Why Do Drugs Cost So Much?

by Chris Adams

A response to A Tale of Two Drugs, an article by Barry Werth published in the MIT Technology Review Oct. 2013

Drug prices. Why are they so high?

In a recent article for the MIT Technology Review, Barry Werth considers the pricing of two recently developed and very expensive drugs. The first drug is used for cystic fibrosis and costs almost $25,000 per month. The second drug is used for metastatic colon cancer and is priced at $11,000 per month.

So why are these drugs so expensive? Why do companies charge so much for their drugs?

The simple answer is that they can and so they do.

As you may have learned in Econ 101, prices are determined by the “X” of supply and demand. We can safely ignore the “supply curve” as drug production costs are approximately zero when compared to the prices charged. What about demand? Economists usually think about demand as determined by the consumer’s willingness to pay for the product.

Consider the case of “whatchamacallitmab.” Consumers are all different and their willingness to pay could be as high as tens of thousands a month to as little as a few dollars a month. The maker of “whatchamacallitmab” wouldn’t charge the highest price a consumer was willing to pay, but rather find the price that balances the quantity lost from selling at a higher price with the increase in revenue for each product sold.

Is this how it works for drugs? Sort of. Well, not really. Actually, as you suspected long ago, there is very little in Econ 101 that represents the real world.

Working out demand for drugs is more complicated because there are three different groups involved in determining what is used by the patient. There is the patient of course. However, the patient usually doesn’t actually pay for the drug or may only pay a small fraction of the drug’s actual price.

Then there is the doctor. The doctor often has a lot of influence over which drug the patient takes, but the doctor doesn’t pay for the drug. In fact, the doctor may make money off the drug used by the patient.

Finally, there is the actual “payor.” This is often the insurance company or it could be the hospital, or in many cases it is the government through Medicare or Medicaid. Given this separation between the decision maker (the patient and the doctor) and the payor (Medicare) how is “willingness to pay” determined?

Hospitals and insurance companies negotiate directly with the pharmaceutical companies or intermediaries. The main way they negotiate good prices is through something called a “formulary.” This is a list of drugs that the doctor may choose from to treat a certain condition.

Payors usually allow doctors to use drugs other than the ones on the formulary, but it is much more difficult to do so. Drug companies know that if they can get their drug on the formulary then their sales will be higher, so they are willing to offer lower prices in order to get on formulary.

Payors have an easy time negotiating if there are numerous drugs that are similar and treat the same condition. If there is only one drug for a particular condition, then payors are forced to put that drug on the formulary and it is not really possible to negotiate with the drug company. This is what happens with orphan drugs like those mentioned in the article.

Medicare is one of the largest payors and a particularly important payor for colon cancer drugs given the share of colon cancer patients on Medicare. How does Medicare negotiate with the drug companies and determine prices?

It doesn’t.

Medicare is not allowed to negotiate with drug companies. Medicare must pay the “market price” for the drug.

Have we come full circle? The market price is determined by the payor’s negotiations with the drug companies, unless the payor is Medicare, in which case they pay the market price. But the market price is determined by the pay.

You may not be surprised when I say that economists find that drugs for which the main payor is the U.S. government tend to have high prices.

In the article, Werth argues that such high prices may come with an obligation to show effectiveness. “Though the advent of these more targeted, more effective drugs will introduce the prospect of ever­rising prices, highly effective and ultra­​expensive so­called orphan drugs like Kalydeco may impose a stricter rubric for determining the price of all new medicines.”

Unfortunately, the law of supply and demand does not require high priced drugs to be better, only that someone is willing to pay the price.

As an advocacy organization working on behalf of patients, this article shows the need for further research when it comes to individualized medicine. Not only will this research allow patients to receive better treatments, but it would reduce the overall cost burden placed on the health system. A targeted approach will save lives and money.

We may not understand how the complicated web of drug pricing works, and you may need multiple Ph.D. degrees to figure that out — but we know that we can’t make the future of treatment more effective and less costly without better research.

Fight Colorectal Cancer funds young and talented scientists through our Lisa Fund who are dedicated to finding individualized, personalized treatments and we continue to work with the research community to push for answers and a cure.


Disclosure: Fight Colorectal Cancer has accepted funding for projects and educational programs from Regeneron, producers of the colorectal cancer drug mentioned in the article, in the form of unrestricted educational grants. Fight Colorectal Cancer has ultimate authority over website content.

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