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Uwe E. Reinhardt, PhD
James Madison Professor of Political Economy
Princeton University
HOW THE PRODUCERS OF SPECIALTY DRUGSHOW THE PRODUCERS OF SPECIALTY DRUGS
ARE PROBING OUR MORAL VALUESARE PROBING OUR MORAL VALUES
Uwe Reinhardt
Princeton University
Partnership for Quality Care
and
Kaiser Permanente Center for Total Health
2015 PQC FORUM
Sustainable Prescription Drug Pricing
May 15, 2015
I. MODELS OF MODERN CAPITALISM
In a fascinating paper published by the Belgian Brueghel Policy
Contribution, Andre Sapir distinguished between four quite
distinct European models of capitalism, to which one could add
one more of Asian vintage.
http://www.bruegel.org/publications/publication-detail/publication/31-glob
The four European models are:
1. the Nordic model (Denmark, Finland, Sweden, Holland);
2. The Rhineland model (Germany, Austria, Belgium, France and
Luxembourg)
3. The Mediterranean model (Greece, Italy, Spain, Portugal)
4. The Anglo-Saxon model (Ireland, UK, Canada, U.S.)
For Asian countries, one might add “state capitalism,” which has
been the origin of the TIGERS (e.g., Taiwan, Hong-Kong, Korea,
Singapore) and is now the foundation of the Chinese economy.
A distinguishing feature of Anglo-Saxon capitalism is that the
management of the firm, as Board-appointed agents of the
owners, are to operate the company for the economic benefit of
one and only one constituency: the firm’s owners (partners or
shareholders).
ANGLO-SAXON CAPITALISM
MONEY
Fraction of
Social value
captured by
ABC Co. as
“Revenue”
VALUE
SOCIAL VALUE
CREATED
EMPLOYEES
$
R&D INVESTM.$
OWNERS
(Shareholders)
$
The ABC
Pharma
Co.
SOMEONE
INSOCIETY
DISTRIBUTION OFDISTRIBUTION OF
CAPTURED VALUECAPTURED VALUE
RETURNS TORETURNS TO SOCIETYSOCIETY AND TOAND TO INVESTORSINVESTORS IN PHARMA COMPANIESIN PHARMA COMPANIES
SUPPLIERS,
CREDITORS$
GOVERNMENT
RetainedRetained
EarningsEarnings
One has to understand the pricing policies of investor-owned
producers of drugs – be they generic or patent-protected
brand-name drugs) -- within Anglo-Saxon capitalism.
Under the Anglo-Saxon model of capitalism greed is indeed
looked upon as good, as Gordon Gekko so delicately put it in
that movie.
Private equity firms live by that mantra.
Under the Anglo-Saxon model – often decried in Continental
Europe as “savage capitalism” -- it is the fiduciary duty of
management to extract on behalf of the firm’s owners as much
money from the rest of society as can possibly be extracted, by
any legal means, including what is known as “crony
capitalism.”
REVENUE = SPENDING = PRICE EXRACTED x QUANTITY SOLD
There is no point in rendering moral judgment on the pricing behavior
of drug manufacturers.
Anglo-Saxon capitalism is explicitly designed to accept that behavior
as normal and even desirable.
The only way to curb that behavior is either through
1. product markets that are structured to be fiercely price-
competitive, or
2. government set constraints on pricing.
Indeed, drug manufacturers have many defenders, esp. among
economists
How have suppliers of equity capital to pharmaceutical
enterprises fared over time?
SOURCE: http://finance.yahoo.com/q/bc?s=MRK&t=my&l=off&z=l&q=l&c=%5EGSPC
19751975
20152015
SOURCE: http://finance.yahoo.com/q/bc?t=5y&s=MRK&l=on&z=l&q=l&c=&ql=1&c=%5EGSPC
20102010
20152015
SOURCE:http://finance.yahoo.com/q/bc?s=PFE&t=my&l=off&z=l&q=l&c=%5EGSPC
19751975
20152015
SOURCE:http://finance.yahoo.com/q/bc?s=PFE&t=5y&l=off&z=l&q=l&c=%5EGSPC
20102010
20152015
SOURCE:http://finance.yahoo.com/q/bc?s=LLY&t=my&l=off&z=l&q=l&c=%5EGSPC
19751975
20152015
SOURCE: http://finance.yahoo.com/q/bc?t=5y&s=LLY&l=off&z=l&q=l&c=&ql=1&c=%5EGSPC
20102010
20152015
II. PRICES AND COSTS
Among non-economists it is often thought that prices should
be pegged on costs with only a modest margin for profits.
People either get this idea from the medieval theory of “just
price,” or from one Econ 101 lecture in which it is shown that
in perfectly price-competitive markets prices are determined
by the “marginal” buyer and seller.
At that point, the marginal buyer’s bid price just covers the
costs (including a small, normal profit margin) of the marginal
seller.
A
B
D
E
Demand (bid prices)
Supply (production costs)
Price
Q = Qty traded
ACME
APEX
XYX Co.
RVU Co.
C
ABC Co. and C are the
marginal buyer and seller
PRICE DETERMINATION IN A PRICE-COMPETITIVE MARKET
ABC Co.Pe
This competitive model may come close to describing price-
determination for some generic drugs.
But competitive-market mechanism have been ruled out by
the legislature for the express purpose of prohibiting price
competition.
Far from being truly free enterprisers, the research-oriented
pharmaceutical industry is like a little bird in the protective
hand of government.
Drug industry
Government protections granted the research-oriented
pharmaceutical industry:
1. Time-limited monopoly power on brand-name drugs;
2. Sometimes even time-limited market exclusivity;
3. Prohibition of resale among buyers (which allows market
segmentation and price discrimination;
4. Prohibition of parallel imports;
5. Sundry tax breaks.
So there really is no free-market price of specialty drugs.
III. PRICING UNDER MONOPOLY
A. The cost structure of drug manufacturers
The development of a new drug or biological product is aThe development of a new drug or biological product is a
lengthy and highly uncertain venture, usually spanning alengthy and highly uncertain venture, usually spanning a
decade or more, with many dead ends along the way anddecade or more, with many dead ends along the way and
the prospect of ultimate failure ever present.the prospect of ultimate failure ever present.
SOURCE: Adapted from Michael Dickson and Jean Paul Gagnon, “Key Factors in the Rising Cost of NewSOURCE: Adapted from Michael Dickson and Jean Paul Gagnon, “Key Factors in the Rising Cost of New
Drug Discovery and Development,”Drug Discovery and Development,” Nature ReviewsNature Reviews , Volume 3, May 2004:417-29, Figure 1., Volume 3, May 2004:417-29, Figure 1.
NDA ReviewNDA Review
2 mos. – 7 years; avg. 2 years2 mos. – 7 years; avg. 2 years
Preclinical testingPreclinical testing
1 – 3 years; avg. 18 mos1 – 3 years; avg. 18 mos..
Animal testingAnimal testing
Clinical research and testingClinical research and testing
2 – 10 years; avg. 5 years2 – 10 years; avg. 5 years
Phase IPhase I Phase IIPhase II Phase IIIPhase III
NDANDA
submittedsubmitted
NDANDA
approvedapproved
Report of theReport of the
AdvisoryAdvisory
CommitteeCommitteeProb. ofProb. of
survivalsurvival
pp1
Prob. ofProb. of
survivalsurvival
pp2
Prob. ofProb. of
survivalsurvival
pp3
Prob. ofProb. of
survivalsurvival
pp3
Prob. ofProb. of
survivalsurvival
pp4
Prob. ofProb. of
survivalsurvival
pp5
THE DRUG APPROVAL PROCESS IN THE UNITED STATESTHE DRUG APPROVAL PROCESS IN THE UNITED STATES
Only a few of the compound under experiment ever make it throughOnly a few of the compound under experiment ever make it through
the gauntlet of research and trials to end up in a marketable product.the gauntlet of research and trials to end up in a marketable product.
The cost of the thousands of wrongs starts has to be recovered byThe cost of the thousands of wrongs starts has to be recovered by
the winning compound, just as a gusher in an oil company’sthe winning compound, just as a gusher in an oil company’s
exploration program has to help recover the cost of al the dry holesexploration program has to help recover the cost of al the dry holes
that were bored.that were bored.
The opportunity cost of capital funds invested in the R&D phaseThe opportunity cost of capital funds invested in the R&D phase
also must be added to costs to be recovered through prices.also must be added to costs to be recovered through prices.
YRS.YRS.
START OFSTART OF
SALESSALES
START OF R&DSTART OF R&D
PHASEPHASE
|| || || || || || || || || || ||·· ·· ··
THE CASH FLOW INVESTED IN AN R&D PROJECTTHE CASH FLOW INVESTED IN AN R&D PROJECT
CC00 CC11 CC22 CC33 CC44 CC55 CC66 CCN-3N-3 CCN-2N-2 CCN-1N-1 CCNN
AccumulatedAccumulated
future value,future value,
incl. interestincl. interest
on investedon invested
cashcash
etc.etc.
PresentPresent
value ofvalue of
cash flowcash flow
Same cash flow,Same cash flow,
but vastly different PV and FVbut vastly different PV and FV
PRESENT VALUE (PV) AND FUTURE VALUE (FV) OF INVESTING $50
MILLION A YEAR IN R&D (NUMBERS ARE MILLIONS OF
DOLLARS)
COST OF CAPITAL (k0)
N = 10 N = 15
PV(k0) FV(k0) PV(k0) FV(k0)
6% $368 $659 $486 $1,164
9% $321 $760 $403 $1,468
12% $283 $877 $341 $1,864
15% $251 $1,015 $292 $2,379
In Econ 101 terms, the annual amortization of the total costs
sunk into R&D it is part of the F in the total cost function
TC = F + mQ
where
TC = total cost/year,
Q = output volume/year
F = fixed overhead/year,
m = incremental (marginal) cost per unit of Q
Q = Output / periodQ = Output / period
Cost / periodCost / period
Total Cost = Fixed cost/period + unit variable cost x QTotal Cost = Fixed cost/period + unit variable cost x Q
AnnualizedAnnualized
fixed costsfixed costs
The pharmaceutical industry has a very high operating leverageThe pharmaceutical industry has a very high operating leverage
(ratio of fixed to incremental costs), with all the economic problems(ratio of fixed to incremental costs), with all the economic problems
that follow from high operating leverage.that follow from high operating leverage.
Volume of output per year
$/unit
On a unit-cost basis, the cost structure for a new drug looks asOn a unit-cost basis, the cost structure for a new drug looks as
follows:follows:
Marginal Costv
Fully Allocated Cost, including the annualized cost of financing
R&D.
ATC
III. PRICING UNDER MONOPOLY
A. The cost structure of drug manufacturers
B. The sales possibilities curve (alias demand curve)
Output / period
$/unit
THE FIRM’S SALES POSSIBILITY CURVETHE FIRM’S SALES POSSIBILITY CURVE
The firm’s sales possibility curveThe firm’s sales possibility curve
The dots represent the maximum bid pricesThe dots represent the maximum bid prices
marginal buyers would offer for an additionalmarginal buyers would offer for an additional
unit of output at given output volumes alreadyunit of output at given output volumes already
absorbed by the market.absorbed by the market.
These maximum bid prices reflect the real orThese maximum bid prices reflect the real or
imagined value of the drug in the eyes of differentimagined value of the drug in the eyes of different
buyers (both physicians and patients). This imaginedbuyers (both physicians and patients). This imagined
value can, of course, be manipulated throughvalue can, of course, be manipulated through
advertising.advertising.
So here we come to the truly tricky part of the story:So here we come to the truly tricky part of the story:
What monetary value does society put onWhat monetary value does society put on
the outcome that a specialty drug canthe outcome that a specialty drug can
achieve, assuming we can measure thatachieve, assuming we can measure that
outcome?outcome?
For example, what is the monetary valueFor example, what is the monetary value
Americans impute to a Quality-AdjustedAmericans impute to a Quality-Adjusted
Life Year (QALY)?Life Year (QALY)?
-1
-0.9
-0.8
-0.7
-0.6
-0.5
-0.4
-0.3
-0.2
-0.1
03 4 5 6 7 8 9 1 0 1 1 1 2 1 3 1 4 1 5 1 6 1 7 1 8 1 9 2 0 2 1 2 2 2 3 2 4 2 5 2 6 2 7 2 8 2 9 3 0 3 1 3 2
NO. OF QUALITY-ADJUSTED LIFE YEARS (QALYs) SAVED PER YEAR
COSTPERADDITIONALQALYSAVED
THE COST-EFFECTIVE SUPPLY CURVE FOR QUALITY-ADJUSTED LIFE
YEARS WRESTLED FROM NATURE BY A HEALTH SYSTEM
D
C
B
Inefficient
Efficient
A
It is the job of physicians and hospital executives to get
the health system onto its efficient QALY supply curve
It is the politician’s job to determine, on behalf of the people, the
maximum price at which society should buy additional QALYs
with taxpayers’ funds.
It is the peoples’ job to decide whether
the maximum price to be paid per
QALY should vary by the income class
of the person for whom the QALY
would be bought—i.e., to decide what
social ethic should drive our health
system.
The producers of specialty drugs know that Americans areThe producers of specialty drugs know that Americans are
too squeamish to even think about the value of a QALY, astoo squeamish to even think about the value of a QALY, as
they brand anyone who articulates a thought about it athey brand anyone who articulates a thought about it a
Nazi.Nazi.
How the Producers of Specialty Drugs are Probing Our Moral Values
Consider the following statement: "It must be made clear to anyone suffering
from an incurable disease that the useless dissipation of costly medications
drawn from the public store cannot be justified."
This notion is fully in the spirit of the partisans of efficiency but came from a
program instituted in Hitler's Germany called Aktion T-4. Under this program,
elderly people with incurable diseases, young children who were critically
disabled, and others who were deemed non-productive, were euthanized. This
was the Nazi version of efficiency, a pitiless expulsion of the "unproductive"
members of society in the most expeditious way possible.
THE WASHINGTON TIMES
EDITORIAL: “Health 'efficiency' can be deadly”
Wednesday, February 11, 2009
Knowing our reluctance to even think about the monetaryKnowing our reluctance to even think about the monetary
value of a QALY, the producers of specialty drugs now arevalue of a QALY, the producers of specialty drugs now are
probing how high they can push their “value-based” (asprobing how high they can push their “value-based” (as
distinct from cost-based) pricing before we will react anddistinct from cost-based) pricing before we will react and
push back.push back.
They do so not with one single price charged all potentialThey do so not with one single price charged all potential
buyers, but through the judicious price discriminationbuyers, but through the judicious price discrimination
made possible by the prohibition of resales amongmade possible by the prohibition of resales among
customers.customers.
III. PRICING UNDER MONOPOLY
A. The cost structure of drug manufacturers
B. The sales possibilities curve (alias demand curve)
B. The mechanics of price discrimination
Output / period
$/unit
Incremental Cost
Unit total cost
THE COST STRUCTURE OF A PHARMACEUTICAL COMPANYTHE COST STRUCTURE OF A PHARMACEUTICAL COMPANY
Output / period
$/unit
SOCIETY’S MARGINAL VALUE CURVESOCIETY’S MARGINAL VALUE CURVE
The firm’s sales possibility curveThe firm’s sales possibility curve
Output / period
$/unit
Incremental Cost
Unit total cost
PP11
QQ11
ATCATC11
Profit
FOR A DRUG UNDER PATENT PROTECTION WOULD AFOR A DRUG UNDER PATENT PROTECTION WOULD A SINGLE-PRICESINGLE-PRICE POLICY BEPOLICY BE
DESIRABLE FROM SOCIETY’S POINT OF VIEW?DESIRABLE FROM SOCIETY’S POINT OF VIEW?
Output / period
$/unit
Incremental Cost
Unit total cost
PP11
QQ11
Profit
DOING BETTER BY DOING GOOD: PRICE DISCRIMINATIONDOING BETTER BY DOING GOOD: PRICE DISCRIMINATION
PP22
QQ22
$/unit
Incremental Cost
Unit total cost
PP11
QQ11
Profit
FOR A DRUG UNDER PATENT PROTECTION WOULD A SINGLE-PRICE POLICY BEFOR A DRUG UNDER PATENT PROTECTION WOULD A SINGLE-PRICE POLICY BE
DESIRABLE FROM SOCIETY’S POINT OF VIEW?DESIRABLE FROM SOCIETY’S POINT OF VIEW?
PP22
QQ22 QQ33
PP33
QQ44
PP44
IV. CAN SOCIETY PUSH BACK?
SOURCE: Hirsch, Bradford R., Suresh Balu, and Kevin A. Schulman. "The Impact Of Specialty
Pharmaceuticals As Drivers Of Health Care Costs." Health Affairs 33.10 (2014): 1714-1720.
Net Social Value
Added by the
Health System
Net Social Value
Added by the
Health System
=
Gross Value
Added by Health
Care to Patients
Gross Value
Added by Health
Care to Patients
The Opportunity
Costs of that Care
for Society
The Opportunity
Costs of that Care
for Society
-
Among these opportunity costs are:
• Neglecting the education of our young
• Neglecting science and R&D
• Neglecting the nation’s infrastructure
• Neglecting the nation’s internal and external securities
• Neglecting cultural investments
• Giving up other things families might want
HEALTH-CARE SPENDING HAS OPPORTUNITY COSTS
SOURCE:Fiscal 2011 data based on enacted budgets; fiscal 2012 data based on governor's proposed budgets
Source: National Association of State Budget Officers, as presented by Dan Crippen, National Governors Association. Cited by Eugene
Steuerle, Education Presidents And Governors: Ain’t Gonna Happen, February 20, 2013.
Look at this trade-off and think of education
in Shanghai or Seoul.
A case can be made that government has the right to limit the
profits that can be extracted from the rest of society for a
specialty drug, by means of the sundry protections government
grants the drug industry and, thus, society’s opportunity costs.
Society has a right to inquire what
life styles among the producers of
specialty drugs a given drug must
support for us to have sufficient
innovation in health care.
Government, for example, might impose a price ceiling onGovernment, for example, might impose a price ceiling on
specialty-drug producers in a way to grants them a veryspecialty-drug producers in a way to grants them a very
high but not what is deemed excessive rate of return onhigh but not what is deemed excessive rate of return on
invested capital.invested capital.
The UK has engaged in such rate-of-return regulation inThe UK has engaged in such rate-of-return regulation in
putting price ceilings on patented drugs.putting price ceilings on patented drugs.
Output / period
$/unit
Incremental Cost
Unit total cost
PP11
QQ11
ATCATC11
Profit
RATE-OF-RETURN REGULATION OF DRUG PRICES (as in UK)RATE-OF-RETURN REGULATION OF DRUG PRICES (as in UK)
P1
Price ceilingPrice ceilingPc
Profit
Reference pricing on the German model can sometimes beReference pricing on the German model can sometimes be
used to rein in drug prices.used to rein in drug prices.
That model, however, cannot be used for truly uniqueThat model, however, cannot be used for truly unique
products without close substitutes.products without close substitutes.
Some countries (Japan and France, I think) have initiallySome countries (Japan and France, I think) have initially
allowed high prices but subjects them to a mathematicalallowed high prices but subjects them to a mathematical
decay function that lowers prices systematically over time.decay function that lowers prices systematically over time.
Len Nichols has yet other ideas for pushback that he willLen Nichols has yet other ideas for pushback that he will
explain.explain.
In the interim, however, I recommend that insurers treat their outlays onIn the interim, however, I recommend that insurers treat their outlays on
specialty drugs as limousine companies routinely do with rising fuelspecialty drugs as limousine companies routinely do with rising fuel
costs.costs.
It would mean that premium increases would be presented to the insured inIt would mean that premium increases would be presented to the insured in
two parts:two parts:
1.1. a regular part, anda regular part, and
2.2. a surcharge reflecting the rising cost of specialty drugs.a surcharge reflecting the rising cost of specialty drugs.
Included in the statement should be a list of specialty drugs along withIncluded in the statement should be a list of specialty drugs along with
the cost of those drugs per treatment and the name of thethe cost of those drugs per treatment and the name of the
manufacturer.manufacturer.
Full transparency vis a vis patients could only be helpful.Full transparency vis a vis patients could only be helpful.
IV. CONCLUDING OBSERVATION
Having studies health policy and debate around it, I haveHaving studies health policy and debate around it, I have
found that in no other country does there reign as muchfound that in no other country does there reign as much
mental confusion over health policy as it does in the Unitedmental confusion over health policy as it does in the United
States.States.
It is not at all uncommon for the producers of new medicalIt is not at all uncommon for the producers of new medical
technology totechnology to
1.1. lament limits on the “reimbursement” for their products;lament limits on the “reimbursement” for their products;
2.2. argue that everyone in society should have access to theirargue that everyone in society should have access to their
products; but alsoproducts; but also
3.3. Deplore increase in insurance premiums and taxesDeplore increase in insurance premiums and taxes
all with the utmost sincerity.all with the utmost sincerity.
It is both touching and frustrating.It is both touching and frustrating.
A little education here certainly would help.A little education here certainly would help.
THANK YOU FOR YOUR ATTENTIONTHANK YOU FOR YOUR ATTENTION

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How the Producers of Specialty Drugs are Probing Our Moral Values

  • 1. Uwe E. Reinhardt, PhD James Madison Professor of Political Economy Princeton University
  • 2. HOW THE PRODUCERS OF SPECIALTY DRUGSHOW THE PRODUCERS OF SPECIALTY DRUGS ARE PROBING OUR MORAL VALUESARE PROBING OUR MORAL VALUES Uwe Reinhardt Princeton University Partnership for Quality Care and Kaiser Permanente Center for Total Health 2015 PQC FORUM Sustainable Prescription Drug Pricing May 15, 2015
  • 3. I. MODELS OF MODERN CAPITALISM
  • 4. In a fascinating paper published by the Belgian Brueghel Policy Contribution, Andre Sapir distinguished between four quite distinct European models of capitalism, to which one could add one more of Asian vintage.
  • 6. The four European models are: 1. the Nordic model (Denmark, Finland, Sweden, Holland); 2. The Rhineland model (Germany, Austria, Belgium, France and Luxembourg) 3. The Mediterranean model (Greece, Italy, Spain, Portugal) 4. The Anglo-Saxon model (Ireland, UK, Canada, U.S.) For Asian countries, one might add “state capitalism,” which has been the origin of the TIGERS (e.g., Taiwan, Hong-Kong, Korea, Singapore) and is now the foundation of the Chinese economy.
  • 7. A distinguishing feature of Anglo-Saxon capitalism is that the management of the firm, as Board-appointed agents of the owners, are to operate the company for the economic benefit of one and only one constituency: the firm’s owners (partners or shareholders). ANGLO-SAXON CAPITALISM
  • 8. MONEY Fraction of Social value captured by ABC Co. as “Revenue” VALUE SOCIAL VALUE CREATED EMPLOYEES $ R&D INVESTM.$ OWNERS (Shareholders) $ The ABC Pharma Co. SOMEONE INSOCIETY DISTRIBUTION OFDISTRIBUTION OF CAPTURED VALUECAPTURED VALUE RETURNS TORETURNS TO SOCIETYSOCIETY AND TOAND TO INVESTORSINVESTORS IN PHARMA COMPANIESIN PHARMA COMPANIES SUPPLIERS, CREDITORS$ GOVERNMENT RetainedRetained EarningsEarnings
  • 9. One has to understand the pricing policies of investor-owned producers of drugs – be they generic or patent-protected brand-name drugs) -- within Anglo-Saxon capitalism. Under the Anglo-Saxon model of capitalism greed is indeed looked upon as good, as Gordon Gekko so delicately put it in that movie. Private equity firms live by that mantra.
  • 10. Under the Anglo-Saxon model – often decried in Continental Europe as “savage capitalism” -- it is the fiduciary duty of management to extract on behalf of the firm’s owners as much money from the rest of society as can possibly be extracted, by any legal means, including what is known as “crony capitalism.” REVENUE = SPENDING = PRICE EXRACTED x QUANTITY SOLD
  • 11. There is no point in rendering moral judgment on the pricing behavior of drug manufacturers. Anglo-Saxon capitalism is explicitly designed to accept that behavior as normal and even desirable. The only way to curb that behavior is either through 1. product markets that are structured to be fiercely price- competitive, or 2. government set constraints on pricing. Indeed, drug manufacturers have many defenders, esp. among economists
  • 12. How have suppliers of equity capital to pharmaceutical enterprises fared over time?
  • 19. II. PRICES AND COSTS
  • 20. Among non-economists it is often thought that prices should be pegged on costs with only a modest margin for profits. People either get this idea from the medieval theory of “just price,” or from one Econ 101 lecture in which it is shown that in perfectly price-competitive markets prices are determined by the “marginal” buyer and seller. At that point, the marginal buyer’s bid price just covers the costs (including a small, normal profit margin) of the marginal seller.
  • 21. A B D E Demand (bid prices) Supply (production costs) Price Q = Qty traded ACME APEX XYX Co. RVU Co. C ABC Co. and C are the marginal buyer and seller PRICE DETERMINATION IN A PRICE-COMPETITIVE MARKET ABC Co.Pe
  • 22. This competitive model may come close to describing price- determination for some generic drugs. But competitive-market mechanism have been ruled out by the legislature for the express purpose of prohibiting price competition.
  • 23. Far from being truly free enterprisers, the research-oriented pharmaceutical industry is like a little bird in the protective hand of government. Drug industry
  • 24. Government protections granted the research-oriented pharmaceutical industry: 1. Time-limited monopoly power on brand-name drugs; 2. Sometimes even time-limited market exclusivity; 3. Prohibition of resale among buyers (which allows market segmentation and price discrimination; 4. Prohibition of parallel imports; 5. Sundry tax breaks. So there really is no free-market price of specialty drugs.
  • 25. III. PRICING UNDER MONOPOLY A. The cost structure of drug manufacturers
  • 26. The development of a new drug or biological product is aThe development of a new drug or biological product is a lengthy and highly uncertain venture, usually spanning alengthy and highly uncertain venture, usually spanning a decade or more, with many dead ends along the way anddecade or more, with many dead ends along the way and the prospect of ultimate failure ever present.the prospect of ultimate failure ever present.
  • 27. SOURCE: Adapted from Michael Dickson and Jean Paul Gagnon, “Key Factors in the Rising Cost of NewSOURCE: Adapted from Michael Dickson and Jean Paul Gagnon, “Key Factors in the Rising Cost of New Drug Discovery and Development,”Drug Discovery and Development,” Nature ReviewsNature Reviews , Volume 3, May 2004:417-29, Figure 1., Volume 3, May 2004:417-29, Figure 1. NDA ReviewNDA Review 2 mos. – 7 years; avg. 2 years2 mos. – 7 years; avg. 2 years Preclinical testingPreclinical testing 1 – 3 years; avg. 18 mos1 – 3 years; avg. 18 mos.. Animal testingAnimal testing Clinical research and testingClinical research and testing 2 – 10 years; avg. 5 years2 – 10 years; avg. 5 years Phase IPhase I Phase IIPhase II Phase IIIPhase III NDANDA submittedsubmitted NDANDA approvedapproved Report of theReport of the AdvisoryAdvisory CommitteeCommitteeProb. ofProb. of survivalsurvival pp1 Prob. ofProb. of survivalsurvival pp2 Prob. ofProb. of survivalsurvival pp3 Prob. ofProb. of survivalsurvival pp3 Prob. ofProb. of survivalsurvival pp4 Prob. ofProb. of survivalsurvival pp5 THE DRUG APPROVAL PROCESS IN THE UNITED STATESTHE DRUG APPROVAL PROCESS IN THE UNITED STATES
  • 28. Only a few of the compound under experiment ever make it throughOnly a few of the compound under experiment ever make it through the gauntlet of research and trials to end up in a marketable product.the gauntlet of research and trials to end up in a marketable product. The cost of the thousands of wrongs starts has to be recovered byThe cost of the thousands of wrongs starts has to be recovered by the winning compound, just as a gusher in an oil company’sthe winning compound, just as a gusher in an oil company’s exploration program has to help recover the cost of al the dry holesexploration program has to help recover the cost of al the dry holes that were bored.that were bored. The opportunity cost of capital funds invested in the R&D phaseThe opportunity cost of capital funds invested in the R&D phase also must be added to costs to be recovered through prices.also must be added to costs to be recovered through prices.
  • 29. YRS.YRS. START OFSTART OF SALESSALES START OF R&DSTART OF R&D PHASEPHASE || || || || || || || || || || ||·· ·· ·· THE CASH FLOW INVESTED IN AN R&D PROJECTTHE CASH FLOW INVESTED IN AN R&D PROJECT CC00 CC11 CC22 CC33 CC44 CC55 CC66 CCN-3N-3 CCN-2N-2 CCN-1N-1 CCNN AccumulatedAccumulated future value,future value, incl. interestincl. interest on investedon invested cashcash etc.etc. PresentPresent value ofvalue of cash flowcash flow Same cash flow,Same cash flow, but vastly different PV and FVbut vastly different PV and FV
  • 30. PRESENT VALUE (PV) AND FUTURE VALUE (FV) OF INVESTING $50 MILLION A YEAR IN R&D (NUMBERS ARE MILLIONS OF DOLLARS) COST OF CAPITAL (k0) N = 10 N = 15 PV(k0) FV(k0) PV(k0) FV(k0) 6% $368 $659 $486 $1,164 9% $321 $760 $403 $1,468 12% $283 $877 $341 $1,864 15% $251 $1,015 $292 $2,379
  • 31. In Econ 101 terms, the annual amortization of the total costs sunk into R&D it is part of the F in the total cost function TC = F + mQ where TC = total cost/year, Q = output volume/year F = fixed overhead/year, m = incremental (marginal) cost per unit of Q
  • 32. Q = Output / periodQ = Output / period Cost / periodCost / period Total Cost = Fixed cost/period + unit variable cost x QTotal Cost = Fixed cost/period + unit variable cost x Q AnnualizedAnnualized fixed costsfixed costs The pharmaceutical industry has a very high operating leverageThe pharmaceutical industry has a very high operating leverage (ratio of fixed to incremental costs), with all the economic problems(ratio of fixed to incremental costs), with all the economic problems that follow from high operating leverage.that follow from high operating leverage.
  • 33. Volume of output per year $/unit On a unit-cost basis, the cost structure for a new drug looks asOn a unit-cost basis, the cost structure for a new drug looks as follows:follows: Marginal Costv Fully Allocated Cost, including the annualized cost of financing R&D. ATC
  • 34. III. PRICING UNDER MONOPOLY A. The cost structure of drug manufacturers B. The sales possibilities curve (alias demand curve)
  • 35. Output / period $/unit THE FIRM’S SALES POSSIBILITY CURVETHE FIRM’S SALES POSSIBILITY CURVE The firm’s sales possibility curveThe firm’s sales possibility curve The dots represent the maximum bid pricesThe dots represent the maximum bid prices marginal buyers would offer for an additionalmarginal buyers would offer for an additional unit of output at given output volumes alreadyunit of output at given output volumes already absorbed by the market.absorbed by the market. These maximum bid prices reflect the real orThese maximum bid prices reflect the real or imagined value of the drug in the eyes of differentimagined value of the drug in the eyes of different buyers (both physicians and patients). This imaginedbuyers (both physicians and patients). This imagined value can, of course, be manipulated throughvalue can, of course, be manipulated through advertising.advertising.
  • 36. So here we come to the truly tricky part of the story:So here we come to the truly tricky part of the story: What monetary value does society put onWhat monetary value does society put on the outcome that a specialty drug canthe outcome that a specialty drug can achieve, assuming we can measure thatachieve, assuming we can measure that outcome?outcome? For example, what is the monetary valueFor example, what is the monetary value Americans impute to a Quality-AdjustedAmericans impute to a Quality-Adjusted Life Year (QALY)?Life Year (QALY)?
  • 37. -1 -0.9 -0.8 -0.7 -0.6 -0.5 -0.4 -0.3 -0.2 -0.1 03 4 5 6 7 8 9 1 0 1 1 1 2 1 3 1 4 1 5 1 6 1 7 1 8 1 9 2 0 2 1 2 2 2 3 2 4 2 5 2 6 2 7 2 8 2 9 3 0 3 1 3 2 NO. OF QUALITY-ADJUSTED LIFE YEARS (QALYs) SAVED PER YEAR COSTPERADDITIONALQALYSAVED THE COST-EFFECTIVE SUPPLY CURVE FOR QUALITY-ADJUSTED LIFE YEARS WRESTLED FROM NATURE BY A HEALTH SYSTEM D C B Inefficient Efficient A It is the job of physicians and hospital executives to get the health system onto its efficient QALY supply curve It is the politician’s job to determine, on behalf of the people, the maximum price at which society should buy additional QALYs with taxpayers’ funds. It is the peoples’ job to decide whether the maximum price to be paid per QALY should vary by the income class of the person for whom the QALY would be bought—i.e., to decide what social ethic should drive our health system.
  • 38. The producers of specialty drugs know that Americans areThe producers of specialty drugs know that Americans are too squeamish to even think about the value of a QALY, astoo squeamish to even think about the value of a QALY, as they brand anyone who articulates a thought about it athey brand anyone who articulates a thought about it a Nazi.Nazi.
  • 40. Consider the following statement: "It must be made clear to anyone suffering from an incurable disease that the useless dissipation of costly medications drawn from the public store cannot be justified." This notion is fully in the spirit of the partisans of efficiency but came from a program instituted in Hitler's Germany called Aktion T-4. Under this program, elderly people with incurable diseases, young children who were critically disabled, and others who were deemed non-productive, were euthanized. This was the Nazi version of efficiency, a pitiless expulsion of the "unproductive" members of society in the most expeditious way possible. THE WASHINGTON TIMES EDITORIAL: “Health 'efficiency' can be deadly” Wednesday, February 11, 2009
  • 41. Knowing our reluctance to even think about the monetaryKnowing our reluctance to even think about the monetary value of a QALY, the producers of specialty drugs now arevalue of a QALY, the producers of specialty drugs now are probing how high they can push their “value-based” (asprobing how high they can push their “value-based” (as distinct from cost-based) pricing before we will react anddistinct from cost-based) pricing before we will react and push back.push back. They do so not with one single price charged all potentialThey do so not with one single price charged all potential buyers, but through the judicious price discriminationbuyers, but through the judicious price discrimination made possible by the prohibition of resales amongmade possible by the prohibition of resales among customers.customers.
  • 42. III. PRICING UNDER MONOPOLY A. The cost structure of drug manufacturers B. The sales possibilities curve (alias demand curve) B. The mechanics of price discrimination
  • 43. Output / period $/unit Incremental Cost Unit total cost THE COST STRUCTURE OF A PHARMACEUTICAL COMPANYTHE COST STRUCTURE OF A PHARMACEUTICAL COMPANY
  • 44. Output / period $/unit SOCIETY’S MARGINAL VALUE CURVESOCIETY’S MARGINAL VALUE CURVE The firm’s sales possibility curveThe firm’s sales possibility curve
  • 45. Output / period $/unit Incremental Cost Unit total cost PP11 QQ11 ATCATC11 Profit FOR A DRUG UNDER PATENT PROTECTION WOULD AFOR A DRUG UNDER PATENT PROTECTION WOULD A SINGLE-PRICESINGLE-PRICE POLICY BEPOLICY BE DESIRABLE FROM SOCIETY’S POINT OF VIEW?DESIRABLE FROM SOCIETY’S POINT OF VIEW?
  • 46. Output / period $/unit Incremental Cost Unit total cost PP11 QQ11 Profit DOING BETTER BY DOING GOOD: PRICE DISCRIMINATIONDOING BETTER BY DOING GOOD: PRICE DISCRIMINATION PP22 QQ22
  • 47. $/unit Incremental Cost Unit total cost PP11 QQ11 Profit FOR A DRUG UNDER PATENT PROTECTION WOULD A SINGLE-PRICE POLICY BEFOR A DRUG UNDER PATENT PROTECTION WOULD A SINGLE-PRICE POLICY BE DESIRABLE FROM SOCIETY’S POINT OF VIEW?DESIRABLE FROM SOCIETY’S POINT OF VIEW? PP22 QQ22 QQ33 PP33 QQ44 PP44
  • 48. IV. CAN SOCIETY PUSH BACK?
  • 49. SOURCE: Hirsch, Bradford R., Suresh Balu, and Kevin A. Schulman. "The Impact Of Specialty Pharmaceuticals As Drivers Of Health Care Costs." Health Affairs 33.10 (2014): 1714-1720.
  • 50. Net Social Value Added by the Health System Net Social Value Added by the Health System = Gross Value Added by Health Care to Patients Gross Value Added by Health Care to Patients The Opportunity Costs of that Care for Society The Opportunity Costs of that Care for Society - Among these opportunity costs are: • Neglecting the education of our young • Neglecting science and R&D • Neglecting the nation’s infrastructure • Neglecting the nation’s internal and external securities • Neglecting cultural investments • Giving up other things families might want HEALTH-CARE SPENDING HAS OPPORTUNITY COSTS
  • 51. SOURCE:Fiscal 2011 data based on enacted budgets; fiscal 2012 data based on governor's proposed budgets Source: National Association of State Budget Officers, as presented by Dan Crippen, National Governors Association. Cited by Eugene Steuerle, Education Presidents And Governors: Ain’t Gonna Happen, February 20, 2013. Look at this trade-off and think of education in Shanghai or Seoul.
  • 52. A case can be made that government has the right to limit the profits that can be extracted from the rest of society for a specialty drug, by means of the sundry protections government grants the drug industry and, thus, society’s opportunity costs. Society has a right to inquire what life styles among the producers of specialty drugs a given drug must support for us to have sufficient innovation in health care.
  • 53. Government, for example, might impose a price ceiling onGovernment, for example, might impose a price ceiling on specialty-drug producers in a way to grants them a veryspecialty-drug producers in a way to grants them a very high but not what is deemed excessive rate of return onhigh but not what is deemed excessive rate of return on invested capital.invested capital. The UK has engaged in such rate-of-return regulation inThe UK has engaged in such rate-of-return regulation in putting price ceilings on patented drugs.putting price ceilings on patented drugs.
  • 54. Output / period $/unit Incremental Cost Unit total cost PP11 QQ11 ATCATC11 Profit RATE-OF-RETURN REGULATION OF DRUG PRICES (as in UK)RATE-OF-RETURN REGULATION OF DRUG PRICES (as in UK) P1 Price ceilingPrice ceilingPc Profit
  • 55. Reference pricing on the German model can sometimes beReference pricing on the German model can sometimes be used to rein in drug prices.used to rein in drug prices. That model, however, cannot be used for truly uniqueThat model, however, cannot be used for truly unique products without close substitutes.products without close substitutes.
  • 56. Some countries (Japan and France, I think) have initiallySome countries (Japan and France, I think) have initially allowed high prices but subjects them to a mathematicalallowed high prices but subjects them to a mathematical decay function that lowers prices systematically over time.decay function that lowers prices systematically over time.
  • 57. Len Nichols has yet other ideas for pushback that he willLen Nichols has yet other ideas for pushback that he will explain.explain.
  • 58. In the interim, however, I recommend that insurers treat their outlays onIn the interim, however, I recommend that insurers treat their outlays on specialty drugs as limousine companies routinely do with rising fuelspecialty drugs as limousine companies routinely do with rising fuel costs.costs. It would mean that premium increases would be presented to the insured inIt would mean that premium increases would be presented to the insured in two parts:two parts: 1.1. a regular part, anda regular part, and 2.2. a surcharge reflecting the rising cost of specialty drugs.a surcharge reflecting the rising cost of specialty drugs. Included in the statement should be a list of specialty drugs along withIncluded in the statement should be a list of specialty drugs along with the cost of those drugs per treatment and the name of thethe cost of those drugs per treatment and the name of the manufacturer.manufacturer.
  • 59. Full transparency vis a vis patients could only be helpful.Full transparency vis a vis patients could only be helpful.
  • 61. Having studies health policy and debate around it, I haveHaving studies health policy and debate around it, I have found that in no other country does there reign as muchfound that in no other country does there reign as much mental confusion over health policy as it does in the Unitedmental confusion over health policy as it does in the United States.States.
  • 62. It is not at all uncommon for the producers of new medicalIt is not at all uncommon for the producers of new medical technology totechnology to 1.1. lament limits on the “reimbursement” for their products;lament limits on the “reimbursement” for their products; 2.2. argue that everyone in society should have access to theirargue that everyone in society should have access to their products; but alsoproducts; but also 3.3. Deplore increase in insurance premiums and taxesDeplore increase in insurance premiums and taxes all with the utmost sincerity.all with the utmost sincerity. It is both touching and frustrating.It is both touching and frustrating. A little education here certainly would help.A little education here certainly would help.
  • 63. THANK YOU FOR YOUR ATTENTIONTHANK YOU FOR YOUR ATTENTION