Drug Pricing and the Incentives to Innovate

by: Fredric Cohen, M.D.

Thanks to Derek Lowe for bringing to my attention Arnold Relman’s long-winded answer in the New Republic (reg. required) to Richard Epstein’s book on the drug industry, Overdose, published last year.  I thought I’d spend far less space than Dr. Relman illuminating some of the ‘facts’ he uses in his arguments against Epstein and the industry.  I will also note out of fairness to Dr. Relman that I find myself in agreement with much of what he argues against.  I am in particular agreement with his views about the need to regulate the sale and marketing of drugs and the myth that drug prices are directly tied to R&D costs, as many of my prior posts will attest.  Relman’s words words are italicized; mine plain text.

Adding to the obscurity of these estimated research and development costs are a number of other inconvenient facts. First, most new drugs entering the market these days are not new molecular entities….

Industry critics frequently cite the decline of innovation since the mid-1990’s as evidence of the industry’s ills; they support this assertion with the suggestion that the decline of new molecular entity (NME ) approvals is symptomatic of a larger trend towards development of what are perjoratively termed ‘me-too’ drugs and away from ‘truly innovative’ drugs (Relman calls ‘me-too’ drugs an “inconvenient fact.”  While it may be more convenient to speak only of NMEs when discussing drug-industry innovation, follow-on drug products have important therapeutic and economic benefits that must be discussed in order to understand the total value of drug-industry innovation; too bad there are few within the industry who feel compelled to extoll their virtues).  Please refer to my article published a couple years ago in NRDD and available through the PGS website, which presents some of the information I will refer to.  The primary source of drug-approval information in the U.S. is provided by FDA and is freely available.  There is no question that productivity, as defined by the cost of R&D per dollar-value of approved drugs has been in decline.  The productivity decline appears much more pronounced when productive output is defined by the number of new molecular entities approved per dollar of R&D spent.  It is also true that most new drugs entering the market these days are not NMEs, and that the proportion of NDAs approved by the FDA that are NMEs has declined since 1990, as shown below (data derived from FDA tables).  NMEs make up a higher proportion of drugs when only NMEs and follow-on drug NDAs are counted (range 22%-88%), but the time trend is similar to what is shown.  So far, Relman and I are in agreement over the facts about NME approvals.

NME approvals 1990-2007

…and therefore they [follow-ons] are less costly to develop and to test than the new molecules for which cost estimates are made.

So much for our agreement.  I am aware of no published data that purport to show that costs to develop a follow-on product are lower than the costs to develop an NME, all else held equal.  Indeed, DiMasi and Paquette’s study on the economics of follow-on drug development, while not directly demonstrating the equivalency of costs of development for pioneering versus follow-on drugs, does support this proposition that follow-on drugs are no cheaper to develop than pioneers.  The authors eloquently demonstrate that the distinction between pioneering and follow-on drugs has become blurred by the quickening race to market.  Improvements to existing drugs are a different story.  It is reasonable to assume, for instance, that the cost of developing a new formulation of a previously approved active ingredient will be less costly than the original formulation.  If that is what Relman meant, it is not what he said.

Second, a large (and growing) fraction of new drugs marketed by the big companies were not discovered and developed entirely within the company…A significant portion of new drugs came from publicly supported academic or government laboratories….

It is a fact that many new drugs are “not discovered and developed entirely within the [NDA-sponsoring] company..”  Good.  That’s what is supposed to happen.  Governments and charities support basic research that will lead to preventive, therapeutic and diagnostic innovations.  That’s pretty much the whole point of basic medical research.  It doesn’t mean that the industry has acted unethically, nor does it mean that it has invested less money and time to bring its inventions to the market.

The drug industry’s stock prices may have declined in recent years (along with its innovativeness and productivity), but its net income has suffered very little. Does this justify describing the industry as “highly risky” and seriously threatened by any government actions that might rein in its power to dictate prices?

A popular argument among price-control proponents.  It basically amounts to using price controls to constrain profits to something considered “reasonable” as opposed to letting markets decide what prices they will bear.  This argument fails to consider the costs of price controls per se on the incentives for making investments that are indeed quite risky, economically speaking (i.e. they have a long payout and are associated with a high proportion of technical and market failures; only about 10% of drugs entering clinical studies get approved; only about 30% of NCEs (similar to NMEs) entering the market have a present value that exceeds the average cost of developing a drug).  High industry profits persist (although their growth has slowed recently) for two reasons:  prices have risen year over year until very recently (price inflation may have now hit a ceiling; we will see soon enough) and sales volume has continued to grow robustly .  Sales volume growth in the U.S. is largely due to exogenous factors, the aging population and the adoption of a prescription drug plan for seniors, being two of the more obvious.  A shift to DTC advertising has probably also played a role by driving demand.  Note, however, that speaking only of profit growth among “big drug firms” as Relman does, obscures the larger role of free-market pricing to maintain incentives–the importance of maintaining innovation incentives for companies of all sizes to seek profits, this includes most of the several thousand pharmaceutical and biotechnology companies that are unprofitable and funded largely by private investment capital that seeks a high rate of return for their…wait for it…very risky investments. 

Instead of burying today’s quasi-free market for drugs in the U.S. under a heap of price-control legislation, how about instead making the market freer, to see if bona fide freedom of choice might actually constrain price growth long-term?  Why not allow all purchasing groups, including all governmental groups, free reign to negotiate prices for drugs they purchase?  Why not force manufacturers to allow large purchasing groups to buy direct from them instead of wholesalers?  How about giving government purchasers the authority to use price (via cost-effectiveness assessments) in their coverage/formulary decision-making?  How about making the importation of drugs legal and setting up a mechanism to monitor the foreign drug supply to ensure its (relative) safety?  How about defining a reasonable accelerated approval pathway for generic biologics (biosimilar proteins)? These are all steps that have been debated by our Congress in the last couple of years without any meaningful action.  Such measures would be worth trying before trying something as potentially catasrophic as setting price limits on new drugs, or erecting ill-conceived barriers to marketing approval, such as head-to-head demonstrations of relative efficacy against pioneering products.  In a functioning market, there’s no reason why the rewards available to drug innovators must be artifically elevated.  If allowed to work properly, markets can determine the ideal balance between risk and reward available to innovators, and that balance–not any pundit’s, politician’s, policymaker’s, or ethicist’s sensibility–will define the reasonableness of the drug industry’s prices and of profits.