Prices and Profits, Pharma

Megan Mcardle writes, in Does the US Really Account for So Much Pharma Profit?:

…I repeated an estimate I had heard from several people, that the US accounted for something in the range of 85% of pharma net profits…I may be in error on that–I’ve heard 80-90% from people in healthcare consulting, and I’ve seen that sales and profits in the US are usually larger when they’re broken out on financial statements, which they aren’t all that often…Next, we can look at where the revenues come from. According to the OECD’s invaluable Pharmaceutical Pricing Policies in a Global Market, which really is a bargain at the price, 45% of global sales come from the United States, 30% from Europe, and 9% from Japan…

So let’s back up. Revenues on annual income statements are almost always broken down by region. Let’s look at some: Pfizer (p. 94, USA 41%), GSK (p 118, USA 39%), Johnson and Johnson (p. 57, 53%, excluding consumer products), Bayer (p. 60, pharma as opposed to consumer health, North America including Canada is 28%), Sanofi (p 283, USA 31%).

This is consistent with the numbers Megan gets from the OECD’s revenue estimate of 45% from the United States. 45% is a large number, but it isn’t 80%. Now remember our accounting identities:

Profits = Revenues – Costs
or
Profits = Quantity * Price – Costs

Megan goes next to arguments about prices. We can tell that profits are higher in the United States since prices are higher, back out information from prices, etc. But we are done with prices – we already have good information on the revenues, and that is all we need prices for. What we need is information on profit margins, or the costs for sales. And we should think something is really off if the Rest of the World gives a majority of revenues at 55% but only 20% of profits.

From Wikipedia, we have the revenues of the top 10 pharma companies at $425.3bn, and profits at $87.5bn. That’s a profit margin of about 20%. To solve the profit margin equation above, with the United States generating 80% of profits, the profit margins of the United States would be about 37%, and the Rest of the World would be about 7.4%. This may be boring income statement talk, but it’s hard for me to imagine anyone justifying a situation where the profit margin is 500% higher on one group of people than another group as correct.

But I don’t think that’s the case. Going back to the sheets above, GSK has operating profit margin at United States 65%, rest of world 54%. Sanofi’s 20-F filing gives 55% operating profit margin in the United States, rest of world 41%. Assuming a 10% higher profit margin, and solving the equations again, we get the United States at 57% of profits. This is a far cry from 80%.

Simple economics tells us if we lower prices, quantity sold increases. We’ll also be bringing more people into the health care market, and direct dealing may cap some of the operational costs. So it isn’t clear what the effect of lower prices would do; decreasing prices by x% would only decrease profits by < x %.

Let’s build a lighthouse and make the poor pay for it.

I understand Megan’s meta-argument; we are a rich country, other countries are free-riding off our innovation by shaving the profit margins to clearing rates, and though there is a lot of leakage overpaying for drugs now will help us find better drugs for all tomorrow. I agree.

However that very quickly leads me to supporting government prizes for drugs, as opposed to paying more in the market. Right now the people paying this extra-charge for innovation are the sick. I’m not paying directly for this innovation since, knock on wood, I’m healthy and currently not on prescription drugs. I’m paying in part, since Medicare Part D is paying too much for drugs. But the people who have to go to the pharmacy and buy drugs are paying in addition to that.

I know, putting on my sunglasses of ignorance, that if we want more R&D we should have the government subsidize it by buying it. It is worth paying for. I also know that I’d rather pay for it now when I’m young and healthy than when I’m older and/or sicker. When I’m sick, the quantity/quality of the labor I can sell decreases. I’ll have fixed expenses and/or fixed income that it is harder to marginal adjust to handle this extra innovation fee I am paying. And of course I’ll be at higher risk of bankruptcy because of an increase in medical expenses. I’m also paying for innovation that I’ll likely not benefit from, considering the time it takes to get drugs through the pipeline.

R&D prizes would take care of the problem of whom is going to pay out of pocket to help fund this next wave of innovation – making the sick pay for it seems cruel when the government can bid for it wholesale for all of us.

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6 Responses to Prices and Profits, Pharma

  1. krishna says:

    McArdle is wrong on a basic premise. The pharma industry does not innovate all that much, and most new drugs are a result of university, government (NIH) funded research. Industry has even reduced the amount of basic research supported, and instead outsourced it to academia. Ben Domenech of all people had a nice article about this, which can be read here:
    http://newledger.com/2009/07/how-medical-breakthroughs-happen-a-response-to-megan-mcardle/
    Also see Ezra Klein on this:
    http://voices.washingtonpost.com/ezra-klein/2009/07/ben_domenech_on_pharmaceutical.html

    Of course, if Ms. McArdle had her way, the $28 billion spent on the NIH by the US govt would probably be cut instead.

  2. This statement stood out to me: “Simple economics tells us if we lower prices, quantity sold increases.”

    I think that’s true for bread, TVs and computers, but pricing alone does not determine whether or not a medical product is sold. Consumers generally do not “choose” to purchase medicine – they’re prescribed by doctors as part of a treatment for a health condition. One hopes that the lowering of the price of an antibiotic or other medicine would not then have us pounding of the doors of a medical practice, like consumers who cluster in front of Wal-Mart prior to the pre-Christmas sales.

    Now what determines the price of a pharmaceutical product – that is a fascinating subject that I’d like to see more on…. I’d really like to understand why a particular cancer treatment is $50,000 a shot or whatever is charged to the health insurance company. Is it because just a couple hundred of those treatments are used in a year? If we could get more people with that kind of cancer, the cost would go down? Somehow, I think not.

    ALL health care pricing is opaque and rather mystical. And certainly none of it is subject to the rigors of the efficient market theories so popular these days.

  3. Adam Kotsko says:

    But you’re forgetting that for McArdle, everything the government touches turns to shit, so the only types of products the government could develop using its R&D money would be laxatives.

  4. Mitch says:

    One thing that always confuses me in this debate is how much of the innovation really comes from the U.S. You always hear the line that “other countries are free-riding off our innovation.” Looking at wikipedia (http://en.wikipedia.org/wiki/List_of_pharmaceutical_companies) one 6 of the top 10 largest drug makers in the world (by revenue) are not based in the U.S. and are instead based in Europe. Do they somehow use American innovation? Or are they using profits earned in America to subsidize less profitable domestic businesses?

    I completely second krishna’s comment that Big Pharma really does very little in terms of innovation; most stems from academic/biotech research. Big Pharma then buys promising compounds and funds the lengthy FDA approval process, but they aren’t doing the innovating.

  5. The whole thing about increasing the profits of pharmaceutical companies to increase medical advancement is a very important issue to explain.

    Basically, there are terrible, and well established in economics, free market problems with medical research and advancement. Two of the crucial ones, among many, are inability to price discriminate practically and well (so society does not spend far less than what medical research is really worth to people), and inability to patent practically and well. The result is that a strong government role can tremendously increase efficiency, total societal utility and growth in medical understanding and proficiency.

    Ezra Klein has a great post on this, (at: http://voices.washingtonpost.com/ezra-klein/2009/08/in_defense_of_experts.html ):

    I posed a similar question to [MIT Health economist] Finkelstein. If she had billions of dollars and wanted to supercharge innovation, how would she do it? Would she simply increase reimbursement rates for drugs? Would she give it to pharmaceutical companies? What’s the most efficient engine for medical innovation?

    In reply, she pointed me to the work of Harvard’s Michael Kremer (another expert, sadly). “The two main things that people talk about,” she said, “are funding a lot of basic research — push strategies — and then pull strategies, where governments get together and define a prize for innovation on a particular disease.” In other words, funding innovation and scientific discovery in a direct and targeted fashion.

    End Quote

  6. jeff says:

    The author gives some numbers on a handful of pharma’s operating margins, but what people really care about is the price discrepancy between the US and other countries, which leads to a discrepancy in gross margins.

    Operating costs include everything from manufacturing costs to research, rent, advertising, salaries, shipping and legal bills. To what geographic region are these costs being allocated? If LLY does all its R&D in the US and spends 85% of its advertising budget in the US, and classifies these costs as US operating expenses, then it makes US operating margin look similar to ex-US operating margin even US prices are far higher than ex-US prices.

    Given the popular outcry over healthcare costs, pharma companies do everything they can, accounting-wise, to reduce the operating profit difference between the US and ex-US. But what matters is gross profit difference, which is driven entirely by price difference (which they will never, ever tell you).

    P.S., Mitch, to clear up your confusion about innovation and 6 of the 10 largest pharma companies being based in Europe, you might try digging deeper than Wikipedia. Take a look at the drugs that those European companies are selling, and then go find out who developed those drugs before licensing them to the the European companies. Same goes for Japan.

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