Why Drug Prices Never Go Down: They're All Above Average for Effectiveness

Drug prices rose 9.3 percent a year, according to a study by the AARP. The House Commerce subcommittee is holding hearings into why drug prices seem only to go up, and never down.

The panel may want to examine a recent ruling in a lawsuit filed against Eli Lilly (LLY) over the antipsychotic drug Zyprexa. The judge threw out allegations that Mississippi's state Medicaid had overpaid for the drug because of Lilly's off-label promotion of the drug for unapproved purposes.

The ruling contains an extended discussion of Lilly's drug pricing policy. In the case, Lilly presented a drug pricing expert, "Dr. Kolassa" (who is probably Dr. Eugene "Mick" Kolassa of the University of Mississippi School of Pharmacy.) Kolassa said:

The primary principle that should guide every pricing decision is that the price should reflect the value of the product to the customer.

When a product delivers better outcomes, it deserves to be priced at a premium relative to competitors. Should the outcomes not differ from competitive products, a parity price is in order. Worse relative outcomes should be reflected by a price that is lower than prevailing levels.

This, of course, is belied by what happens when you look at individual drugs. The price of Pfizer (PFE)'s Viagra has risen 108 percent since it was launched, and Pfizer takes a price increase on it every year. Viagra is not becoming more effective, obviously. (In fact, since a once-a-day version of Lilly's Cialis was approved, Viagra is relatively less effective than its competitor.) What's really happening is that Pfizer is trying to find the maximum price that patients will pay for their sex lives before they balk and live without. (Indeed, if every new drug were better than its predecessors, shouldn't price of all the older drugs actually go lower?)

A similar dynamic appears to be at play in the recent controversy over Allos Therapeutics' (ALTH) cancer drug Folotyn. The drug costs $30,000 per month, and doesn't extend the lives of patients. It has a temporary effect on tumor size. James V. Caruso, the chief commercial officer for Allos, told the NY Times, "We believe we are fairly priced," a quote which echoes the way Kolassa thinks about pricing.

The idea that companies should simply take what the market will pay is fair if the market is selling apples or cars. Consumers have alternatives to those products -- oranges and buses -- and can go elsewhere if the price is too much. A person with cancer who will die without treatment is not in a position to negotiate price. When the alternative is death, companies can charge whatever they want.

The second interesting conclusion about Kolassa's testimony is what it implies that drug pricing is not based on. Here's a list of cost issues that are apparently irrelevant to pricing, even though all of them have been raised in the pricing debate over the last few years. Drug prices are:

• Not based on customers' ability pay.
• Not based on drug development costs.
• Not based on manufacturing costs.
• Not based on public health policy (i.e. whether it would be better for society is everyone had the drug, such as a vaccine).
• Not based on marketing costs.

... it was a staggering $3 billion. [And as the FDA became more strict] our studies became longer, more costly and we have more often failures, and that makes the whole thing more expensive.

Now you can see why drug companies are so careful to develop rationales for drug price increases. They're living in a Shangri-La of ever-rising prices, facing customers who are too sick or forbidden by law from negotiating, and the justification for it is that their drugs all have above-average effectiveness.