Mike the Mad Biologist

How Companies Price Drugs

Since it’s election season, it’s pretty much guaranteed that the price of medical drugs will come up. While I’m on vacation, this post from the archives is pretty interesting. Keep in mind, the person making this claim is a former CEO of Pfizer, so he might know what he’s talking about…

This is a headline from the June 1st, 2005 edition of ScripNews (subscription only; so I’m a little behind in my reading-what scientist isn’t?). Here’s the punchline for lazy stupids that don’t like to read: the head of Pfizer has admitted that the cost of making a drug has nothing to do with how much drug companies charge for that drug.

Holy florfenicol sulfonamide, Batman! For years, defenders of Big Pharma (as well as Big Pharma itself) have claimed that they have to jack up drug prices to recoup research and development costs. But that ain’t so, says Pfizer CEO Dr. Hank McKinnell:

“It’s a fallacy to suggest that our industry, or any industry, prices a product to recapture the R&D budget spent in development,” he says. “Business doesn’t work like that.”

R&D is a sunk cost and can never be “recovered”, no matter what the industry decides with regard to the pricing of its products, he argues. Thus, a company sets its prices not on some historic cost (which is basically irrelevant), but on future possibilities and value to customers.

To drug companies, what Jonas Salk described as “patenting the sun”, is just a product:

In explaining his thesis, he compares the pricing of medicines to the pricing of a car or consumer product, where sustaining investors’ confidence in the risks and rewards of the industry is paramount. “A number of factors go into the mix,” he notes. “These include cost of business, competition, patent status, anticipated volume, and, most important, our estimation of the income generated by sales of the product. It is the anticipated income stream, rather than repayment of sunk costs, that is the primary determinant of price.”

The real problem, McKinnell argues, is that the business:

has not produced many important medicines in the past four or five years. “If the industry were innovating at the rate it was 25 years ago, I don’t think there would be as many complaints about costs.” Dr. McKinnell cites the example of Pfizer launching its impotence product, Viagra…, in 1996 at a cost of $8-9 per pill to patients without insurance. The product was so novel that price was not foremost in the picture, because “the only thing people saw was value.”

I realize we have a war going on, but this is pretty damn big. I haven’t heard this admission reported anywhere (outside of Scripnews). We’ve always been told that the U.S. consumer has to pay high prices for medicines because of high R&D costs. McKinnell puts the lie to that argument. For a lot of people, the price of drugs is a life or death matter. Doesn’t this statement qualify as important news? The mainstream media apparently doesn’t just suck at covering evolution…

Comments

  1. #1 MartinB
    October 9, 2008

    This seems not too unusual to me. To give another example, gas turbine manufacturers (I know this from someone working for a jet engine manufacturer) have to invest heavily in R&D to develop new products which have a development time of about 10 years or so. The monetary balance is such that a turbine starts to yield money long after it is sold by repair and maintenance costs. The money earned then is sufficient to allow the company to develop the next turbine so they won’t fall out of business ten years in the future.
    So I really do not understand what the problem is here: The earnings from current products are used to finance the research on tomorrows products. That has to be the standard in a business where development times are years or decades. I think the last quote actually confirms this view.
    Or do I misunderstand something?

  2. #2 z
    October 9, 2008

    Well, sure. Intel/AMD and such have the same buysiness model; they basically bet the company, or a good fraction of it, on each new product; then they collecxt the winnings and place the next bet.

    One problem is that the front end of R&D, generating new compounds that look promising, has gotten too good, while the back end, testing these compounds, is still the same. So the molecular end of the business is now generating new candidates like crazy, which get tossed over the net where they soak up the companies’ resources in the process of failing. If you’re lucky, they fail pretty early, kill mice wholesale or some such. But a drug that looks promising right up until the third phase of clinical trials then fails is a major financial disaster for the company.

  3. #3 phisrow
    October 9, 2008

    While I don’t disagree with the notion that reduced innovation increases grumbling about costs(and, since companies with less expected innovation in the pipeline are likely to turn the screws even harder on what they have, I imagine you see an even greater effect), I think Viagra is an unrepresentative example.

    Because erectile disfunction is a fairly common effect of aging, and one that doesn’t generally have dire health effects, the cost of its treatment is subjectively easier to bear. “Have erectile dysfunction? Regain the ability to have sex for less than the cost of a movie ticket.” is a fairly attractive deal. Sure, it’d be nice if it were cheaper; but that deal feels fair, in a way that “Hmm, I sure hope you have X dollars a day for test strips, it’d be a pity if your leg were to rot off…” doesn’t.
    Innovation certainly polishes the image of drug development as a whole, in that anybody who feels that the history of medicine is a series of significant victories will likely be willing to pay more without feeling ripped off; but I suspect that drugs that feel like “enhancements” will always feel fairer than drugs that feel like necessities.

  4. #4 phisrow
    October 9, 2008

    While I don’t disagree with the notion that reduced innovation increases grumbling about costs(and, since companies with less expected innovation in the pipeline are likely to turn the screws even harder on what they have, I imagine you see an even greater effect), I think Viagra is an unrepresentative example.

    Because erectile disfunction is a fairly common effect of aging, and one that doesn’t generally have dire health effects, the cost of its treatment is subjectively easier to bear. “Have erectile dysfunction? Regain the ability to have sex for less than the cost of a movie ticket.” is a fairly attractive deal. Sure, it’d be nice if it were cheaper; but that deal feels fair, in a way that “Hmm, I sure hope you have X dollars a day for test strips, it’d be a pity if your leg were to rot off…” doesn’t.
    Innovation certainly polishes the image of drug development as a whole, in that anybody who feels that the history of medicine is a series of significant victories will likely be willing to pay more without feeling ripped off; but I suspect that drugs that feel like “enhancements” will always feel fairer than drugs that feel like necessities.

  5. #5 SouthernFriedSkeptic
    October 9, 2008

    I think that drug company reputations suffer from the bottom shelf effect or BSE. The BSE is simply the fact that if you are on a very tight budget, and go to your local grocer, you may opt for the bagged cereal found on the bottom shelf at the store rather than the name brand boxes most families are familiar with. Not everyone does this, despite the cereals being almost completely identical. But the option is there is money is tight. Drug companies put out medication that may be fundamental to someone’s quality of life- far more so than eating a cereal. And unlike cereal, it may be the case where a big pharmaceutical releases a product with no competition on the market. People don’t like making a choice between quality of life and paying for an expensive drug. At least with cereal there is a generic available fairly quickly. It doesn’t seem to hurt the cereal companies too much. You can have fruit-loops or fruity-ohs. And though the latter is cheaper, the former shows no signs of going under financially (at least no more so than the rest of the nation). And though drug companies have large research costs, cereal manufacturers have very large marketing costs which the pharmaceutical industry does not have. Oh wait, never mind. Make that should not have. I think that the public feels that the price of drugs is artificially inflated and that the drug companies are working hard to keep it that way. And of course, I have no way of knowing whether that is true or not. I am not privy to their research and sales balance sheets. I support research. I love to hear about new scientific advances. But if big pharm wants to earn good will, it should become a non-profit. You can still make a living and pay employees, etc…just make sure all money above the line is fed directly back into research. Make sure you don’t have CEO’s with multi-million dollar bonuses enjoying the good life with mansions and private planes while someone in poverty suffers terribly or dies unable to afford the medication from which those riches came.

  6. #6 Steve
    October 10, 2008

    I can’t remember exactly when and where I saw this (PLoS Medicine ~6 mo. ago??) but a paper I read stated how the stated R&D costs of a drug company appear to be heavily inflated. Sorry, but I’m too busy to look up the paper right now.

  7. #7 Eric
    October 10, 2008

    I agree with MartinB. I don’t see what the problem here is. Drug companies charge people what they’re willing to pay for a product, just like every other company. It’s not like the drug industry doesn’t function under the same laws of supply and demand like all other industries. Just happens that drug companies rely heavily on patents to make prices higher, giving them some leeway and making it easier to pay back their research debts.

  8. #8 Eric
    October 10, 2008

    I agree with MartinB. I don’t see what the problem here is. Drug companies charge people what they’re willing to pay for a product, just like every other company. It’s not like the drug industry doesn’t function under the same laws of supply and demand like all other industries. Just happens that drug companies rely heavily on patents to make prices higher, giving them some leeway and making it easier to pay back their research debts.

  9. #9 Armen Shirvanian
    October 12, 2008

    I had heard that same information in the past about how the price of drugs serves to pay off R&D costs. I am glad you have brought up a counterpoint here as that explanation is an easy way for drug companies to increase prices a bit without being questioned much more. I would have to side with your viewpoint here as it seems more appropriate. Possibly a small amount of gains pay back R&D expenses, but it is probably much lower than what is said to consumers.

  10. #10 EnvironmentalMed
    October 13, 2008

    Obviously, drugs will be sold for what the market will bear, as long as that’s above the price of production. But expectations of those sales and prices are what direct research. For a classic example of sunk cost, look at Bayer’s Baytril (enrofloxacin). A variant of ciprofloxacin, with better oral bioavailability (on other words, when you swallow it in pill form, more of it get into your body where it does some good), it looked like a profitable super-Cipro.

    Then testing revealed that it gave people hallucinations.

    That took everyone completely by surprise, because it didn’t do that to the standard lab animals.

    So it was re-launched as an animal drug. Bayer took a bit of beating after funding all those human-approval-oriented studies, but it’s widely used in veterinary medicine now.

    But while it fluctuates wildly – just like Hollywood hits and flops – you still have to let drug companies generate a return on their research costs competitive with other industries, or they won’t fund any research. Indeed, their stock will tank so they won’t be able to.

    I’m not claiming that they’re the best people to fund research, but if that’s the model you’re following, it better be profitable or it’ll come to a screeching halt.

    A more important insight is to realize that the same market forces mean that the last thing that a drug company wants to produce is a cure. A cure is a drug that you take once or a few times and never again. Very limited market.

    Far more profitable to generate palliatives for chronic conditions. Cholesterol medications, blood pressure medications, antidepressants: all of it wildly popular because people buy it weekly for years. They’re even gung-ho on AIDS drugs now that AIDS patients are living long enough to spend significant money.

    If one of their researchers has an idea for an outright cure and asks for internal funding, they’ll first check if anyone else is going to be producing it (in which case there’s PR value in being first), and if not, bury it for as long as the market for the palliatives can be maintained.

    This is not underhanded corporate corruption; an officer of a publicly traded company is legally required to place shareholder value ahead of wider societal good. (Dodge v. Ford Motor Company)

    The problem is exacerbated by the way that front-end fees and costs are loaded onto would-be drug marketers. The problem is that the number of coral snake envenomation victims in the U.S. is too low to support marketing approval of the superior Mexican Coralmyn antivenom. At least until recently when the older Wyeth product ceased production and orphan drug status became available.

    That still doesn’t help the rattlesnake bite victims, having to use large quantities of the expensive F(ab) fragment Crofab antivenom instead of the superior (and far cheaper) F(ab’)2 Mexican Antivipmyn antivenom.

    All because rattlesnake bites aren’t a big enough market.

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