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A health economist explains the real reason American drugs are expensive

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Craig Garthwaite is a health economist at Northwestern University’s Kellogg School of Business whose research often focuses on America’s pharmaceutical market. So it’s no surprise he’s been a very interested observer of Daraprim, the generic drug that recently got a 5,500 percent price hike.

Turing Pharmaceuticals, which owns Daraprim, announced Tuesday it would lower Daraprim’s price in the wake of public backlash. Still, the company hasn’t said how much it would charge for the drug that used to cost $13.50 until Turing upped the price to $750. The whole debacle raised a key policy question for the United States: How do we regulate the price of generic drugs? Is there a good way to combat the high prices that companies like Turing want to charge for drugs with relatively few users — markets that aren’t especially desirable to competitors?

Much of Garthwaite's work as a researcher tackles these exact questions. He spends a lot of time thinking about the good and the bad of high American drug prices. On the one hand, there's ample research to support the idea that more drug spending leads to more research and innovation from drug companies — that when the financial rewards are bigger, companies invest more money pursuing them.

But there's also a trade-off here: More expensive drugs are less accessible to the public. They're a bigger burden on the federal government, which runs Medicare and Medicaid. When the government has to spend more money on prescription drugs, it has less money to spend on things like roads or education or other services we value.

In Garthwaite's mind, the question isn't whether we're spending too much money on drugs. It's whether we're spending too much money on innovation — if we think the money we spend on drugs is worth the discoveries that pharmaceutical companies will make in the future, or is better spent on other things.

We spoke about that issue and others on Thursday morning. What follows is a transcript of our discussion, lightly edited for clarity.

Sarah Kliff: Let’s start with the most basic question: Why are drugs so expensive in the United States? And what do we get for that money we spend?

Craig Garthwaite: Drugs are more expensive in the United States because we don’t allow one large payer to try to negotiate the price of a drug down. In other countries, that’s a choice they’ve made. They have a monopsonistic buyer and aren’t setting a price in a formal way, but are using their market power to drive down the price.

I don’t love the fact that the United States is effectively subsidizing drug innovation worldwide. But I’d rather have that happen than have no one subsidizing development. It’s completely possible we might be having more innovation than our society values.

We’ve all made decisions about the amount of dynamic incentive we want — that is, how much financial incentive we want to make new drugs in the future. A side effect of high incentives is a static inefficiency right now: that higher prices lead to lower consumptions of a drug.

That’s a trade-off we make whenever we talk about the patent system and how we’ll develop new drugs in the future. And it’s not an easy question to think about, how much innovation we’re comfortable paying for — or the idea that we might be spending too much on innovation.

SK: Can you talk about that a little more? How good is the evidence that the larger amount we spend on drugs in the United States really does increase innovation? I think some people look at the profit margins of pharmaceutical companies and think that certainly they could do just as good work if they weren’t making as much money.

CG: There are several studies that show it’s certainly a positive market, and that when markets become more profitable we see drug research targeting those markets. I have research showing that when we passed Medicare’s drug benefit, there was an increase in clinical activity around drugs that treat the diseases of elderly people. Amy Finkelstein at MIT has shown that the passage of vaccine mandates leads to more research in developing vaccine products. We definitely show the market responds in the way you think it would.

SK: Is this true in the case of generic drugs, as well? This sounds similar to an argument that Martin Shkreli at Daraprim made to Matthew Herper at Forbes recently. He made the case that drugmakers need to charge a lot for drugs that treat rare disease, in order to make those drugs financially appealing to pharmaceutical companies.

CG: We have to allow people to make profits to invest in technology that doesn’t exist today. They have to have some kind of rate of return. But buying an existing generic drug and raising the price, and taking advantage of the fact that people won’t enter that market, that’s not the same thing. We want to allow drug companies that develop new drugs to have a period of market exclusivity as a reward. But the effective situation with Daraprim is that due to market inefficiencies, they could be a monopoly producer for a good long time, and there’s no reason to think someone else will enter.

What’s happening with Turing is you have people outside the drug industry making these pricing decisions. If what you think has held generic drug prices in check is some sort of informal belief that you don’t want to draw the attention of regulators, then that won’t work for a hedge fund business, where this is a one-time investment for you.

SK: There’s been a lot of discussion lately about whether the United States should let Medicare negotiate, or do some kind of rate-setting for pharmaceuticals. What do you think about that type of policy?

CG: If you think drug prices are too high and have too much market power, I don’t think the solution is granting more market power to another entity. If you have a bicycle and your tire is flat, you don’t flatten the other tire to make it work well. I don’t know why we think that if Medicare is our negotiator, they’ll think about these future innovations very far. They don’t know the correct level to set.

I don’t view Sovaldi charging $84,000 as a problem. I think it’s actually a good thing, and we’d like to reward these really innovative cures. That’s also fundamentally different from raising the price of a generic drug, so I don’t want to conflate those.

SK: So what are the possible policy approaches to deal with a situation like Daraprim?

CG: There are a few that might work. One would be some kind of price regulation, like what you have in electricity. It could be some kind of rate-of-return regulation, where manufacturers have to spend a certain amount of their returns. Those could be difficult to implement, though, because it’s a bit hard to know when something is a natural monopoly. You don’t really want to use the pornography definition, like you know it when you see it.

Another way to do it is have some type of public trust that produces generics, maybe a government-sponsored nonprofit. We could think a little more carefully about the fixed costs of entering these markets. You don’t want any drug to be able to get on the market, and obviously want some quality control, but one thing driving the lack of competition is the high cost of entry into the market.

We know there are generic versions of these drugs made globally, and maybe we also could allow the importation of these drugs for lower costs.