Pharmaceutical Industry Ought To Justify Drug Prices On Value, Not R&D Costs

Drug companies will often claim they need to charge high prices to recover their research and development (R&D) costs. While this certainly is the case for drugs targeting (ultra) rare diseases, in an optimally functioning pharmaceutical market most prices ought to reflect value, not R&D costs.

The Inflation Reduction Act’s drug pricing provisions include as one of three main pillars, direct negotiations between Medicare and drug makers for a limited subset of branded drugs without both exclusivity and generic or biosimilar competitors. The bill’s text and subsequent guidance from the Centers for Medicare and Medicaid Services lay out several explicit criteria which drug makers may use to support their counteroffers to the price Medicare determines is a benchmark “maximum fair price.”* Conspicuously, R&D costs of the drug and the extent to which the manufacturer has recouped R&D costs are formal criteria that can be used in negotiations to support a drug maker’s counteroffer. This is a somewhat peculiar criterion to include. Sunk costs shouldn’t enter the pricing equation for a commodity.

Of course, from an accounting perspective, drug companies must recoup their investment in order to be going concerns. This is a truism. It’s also valid that higher prices increase the incentive for investment in new drug development down the road.

And, to be sure, R&D is extraordinarily important for the purposes of developing new drugs. For firms developing and producing therapies for rare diseases, it’s vital they obtain tax credits for the R&D (as a partial offset) that goes into drug development. However, even here the products that receive marketing authorization should be priced in accordance with value. In some instances, like the recently approved gene therapy Hemgenix indicated for hemophilia B, eye-popping prices for a single dose may actually be cost-effective (a proxy for value) if the product turns out to be durable.

Ultimately, there isn’t a necessary connection between a drug’s value in the market and the amount of investment required to get that product to market. In a competitive market, in which price and value align, a purchaser’s willingness to pay price for a product will determine its value, not the labor and capital that have gone into that product’s development.

Labor and other related theories of value were debunked a long time ago. It’s been known in economics since around 1870 – the period of the so-called marginal revolution – that a product’s value isn’t determined by its cost of labor or capital.

Even Adam Smith, 18th century pioneer of economic thought who postulated a labor theory of value, pointed to the irrelevance of cost of production in the actual purchase of a commodity in the marketplace: “When a buyer comes to the market, he never asks the seller what expenses he has had in producing his wares.”**

However, the pharmaceutical industry has seemingly lost sight of this when it seeks to justify prices on the basis of the cost of R&D. Furthermore, in setting prices together with payers and pharmacy benefit managers (PBMs) it often exploits the confusing and obtuse intricacies of a suboptimal market in which price and value often aren’t aligned.

It’s not surprising, therefore, that according to a recently published article in the Journal of the American Medical Association, researchers did not find a correlation between R&D costs and drug prices. The investigators examined the estimated R&D costs for 60 approved drugs – between 2009 and 2018 – and compared it to the prices of the drugs. They found “no correlation … between estimated research and development investments and log-derived treatment costs.”

The authors noted that the absence of a link wasn’t necessarily unexpected. Well, sure. In microeconomic theory, value is traced to the individual purchaser whose marginal utility measures what a good is worth. Given a good’s supply, price then becomes became a function of the purchaser’s willingness to pay, not the investments that went into the product.

Similarly, other peer-reviewed articles have shown a disconnection between high drug prices and R&D cost.

There’s no nexus between drug prices and R&D costs, which makes it curious that the Inflation Reduction Act explicitly states that R&D costs and the extent to which a drug maker has recouped R&D costs are to be used in negotiations as ways to support counteroffer prices.

The Aduhelm (aducanumab) debacle, for example, shows that products with marginal value, or perhaps even no incremental value, don’t fetch a price (or reimbursement) they `deserve’ based on all the work put into them.

Perhaps the pharmaceutical industry is on more solid ground when it defends “price premiums” in the U.S. relative to what is charged in other countries. But here again “large R&D budgets” aren’t the justification. Instead, one can make the argument that in some cases price ceilings imposed outside the U.S. distort the market because the capped price is not reflective of value. In this context, charging a higher price in the U.S. makes sense.

So, it’s important to emphasize that high drug prices per se aren’t the problem. There are quite a number of very expensive drugs that have value commensurate with the benefits they confer. Accordingly, their high prices are certainly warranted. Take, for example, drugs that are cost-saving.

But purchasers shouldn’t pay for something simply because of all the R&D that went into it. Sometimes a lot of R&D goes into what turn out to be only marginally effective therapeutics, compared to existing standards of care. Other times, drugs with relatively minimal amounts of R&D wind up having lots of value. In each instance, irrespective of R&D costs of development the product’s price ought to reflect value.