Code Red: Two Economists Examine the U.S. Healthcare System

May 27, 2014

Is there a just price for pharmaceuticals?

Filed under: Uncategorized — David Dranove and Craig Garthwaite (from Oct 11, 2013) @ 6:17 am

In America’s ongoing efforts to address the rate of health care spending, there has been a renewed focus on the prices paid for pharmaceuticals.  The poster child is Gilead’s Sovaldi, a once-a-day oral treatment that represents the first real cure for hepatitis C – a condition affecting over 3 million Americans.  Prior to Sovaldi, treatment for this condition required a painful course of Interferon which had many side effects and was ineffective for many people.  No one doubts that Sovaldi is a breakthrough product, the type of innovation that clearly increases welfare.  In addition, everyone seems to agree that the current cost of Sovaldi – approximately $84,000 for a 12 week course of treatment – is unreasonable and potentially crippling to the nation.  Even the well-known “champion” of price controls and improved access to medical services at low prices, the insurance industry’s trade association America’s Health Insurance Plans (AHIP), has come out against the “unsustainable” price of this medication.

While seemingly everyone agrees with AHIP, don’t count us in.  The pricing of pharmaceuticals is a very difficult economic question and we would like a little bit more caution in the attacks against innovative pharmaceutical firms.  We can all agree that firms developing products that simply imitate existing products are primarily rent seekers (ironically this activity, while decried by many, likely lowers prices for consumers).  We don’t think that we need high prices to reward this behavior. But this clearly is not the case with Sovaldi.  Everyone agrees that this drug is both a true scientific advancement and an expansion of available treatments for a chronic, extremely unpleasant, and potentially contagious medical condition – a combination that almost unequivocally benefits shareholders and patients.  These are the very products we want more of in the future.

So let’s stop patting ourselves on the back for attacking the evil pharmaceutical firms and their high drug prices and instead ask a deceptively simple question:  Why is the price for Sovaldi (and other recent lifesaving treatments) so high in the first place?  While there are many factors, two predominate.  First, these branded drugs are provided by firms that have monopoly production rights as a result of their patent protection.  Second, these drugs provide what most people value more than anything else – healthier and longer lives.  Even more so than prior blockbuster drugs like the statin Lipitor, there is a direct connection between the latest generation of expensive products like Sovaldi, and the substantial health benefits they deliver.

Okay, so these drugs save lives and are therefore incredibly valuable.  Why do we allow pharma companies to extract so much of this value, in the form of patents?  For one thing, patents do not last forever, as the effective patent lives of most new drugs is only about 8-10 years.  After that, these innovations become available to all, forever, at a fraction of the original price.  If we take the long view, the innovators reap just a small portion of the benefits they deliver.  But much more importantly, the patent system promotes innovation.  Take away monopoly pricing, and you take away the profits that motivate research.  (Even this statement, which appears to come straight from the PR department of a pharmaceutical firm, has important limits and nuances that we discuss below.)

Let us be clear, patents create a trade-off between different inefficiencies: one static and another dynamic.  Patents create a static inefficiency because they allow firms to charge monopoly prices and therefore an inefficiently low quantity is sold in the current time period.  We can easily solve that problem by instituting price controls or allowing the government to use its monopsony power to bid down prices – as they do in Europe and Canada where the same drugs are often sold at less than half the U.S. price.  However, this “solution” creates its own inefficiency – a low quantity of products developed for the future.   Here is another way of looking at it: Someone who is sick with something for which there is a cure today would naturally be a proponent of price controls.  But someone with an untreatable condition might want to be a bit circumspect about the long arm of government in this setting.  And the same is true for anyone who might, in the future, develop an untreatable condition.  And that means all of us!

If innovation is so great, then perhaps we should support price increases.  Let Gilead double its price! Triple it!  We could have every scientist in the world working on the next $300,000 pill.   Without trying to be stereotypical economists, it isn’t at all clear that drug prices are too low, and this is not what we are claiming.  Here we make two points.  First, we note that Gilead has not been granted the power to just arbitrarily pick a price out of the air.  If that were the case they, they wouldn’t have stopped at $84,000.  Instead, Gilead gets to pick the profit maximizing price for a monopolist.  Second, we are not claiming that any price is justified just that mandated price reductions may lead us down a slippery and dangerous slope.  Certainly, a “modest” reduction in pharmaceutical prices will not stop all lifesaving treatments from coming to market.  We will have new research coming out addressing this point in the coming weeks.  But much like Justice Potters Stewart’s difficulty with pornography, the definition of a “modest price decrease” is hard to pin down.  And here is the point:  We do not have faith that government bureaucrats can appropriately account for the variety of incentives necessary if they were in charge of either setting prices by fiat or effectively setting prices by exploiting their monopsony power.  It is indeed a slippery slope, and we fear the consequences if we take the first step.

Isn’t it unfair that drugs are so much less expensive in other nations?  Certainly!  But as we tell our children and MBA students, life isn’t fair. If prices were higher in Western Europe and Canada, the case for reducing prices in the U.S. would be more compelling.  There would still be enough of a profit incentive to motivate R&D.   But we shouldn’t hold our breath waiting for others to raise prices.  Americans are stuck in a bad equilibrium in which we have to choose among two options: subsidizing innovation for the citizens of the world, or allowing innovation to grind to a halt?  While our cold economist hearts give a resounding slow clap to the free riding strategy of the Europeans, given the wide range of conditions for which we still lack effective treatments, we would rather err on the side of caution – even if it means that American consumers must serve as the greater fool. 

We should also caution that even a limited attempt at setting prices for drugs like Sovaldi might have a chilling effect across the market.  Firms will make their investment decisions with the specter of price controls lurking overhead.  We worry about the potential long terms effects of this decision.

We finally note that this is a problem that the market appears poised to address.  AbbVie is readying a competing product to Sovaldi and Express Scripts, the nation’s largest pharmacy benefits manager is readying plans to pit these two products against each other in order to lower prices.  This seems like a much better means of achieving a lower price for Sovaldi, though we can’t help but recognize the irony that it puts the opponents of Gilead and Sovaldi in the position of rooting for “me too” products. 


  1. How would you say increasing the length of the patent (say, from 10 years to 20 or 100 years) and moving to a single payer system where people collectively negotiate the price affect the overall price of the treatment and the incentive to move drugs like these into clinical trials?

    Comment by Justin — May 27, 2014 @ 12:47 pm

  2. Any individual will have a hard time arguing against innovation. Kind of like puppy dogs and apple pie.

    However, consider not just Sovaldi, but a hypothetical host of Rx entrants for common (expensive) conditions several years hence arriving in a simultaneous manner. THe ROI’s of each may weigh favorably against using current therapies. But just like a college education–whose tuition costs cannot be paid up front in one lump sum, but also have a favorable ROI–we cannot expect a payer to front the cost of 80-100K for millions of people. The alleged bluff from insurers, states, and employers has meaning this go around. We really cant afford the price tag. I think at least.

    Do we amortize the costs over several decades of life and take the expenses out of the pocket books of multiple payers? Conversely, do we rethink how we can make the dollars work and ask, whats too much to pay…regardless of the benefits.


    Comment by Brad F — May 27, 2014 @ 6:12 pm

  3. The patent system does provide monopoly protection, but only for one product type. Should another manufacturer devise an alternative hepatitis treatment, it would also have patent protection, but also compete for patients. With fewer regulatory and structural barriers to pharmaceutical entrants, more competition would lower prices, even with the current patent system. Regulations are a benefit to large pharmaceutical companies, since they allow them to restrict competition from new entrants, thereby allowing them to charge higher prices than in a competitive market. Reducing regulatory barriers would help a free market develop a just price.

    Comment by Mike S. — June 5, 2014 @ 5:19 pm

  4. Seems to me that if every scientist involved with an effective new drug was given a prize of $1 million after taxes, and then we went to full generic competition immediately, we would not be worse off.

    I think that the high prices for specialty drugs are feeding corporate empires, and have little to do with motivation to innovate.

    Comment by Bob Hertz — June 19, 2014 @ 5:28 am

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