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You’ve probably already heard about the pharma outrage du jour. In short: start-up Turing Pharmaceuticals, led by combative ex-hedge fund manager Martin Shkreli, recently acquired Daraprim, a 60+ year-old drug to treat a parasitic infection called toxoplasmosis – the only available treatment for this rare infection – which can become deadly for HIV+ individuals and others with weakened immune systems. Turing then promptly raised the price by more than 5000%, from $13.50 to $750 per tablet, such that a single individual’s treatment can now cost up to $634,000. Many, including prominent politicians, are understandably outraged by this “price gouging” of AIDS patients – and the political class seems highly motivated to take action.

In this case, their drive for policy change is backed by a solid economic rationale. This excellent Vox article lays out many of the issues at play in the current drug price flame war – but it doesn’t fully capture the impact of insurance. While there is no legal upper bound to the price of drugs in the US, the same is also true for shoes, cars, and croissants. The profit-maximizing owner of the exclusive distribution rights for any of these products would set its price-cost margin to the inverse of the elasticity of demand. While there is no legal price limit in the US, the profit-maximizing monopolist would be a “moron” (Shkreli’s word) to set the product’s markup price lower or higher than the inverse of its price elasticity.

The VOX article rightly points out that patients are desperate to receive the drug – without it, they will often die – implying that the elasticity of demand is very low. (In plain English, "elasticity" is just the degree to which consumers reduce their purchases in response to a price increase. A good presentation of the math behind Shkreli’s textbook pricing strategy is here.) Insurance coverage decreases the elasticity of demand even more, by lowering the effective price paid by the consumer while passing it on to others in the insurance risk pool.  It is these two aspects together that distinguish demand for any drug without substitutes from demand for shoes, cars, or croissants.

But in this case, the product Daraprim is off-patent, so there should be few barriers to a firm wishing to make and sell it. ("Should" may be the operative word here; Turing seems to have taken deliberate steps to hide Daraprim from generic manufacturers in order to artificially limit competition). But to date, the only reason there are no substitutes is that few Americans need the drug. (Although toxoplasmosis used to be one of the most common opportunistic illnesses for AIDS patients, HIV infected people today who promptly begin and rigorously adhere to anti-retroviral therapy will never need this drug.) As soon as Turing decides to sell this drug at this high price, other companies could decide to make it and sell it at a lower price, stealing Turing’s market and quickly driving the price back down. 

The CEO chose the price of $750, instead of a much higher price, because it is high enough to make a profit for a few months or years, but low enough to dissuade the biggest global manufacturers from immediately entering the market. The CEO knows that lower-cost generic manufacturers will soon be competing for the same clients, so this is a short-run opportunity, lasting only a few years. People who need the drug but lack insurance will be the biggest losers (AIDS patients who start treatment late are often in this category). But almost all Americans will contribute to Turing’s profits through our higher insurance premiums and taxes (for government-financed care and insurance).

Profit-maximizing ploys like this suggest that in the long-term interest of global health, private corporations require more regulation over their international pricing structure. The public deserves a say in how these firms assigns prices – and how they distinguish pricing across countries with different insurance systems and health needs (so-called "tiered pricing").  Just as utility companies best serve the public interest under government regulation for their local markets, multinational pharmaceutical companies would best serve global health under global regulation that supervises their international pricing as well as their research expenditures. Such regulation should authorize higher prices for drugs in rich countries (where we have higher incomes and health insurance) only on condition that companies give back to society in the form of research on high burden diseases and prices no higher than necessary in poor countries.

One ironic postscript of this entire saga: big pharma itself may end up among the biggest losers. Mr. Shkreli’s transparent greed and “gotcha” attitude have elicited such public outcry that politicians have been forced to take notice – and, anticipating a looming policy crackdown, biotech stock prices have plummeted. This elasticity of public response is why Mr. Shkreli, in addition to suffering the public shaming of media and Reddit attacks, may already be persona non grata among his big pharma peers – and it’s the likely explanation for his recent decision to rescind at least part of the price increase. Perhaps he’ll soon learn that he was the “moron” to dismiss so rudely and transparently the idea that something other than profit-maximization might guide the pricing strategy of a pharma CEO.

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CGD blog posts reflect the views of the authors, drawing on prior research and experience in their areas of expertise. CGD is a nonpartisan, independent organization and does not take institutional positions.