A Secret Revealed: Why Drugs Cost What They Do

Few are the people who have not wondered why drugs cost what they do and, when the price tag has a pinch, sighed with exasperation. We’ve all read countless reports on the time- and resource-consuming labor of research and development (PDF). Elaborate studies have been done to count up (and debunk) all the dollars spent on creating new drugs. Even reports enumerating all the various pharma expenses still explain the price of prescription drugs by looking at what companies spend. And we’ve all read (or had our own) complaints: if only drug companies would advertise less, the price would go down. If only drug companies stopped wining and dining physicians, the price would go down. If only CEOs weren’t so greedy. But here’s the thing: none of this explains the price of medications.

So what is the great, big secret about why drugs cost what they do? Read on. 

Drugs cost what the market will bear. It’s that simple. Drug prices are set at whatever the market will bear.

So what does that mean? It means that if no one purchased a drug that cost $X, then the price would be lowered. Prices are set at exactly—and I mean exactly—at what the consumer/insurance infrastructure is able to carry.

It would be wrong to say that the prices reflect what we are willing to pay because for the most part, we don’t pay the price tag; we pay for our insurance and then the co-pay amount for a given prescription. Of course this insight is referring to prescription drugs. When it comes to, say, headache medicine on the drugstore shelves, then the price more closely reflects what the customer is “willing to pay,” the economic counterpart to “what the market will bear.” But once we get into the domain of prescriptions, prices are guided by the market.

As simple as that explanation is, the calculations behind the price are complicated. They factor in how many people will buy a drug, how many of those people are likely to be privately insured, how many are likely to have Medicare or Medicaid, how many will have no insurance at all, for how long will a given patient be on the drug (on average), how much it costs to make the drug (yes, this does matter), and even what’s at stake (is the drug treating a life-or-death condition, or is it treating something more mild?).

Also important is the number of years that a drug will have market exclusivity and whether exclusivity can be extended through any of a number of legal loopholes. Even patient assistance factors in. Everyone has heard the gently spoken words at the end of a prescription drug commercial: “If you can’t afford your medication, drug company X may be able to help.” These “patient assistance programs” are vital for assuring that people without insurance do not go without needed medications. But they are also part of the pricing strategy (a topic for a very juicy future post). There are companies that specialize in such forecasting, helping drug makers to decide on a price.

As convoluted as those calculations may be, the fact itself is simple: drugs cost what they do because that’s what they can. (As one insider once told me, cancer drug prices could be lower, but they don’t need to be.) This explains why different procedures cost different amounts in different places. It also explains why drug prices are different for taxpayer-funded insurance than for private insurance than for the uninsured.

The minute enough people stop filling prescriptions because they are too expensive, the prices will be lowered. The science is exact. Yes, there are plenty of people who do not fill their prescriptions because even with insurance, the price is still unaffordable. That’s not good, but in the clear-cut economics of market-driven health care, only when enough people can’t afford their co-pays to upset the profit margin will the price be lowered. And remember, private insurers are businesses, and are also part of the market equation.

Drug companies justify prices with the high cost of R&D because stating outright that the prices are simply what the market will bear would look very bad. But consumers complaining about advertisements, etc. is equally unproductive. Drug companies advertise because the amount of profits guaranteed by what the market will bear allows them to advertise, which of course in turn increases earnings. Consumers are still at the whim of the corporate wheels, but also need to acknowledge the fact of the role that consumers play in the market.

So there you have it, the big secret behind the price of prescription drugs: they cost what the market will bear. Interesting, isn’t it?

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9 Responses to A Secret Revealed: Why Drugs Cost What They Do

  1. Sorry to immediately make this political, but is this an argument for or against e.g. a single payer system? If drug prices are set at “what the market will bear” than it seems obvious that a body with “collective bargaining” power could push those prices lower. Or am I missing something?

  2. KLM says:

    Another aspect is the fact that there are strategies in place to increase the number of people prescribed certain drugs. For example, by lowering the recommended value on safe cholesterol levels, they assure more people will be prescribed statin medications. Same for blood pressure, etc. Notice this every time we get a new message about a change in the American Society of XXX recommended values of YYY.

  3. Jessica says:

    Hi Christopher,

    I’m glad you asked. This post is not an argument in favor of anything. It’s not political. It’s simply looking at the mechanisms at play behind what we see. Whatever conclusions a person draws about what mode of insurance is best, etc. is up to each individual. I find it hard not to wonder about what health care would look like if there were no insurance at all, but that’s just me, and it’s just a wonder. My goal with the post is only to explain, not to opine or persuade.

  4. LogicBot 3000 says:

    Your market analysis is missing a crucial element. Market prices are only ideal in a competitive market. And unfortunately, it is a generally agreed upon fact that drug markets are NOT competitive. Patents, by their nature, are monopolistic. Of course, this isn’t necessarily a bad kind of monopoly. Many believe that the monopoly privilege is necessary in order to push innovation.

    I think, at best, you can say that drugs are priced at what experts and regulators believe is the right price. Of course those experts and regulators could be wrong, which is what a lot of economic research into drug pricing is all about.

    To summarize, you can’t really claim that drug prices are appropriate due to market forces because drug prices don’t operate in a normal market.

    P.S. You can certainly try to prove that the drug market is a normal competitive market, which if you could, might win you a Nobel Prize in Economics. Such a discovery, however, would likely radically change everything we think we know about economics, and we would have to burn all our Econ 101 textbooks. Not that I’m opposed to that. :)

  5. Karen says:

    A great recent example is the Makena controversy, in which KV Pharmaceutical was forced to drop the price of the drug to prevent premature births, which they had priced at $1500, to $699. See the AP story here. Thanks for putting the issue so baldly!

  6. Marsha says:

    I have had to switch drugs & also stop taking ones that did not have a generic! We need more help for those of us who have lost their jobs due to illness & also lost their insurance! Being on SSDI does not make up for the loss of income & insurance. After being in the donut hole two years in a row, I had to ask all my dr’s for generic drugs & I switched pharmacies. The new pharmacy charges $16.00 for a 90 day generic rx

  7. Keiron Sparrowhawk says:

    Drugs are often priced at the value they bring to the healthcare system. If a drug reduces time in hospital, time in intensive care units, if it reduces visits to specialist physicians, then they are worth a lot of money and can be priced accordingly. By saying you want low prices you are arguing that you value life cheaply. Without drugs the cost of healthcare would be dramatically higher. In the US drugs account for less than 15% of the total healthcare spend. Look at other parts of your health system to make savings.

  8. Pingback: Why Drugs Cost So Much - Drugsdb.com

  9. Carolyn says:

    I am still at a loss about the cost of drugs. It is totally rediculous what the drug companies charge. Case in point. I have Narcolespy and have been on Dexedrine ant its generic dextroamphetamine Sulf ER 15 mg. Two years ago, I paid $7.00 for my prescription. At the first of last year, I paid $9.00 Then my insurance company moved it to a higher tier so it cost me $39,. In June of last year my insurance company indicated they paid about $400 for the drug. Then in July they claim they had to pay $800. How can a drug cost double in one month’s time?

    This year I am in the donut hole again, Last month my medication (the same maedication) cost me $249, This month it cost me $681,95. That is three times the amount. How can they justify this?

    Something is totally wrong with the drug prices. I wish I knew what I could do about it. If I want to stay awake, I have to pay the price. But it simply is not right.