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

September 23, 2015

All low-priced drugs are alike, all high priced drugs are high priced in their own way

Filed under: Uncategorized — David Dranove and Craig Garthwaite (from Oct 11, 2013) @ 9:08 am

The past year has brought a lot of attention to an already charged topic, the price of pharmaceutical treatments in the United States.  This week, the shocking price hikes for the generic drug Daraprim (which we will discuss more below) has drawn even more focus to this issue, as has Hillary Clinton’s announced plan to reign in high pharmaceutical prices.

In this discussion about prices it is tempting to lump all high priced drugs together.  For example, in conversations about Daraprim many have brought up last year’s poster child for pharmaceutical company “greed,” Sovaldi – the first cure for hepatitis C.  And media reports about Daraprim often cite a Gallup poll on American’s positive and negative views of industry in which drug makers rank 23rd out of 25 industries.  But lumping all drugs into a single category of “good products made by evil firms” is not only incorrect on its face, it can lead to very poor public policy.  It is critical that we realize that the high prices charged by Gilead are fundamentally different than the current increase for Daraprim and other older generic drugs that provide value to a small patient population.

To understand this, we need to be very clear about how Turing Pharmaceuticals is able to “get away” with the high prices it is charging for a generic drug.  In August, Turing bought the manufacturing capabilities for Daraprim and it is currently the only manufacturer of the drug.  If another firm wants to manufacture the drug there are no intellectual property related restrictions why they cannot (the patent protection for this drug has long since expired).  They would however have to receive FDA approval for selling this drug and secure production capabilities which involves both actual and opportunity costs. However, it isn’t clear that it would be profitable for two manufacturers to supply this drug because it serves a very small patient population (roughly 10,000 prescriptions a year) and therefore given the high fixed costs of entering two firms might not be able to minimize their costs.  As a result, the market currently has only one firm that is using its monopoly power to charge an exceptionally high price.

Economists call these situations natural monopolies, and there is a long history of price regulation of other natural monopolies such as utilities. But a large body of economic research questions the success of these price regulations, as regulated industries are able to “capture” the regulatory process, not only extracting prices that may be just as high as regulated prices but, perhaps more importantly, stifling any hope of significant innovation.  Complicating matters further here is the decision to define a particular product or segment as a natural monopoly.  We certainly wouldn’t want this to apply to all pharmaceuticals or even all generic products.  It is also difficult to use a “we know it when we see it” line of reasoning in these settings.

We also need to contrast situations like Daraprim from other high prices drugs. For example, Sovaldi is a new product that provided the first cure for hepatitis C.  It also charged a very high price, $84,000 for a 12 week treatment cycle.  But this monopoly position was short lived; Express Scripts has already ditched Sovaldi in favor of a lower priced alternative, Abbvie’s Viekira Pak.  While prices for both products remain high, the lure of profits is attracting additional research into other hepatitis C drugs, and, more generally, into treatments for a host of other diseases that are currently either untreatable or treatable only at a high cost.

Industry critics may argue that we would be better off with lower profits and less innovation.  This is a valid argument and worth debating.  But let’s not lump the high prices for innovative new drugs with the behavior of firms such as Turing, which as far as we know has never innovated anything.  We now run the risk of letting the pricing decision of a small firm affecting a few thousand consumers become the poster child for sweeping regulations of a large, dynamic and innovative sector of the economy.  In the process, we may forget that there are two sides to the drug pricing debate.

As a side note, part of Clinton’s plan for lowering drug prices is an attempt to increase the amount of money that pharmaceutical firms spend on research.  To the extent that this money is used to develop new and innovative products, we should expect it will only lead to more of the high prices she is decrying.

4 Comments

  1. Hi This is spot on analysis but you left me hanging. What’s the solution to the price gouging when lives are in the balance?

    I continue to enjoy reading your work. Ray

    Sent from my iPhone

    >

    Comment by Ray Boyer — September 23, 2015 @ 9:35 am

  2. @RayBoyer

    I’m no economist, but it seems to me that lowering that high fixed cost of entry (which is mostly caused by regulatory costs) would be the key in the case of these generics.

    Comment by Gimlet — September 23, 2015 @ 7:12 pm

  3. @RayBoyer, frankly, the fixed costs aren’t going anywhere. The regulations are there to keep companies like Turing from selling sugar pills and snake oil and then telling patients that their sugar pills and snake oil will cure cancer. It’s the same reason that the FDA is now going to have to start regulating so-called homeopathic ‘remedies’.

    The information asymmetry in the pharmaceutical market is simply too high for a wise government to let it go unregulated.

    Comment by Adam Limehouse (@ACBLimehouse) — September 24, 2015 @ 10:25 am

  4. I wonder if the characterization of the pharmaceutical industry as a “large, dynamic and innovative sector of the economy” is somewhat misrepresenting the facts. Wasn’t the science underlying most breakthrough drugs (including Solvaldi and its new competitor) publicly funded? What might happen if, instead of granting monopolies and restricting Medicare’s ability to bargain price, we sharply increased public funding of pharmaceutical research and testing and then competitively licensed production?

    Comment by Dave Kelleher — September 24, 2015 @ 10:11 pm


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