Shrinking Big Pharma Is the Best Way to Expand Drug Costs

Pharmaceutical companies are under attack (again) for the simple fact of being very successful, both as life savers (or extenders) and as profitable companies. As reported by the New York Times, six states have pending legislation designed to force more disclosure by pharmaceutical companies about their costs so as to examine their pricing policies. One hundred top oncologists are supporting a protest about the high cost of some cancer drugs. Congress is getting into the act, too, with the Senate Finance Committee investigating drug costs out of worry about how much all those drugs are costing the government. The only problem with all this investigating is that the facts assumed are mostly wrong and the economics applied are shortsighted in the extreme.

People are upset because they find many of today's latest pharmaceutical breakthroughs to be unreasonably expensive and suspect the big drug companies of extorting exorbitant profits from desperate patients. Yet, a quick look at the facts will reveal otherwise.

Drug company profits are in line with many other industries. A quick look at any stock information website for financial data on the largest pharmaceutical makers will reveal that Pfizer's recent profit margin was 18.4 percent; Sanofi's, 12.9 percent; Merck's was 28.2 percent, and GlaxoSmithKline actually lost money with a negative 1 percent profit margin. For a little perspective, Cisco had a 16.7 percent profit margin, Microsoft ran a 25.4 percent profit, and (do no evil) Google enjoyed a 21.9 percent profit margin. Clearly, pharmaceutical companies are not the only ones who charge more than necessary when selling their products.

As much as misguided people may wish to proclaim healthcare a right, it is not. Drugs are products with prices determined by supply and demand just like any other product (at least without government interference). If customers (patients and insurers) were not willing to pay the drugs' asking prices, the makers would soon be slashing prices or searching for other drugs to develop and sell. Drug prices are high because we are willing to pay; we are willing to pay because we find the products worth the money.

National health expenditures on prescription drugs were $271 billion in 2013, which is a big number but still only 9.3 percent of total healthcare spending. Thus, even cutting all drug prices by one-third would only lower the total cost of healthcare by about 3 percent, or roughly one year's worth of health care inflation.

Having briefly reviewed the facts on drug prices and profits within the big picture, let us turn to the oft-misunderstood economics involved.

Some of the latest drugs, particularly those referred to as biologics are very expensive to make, with their manufacturing cost going a long way toward justifying their price. In contrast, many other drugs are quite cheap to manufacture with their costs bearing little, if any, relationship to the prices charged. In both cases, prices are much more determined by demand, and demand is determined by the benefit of the drug to a patient.

If a drug allows you to avoid a surgery costing $100,000, then a price of $50,000 may be a relative bargain. Similarly, drugs that extend life by defeating a cancer or that allow a person to resume a normal life rather than being devastated by an autoimmune disease will likely be seen both by patients and economists as worth a high price because of the value they deliver. And it is precisely this value that keeps big pharma in business.

If a drug costs one or two billion dollars to develop and get approved (which is a plausible range these days for drug development, testing, and regulatory approval costs), that actually has nothing to do with the eventual price charged. Those costs are sunk; patients and insurers don't care if the drug company earns back these costs, only if the drug is worth more to them than the money they must pay for it.

However, if the drug companies do not earn back those investments, they will have no money to develop the next round of drugs. If we set drug prices at the marginal cost of manufacturing them, the drug companies can stay in business, but they will have no extra money for future research and development. Think of high drug prices not as the cost of your current drugs, or as a pool of profits to the drug companies, but as an investment in future pharmaceutical advances.

Pushing down drug prices and shrinking the profit margins of the big pharmaceutical companies might feel good in the short run, but in the long run such a strategy is killing the goose that lays the golden eggs. Without sufficient profits, no new drugs will be developed and illnesses that might have been cured will continue to afflict us. Adding price regulations to the drug industry will save us some tax dollars and insurance premiums now, but we will never know what lives such a shortsighted policy will cost us in the future.