Sorry, Agnes. Pharmaceutical Pricing Does Follow the Laws of Supply and Demand

Aug. 17, 2011
Reader response from last month's Editor's letter.
In response to last month’s editorial (“Drug Prices? Eenie Meenie Miney Mo”), this reader shared some insights into drug pricing, and how it does follow the basic laws of economics. –Agnes Shanley, Editor in ChiefTo the Editor:

These prices are not arbitrarily set but based on the simple economics of supply and demand. What’s at issue in these cases is the slope of the demand curve.

For the past 28 years, I’ve worked as a chemical engineer, and have designed almost any type of chemical facility you can imagine from atomic weapon manufacturing to oil refineries, pulp and paper mills, semiconductors and biopharmaceuticals. All these facilities (except one . . . guess which one?) operate under the same basic conditions. Thus, much of what is applicable to designing and running a successful pulp mill will also apply to an oil refinery.

This is not the case with pharma/biopharm. I saw that Toto wasn’t in Kansas anymore the first time I peeked through the window of a cleanroom and saw two PhD’s dressed head to toe in Tyvek, preparing a simple buffer solution in a 55-gallon polypropylene drum using a polypropylene oar.

After a stint with a biotech startup early in my career, designing two mammalian cell culture facilities, I was surprised by the inefficiencies. Daily realities bore little resemblance to what I’d seen as a college student working at the DuPont Experimental Station in Wilmington. I chalked this up to lack of exposure to how other industries move potential products from lab to production, so I started a monthly column on Genetic Engineering News, entitled Process Transfer to explore this. It ran from 1996 to 2003 (see for a list of titles.)

I’d hoped that my writing might bring about at least a glimmer of change but it didn’t. My conclusion? Biopharma’s and pharma’s cost of production is still insignificant in relation to the price their products can command.

Let’s revisit Economics 101 and the traditional supply and demand curve. The intersection determines the price and quantity of any product or service in a free market, and the slope of the demand curve depends on customers’ wants and needs.

The supply curve depends completely on producers and is influenced by their costs of production and the return they want. Of most importance to the producer is price times quantity.

As the producer shifts the position of the supply curve up, the slope of the demand curve in a specific area will determine whether the move will hurt or help profits.

The flatter the demand curve, the more a small change in price will result in a large reduction in quantity, probably making this price increase unprofitable. 

Thus, with a flat demand curve, the pressure is on the producers to shift their supply curve down and to the right, since that will increase demand, and profits.

Most technological innovation in our society has been due to flat demand curves that force producers to be ever on the lookout to nudge their supply curve to the right. The aggressive nature of a flat demand curve promotes innovation, a fact that flies in the face of pharma manufacturers’ insistence that price controls stifle innovation.

The flatter the demand curve, the more choices consumers have, the more pressure is put on producers, and the more innovative they must become which is the true path to progress and a higher standard of living. 

This is true whether you are talking about Nylon in the 1940s, Teflon in the 1970s, Gortex in the 1980s, or computer chips at the end of the 20th century. 

But what if the demand curve is nearly vertical instead of horizontal, what if the product supplied is something that people literally cannot live without? 

Companies that produce such drugs can charge whatever they want, since any price increases results in little to no drop in demand and thus just adds to profit. This is why they can use antiquated and inefficient production processes.

The law of supply and demand still applies. The reason the pricing of these drugs seems haphazard is that producers have to use some other mechanism to set it.  Since the customer has no other choice, Adam Smith's Invisible Hand starts to break down. Consumers are not faced with the choice of whether to purchase this product or not, their choice becomes whether they should pay the price requested by the producer or find some other way to get the item.
Nylon, Teflon, Gortex, and computer chips took as much money to develop as the next blockbuster drug and they all had traditional to flat demand curves. 

When products that have steep demand curves are concerned, history has shown that public intervention may be needed, yet that control cannot be too extensive. 

Luckily in our society, the system is still skewed in favor of producers. However, some degree of public intervention may be needed to bring the system into equilibrium.

--John Kossik