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Review Essay

Misleading Congress about Drug Development Congressional Budget Office. Research and Development in the Pharmaceutical Industry — A CBO Study. Washington, DC: U.S. Con-

gress, 2006. www.cbo.gov/showdoc.cfm?index=7615&sequence=0. Members of the U.S. Congress, state legislatures, and European and Canadian parliaments depend on the Congressional Budget Office (CBO) as an internationally respected body to provide rigorous, objective, and critical assessments of important policy issues. The purpose of the CBO is to establish authoritative figures and facts for bills and other actions. Thus one is surprised to find that the CBO study into pharmaceutical research and development (R&D) uses widely criticized figures without qualification and fails to review objectively the range of evidence about pharmaceutical R&D or its quality. It relies almost entirely on figures from studies by researchers supported by the industry, without assessing for nonspecialists how reliable they are. As a result, the CBO uncritically reiterates the industry-endorsed “facts” and the story of huge R&D costs, modest and precarious profits, and prices that represent good value. This new study of pharmaceutical R&D therefore comes close to reading as if it were written by the industry for its lobbying efforts. I am grateful to the research and insights of Andrew Mulcahy and Rebecca Warburton, although they are not responsible for the contents of this review. Journal of Health Politics, Policy and Law, Vol. 32, No. 5, October 2007 DOI 10.1215/03616878-2007-036  © 2007 by Duke University Press


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What Does It Cost to Develop a New Drug?

After an executive summary, the report has chapters on trends in R&D spending, the output of new drugs, and the cost of R&D. The fourth chapter asks whether federal R&D spending crowds out private spending, and the fifth chapter addresses the question of whether the industry’s innovative performance has declined. The final chapter examines the relationship between profitability and R&D spending. This review starts by looking at the report’s material on cost, profitability, and innovation. The CBO study almost exclusively uses the study by DiMasi, Hansen, and Grabowski (2003), three of the industry’s favorite leading health economists, who “put the average cost of developing an innovative new drug at more than $800 million, including expenditures on failed projects and the value of forgone alternative investments” (2). This was announced in 2001 at a press conference featuring Raymond Gilmartin, CEO of Merck (Harris 2001). All the estimates of R&D costs used by the CBO in its historical trend table come from the same group. The $800 million estimate was based only on new molecular entities (NMEs) developed entirely within the companies selected from those that submitted confidential information to the Center for the Study of Drug Development at Tufts University. Thus the $800 million estimate applied to this, the most costly subgroup of NMEs, and then was widely misrepresented as the average cost for all new drugs. The CBO does not correct this error. It does note that only one-third of all new drug approvals are new NMEs and reports that “most new drug products have much lower R&D costs than NMEs because they are incremental improvements on existing drugs. . . . Their average direct cost may be only about one-fourth that of an NME. Their opportunity costs are also lower due to the extent that they take less time to develop” (2). That estimate sounds about right to me, but the CBO continues to feature only the $800 million figure as the grand average. Since the $800 million figure was announced, DiMasi, Hansen, and Grabowski (2005) have written that they are working on estimates of the R&D costs for me-too derivative products that will add all the R&D costs of the original drug to the development costs of a new variation. Will the CBO help congresspeople and policy makers understand how unreasonable this is? Or will they merely report it? If one-third of new drugs average $800 million in R&D costs and twothirds average one-quarter of that cost, or $200 million, then should not the CBO point out that the overall average is only $400 million? And why do they keep using a single average figure when they note that R&D costs


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vary widely, especially because a few drugs have unusually high costs? The median would be more representative and would bring the overall figure down to about $300 million. But no single number should be used to represent wide variation; a range of one standard deviation — such as $50 – $600 million, with a median of $300 million — should be used. This puts the R&D costs of new drugs in a rather different perspective than saying the average is $800 million. It is surprising to find that the CBO does not critically assess the sample, data, and methods of this estimate. Thus policy leaders do not learn that the sample was nonrandom and small, using only ten firms (Light and Warburton 2005). Originally, the researchers invited twenty-four firms, using unstated criteria, and twelve of them declined for unstated reasons (DiMasi, Hansen, and Grabowski 2003). The other twelve corporations chose to participate, but two provided inadequate data. The CBO does not discuss several published reasons for doubting the validity of the data from the remaining ten as representing either their own R&D costs or the R&D costs for the pharmaceutical industry as a whole. First, no one knows how the data were collected or what each firm counted as R&D costs or how firms varied from each other or from one executive regime to the next (Light and Warburton 2005). Second, the data are likely to be self-serving, because all the companies involved knew that the higher they could make their R&D figures, the more strongly the study would support the single most effective argument in the past fifty years for high prices, government protections, and support. Firms may have included the costs of seeding trials and postapproval trials, as well as general expenses that benefit R&D, such as upgrades to entire corporate computer or software systems or legal expenses pertinent to R&D, patents, and new products (Light 2006a). Third, no mention was made by the authors of verifying the data or cleaning it in the usual ways done by researchers using open-source data sets. Fourth, there may have been upward bias in how the firms were selected, how they selected themselves, and how accurately the sixty-eight drugs represented all newly approved drugs. Fifth, only NMEs alleged to be discovered and developed entirely within the companies were used. These represent only 22 percent of all newly approved products and have been reported by the authors to be 3.7 times more costly than licensed-in NMEs and much more costly than new formulations, administrations, or indications of existing NMEs. Sixth, direct and indirect government subsidies are not disclosed by the companies or deducted so that companies’ net costs, as distinct from total costs to society, were overestimated.


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For these reasons, a watchdog CBO should have concluded that no estimate made from unverifiable industry data, subject to so many sources of possible inaccuracy or bias, should be taken seriously by policy makers. Instead, the same policy research center at Tufts, using the same secret data, has fired the first shot of a new public-relations campaign to claim that R&D costs have jumped 50 percent in about five years to $1.2 billion (Tufts Center for the Study of Drug Development 2006). Will the CBO and Congress believe this figure, too? The CBO report on R&D does not refer to an important critique of the DiMasi methodology and the reestimate of R&D costs by Public Citizen, which has built up extensive in-house expertise about drugs and pharmaceutical policy (Public Citizen 2001). Public Citizen’s report argued that R&D costs should be regarded as an expense, not an investment, and therefore costs of capital are irrelevant. The Public Citizen team used a simple, back-of-the-envelope method for calculating R&D expenses, but this method is intuitively appealing. They took the industry’s self-reported total R&D between 1994 and 2000, noting that it was probably inflated, and divided it by the total number of approved drugs, with a time lag. What could be simpler? The resulting average was only $108 million per new drug before tax benefits and $71 million after. They concluded that the pharmaceutical industry was campaigning to scare policy makers by making them believe R&D costs were soaring and had to be covered by higher prices. A literature now surrounds this study, but it is another plausible estimate of R&D costs based on self-reported and probably inflated industry figures that is only about one-tenth the size of the estimate used in the CBO’s report. Even if the median R&D cost per new drug had been stated as $300 million rather than $800 million, the CBO or any rigorous reviewer would have further reason to doubt its validity. At the same time that the study appeared, James Love (2003) issued, on the widely read Consumer Project on Technology (CPtech) Web site, evidence that the average sizes of phase 1, 2, and 3 trials in the study by DiMasi, Hansen, and Grabowski (2003) were substantially higher than those of other sources. DiMasi, Hansen, and Grabowski reported an overall average of 5,303 subjects used in trials per approved NME, while the Food and Drug Administration (FDA) reported an average of only 2,667 subjects over a much larger sample of approved NMEs (Love 2003). Michael Palmedo, then a staff member of CPtech, updated the FDA study and found the same average number of subjects for NMEs under standard review for drugs with no distinct advantage over existing drugs, but trials for priority drugs used an average


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of only 1,461 subjects (ibid.: 18). This is close to the average in a study of R&D costs (Global Alliance for TB Drug Development 2001; also not cited or reviewed by the CBO) of 1,368 subjects that was much more detailed than that of DiMasi, Hansen, and Grabowski (2003). Thus the $800 million average R&D cost per self-originated NME (or $300 million median cost per newly approved drug) is based on trials with sample sizes two to four times greater than those of other official and reliable sources. Once again, the range and variation is large, from about one thousand to seventeen thousand subjects, according to the FDA study (Love 2003); so once again using the average represents a strong upward bias, which the CBO does not discuss. The median number of subjects is about onequarter lower, or two thousand subjects, which puts the average calculated by DiMasi, Hansen, and Grabowski (2003) still further out of line with FDA and National Institutes of Health (NIH) figures (as reported in Love 2003: 10 – 11) and makes the secret data submitted by drug companies still more suspect. The largest trials are often for NMEs that provide the least additional benefit so that they require large and long trials to make small differences statistically significant. Does this mean the unnamed drugs in the nonrandom sample used by DiMasi, Hansen, and Grabowski (2003) had disproportionately large trials because more of them offered small therapeutic gains? No one can know, because the identity of the drugs is confidential, too. Love (2003) also presented evidence that the industry data submitted to the Tufts Center and the DiMasi, Hansen, and Grabowski (2003) study had a cost per subject far higher than those calculated by reliable, independent sources. DiMasi, Hansen, and Grabowski reported that the average cost per patient was $23,572 for their sample of NMEs, which started clinical trials between 1983 and 1994. By contrast, NIH data showed an average cost of only $3,861 in fiscal year 1993, rising to $6,202 in fiscal year 1999 (Love 2003: 10 – 11). Several other industry sources reported figures somewhat higher and lower than these NIH figures (ibid.: 9 – 13). If DiMasi, Hansen, and Grabowski’s estimates were redone using FDA and NIH estimates of trial sizes (nearly one-third as large) and costs (onefourth as large), the total cost for trials would be only 9.5 percent as large as claimed. Given that cost of capital makes up 40 percent of the total cost of trials, the uncapitalized estimates would be about 6.3 percent as large. That would be only $18 million rather than the $282 million reported by DiMasi, Hansen, and Grabowski for total trial costs. Such a low estimate may seem unreasonable until one learns that the audited costs of all clini-


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cal trials submitted by pharmaceutical companies to the Internal Revenue Service (IRS) were $11 million for orphan drug candidates and $33.6 million for all orphan NMEs, an average of $22.5 million (Love 2003: 7 – 8). Clinical trials for orphan drug candidates may differ in some ways but not by a lot. In sum, the CBO had good reason to inform Congress that R&D costs based on official and audited figures are a fraction of what the industry’s lobbyists tell them they are. The CBO should also have educated policy makers that no one knows the costs of basic research to discover new molecules. Sometimes a discovery occurs accidentally, like the heart medicine that became Viagra. Sometimes there are thirty years of efforts and failures before the lock and key are found to open the door to a therapeutic breakthrough. Sometimes the cost and time can be precisely known but usually not. Often the basic research costs are shared or the same research contributes to several discoveries. It is also not clear how far back one should go to start counting the costs. In sum, the costs of R&D consist most realistically of an unknown cost of research and a known cost of development. Yet DiMasi, Hansen, and Grabowski (2003) backed a high estimate of all preclinical costs that contribute 42 percent of either the total $800 million average or $300 million median R&D cost per newly approved drug. Finally, one-half of these estimates consist of what is called “cost of capital” or “opportunity cost,” not real cash spent. Cost of capital is more accurately described as “estimated profits forgone” by not putting the R&D money into bonds or an equity fund. By estimating profits forgone, there is an expectation that a company should make back, free of risk, all the money it says it would have made without R&D expenses. In the real world of business, companies hope this will turn out to be the case, but here it is used to double the claim against society for having risked money to find better drugs. Is cost of capital then a reasonable claim to Congress or any other national legislature by an industry making a social good? If so, the usual discount rate used is less than one-half that used by DiMasi, Hansen, and Grabowski (2003). Correcting for this inflationary part of the estimate would make the cost of R&D to corporations even smaller. In sum, if the CBO had fulfilled its role as an independent, critical agent for Congress and policy makers throughout the world, it would have concluded that estimates of the costs of R&D for new drugs range from $1.7 billion including launch costs, as estimated by a major consulting firm for the industry (Gilbert and Rosenberg 2004), to $800 million as estimated by the industry’s policy research center at Tufts based on confidential


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industry data, to an unknown and highly variable research cost plus about $22.5 million for development, as reported by companies to the IRS. Profitability

Profit margins of the major pharmaceutical companies have been consistently two to four times greater than the average for Fortune 500 companies, an indication of excess profits and low risk caused by spreading risk across an increasingly large portfolio as large companies acquire other companies or merge. The CBO, however, does not point this out but instead uncritically reiterates the argument made by industry-supported health economists that R&D expenses are really intangible capital investments. This leads to adding costs of capital at a high discount rate and results in “proving” that profits are only “somewhat above average” (44). However, R&D costs are deducted entirely within each tax year like other business expenses that are fully recovered each year (Light and Lexchin 2005). The CBO should have pointed out that the pharmaceutical industry cannot count R&D costs both ways. The CBO report reiterates the industry argument that profits are needed to pay for R&D: more profits will result in more R&D, and lower profits will mean that important research will not take place. This sounds completely logical and realistic, but how much more is more and how much less is less? If the government were allowed to negotiate lower prices for Medicare drugs, for example, and profit margins declined by 20 percent, would “less” mean $1 million less, 20 percent less, or disproportionately less, such as 30 percent less? Consider a real example. In 1985, profits were $540 million and R&D was $426 million at Merck.1 If profits increased by 330 percent to $1,781 million in 1990 (as they did), would more R&D mean any absolute increase, such as $1 million more to $427 million? Or would it mean proportionately more? That would be $426 × 330 percent or $1,406 million. Or does the promise by the pharmaceutical industry that more profits will be devoted to R&D mean disproportionately more? For example, Merck’s R&D was 79 percent of its $540 million profit in 1985; so if profits skyrocket to $1,781 million, should we expect that R&D will be increased proportionately more, say to 85 percent of profits? That would be $1,514 1. Analysis by Andrew Mulcahy, based on Merck’s 10-K reports to the U.S. Securities and Exchange Commission.


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million. The same questions hold for less. If profits decline by 20 percent, does less mean a million dollars less for R&D, 20 percent less, or proportionately less, like 30 percent less? What actually happened was that Merck doubled its R&D budget between 1985 and 1990 while its profits more than tripled, so that R&D dropped from 79 percent of profits to 48 percent. This trend continued. Between 1990 and 1995, Merck’s profits doubled, but it increased its R&D by proportionately less so that R&D dropped to 40 percent of profits. In the next five years, Merck’s profits doubled again, but it increased R&D proportionately even less, so that R&D dropped to 34 percent of profits. So more in this case means more in absolute dollars but proportionately less — a bad deal for society. Proportionately more of profits went to marketing and executive compensation packages. When profits decline, my guess is that R&D budgets decline less. In other words, the R&D budgets probably rise and fall with less fluctuation than profits, for obvious reasons. They reflect investments in long-term, ongoing projects. None of these important points is discussed in the CBO report. Rather, without reviewing the data or methods, the report cites a major study by Frederick Scherer (2001) on the relationship between profits and R&D budget from an issue of Health Affairs that, as its editor writes in the preface, was supported by the Merck Foundation and the National Pharmaceutical Council (Iglehart 2001). Scherer is a distinguished economist from Harvard, but he has also been an adviser or consultant to the pharmaceutical industry since the Kefauver hearings in the late 1950s. The question is how much pharmaceutical companies raise or lower their R&D budget when profits rise or fall? Within the limits of gross figures published by companies, Scherer or the CBO could have assembled the data to answer this question from 10-K reports. Instead, Scherer (2001: 217) compares the whole industry’s “actual R&D spending around a bestfitting long-term R&D time trend, assuming steady exponential growth” and then compares the deviations of actual spending from that exponential trend with deviations of gross margins from their exponential time trend. He finds that these deviations correlate 0.92. Does this mean that a decrease in profits will lead to a decrease in R&D, as those who cite the study believe it proves? With a few exceptions, all the gross margins and R&D budgets increase every year in Scherer’s analysis. His artificial exercise is several steps removed from the real world of research-based companies. The two key figures of R&D and gross margins come from different data sets. As an independent critic wrote, the analysis highlights rather small variations to arrive at a high


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correlation from which causation is inferred, using data at the industry level although decisions are made at the company level (Young 2001). Further, Scherer (2001: 217) used plant gross margins, “that is, the surplus of revenues over in-plant production costs.” Thus besides allocating gross profits to R&D, companies also allocate them to marketing, executive compensation, administrative overhead, and other major budgetary areas; Scherer does not analyze the fluctuations with gross profits of these areas. Pharmaceutical companies spend two to three times more on marketing, advertising, and administration than they do on R&D, so the most relevant question is by how much their budgets fluctuate compared to the R&D budget when profits decline. To what extent do pharmaceutical companies try to increase sagging profits by pouring more into marketing or by pouring more into R&D? If companies pour more into marketing, then they are more like General Foods. If they pour more into R&D, then they are more like Intel. Congresspeople will learn none of this from the CBO report. The actual relationship between sales and R&D may be a random walk, because decisions about R&D are made for a variety of short-term and longer-term reasons and in response to idiosyncratic opportunities. It also depends heavily on executive policy. When Merck’s CEO, Raymond Gilmartin, hosted and launched in 2001 the record-high estimate that R&D costs were $802 million, he emphasized the central role of research for innovation, and he loved to emphasize how Merck is the quintessential research-oriented company in the industry. Yet, looking at the company’s 10-K forms, he oversaw the rapid decline in Merck’s own R&D from 12 percent of sales in 1985, to 8.8 percent in 1995, to 5.8 percent in 2000. Other studies on profitability cited approvingly by the CBO are led by the industry-supported author Henry Grabowski. These studies purport to demonstrate that profits are not very high and most drugs do not bring in enough revenues to recover even their R&D costs (Grabowski, Vernon, and DiMasi 2002; Grabowski and Vernon 1994). The low-profit argument depends on treating R&D costs as an intangible, long-term investment with a very high multiple used to add on large costs of capital, even though these expenses are deducted and recovered every year (Light and Lexchin 2005). The widely circulated graph showing that seven of every ten new drugs do not generate enough revenue to recover even their R&D costs is based on the authors using the high estimates of R&D costs from DiMasi, Hansen, and Grabowski (2003) and an artificial exercise that has revenues recovering all other costs before the sunk R&D costs, rather than after them (Grabowski, Vernon, and DiMasi 2002). Turn the order of the analysis around, and Grabowski’s research could more reasonably conclude that


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Figure 1a  Pharmaceutical Myth: 70 Percent of New Drugs Do Not Earn Back Average Research and Development Costs Source: Grabowski, Vernon, and DiMasi (2002: 22, figure 7). Reprinted with permission from Wolters-Kluwer.

Figure 1b  Pharmaceutical Reality? 70 Percent of New Drugs Earn Back Average Research and Development Costs, but Only 40 Percent Recover Marketing Expenses Source: Adapted from Grabowski, Vernon, and DiMasi (2002: 22, figure 7), using author’s calculations


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seven of every ten new drugs do recover their R&D costs but not their marketing costs! As we have seen, if the more realistic and better-documented figures in this review were used for size and costs of trials, for most drugs that cost much less than self-originated NMEs, and for other factors, the median estimate of R&D costs would be about one-tenth that estimated by DiMasi, Hansen, and Grabowski (2003), and Grabowski’s figure would show that most new drugs recover their R&D costs and most recover all other costs as well. This is illustrated in figures 1a and 1b. In sum, the CBO buys into the “big-pharma” myth that if prices were lower, R&D would suffer. No other research-based industry makes this argument. When other research-based companies find their profits or market share declining, they redouble their R&D efforts and hope they can discover new features or products that can justify higher prices and greater profits (Goozner 2004). Companies such as Motorola, HewlettPackard, or General Motors had to reinvent themselves through intense R&D. If Pfizer’s profits decline and its CEO responds by reducing R&D, he should be fired for abandoning the company’s future. Yet by repeating the opposite claim for fifty years, research-based pharmaceutical companies have persuaded journalists and policy makers — and apparently the professional economists at the CBO — that lower profits will lead them to reduce R&D and therefore patients will suffer because they will not benefit from therapeutically significant new drugs. By emphasizing the claim that lower prices will lead to less innovative research and fewer supposedly new drugs, the CBO makes the pharmaceutical industry’s mythic claims into officially authoritative facts. This is a great disservice to policy makers. No “Free Riders”

A puzzling omission in the CBO discussion of profitability is an independent study published in a prominent journal that uses industry and government data to show that drug companies earn back all their R&D every year, with solid profits, at British and Canadian prices (Light and Lexchin 2005). Lower European prices do not reduce R&D investments. On the contrary, between 1990 and 2003, pharmaceutical companies increased their R&D investments in Europe 2.6-fold. Moreover, R&D investments in the United States, as a percent of the nation’s gross domestic product, were lower than in Sweden, Switzerland, and the UK. Thus both the size of R&D investment and its upward trend indicate that European and Canadian prices are sufficient to fund a steady growth in R&D. These contradict the industry’s claim that Europeans are free riders on Americans


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because their lower prices do not pay for their R&D. The free-rider argument also makes no sense when pharmaceutical markets are global. Of course, pharmaceutical companies prefer to set their own patent-protected prices in the “free” American market, which they contrast to European government price controls, but “government price controls” are actually negotiated prices between large-volume purchasers and the companies. Americans and Congress are subjected to corporate price controls when companies set their own, largely unpublished prices. This is the key question about the cost of drugs for the elderly in Medicare: does the nation want pharmaceutical companies to control patent-protected prices (which are set at roughly twice the European prices that cover all expenses, with profits)? Or do Americans want to pay European-level prices by negotiating large-volume discounts without extra layers of middlemen? Finally, Light and Lexchin (2005), who show that all R&D costs are recovered at European and Canadian prices, with profits, imply that estimated costs of R&D per drug, like the new $1.2 billion estimate for R&D costs, are irrelevant to Congress. Research and development is a business expense that is recovered every year and is deducted every year. Health economists can design models to make ever-higher estimates of costs per drug over many years of development, but these estimates are political and rhetorical figures used to awe Congress and to persuade the European Commission, in its desperate effort to retake the lead in R&D, that European prices must be higher. Has Innovation Declined?

The CBO chapter on innovation begins with the blunt statement that “the number of new drugs introduced each year has not kept pace with research and development spending in the drug industry” (35). Then it mollifies this statement in ways reflecting the industry’s public-relations pitch that the measures of innovation are misleading and everything they do adds value. The CBO then endorses the industry’s arguments that even though there are fewer new drugs, they add a lot of value. The examples they use, such as statins and selective serotonin reuptake inhibitors, are precisely the groups of drugs widely criticized for their marginal benefits, adverse side effects, and promotion to large populations with little need for them (Moynihan and Cassels 2005; Healy 1997). These are showcase examples of pharmaceutical R&D spending billions on new mechanisms of action that provide little new benefit and substantial new risk (Prescrire International 2003). Next follows a list of factors that could diminish innova-


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tion — more excuses in a chapter that provides no incisive analysis of why so few new drugs offer significant additional benefits. What the CBO and good economists need to tell Congress and policy makers throughout the world is that the present laws and rules provide strong incentives to develop supposedly new, me-too drugs. For less cost and risk and in less time, pharmaceutical companies are rewarded with patent-protected pricing for new drugs that add little benefit for patients. When the CBO uses such terms as “innovation” and “new” uncritically, it buys into the unfounded industry rhetoric that all new drugs are therapeutically better than old ones, when five-sixths of them are not (National Institute for Health Care Management Research and Education Foundation 2002; Prescrire International 2004). Equally misleading is using the label “new” to claim that if prices are lower there will be less innovation and fewer new drugs. Again, new implies better — why else would anyone bother to create something new? The answer is that Congress has created strong market protections and incentives to reward new drugs that are little better. These in turn require larger trials to have enough statistical power to establish the reliability of small differences. New drugs of marginal value also put a premium on shortening time to market. Companies will pay any amount to recruit patients and run trials, because government protections from generic competition allow corporations to set prices at forty to one hundred times manufacturing costs to recover them, as I have explained in an examination of pricing (Light 2006b). If Congress or the European parliaments provide the same government protections from normal price competition for new drugs of marginal benefit that are less risky and less costly to development, then corporations will rationally focus R&D on less cost and more profit for new drugs of marginal benefit. Any newly approved drug is rewarded by locking in monopoly prices and high profits regardless of whether it is therapeutically superior to existing ones. All new drugs have to do is be better than a placebo. From Market Failure to Value Pricing?

The opening summary of the CBO report is all that most policy makers will have time to read, and it emphasizes forms of market failure. The great cost of R&D is the principal reason given by the industry for the high prices of patented drugs, which “cost only a few cents per dose to manufacture” (1). Thus “the price of the drug will have no obvious connection to either cost” (1). Further, “Comparative information about drug


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quality from unbiased, head-to-head clinical trials of competing drugs is seldom published, although it would help drug purchasers make the best choice — and in turn improve the market signals that guide private companies’ decisions about research and development” (1). This lack of basic market information contributes to people in America paying more for new drugs “than almost anywhere else in the world,” and the CBO attributes this to two kinds of market failure: patients do not shop and buy directly but buy “indirectly, mediated by doctors and health insurers” (1). Market signals are made still more inaccurate by Congress making employer insurance tax deductible, and the authors return to this theme in the report. Because insurers, Medicaid, and Medicare keep consumers “from bearing the full weight of those prices, the demand for new drugs is higher than it otherwise would be at any given price” (4). They also “may sometimes create incentives to invest too much in R&D (from the standpoint of the amount of investment that is optimal for society)” (5). This fundamental framework for why prices may be too high, demand too great, and investment in R&D excessive is the only part of the report that pharmaceutical executives would not endorse, because they depend so heavily on government credits, deductions, and market protections to minimize normal price competition and to achieve just what this critique points out: excessively high prices and profits, demand beyond what consumers in a normal market would afford, and more invested in R&D than a free market would justify. This framework echoes the perspective of Milton Friedman and warrants attention. Would the CBO authors really like people to pay cash for medical, hospital, surgical, and pharmaceutical bills? Are they advocating that new, patented drugs be sold in transparent cash markets — like new, patented cell phones or new, copyrighted books — in which the consumers are the buyers? It might work. Prices might cover the high initial costs and come down to at least European levels. For example, books and the patented technology in cell phones also have high initial costs but low manufacturing costs. A new book for $24 or a new cell phone for $240 allows well-run companies to recover all these high fixed costs and make a profit. Many new models of cell phones or books sell poorly and lose, but others sell well and make up those losses. Of course, the danger is that a Friedmanesque market will drive down prices to manufacturing costs, as has happened with vaccines in the past, so that the losses lead companies to exit the market. If the CBO authors were designing an ideal pharmaceutical market,


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would they eliminate prescriptions so that patients would choose their own drugs in an open, price-competitive market? There is a case for that. Given that new drugs are carefully tested and we have licensed professionals called pharmacists, one can argue, as a prominent historian of the American industry does (Temin 1980), that the sudden heavy use of doctors as gatekeepers in the 1930s and 1940s was unnecessary and still is. Under current arrangements, there is no purchaser. There is a prescriber and there are payers — insurance companies and patients — but no purchaser as such. Would the CBO also eliminate health insurance, Medi­ caid, and Medicare? Their report certainly reads as if they would. Since high prices are a burning issue and a principal reason for the CBO doing this study as congresspeople press for ways to lower prices for Medicare, it would have helped to let them know that if a month’s supply (thirty pills) of a 10 mg statin costs $1.50 to manufacture at “a few cents per dose,” a month’s supply of 20 mg pills does not cost double but only $1.50 plus the extra cost of the active ingredient, approximately a penny more per milligram, or about $1.80. A 40 mg pill would cost another $0.30 for a month’s supply or about $2.10 to manufacture. A concrete illustration will make clear basic issues in both the CBO’s vision of what the relationship between prices and R&D should be and what they are. I am one of those millions with somewhat elevated LDL cholesterol who may need it lowered less than 30 percent, although there is a good case that the millions like me need no drug (Moynihan and Cassels 2005). My board-certified gastroenterologist initially put me on Lipitor 10 mg, priced by Consumer Reports (2007), in their major effort to create something resembling a normal market, at an estimated $92 for a month’s supply in November 2006. This price, at 61.3 times manufacturing cost, or a 6,130 percent markup, allows a great deal of R&D to be paid for, although more of it probably goes to marketing to persuade physicians to prescribe more Lipitor and to Pfizer executives for figuring out ways to make more people into “lifers” who take the drug indefinitely in the belief that it will make them live longer. Then Lipitor (or atorvastatin) 20 mg is priced by Pfizer not for $0.30 cents more per month ($92.30) but for $39 more per month ($131) (ibid.). Since all of their other costs are the same — packaging, distribution, even a huge marketing budget — the figures indicate that Pfizer makes $39 of pure profit on an additional $0.30 of cost, or a 13,000 percent markup beyond the gross and net profits on the 10 mg pills. A price structure like this means that no normal price-competitive market exists. The next part of this example illustrates even deeper forms of market


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failure not considered by the CBO or policy makers in their discussions of prices as a framework for financing R&D. My internist said there was no point in my paying for a patented statin, and he recommended sim­ vastatin (the generic version of Zocor). He said the 40 mg pill would be equivalent to the 10 mg of Lipitor I was taking and put me on it. But the Oregon Health and Science University (2007) Drug Effectiveness Review Project, which provides objective comparisons of the effectiveness, safety, and prices for fifteen states and the Consumer Reports Best Buy Drugs project, shows that my experienced internist (the best that Princeton can offer) was dead wrong clinically and financially. Simvastatin 10 mg, not simvastatin 40 mg, has the equivalent effect of Lipitor 10 mg, and these simvastatin 40 mg pills cost $182, double the price of the Lipitor I was taking! Perhaps he had in mind my costs, which dropped from a $10 co-payment for a patented drug to $1 co-payment for a generic. Even simvastatin 10 mg costs more ($104) than Lipitor 10 mg ($92). So here is the second market failure after the clinical and financial errors of the key market decision maker (the doctor): why do the highly paid professionals running the Aetna formulary and insurance plan that I pay for create an incentive for me and my doctor to put me on a generic that costs more than the patented drug I was on? Given the games that generics play with their own high prices and with large markups for generic brands, why not calibrate co-payments by price bands for equivalent clinical effects rather than by whether the drug is on or off patent? In fact, why does Consumer Reports not do that, too, in order to calculate their best buy recommendations? For example, Merck charges $182 for generic simvastatin and $22 more for calling the same drug “Zocor.” Just to get a sense of proportion, that’s a 5,470 percent markup on manufacturing cost for the generic and a 6,930 percent markup for Zocor, based on these prices and my estimate of costs. Meantime, lovastatin 40 mg is the only reasonably priced choice for the millions who need to lower their LDL less than 30 percent. It costs only $58 for a month’s supply, and it is equally effective against heart attacks. That is a substantial savings (largely for the insurer, not the patient). Merck plays the same game of having a brand version of lovastatin called Mevacor priced at $153 — $95 more just for the brand name! Similar stories of profiteering in a nominally free market, in which prices do not seem to matter much, could be told about Crestor, Lescol, Altoprev, and Prevachol. In sum, what members of Congress and policy makers in Canada, Europe, and throughout the world need to know and what the CBO fails


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to point out about the bigger framework for this study is that the so-called American free market for drugs was designed by industry lobbyists not to have head-to-head clinical trials, not to require that clinical trial results be publicly available, and to have largely secret or difficult-to-find prices. (The initiative by Consumer Reports and the Engelberg Foundation is an exception.) If policy makers want a real market, they must have full comparative information on price, quality, and other measures of value. Further, policy makers need to find out why insurers and even highly trained and experienced doctors do not know what any patient can read on the Consumer Reports Web site about either dosage or prices. Yet Congress voted to pay insurers billions of extra dollars to act as an unnecessary intermediary for the unneeded Medicare prescription drug plans, essentially a taxpayer giveaway to insurance companies and pharmacy benefit – management companies. If administrators of drug plans were rational and wanted to serve the interests of taxpayers and patients, they would use their buying power to create “value pricing,” the same price for the same therapeutic value, and proportionately higher prices for greater therapeutic value. In that case, they would pay no more for any drug that achieves a 30 percent reduction of LDL than the $58 for lovastatin 40 mg. They would also create a truly competitive market to drive down prices closer to the $2.10 it probably costs to manufacture a month’s supply for any new drug that is not therapeutically superior. It is value pricing that will achieve the CBO goal of sending the right signals for R&D: therapeutically better drugs will command high prices, but drugs with only slightly different profiles of main effects or side effects will not. Of course, the pharmaceutical industry loves the current nonmarket in which the decision makers are uninformed and asleep with the till open. The clear market signals now are that anything new, even if not better, will be granted a government-guaranteed monopoly for years and then can be sold to the somnolent payers for just as high a price or higher, as in the case of overpriced Zocor, Mevacor, Crestor, or Prevachol. Thus R&D is focused on developing lower-risk and cheaper variants of existing molecules and molecular manipulations that are not therapeutically superior, because one can make far more money at lower cost and risk than trying to discover breakthrough drugs. We get what we ask for. If Congress and other policy makers want R&D to focus on breakthrough drugs, they have to reward it with value pricing. Donald W. Light, Netherlands Institute for Advanced Study and University of Medicine and Dentistry of New Jersey


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References Consumer Reports. 2007. Consumer Reports Best Buy Drugs: Treating Elevated Cholesterol and Heart Disease — The Statins. www.crbestbuydrugs.org/drugreport _DR_Statins.shtml (accessed January 30, 2007). DiMasi, J. A., R. W. Hansen, and H. G. Grabowski. 2003. The Price of Innovation: New Estimates of Drug Development Costs. Journal of Health Economics 22:151 – 185. ———. 2005. Reply: Extraordinary Claims Require Extraordinary Evidence. Journal of Health Economics 24:1034 – 1044. Gilbert, J., and P. Rosenberg. 2004. Addressing the Innovation Divide: Imbalance Innovation. Boston: Bain. Global Alliance for TB Drug Development. 2001. The Economics of TB Drug Development. New York: Global Alliance for TB Drug Development. Goozner, M. 2004. The $800 Million Pill: The Truth behind the Cost of New Drugs. Berkeley: University of California Press. Grabowski, H. G., and J. M. Vernon. 1994. Returns to R&D on New Drug Introductions in the 1980s. Journal of Health Economics 13:383 – 406. Grabowski, H. G., J. Vernon, and J. A. DiMasi. 2002. Returns on Research and Development for 1990s New Drug Introductions. Pharmacoeconomics 20 (suppl. 3): 11 – 29. Harris, G. 2001. Health Costs of Developing New Medicine Swelled to $802 Million, Research Study Reports. Wall Street Journal, December 3. Healy, D. 1997. The Antidepressant Era. Cambridge, MA: Harvard University Press. Iglehart, J. K. 2001. America’s Love Affair with Medical Innovation. Health Affairs 20 (5): 6 – 7. Light, D. W. 2006a. Basic Research Funds to Discover Important New Drugs: Who Contributes How Much? In Monitoring the Financial Flows for Health Research 2005:Behind the Global Numbers, ed. M. A. Burke, 27 – 43. Geneva: Global Forum for Health Research. ——— . 2006b. Pricing Pharmaceuticals in the USA. In Excessive Medical Spending: Facing the Challenge, ed. N. J. Temple and A. Thompson, 63 – 79. Oxford: Radcliffe. Light, D. W., and J. Lexchin. 2005. Foreign Free Riders and the High Price of U.S. Medicines. BMJ 331:958 – 960. Light, D. W., and R. N. Warburton. 2005. Extraordinary Claims Require Extraordinary Evidence. Journal of Health Economics 24:1030 – 1033. Love, J. 2003. Evidence Regarding Research and Development Investments in Innovative and Non-Innovative Medicines. September 22. www.cptech.org/ip/health/rnd/ evidenceregardingrnd.pdf. Moynihan, R., and A. Cassels. 2005. Selling Sickness: How the World’s Biggest Pharmaceutical Companies Are Turning Us All into Patients. New York: Nation. National Institute for Health Care Management Research and Education Foundation. 2002. Changing Patterns of Pharmaceutical Innovation. May. www.nihcm.org/ finalweb/innovations.pdf.


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Oregon Health and Science University. 2007. Drug Effectiveness Review Project (DERP) 2007. www.ohsu.edu/drugeffectiveness/ (accessed January 30, 2007). Prescrire International. 2003. A Review of New Drugs and Indications in 2002: Financial Speculation or Better Patient Care? Prescrire International 12 (64): 74-77. ——— . 2004. Industrial Interests versus Public Health: The Gap Is Growing. Prescrire International 13 (70): 71 – 76. Public Citizen. 2001. Rx R&D Myths: The Case against the Drug Industry’s R&D “Scare Card.” July. www.citizen.org/publications/release.cfm?ID=7065. Scherer, F. M. 2001. The Link between Gross Profitability and Pharmaceutical R&D Spending. Health Affairs 20 (5): 216 – 220. Temin, Peter. 1980. Taking Your Medicine: Drug Regulation in the United States. Cambridge, MA: Harvard University Press. Tufts Center for the Study of Drug Development. 2006. Average Cost to Develop a New Biotechnology Product Is $1.2 Billion, According to the Tufts Center for the Study of Drug Development. November 9. csdd.tufts.edu/NewsEvents/NewsArticle .asp?newsid=69. Young, B. 2001. Faulty Links between Profits and R&D Spending. Health Affairs 20 (6): 310.



Big Pharma Misleads Congress About Drug Development