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  • Logan Delavan-Hoover

Why are Prescription Drug Prices so High? A Primer on Price Elasticity

In 2015, the price of the lifesaving drug Daraprim was raised from $13.50 per tablet to $750.00 per tablet. A vial of the insulin brand Humalog, which cost $21 in 1999, now costs $332. These price increases are being seen across the board in the pharmaceutical industry. They’re putting uninsured people with chronic conditions who need life saving medication in the position of choosing between financial ruin or death. It’s a basic economic tenet that free markets create socially optimal conditions, so why hasn’t that occurred here? Why have many drug prices failed to reach an optimal point, or is this an optimal point? This market failure goes back to one simple economic concept.

In order to understand this situation, we need to revisit the basic economic concept of price elasticity. Let’s use the most fundamental graph in economics to visualize this, the price vs. quantity graph. Each point on the line indicates the price a product will take if sold at the corresponding quantity. The slope of the demand line is called elasticity, because it indicates how flexible the quantity is in response to a change in price. For an elastic good, the quantity can stretch, change, and bounce around a lot in response to a small change in price, because consumers can do without it or find substitutes. For example, think clothing or restaurant food- a price increase will reduce the amount customers want by a larger proportion than the increase in price. However, for an inelastic good, changes in price create proportionally small changes in the quantity. Think gasoline- even though the price may have just increased substantially, you still need to buy just as much gas to get around.

With that new lesson in mind, take a guess: are lifesaving prescription drugs an elastic or inelastic good? Of course, they’re inelastic, because even if the price of the drug just doubled, patients still need to buy it or die. In fact, prescription drugs are one of the most inelastic goods in existence. On some of the most monopolized and essential drugs, decreases in quantity are mostly due to people not being able to buy the drug anymore at all. Note that, for a highly elastic good, a firm that wants to maximize revenue will try to sell as much of the product as possible, since small decreases in price will be offset by large increases in quantity. But for inelastic goods, the opposite is true. The firm wants to restrict the supply in order to set the price as high as possible, since the small decreases in quantity will be offset by the massive increases in price. The point is, the market rules surrounding highly inelastic goods incentivise companies to massively increase their prices, because their customers don’t have any choice but to keep buying their drugs.

Of course, elasticity isn’t the only determinant of price, in pharmaceutical markets or anywhere else. After all, gasoline is also highly inelastic, and its price isn’t randomly increasing by 5,000% like Daraprim did. And competition sets an upper limit on price in most markets, especially elastic ones. If Sephora tripled the prices on its makeup, an elastic good, most of its customers would simply shop elsewhere. But many of those barriers to unlimited price increases just don’t exist in the pharmaceutical industry. Pharma companies own the patents to most of their drugs, giving them a federally enforced monopoly and eliminating competition. Most of the time, pharma companies didn’t even invent their drugs or undergo the risk of trials, they simply bought smaller companies and their patents when the drugs were finished. For example, only 23% of Pfizer’s best selling drugs were developed by Pfizer’s own R&D. The pharmaceutical industry is also the largest spender on lobbying out of any industry, effectively giving them the ability to write the laws that regulate them.

Defenders of big pharma tend to repeat one claim to excuse these prices: The prices are to compensate the company for the high cost and risk of developing the drugs in the first place. Everyone agrees that more medical R&D is a good thing, as developing new drugs and treatments expands the human arsenal against disease and prolongs life. After all, developing new drugs is certainly very expensive. One estimate, which accounts for the cost of R&D that failed, puts the average cost of successfully bringing a new drug to market at 2.6 billion dollars. So, pharma-lobbyists and PR representatives argue that high drug prices are meant to cover the price of developing the drug. However, if that were true, and the prices are just to cover a fixed cost of development, pharmaceuticals would not be seeing absurdly high profit margins of 76%. If that were true, insulin, which was invented as a drug a century ago, would not be seeing price increases, since none of the companies that currently monopolize it ever spent a cent on developing it. If that were true, pharmaceutical companies would be spending most of their profits on further R&D, rather than using billions upon billions in profit on stock buybacks to enrich their major shareholders, as Rep. Katie Porter pointed out in this exchange, which is worth watching.

In conclusion, the free market isn’t going to rescue us from these high prices, both because this market is full of perverse incentives and isn’t a free, openly competitive market in the first place. All this information inevitably raises two questions: why aren’t other developed countries having this problem to the same extent? And what can we do about it? That’s a question for an entirely separate article, but here’s a hint: the answer starts with universal and ends with healthcare.


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