TCS Daily

Drug Company Profits aren`t the Problem, They`re the Solution

By Merrill Matthews - November 6, 2000 12:00 AM

Pharmaceutical companies are taking their lumps lately. If it`s not Vice President Al Gore lambasting them as those special-interest "Big Drug Companies" he aims to tame, then it`s the NBC TV series " The West Wing" implying they are insensitive to the plight of AIDS victims in a fictional African land.

The source of critics` heated complaints about these particular health care providers is that they think the companies are charging too much for the drugs they provide. Media pundits looking at the presidential candidates` proposed Medicare prescription drug benefit plans have spread the idea that drug company profits are high, much higher than most other industries. The obvious implication is that since drug companies make so much money off the elderly, what`s the harm if the federal government dips into the firms` deep pockets by forcing them to charge a little less? But that approach ignores the realities of the pharmaceutical industry and the facts about drug companies` profits.

There are really two pharmaceutical industries. One industry`s products can be see on the drug store shelf. It is made up of what the Organization of Economic Cooperation and Development, an international agency of which the United States is a member, calls the "me-too" drug companies. These companies mass produce aspirin, cold medicines, ointments and other off-the-shelf drugs. Many, if they make prescription drugs at all, often provide only generic copies of what the other pharmaceutical industry creates.

That other pharmaceutical industry - the "pharmatech" industry - is a New Economy industry, where initial costs to create and test a patentable item are very high, but once achieved the reproduction costs are usually minimal.

It is these companies that are drawing much of the fire from critics for high drug prices. It is true that many prescription drug manufacturers are profitable, and several have been consistently profitable over the years. But how do those profits compare with other industries, both those in the New Economy and others that make popular or vital products?

Well, according to Fortune magazine`s annual survey of the top 1,000 companies, the drug industry`s median profit - the middle point between the most and least profitable of the 12 drug companies included - was 18 percent of revenue. Amgen had the highest profit at 33 percent, with American Home Products the lowest, having lost 9 percent. Most companies ranged between 15 and 20 percent.

That`s pretty good, to be sure. But that isn`t the whole story. Many very profitable firms spend far less on research and development, take much lower risks, and make as much or more money than even the most profitable drug companies. Nabisco, for example, reported a 36 percent profit last year, according to Fortune. Coca-Cola, which produces a product that is competitively priced and very affordable, had higher profits than the drug industry median for most of the 1990s.

Or how about The New York Times, which prints so many stories about excessive drug company profits? The Times made 10 percent last year. And Gannett, publisher of USA Today, made 17 percent - right up there with the drug companies.

No one, though, is accusing the Times or Gannett of price gouging. Nor have they gone after another media conglomerate that includes the Chicago Tribune, the Los Angeles Times and a number of broadcasting stations, which made 46 percent profit, according to Fortune. Yet, it`s the news media that are voicing most of the criticism.

When CBS ran the final segment of its hit program "Survivor," it charged $600,000 for a 30-second ad. At the time, that was the highest any network had charged for a slot in prime time, up from the previous high of $319,000.

This fall, however, the popular program "ER" will also command $600,000 for a 30-second ad. The networks are very clear that when they have a popular show, they charge as much as the market will bear.

By contrast, one Celebrex tablet, which when taken daily relieves arthritic and other chronic pain so people can lead normal lives, costs a little more than $2.

Still, if CBS news does a story on price gouging, which is the most likely subject: drug companies or the networks? And what about the other New Economy companies? Software companies also make knowledge-based products, and like pharmaceutical companies spend a lot of money up front researching and developing those products. But their R&D bill is still only about half that of pharmaceutical companies, which at $24 billion amounts to about 21 percent of the industry`s sales. Despite the lower bill, Microsoft reported a 39 percent profit, while BMG Software reported 28 percent. Of course, once a knowledge-based company produces a prototype, mass producing the product is usually very cheap.

But companies have to charge significantly more than it costs to produce the product in order to recoup research and development outlays. As the Congressional Budget Office in a 1998 report pointed out: "For most drugs, the returns from marketing do not exceed the average capitalized costs of development. As a result, for a company`s average returns to exceed its average development cost, the company must discover and market a highly profitable drug from time to time." In laymen`s terms, if it doesn`t make big profits on some new drugs, the company may not stay in business very long.

That stance may be difficult to defend from a public relations standpoint when a low-income person who wants or needs the product, but can`t afford its retail price, is going public with his or her complaint. But the reality is without the profits, more outlays for new and better drugs would be impossible. In short, the product would never have been created.

Unfortunately, that fact usually gets lost in the discussion. Pharmaceuticals and software are not the only products facing this pricing dilemma. Novelist Stephen King can command millions of dollars in advance royalties, which explains why a publisher might charge $25 for one of his novels that only cost a dollar or two a copy to print. Similarly, $39.95 for a movie that has just been released in video is much more than it actually costs to create a copy of the film. In both cases, companies must lay out millions of dollars up front for authors and actors, and make their return by charging much more than the marginal cost of making one more copy.

Treasury Secretary Lawrence Summers understands the principle well. In a May speech delivered in San Francisco and entitled "The New Wealth of Nations," Summers noted that in an information-based economy, "the only incentive to produce anything is possession of temporary monopoly power -- because without that power the price will be bid down to the marginal cost, and the high initial fixed costs cannot be recouped."

Yes, drugs can be expensive -- in some cases, very expensive. But if the drug companies are allowed to continue their R&D unfettered, we will see more drugs that, while expensive, will make our lives better. Thus, profits are not the problem, they are the solution -- ensuring that consumers have access to advanced pharmaceutical products for years to come. Which brings up an important point: Drug companies aren`t profitable because they charge so much; they are profitable because they make products that patients and their physicians want.

In short, it`s the demand, stupid.

While total spending on pharmaceuticals has been growing rapidly - averaging a 13.7 annual increase between 1995 and 1999 - most of that spending is due to an increased volume of sales, not higher prices. For example, while prescription drug sales grew by 18.8 percent in 1999, almost three-quarters of that growth was due to increased volume and new products. Only about a quarter of the increase was due to higher prices. Nevertheless, drug company profits have become a political issue as both Democrats and Republicans look for a way to provide seniors with a prescription drug benefit, even though about 65 percent of seniors already have some type of coverage for prescription drugs.

If politicians really want to control prescription drug prices, there is a better way to do it than by government fiat. It`s called competition. But can prescription drugs, many of which are protected by a patent and provided at low cost due to insurance, act like a real market? Yes. The drug industry is already very competitive, with no drug company having more than 7.2 percent of the U.S. market. And changes in the health care system and patients` ability to access information are making the market even more competitive.

Steps such as reforming Medical Savings Accounts would reduce insulation from the cost of health care for patients, making more of them price conscious consumers. And elimination of the Food and Drug administration`s "efficacy" requirement - which requires drug companies to spend millions of dollars to prove not just that a drug is safe, but that it works on a sufficient number of people -- would also help make the industry more competitive. The FDA may be justified in determining whether a drug is safe, but doctors practicing medicine should determine whether or how well a drug works.

Competition would bring more choice and lower costs. And if drugs are available and easily affordable, who cares how much money drug companies make? Only those who like to demonize any business for providing a valued service and making money while doing it.

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