David R. Henderson  

Rebuttal to Jeffrey Sachs on Sovaldi

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One of the big breakthroughs in economics was the "Marginal Revolution" of the 1870s, when economists figured out that the value of something is not the same as the cost. The value of Sovaldi to many people is far above the production cost. Allowing companies to charge high prices that reflect that value will give them an incentive to keep on researching, discovering, and producing high-value--and sometimes life-saving--drugs.
This is the closing paragraph of my article "In Defense of an 'Expensive' Drug," Defining Ideas, April 30, 2015. In it, I take on Jeffrey Sachs's piece in which he criticized Gilead for charging such a high price of its drug Sovaldi.

Another excerpt:

But, first, let's consider the relevant question about Sovaldi: Is its value higher than its price? For many people, it is. Indeed, when we understand just how valuable the drug is--not to Gilead, but to patients--it's clear that Sovaldi is an incredible bargain. Consider how doctors treated Hepatitis-C shortly before Sovaldi came along. According to WebMD, "the typical treatment for hepatitis C was a combination of interferon and ribavirin with two antiviral drugs," telaprevir or boceprevir, both of which were introduced in 2011. This combination led to cure rates between 30 and 80 percent. But the side effects were awful: flu-like symptoms, fatigue, anxiety and depression, and anemia. Sovaldi has only mild side effects and a 90-percent cure rate. Also, the previous treatments took 28 to 48 weeks to cure Hepatitis-C, whereas Sovaldi takes only 12 weeks to work.

Moreover, according to Jonathan M. Fenkel, a doctor who directs Thomas Jefferson University's Hepatitis C Center, the price of a Sovaldi treatment is "on a par with the costs of telaprevir or boceprevir." So the price of Sovaldi is about the same as the combined prices of telaprevir or boceprevir; the cure rate is higher; the side effects are much milder; and the therapy takes less time. Sovaldi sounds like a bargain.


I also consider the case for intellectual property and argue that, if we take as given the FDA's restrictions on new drugs, the case for intellectual property for drugs is strong.




COMMENTS (22 to date)
Craig J.Bolton writes:

Yept, the point of monopoly is always to transform value into a price above cost.

Nick writes:

I think in these excerpts you're glossing over the main concern, which isn't that people paying for the drug aren't getting enough value for their money, but rather that there are people out there whose value of getting the drug is below the price but above the production cost.

You do talk in the article about how Medicaid regulations prevent price discrimination, which I thought was interesting. But there are other potential solutions to the problem, such as price regulation or subsidies. You say that if we regulated the price, pharmaceutical companies would have no incentive to develop new drugs because of the onerous FDA process, so we would 'probably' have no new drugs. But Jeffrey Sachs was careful to point out that profits from the drug so far have well exceeded both his estimate of development costs as well as your 2.5 billion estimate.

Slugger writes:

I have long thought that while the pharmaceutical industry frequently complains about the onus of governmental regulations, they do derive large benefits from them. The profitability of Big Pharma is insured by the full power of the law. There is a wall of laws that prevent competition. Typically, the patent law process does not just protect a specific molecular compound, but is used to patent many similar molecules and even the chemical processes to make any similar compounds. Many pharma companies employ as many attorneys to suppress competitors as scientists. With the addition of laws such as the no price haggling provisions of the Medicare D law, the pharmaceutical industry is a great example of industry-government pricing. The biggest opponent of free-market capitalism is not socialism but the established industrial powers.

Don Boudreaux writes:

Nice piece, David!

Your point would be less obscure to economists if more of them had, like you and me, studied Coase's writings more carefully. I'm thinking here especially of Coase's brilliant, and relatively unsung, August 1946 Economica paper, "The Marginal Cost Controversy."

David R. Henderson writes:

Thanks, Don Boudreaux.
Re Nick’s comment above, there’s a fairly obvious rebuttal to his point. It involves ex post and ex ante. I’m holding off to see if some other commenter steps up and points it out.

David R. Henderson writes:

Oops.
I just noticed that Nick misstates my argument. So now there are two obvious rebuttals, the second of which is even more obvious than the other one I had in mind.

Charley Hooper writes:

Nick,

You're falling into a classic trap by looking at a biased sample. By considering only Sovaldi, which is a hyper-successful drug, you are ignoring the thousands upon thousands of drugs that have been less successful and those that have failed outright during clinical trials.

If drug prices were regulated in such a way that the Sovaldis of the world still made economic sense to develop, but just barely, there would be far less drug discovery and development occurring.

I work in the pharmaceutical industry building models to help companies decide what products to develop and I have recommended against developing a number of drugs because of the economics.

Mr. Econotarian writes:

Gilead's 5 year average profit margin is 35%. Not low, but not as high as Sach's analysis would suggest.

Drug companies have a lot of overhead, and a lot of loser drugs as well. They need to be looked at like a VC firm, taking promising new drugs, investing in them and rolling the dice, and getting profits 1/10 candidates or less. Plus their "analysis" group generally is a significant research operation unlike a bunch of quants at a VC firm.

Charley Hooper writes:

Slugger,

A ballpark estimate is that because of government regulations, there are 1/10 as many drugs on the market and they cost 10-times as much.

Does the drug industry like this regulation? Sometimes yes and sometimes no.

From my experience, my clients don't like it because they are daily facing the regulatory headwinds that make it so hard to develop and market drugs. Even when they like it, I think they are generally wrong.

michael pettengill writes:

Selling Sovaldi to 10% of the patients who could benefit at 1000 times the marginal cost is obviously better than selling it to 90% at only 10 times marginal cost??

Is that really welfare maximizing in economic theory today?

Pajser writes:

The patent law is attempt of the state to capture positive externalities and give them to one who caused them. It is logical extension of the concept of the property. It certainly reduces human freedom, but it does it on the same way original property over material things does. FDA is relatively unimportant for justification of patent laws.

If FDA actions make drugs more expensive, then it is not fair that only drug users pay the price for that. Some direct redistribution from owner of the FDA - USA citizens - toward pharmaceutical industry would be more adequate. R&D of new drugs would be even more profitable. As long as one cares about market.

Charley Hooper writes:

michael pettengill,

Virtually everyone who wants Sovaldi can get it due to the way insurance and patient assistance programs work. Those who have insurance get it through their insurance company. Those who don't have insurance, or have poor insurance, can get assistance or free product directly from Gilead Sciences.

Nick writes:

@Charley Hooper

If I understand you correctly your point is that we need to look at overall profit margins, including all drugs that didn't pan out.

David however does not cite statistics on average profit margins for pharmaceutical companies, only an average cost of 2.5 billion. I believe profit margins are actually very high, suggesting that we are not at average cost pricing. I don't know though, but that would have been the relevant number for David to cite.

But the real relevant question here is 'what is the value and cost to the marginal consumer'. Since David mentions price discrimination, I assume he agrees that right now, the marginal value is much higher than the marginal cost. What I don't understand is why he spent so much time arguing that the drug is worthwhile to the people currently buying it, which is (a) pretty plausible sounding and (b) completely irrelevant when thinking on the margin.

Lupis42 writes:

if we take as given the FDA's restrictions on new drugs, the case for intellectual property for drugs is strong.

"Other than that, Mrs. Lincoln, how was the play?"

Charley Hooper writes:

Nick,

But if virtually everyone who wants Sovaldi is currently getting it, is there a difference between the current consumer and the marginal consumer?

David R. Henderson writes:

As I mentioned above, I was giving commenters a chance to find the two flaws in Nick’s argument above. Charley Hooper caught the subtle one. No one caught the obvious one.

The subtle one: I would put it a little different from Charley’s formulation. If Gilead could have known ex ante how well this drug would work out for the company, then, of course, Gilead could have settled for a much smaller price and for revenues equal to a much smaller multiple of costs. But they don’t know ex ante. Charley’s first paragraph in his first comment makes this point.

The obvious one that no one caught: One of the easiest ways to “win” an argument against someone is to misstate what that person said.

Here’s what I wrote: "With such extreme FDA regulations and with no patent protection, we would probably have no new drugs.”

Here’s what Nick wrote: “You [DRH] say that if we regulated the price, pharmaceutical companies would have no incentive to develop new drugs because of the onerous FDA process, so we would 'probably' have no new drugs.”

I trust that readers can see the difference between “no patent protection” and regulating prices.

Michael Byrnes writes:

Mr Econotarian wrote:

"Gilead's 5 year average profit margin is 35%. Not low, but not as high as Sach's analysis would suggest."

They haven't had Sovaldi on the market for those 5 years, though - so I would imagine that figure is headed north. (Not that this matters for the issue at hand...)

Sieben writes:

I would like to see you address the Kinsella style arguments that IP is not legitimate. You can have contractual "IP" on a free market, but the notion that ideas can be "owned" appears to be nonsense. Particularly, what kind of property right expires after 100 years? etc. etc.

Nick writes:

@David

Thank you for pointing out my misquotation of your article, I misread it and I apologize. By the way, I don't see this as an argument to be 'won' through deception, and I did not deliberately misquote you.

Instead I care about getting this right. Large parts of your article are incomprehensible to me. You mention thinking on the margin, after spending a lot of time arguing that for the people currently buying the drug it's a great deal. How exactly is that relevant to the question of whether the marginal value is currently too high?

You cite none of the statistics I would expect to back up your claims. What is the marginal value / cost of the drug currently? What are the average profit margins of these pharmaceutical companies? You only cite something like average cost, it's still well below the profits mentioned by Sachs. You respond in your comment that I'm failing to consider average profits over all drugs, not just the successful ones. I agree -- and doesn't that sound like information you should have included in your article?

@Charley Hooper

But if virtually everyone who wants Sovaldi is currently getting it, is there a difference between the current consumer and the marginal consumer?

If that's true, then I agree. David says at the end of the article that there are probably uninsured people who aren't getting it, which is what I was reacting to.

Roman Lombardi writes:

Why is this even a thing? Didn't ObamaCare solve all this?

David R. Henderson writes:

@Nick,
Thank you for pointing out my misquotation of your article, I misread it and I apologize.
You’re welcome. And I accept your apology.
By the way, I don't see this as an argument to be 'won' through deception, and I did not deliberately misquote you.
Good.
You mention thinking on the margin, after spending a lot of time arguing that for the people currently buying the drug it's a great deal. How exactly is that relevant to the question of whether the marginal value is currently too high?
I don’t think you mean marginal value. If the marginal value is high, that’s great, because it’s likely to be above the price.
You cite none of the statistics I would expect to back up your claims. What is the marginal value / cost of the drug currently? What are the average profit margins of these pharmaceutical companies?
On the contrary, I cite the main statistic that backs up my claim: this drug is a very good deal compared to the alternative. I wrote my article to challenge Sachs’s claim. I did that. Notice that in his piece, he doesn’t ever mention what the inferior alternatives to deal with Hep-C are priced at.

Nick writes:

@David

If the marginal value is high, that’s great, because it’s likely to be above the price.
If the marginal value is high, that's bad, because it means too few people are getting the drug. I think you explained this well in the second-to-last paragraph
On the contrary, I cite the main statistic that backs up my claim: this drug is a very good deal compared to the alternative.
You mention the 'marginal revolution'. Accordingly, I have in mind the textbook picture of a natural monopoly,

http://www.appstate.edu/~whiteheadjc/eco3660/boardman/images/fig4-5.jpg

Where do you currently think we are on this graph? Your endorsement of price discrimination as a solution suggests that you think we're somewhere on the marginal value curve between (a) and (c), i.e., the marginal value is too high. Charley Hooper argues that due to our current system of insurance and subsidies, we are actually at point (c).

But no matter what the marginal value is, it's a truism that the people buying the good are getting a good deal, simply by the definitions of economic cost and value!

The relevant questions are: Where along the marginal value curve are we (what is the marginal value and marginal cost?) and what are the average profits of pharmaceutical companies (important because as your argue we need to make sure they're high enough to make it worthwhile to develop new drugs, if they are very high then that suggests that at the margin regulating lower prices may be welfare improving.)

Don approvingly mentions an article by Ronald Coase which argues for price discrimination, and does so within this framework. Are you using a different framework? If so, I think you should spell it out.

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