Price Gouging and Research Costs in the Pharmaceutical Industry

The pharmaceutical industry in the United States often argues that high drug prices are justified as a reward for world-class innovation. In reality, America's pharmaceutical industry delivers very little in the way of innovation, and can only jack up prices to obscene levels because it operates in a political system that allows it do so.

The Political Economy of Pharmaceuticals in the United States

The pharmaceutical industry in the United States is one of the most ruthless and corrupt in the entire world, aided and abetted by a feeble government that refuses to rein it in. In many countries around the world, it’s typical for governments to negotiate with drug companies so that drug prices stay low and affordable. But in the dystopian system that operates in the United States, the dominant capitalists who control the pharmaceutical industry won’t allow that to happen. What makes the situation even more infuriating is that so many essential drugs, which make billions in profits for Big Pharma, can only be developed because of critical government funding and research from the National Institutes of Health (NIH) and other bodies. We have a system where public money is subsidizing private profit, and thousands of people in America die every year because of it. Because it operates in such a lax regulatory environment, the American pharmaceutical industry has managed to score sky-high profit margins relative to other major industries.

For some concrete examples, consider the drug sofosbuvir, also known as Sovaldi under its brand name. It’s a highly effective treatment for hepatitis C, an infectious disease that harms the liver. The NIH provided $62 million for the fundamental research that led to the drug’s development. The drug company Gilead Sciences then bought sofosbuvir from its developers for a whopping $11 billion. Gilead priced the drug in the United States at $1,000 per pill, compared to just $4 a pill in India. Perhaps the most notorious example of this casual corruption is insulin, which roughly 30 million diabetics in America need to survive. Insulin is a critical hormone that allows cells to absorb the energy contained in food. In Type I diabetes, which affects roughly 5% of diabetics, the body has a difficult time producing insulin because the immune system attacks insulin-creating cells, so patients need to inject some more into their bloodstream with an insulin shot. In Type II diabetes, the body can produce insulin just fine, but cells have a hard time interacting with it and they grow resistant to its effects. Patients with Type II also take injections of insulin.

This important hormone was discovered in 1923 by Frederick Banting, James Collip, and Charles Best, working under John Macleod at the University of Toronto. Banting himself refused to put his name on the patent because he reasoned that doctors shouldn’t profit from life-saving drugs. Collip and Best ended up selling the insulin patent to the University of Toronto for a single dollar. They wanted the drug to be cheap and widely available. But fast-forward a century and one can see how insulin has become emblematic of pharmaceutical price-gouging. From 2010 to 2020, the cost of insulin tripled in the United States. The average price per month in 2016 shot up to $450. A 2019 study that administered a survey to people going to the Yale Diabetes Center found that about 25% of them reported rationing insulin, and cost was a major reason why they did it.

To understand why pharmaceutical companies operate this way, it's useful to understand their basic business model. Drug companies are interested in scoring profits and delivering "shareholder value," a euphemism for pumping up the stock price as high as it can go. Perhaps the most important profit mechanism to a drug company is the patent, because that’s what allows them to restrict access to medicine, to make their products exclusive, and to therefore charge high prices. When patents on existing drugs are close to expiring, Big Pharma companies invest a lot of money on developing minor variants of those older drugs so that they can extend patent protections and maintain market dominance. For the most part, these new variants are hardly better than their predecessors, but a medical marvel is not the goal. As long as some manipulative study can show a marginal improvement over previous versions, the companies will get both the patents and the profits they so desperately crave from the government agencies that are beholden to this corrupt system.

This is exactly what’s happened with insulin. Most of the insulin medications that American consumers buy nowadays are newer variants, allegedly better than the older versions of insulin. But studies show that the differences are often trivial or insignificant. As a result, a 2017 paper concluded that "older insulins have been successively replaced with newer, incrementally improved products covered by numerous additional patents." Over 90% of Type 2 patients with private insurance are prescribed the latest and most expensive insulin variants, even though these don’t produce much better health outcomes.

The Role of the State in Fostering Innovation

Pharma executives know that a huge chunk of their bottom line depends on robust government funding, since it's precisely the government that largely funds the risky fundamental research that the industry doesn't want to touch for fear of failure. Using patent information on drugs approved between 1988 and 2005, a 2011 paper from Bhaven Sampat and Frank Lichtenberg made the following conclusion about the role of state funding:

Overall, we find that direct government funding is more important in the development of “priority-review” drugs, sometimes described as the most innovative new drugs, than it is for “standard-review” drugs. Government funding has played an indirect role...in almost half of the drugs approved and in almost two-thirds of priority-review drugs.

The researchers take time to emphasize the importance of state-funded research in the context of HIV drugs:

The nineteen HIV/AIDS drugs we studied were exceptional in terms of all our indicators of direct or indirect government influence...Nearly a third of these drugs had a public-sector patent, and close to 95 percent cited government-funded research.

A study published in 2018 by Ekaterina Galkina Cleary and her colleagues also found that federal funding played a critical role in drug development. They examined "the contribution of NIH funding to published research associated with 210 new molecular entities (NMEs) approved by the Food and Drug Administration from 2010–2016." The research group described some of its main results as follows:

NIH funding contributed to every one of the NMEs approved from 2010–2016 and was focused primarily on the drug targets rather than on the NMEs themselves. There were 84 first-in-class products approved in this interval, associated with [over] $64 billion of NIH-funded projects.

As in so many other economic sectors, the state is usually the one that carries the burden of funding fundamental research for new drugs, since capitalists are unlikely to pour vast sums of money into something that may not yield any concrete financial benefits. But despite this reality of state-backed innovation, Big Pharma is allowed to price gouge consumers as if public interests aren't even an afterthought.

Price Gouging as a Systematic Strategy

Price gouging is a core profit-boosting strategy of the pharmaceutical industry in the United States, all facilitated by a corrupt government that refuses to do anything about it. Pharmaceutical companies like to spread propaganda about pouring money into research for innovative drugs, but the reality is that their priorities are entirely about profits and shareholders. After the 2017 tax law passed by Republicans slashed corporate tax rates, the pharmaceutical industry showered its shareholders with money. Nine drug companies alone spent a total of $50 billion on stock buybacks and dividend programs. Four companies accounted for 80% of this total; Pfizer, AbbVie, Merck, and Amgen each spent $10 billion for their shareholders.

The pharmaceutical industry commits price gouging simply because it can, because there’s no effective mechanism of state or social control to stop them. Let’s consider a few concrete cases. The company Mylan maintained a virtual monopoly on sales of EpiPens for years after first acquiring the device in 2007. EpiPens are injection devices that administer the hormone adrenaline, also known as epinephrine; they are used by people, often children, who suffer from severe allergies or asthma attacks. In 2009, two EpiPens had a $100 wholesale price for pharmacies. By July 2013, Mylan had jacked up the price to $265; in May 2015, the price reached $461, and by May 2016 Mylan raised it again to $609. The price hikes enraged parents throughout the country, since so many kids depend on the device to prevent serious health issues, and even to save their lives.

Another notorious case emerged in 2015, when the company Turing Pharmaceuticals (later renamed Vyera) purchased the marketing rights for Daraprim, the brand name for a generic drug known as pyrimethamine. The drug is used for a wide variety of purposes, such as treating parasitic infections like malaria and toxoplasmosis and helping patients with weak immune systems suffering from AIDS or cancer. After Turing took control of Daraprim, its CEO and founder, Martin Shkreli, immediately hiked the price from $13.50 per tablet to $750 per tablet, an increase of over 5,400%. The move drew widespread scorn and outrage, especially since many people had to take the drug for long periods of time. Shkreli defended the move by resorting to the usual nonsense about high pharmaceutical research costs. In reality, the pharmaceutical industry spends the vast majority of its R&D funds on useless and ineffective variants of pre-existing drugs. Shkreli later offered hospitals half off for Daraprim, which still amounted to a price hike of 2,500%. Not that the reduction mattered much anyway; patients generally take the medicine at home, after they leave the hospital, meaning that they and their insurance companies still had to foot the bill for $750 a tablet.

Shkreli also tried to defend the price hike by claiming that insurance would cover it anyway, apparently unaware that businesses in America do something called "passing on the costs to consumers." Shkreli was later arrested and imprisoned for an unrelated issue: committing securities fraud with the hedge funds he operated before he entered the pharmaceutical industry. In 2022, a federal judge ruled that Shkreli and his former pharmaceutical company must return $64.6 million in profits that they made from the obscene price hike on Daraprim, and two years later the Supreme Court refused to hear Shkreli's appeal on the matter.

Shkreli’s outrageous price hike was in no way unique or very unusual. After buying the drugs Isuprel and Nitropress in 2015, Valeant Pharmaceuticals immediately proceeded to jack up their prices by 525% and 212%, respectively. The drugs are used to treat heart-related conditions and high blood pressure. Like Turing’s speculation with Daraprim, Valeant’s brazen decision sparked widespread outrage in the media, but Valeant’s stock price soared to record highs by the summer of 2015 as investors cheered the prospect of higher profits. In 2016, outgoing Valeant CEO Michael Pearson testified at a Senate hearing that his company had been "too aggressive" with the price hikes. Valeant was later mired in a number of legal controversies, as several of its high-ranking executives were charged with fraud and the company’s stock price plummeted. By 2017, the stock had fallen over 90% from its record highs. The company eventually changed its name to Bausch Health in 2018 as a way of trying to distance itself from these prior scandals. But despite the name change, Bausch continued the nefarious strategy of hiking prices for drugs used by vulnerable populations that had few other options.

Figure 1: Price gouging in action for various drugs. Drugs in America often experience ridiculous price swings that have nothing to do with supply and demand and everything to do with monopoly power and a corrupt political economy that allows it to fester unimpeded. Chart above can be found here.

Indeed, many pharmaceutical companies target buying opportunities for critical drugs that have no cheap generic alternatives on the market, then spike the price right away to exploit their market power, since patients have no other choice but to keep buying these drugs. These price hikes have nothing to do with supply demand. It’s not like orders for Daraprim spiked by 5,000% when Shkreli decided to send its price through the stratosphere. These corrupt corporations are committing ruthless price gouging, pure and simple. They’re exploiting monopoly power over particular drug markets to artificially jack up prices as a way of boosting profits and market capitalizations. Their selfish decisions are all about capital accumulation for their tycoons and large shareholders, not about serving the market. 

The Manipulation of Research Costs

Although pharmaceutical companies claim that R&D costs represent a substantial share of their revenues, there are many good reasons to be skeptical of these claims. In the 2000s, the pharmaceutical industry claimed that roughly 17% to 19% of its revenues went into R&D. More recently, an average as high as 25% has been cited by some sources. But as scholars like Donald Light and Rebecca Warburton have pointed out, the majority of this funding is heading towards low-quality and low-efficacy replacement drugs designed to extend patent protections. Funding for basic or fundamental research in new drugs only makes up roughly 1-2% of all industry revenues. In a 2014 article, Donald Light points out that many new prescription drugs cause more harm than benefits. He writes the following:

Few people know...that systematic reviews of hospital charts found that even properly prescribed drugs...cause about 1.9 million hospitalizations a year. Another 840,000 hospitalized patients given drugs have serious adverse reactions for a total of 2.74 million. About 128,000 people die from drugs prescribed to them...A policy review done...at the Center for Ethics at Harvard University concluded that prescription drugs are tied with stroke as the 4th leading cause of the death in the United States. The European Commission estimates that adverse reactions from prescription drugs cause 200,000 deaths; so together, about 328,000 patients in the U.S. and Europe die from prescription drugs each year. The FDA does not acknowledge these facts and instead gathers a small fraction of the cases.

Light elaborates by explaining that very few new drugs represent genuine innovations:

About 170 million Americans take a prescription drug, and many benefit from them. For some, drugs keep them alive...However, independent reviews over the past 35 years have found that only 11 to 15 percent of newly approved drugs have significant clinical advantages over existing, better-known drugs. While these contribute to the large medicine chest of effective drugs developed over the decades, the 85 to 89 percent with little or no clinical advantage flood the market. Of the additional $70 billion spent on drugs since 2000 in the U.S. (and another $70 billion abroad), about four-fifths has been spent on purchasing these minor new variations rather than on the really innovative drugs. In a recent decade, independent reviewers concluded that only 8 percent of 946 new products were clinically superior, down from 11 to 15 percent in previous decades...Only 2 were breakthroughs and another 13 represented a real therapeutic advance.

Part of the problem is that much of the biomedical research which supports the adoption of these new drugs is full of flaws and loopholes that are ignored and marginalized. It's well-known, for example, that p-hacking is a major problem in the social sciences, especially for biomedical research conducted by smaller companies. P-hacking is the practice of manipulating and distorting datasets or experimental procedures so that they yield a p-value of under 5%, which is the widely accepted alpha level in the social sciences, otherwise known as the point of "statistical significance." Getting results under this alpha level is critical to having research published in peer-reviewed journals, so many research teams will search for ways to make that happen if the initial results look disappointing. For example, a company may initially design a study to last for a year, but then may call it quits after 7 months because they've obtained the statistically significant results they wanted. For a similar example, a drug might be initially intended to work for men and women, but then the company digs through the data and finds statistically significant results for men over 60, so the whole marketing strategy shifts and all of a sudden it's a drug meant for older men!

Light emphasizes the importance of what he calls the "trial-journal pipeline," in which research teams work with marketing departments to feed the FDA with biased studies. He points out that "commercially funded clinical trials are at least 2.5 times more likely to favor the sponsor's drug than non-commercially funded trials." In a 2013 paper, Marc Rodwin made the same basic observation, explaining that "scholarly studies have revealed that drug firms design trials that skew the result and that they distort the evidence by selective reporting or biased interpretation." The central point is crystal clear: the pharmaceutical industry has flooded the world with numerous drugs that are largely ineffective or harmful, yet preposterously claims that it deserves sky-high profit margins because it's producing so much innovation!

To better understand the claims of the pharmaceutical industry on research costs, it’s worth looking at the work of Joseph DiMasi, a professor at Tufts University who has become widely known for publishing severely flawed statistics on average R&D costs for new drugs. First of all, we should note that the Tufts Center for the Study of Drug Development where DiMasi worked is heavily funded by the pharmaceutical industry. In 2001, for example, roughly 65% of the funding received by the Center came from pharmaceutical companies. That rate has varied over the years, but it’s always been true that drug companies have strongly supported the work of the Center, thus clearly posing a conflict of interest.

In a 2003 paper, DiMasi claimed that the average R&D cost for a new drug was roughly $800 million, a huge value. Thirteen years later, he updated that already ridiculous figure to an even more ridiculous $2.5 billion, an astonishing sum. DiMasi obtained these numbers from surveys that he sent out to various pharmaceutical companies. In both 2003 and 2016, ten of these companies responded to him, although he doesn’t disclose which ones. In fact, there are many important details about his data and his sources that are never publicized, making it impossible to actually replicate his work. But what we do know is enough to fully invalidate his conclusions.

The central problem is that his samples are extremely biased because they only include high-priority and innovative drugs that receive lots of research funding. It would be like trying to determine the average price of new cars and only looking at Teslas; you’re obviously going to get a sharply inflated number. In reality, the vast majority of new drugs that enter the market are actually generics, biologics, and variants of pre-existing drugs. The development costs for these types of drugs are generally low, or least much lower than for priority review drugs.

Another problem with DiMasi’s numbers is that he adds an estimated opportunity cost to the initial average cost he determines from his data. In the 2003 study, for example, his initial estimated average was $400 million, which he then inflated to $800 million after the opportunity cost calculation. The basic idea behind this adjustment is that a pharmaceutical company could’ve used the R&D money for the drug in other ways, such as marketing for existing drugs or expanding production capacity. Since the company would’ve made money through these other investments, DiMasi then infers that it therefore incurred an additional “cost” when it developed its drug. The main problem with this argument is that, for many pharmaceutical companies, blockbuster drugs comprise a substantial share of their total revenues. It’s not uncommon for a single drug to make up half of all annual sales. If these companies don’t produce new blockbusters, they’ll basically go bankrupt because rival companies will outcompete them in the market. The real opportunity cost of R&D funding is the firm’s survival, and it’s impossible to quantify that in any meaningful sense, so no one should bother trying.

In addition, the notion of opportunity cost is highly ambiguous. No one can possibly know the outcome of a hypothetical scenario, because by definition it’s hypothetical. Sure, maybe a drug company could’ve taken that money it spent on R&D and used it effectively to boost profits, but it could’ve also done something stupid with that money that would’ve caused the firm’s total collapse. There’s no way to know. Opportunity cost can never be measured, even in principle; it can only be guessed. In addition to these arguments, others have pointed out that government funding is absolutely critical to the development of new revolutionary drugs, but DiMasi’s studies say absolutely nothing about that. In short, nobody really knows the average R&D cost for new drugs, because determining that information would require the pharmaceutical industry to open up its books in a radical way. The simple truth is that the pharmaceutical industry loves to exaggerate research and development costs because it wants to justify sky-high drug prices across the board, even for what should be cheap generics.

The Road Ahead

We’re stuck in a situation where a corrupt industry is making huge profits and, apart from the production of vaccines and generics, delivering pathetic results in many cases. The federal government is afraid of upsetting Big Pharma’s crony capitalists by bringing down the hammer on their predatory industry. Instead of regulating the pharmaceutical industry, the government helps it make lots of money, regardless of all those who die along the way.

We need a new economic and political model that views drugs as public goods. The government needs to have greater pricing power so that a few corrupt capitalists aren't setting prices based on whichever direction the wind is flowing that day. The patent system needs to be thoroughly reformed, as I have argued elsewhere, so that ineffective variants of pre-existing drugs don't receive patent protections and market exclusivity. The government also needs to impose greater requirements and regulations on how the pharmaceutical industry reinvests its profits, since so much of that money now is being squandered on stock buybacks and dividend payments for shareholders. And there are a million other things that need to change as well. The pharmaceutical industry is too important for public health to be left in a putrid state of anarcho-capitalism. We need more public oversight and control. Our lives are at stake, and promoting major change in this corrupt industry should be a national priority.