Prices, Profits and the Economics of Big Pharma

by: Rortybomb

Megan Mcardle writes, in Does the US Really Account for So Much Pharma Profit?:

…I repeated an estimate I had heard from several people, that the US accounted for something in the range of 85% of pharma net profits…I may be in error on that–I’ve heard 80-90% from people in healthcare consulting, and I’ve seen that sales and profits in the US are usually larger when they’re broken out on financial statements, which they aren’t all that often…Next, we can look at where the revenues come from. According to the OECD’s invaluable Pharmaceutical Pricing Policies in a Global Market, which really is a bargain at the price, 45% of global sales come from the United States, 30% from Europe, and 9% from Japan…

So let’s back up. Revenues on annual income statements are almost always broken down by region. Let’s look at some: Pfizer (p. 94, USA 41%), GlaxoSmithKline (NYSE:GSK) (p 118, USA 39%), Johnson & Johnson (NYSE:JNJ) (p. 57, 53%, excluding consumer products), Bayer (OTC:BYERF) (p. 60, pharma as opposed to consumer health, North America including Canada is 28%), Sanofi (NYSE:SNY) (p 283, USA 31%).

This is consistent with the numbers Megan gets from the OECD’s revenue estimate of 45% from the United States. 45% is a large number, but it isn’t 80%. Now remember our accounting identities:

Profits = Revenues – Costs
Profits = Quantity * Price – Costs

Megan goes next to arguments about prices. We can tell that profits are higher in the United States since prices are higher, back out information from prices, etc. But we are done with prices – we already have good information on the revenues, and that is all we need prices for. What we need is information on profit margins, or the costs for sales. And we should think something is really off if the Rest of the World gives a majority of revenues at 55% but only 20% of profits.

From Wikipedia, we have the revenues of the top 10 pharma companies at $425.3bn, and profits at $87.5bn. That’s a profit margin of about 20%. To solve the profit margin equation above, with the United States generating 80% of profits, the profit margins of the United States would be about 37%, and the Rest of the World would be about 7.4%. This may be boring income statement talk, but it’s hard for me to imagine anyone justifying a situation where the profit margin is 500% higher on one group of people than another group as correct.

But I don’t think that’s the case. Going back to the sheets above, GSK has operating profit margin at United States 65%, rest of world 54%. Sanofi’s 20-F filing gives 55% operating profit margins in the United States, rest of world 41%. Assuming a 10% higher profit margin, and solving the equations again, we get the United States at 57% of profits. This is a far cry from 80%.

Simple economics tells us if we lower prices, quantity sold increases. We’ll also be bringing more people into the health care market, and direct dealing may cap some of the operational costs. So it isn’t clear what the effect of lower prices would do; decreasing prices by x% would only decrease profits by < x %.

Let’s build a lighthouse and make the poor pay for it.

I understand Megan’s meta-argument; we are a rich country, other countries are free-riding off our innovation by shaving the profit margins to clearing rates, and though there is a lot of leakage overpaying for drugs now will help us find better drugs for all tomorrow. I agree.

However that very quickly leads me to supporting government prizes for drugs, as opposed to paying more in the market. Right now the people paying this extra-charge for innovation are the sick. I’m not paying directly for this innovation since, knock on wood, I’m healthy and currently not on prescription drugs. I’m paying in part, since Medicare Part D is paying too much for drugs. But the people who have to go to the pharmacy and buy drugs are paying in addition to that.

I know, putting on my sunglasses of ignorance, that if we want more R&D we should have the government subsidize it by buying it. It is worth paying for. I also know that I’d rather pay for it now when I’m young and healthy than when I’m older and/or sicker. When I’m sick, the quantity/quality of the labor I can sell decreases. I’ll have fixed expenses and/or fixed income that is harder to marginal adjust and therefore handle this extra innovation fee I am paying. And of course I’ll be at higher risk of bankruptcy because of an increase in medical expenses. I’m also paying for innovation that I’ll likely not benefit from, considering the time it takes to get drugs through the pipeline.

R&D prizes would take care of the problem of who is going to pay out of pocket to help fund this next wave of innovation – making the sick pay for it seems cruel when the government can bid for it wholesale for all of us.

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