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How to lower the cost of drugs

There was a discussion at the Becker Posner Blog last week (Becker on pharmaceutical patents, Posner's response, Becker's response, and Posner's final response) about pharmaceutical patents that tangentially touched upon the high price of drugs and the huge amounts of money spent on marketing by the big drug companies. Judge Posner didn't seem to think this was a big deal. I disagree, it's a very big deal.

Pfizer, the biggest drug company in terms of sales, in the year ending in 2003, reported spending $7.1 billion on R&D, in comparison to $15.2 billion on "selling, informational, and administrative expenses." Pfizer also reported "cost of sales" to be $9.8 billion. The naive among you may think that last figure means that Pfizer spend $9.8 billion manufacturing drugs, but in fact the cost of sales includes all costs that can be directly applied to a single sale, which includes commissions paid to salespeople. I would assume that the majority of the $9.8 billion represents commissions paid to salespeople.

Thus we conclude that in 2003, approximately two thirds of Pfizer's expenses went to marketing, and only one third went to R&D and the actual manufacturing of drugs.

Pfizer's expenses are ultimately passed on to the public in the form of high prices for drugs. If Pfizer could lower its marketing expenses to a more reasonable amount of, let's say, half of its R&D and manufacturing costs, then the price it charges for drugs could be reduced by 50%!

Now the reason why a drug company spends money on marketing is the reason why any company spends money on marketing. To increase the perceived value of its products. For some types of companies, increasing the perceived value of a product might simultaneously increase its actual value. For example, the actual value of a handbag is partially a function of how much it impresses other people who sees the owner carrying it. So when Gucci spends huge amounts of money on marketing, it increases the actual value of it's products at the same time that it increase their perceived value.

Spending a lot of money on marketing is fine for a handbag company, but creates a moral problem for a drug company. First of all, high marketing expenses increase the price of the drugs, which means that some people who need the drugs for their health won't be able to afford them. No one will die if they can't afford a Gucci handbag, but people might die if they can't afford a needed drug. Secondly, unlike a handbag, a drug has an actual real value, and increasing its perceived value above it's actual value will cause people to take the drug who don't really need to take it, thus adversely affecting their health.

Liberals would probably say that the inefficiently high amount of money spent by drug companies on marketing represents a failure of the free market. But they would be wrong. Drug companies spend so much on marketing because there ISN'T a free market in drugs.

First of all, the government prohibits people from shopping for their own drugs. They must go to a doctor who decides what drug the patient is allowed to purchase. Because the doctor is not the person who is paying the bill, he will not be influenced as much by the price of the drug as if the person paying for the drug was deciding what drug to buy.

Secondly, very often the patient doesn't pay for the drug either, but the patient's insurance company pays for it. Where neither the doctor nor the patient has to pay for the drug, obviously for them their demand for the drug is completely unrelated to the price of a drug, and they will gladly use a drug that costs ten times the price of an alternative drug so long as they perceive that the more expensive drug will be even a fraction of a percent more effective than the less expensive drug. The existence of drug insurance does not represent a free market choice of patients, but rather is strongly encouraged by the goverment because cost of the drug insurance is usually paid pre-tax.

In a market where the buyer is not sensitive to the price of the product, the logical profit-maximizing strategy for the manufacturer is to spend more money on increasing the perceived value of the product, even if that means significantly raising the price of the product.

Now that we have figured out why drug companies spend so much money on marketing, we have a solution on how to fix it and to lower the cost of drugs. We simply remove the non-free market impediments that makes the demand for drugs price-inelastic. (1) The government should abolish the tax subsidy for drug insurance. This would make drug insurance no longer sensible for the majority of people, and this would ensure that the vast majority of patients are paying for their drugs with their own money, therefore making them sensitive to the price. (2) The government should allow the majority of drugs to be sold "over-the-counter," which would allow true free-market behavior on the part of patients. When Schering-Plough was forced to sell Claritin over-the-counter, the price of Claritin dropped to a tiny percentage of its behind-the-counter price. Schering-Plough fought that decision by the FDA. This shows how messed up the drug industry is that a company would try to prevent people from actually being allowed to buy its products.

As simple and common sense as the above solutions are, the typical liberal idea is the opposite of common sense. Liberals want to make drug insurance more available to everybody. The liberal "solution" would make patients even less price-sensitive than they already are, causing drug companies to spend even more money on marketing and raising their prices even higher.

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I have previously written about high healthcare costs and the lack of a free market in healthcare in my post Pay at time of service healthcare. Maybe this is the reason I haven't been writing as much economics and political stuff in my blog. I've reached the point where I am covering the same topics that I've already covered.

posted Tuesday, December 28, 2004