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Forbes Asks: Should Economists Perform Surgery and Doctors Conduct Economic Policy?

February 6, 2015
Over at Forbes, University of Chicago economist Tomas Philipson has an insightful post analyzing several of the arguments frequently made in recent debates about the price and value of innovative medicines. Philipson argues that physicians are often self-interested as buyers when complaining about drug prices, and often fail to understand the broader economic context in which drug pricing decisions must be made: “Just as you wouldn’t let a financial planner perform cancer surgery, we shouldn’t let physicians dictate complicated economic policy even if it has to do with medicines.”

Philipson’s main critique is that one cannot look at the cost of R&D for any given drug when deciding how much ought to be charged for it, as this ignores the costs of the many failures inherent in the drug discovery process. Successful products must pay for themselves as well as the many other drugs which never made it out of the clinic, but still generated significant R&D costs.
When it is boiled down to its bare essentials, much of the drug pricing debate is essentially about the fact that some people think manufacturers make too much money at the expense of sick patients. The first line of evidence to support this view has been to pick a drug and compare research and development costs (R&D) to its marketed profits. Many providers, including Sloan Kettering, argue that there are abnormal profits since looking at marketed drugs often shows they earn well above their past R&D costs. This, however, ignores the basic economics of drug development. Suppose I offered to sell you a lottery ticket for $100 dollars that paid you $100 in case you won. You would laugh at me and throw me out the room, and rightly so. But that’s the investments Sloan Kettering would like the industry to make based on this argument. For these innovators, a $100 million R&D budget more often than not fails, indeed about 90% of the time. Thus, if profits were only $100 million for a drug that succeeds and reaches the market, the company would go bankrupt overall. In fact, profits would need to be ten times greater than the observed R&D costs to earn normal returns on capital. This is not unique to medical innovation as in most innovative industries the few winners pay for the many losers. This is basic economics which buyers arguing for lower prices fail to appreciate.

Read the whole piece here.