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Barking up the wrong tree: More on drug pricing
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A bill currently before the Massachusetts Senate, S.1048, would require pharmaceutical companies to release information about the cost of the development and production of their medications “to promote transparency and cost control of pharmaceutical drug prices.” However, an economic fallacy underlies this and similar legislation in other states. The fallacy is that price is a function of cost, that if we can determine how much it costs to make a drug, then we could judge the appropriateness of its price.
Price vs. cost
According to the laws of economics, price is not a function of cost. If price and cost were functions of each other, we would be able to graph them. Then if we knew the cost, we could compute the price. This is fallacious because both the cost and the price can be any amount. They could be different from each other; they could be the same as each other. Points would be scattered all over the graph because cost and price are not a function of each other.
When a company or an individual comes to the marketplace with a good or service to sell, the goal is usually to sell it at a profit. To do this, the price must be higher than the cost. The difference equals the profit. But if there is little demand for the product, then the best the seller might be able to do is to sell it at the cost that it took to produce it. The seller would then only break even. If there is even less demand for the product, the highest price it might command in the marketplace might actually be less than it took to produce it. In this case, the seller would take a loss. Thus, the price can be more, less or the same as the cost. Knowing the cost does not give you the price.
Instead, price is a function of supply and demand. As the supply of a product increases, downward pressure is placed on the price; and as the supply of a product decreases, upward pressure is placed on the price. We are seeing this today with gasoline prices. Likewise, with demand, as the demand goes up for a product, upward pressure is exerted on price; as the demand goes down so does the price.
Pharmaceutical exception
Yet, we are not seeing this in the pharmaceutical marketplace. Quite simply, this is because this market is so heavily regulated that it constrains the impact of supply and demand on price. This has resulted in severe distortions and aberrations in both the pricing and distribution of pharmaceutical products. We see it, for example, in the extreme variation of insulin prices. We also see it in the shortages of various drugs, some as simple as normal saline, others as critical for patients with cancer as fluorouracil (5-FU).
Government intervention in the pricing of drugs is quite extensive, as can be seen by a review of the Covered Outpatient Drugs Final Rule, which implements provisions of the Affordable Care Act, released by CMS in February. Although it is only about the pricing of outpatient drugs, it is 658 pages and extremely complex. Implementation will cost millions of dollars, which can only add to the cost of drugs.
This rule is a major determinant for the pharmaceutical pricing of all outpatient drugs, both those sold in and out of government programs. With this law, the drug prices in the various sectors of the market are linked. Thus, any change made in the price of a drug in one sector of the market will ripple through the entire price structure of that drug into the other sectors of the market. Because of this, patients who have neither private insurance nor a government plan can wind up paying extremely high prices for their drugs, as can patients when they enter the so-called “doughnut hole.”
Difficulty of determining drug costs
The price of drugs is a concern of states, too. Those states succumbing to the fallacy that price is a function of cost are demanding to know how much it costs to produce a drug so they can pass judgment on its price.
How much a company spends on research and development can be found in its annual audited financial statements, but determining how much was spent for an individual drug is difficult. Most large pharmaceutical companies have multiple drugs in their development pipeline at any one time. Discoveries made when working on one drug might prove to be beneficial in the development of another or unknown future drug. But apportioning costs for an individual drug, especially when multiple drugs might have been using the same research staff, instruments or facility, might be impossible.
To illustrate, endocrinologists could not determine our costs for each individual patient. We would need to factor in the cost of medical school. Younger physicians are still paying off their education loans while senior physicians have already paid off their medical school bills years ago. The new physician might argue that she is justified in charging a higher price than the experienced older physician. And the math gets complex for the physician seeing a patient in one room while waiting for lab results from an assistant for a patient in another room. Both patients are generating costs but from different providers. Even keeping the data to calculate the costs contributes to the cost.
Yet, this is the approach that many are mandating from pharmaceutical companies when they are investigating the price of drugs. But, because price is not a function of cost, these are meaningless mandates that merely send people barking up the wrong tree.
- Reference:
- CMS. Medicaid Program; Covered Outpatient Drugs. Federal Register website. Feb. 1, 2016. Available at: https://www.federalregister.gov/articles/2016/02/01/2016-01274/medicaid-program-covered-outpatient-drugs. Accessed April 19, 2016.
- For more information:
- Richard O. Dolinar, MD, is an Endocrine Today Editorial Board member, and a senior fellow in health care policy at the Heartland Institute. He can be reached at rdolinar@heartland.org. He reports various financial relationships with multiple pharmaceutical companies.