Online Extra: Commentary: The Tangled Economics of Drug Prices

Yes, Big Pharma needs profits to continue R&D. Sure, consumers need affordable drugs. Striking a fair balance is the hard part

Are drugmakers charging too much for prescription medicines? The American public thinks so. A poll last year by Harris Interactive Inc. in Rochester, N.Y., found that only 10% of respondents thought prescription drug prices were "fair and reasonable." And 73% favored government price controls.

That's wrong, pharmaceutical companies say. They protest that producing new medicines is expensive and risky work, and they need to charge a lot for the drugs they manage to develop to make up for all the times they try but fail.

THE PUBLIC PAYS. The argument boils down to a question of what's fair -- and it always seems to erupt anew each time a costly new drug hits the market. No one questions the fairness of charging $250,000 for a Ferrari, but prescription drug prices are a different matter.

Society believes that sick people shouldn't suffer or die for lack of a drug they can't afford. So, most of the time, society ends up picking up at least part of the tab. Either the government requires private insurers to cover supercostly drugs -- knowing that doing so will force up premiums for healthier policyholders -- or the government picks up the cost directly via Medicare and Medicaid. Since the public ultimately pays, the public demands -- and deserves -- to know if prices are fair.

So, are prescription drug prices fair or unfair? As it turns out, some criteria support the drugmakers' case, while others give fodder to the critics. Here's a quick survey of the issues:

Drugmakers should be able to earn a good living. Regardless of whether you like pharmaceutical companies, it's short-sighted to clamp down too hard on what they can charge. They won't spend the money to develop more life-saving drugs if they don't think they can earn a return on the investment. Proof of that is the dearth of investment in drugs to combat many tropical diseases. Potential consumers of those treatments don't have the money to pay much for prescriptions.

And drugmakers justifiably worry that if they develop useful drugs, their sales will be undercut by patent violators in countries like Brazil and India. Result: The drugs simply don't exist, and people are dying needlessly. Tight price controls would have the same discouraging effect on drugmakers.

WRONG STANDARD. The public grasps this dilemma. Harris Interactive's poll, which found such disgust over high drug prices, also found that 58% of those surveyed wouldn't favor price controls if they would lead to substantially reduced spending on medical research.

Production costs are the wrong standard for setting drug prices. It's tempting to tell drugmakers that they must sell drugs at slightly above than the cost of production and distribution. After all, drugmakers can actually add to their profits by selling into new markets like Africa at pennies above their production and distribution costs.

If they can lower prices for Africa, critics ask, why can't they lower prices for the U.S.? The reason is simple: There has to be some market where profit margins are high enough to recoup the costs of developing and testing drugs. If prices are low everywhere, the companies will never make sufficient money and will have no incentive to develop future drugs.

OUTSIZED RETURNS. That said, some profit levels are simply too high. Pharmaceutical companies claim that their earnings are fair compensation for the risks they take. But take a closer look. The return on capital for the big drugmakers is stratospheric: 30% over the last 12 months for Merck, 38% for Eli Lilly, 37% for Schering-Plough. Even Pfizer, which trailed the bunch, managed a 19% return. In contrast, famously profitable Microsoft had a return on capital of 27%, and General Motors was down at 6%.

Risk? Sure, some drugs flunk out after heavy R&D spending. Overall, though, profits of individual companies are high and rising. "If you went to Vegas with $1,000 and routinely came back with $1,400, could your family accuse you of gambling?" asks Alan Sager, co-director of the Health Reform Program at Boston University's School of Public Health. Probably not. And another point is the ups and downs of drug stocks aren't closely correlated with the overall market. As a result, they dampen the volatility of a diversified stock portfolio. Investors like stocks with a beta -- a measure of correlation with the Standard & Poor's 500-stock index-that's less than 1. Merck's is about 0.5, and all the other drug biggies are also well under 1.

Drugs haven't been a classic free market for decades

Appearances matter. Free-market stalwarts get high blood pressure when people talk about profits being "too high." But drugmakers haven't been operating in a classic free market for decades -- not since the government and highly regulated insurers became the major buyers. Many of the superpricey drugs for relatively rare diseases wouldn't even exist if it weren't for the government's involvement as a payer and regulator.

What's more, many patented drugs are based on taxpayer-funded research. One much-criticized example is Cerezyme from Cambridge (Mass.)-based Genzyme, which fights a rare genetic disorder called Gaucher disease. The company charges more than $100,000 a year for enough of the drug to treat a typical patient, even though the active enzyme was discovered by government scientists. (The feds get a licensing fee.) Genzyme says its prices are warranted because of the high cost of factories to synthesize the drug.

TWO SIDES. The bottom line on all this? Pharmaceutical companies are correct when they say that they need healthy profits to attract investment so they can keep developing new drugs. They're right, too, that they'll never recoup their expenses if worldwide prices are forced down toward the cost of production. But Big Pharma needs to recognize that its critics make some good points, too. If drugmakers don't bend on pricing, the public backlash that's building against them could not only damage the industry's profitability, it could trigger price freezes that would cause long-lasting harm to innovation in pharmaceuticals.

By Peter Coy

Edited by Douglas Harbrecht

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