Why New Drug Prices Are So High

Recently, Pfizer abandoned the development of a new drug after spending a billion dollars. Finding new drugs and navigating the FDA regulatory process is a risky endeavor. As Pfizer and other drug companies know, there are few successes, many failures and the cost of searching for and finding effective new medicines is high.

Despite the high costs of developing new drugs, the actual production cost of an effective and approved drug can be low. Companies that make generic versions of useful drugs can take advantage of low production costs and sell the medicines at a reduced price, once the original patents lapse. These generic drug companies do not have to recoup the funds they paid for finding, developing, proving effectiveness and marketing. They know the chemical formulas for the approved medicines, which work and have a market.

Let's make up an example to see how a generic drug company can sell a drug for a significantly lower price than a developing drug company can.

Let's say only 1 in 10 drug prospects is effective, gets regulatory approval and has a consumer market. If pharmaceutical companies spend a billion dollars on each of these prospective drugs, for each $1 billion spent on a successful drug, they spend $9 billion on unsuccessful drug efforts.

To attract funds to invest in new drug research, companies and investors expect a fair return for their money. Companies however do not know beforehand which drugs will be successful and which will be failures, which will pay them a return and which will lead to investment losses.

Let's say for this example a realized 5 percent return on the invested funds is a fair return. Since there is only a 1 in 10 chance of a successful drug and getting the fair return, an investor in all the drugs would like to see a 50 percent expected return from each project. Since there is a 1 in 10 chance of success, a 50 percent expected return from a project is a 5 percent expected value.

For a $1 billion investment, the investor wants a return of $50,000,000 but to get that $50,000,000 return, on average, $10,000,000,000 is invested. The $10,000,000,000 must have an expected 5 percent fair return and profit of $500,000,000. Only 1 in the 10 investments will succeed and the successful $1 billion investment must pay $500,000,000 to have a fair 5 percent return on the total $10 billion invested, which is a 50 percent return on the one successful drug's investment of $1 billion.

Suppose, a generic company can sell a drug to make a 5 percent return, but a research and development drug company must make a 50 percent return. The research drug company must make a profit that is ten times the amount of the generic company.

Let's say a generic drug company can make a pill for 60 cents and sells it at 70 cents (10 cents profit) to make a fair after tax profit. The developing drug company must sell the same drug at $1.60 to make a fair return ($1.00 profit).

When politicians and consumers look at a drug's selling price and costs, they look at only that drug's production costs and investments. They only look at the successful drugs in the marketplace. They ignore all the false starts and costs associated with those failed efforts. To stay in business and attract new investment funds, a pharmaceutical company must be able to recoup its lost funds on unsuccessful efforts in the profit it makes on successful drugs.

New drugs are expensive and cost more than the later generic version because the cost of finding and proving the effectiveness of new medicines is high. The generic drug companies do not bear the cost of finding new medicines and can set drug prices based solely on production costs, which are a small part of the cost of most drugs.

The price of a new drug represents more than the cost of its development and production. It also represents a fair return on all the funds invested, including the investments on the failures without which the drug company could not find and bring to market successful medicines.