May 6, 2019
My dear Grandkids,
I want to help you think about the cost of drugs because this is a subject about which you will eventually need to do some rigorous thinking. On the left, you hear a lot about “Big Pharma”, the evil ones. The right has very little to say, ignoring real conflicts. Again, our political process does not educate us. But, you’ll get blasted with very unequivocal statements in coming campaigns. So, maybe the following will help you evaluate what you hear.
Why should we care about the cost of drugs? 23% of the cost of Medicare is drugs. Medicare is now forecasted to go broke in 2026. The US spends $10,300 per person, annually, on health care. (2016 statistics), which is 30% larger than the next highest country, which is Switzerland or Norway. 17% of that is for drugs, which is about 3% of US GDP. Health care costs globally are about one trillion dollars. 50% of that is spent in the USA, with less than 5% of the world’s population. If current patterns continue, one-fourth of us will die of cancer. Hey, you need to die of something, so the percentage isn’t the issue. The issue is that the average annual cost of cancer drugs is about $130,000 per year, and it is rising at 20% per year. All drug costs are rising about 6% per year. And if you have cancer, you won’t feel as if it is a discretionary expenditure. Indeed, you’ll feel a bit held hostage. And if the cost pressures on Medicare and private insurance continue, you can bet that you’ll be paying an increasing part of that.
The core economic problem here is quite simple. Nobody is behaving immorally. Everyone is just following the rules of the economic system within which they are playing. Decades ago I was introduced to an IBM model – maybe someone else created it, but this is the way I knew it – for determining the dynamics of product pricing. It had unusual clarity. In a truly market economy, Price is a function of cost, value, and competition. Each element stands alone without human judgment. Whatever it costs you to develop and produce your product, you better get enough revenue to cover that, plus reasonable profit, or you go out of business. This is the low end. At the high end, charge as much as the market will bear. That is, whatever value your buyers place on your product, charge it. However, excess profit – defined as what you earn above cost plus minimum profit to pay for your cost of capital – invites in competitors. Competition pushes prices back toward cost plus minimum necessary profit. This is why fluid and relatively unrestricted competition is so very important in capitalistic markets.
The drug industry has been given permission to not follow this formula. The drug industry is given patent protection for many years after a drug is introduced, during which time they can establish a price that is a pure function of value. What is it worth to you to not die of cancer, during the next six months, the next year, or perhaps for many years? And, for you, is this a need or a want? This is one of those few instances where it really is a need.
Of course, there is also another problem. When your doctor prescribes a drug he/she probably doesn’t even know what it costs. And since you expect your insurance company to pick up most of the tab, or Medicare, you are also not fully interested. Your lack of interest will continue so long as your insurance covers you. But, dear reader, if you are middle age or younger, this game will surely run out. So, here is a very old guy telling you that you better pay attention.
So, I recently did a deep dive – for you – into this. I was influenced by a lecture given by Ezekiel Emanuel at a series sponsored by the RAND Corporation, October 17, 2018. His entire lecture is available on the RAND site. As you all know, I trust RAND, so when they put their imprimatur on it, I regard the data as fact. The data above comes from that lecture, as also that below.
Following are a few other things you should worry about and then we will discuss how reasonable people might think about this. The starting price for cancer drugs in the 1960’s was $100 to $300 per month. By the 1990’s, it was already at $10,000 to $15,000 per month, and growing. If you are one of the 30,000 people who have multi-myeloma, your initial drug treatments and your follow up treatments will cost on average about $500,000. There is an economic problem here when you consider that if you are an American male, with a BA degree, your lifetime earnings are estimated at $2.27 million. Further, according to studies provided by Emanuel, when you subtract from that the lifetime earning amount the cost of rearing children, food, housing, transportation, and public education, such a person will have lifetime disposal income of about $650,000. If you work for 45 years to accumulate these amounts, your average yearly disposable income is about $14,500 per year. Re-read the second paragraph above. The US spend on drugs right now, per year, per person, is $10,300. If you are a family on the wrong side of the median household income of $61,000 per year you are just shit out of luck. Obviously, if you are fortunate enough to be in the upper 5% or a bit more of incomes, you may be less fearful of these numbers. Can we have a Country that fully works for so few people?
I implied above that it is only going to get worse. Under the current system, Big Pharma R & D dollars will be directed at drugs designed to address very serious, and very common disease. Think Alzheimer’s disease. The 5 million unfortunate people with this terrible disease are spending on average $20,000 a year on drugs, which is $100 billion industry wide. And without competitive pressure on new drugs, as the demand increases, the prices will go up much, much faster than inflation, probably between 6%, the current average for all drugs, and 20%, the current average increase per year for cancer drugs.
We have already discussed why costs are so high, because of the absence of competition during the most formative years of a drug’s value. The Pharmaceutical Industry says drugs cost a lot because they are so expensive to develop and because there is so much risk. Well, while there is truth to both of these arguments, the top 20 drug companies made $112 billion operating profit in a recent year, suggesting that cost and risk are not causing their knees to buckle. Moreover, there is no way an industry is going to maximize efficiency when it has price protection. Silicon Valley has learned how to fail quickly. Big Pharma could do will to exercise that model. It really is as simple as this: if you produce something of value you will charge as much for it as you can get until your price starts to reduce your profits. When the government outlaws competition through the patenting process it removes the product from the market. The “markets” as we know and revere them are not functioning. We have already done that.
There is an equally simple solution for the high price of drugs. Put it all back into the “market”. Take the insurance companies out of the game, take the government out of the game, allow consumers to pay for 100% of the price of their drugs and you will see prices tumble like crazy. However, that ship has sailed, and ain’t going back into the harbor because, of course, there are other very negative consequences of returning to a consumer direct pay model for drugs.
Now, this is where it all gets very interesting because the only remedy for unfair pricing within a monopoly is regulation. I listened to Emanuel present a very cogent model of a set of principles that could guide price setting for drugs. In fact, I could probably get on board with his model. Great start for a serious discussion. (Pull up his lecture from the RAND site.) But, I can just imagine the outcry from so many directions at the numerous layers of judgment calls that would be necessary to arrive at his notion of a “fair” price. This is the fact that many people don’t get who are worried about capitalism and markets. If you get rid of the market – price is a function of cost, value and competition – you must replace it with an alternative allocation system. What is that? Your neighbor’s opinion? Your rabbi’s? Your priest’s? Your Congressman’s, god help us? The President’s? The professor’s at Harvard or Stanford? And what makes it fair? What makes it efficient – that is, so huge amounts of resources are not just wasted?
But, here’s the problem. When it comes to health care overall, and drugs in particular, there is an immense clash between what individual citizens are demanding, and what it might cost to meet those demands. Think for a second about what I have written so far. Pause. Now imagine the disaster of having a serious discussion about Medicare for All if you had not previously addressed the problem with drug pricing. And there are very similar problems throughout the entire value chain of Health Care Delivery.
Which means that we, as a nation, may actually be forced to have an adult conversation on this subject. And this is why I write. The Pharmaceutical companies are not bad people. They are just following the economic rules of the game they are playing. But the game needs to be changed. Adjustments need to be made. If you are going to have patents and monopolies, you must have price regulation. Our body politic will need to decide “what is fair and just”. Emanuel’s very sophisticated models suggest that the average person should spend $71,000 during his/her lifetime on drugs. He believes that such a benchmark would still deliver an adequate return on capital to keep most suppliers in the game. Such models need to be torn apart and deeply examined, and compared with others, until we evolve to a solution that the vast majority can agree on.
My purpose here is to provide you some fact based data that may allow you to think about this problem, to guide your informed and considerate discussion with responsible people of varying opinions, and to help you contribute to the evolution of a model that will work for my grandkids, and maybe even my own children. This is an inescapable conflict. It will not simply dissolve. There are no villains. We will need to manage our way into a fair and just model for the future. Good luck.
