This is the fifth installment of a nine-part series excerpting the chapter on medical care from the new edition of economist Thomas Sowell's "Applied Economics".

IBD Exclusive Series: Thomas Sowell on The Economics of Medical Care

The high prices of pharmaceutical drugs have been a contentious issue, though they are a relatively small part of total spending on medical care in the United States — about 10%, according to data from the Centers for Medicare and Medicaid Services.

The costs behind these prices are not only high, but unusual, in the predominance of research costs over the cost of actually manufacturing the medications themselves. While the process of creating a new pharmaceutical drug involves science, it also involves trial and error, often taking years.

In the pharmaceutical drug industry, creating a new medicine to cure a particular disease can involve many failures before finally developing a drug that is simultaneously effective, affordable and without major adverse side effects for most people.

In 2003, an official of the drug producer Pfizer said: "Last year we made over 5,000 compounds. Only half a dozen of them will make it to clinical trials." How many of those half dozen would prove to be successful in the clinical trials and then make it through the approval process of the Food and Drug Administration (FDA), only the future would tell.

If the pharmaceutical company has spent years working on many different chemical compounds before finally coming up with one that meets all the criteria — and gets the approval of the FDA as well — then its profits on that successful drug have to cover all its costs on the many unsuccessful ones. Otherwise there will not be sufficient earnings to repay all the individuals, pension funds and other investors whose money they use to finance the creation of new drugs.

Since the creation of a single new drug typically costs hundreds of millions of dollars, keeping enough investors willing to continue supplying such huge sums of money is essential to keeping the discovery of new drugs going.

Those who do not think beyond stage one see the situation in wholly different terms. Rather than examine what happens before and after a new drug is created, they essentially treat existing drugs as having been created somehow and focus on how these drugs are priced, what profits they earn, and how those prices can be brought down.

Since the cost of manufacturing a pharmaceutical drug is often a small fraction of its total costs, or of the price paid by the consumer, there are ample opportunities for politicians, journalists and others to decry the "unconscionable," "outrageous" "obscene" profits made by charging $2 a pill when the ingredients in the pill may cost only a quarter.

By ingredients, they mean physical ingredients, which are usually inexpensive, rather than the knowledge ingredient, which is usually astronomically expensive because of years of research, with much trial and error, including many costly and failed attempts to create effective new medicines.

The same misconception of costs can appear in another form when politicians, journalists, etc., contrast the high price charged for a pharmaceutical drug by the company that created it vs. the much lower price of a "generic equivalent" produced by another company, which simply uses the same formula, free of charge, after the patent has expired.

The second company's costs are just the low costs of manufacturing the drug, so that they may be able to make a profit selling a generic equivalent for a fraction of what the company that created the drug charged.

In the case of a pill whose ingredients cost a quarter, the generic manufacturer may be able to make a profit charging 35 cents for the same pill, causing the brand-name manufacturer that created the drug to be accused of unconscionably exploiting people who are ill and desperate by charging a much higher price before the patent expired.

The combination of very high fixed costs for developing a new drug and very low incremental costs of producing it leads to other economic consequences that are easy to misunderstand or misrepresent by those who do not think beyond stage one.

For example, Canadians pay much lower prices for American pharmaceutical drugs than Americans do. When a government agency in Canada buys vast quantities of medicines for its comprehensive, government-run medical care system, and offers an American pharmaceutical company a price that covers the incremental costs of manufacturing a particular drug, but not the vast costs of developing that drug in the first place, the pharmaceutical company's alternatives are (1) to lose millions of dollars in sales by not accepting the offer or (2) earn whatever money it can by accepting the offer, since the past costs have already been paid and are irrelevant to current decision making.

As economists say, "sunk costs are sunk." Seldom is a given medicine the only one that can be used in treating a given disease, so a drug company's ability to hold out against Canadian or other governments is very limited, when those governments can buy someone else's medications if they do not get the price they want from a particular pharmaceutical company.

Moreover, in countries with government-controlled comprehensive medical care systems, there may be little or no market for a given medicine from the small, or nonexistent, private sector.

Those who do not think beyond stage one focus on the money that can be "saved" by allowing Canadians to re-export back to the United States the American drugs they have bought at lower prices than Americans pay, thereby reducing the costs of medical care for the American government, individuals and medical organizations.

Not only would there be direct savings by individuals and organizations importing American medicines from Canada, the pharmaceutical drug companies would then be under pressure to lower the prices they charge in the United States as well, after losing sales because of competition from the sales of their own medicines being imported back from Canada.

None of this, however, deals with the crucial question for those who do think beyond stage one: Since the fixed costs have to be paid by somebody, if the development of new medicines is to continue, how can evasions of such payments of fixed costs fail to reduce the rate of investment and discovery of new medicines?

Even in the United States, there are large buyers of pharmaceutical drugs, such as health maintenance organizations and the federal government, who can likewise present a pharmaceutical company with a take-it-or-leave-it offer at a price that allows the company to make some money over and above manufacturing costs, but not nearly enough to cover the high fixed costs required to develop new drugs.

Policies or legislation prescribing the substitution of generic pharmaceutical drugs for similar or identical brand-name drugs can often reduce the cost to hospitals or health insurance systems.

Some demand that all drugs be generic, ending the high prices and presumably unconscionable profits of the brand-name drug producers.

But here we must beware of the fallacy of composition. What is true for some is not necessarily something that can be made true for all. The overlooked factor is that generic drug producers are essentially getting a free ride on the costs and experience built up at great expense by producers of brand-name drugs.

Since it usually takes a decade or more to develop a new pharmaceutical drug, this situation is virtually ideal for political demagoguery. A politician can gain instant popularity by advocating any of a number of ways of forcing down the price of medications immediately, and it could be at least 10 years later before people begin noticing a decline or disappearance of new pharmaceutical drugs to deal with deadly diseases that still ravage millions of people.

But by this time, our popular politician could be elected president, serve two terms in the White House and be living in retirement as a revered figure. Killing the goose that lays the golden egg can be a viable political strategy.

It should also be noted that "generic equivalents" may not all be equivalent for all people. Some patients report adverse side effects from generic equivalents that they did not have from the original brand of the medicine. Generic equivalents do not have to be chemically identical, as a health reporter noted:

By law, generics must have the same active ingredient and the same action as the brand-name version, which allows them to piggyback on the original safety and efficacy trials. But generics do have different inactive ingredients, which can affect how they are absorbed into the body. Generics can produce blood levels as much as 20% below or 25% above that of the original drug and still be considered "bioequivalent," according to Food and Drug Administration guidelines.

Leaving aside the question whether an ingredient is truly inactive if it affects the rate at which the active ingredient is absorbed by the body, there is also a question whether a lesser known firm — perhaps in a Third World country — copying a medication developed by an internationally known pharmaceutical company, has the same incentives to maintain production quality standards as the original producer of the drug, for whom billions of dollars' worth of international brand-name reputation is at stake, not just for this particular drug but for all its many other drugs, present and future.

Wednesday: Price controls in the drug industry.

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From the book "Applied Economics"  by Thomas Sowell. Excerpted by arrangement with Basic Books, a member of the Perseus Books Group. Copyright © 2009.