US Drug Prices And R&D, Take 2: A Reply To Grabowski And Manning, And To Light

Recently we (along with Zachary Helms) published a Health Affairs Blog post refuting the pharmaceutical industry argument that the higher prices the industry charges in the US are justified because they are necessary to support research and development (R&D). Our analysis found that US taxpayers, patients, and private industry were paying 1.7 times the global R&D expenses of major pharmaceutical corporations as a result of paying more than these corporations charge European countries for the same products — an excess amounting to $40 billion in 2015, about 10 percent of total spending in the US on pharmaceuticals.

Health Affairs Blog published two posts responding to our work. While we appreciate the comments from Grabowski and Manning and from Light, and we note the extent to which their views differ from one another, we think both responses may have misunderstood the inferential framework of our analysis.

How We Partitioned The US Premium For Pharmaceuticals Into Required Profit, Global R&D Expenses, And Excess Above These Two

Our analysis began with a bold assumption: that it was reasonable that global R&D costs incurred by major pharmaceutical corporations should be 100 percent subsidized by US sources, even though these are global companies, patients all over the world benefit from the products, and many of the companies earn more in revenue outside the US than within it. We applied this assumption because when combined with other conservative assumptions, it provides the greatest justification for the industry’s argument as to why they must charge higher prices in the US. Yet as we showed in our post, the industry argument ultimately fails even under this best case scenario.

To partition these companies’ US revenues, we first took as a surrogate for the required level of the subsidy each company’s global research and development costs that they report in their SEC filings. We then assumed that after R&D costs are fully paid for from US sources, the industry should garner an acceptable marginal profit for its US sales on top of the subsidy. To determine that margin, we looked to Western European prices for the floor of acceptable profit level: what Grabowski and Manning call the drug company’s “reservation price,” or the price below which the manufacturer would not sell its product.

We then quantified the excess the drugmakers capture due to premium pricing in the US market by netting out the required profit and global R&D spending from total sales in the US. That is how we arrived at $40 billion in excess for 2015. Since our paper is a response to the industry’s common claim that premium pricing is required to fully fund R&D, it is outside the scope of this analysis to look at other discretionary expenses, such as selling, marketing, or manufacturing, even though Grabowski and Manning seem to believe that these too should be fully funded through the premium paid in the US market.

A Long List Of Conservative Assumptions

As we noted, our analysis was designed to be conservative in every respect. Assuming the US is and should be the sole bearer of all global R&D costs is the first conservative assumption. To the extent the US does not or should not solely bear this cost, it reduces the amount of allowable premium and increases the excess above our $40 billion estimate. This assumption in our analysis is what Light points out serves to perpetuate the “foreign free rider myth.” We did not intend to perpetuate this myth. Further, the assumption that it should be 100 percent subsidized is the same as applying no future value to R&D. Although returns on R&D have declined, they are not zero as the article from Berndt cited by Grabowski and Manning notes.

Our reservation price estimates themselves are also conservative on two fronts. As Light notes European prices are undoubtedly higher than the drug corporation’s true reservation price. Moreover, the list prices themselves are conservative, while the true prices net of confidential rebates are necessarily lower. In the context of our analysis, then, that these prices are higher than they should be along two dimensions leads us to underestimate the true excess.

Specific Concerns And Claims Of Grabowski And Manning

Grabowski and Manning offer no logic or data to support a bold claim that our estimates are biased upwards due to our sampling frame. Moreover, they have mischaracterized our methods. We did not only consider blockbusters; we focused on the companies that dominate the market because that is where the money is and individually analyzed every drug that accounted for 5 percent or more of each of these company’s sales (more than 100 drugs in total). We could not go further because we hit the limit of the companies’ disclosures at the product level. A positive correlation between revenues of a particular drug within a company and the spread between its US and European prices would be evidence of the bias Grabowski and Manning insist plagues our result, since it would suggest that leaving out drugs under the 5-percent-of-revenue threshold could have inflated our estimate of the excess of US prices over European prices; however, we found no such correlation.

Numerous of the statements by Grabowski and Manning are more adage than argument. They label European government’s monopolists (we think they meant “monopsonists”). What they mean is that these governments have too many covered lives to be fair players in the market. Yet they label the US as a competitive market. Objectively it is hard to see how the government of Ireland is exerting unfair market power representing its 4.6 million inhabitants, but Express Scripts is merely a market actor when it represents 85 million covered lives. Moreover, even while claiming the US market is well functioning—and we all know markets are brutal—they plead for sympathy for some of the companies in our analysis, which they characterize as young and tender. Included in their list are Biogen, which was founded in 1980 and has a $55 billion market cap, and Amgen, founded in 1978, which 15 years ago exceeded $5 billion in revenue and today has a market cap of $122 billion.

In sum, with at least $40 billion to work with even after corporations capture their acceptable profits and have their R&D fully subsidized, we believe there is plenty of middle ground between the US’ broken market processes and the point at which the industry will be “unable to cover the high fixed costs of research and development investment and earn a return to sustain future innovation.”

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