Just How Much Should the Second Pill Cost?

In which we consider some ways drug pricing is very different than any other pricing.

In that old T.V. show, The West Wing, there is a scene where pharamceutical executives are debating with White House staffers about the price of a new treatment for HIV. It’s one of those rapid fire, witty, exchanges the screenwriter, Aaron Sorkin is famous for. One of the staffers remarks something like, “It only costs them 25 cents to make the pill.” To which, I think it’s the dour and razor sharp, Toby Zeigler who retorts, “The second pill cost 25 cents, the first one cost 900 million dollars.”

This is a great way to illustrate an important point about pharmaceutical pricing and research. Researching new drugs is expensive and high prices may reflect hidden costs.

In a new article for the Bioethics thinktank, The Hastings Center, Paul Menzel (Emeritus at Pacific Lutheran University) gives a consumer-friendly overview of the problem with figuring out just how much should the second pill cost. It’s a great article to present to students because it’s relatively clear. It is also not particularly one-sided. It’s the sort of paper The Hastings Center excells at.

Something students and the average consumer don’t understand is that drug pricing is different than pricing other consumer goods like a car or a vacation because of insurance skews actual consumer spending.

Drug prices are high partially because they are not as subject to the same forces of supply and demand as other prices. “Even if what an individual pays is not high, many drug prices are.” It was economist Fredrick Hayek who argued that prices are a form of information about costs and consumer demand. That flow of information is affected by how transparent these costs and mark ups are determined.

Pharmaceutical companies don’t have to respond to consumer spending because they negotiate with health insurance plans spread over thousands of insurance companies and Medicare and Medicaid. The insurers are in competition with each other and so their collective bargaining power is greatly reduced. On the other hand, Medicare and Medicaid exert tremendous influence as the largest insurers.

Dr. Menzel remarks also that “the government imposes no price controls.” Price controls may seem like the most intuitive way to keep costs down. Force the pharmaceutical companies to lower their prices. A whole lot of economics I barely understand indicate they are generally a bad idea. (See the aforementioned Hayek’s The Use of Knowledge in Society but a warning: they don’t call economics the “dismal science” for nothing ;-) Price controls don’t lower prices as much as shift costs.

Dr. Menzel isn’t quite right about government price controls, however. If I understand Dr. Menzel’s own reasoning, the government does artificially control much of the pricing in healthcare in two ways

First, Medicare has tremendous influence on the ceiling price of many pharmaceuticals. As Menzel says, “Medicare requires all FDA-approved drugs to be covered regardless of price.” While this may not look like a price control. It actually is. Price controls can artificially set a ceiling or a floor for prices. By requiring all FDA approved drugs to be covered, this gives perverse incentives to pharmaceutical companies to create and offer drugs that may not be effective as long as the insured ask their doctors for the prescription, Medicare and Medicaid will likely pay.

Menzel even mentions drugs that are not any more effective that current drugs but with FDA approval must be covered. These are the so-called “me-too” drugs and when FDA approved, they must be covered according to Menzel, you can see how this creates a perverse incentive to make these drugs rather than risk research on new innovative treatments.

Second, government regulations can have the unintended consequence of artificially skewing prices. Menzel explains that when negotiating a ceiling for new drugs, Once again Medicare and Medicaid, the two largest insurers, drive pricing. “Pharmaceutical companies may complain that a huge insurer like Medicare exercises too much power in any negotiation.” This sounds like a form of price control to me. Normally prices are not negotiated in this manner. Imagine if car dealers met together with the Secretary of Transportation to set prices based on what the government would pay for a vehicle subject to congressional funding!

One element that affects drug pricing that readers of Practical Bioethics will recognize is the FDA (and the European equivalent, the EMA) “Allow applicants to use placebo-comparison trials” but they do not require comparisons of new drugs with the best available treatments.”

Now this is certainly news to me and I’m not sure exactly what Menzel is saying here, so drop a comment if you know more. He seems to be saying that the FDA and EMA put more emphasis on placebo-controlled trial data than data comparing new drugs to existing treatments. This generates lots of new drugs that are better than a placebo but leaves their effectiveness as superior treatments in doubt. “Lack of such [effectiveness trials], though, certainly increases the number of brand-name drugs, which means greater spending.”

Those who are using Practical Bioethics will also recognize Menzel’s use of “QALY” or quality adjusted life years as a measurement of the effectiveness of drugs as well as end-of-life decision making. Menzel is concerned about QALYs as a measure of drug effectiveness. However, Menzel quotes Peter Neumann, QALYs are “the worst way to measure health, except for all the others.”

As a final note, I would certainly agree with Menzel’s closing comment, “ . . . [P]harmaceutical pricing warrants the same persistent ethical assessment by bioethicists, economists, and policy analysts as more traditionally prominent issues in bioethics recieve.”