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DBL%20Hendrix%20small.png College chemistry, 1983

Derek Lowe The 2002 Model

Dbl%20new%20portrait%20B%26W.png After 10 years of blogging. . .

Derek Lowe, an Arkansan by birth, got his BA from Hendrix College and his PhD in organic chemistry from Duke before spending time in Germany on a Humboldt Fellowship on his post-doc. He's worked for several major pharmaceutical companies since 1989 on drug discovery projects against schizophrenia, Alzheimer's, diabetes, osteoporosis and other diseases. To contact Derek email him directly: Twitter: Dereklowe

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October 11, 2004

Prices and Innovation

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Posted by Derek

Alex Tabarrok over at Marginal Revolution has called attention to a very interesting study on the financial aspects of drug discovery. Price reductions could have a disproportionate effect on R&D, the authors say, which fits in with my personal industry experience. If you cut everything by, say, 20%, you're not going to have just 20% fewer drugs to show for it. It isn't linear (not much is, as far as I'm concerned. . .) (Note his correction, though, which makes the effect less drastic, but also see Tyler Cowen's post just above the original post.)

That inspired this post over at Asymmetrical Information. Jane Galt finds the prospect "frankly terrifying". There are 80 comments so far - it's quite a discussion, and I encourage anyone interested in the issue to have a look.

Comments (6) + TrackBacks (0) | Category: Drug Prices


1. otey on October 11, 2004 9:00 AM writes...

No question that lower prices will have a dramatic impact on R&D.

But how do we get past the fact that my 85 year old mother in Atlanta is underwriting the R&D for the same drugs being taken by my 85 year old mother-in-law in Toronto?

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2. Derek Lowe on October 11, 2004 9:21 AM writes...

That's the problem, all right: the position my industry has wedged itself into isn't sustainable. We're going to have to do something new, and it's going to be painful for everyone, I think. . .

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3. Ben A on October 11, 2004 12:50 PM writes...

I am a biotech guy, and likely have a biotech-centric view of the world. But if you think price controls will hurt pharma R+D, I can assure you all that they will devestate the access to capital for small biotechs. My company, e.g., has burned through close to $40mm to get some drugs to phase II. We still have no idea if they work. Our investors are willing to foot this bill only with the explicit expectation that big pharmas like Derek's will pony up hundreds of millions to acquire successful phase III programs. Private equity investors are pure profit maximizers. If the return on investment fro biotech falls relative to tech, or other opportunities, they're gone.

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4. jeet on October 11, 2004 4:31 PM writes...

So we should let pharma companies raise their prices by 10% to enjoy a 20% gain in the number of new drugs? By the same logic pharma companies should reduce their marketing budgets by 10% and shift it to the R&D budget due to the pipeline gain. Or translate their massive free cash flows into a huge bond financing and fund every drug program that they can think of. Or cut dividends to zero in order to finance additional growth like most software/ hardware firms.

Funny/ stupid arguments aside, what I'm trying to point out is that today's large firms are not really capital constrained in the number of research programs that they are currently supporting. If the 10% investment to 20% gain relationship is true, these firms have a number of options to finance additional research programs


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5. jeet on October 11, 2004 4:48 PM writes...


I wanted to add that this paper doesn't look very applicable to the branded drug market. As is

"The demand curves in (2) have an elasticity equal to 1, so an unconstrained monopolist would
charge an arbitrarily high price. However, the firm with the best drug in line j is competing
with the next best drug in that line. An arbitrarily high price would allow the next best firm to capture the entire market. Therefore, the firm with the best drug sets a limit price to exclude the next best firm –i.e., to ensure that consumers prefer its product rather than the next best drug supplied at the lowest possible price (i.e. equal to marginal cost, which is 1)."

This sounds very true in the generic drug market, but in the branded market the market leading (first entrant) firm sets the price of the drug at the MARKET MAXIMUM price. That is the price that healthplans will be able to save using your drug vs. not using it. These calculations are typically a combination of related savings and improvement in the health status of the patient over a two to three year timespan. Medicare/ Medicaid then jumps in and says that they want 5-15% off of this "free market price."

Due to a number of market barriers (i.e. getting doctors to switch brands, getting patients to switch brands) and economic rewards of high prices the second, third and subsequent entrants into a particular market almost never compete on price. This means that the firm with the best drug does not set the limit price to exclude the next best firm.

In fact, market leaders (and followers) keep prices high for all branded products, because to get in a price war means that everyone loses.

The long and short of it is that I don't think that this paper is very applicable.

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6. Derek Lowe on October 12, 2004 6:23 AM writes...

That's true, Jeet - we rarely compete on price, since even in the "me-too" markets there's almost always some medical/technological selling point for the newer drugs. I'm working through the paper, as much as my economic background will allow, to see how much that affects their broader points. Another reader has forwarded another 2004 study which seems to make the point more directly, as well. . .

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