Where Have You Gone, Vilfredo?

We’re still talking about the high price of drugs and how to lower them while not decreasing incentives for research and development. There is a mechanism for achieving this that was explored over a hundred years ago by an Italian engineer, statistician and economist named Vilfredo Pareto.

Government economic policies often contemplate exchanges of wealth where one side benefits at the expense of the other, such as a wealth tax or land reform. One of Pareto’s contributions was that markets are forums for mutually beneficial exchange, the special case of transactions where both sides benefit.

Naturally, involuntary wealth redistribution is difficult to achieve politically. Reallocations where at least one person benefits and no one loses are always preferable. Under the right conditions, a market will solve an economic problem through only mutually-beneficial exchanges.

The policy implication is that if the right conditions do not exist, create them in order to find the politically easy way to solve the economic problem.

The economic problem with the international pharmaceutical industry is that people are dying who could be saved at a cost of only a few dollars. The missing condition is that the marginal cost of producing a drug is much less than the price necessary to make its development feasible. For a market to function well, the price of the good must equal the marginal cost of producing the good (P = MC).

The existence of unexploited mutually beneficial exchanges is a clear sign that a condition for an efficient market solution is missing. Such is the case with today’s pharmaceutical industry.

Today’s Pharmaceutical Industry

To see how this might work today, let’s establish some broadly summarized facts.

There are several patented drugs that fit the following general description.

  1. Of all the people world-wide who suffer from a treatable condition, US residents represent no more than 10%.
  2. The multinational pharmaceutical company that has patent protection for a drug that effectively treats the condition sets a price that will maximize the return on its investment, a price much greater than the marginal cost of production.
  3. Private and public insurers in the US — representing the majority of US residents with the condition — pay the high price.
  4. Payers in many other countries decide that at such a high price they can save more lives by not purchasing the patented drug at all or rationing a limited quantity of it.

Each point makes perfect sense separately. It is only the final result that is a real head scratcher: a large percentage of the people in the world with a treatable condition do not receive the effective drug even though the marginal cost of producing it is almost zero.

Many prescription drugs sold by pharmacies fit this description. For example, there is Harvoni, a treatment for hepatitis C, an often-fatal infection, produced by Gilead Sciences. In 2017, Medicare and Medicaid (M&M) paid more than $3.7 billion dollars to treat 50,000 beneficiaries. M&M pays for the treatment for any beneficiary diagnosed with hepatitis C. Even more U.S. residents with hepatitis C are covered by private insurers. These insurers have a similar policy and pay similar prices. In contrast, the UK’s National Health Service (NHS) spent a comparable amount per beneficiary, but for only 10,000 beneficiaries. There are 210,000 people in the UK diagnosed with hepatitis C.

Revlimid (generic name: Lenalidomide) is another example. M&M paid over $3.5 billion to treat over 40,000 beneficiaries for this cancer fighting drug in 2017. The NHS covers this drug for multiple myeloma, but only for patients who cannot take the current thalidomide-based standard of care or are not able to have a stem cell transplant. Coverage is denied when used to treat myelodysplastic syndrome (MDS), a rare blood disorder. Consequently, only 2,100 patients are covered for this drug in the UK.

Clinically administered drugs, usually injected into the patient in a clinical setting, also fit this pattern. For example, Opdivo (generic name: Nivolumab) is used to treat cancer. In 2017 M&M spent $1.6 billion to treat 33,000 patients. The UK’s NHS only approved this drug in late 2017 and only for 1,300 cancer patients.

A study published in 2009 found that 26% of cancer drugs evaluated by the NHS were either denied coverage or only covered provisionally due to a lack of effectiveness relative to cost. Another study published in 2017 concluded that the U.S. paid the highest average price for cancer drugs compared to six other countries, but the authors could find complete price information in each country for only eight patented drugs out of 99 approved by the Federal Drug Administration. Many of these drugs are very hard to obtain in these other countries because of rationing, even if their prices are relatively low.

A Pareto Solution

The world pharmaceutical market exists in what economists call a Pareto Inferior solution. This is the situation where there are mutually beneficial trades that are left unconsummated. For illustrative purposes, here is a hypothetical life-threatening medical condition and its hypothetical effective drug treatment.

There are 10,000 insured patients in the US with the medical condition. At $250,000 per patient, the producer receives $2.5 billion as compensation for the cost of developing the drug.

World-wide there are 100,000 people who suffer from this medical condition, but at such a high price, other countries either ration the drug or deny coverage entirely.

It doesn’t take high-level math skills to see that if all countries agreed to pay $25,000 for each patient, a 90% reduction in the price, the producer would still earn its $2.5 billion reward (100,000 × $25,000 = $2.5 billion). Remember that the marginal cost of producing additional units of the drug is zero.

This is a Pareto improvement because at least one person benefits and no one suffers a loss. Specifically, the U.S. treats the same number of patients, but spends less money and the rest of the world increases the number of patients treated at a favorable price while the producer is unaffected.

The Bottom Line

Since large pharmaceutical companies are multinational monopolies, the best way to negotiate with them is vis-à-vis an international organization deputized to represent the participating governments of the world. A lone government simply setting the price it pays to be no larger than those paid by other countries will achieve little. The pharmaceutical giants already set their prices globally. The occasional exception to this rule will disappear if the suppliers see that a price concession to one country brings down the world-wide price.

By widening the base, the number of patients covered, this international agency could offer a deal to the pharmaceutical companies too good to refuse. A single, international price would eliminate arbitrage, the very phenomenon pharmaceutical companies fear so much. Research and development costs would be covered. The U.S. would save money and the rest of the world would save lives.

As Vilfredo Pareto might have said, vincono tutti (everybody wins).

Published by TheLoneEconomist

I am a PhD economist who studies just about anything and proudly specializes in nothing.

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