Saturday, July 19, 2014

Use Value and Price Discrimination

For an excellent example of the idea of "use value" as a justification for price discrimination, see Joe Nocera's column in today's New York Times.


Susan Fitzwater said...

A couple of noteworthy things though: 1) Kalydeco is an orphan drug, 2) Vertex has spent $6.5 x 10^9 on R&D, 3) Vertex doesn't have many other products. If you assume 2 x 10^3 users at $3 x 10^5 / yr, it will take them ~10 yrs for Kalydeco to pay off their R&D costs. Probably longer since they won't get that $3 x 10^5 / yr for 10 years, production costs are probably high, and they are not collecting $ from all 2 x 10^3 potential users.

This is actually an instance of the problems with the way we do drug R&D in this country. There are no good answers to a lot of these problems.

However, consumers (like all of us) need to realize that miracle drugs will increasingly come with high costs.

This is not to excuse gouging by Vertex, but too many people (including all to many in our government) seem to have the idea that human beings have a "right" to any drug at low cost. Some drugs just cost a lot to develop and make. Someone has to pay for that - and I can tell you that drug companies won't. After all, they can just resort to "me too" drug development - financially, it's a much safer strategy than tackling the really hard diseases.

John Tiemstra said...

I meant this just as an illustration of the increasingly common use of "what it's worth to the consumer" as a justification for pricing decisions. Taking demand into account is an indicator of monopoly power. Of course, this is a patented drug. But still, we're way too comfortable with this.

Standard economics says the efficient price is the marginal production cost of the pill. With orphan drugs, I believe there is some government support for successful introductions. Insurance companies also make big payments for formulary access. This is a better approach than $30K pills, which are beyond any ordinary person's means.

Susan Fitzwater said...

Okay .... if I understand what "marginal production cost of the pill" means, then Vertex may never get there with Kalydeco. Sort of depends on how much they really put into development (probably impossible even for them to tell). But even at introduction time, they probably had less than 10 years' worth of patent protection left. As my earlier comment shows, they may need 10 years of sales at their admittedly outrageous price to get to break-even.

In my opinion, the real scandal here is the way (or ways) we pay for drugs in this country and indeed worldwide. Yes, the $300K / yr price tag for Kalydeco makes Vertex look like a band of bloodsuckers. They know that - they're not stupid - and in my opinion drug companies really appreciate the problems with bad PR. So why are they going ahead with a pricing structure which draws unfavorable attention in the NYT? I think they're doing it because that is the only way they have a hope of recovering their costs and making some profit. Okay, maybe a lot of profit. But those costs are huge, and you can't expect Vertex to just eat them. If they priced Kalydeco 100x lower, I'm sure that the insurance companies and Medicaid would be much happier, and Joe Nocera would not be writing about them in the NYT. And Vertex might well be out of business in the next few years, with the knowledge they've gained about developing CF treatments scattered to the four winds.

Remember that we really have no national infrastructure for developing and commercializing drugs and medical devices. The FDA has NO capacity for generating its own data. I don't think that's a good situation for us to be in as a nation, but it's where we are.

Drug pricing is a mess anyway. Countries with a single-payer system use their clout to extract lower prices. [Why do you think it is cheaper to buy drugs from Canada?] Prices in countries with a gazillion payers (like - gasp - [the] US!) subsidize prices in the rest of the world.

Sorry, you hit one of my hot buttons here.

Also, I guess I don't see what's wrong in general with pricing stuff according to "what it's worth to the consumer". Isn't this really common? I would think that Apple is a prime example.

John Tiemstra said...

Last things first. Pricing based on demand does not give the buyer useful information about the scarcity or value of the resources that went into the good. The great thing about a market economy is that prices are supposed to convey information about scarcity and cost. If monopolists price by demand, this is lost.

The sad thing about a case like the one we are discussing is that people are being denied help when all it would cost would be the manufacture of a few more pills. Economists call this inefficient.

There are lots of ways to fund pharma research, but the basic point is that it is a public good (indivisible and non-excludable). It should be underwritten (and often is) by government and philanthropy.

Susan Fitzwater said...

Okay I think that the Nocera column pointed out that Vertex does supply the medication free to those with no health insurance. I think that the real problem is that Medicaid in some states balked at paying $300K/yr. I am sure that private insurance companies also weren't thrilled.

In practice, there is only one way in which pharma research is funded: by drug companies, which are for-profit entities. They have to at least get back their development costs, or they won't stay in business. The government funds some very basic research, but this practically never results directly in safe, effective, saleable drugs. [If it does, the people who did the research - usually in universities - often form a little company that partners with a large drug company to commercialize. No little company can afford the costs of the clinical trials.] Government-funded research tends to generate information which can be (but is not always) useful for developing drugs. Philanthropic funding tends to work the same way.

The drug companies have to start with information (which is practically never a compound)and then develop a drug which has the following characteristics:

1) is effective against the disease,
2) has no harmful side effects,
3) can be made bioavailable (this part can be really hard).

Probably they patent at step 1, certainly no later than step 3.

Then they have to develop a process for making the drug on a commercial scale. LOTS of hard synthetic chemistry here. Also lots of safety considerations.

And then they have to do the clinical trials: stages I, II, and III. I think that this is where most of the money is spent. Also these can take years, with the clock running on the patent the whole time.

NO ONE other than a drug company pays for clinical trials. There was a good article on drug development in the NYT last week which touched on some of the economics, one of the things that it said was that orphan drugs get a free pass on some of the clinical trials (it's not that someone else pays for them, it's that they don't get done). I will try to find that - but later.

I still think that Apple products are good examples of pricing by demand rather than cost. For most of their products, you can get a different brand with very similar functionality for much less. They use basically the same components as their competitors, and their development costs are sunk (assuming that they did much development), so the Apple products should cost the same as their competitors products - except that they don't, and many people happily pay the higher prices for an Apple product.

Another weirdo example is inkjet printers. There, they are actually losing money (or at least not making any) on the printer itself. They make all of the money on the ink. Amazon Kindle is probably a similar example.

Pricing in the real world is really complex.

Susan Fitzwater said...

Yup, here's the NYT article:

I had to laugh (in a sick sense) a few years ago when there was a flu vaccine shortage because one of 2 or 3 plants in the world which made the vaccine had had to close because of quality problems. There were panicked letters to the editor, "Why doesn't the government DO something?" Well, the government couldn't do something because it had already done two things:

1) abandoned vaccine production to the private sector, and
2) pushed and pushed for lower vaccine prices, to the point where making vaccines wasn't very profitable.

Not surprisingly many manufacturers decided that there were better (ie more profitable) things that they could do with their money, and got out of the business. Then, when one of the few remaining ones had problems, !BOOM! vaccine shortage and potential public health problem.

I don't think that it's a good situation for us as a nation to be in, but it's a very predictable situation.

John Tiemstra said...

Yes, pricing in the real world is really complex. Monopoly power and price discrimination guarantee that. The printer companies (and there are only, what, two of them?) make sure their cartridges are incompatible, and then make their money on them. This is "measure-the-use" price discrimination: higher prices for heavier users, who probably have less elastic demand. In this version, at least the poorer users are probably the ones who benefit. Apple has arguably a better operating system, at least for certain purposes, and surely a better tech support system, at least for consumers, and people are willing to pay for that. Product differentiation gives Apple market power, so the premium is probably too high to be efficient.

I understand why the pharma companies do what they do. But is there a case to be made that it's right from any point of view except the companies'? I don't think so. It's not efficient, in the economists' technical sense of the term. I don't see it has humane, since it denies help to people based on an inefficiently high price. It contributes to all the cost and access problems of our ridiculous healthcare system.

There have been many proposals to reform it. For example, some have suggested that the government pay a large bounty to a company for every drug it gets through the approval process. It could be prorated and paid as each stage is successfully completed. But there are lots of ways to do this. Any of them would be better than what we have now.

Price discrimination is prima facie evidence of monopoly power, which is growing in our society. As it grows, it impoverishes the middle and working classes. Monopoly wouldn't be so bad if there were still the sense (as there was in the 50s and 60s) that we are all in this together, and that as productivity grows and technology advances, the benefits should be widely spread. It would be better too if there were a sense that it's not really fair to charge different people different prices for the same good. But all of that is gone, and our economy and our society are falling apart as a result.

You see, this touches a really sore spot for me too.


Susan Fitzwater said...

Hey, I don't want to leave you with the impression that I like the current drug pricing system. I don't. But I disagree with you that "Any [funding system reform] would be better than what we have now." You have to be careful in making changes - there are lots of potential unintended consequences. See the flu vaccine example in my earlier post.

I also think that we the public have to be aware that in a lot of instances medical innovations (including drugs) just cost a lot of money. If "we" want the innovations "we" have to pay for them. Of course the problem is who is "we". In our current environment "we" often tends to mean "someone else, not me (but it's gotta be there in case I or someone dear to me really needs it!)."

So the basic problem is human selfishness - we're sinful, how surprising! What I think is different now from the '50's and '60's is that we now have a well-established political movement whose major message is that selfishness is good and that it's those who need material help who are sinful, shiftless, lazy, etc.

That said, sometimes material needs result from people making unwise or just plain sinful "lifestyle choices". Like getting Hepatitis C, which can now be cured by one of those exorbitantly expensive new drugs (see the NYT article). Most people get hepatitis C from illegal drug use. It sort of sticks in my craw that "we" should pay for medical treatment for the consequences. I feel the same way about treatment for head injuries for those who choose to ride motorcycles without helmets (legal here in PA - economic and other insanity). Doubtless you could come up with similar examples from your own life, some of which might hit pretty hard for me.

Related, though not obviously: We had a really good study of Generous Justice by Tim Keller this past year. I learned a lot, mostly from the Scriptures that we studied. One that really hit home to me was Job 31, which I ended up thinking of as "God wants it all." That is, both personal purity AND generosity to the widow, orphan, sojourner, etc.

All for now - read the NYT article cited in the earlier post, if you haven't already - I think you'd find it interesting.