Why is the market design for innovative pharmaceuticals not well understood? – Healthcare Economist

That is the title of a fantastic editorial by Olivença and others (2024)Many people, when they look at drug prices, think they are “too high” or “too low.” But the question is, too high or too low relative to what? What are our goals for drug pricing? The editorial makes it clear that this is a market design problem. I have heard one of the co-authors (Dr. Lou Garrison) make this point several times at conferences, but it is helpful to see it written down.

It is noteworthy that the market exclusivity enjoyed by medicines covers only the manufacture of a specific product; competitors may come up with competing treatments and identical generic copies may arrive once market exclusivity ends.

The value of this monopoly power is limited by market competition and time. This leads to a market framework that promotes medical innovation by offering potentially large but uncertain returns for high-risk investments, while using competition to regulate prices in the later stages of the product life cycle.

The article begins by arguing against setting drug prices based solely on the cost of research and development (R&D):

[Cost plus pricing]…not only fails to recognize the risk of these investments and the irrelevance in this market design of the costs of any specific product, but also the difficulties in identifying relevant failed products and measuring their costs. Moreover, this perspective would not convey the true value of novel drugs to patients and society and would therefore stifle innovation by failing to send value signals to investors in the highly risky field of drug development.

The article argues against price fixing as advocated by Bernie Sanders, among others:

It is worth noting that Senator Bernie Sanders recently asked Novo Nordisk for the R&D costs of semaglutide, a treatment for obesity. It is imperative that we communicate that using R&D costs to determine price is flawed and that we should instead focus on calculating the full value a drug provides to patients, their families, and society. The “blockbuster model,” which relies on revenues from successful drugs to cover the costs of numerous failed attempts, is often misunderstood or overlooked in discussions of drug pricing and regulation. Of course, companies can still make a profit on a “marginal” product if revenues cover the marginal cost of R&D and the costs of production and distribution; but a company needs a few products whose average R&D cost is a multiple of the average R&D cost to cover the failed products.

The following figure summarizes the blockbuster model.

A very interesting editorial, clearly articulated throughout. Read the full article here.