More MS news articles for June 2002

Drug Pricing vs. Drug Development

May 15, 2002
By Prof. Robert Crowner
Prof. Robert Crowner is the director of the Center for Entrepreneurial Stewardship at the Acton Institute for the Study of Religion and Liberty.

One of the unintended consequences of September 11 is the additional pressure being applied to pricing in the pharmaceutical industry. Prior to "9/11," the urgent topic regarding drug pricing was the availability of HIV drugs at very low prices in Africa where HIV\AIDS has reached pandemic proportions. Incidentally, more recent studies show that the former Soviet Union is experiencing an even more rapid rate of increase in HIV infection than Africa.

Since "9/11," some new players have entered the fray to reduce prices by circumscribing intellectual property rights—patents which are authorized in concept by the U.S. Constitution. Probably one of the least expected antagonists is the U.S. government itself. In anticipation of the need to purchase a large amount of Cipro to combat a possible epidemic of anthrax, Senator Schumer of New York demanded that Bayer, who controls the patent for Cipro, supply the drug to the U.S. at a price greatly reduced from the $1.77-per-pill then charged to the U.S. government. The average wholesale price of the drug was $4.67. His comments were followed by Secretary of Health and Human Services Tommy Thompson demanding a reduction, also. Secretary Thompson threatened abrogating Bayer's patent if they did not comply with the change in pricing. As a result of the outcry over his remarks, he later modified his threat by negotiating a reduced price of $.95 for the first 100 million with reductions to $.85 for the second 100 million and to $.75 for the third 100 million. This pricing could presumably be justified in light of the large quantity being purchased. Incidentally, the issue seems to have been pricing, not concern about Bayer's ability to supply sufficient quantities, since they indicated sufficient production would be available. In agreeing to these lower prices, did Bayer really have a choice?

This incident was followed some time later at the World Trade Organization meeting in Doha, Qatar, by the affirmation of a policy to allow countries to seize patents on drugs to combat a wide range of public health needs. This is accomplished by allowing poor nations to buy cheap generic versions of patented drugs. The long-term effect of this policy will not be known until countries begin drawing the line between drugs desperately needed to meet very serious health threats and those that are just good for people.

Still more recently, Governor John Engler and Michigan's Republican-controlled legislature passed a budget that included language authorizing unspecified pharmacy-practice changes. Two days before the budget implementation deadline, the state health department disclosed that a preferred list of drugs would be put together. A committee of eleven doctors and pharmacists meet privately to select a best-of-class drug in forty categories. These selected drugs will get a large share of the money Michigan spends on drugs for Medicaid and the state-funded program for the elderly. Other drugs can be prescribed by doctors, but only after justifying their action to a phone bank of pharmacy technicians. This procedure is designed to force drug companies to reduce their prices to the level of the best-of-class drugs that are presumably selected for their value.

Drug producers have objected, alleging that the program lumps old and new drugs together and, in effect, says that all drugs in a given category are equivalent. Thus, the incentive to develop new drugs is reduced. Many of the large drug companies who do much of the research for new drugs have indicated they will not participate in the Michigan plan. The Pharmaceutical Research and Manufacturers of America, a trade association, has filed a lawsuit alleging that Michigan's plan violates the state constitution and state laws.

In an effort to reduce costs by setting prices through the qualifying process, Michigan appears to be eroding the right of doctors to prescribe the drug they believe is best for the patient if the cost is to be paid by the state. Obviously, the patient could lose, as well, either by using a potentially inferior drug or by not having their prescription paid by the state. Maine and Florida have already instituted price controls of one sort or another. Thus, the efforts to control drug prices seem to be spreading with potentially restrictive effects on patient care.

Can issuing patents to drug companies be justified when the health of patients, who are too poor to buy the drugs at the prices set, is at stake? For that matter, should all drugs be free to those who need them if they fail a means test? Should all countries that participate in the WTO be required to honor the patents of other member countries? To answer these questions, the process and costs of developing new drugs must be examined.

Drug Development Process

New drug development begins with a drug sponsor—individuals, corporations, government agencies, or scientific institutions—identifying molecules or substances for further development. Pre-clinical studies of the substance in mice and other animals are performed. If the pre-clinical studies show promise, the drug sponsor notifies the Food and Drug Administration (FDA) of its intent to conduct clinical studies on human subjects, which is called filing an Initial Drug Application (IND). The IND involves a detailed review process by the FDA which, if successful, leads to clinical studies.

Clinical development typically involves three phases of study.

Phase 1 includes studies in patients, typically healthy volunteers, to determine how the drug is absorbed, distributed, metabolized, and excreted by the body, as well as actions of the drug in humans and the side effects at various dosage levels.

Phase 2 is designed to determine the effectiveness of the drug for a particular disease or condition in patients. The short-term side effects and risks of the drug are determined. These studies are conducted on a relatively small number of patients. A decision is made at this point as to whether to do further research on the drug.

Phase 3 studies are expanded controlled and uncontrolled trials of the drug including blind and double blind studies. The purpose of these studies is to obtain additional data about the efficacy and safety of the drug in order to evaluate its benefits and risks. The number of patients involved typically ranges from several hundred to several thousand.

The FDA oversees the clinical trials and can halt the studies if it believes them to be unsafe or if it believes the design of the studies will not meet the stated objectives. The FDA engages outside advisors to help review the study results. Finally, the FDA either approves or denies approval of the drug.

This entire process takes an average of twelve years before approval to market a drug is given. On average, only five of every 5,000 substances are tested in clinical trials and of these, only one is approved for patient use. This represents a success rate of .02 percent, which highlights the risk involved.

Drug Development Costs

A recent study by Tufts University of ten major drug firms stated that the average cost of discovering and developing a new drug, including the costs of drugs that do not make it to market, has risen from $231 million in 1987 to $802 million today. Within this figure, $403 million are out-of-pocket expenses, including $121 million in pre-clinical costs and $282 million in clinical costs. The balance is the estimated cost of capital employed at 11 percent over the development cycle, averaging twelve years.

Pfizer is an example of a major drug company that makes a significant investment in research and development. In 2000, Pfizer had total assets of $33.5 billion employed in its business. Revenues of $29.6 billion were recorded which generated net income of $3.7 billion, or 12.5 percent. Research and development expenses were $4.4 billion or 15 percent of revenues.

Merck, another major drug company, employed $39.9 billion in total assets in its business in 2000. Revenues of $40.4 billion were recorded, which generated a net income of $6.8 billion or 16.8 percent. Research and development expenses were $2.3 billion or 5.7 percent.

Thus, it is readily apparent that vast sums of money must be spent to maintain a flow of new drugs that ultimately mitigate human suffering and prolong life. These funds must come from revenues, for how else would they be paid? Certainly we would not want the government with the efficiency of the post office and the compassion of the IRS to be the developer of new drugs.

Another significant cost for pharmaceutical firms is litigation. No matter how much testing is done, there will be some adverse reactions to drugs, and even deaths. Drug companies must defend themselves in lawsuits which may have large settlements prescribed by juries who are sympathetic to individuals versus large, "rich" firms who can "afford" generous awards.


A drug patent has a life of twenty years by law. Of this time, about ten to twelve years or over half the patent life is consumed before the drug can be marketed. Only the remaining time is available for recovering the development costs, since once the patent expires, generic drug manufacturers, who do no development work, are free to produce the drug and do so at a significantly lower price.

Coercing or legislating a lower price or allowing generic manufacturers to produce the patented drug without penalty will quickly dry up new drug development. The United States developed 45 percent of the world's most innovative drugs marketed worldwide in the 1990s. Surely, this is no accident, since the U.S. has no widespread price controls in contrast to other countries. Britain and France, who have significant price controls, have an abysmal record for new drug development. Investors seek the best return on their money, but the degree of risk is of major importance.

What are the relative expenses for drugs in the U.S.? Americans spend 1.2 percent of the gross domestic product (GDP) on both private and public expenditures for drugs. In 1996, Americans spent 9.4 percent of total health expenditures on drugs, down from 12 percent in 1970. Every other major country spent considerably more, with Japan being the highest at 21.2 percent. Given this low percentage in the U.S., drug expenditures have received disproportionate attention because they are the only part of health expenses that are often paid directly by the patient. Every dollar spent is associated with a $4 decline in spending on hospitals. In 1998, of the 14.2 percent increase in total drug costs, only 2.5 percent stemmed from price increases.

Would price controls for drugs help? Like all price controls, they would have two unintended consequences—they would encourage increased consumption of drugs and would lead to the consumption of inferior drugs. Price controls substitute a political process for the free market.

Weakening patent protection for drugs would reduce investment in private research and development because such spending depends upon the expectation of future returns. This can be demonstrated by the reaction to the threat of the Clinton health care reform proposals in 1992-93. According to an estimate by economists Sara Ellison and Wallace Mullin, the market value of pharmaceutical firms decreased by 44 percent during the period from September 1992 to October 1993.

What must be done at this juncture? The U.S. government must resist any further efforts to erode patent protection by foreign governments. Along with state governments, they must indicate a commitment to furthering private drug research and development by resisting the use of their tremendous purchasing power to drive prices down below the economies of scale achieved by large orders, as in the Cipro case. Finally, Americans must be alert to the efforts being made to significantly alter medical treatment in the U.S. for the worse under the guise of improving the system. The free market has amply demonstrated its ability to outperform socialist schemes in cost and quality.

© Acton Institute 2002