Pricing Pharmaceutical Drugs: An Oligopoly in Action

Economists refer to a market that is dominated by a few producers who act collusively as an oligopoly.  This term may not be very familiar in this context, but the behaviors it represents are quite common.  Wikipedia provides this description of what is involved.

“Oligopolistic competition can give rise to a wide range of different outcomes. In some situations, the firms may employ restrictive trade practices (collusion, market sharing etc.) to raise prices and restrict production in much the same way as a monopoly. Where there is a formal agreement for such collusion, this is known as a cartel. A primary example of such a cartel is OPEC which has a profound influence on the international price of oil.”

“Firms often collude in an attempt to stabilize unstable markets, so as to reduce the risks inherent in these markets for investment and product development….There are legal restrictions on such collusion in most countries. There does not have to be a formal agreement for collusion to take place (although for the act to be illegal there must be actual communication between companies)….”

If a few companies control a market, they have the option of competing on price and quality, hoping to increase profit by gaining market share. However, that requires hard work and it is risky.  Why do that when a more stable situation can be attained by agreeing, tacitly or otherwise, that the market is big enough to be shared, with each participant charging whatever the market will bear for its product.  This path provides the illusion of competition and avoids any suggestions of monopolistic abuse.

There are specific market situations that invite monopolies or oligopolies.  Consider the case of a good being provided that is so essential that society could not exist without it.  Water is an example of a commodity without which life itself could not exist.  Electrical power is a commodity without which society could not exist.  These are areas in which society has decided that they were too important to be left to free-market vagaries.  The standard solution is to set up strictly regulated monopolies to provide these goods and services.

The defense industry provides an interesting example of a market dominated by a few large contractors.  Producing state-of-the-art defense systems is an expensive process requiring considerable experience and technical resources, quantities that few can attain.  The nature of the defense establishment essentially requires that a few good corporations be maintained so that its needs can be met—just enough to provide some technical competition, but not so many that the scale of capabilities fall below some critical level.  This area also should provide contractors with considerable leverage in pricing their products.  After all, what is more important than protecting our civilization, our society, and our lives?  Well, guess what?  The Defense Department and its contractors have agreed to mechanism by which the profits of the defense contractors can be limited to a reasonable rate of return.  A modest rate of return on a large source of revenue is a quite healthy business model.

A study (Defense Department Profit and Contract Finance Policies and Their Effects on Contract and Contractor Performance) by the Institute for Defense Analyses looked at the complex options and incentives provided to contractors and concluded that the effective rate of earnings on sales was between 5% and 10%, and the system was working well.

“At roughly 5–10 percent of sales, earnings of defense companies are typically a lower fraction of total sales than those of firms in other industries.”

“Our study shows clearly, however, that the profits of the major U.S. defense contractors are above the levels required to keep them in the defense industrial base.”

There is another industry whose value to society rivals that of defense.  The pharmaceutical industry produces medicines that are critical to our health and welfare.  Often its products are the difference between life and death.  It is also an industry comparable in size to that of defense and could have decided that a modest profit rate on huge revenues was an acceptable business model.  Instead it has announced its intention to extract every dollar it can from its customers and our society.

Paul M. Barrett and Robert Langreth provide insight into the current state-of-affairs in an article in Bloomberg Businessweek titled How Much Should a Miracle Cost.  The article appears online with a different title: Pharma Execs Don't Know Why Anyone Is Upset by a $94,500 Miracle Cure.

The authors provide an excellent example of the tacit collusion involved in forcing drug prices ever higher.  Consider the pricing history of drugs for multiple sclerosis.  As new and supposedly better drugs arrived on the market they increased in price.  Instead of trying to compete for market share by lowering price, competitors raised the price of the older drugs to match that of the newer ones.  It is a strange market in which you can lose market share but maintain profit flow by increasing the price of your product.

“In the 1990s, multiple sclerosis drugs generally cost about $10,000 a year. As new MS treatments have hit the market, the prices of older ones have risen to the higher levels of newcomers, researchers reported in April in the journal Neurology. Today, all MS drugs cost $50,000 to $60,000 a year, or more.”

For years we have been told that drugs must be expensive because of the long and expensive research and development involved in bringing a drug to market.  Those were lies.  R&D is a small expense compared to the marketing costs required to keep doctors prescribing their medications no matter what the cost and no matter what the competition might be.  Now they no longer even bother with lies.  They believe that they are in such a powerful position that they can admit that they will maximize their profit no matter who gets hurt in the process. 

The issue of pricing elevated to a boil when Gilead Sciences marketed a very effective drug that promised to cure those infected with hepatitis C.  Gilead obtained this miracle drug by using its accumulated wealth to purchase the original developer, Pharmasset, for $11 billion.  Gilead assumed responsibility for marketing the product and getting it approved by the FDA.

The drug hit the market under the name Sovaldi and subsequently in a more convenient form as Harvoni.  The price of Sovaldi was $1,000 per pill, or $84,000 for a full treatment.  Since there are thought to be at least 3 million hepatitis C sufferers in the US, treating them at that price would cost over $252 billion.  Worldwide, there are thought to be 150 million sufferers.

The community gasped when the price was announced and demanded to know how Gilead arrived at it.  Gone were the claims of costs to be recovered.  Now the logic was that Gilead should be paid what the drug was worth.  Price should not be an issue; the focus should be on value.

“Milligan [Gilead’s president] responded to the mounting unease at Sovaldi’s $84,000 price tag during a symposium at the Brookings Institution in Washington. The company, he said, charged what it thought the market would bear. ‘We looked very hard at what value we were bringing to the system,’ he explained, ‘but at the end of the day, the pricing analysis was relatively simple: What is the current cost of other therapies?’ He continued: ‘We were providing more value, better outcomes, shorter duration, better patient experience at the same cost as the standard of care’.”

This reasoning seemed to involve tallying the costs of treating a person without Sovaldi, adding up the lifetime of costs and perhaps death, converting that into a dollar cost, and demanding that it be handed over to Gilead immediately.  By this logic, there can be no savings in healthcare costs due to R&D because any savings must be turned over to the developer of the product—immediately.

The effect of releasing Sovaldi was not to diminish costs, but to increase them.  The extreme expense of the treatment meant that insurers and government administrators had to limit access to the drug to only the most sick.

“More than two dozen state Medicaid programs for low-income patients, as well as for-profit insurers such as Anthem, have restricted coverage for Sovaldi to those with severe liver damage. ‘Never before have drugs been priced so high to treat such a large population,’ says Steve Miller, chief medical officer at Express Scripts, the country’s largest manager of drug benefits for employers and insurers.”

Those in early stages of the illness will be forced to wait for treatment until their condition becomes more severe.  An infectious disease that could possibly be eliminated will continue to harm more individuals.  According to Gilead officials the fault lies not with them, but with policymakers who refuse to recognize the new reality of drug treatment in this country.

“American society needs to make tough choices, Milligan [Gilead’s president] says. ‘It’s not up to Gilead to forward that conversation,” he says. ‘It’s up to public policymakers to forward that conversation’.”

Gilead and its pricing policy represent the future if drug companies have their way.  The grand strategy is to produce many drugs aimed at small sections of the population.  If these drugs are successful they can be claimed to be expensive to develop and have only a small market.  Therefore, they will be terribly expensive—priced at “whatever the market will bear.”

“More and more pharmaceutical manufacturers are seeking to develop specialty drugs because of the rich payouts associated with Sovaldi and Harvoni. Profits can be so hefty because the American health-care finance system allows companies to charge more or less what they choose. In Europe, governments negotiate directly with manufacturers, which keeps prices lower. In the U.S., that doesn’t happen. Medicare, the federal insurance program for senior citizens, is barred by law from using its size to negotiate discounts.”

“Half of the 38 cancer drugs introduced since 2010 cost $10,000 a month or more. All were at least $5,000 a month, according to data from Memorial Sloan Kettering Cancer Center in New York. Some of those drugs merely extend life expectancy for a matter of months.”

Targeting a captive audience that needs your drugs to exist and charging them “what the market would bear” is a well-known business model.  However, in the old days such people were hunted down and put in prison—if not executed.

Depending on a market-based system to provide needed drugs has never made much sense.  Can one really expect the market to make the appropriate decision on how to allocate resources between high-profit cancer drugs and low-profit antibiotics.  Pharmaceutical companies have always depended on the government to fund the training of their scientists and provide the long-term R&D required for developing their products.  It is time for them to recognize that they are part of society and must make accommodations accordingly.  They must not be allowed to hold society hostage to their profit desires.

The much-maligned defense industry has made an accommodation with society.  Perhaps it provides an example of where the drug industry should be headed.  Defense contractors are creative and innovative—some would argue too much so—and they drive the definition and development of new weapon systems.  And they are healthy, profitable corporations thriving under government regulation.