The REAL Reasons Why American Pharmaceutical Prices Are So High and What We Should Do About It

By Jim Walker

Most of the discussion that takes place in the media about pharmaceutical prices consists of a fog of obfuscation and red herrings sprayed out by the pharmaceutical industry and its apologists and a chase after chimeras by consumer advocates which ignore the real economic and political issues that are actually operative here. A real understanding of the issues involved requires a look at the economic principles and political history involved in the issue.

Let’s look briefly at some of them:

PATENTS

A patent is an exclusive right issued by a government to the inventor of a product or process living that person an exclusive right to market that product or process for a fixed number of years.

In effect, it is a legal monopoly. For centuries, governments have almost universally recognized the patent as a tool for creating economic progress that encourages research and innovation since the inventor is rewarded with the ability to make profits larger than they could get if a competitive market existed for the product. Most countries accept this and honor each other’s patents. Drug companies often try to extend this patent period by tweaking the product in a minor way and applying for a patent for a new drug.

MONOPOLY MARKETS

A monopoly occurs when a single producer entirely or almost entirely dominates the market for a product or service. The producer is free to set the price wherever they choose. Their desire, even their duty to shareholders, is to maximize profits. They search for the price that accomplishes that purpose. This “monopoly price” is not the highest price they could charge. Because as price increases, some customers decide to do without the product or turn to inferior substitutes. The proper “monopoly price” is where the next penny of price increase will cause enough customers to stop buying that the revenue gain from the remaining customers does not further increases profit. This is the profit maximizing or “monopoly price”.

COMPETITIVE MARKETS

Competitive markets were first thoroughly described in Adam Smith’s blockbuster book, The Wealth of Nations, which forms the cornerstone of “classical” economics. In a competitive market there are many producers and many customers. There are so many of each that no one producer or customer can have any influence on price. This kind of market produces the lowest price at which enough producers can make a profit thereby remaining in business to satisfy existing demand. Alas, the only significant industry in the United States that fits the competitive model is agriculture.

Let’s take the example of corn production. There are millions of farmers growing corm. There are at least thousands of buyers of corn for making breakfast cereal, corn meal, livestock food, frozen corn, etc. No farmer can reasonably claim that his corn is better than that of other farmers. A farmer could decide that he will withhold his crop this year because he doesn’t like the price he’s offered; however, this will not raise the market price of corn a single penny. A cattle food processor can decide he will no longer include corn in his mix because it is too expensive. This will not lower the price of corn a single penny.

MONOPOLY MARKETS VERSUS COMPETITIVE MARKETS

We have already seen that a patent is an “artificial” or manmade monopoly. There are also “natural monopolies” where the nature of the production of the product makes a monopoly the most efficient way to produce it. The best example of a natural monopoly is electricity. The necessity of large, costly production plants near the consumer and costly transmission lines to bring electricity to the consumer make it impractical to have any other kind of market than a monopoly.

Because of heavy dependence of the public on electricity, electric utilities are usually strictly regulated by the government. A regulatory board negotiates a price with the utility. The regulated price must be high enough that the utility can cover its costs plus enough profit to be willing to invest its capital in the industry and remain in business. The electric company would prefer the monopoly price, but regulators prefer to set the price at the much lower competitive price. The price battle is fought between these two goalposts. The final agreed upon price is set between the two; usually set to allow a very substantial profit margin high enough to encourage the producer to continue to increase capacity to satisfy a growing market and gain acceptance by the industry lobbyists who have leverage with the legislature. This price is considerably lower than the monopoly price.

MONOPSONY

So far, our discussion on pricing has focused almost entirely on the producer side. Let’s look now at the buyer side of pricing. A monopsony is a kind of buyer’s monopoly. It exists when there is a single buyer for a product. A place where monopsonies frequently exist is defense industries. American individuals and corporations do not buy tanks, fighter planes, or aircraft carriers. The sole purchaser of these items is the government. The government negotiates prices with defense contractors. The price must be high enough to ensure production costs are covered plus an adequate profit. Costs are often difficult to determine in advance in this industry and the military-industrial complex has a strong lobby, so a generous profit is usually built into the contract often on a cost-plus basis.

ELASTICITY OF DEMAND

Elasticity of demand for a product is the responsivity of demand for that product to changes in price. For a product with highly elastic demand, a modest increase in price reduces demand for that product substantially. For a product with inelastic demand, a large increase in price produces little reduction in demand. An example of a product with inelastic demand is gasoline. During the last couple of years, we experienced a very large increase in the price of gasoline. Demand for gasoline scarcely diminished at all. The purchases of gas guzzling SUVs and pickup trucks hardly budged. Life went on as always but there was a lot of complaining and blaming of Joe Biden.

It happens that pharmaceutical prices have among the lowest elasticity of demand of any product. If someone has cancer, they will pay as much as they can for medication to cure it. If they don’t have cancer, they will not buy any of the medication no matter how cheap it is. Price has almost no influence on demand. This has powerful implications for drug pricing.

FREE RIDERS

Economists call a person a free rider when they enjoy a benefit without paying the cost or full cost of it. They arise in anomalous situations where the cost is small and it’s not worth the trouble to identify and charge the user or when the users are very hard to identify or out of reach for charging. Some examples are someone who uses the restroom at a fast-food restaurant without patronizing it. Another example is the recently publicized sharing of identification codes with non-subscribers on Netflix.

THE COST STRUCTURE OF THE PHARMACEUTICAL INDUSTRY

Most people would be very surprised at the cost structure of the pharmaceutical industry. It seems logical to assume that medicines are expensive because they are hard to manufacture and contain expensive raw materials. This is usually incorrect. The categories of cost in the industry are:

1. Advertising and marketing - If you see a drug advertised on television on an NFL football game or the nightly news, you can be pretty sure it is patented and very expensive. How long has it been since you saw a television ad for aspirin? Pharmaceutical companies also maintain a virtual army of sales agents who besiege doctors’ offices with their sales pitches, literature, and free samples. It was once illegal to market pharmaceuticals directly to the public, but the pharmaceutical lobby got that restriction lifted some time ago.

2. Research and development - It is usually costly to develop a new medication. Many efforts lead to costly dead ends and a truly new drug often takes years to bring to market. These costs must be built into the price of the drugs during the monopoly-priced period of the patent. Companies often try to lengthen the period by making a small change in a popular drug and applying for a patent for it as a “new” drug. The most blatant case of this that I recall is one in which a company combined two well established drugs often used by the same people into a single pill, patented it, and then trumpeted it through advertising as a “new” drug that had the advantage of only having to take one pill a day instead of two. What a terrific advance in medical science!

3. Actual production cost - Once a drug is developed, tested, approved, and patented, actual production cost is usually very low. Hence, production cost comes in a distant third in the cost structure of the industry. This means that once a drug is placed into production, additional units can be produced often at a very low cost. This has powerful implications in several ways for profitability which will be discussed in the next section.

THE WORLD PHARMACEUTICAL MARKET

Most developed countries and many developing countries have a national health service which tightly controls all or nearly all of the health care industry in the country. This is often referred to by the scary moniker of “socialized medicine”. As part of their task, national health services negotiate prices for and purchase the nations’ drugs. These health services are a monopsony in that market with the considerable pricing power of a monopsony which allows them to negotiate prices well below what the price would be in an unfettered monopoly. Since the manufacturing of additional units of the drug are very low, these countries can wangle very low prices compared to buyers without the advantages of monopsony power while the pharmaceutical companies can still reap very substantial profits from the sales. Not surprisingly, the pharmaceutical companies agree to those prices.

THE UNITED STATES PHARMACEUTICAL MARKET

The United States does not have a national health service to control the healthcare industry and purchase the nation’s drugs, so the consumer and the insurance companies are left on their own to deal with the pharmaceutical industry. Guess who wins? The pharmaceutical industry is free to set the price at the monopoly price level resulting in much higher prices than countries with dreaded “socialized medicine”.

In the George W. Bush administration, the President and Congress committed political malpractice when they passed a law requiring Medicare to cover drug costs for its participants (good) but forbade use of its enormous buying power which would have given it a near monopsony position on many drugs which are used almost exclusively by the elderly (very bad). These factors are the reasons behind the substantially higher drug prices in the United States compared to most other countries.

PRICING ANOMALIES OF DRUGS IN COMPARISON TO OTHER PRODUCTS

• Inelastic demand - Since willingness to buy drugs is very insensitive to price, it is relatively easy to get very high profit margins with them.

• The fact that other nations have national health services to purchase drugs on their behalf in a monopsonistic relationship with the pharmaceutical industry, leaves the United States is in a disadvantageous position relative to them.

• The law requiring Medicare to forfeit its near monopsonistic position on some drugs almost exclusively used by the elderly destroys our power to resist high prices on these drugs.

The combination of inelastic demand and no pricing power on the part of the consumer in the United States allows the drug companies to achieve the seller’s dream. We have already seen how the patent allows the monopolist to set the price at the profit- maximizing “monopoly price” point which with inelastic demand can be much higher than the competitive price would have been. The only weakness in the classical monopoly model is that as price increases more and more customers can no longer afford to buy. The monopoly profit-optimizing point has been reached when the last penny of price increase causes enough buyers to drop out that no increase in profit is gained. However, in this unusual situation where we have a monopoly in which the buyer has no countervailing pricing power and is in desperate need of the product, the seller can, under the guise of humanitarianism, invite the buyer to submit data on how much he can afford to pay. This will of course usually have a very high profit margin though somewhat less than would the “sticker price”. The seller then accepts this offer. In this situation, the “sticker price” can be set higher than the profit-maximizing price in the classical monopoly model, and the seller’s dream has been achieved—everyone pays not a fixed price but as much as they can afford to pay, and the seller loses no customers because the price is too high for them. This yields higher profits that the already high profit margin of the classical monopoly model. You have no doubt seen the television ads ending with the statement “if you cannot afford this medicine, contact (manufacturer’s name) and maybe we can “help”.

RED HERRINGS AND FLIM FLAM IN ARGUMENTS IN FAVOR OF PRICING POWER

1. Reimportation - It is currently illegal for druggists to buy American drugs in other countries at much lower prices than they are available for here where they are made and “reimport” them selling them at a cheaper price than the “sticker price”. The drug companies defend this prohibition by claiming that the foreign importing companies might not be ethical and would sell us unsafe or ineffective drugs. If you really think that companies in Holland or Sweden are less ethical that those in America, I have some land in Florida and a bridge over the Hudson River to sell you. The real issue in drug reimportation is why have we made ourselves so vulnerable to exploitation by drug companies that such a workaround is needed.

2. Cost of Research and Development - Drug companies love to harp on the idea that very high prices are necessary to pay for the research to develop the drugs. While it is true that drug development is costly, the companies never disclose that it is only the second highest item in their cost structure. Advertising and marketing together are the number one cost in the industry raising costs and hyping demand to increase profits.

3. Free Riders - The drug companies never mention that the high prices for drugs in the United States allow the rest of the world to be free riders on drugs. The United States consumer pays disproportionately to fund the costs and profits of the world pharmaceutical industry because we allow ourselves to bear a disproportionate share of the world’s cost relative to other nations who more effectively resist high prices.

WHAT WE CAN DO ABOUT HIGH PRICES

1. Create a collective drug purchasing agency to bargain for the whole nation on drugs as the national health services do in other nations.

2. The United States government would have terrific bargaining leverage with the pharmaceutical industry if it would only choose to use it. Because we are one of the world’s highest average income countries, its third most populous country, and has a high percentage of elderly people who use a lot of medicine, we provide much of the world pharmaceutical industry’s income. The government should recognize that the nation needs the wonderful, life-saving products of the pharmaceutical industry. Because of this, the industry should be rewarded and allowed to make a handsome profit on them. The industry, on its part, should agree not to soak an obscene level of profits out of the public which exploits its patent monopoly privilege to impoverish many of its customers. To implement this understanding, there should be an agreement, contract or perhaps a law that incorporates the following points:

   1. The producer should be allowed to set the nominal (sticker) price of a patented drug at the classical optimal monopoly price but not higher than that.

   2. People who can prove that the sticker price would work a financial hardship on them should be allowed to purchase it at the minimum price that would allow for an economic profit. (An economic profit is one that is just above the amount earned by a currently risk-free investment such as a short-term treasury bond.)

   3. These pricing rules should apply to all classes of purchasers in our country, including Medicare and Medicaid purchasers, private insurance companies, and uninsured individuals.

   4. In cases where there is more than one comparable drug, government agencies or the producers should be free to initiate offers below these ceiling price levels.