the products that result from their research.

As a result, our country produces very high-quality medicine. But another consequence is that said medicine is increasingly becoming too expensive for anyone to actually use. Economist Dean Baker, who writes frequently on this topic, criticizes our current policies in his 2011 book “Loser Liberalism: Making Markets Progressive”:

…the nation will spend close to $300 billion in 2011 on prescription drugs. In the absence of government-enforced patent monopolies, the same drugs would cost around $30 billion, an amount that implies a transfer to the pharmaceutical industry of close to $270 billion a year, or about 1.8 percent of gross domestic product.

Baker’s perspective on patents- that they are “government-granted monopolies and forms of interference in a free market” — helps us think more clearly about the full economic effects of patents. A company having a legal monopoly prevents other producers who can produce the exact same goods for a lower price from doing so. This keeps prices artificially high, benefiting the producer at the expense of consumers. By granting patents to pharmaceutical drug producers, we do exactly this: we prevent the type of competition that could make medicine cheaper from forming. By guaranteeing a company that they will be the only recipients of the profits of their creation, we succeed in encouraging them to create new things, but we also make it so that they can charge far more for the creation than what it’s actually worth at market value.

The dire necessity of prescription drugs, resulting in low elasticity of demand, only makes the problem worse. In Baker’s words, “Giving the drug companie[s] monopoly control over potentially life-saving drugs is like allowing firefighters to negotiate their pay package with the homeowner when the house is on fire”. When only one party has what you need in order to survive, that party effectively controls you.

With this understood, we can now turn to policies to fix these problems. Some of the policies proposed by Clinton and Sanders hit the nail on the head, while others miss the mark. In particular, Clinton’s proposal to lower the period of time in between when a drug is introduced and when “biosimilars” (a class of drugs that are virtually identical to ones currently on the market, but produced by other companies than the patent-holders) can be produced could help a lot in bringing more competition to the market. The proposals to ban “pay-for-delay” agreements and allow more drug imports from abroad would also result in more low-cost drugs being introduced, helping further drive down costs.

Some of the policies don’t strike at the root of the problem, but address it further down the line. Allowing Medicare to negotiate with drug companies over prices, something practically every other developed nation allows their public healthcare agencies to do, wouldn’t touch the core issue, but it would save an enormous amount of money on public healthcare spending. Baker estimates that it would save $229.7 billion to $541.3 billion over 10 years, based on the cost differences between America and other nations. However, it may be less effective than that here since we don’t have a single-payer healthcare system, reducing the government’s bargaining power. If we adopted single-payer healthcare, like Sanders wants, this policy would likely be at its most effective and be the only additional policy necessary at the point of consumption. Clinton, on the other hand, is not calling for single-payer healthcare, but proposes capping out-of-pocket prescription costs for private insurance plans on top of Medicare negotiation. This proposal is less likely to work as well, as setting what are effectively price ceilings in the insurance market is much less economically efficient than just providing healthcare directly through the public sector.

Looking beyond all of this, there is one highly promising and transformative policy proposal that neither candidate has discussed at all. Clinton proposes a number of policies to encourage additional private research in order to make up for the reduced research incentives that result from her other policies aimed at lowering costs. But what reason is there to keep the bulk of pharmaceutical research a responsibility of the private sector at all? In his book, Baker makes the claim:

The key goal of progressive policy should be to separate the payment for the research from the payment for the drug. If the payment for the research is made independent of the payment for the drug, then all drugs can be sold in a free market without patent monopolies, just as generic drugs are sold today.

Remember: the knowledge that results from research is a public good. We do need public goods for a healthy market economy, but we don’t need private companies to be the ones providing them. In fact, many of the public goods we currently have, like infrastructure and a national military, are already provided by the government. Why not handle the production of highly important information in the same way?

Baker proposes a way to do this in a report titled “The Benefits and Savings from Publicly-Funded Clinical Trials of Prescription Drugs”. Under this system, government agencies like the National Institute of Health would contract private companies to do clinical trials on drugs “based on their potential to improve public health”. Once the trials are complete, all of the results of the research would be made publicly available on the internet. Any pharmaceutical company who has an interest in using the research to develop a new drug can take it and use it free of charge. This way, companies would compete with one another on who can take publicly available research and turn it into the best functioning drug for the lowest cost. This would be a bittersweet reform for drug producers: “…the pharmaceutical industry would be compensated for lower drug prices by having the public sector pick up the cost of conducting clinical drug trials.” The cost of funding for such trials could be more than made up for by the reduced public healthcare spending that results from lower drug costs.

This type of system can be accompanied by substantially increased funding for other forms of public sector pharmaceutical research taking place at public universities and government agencies like the National Institute for Health. The same principal applies: the full findings of public research should be provided for anyone to use. Pursuing this goal would require us to repeal the Bayh-Dole Act, which gives private institutions and public colleges the ability to patent the research they conduct with public funding. Such research should be kept permanently public.

This isn’t at all to say that we should just abolish patents entirely, or that we should do anything to prevent private companies from engaging in research (much private research is still useful and neccesary), but we should begin looking towards an new system of open information and competitive innovation when it comes to medical development. Unlike various other reforms to the patent system, such an alternative would have benefits beyond the matter of cost: making incentives for the creation of new drugs without patents will avoid the problems with patents that stifle innovation. One example of such an issue was when the Malaria Vaccine Initiative discovered an antigen that might help in crafting a vaccine for the disease, only to realize that there were “up to 39 patent families that are potentially relevant in developing the vaccine from” it. Such a vaccine would have enormous humanitarian benefits, but would primarily be used for charity purposes and thus not be that profitable. Despite this, the “holders of intermediate patents often put an unrealistically high value on their technologies”, making further development of the vaccine inordinately expensive and difficult.

While many of the policies proposed by Sanders and Clinton would help a lot in lowering the unreasonably high costs of prescription drugs and other medicine, they don’t fundamentally change the anti-competitive system that’s at the heart of the problem. We need to not only implement the reforms they proposed, but also change the system by making research publicly available. That is how we stop pharmaceutical companies from squeezing every last cent out of the ill.

Originally published at on September 28, 2015.

Writer on politics, public policy, and current events. All opinions here are mine alone and do not necessarily reflect the views of employers past or present.

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