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Drugs and Gas

10 July 2006

I’m something of a talk radio junkie so, as is typical for me, I was listening to a local talk show on my way to work this morning. The talking head was pontificating about the price of gas reaching a $3.00/gallon national average. So, just to keep his listeners on their collective toes, he compared gas prices to pharmaceuticals. He proceeded to complain about the high cost of prescription drugs and to particularly complain that, now that cholesterol drug Lipitor is about to go generic, the manufacturers of Lipitor are going to release their own generic version. The implication was that they could have priced Lipitor as generic all along, thereby saving millions of people lots of money. In other words, he believes that pharmaceutical companies are engaging in price gouging.

The general lack of understanding in our country when it comes to basic economics never ceases to amaze me. People can, of course, be excused for not understanding the specifics of a particular industry, although it isn’t too difficult to find the truth if you are motivated to look for it. So allow me to present a short course in pharmaceuticals.

It may come as a surprise that the overwhelming majority of new drug therapies developed every year in the entire world are developed in the United States. It is reasonable to enquire as to why that might be so. After all, the US doesn’t have a monopoly over intelligence. The answer is pretty simple. It does take some background knowledge but the short answer is prices.

Much of the world has price controls on drugs. The US has fairly recently been engaged in debate over the prospect of importing drugs from Canada, where prices are kept low by government fiat. Not surprisingly the Canadian government made it clear early on in the debate that they would not allow the US to re-import large quantities of drugs back into the United States. On some level even they understand that everyone will suffer if pharmaceutical companies are not allowed to make a profit.

So American pharmaceutical companies supply most of the western world with drugs at much lower costs that they do here in the US. They don’t, of course, do this out of the goodness of their hearts. They do it because governments in those countries mandate it. The drug companies could simply refuse to sell at the reduced prices but the effect of that would be for companies in those countries to manufacture them as generics and the American drug companies would lose much needed revenue.

A typical new drug therapy requires over fifteen years to develop. During that time there is a lot of money going on in the development process and no money coming in from the prospective drug. Additionally, there is no guarantee that any line of research will ultimately lead to a new drug. In fact, most do not. For every successful new drug therapy there are at least 20 lines of research that were dead ends. But the dead ends still cost as much to follow as the successes did.

On top of all that, and adding significantly to the cost, are FDA requirements to gain approval for a new drug. Years of clinical trials are required because we here in America are risk averse. There are some good arguments about the cost to millions of people for having to wait so long but that will have to wait for another column. Suffice it to say, the US government itself adds significantly to the cost of developing a new drug therapy. Every new drug that makes it to the market costs billions of dollars to develop along with far more prospective drugs that never made it. Pharmaceutical companies incur extremely high costs in developing new drugs. They also incur exception risk with every new drug. Everyone will recall recent law suits over prescription drugs that were vastly popular and very helpful to millions of Americans. Yet some of those drugs are no longer on the market because a tiny few suffered adverse reactions of complications to those drugs. The pharmaceutical companies have to defend against these law suits and that is a costly proposition.

Imagine that you have a business. You make widgets and it costs you X dollars to develop new varieties of widgets. If you want to remain profitable and stay in business you must charge a price greater than X dollars for those widgets. Otherwise, your costs will exceed your income and you will go bankrupt. Pharmaceutical companies are no different. Every new drug that goes to market must generate enough revenue to the company that developed it to cover the cost of developing that drug, as well as the costs of the dead ends and the costs of defending against law suits. If new drugs do not cover those costs, the pharmaceutical companies will not remain in business very long.

Back to our original question regarding drug companies in other countries. Why don’t they develop new drugs like US companies do? The answer is, they have no economic incentive to do so. In almost all other western countries price controls exist that prevent drug companies there from being able to recover the costs associated with research and development as well as litigation. As long as that is true the drug companies in those countries will not engage in those activities. Instead they will concentrate on manufacturing whatever generic drugs they are allowed to make.

It is easy to point to a particular drug and say it costs a certain amount to make it and drug companies should not be charging more than a certain percentage above that. It is easy but it is also lazy because it does not require looking at all the facts involved. When those facts are examined one is hard pressed to conclude anything except that American drug companies are a pretty good job. And they are doing that job under less than ideal circumstances.

So to the talk show host this morning I say, do a little research before you go shooting from the hip. While you may have plenty of people saying “yeah” when you point the finger, you are not helping the situation at all. Rather, you are making it worse by disseminating disinformation and flat out falsehoods.

For the reader interested in a nice treatment of this subject I highly recommend Thomas Sowell’s book, Applied Economics. You can find it on the reading page along with a number of other excellent books.