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March 2001, Vol. 4
No. 3, pp 36–38, 41, 42.
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Focus: Business/Economics
Feature Article

The Pricing Puzzle


Prescription medicines play a leading role in health care, but a public debate rages over what these drugs should cost.

Today’s innovative medicines have turned many diseases that were once virtual death sentences into treatable conditions, including diabetes, congestive heart failure, and some forms of cancer. Prescription drugs can also ease the symptoms ofarthritis and other chronic ailments, and they can help prevent degenerative disabilities, such as osteoporosis, that were once considered a normal consequence of aging.

Humankind—particularly the citizens of developed nations like the United States—has clearly benefited from the efforts of the pharmaceutical industry, yet those efforts can hardly be characterized as altruistic. Producing “wonder drugs” is one of the most lucrative enterprises in the United States; its average profit margin of 15% has given investors an annual return of 25% during the past decade.Little wonder, then, that Big Pharma is constantly increasing its commitment to R&D. In 2000, companies invested more than $26 billion to discover and develop new medicines (see Figure 1).

Figure 1. R&D investments by research-based pharmaceutical companies
Figure 1. R&D investments by research-based pharmaceutical companies. (Data source: PhRMA Annual Survey; Pharmaceutical Research and Manufacturers of America: Washington DC, 2000.)
No one disputes the dramatic changes in our quality of life that are attributable to prescription drug advances. But many Americans want to know why the United States has the highest drug prices in the world. During the 2000 presidential campaign, Al Gore criticized the manufacturer of the arthritis drug Lodine for selling it for $108 a month when prescribed for humans and $38 when prescribed for dogs.And why was it necessary for Congress to enact legislation last year that allows pharmaciststo import prescription drugs from countries such as Canada, where, due to government price controls, they sell for substantially less than in the United States?

Former President Bill Clinton posed that questionin October 1999, when he ordered a comprehensive study of why drug prices are so much higher in the United States than elsewhere. Some say the study was Clinton’s way of getting even with the pharmaceutical industry for its role in killing Clinton’s plan to add prescription drug coverage to Medicare for the elderly.

“Pharmaceutical companies use the United States as their safety valve,” claims Alan Sager, head of the Access and Affordability Project at Boston University’s School of Public Health. “If other countries negotiate or regulate to win lower prices, drugmakers raise their prices on the hapless American consumer” (1).

But before you conclude that Big Pharma is ripping us off, keep in mind that finding the correct pricing strategy for prescription drugs is a complex, high-stakes puzzle for drug companies. Covering all the costs of bringing a single new drug to market and achieving commercial success—even after patent protection, cash incentives, tax credits, orphan drug protection, and managed care reimbursements have kicked in—requires complex pricing strategies. Indeed, according to research conducted by Duke University economists Henry Grabowski and John Vernon, from a historical standpoint, only 3 out of 10 drugs have recouped or exceeded their R&D costs (see Figure 2). That means those three drugs must be priced so they will earn enough to recover the R&D costs of the seven drugs that were not commercial successes.

Figure 2. Revenues from marketed drugs versus R&D costs.
Figure 2. Revenues from marketed drugs versus R&D costs. (Data source: Grabowski, H.; Vernon, J. J. Health Econ. 1994, 13. Note: The drug development cost cited in this chart is after-tax in 1990 dollars for drugs introduced 1980–1984. Based on a separate analysis by Boston Consulting Group, the pretax R&D cost per drug introduced in 1990 is $500 million.
The pharmaceutical industry correctly points out that the cost of a medicine is not simply the cost of its ingredients. Big Pharma contends that discovering, developing, testing, and gaining regulatory approval for new medicines do not come cheap: As an example, for every 5000 medicines initially evaluated, on average, only five are tested in clinical trials, and only one of those is approved for patient use. Accordingly, the industry strongly believes that revenues from successful medicines must cover the costs of the vast majority of “losers”.

Big Pharma’s case

Other data cited by the pharmaceutical industry in support of how it prices drugs include the following:

  • The average cost of bringing one new medicine to market is $500 million (see Figure 2 note).
  • It takes an average of 12 to 15 years to discover and develop a new medicine. Most of that time is spent testing the drug to make sure it is safe.
  • Although the cost of developing drugs is soaring, the time that companies have to recoup their investment is shrinking because of stepped-up competition from generic drugs.
  • Companies fund research on future medicines and improvements to existing medicines with revenues from medicines on the market. One out of every five dollars in revenues is poured back into R&D. Pharmaceutical companies now are working on more than 1000 new medicines—for Alzheimer’s disease, stroke, cystic fibrosis, and arthritis, to name a few. More than 350 medicines are in the pipeline for cancer alone.
  • The cost of medicines reflects their enormous value—to patients, society, and the health care system. The industry warns that if drug prices are regulated, pharmaceutical companies may have less incentive to create new medicines because the costs will not be recoverable.

The data just cited suggest that although the pharmaceutical industry as a whole has been enormously successful, only a few large companies with deep pockets can afford to compete in that market because developing drugs is time-consuming, expensive, and risky. For pharmaceutical corporations, investment involves four areas of concern: the development of the drug, which includes all expenses incurred in conducting primary research; testing, which involves the expense of conducting clinical trials required by the FDA to ensure safety and effectiveness; manufacturing, which covers the costs associated with producing the drug (e.g., raw materials, production machinery, and labor); and marketing, which includes expenses incurred to inform physicians, pharmacists, and insurance executives about the drug. Therefore, even under conditions of extensive competition, pharmaceutical prices would be high. The question is, do they need to be as high as they are?

Economic theory and price fairness
One way to determine what the cost of a drug should be is to apply classical economic concepts. In classical economic theory, the price a corporation charges its customers for a product is the total cost of investment plus a normal profit. Critics of the pharmaceutical industry argue that prices charged by pharmaceutical corporations are unfair to consumers because they are excessive, that is, the profit margin is not “normal”. Proponents of free market theory argue that as long as free market forces determine the selling price of pharmaceutical products, the price charged is, by definition, “fair”.

In a free market, there are two pricing models: opportunity-based pricing and risk-based pricing. Opportunity-based pricing sets the price at the highest possible level that buyers are willing to pay, without increasing production volume to the point where it diminishes total profit. Under this model, some patients are inevitably priced out of the market, but this is considered a problem outside the purview of economics.

Risk-based pricing accounts for the financial and market risks that a company takes by pursuing an economic opportunity in a given market. The greater the risk takenby the company, the higher the expectation for profit. Conversely, the lower the risk, the lower the profit expectation. Under a risk-based pricing policy, an “unfair” price is one that is set higher than the risk exposure can justify. Both pricing models are indifferent to the actual distribution of a product among consumers, making it impossible—in theory—for pharmaceutical companies to exercise any social obligations toward price-sensitive patients by adjusting prices. Obviously, pure economic theory will not help us determine how drugs should be priced.

Those who believe that there should be some degree of price regulation argue that you cannot evaluate the fairness of a drug-pricing policy unless you examine how it affects both sellers and buyers. They contend that drug prices that result from either opportunity-based or risk-based pricing and that therefore end up depriving some buyers of necessary, lifesaving drug treatment are “unfair”.

Of the two pricing models, this group prefers the cost-based pricing model because it takes into account a company’s total investment in product development, testing, manufacture, and marketing and then sets profit margins at a certain “reasonable” percentage. The immediate question raised by this preference is, how do you define “reasonable”? Some take the view that a reasonable price is one in which the selling price does not greatly exceedthe full cost of researching, developing, manufacturing, marketing, and distributing the drug, where costs includea return on the investment sufficient to cover the investor’s risks of failureand the opportunity costsof capital. In other words, a fair price is one that allows an investor—in this case a pharmaceutical company—to earn a profit that is comparable to profits (investment returns) that are available in other enterprises.

Although economists can—and do—put forward different pricing concepts, models, and theories, the general public will never view the pricing of pharmaceuticals in this context. A drug can save someone’s life—how can you put a price on that? Certainly not by discussing such esoterica as opportunity-based and risk-based pricing.

Price controls
Price controls have been tried numerous times but have not worked.Instead, they tend to produce shortages and black markets. Price controls on oil and natural gas in the 1970s led to widespread artificial shortages and long lines at the gasoline pump.

There is no question that price controls on pharmaceuticals would discourage investment in drug research. If we accept what the industry tells us—that it takes $500 million and 12–15 years to bring a drug to market—then investors will probably put their money elsewhere unless there is a possibility of a return on that investment commensurate with its high risk. Even the threat of price controls can push down research spending just when we need new treatments most. In fact, every year since 1980, pharmaceutical companies have increased research spending by double digits—except in 1994 and 1995, just after price controls were proposed as part of the Clinton health care reform plan.

The United States is the world leader in pharmaceutical innovation—at least in part because of its relatively free market for pharmaceuticals. Nearly half of the major prescription drugsdeveloped during the past two decades originated in the United States. It is no accident that the United States—where free market competition is allowed to determine prices—produces the most innovation, and that countries with price controls on pharmaceuticals produce the least.

The bottom line
The argument made by the pharmaceutical industry in support of its pricing structure is compelling. It can indeed cost millions of dollars and take many years to research, develop, test, and market a new drug. But there are other industries—the defense industry for one—with similar attributes. There is nothing unique about the drug pricing process. Pharmaceutical companies strive to recover all their costs and make a profit that will satisfy shareholders.

In formulating a pricing strategy to recover all the costs associated with developing and marketing a prescription drug, pharmaceutical companies tend to charge what they think the market will bear. The natural tendency is to set different prices for different markets, which is called “differential pricing”.Drugs sold for humans generally sell for more than drugs sold for animals. Drugs sold in rich countries are priced higher than drugs sold in poor countries. That’s why a daily dose of the AIDS drug PLCsells for $18 in the United States and $9 in Uganda. In many developing nations, prescription drugs—like most other commodities—are often priced lower than in developed countries. In these countries, per capita incomes are much lower than in the United States. If U.S. prices were charged, there would be few buyers. In some cases, prescription drugs are available at a price that enables a pharmaceutical company to cover the extra costs of selling its product in that market and to make some contribution to funding ongoing and future R&D costs.

Price variation is an entirely normal phenomenon. This is even true for prescription drugs that are sold at the retail level. Shop around and see for yourself. It’s true in many countries for all manner of products, which is not surprising, given the fact that local supply and demand conditions differ from country to country. Differences exist not only in the prices of basic consumer items such as food and groceries, but also in the prices of items that depend on creative ability, such as college tuition and professional services. In many international comparisons, drug prices are highest in the United States, but for other commodities, prices are higher elsewhere. A McDonald’s Big Mac costs more than three times as much in Switzerland as in Hungary, while the price in the United States is in the middle of the range. The price of a cappuccino at Starbucks is about twice as high in Tokyo as in New Zealand.

Another factor to consider is the extent and nature of the generic drug industry. The United States has a vital generic drug industry, thanks in large part to the 1984 passage of the Waxman–Hatch Act. Under this law, the entry of generic products into the marketplace is greatly facilitated when the patent of an innovative product expires. Generics significantly affect the prices that American consumers pay for drugs. In this country, generics compete fiercely with each other, with the innovator’s brand, and with other patented products. When a patent expires, generic products enter the marketplace––driving down the sales of the non-patent-protected innovator’s products as well as the prices of the generic counterparts through market competition.

The entry of generic therapies is, and promises to be, increasingly important in this country as a means of cost containment. In 2000, 39 innovative drugs, with 1998 worldwide sales exceeding $13 billion, lost patent protection, and this year, an additional 34 drugs with more than $15 billion in 1998 revenues will be subject to generic competition.

A global mix
Many other complexities confound cross-country comparisons of pharmaceutical prices. Indeed, to assess the overall impact on consumers, it is essential to look at an entire market basket of products. Patricia M. Danzon has created an extensive body of research. Danzon is the Celia Z. Moh Professor of Health Care Systems, Insurance, and Risk Management at the Wharton School of the University of Pennsylvania. In an article in Regulation,a publication of the Cato Institute, Danzon says,“Cross-national and domestic price differences are smaller than has been alleged. Most countries other than the United States regulate drug prices, either directly through controls on prices (e.g., France and Italy), indirectly through limits on reimbursement under social insurance schemes (e.g., Germany and Japan), or indirectly through profit controls (like the U.K.)” (2). Danzon contends that because the U.S. health care system is not regulated, drug prices here are often higher. Individual U.S. health care providers cannot come close to matching the bargaining power of, say, the Canadian government in negotiating drug prices. We pay more (at times) for drugs, which is precisely why the United States is a fertile environment for pharmaceutical R&D.

No matter how you slice it, there is no escaping the fact that U.S. consumers are paying more for drugs because they are, on average, richer than their counterparts in the rest of the world and can afford to spend more of their wealth on health care. Another factor that influences the price of drugs in the United States is the kind of drugs that the U.S. pharmaceutical industry produces. Because the rich countries have most of the money, pharmaceuticals research focuses on health problems of interest to those markets, such as obesity, heart disease, and cancer, and not on malaria and otherpredominantly third-world maladies. So why shouldn’t the pharmaceutical industry attempt to recoup its investment by charging more for its drugs in the rich countries?

Finally, sometimes the absence of competition drives up U.S. drug prices. A pharmaceutical company that is the first to bring to market a new drug that it has patented operates as a monopoly until other companies can offer competing products. Until then, the first company can charge any price it believes it can get in the marketplace. But would you begrudge that company its patent, which was granted after many years of research, testing, and capital investment? Without such patent protection, what pharmaceutical company would be foolish enough to look for a cure for cancer or AIDS? And if you were the CEO of a company that temporarily enjoyed a monopolistic position in the marketplace, would you concentrate on maximizing profits for the benefit of shareholders, or would social goals (the benefit of consumers) be your driving force? The reality of the marketplace is that a CEO who chooses the latter course will be quickly replaced by someone who is profit-oriented. Little wonder that U.S. drug prices are high.


  1. Cuachon, D. Americans Pay More for Medicine. USA Today, November 10, 1999.
  2. Danzon, P. M. Making Sense of Drug Prices. Regulation 2000, 23.

Milton Zall is a freelance writer based in Silver Spring, MD. He is a certified internal auditor and a registered investment adviser. Send your comments or questions regarding this article to or the Editorial Office by fax at 202-776-8166 or by post at 1155 16th Street, NW; Washington, DC 20036.

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