High Prices Today, Effective Drugs Tomorrow

From Megan McArdle.

"A few days ago, Sarah Kliff of Vox published a sort of cartoon guide to pharmaceutical pricing, which I recommend. The basic arguments will probably be familiar to readers of this column, but her stick figures make an important point: When we talk about what to do about pharmaceutical prices, we have to think hard about the trade-offs we’re willing to make.

America pays higher prices for drugs because the government doesn’t negotiate with insurers. The government doesn’t negotiate with insurers in part because we have a powerful pharmaceutical industry that lobbies the government not to, but also in part because we’re not willing to have the government say, “Nope, we’ve decided you can’t sell your expensive treatment here,” which is a major way that other governments get their bargaining power. Telling Americans they can’t have stuff is really politically unpopular, so we mostly don’t do that. Instead, we pay some of the highest prices in the world for prescription drugs.

That sounds terrible! But it also has a benefit: Those profits give drug companies the necessary incentive for innovation.

This issue is often misunderstood on the left, where the argument goes: “If we slashed their profits by 90 percent, they’d still be making money, so obviously they don’t need such high profits in order to do research.” This is a fundamental misunderstanding of how profits function in the pharmaceutical industry, where funding research is not a budget problem; it’s an investment problem.

A budget problem is deciding whether you want to buy steak or tofu. You’re definitely going to eat; the question is only how much you’re going to spend to do so. An investment problem is how you decide how much you want to gamble on future gains, instead of spending that money on something you’d like to consume right now. One major consideration is not just how much you’d like to invest, but where you’d like to invest it. And when you start looking at investment, you quickly start thinking about risk versus reward.

You probably do this in your own financial life. You can buy a new flat panel television, which would definitely be nice. Or you could put that money in the bank, where it will earn you some nanofraction of a cent in interest and frequent e-mails from your bank urging you to “go green” and sign up for electronic statements. Or you could invest it in the stock market, where the potential returns are much higher but there’s also a greater possibility that you will lose your investment. When you decide how much of your money to put in each place, you’re making a trade-off between risks and potential rewards.

Investors also do this when they’re deciding which companies to invest in: a grocery store that offers razor-thin profit margins, but probably isn’t going to see demand for its product vanish any time soon, or something like a tech startup, where you could make a lot of money or you could end up with some commemorative stock shares from Pets.com.

Companies go through a version of the same process when they decide what internal projects get funded.

Pharmaceutical investment is a particularly risky move, because it requires a huge amount of money to research and develop a new drug. And unlike most markets, there’s a binary hurdle once you’ve finished developing the product: Either you get FDA approval, or you don’t. Most drug candidates don’t pan out, and all that invested money is a complete write-off.

So consider the math of our two potential investments: groceries or pharmaceuticals. If you invest in groceries, you get, say, a 5 percent return on your money, all but guaranteed. That same investment in pharmaceutical research may get, a 100 percent return on your money if their new drug candidate succeeds, but there’s a 90 percent chance of getting nothing.


If you just look at the profits, the biotech firm seems to be an obviously better option -- 100 percent returns! Once you add in risk, however, it doesn’t look nearly as exciting; the expected value of your biotech investment is only 10 percent (because of the likelihood of a whiff), while the expected value of your grocery investment is 5 percent.

The biotech firm still has a higher expected value, of course. Investments with highly variable returns need to pay a “risk premium” because people worry about losing everything, which is why stocks offer higher long-term returns than bonds and why pharmaceutical companies have higher profit margins than Wal-Mart.

America’s high pharmaceutical prices are what compensates pharmaceutical firms for the risk of developing drugs. If we drive them lower, we’ll get fewer new drugs. That makes for a hard trade-off: Higher prices drive up the cost of health care and mean that some folks may have trouble accessing the latest wonder drugs until they lose patent protection after a decade or so.

There’s certainly a conversation worth having about whether the innovations we’re getting are worth the cost we’re paying. At a time when we’re getting exciting new treatments for intractable diseases like cancer and Hepatitis C, I’d say the answer is “yes”; others will have different answers.

But as we’re having this conversation, there’s one thing we should keep in mind: the people who are missing from the discussion. Which is to say, the people, many of them unborn, who aren’t sick yet but will be, and who could be helped or even cured by treatments that haven’t yet been developed.
Pharmaceutical research is cumulative. With the notable exception of antimicrobials, whose usefulness degrades over time because strains of bacteria and viruses and fungi develop drug resistance, every new innovation goes into our disease-fighting arsenal and stays there to help every future patient. After a few years of obscene profits, most of these innovations will be pretty cheap and widely available.

Every useful weapon we decide not to try to produce for that arsenal comes at a cost to future people's health.

This matters because there are a lot of future people -- more than there are current people. They don’t get a voice in today’s debates, but we should consider their interests when we talk about pharmaceutical pricing, as we do when we debate what to do about global warming or our entitlements crisis. We’re certainly leaving future generations enough problems. Let’s offer them some solutions as well.

These numbers are completely made up for ease of mathematical calculation and illustration. They are not to be taken as actual values for the potential returns on either grocery stocks, or biotech investments."