What's a Fair Price for Drugs?

Yes, the U.S. pays too much for its medicine. But don't blame it all on drugmakers

In the past few months, drugmakers like Merck & Co. (MRK ) and Abbott Laboratories Inc. (ABT ) have slashed prices for anti-HIV drugs in AIDS-ravaged Africa. Instead of charging $10,000 to $15,000 per year as in the U.S., they will sell their medicines for as little as $600 a year.

This dramatic move gets drugmakers off the hot seat. No longer can they be accused of raking in billions in profits while ignoring the suffering and deaths of millions. But the result will be a stark difference in prices, which will raise the perennial question of why drug prices are so high in the U.S. compared with the rest of the world. "The humanitarian effort could come back and hit them in the eye," says Nancy Myers, senior research analyst at Lehman Brothers Inc.

The deep discounts raise other issues as well. All along, drugmakers have said they need high prices to pay the steep cost of research and development. But do they really? If they can sell AIDS drugs or other medicines for pennies a pill in Africa--or at 60% of the U.S. price in Europe--doesn't that undercut the R&D argument?

The industry's critics think so. Public Citizen notes that the 11 biggest drugmakers raked in $28 billion in profits last year--and for eight of them, profits were higher than R&D spending. "They don't have to make that money in order to do R&D," says Abbey S. Meyers, president of the National Organization for Rare Disorders. "That's the excuse they've been using for years--and no one believes it anymore."

So who's right? There's no simple answer. But here's a step-by-step journey through the thicket of arguments surrounding drug prices:

Should drugmakers offer deep discounts to developing nations?

Unequivocally, yes--and not just for humanitarian reasons. "The economic theory and evidence is clear: Differential pricing can benefit consumers in low-income countries without harming--and perhaps even benefiting--consumers in high-income countries," observes Dr. Jonathan D. Quick, director of essential drugs and medicines policy at the World Health Organization.

Here's why. Most drugs cost only pennies per pill to make. Selling them cheaply to poor nations therefore costs drugmakers nothing--and can even bring in profits that help support new R&D. "It's win-win. Drugmakers would be doing good in the world, creating markets--and making marginal profits," explains Barry R. Bloom, dean of the Harvard School of Public Health.

O.K., but does this mean Americans are shouldering the burden of paying for R&D through high prices?

Yes. And Americans may actually be paying a bit too much--as we'll see below. But at the same time, the U.S. gets the benefits. Even at today's prices, with the nation's total pharmaceutical bill soaring from $51 billion in 1993 to a projected $136 billion in 2001, there are plenty of economists who consider drugs a bargain. Cholesterol-lowering drugs such as Merck & Co.'s Zocor or Pfizer Inc.'s (PFE ) Lipitor, for instance, can prevent heart disease, saving big bucks on surgery and hospitalizations. "We should be happy that pharmaceuticals are the fastest-growing component of the health-care budget, because it means that other components aren't growing as fast as they otherwise would," says pharmaceutical economist Eugene Mick Kolassa at the University of Mississippi.

Is expensive R&D the determining factor in drug pricing?

Contrary to industry's claims, not really. The way a drug's price is set has little or nothing to do with how much that drug costs to develop. Instead, pharmaceuticals are just like any other product: Companies charge what the market will bear. An improved version of heparin, a blood thinner used to prevent clots during procedures such as hip surgery, saves an average of $200 in medical costs each time it's used. So companies charge 100 times more than they did for the original heparin--and still produce overall health-care savings.

Setting prices on considerations such as these is just Economics 101 for drugmakers. Contends Stanford health-care economist Dr. Alan M. Garber: "It would be unfair to portray them as greedy or irresponsible if they charge what they can get."

In this context, are prices really too high in the U.S.?

Yes, many economists say--and they blame our health-care system. In short, it's not a free market. Among purchasers, there's little competition that would exert downward pressures on prices. And under most insurance schemes, neither doctors nor consumers have incentives to seek out and buy the drugs that offer the best value. "Resources are best allocated when markets determine the price, based on value to consumers," says Joseph A. DiMasi, director of economic analysis at the Tufts University Center for the Study of Drug Development. "We're a good distance from that."

High prices do mean that companies can do more R&D. But how much does R&D really cost?

Industry likes to claim that drug development takes a dozen years and costs up to $500 million. The number originally comes from a 1991 study in which DiMasi and colleagues collected data from 12 pharmaceutical companies on 93 drugs. They concluded that the total average cost was $231 million in 1987 dollars. DiMasi now puts the price tag at $318 million in 1999 dollars, while others argue that since clinical trials have become more complex and expensive, the actual cost must be closer to the cited $500 million.

In fact, the amount spent on each drug is a fraction of that amount. About half of the $300 million to $500 million is what companies could have earned with the money by investing it elsewhere--the so-called opportunity cost. And since only about one in 10 drugs tested in human trials makes it to the market, more than half of the rest is the cost of all the failed projects. As a result, cutting either the time to market or the failure rate can dramatically reduce total R&D cost. Ultimately, if drug prices did come down, companies would have no choice but to get smarter about their research. After all, their very future depends on being able to produce a steady stream of new drugs.

How can the U.S. get prices that are appropriate?

Not with price controls. Instead, the nation needs to let the market work better. How? By freeing up big purchasers to negotiate discounts irrespective of the prices the government gets. Consumers and doctors also need to be made aware of the relative costs and benefits of individual drugs. If consumers had to pay more out of pocket for expensive drugs, many would opt for cheaper but still effective alternatives. As for Americans who can't afford drugs, the solution is more insurance coverage.

And what's the right policy for the Third World?

Washington and drugmakers need to embrace the idea of different prices in different countries, as long as those prices are based on ability to pay. There's a sobering lesson from recent history. In the late 1980s, U.S. vaccine makers were bashed by Congress at the first sign that they might cost more in the U.S. than elsewhere. In the end, they stopped selling vaccines to developing countries. Europeans stepped into the breach and took over the markets. Indeed, the right approach is not to complain that Americans are paying too much but to figure out ways to get more drugs to more people around the world--at prices they can afford. Moving beyond the knee-jerk reaction that Americans are being gouged if others can buy drugs more cheaply would be a major step toward a healthier world for everyone.

By John Carey in Washington

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