The Economics of Drug Development and Pricing

The week before last I spent a few days at the XXth International AIDS Conference in Melbourne. I couldn't be there for the whole conference because of my teaching commitments, which was a little disappointing because I appeared to miss a lot of the action. By action, I mean the inevitable protests that are a frequent sideline to these conferences.

However, I was at this session on "The Future of HIV and HCV Treatment - Patents, Pricing and Pharma" which was subject to a protest against the pharmaceutical company Gilead (see footage of the end of the protest here). The protesters were angry about the drug pricing for a new treatment for Hepatitis C, which costs around US$84,000 for a 12-week course of treatment in the U.S. You can see more about the pricing strategies of Gilead in this presentation from the same session. Gilead has negotiated a much lower price for the treatment in Egypt - US$900. However, in both cases (U.S. at $84,000 and Egypt at $900) the treatment is severely unaffordable for the majority of people with Hepatitis C. The protesters argue that this pricing strategy is costing lives.

What is Gilead doing? How can they justify such a wide variation in prices between the U.S. and Egypt? There are two key points here that relate to the economics of drug development and pricing.

First, drug development is very expensive (US$1.8 billion according to this source). Why so much? There are a lot of regulatory hurdles for drugs to overcome before they can be certified as safe and made available for patients, on top of the costs of research and development of the drugs themselves. Pharmaceutical companies have to be sure that they can recover the cost of development - otherwise it would make no sense for them to begin the drug development process. In fact, it's been argued that's the reason why there has been little in the way of development of new antibiotics in recent years - there's more money for pharmaceutical companies in researching drugs for orphan diseases than in developing new antibiotics. And this in spite of the impending doom of a "post-antibiotic era, in which common infections and minor injuries, which have been treatable for decades, can once again kill".

Once a new drug is developed, there is little in the way of ongoing costs and the marginal costs of producing the drug are fairly low. This means that pharmaceutical products are a form of natural monopoly - there are economies of scale, because the more that the company produces, the lower their average costs of production because the development costs can be spread over a greater quantity of production. Their natural monopoly is protected by the patents they are granted for the drugs. The protesters are effectively arguing that the pharmaceutical companies should be pricing at average cost, or even at marginal cost (or at least closer to those costs). In either case, this makes it much harder for the company to recoup their investment in development costs, much less any return on capital invested in the development process (see here for more on the problems of natural monopolies). So, the protesters are missing the point - if the pharmaceutical firms are forced to price their drugs low, they won't develop them in the first place.

The second point relates to the "variable pricing" scheme that the pharmaceutical companies use, where they price the drugs at low prices in developing countries and at much higher prices in developed countries. On the surface, this seems pretty unfair, but it is a straightforward application of price discrimination - where different consumers (or groups of consumers) are charged different prices for the same good or service, and where the difference in price does not arise because of a difference in cost (and which I've previously written on here). In price discrimination, the firm charges a higher price to groups of consumers that are willing to pay more for the good or service. For price discrimination to be effective, there must be different groups with different willingness-to-pay for the good or service, the firm must be able to determine which consumers belong to which group, and there must be no transfers between the sub-markets. It seems to me that patients (or health ministries, or health insurers) in developed countries are willing to pay more than those in developing countries, it's easy for the pharmaceutical company to tell the groups apart, and provided the firm negotiates a tight contract with developing country governments specifying no on-selling there will be little in the way of transfers between the sub-markets. So price discrimination is not only feasible, but likely, in this situation and should come as no surprise to us.

Drug development has also been in the news and blogosphere lately because of the Ebola outbreak in West Africa (see here and here and here). Two U.S. doctors received an untested (in humans) treatment, which is unlikely to be made widely available to public health authorities. Why? It hasn't gone through clinical trials yet, and as this news story notes:

Developing, trialling and licensing vaccines or treatments would cost significant amounts of money, and drugs companies argue there is not enough demand to justify the outlay.

“These outbreaks affect the poorest communities on the planet. Although they do create incredible upheaval, they are relatively rare events,” said Daniel Bausch, a medical researcher in the US who works on Ebola and other infectious diseases.

“So if you look at the interest of pharmaceutical companies, there is not huge enthusiasm to take an Ebola drug through phase one, two, and three of a trial and make an Ebola vaccine that maybe a few tens of thousands or hundreds of thousands of people will use.”

So, it seems unlikely that there will be a widely-available treatment or vaccine for Ebola in the near-term (see also here), because the costs of development outweigh the benefits of producing it for pharmaceutical firms. Of course, that ignores the substantial social benefits associated with saving lives (unless you are willing to argue that those benefits are captured in the willingness-to-pay for the treatment).

How do we get pharmaceutical companies to develop treatments, vaccines, or cures for diseases that mostly affect the developing world? It's stupid to wait until drugs are developed, and then protest and demand that pharmaceutical companies lower their prices - that reduces the incentives to develop the drugs in the first place.

A better option was laid out several years ago by Nobel Prize winner Joseph Stiglitz. Stiglitz argues convincingly that an alternative to the current intellectual property (patent) based regime is to offer prizes for firms that develop medicines, cures or vaccines for diseases that affect the poorest countries. Stiglitz says:

A solution to both high prices and misdirected research is to replace the current model with a government-supported prize fund. With a prize system, innovators are rewarded for new knowledge, but they do not retain a monopoly on its use. That way, the power of competitive markets can ensure that, once a drug is developed, it is made available at the lowest possible price - not at an inflated monopoly price.

The trade-off for firms collecting the prize money (which would be contributed to mainly by developed country governments), is that their drug would have to be made available in the public domain (i.e. not patented). Then, generic drug manufacturers would be able to produce the drugs at low cost to provide to poor countries and rich countries alike. One promising example of this approach is the Health Impact Fund. Advance market commitments are a similar idea.

So, perhaps the protesters' efforts are misguided - instead of banging on the doors of pharmaceutical firms, they should be joining with them to bang on the doors of government and potential donors, to generate funds for new drug development that would avoid the patent and monopoly pricing problems for all.