Price, cost, and willingness to pay

There have been numerous articles recently in popular media about the price of drugs, the costof bringing a drug to market, and the stakeholders and countries involved. Many of them go into detailed statistics about the differences in prices, their rationale, and where they should be. In this weeknote, I’ll attempt to give our view on why systems-based solutions to any issue being talked about today are essential, otherwise we might end up making things worse.

First, it is essential we distinguish between three concepts: the cost of production for a producer, the willingness to pay for a consumer, and the price of a product. In simple economic terms, the cost of production has to be less than the willingness to pay, otherwise there will be nothing sold. Somewhere in between those two dollar amounts is the negotiated price. The difference between the price and the cost of production is called profit, and the difference between price and the willingness to pay is consumer surplus. Profits are self explanatory, and often vilified. Consumer surplus is the dollar amount of happiness when you feel you got a great deal.

This is essential to realize: price is not just determined by the cost of production, but also by how much someone is willing to pay for the product. We are all different, so when negotiating a price, some people are willing to pay more and others less for the same product. Similarly, certain companies can produce the same product for lower cost while others need more resources.

So what has happened to the clinical trial system? First, for many patients, a willingness to pay is replaced by the ability to pay. This is especially true for most life-threatening diseases. So right away, our right-hand limit becomes very high. Second, the cost of producing a drug includes, among other things, the cost of going through the clinical trial system. As we know, not all drugs make it through the system, so this also includes the cost of uncertainty. Combining these two moves our cost of producing our drug very high as well.

Suddenly, we are in a different world. In this world, people are asked to place a dollar amount on their life and companies are asked to declare a cost they aren’t sure about. This leads to both sides looking to the other for a good price point; drug companies try and charge as much as they can and society has developed mechanisms to try and make drugs available for everyone. Drug companies charge higher than the cost of producing a drug and patients, with the help of reimbursements, are able to pay more than they might be willing to. The result is that we have a price that is very likely higher than it should be, but we can never be certain.

From the supply side, high costs are caused by uncertainty in the clinical trial system, the danger of lawsuits, and the fact that developing new drugs that stop death is very difficult. From the demand side, the fact that Medicare is not allowed to negotiate drug prices (though the Veterans Administration is) is one of the reasons we see higher prices. In many economic systems, this is fine, after all, you don’t negotiate the price of salt when you buy it at the store. However, the United States also does not allow imports of drugs, resulting in the same drug being sold in different countries for vastly different prices. A closed system that disallows competition and no negotiating power means that we can see drugs being priced as high as our systems can sustain them. Finally, from the demand side, there is uncertainty on how much we should be spending on healthcare in general, with the last year of life responsible for one-third of medicare expenditures.

This is exemplified with the recent example of Gilead. Recently, a senate committee reviewed how the drug maker priced Sovaldi and Harvoni, both Hepatitis C Drugs. According to Sen. Ron Wyden, Gilead was “fully aware that as the prices kicked up, the number of Americans treated and cured would go down.” This, when viewed from the supply side, makes perfect sense. If there is uncertainty around future profits, a company will aim to charge as much as it can, and lower than the “ability to pay” amount.

Harvoni’s price is about $94,500 per patient and Sovaldi about $84,000 per patient in the US, but in Egypt, Sovaldi is available for $900; Germany, around $67,000; Canada about $55,000. This shows the advantage of operating in a closed economic system. Were imports and reimports allowed from other countries, the discrepancy in price could not be maintained. Further, patent laws restrict similar molecules from being produced.

Gilead spent tens of millions of dollars to complete Sovaldi’s clinical trials. The average drug developed by a major pharmaceutical company costs at least $4 billion. Yet, Sovaldi costs about $130 to manufacture. The next version is expected to be even more expensive. If you visualize the uncertainty range from $130 to $4 billion, you understand why pricing in drug markets is not solely based on the cost of production. Together, Sovaldi and Harvoni generated $14.2 billion in global sales for the first nine months of 2015. That’s a large profit, but Gilead claims it is also a large consumer surplus due to downstream health savings and the quality of the drugs that have saved lives, which of course would have a higher value else we wouldn’t have bought the drugs.

So what is the answer? Simplifying the clinical trials process, protecting pharmaceuticals against lawsuits, and providing more funding for drug development? No, that will only solve one side of the pricing puzzle. It will decrease the cost of drug production, but the price point will still be very high because of the high ability to pay of our current system. Is the answer negotiating drug prices, allowing imports, and better end-of-life counseling? No again, because this only affects the consumer side of the puzzle, and could potentially lead to us not developing cures, and still having high drug prices

Can you do both simultaneously? Potentially, that will require stakeholder alignment, and an overhaul of the system. How would one even start such a process? One answer is here, with many more to come on this website. Our team is currently exploring methods to leverage technology, make information transparent, and provide recommendations to truly take advantage of the strong feeling that the clinical trials system needs to change. We are living in times where the political climate, the changing healthcare system, and a focus on individualization can be used to finally solve this puzzle.

Sauleh Siddiqui