For decades, R&D spending on pharmaceuticals has gone up more or less in tandem with the list prices of prescription drugs. Pharmaceutical companies sometimes cite rising R&D expenditures to justify list prices of prescription drugs in the U.S.
It’s a truism that in order for pharmaceutical firms to be going concerns they must recoup costs, including R&D expenditures. It’s also a truism that if investors aren’t enticed by large returns for taking big risks with their money, the investment dollars to fund pharmaceutical R&D will diminish.
Additionally, variable production costs may play a role in determining drug prices. For large molecule biologics, for example, marginal production costs are relatively high, while for small molecule pharmaceuticals such costs are low.
Nevertheless, sunk costs shouldn’t enter the pricing equation. Ultimately, the value of a product in the market is not connected to the amount of investment to get that product to the market.
In economics, since the so-called marginal revolution 150 years ago traced value to the individual, whose marginal utility measures the value of goods, price became a function of a purchaser’s willingness to pay. Given supply of a good, alignment of price and value occurs by way of consumer demand.
If price and value are not aligned, price will adjust to restore equilibrium. At least, that’s what is supposed to happen in a competitive market. But, pharmaceuticals and other health technologies don’t operate in a fully competitive market. The market is characterized by (temporary) monopolies, often a great degree of uncertainty in terms of health outcomes, asymmetry of information between suppliers and purchasers, and third party payments of the bulk of costs on behalf of end-users.
Some of the violations of competitive market assumptions are intentional. Patents, which establish temporary monopolies, spur innovation. Third-party coverage is necessary, especially with respect to large, unforeseen expenses. Consequently, branded prescription drug prices may not invariably behave the way one would expect in a competitive market. That is, their prices and value can diverge.
Pharmaceutical firms have tried the tack of justifying high prices of certain newly approved products by pointing to the necessity of funding costly research projects that will lead to development of new drugs in the future.
Certainly, ongoing and future drug development requires large investments. But again, when price and value are aligned the price is largely disconnected to prior investment.
Apple doesn’t tell its customers that the relatively high price of its products is due to high R&D, or because it’s needed to spur new innovations in the future. Instead, Apple conveys a value story, if you will, which some customers buy into. In other words, the company says the price of its products reflects their value. And, customers express a willingness to pay for Apple products at prices set in a competitive market. Undoubtedly, Apple plows a portion of its profits, owing to price being above marginal cost, into R&D. But, the point is that Apple isn’t justifying its pricing based on R&D. The same should hold true for prescription drugs.
It’s important to emphasize that the argument here is not against high drug prices per sé. Many branded and generic drugs have value commensurate with the benefits they confer. Accordingly, their prices are certainly justified. Take, for example, the 20% of drugs that are cost-saving, and an even higher percentage that are cost-effective.
Rather, the argument is against justifying high drug prices as a consequence of high levels of R&D. Sometimes a lot of R&D goes into very valuable products that should be priced accordingly. Other times, products with relatively small amounts of R&D turn out to have a lot of value, and should be priced accordingly. On the flip side, products that have been heavily invested in may not work any better than the current standard of care, or only marginally better. Correspondingly, the products’ prices should not be much higher than the standard of care.
In brief, purchasers don’t pay a lot for something simply because of all the R&D that went into it. Irrespective of R&D price should reflect the value of the product.