A recent case illustrates how patents lead to monopoly pricing. In early 2014, the pharmaceutical giant Gilead brought a new treatment for the hepatitis C virus to the market. The drug is called Sovaldi. It is a remarkable advance over existing therapies against this life-threatening disease, which affects around 3 million people in the US and 15 million in Europe.42 Later that year, Gilead released an improved version of Sovaldi called Harvoni. The launch of these two new drugs had wide media coverage. The reason, however, was not their therapeutic power. It was their price. A three-month treatment costs $84,000 (exactly $1,000 a pill) for Sovaldi and $94,500 for Harvoni.43
Sovaldi and Harvoni are not isolated cases. The price of ‘specialty’ drugs – which treat complex chronic conditions such as cancer, HIV or inflammatory disease – has skyrocketed in recent years, fuelling a heated debate about why prices are so high and whether they are justified. Anti-cancer drugs that only add a few months to patients’ life expectancy cost hundreds of dollars a day. The case of Sovaldi drew the attention of the US Congress: two members of the Senate Finance Committee, including the then Chairman Ron Wyden, sent a letter to Gilead expressing concern and demanding a detailed account of how the price of Sovaldi had been determined.44 It was a good question to ask. Prices of specialty drugs are completely unrelated to manufacturing costs. For example, researchers have put the manufacturing cost of a twelve-week course of Sovaldi at between $68 and $136.45 So how does the pharmaceutical industry justify charging prices that are hundreds of times higher than production costs?
Patient Health and Impatient Profits
The standard defence by pharmaceutical companies used to be that these high prices are necessary to cover the R&D costs of developing new drugs and of compensating for the risks associated with both the research and the clinical trials. But public opinion is increasingly sceptical about this argument, and for good reason: research has disproved it.46
First, basic research expenditure by pharmaceutical companies is very small compared to the profits they make.47 It is also much less than what they spend on marketing,48 and often less than what they spend on share buy-backs aimed at boosting short-term stock prices, stock options and executive pay.49
Second, the research leading to real pharmaceutical innovation,50 broadly defined as new molecular entities, has come mostly from publicly funded laboratories.51 The pharmaceutical industry has increasingly concentrated its R&D spending on the much less risky development phase and on ‘me too drugs’ – slight variations on existing products.
For example, NIH and the US Veterans Administration funded the research leading to the main compound in both Sovaldi and Harvoni – from early-stage science even into later-stage clinical trials. Private investors spent no more (and perhaps much less) than $300 million in R&D outlays for Sovaldi and Harvoni over the course of a decade.52 If we consider that in the first six months of 2015 the two drugs combined produced around $9.4 billion in sales (and $45 billion in the first three years since launch from 2014 to 2016) it is clear that their price bears no relation to R&D costs.53
So, unsurprisingly, pharmaceutical companies are turning to a different line of defence. They argue that these prices are proportionate to the intrinsic ‘value’ of the drugs. ‘Price is the wrong discussion,’ declared Gilead’s Executive Vice-President Gregg Alton, responding to criticism over the price of Sovaldi: ‘value should be the subject.’54 John LaMattina, former Vice-President of Pfizer and a leading figure in the pharmaceutical industry, was even more explicit. In a 2014 piece published in Forbes under the title ‘Politicians shouldn’t question drug costs but rather their value’, he argued that:
in the mind of patients, physicians, and payers, the pricing of drugs should have little to do with the expense of biomedical R&D, nor should it be associated with recouping R&D investment. Pricing should be based on only one thing – the value that the drug brings to healthcare in terms of:
1) saving lives;
2) mitigating pain/suffering and improving the quality of life of patients;
3) reducing overall healthcare costs.
Interestingly, LaMattina was also explicit that value-based pricing is meant to justify charging prices that are completely out of line with production costs and R&D expenses. Commenting on the world’s most expensive drug, Alexion’s Soliris, which is used to treat a rare form of anemia and also a rare kidney disorder, Mattina noted that the price (Alexion charges $440,000/year per patient) ‘is really not related to the R&D costs needed to bring this drug to the market’. Yet, he continued:
private insurers and national health agencies in Europe willingly pay for this drug. Why? Because the costs of caring for patients with these conditions can run into millions each year. Soliris, even at this high price, actually saves the healthcare system money because using it results in dramatic decreases in other healthcare system expenses generated by these patients.55
The high price of specialty drugs – the argument goes – is justified by how beneficial they are for patients and for society in general. In practice, this means relating the price of a drug to the costs that the disease would cause to society if not treated, or if treated with the second-best therapy. So we read, in a ‘fact sheet’ prepared by the US industry trade body PhRMA to justify high prices, that ‘every additional dollar spent on medicines or adherent patients with congestive heart failure, high blood pressure, diabetes and high cholesterol generated $3 to $10 in savings on emergency room visits and in patient hospitalizations’, that ‘a 10 per cent decrease in the cancer death rate is worth roughly $4.4 trillion in economic value to current and future generations’ and that ‘research and medicines from the biopharmaceutical sector are the only chance for survival for patients and their families’.56 While these claims may be true, it is striking that they are used as an explanation (or justification) for high drug prices.
Critics have replied that there is in fact no discernible link between specialty drug prices and the medical benefits they provide. They have some evidence on their side. Case studies have shown no correlation between the price of cancer drugs and their benefits.57 One 2015 study, based on a sample of fifty-eight anti-cancer drugs approved in the US between 1995 and 2013, illustrates that their survival benefits for patients do not explain their mounting cost. Dr Peter Bach, a renowned oncologist, put online an interactive calculator with which you can establish the ‘correct’ price of a cancer drug on the basis of its valuable characteristics – increase in life expectancy, side effects and so on. The calculator shows that the value-based price of most drugs is lower than their market price.58
Unfortunately, however, most of the pharmaceutical industry’s critics fight its arguments on the field big pharma has chosen. In other words, they implicitly accept the idea that prices should be linked to some intrinsic value of a drug, measured by the monetary value of the benefits – or avoided costs – to patients and society. This is not as odd as it might sound.
The idea of value-based pricing was initially developed by scholars and policymakers to counteract rising drug prices and to allocate public healthcare budgets more rationally. In the UK, for example, the National Institute for Health and Care Excellence (NICE) calculates the value of drugs in terms of the number of quality-adjusted life years (QALY) that each class of patients receives. One QALY is a year of perfect health; if health is less than perfect, QALYs accrue at less than one a year. Cost-effectiveness is assessed by calculating how much per QALY a drug or treatment costs. Generally, NICE considers a pharmaceutical product cost-effective if it costs less than £20,000–£30,000 per QALY provided. A price-based assessment of this sort is powerful: NICE advises the UK National Health Service (NHS) on its choice of drugs.
A cost-effectiveness analysis like the one NICE conducts makes sense for allocating a national healthcare system’s finite budget. In the US, where there is no cost-effectiveness analysis and the national insurance system is forbidden by law from bargaining with drug companies, drug
prices are much higher than in the UK and are increasing more rapidly. The outcome is that, measured by a yardstick such as QALY, specialty drug prices in the US are not related to the medical benefits they provide.
Basic mainstream analysis of elasticity of demand (that is, how sensitive consumers are to changes in prices, depending on the characteristics of goods) is sufficient to explain the very high prices of specialty drugs, which makes pharma’s vague and rhetorical arguments about value all the more unconvincing. Specialty drugs like Sovaldi and Harvoni are covered by patents, so their producers are monopolists and competition does not constrain the prices they set. Normally, however, you would expect the elasticity of demand to be a constraint: the higher the price, the lower the demand for the monopolist’s product. But the elasticity of demand for specialty drugs is of course very low: peoples’ lives are at stake. They need these drugs to have some chance of surviving, and medical insurers, whether public or private, are under an obligation to pay for them.
The logical outcome of a combination of monopoly and rigid demand is sky-high prices, and this is precisely what is happening with specialty drugs. It explains why pharmaceutical companies enjoy absurdly high profit margins: in addition to the normal profit rate, they earn huge monopoly rents.59 A value-based assessment of the kind NICE carries out can be helpful because it reduces demand for the monopolists’ drugs and prevents them from charging whatever price they choose. The downside, however, is that increased elasticity of demand for drugs comes at the cost of leaving some patients without the medicines they need, because pharmaceutical companies may not cut their prices enough to treat everyone who needs the drug if doing so would reduce profit margins by more than the companies want. This is already happening in the UK, where NICE has rejected some cancer drugs for use in the NHS because of their price. It is also happening in the US, where some private and public insurers refused to provide Harvoni to insured patients until they reached a very advanced stage of the disease.
What is not being pointed out, however, is that the principle that a specialty drug’s price should equal the costs it saves society is fundamentally flawed. If we took such a principle seriously, basic therapies or vaccines should cost a fortune. For that matter, how high should the price of water be, given its indispensable value to society?
The con around drug pricing has created a constant battle between government-funded healthcare systems (where they exist), private and public insurance programmes, and the big pharmaceutical firms. Only by debunking the ideas about value underpinning these drugs can a long-lasting solution be found which results in access to genuinely affordable drugs.
NETWORK EFFECTS AND FIRST-MOVER ADVANTAGES
I have looked at how innovation, something inherently uncertain and cumulative, is financed, and at the dynamics of that finance. We have also explored how the risks and rewards of innovation have been shared problematically, with medical drugs being the most severe case in point. Now, I want to look at another aspect of innovation: the effect of modern digital networks on the ability of a few firms to achieve monopolies in their markets.
In just a few years, firms such as Google, Facebook, Twitter, Amazon and eBay have come from nowhere to being almost indispensable in the lives of billions of people around the world. These companies increasingly dominate how we find information, connect and communicate, maintain our friendships, document our lives, shop and share our thoughts with anyone who cares to listen. The new technologies behind these companies have revealed – or created – in us new wants and needs. Any number of firms, each with broadly similar technologies, might have met these needs. Many have tried. But what is interesting is how quickly and how comprehensively such a small number of firms have come to dominate. And with this dominance comes the ability to extract value on a massive scale.
How has this happened? The answer lies in the characteristics of innovation, where small differences of timing, foresight or chance can have consequences out of all proportion to the initial disparity. Anyone who gains an initial advantage – in setting a standard or capturing part of a ‘sticky’ market – can be very hard to displace. And as their dominance becomes entrenched, they are able to capture a disproportionate share of the value in the market.
The history of many innovations demonstrates these dynamics very well. The internal combustion engine has retained its dominance for over a hundred years, not because it is the best possible engine, but because through historical accident it gained an initial advantage. Subsequent innovations did not seek to supplant it, but clustered around improvements to it, so that it became post factum the best engine.60 The same goes for the QWERTY keyboard layout, named for the first six letters on the top from left to right. In the days of mechanical typewriters, the very inefficiency of this keyboard layout gave it an advantage over alternatives such as the faster DVORAK layout because the mechanical keys would jam less frequently. The mechanical necessity for the QWERTY layout has long passed in these days of electronic keyboards, but its advantage has remained. Once people learned how to type using the QWERTY layout they resisted change. This social inertia meant its arbitrary initial advantage got locked in.
Such examples show the potential for dynamic increasing returns to scale (the more subscribers the better), from innovation due to path dependency (continuing to use a practice or product because of past preference for it) or social inertia, even when the initial advantage may be slight or arbitrary. Another example of the phenomenon are so-called ‘network externalities’. Just as the value of a telephone increases as the number of people its owner can connect to rises, so a social network becomes more valuable to its owner if more people join. Facebook or Twitter do all they can to increase the number of subscribers: the bigger the network, the stronger the company’s position.
Networking Profits
All this sounds fine until you ask yourself what it might mean for the size of companies. A strong source of increasing returns to scale necessarily expands companies. Google’s size is a direct result of the network effects typical of Internet-based services. Google is not just a search engine. It is also an email address (Gmail), a conference call maker (Google Hangout), a document creator and editor – all designed to maximize the advantages of sticking to Google: you cannot use Google Hangout without a Gmail address.
What’s the problem? Giant online firms like Facebook, Amazon and Google are often portrayed by their managers and by their apologists as ‘forces for good’ and for the progress of society rather than as profit-oriented businesses.61 Excited advocates have talked of a rising and revolutionary ‘sharing economy’, or even of ‘digital socialism’,62 advancing a rosy view according to which digital platforms ‘empower’ people, giving us free access to a wide range of services, from social networking to GPS positioning and health-monitoring. Silicon Valley is starkly and favourably contrasted with Wall Street. The Valley bridges the consumption gap by providing services that everyone can access, almost independently of their income; the Street intensifies the concentration of power and wealth in the hands of the 1 per cent.63
Of course the Internet giants are valuable to their users, sometimes greatly so. They can add to people’s well-being and in some cases increase their productivity, for instance by making it easier and faster to find some web content, route, person or book. But the view that these services are offered to everyone for free out of Silicon Valley’s goodwill, with the aim of ‘empowering’ people and creating a more open world, is exceedingly naïve. A more realistic analysis should start from a grasp of how these firms work and where their profits come from, with an eye to assessing their overall social impact in terms of value creation and value extraction.
Firms like Google, Facebook and Amazon – and new ‘sharing-economy’ firms like Airbnb and Uber – like to define themselves as ‘platforms’. They don’t face a traditional market, in which the firm produces a good or service and sells it to a population of potential consumers. They operate, instead, in wh
at economists call two-sided markets, developing the supply and demand sides of the market as the lynchpin, connector or gatekeeper between them. On the one side, there is a service offering to users. On the other side, there is a market offering to other firms – from sales to advertising space to information on users’ behaviour. Firms have long operated in more than one market. The peculiarity of two-sided markets, however, lies in how the two sides are connected. As the number of users on one side of the market (using a search engine or joining a social network) rises, clicks on ads and information on consumers’ behaviour also increases, boosting profitability in the other side of the market. It suits Google and Facebook to charge their users nothing: they need as many people as possible to join to make the product they sell to firms on the other side of the market more attractive. ‘Socialism’, digital or otherwise, doesn’t come into it.
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