Big Pharma and the Cost of Drugs

James Surowiecki provided some thoughts on the financial condition of the drug industry in an article in The New Yorker: Biotech’s Hard Bargain. He points out that stocks in the biotech sector rose more than 120% over the last two years before seeing a downward correction of about 20%. He attributes much of that market drop to the appearance of a new drug with great promise for the ill, but perhaps greater promise for investors.

"Hepatitis C affects 3.2 million Americans; untreated, it leads to scarring of the liver and to liver cancer. Until now, the best treatments cured only about half of patients and often had debilitating side effects. But in December the F.D.A. approved the first in a new wave of hep-C drugs, Gilead’s Sovaldi. This is huge news—not just in medicine but on Wall Street. "

"Sovaldi can cure ninety per cent of patients in three to six months, with only minor side effects. There’s just one catch: a single dose of the drug costs a thousand dollars, which means that a full, twelve-week course of treatment comes to more than eighty grand."

To put this in perspective, the treatment of 3 million people at $80,000 per pop will run up a bill of $240 billion. Can such an extraction from the public purse be justified in any way?

"Investors love drug companies in part because they often have tremendous pricing power. Drugs designed to fight rare diseases routinely cost two or three hundred thousand dollars; cancer drugs often cost a hundred grand. And, whereas product prices in most industries drop over time, pharmaceuticals actually get more expensive. The price of the anti-leukemia drug Gleevec, for instance, has tripled since 2001. And, across the board, drug prices rise much faster than inflation."

"….prices for brand-name, patented drugs aren’t really set in a free market. The people taking the drugs aren’t paying most of the cost, which makes them less price-sensitive, and the bargaining power of those who do foot the bill is limited. Insurers have to cover drugs that work well; the economists Darius Lakdawalla and Wesley Yin recently found that even big insurers had "virtually zero" ability to drive a hard bargain when it comes to drugs with no real equivalents. And the biggest buyer in the drug market—the federal government—is prohibited from bargaining for lower prices for Medicare, and from refusing to pay for drugs on the basis of cost. In short, if you invent a drug that doctors think is necessary, you have enormous leeway to charge what you will."

When one asks why drugs cost so much, the stock reply is that the revenue flow is required in order to cover the costs of research and development (R&D). Let us pause for a moment and consider how big pharma actually uses its money.

The World Health Organization (WHO) provided this opinion on the state of affairs with respect to the pharmaceutical industry:

"As a result of this pressure to maintain sales, there is now, in WHO's words, ‘an inherent conflict of interest between the legitimate business goals of manufacturers and the social, medical and economic needs of providers and the public to select and use drugs in the most rational way’. This is particularly true where drugs companies are the main source of information as to which products are most effective."

This bit of data was also provided:

"The 10 largest drugs companies control over one-third of this market, several with sales of more than US$10 billion a year and profit margins of about 30%....Companies currently spend one-third of all sales revenue on marketing their products - roughly twice what they spend on research and development."

By this reckoning, R&D costs can’t be more than about 15-20% of revenue. And how could marketing costs conceivably be twice as high?

Doctors seem to change their habits slowly. There is inertia involved in accepting the efficacy of a new drug, and there is similarly inertia in switching away from a drug once accepted. It has been estimated that it takes about 10 years for new medical knowledge to wend its way throughout the medical profession. This source provided this extreme example:

"Physicians have been indefensibly slow to adopt guidelines that would potentially prevent premature deaths or harm. One egregious example is the estimated 100,000 heart failure patients that died prematurely each year in the late 1990s because they did not receive beta-blockers. The efficacy of beta-blockers was established by a study published in the JAMA in 1982."

Drug companies spend enormous amounts of marketing money convincing doctors to use their products because time is money to them. To fully take advantage of their pricing leverage they must have their drugs prescribed as soon as possible after hitting the market. Waiting around for word-of-mouth recommendations or dispersion of published articles is too slow and too risky a process.

There is a significant return on a successful marketing campaign. Once a significant base of drug prescribers is established, the drug company can go ahead and raise the prices as much as it wants with little fear that the doctors will notice or care.

Robert Langreth provided an example of how this pricing strategy works in an article in Bloomberg Businessweek: Big Pharma’s Favorite Prescription: Higher Prices.

"New branded rivals in a market sometimes provide cover for older players to boost prices. For example, prescriptions for Biogen Idec’s multiple sclerosis drug Avonex have slowly declined in the U.S. in recent years because of competition. At the same time, Avonex’s wholesale price has risen 147　percent to $1,363.50 per injection this year from $552.19 in late 2007…."

"Largely because of price increases, Avonex’s U.S. sales have grown 75　percent since 2007, reaching $1.9　billion last year."

So, once a market is established it is little affected by price. If sales fall, just raise the price to maintain or increase the cash flow.

Mariana Mazzucato provides more insight into drug companies and their finances in her book The Entrepreneurial State: Debunking Public vs. Private Sector Myths.

"The ex-editor of the New England Journal of Medicine, Marcia Angell, has argued forcefully that while private pharmaceutical companies justify their exorbitantly high prices by saying they need to cover their high R&D costs, in fact most of the really ‘innovative’ new drugs….come from publicly funded laboratories. Private pharma has focused more on ‘me too’ drugs (slight variations of existing ones) and the development (including clinical trials) and marketing side of the business."

"….in recent years, CEOs of large pharma companies have admitted that their decision to downsize—or in some cases eliminate—their R&D labs is due to their recognition that in the ‘open model’ of innovation most of their research is obtained by small biotech firms or public labs."

Big pharma can use its immense wealth to purchase the best of little pharma and make a small company quite wealthy, while it makes the big money in commercializing the drug.

In dealing with public labs, they barely even have to pay for the drug. Mazzucato provides this example:

"After taking on most of the R&D bill, the state often gives away the outputs at a rock-bottom rate. For example, Taxol, the cancer drug discovered by the National Institutes of Health (HIH), is sold by Bristol-Myers Squibb for $20,000 per year’s dose, 20 times the manufacturing cost. Yet, the company pays the NIH just 0.5 per cent in royalties for the drug. In most other cases, nothing at all is paid in royalties. It is simply assumed that the public investment is meant to help create profits for the firms in question…."

Mazzucato also provides us with another example of how big pharma uses its wealth in ways that have nothing to do with R&D. It seems that buying back shares of their own company in order to make short-term market moves is more important to the drug companies than R&D.

"….it cannot be denied that at the same time that private pharma companies have been reducing the R of R&D, they have been increasing the amount of funds used to repurchase their own shares—a strategy used to boost their stock price, which affects the price of stock options and executive pay linked to such options. For example, in 2011, along with $6.2 billion paid in dividends, Pfizer repurchased $9 billion in stock, equivalent to 90 per cent of its net income and 99 per cent of its R&D expenditures…."

Surowiecki wonders if the case of Sovaldi and its price may have been that one step too far. The point at which the public realizes that these prices and the associated profits are no longer sustainable and action must be taken.

"Biotech, in other words, may become the victim of its own success: the bigger the profits, the bigger the likelihood of regulation."

However, he is not optimistic—at least not in the near term.

"You might think that this prospect would encourage companies to be more cautious. But, if you assume that price controls are coming, the rational play is to squeeze out all the profits you can now. The uproar over Sovaldi may, somewhere down the line, help contain drug prices. But in the short run it could well make drugs even more expensive. And that’s what you call a serious side effect."
　
Marcia Angell is the author of The Truth About the Drug Companies: How They Deceive Us and What to Do About It.