Innovation, Drug Pricing, and the Pandemic: A Q&A with Craig Garthwaite

The ongoing search for a COVID-19 vaccine is receiving a great deal of attention. At present, clinical and safety matters are uppermost in people’s minds, but affordability and pricing questions will also eventually arise.

In this Q&A, Professor Craig Garthwaite of Northwestern University, an Analysis Group affiliate, spoke with Managing Principal Noam Kirson about the different kinds of value pharmaceuticals create, how to balance the competing demands of access and innovation, and why market signals are important.

Let’s start by talking generally about drug pricing. What are the basic issues?

Craig Garthwaite: Herman R. Smith Research Professor in Hospital and Health Services Management, Associate Professor of Strategy and Director of Healthcare at Kellogg, Kellogg School of Management at Northwestern University

All our drug pricing policies deal with an inherent market failure that sits at the center of the biopharmaceutical industry – or really, of any intellectual property-intensive industry in which you’re going to create scientific knowledge. Absent any protections, you’re going to have knowledge spillovers: that is, other people will be able to use the knowledge you create. Absent some form of government intervention, you’re going to get an underinvestment in innovation in the biopharmaceutical industry, because firms will know that they can’t capture the value that they create. And that hinders further innovation.

To address this, we’ve come up with various forms of market exclusivity that allow firms some time-limited period where they can recoup their investments, because they’ll be the only people who can sell the actual product on which they have the patent. We’re accepting reduced access today in the form of high prices for drugs. In return, we’re generating the necessary incentives to get new products in the future. And to the extent that those new products generate more value than we lose from reducing access today, this can be welfare-enhancing.

So innovation policy in this area really comes down to figuring out the answers to a set of questions. How much welfare does society lose because of high prices today? What type of new products do we get in the future – or, perhaps more importantly, how much welfare do those new products generate? What determines the public’s willingness to pay for a particular benefit?

That gets us into the issue of value. We all know that pharmaceuticals create clinical value, but are there other kinds of value they create?

Economists have thought a lot about clinical value – how much value is created by the drug for the person taking it? But as the pandemic is starting to teach us, pharmaceuticals create other kinds of value as well.

One of those is insurance value. One of the things that effective drugs do is limit the negative outcome faced by people who contract a disease – that is, they limit the disease burden, which we measure in quality-adjusted life years (QALYs). If you keep in mind that insurance is a financial product that is meant to decrease the risk of a negative health shock, then what biopharmaceutical innovations do is transform uninsurable health risks into insurable financial risks.

There’s another aspect, very relevant to the current pandemic, which we can call contagion value. We’ve effectively had to shut down the American (and the world) economy because of the novel coronavirus, and that has caused losses that are difficult to fathom – $15–20 billion a day, by some estimates. So the value that a pharmaceutical product would create, when you think about the effect on the economy, is massive. Even if we paid around $300–400 billion for a treatment, there would still be tons of consumer surplus left over.

And finally, there’s what we might call scientific option value. Think about remdesivir, which, even though it’s been shown to be effective in shortening the recovery time for COVID-19 patients, is not the home-run treatment that we need, and it’s certainly not a vaccine. But we’re learning things from the use of remdesivir, as well as from the development of other products. That lets us make better products in the future, and that means that every incremental step along the way has its own value.

Noam Kirson: Managing Principal, Analysis Group

So how do all these different types of value figure into setting actual drug prices?

Let’s say we agree that the value is there. Then the question becomes who should pay for that value. If it was a world where patients paid for the drug out of pocket, we might think that it’s inappropriate for these other kinds of value – many of which have societal, rather than individual, benefits – to figure into the price. But that’s obviously not the world we’re in. Worldwide, the vast majority of people who purchase drugs have an insurer that’s paying for them. That means that prices should reflect, in part, the demand curve of everyone in the pool. Whether you’re talking about a public or a private insurer, my need to have access to the drug, and for the very drug to exist, will influence my payer’s negotiations about what they’re willing to pay for that product.

You’re getting to the topic of market signals.

Exactly. One of the basic insights about the pricing of any product is that we’ll only get the things that we’re willing to pay for. Prices send signals to the market. One of the most frustrating parts about talking about drug pricing, particularly right now, is that a lot of people only think about the role of the price as splitting up the surplus value between the manufacturer and the payers or patients. But it’s also sending a signal to future innovators that if you could actually cure the coronavirus, we will pay you for that value.

And a lot of people say, well, you don’t need to do that because the biopharmaceutical industry knows that they need to solve this problem just because it’s the right thing to do. And I agree that most people in biopharma are interested in working on the coronavirus because of an altruistic motive. It is the right thing to do. But I don’t think we can rely just on altruism to solve this. I also want markets involved. I want firms to know that the right thing to do morally and the right thing to do financially are the same thing. And we can do that by paying for the value that a drug creates.

You put a lot of trust in markets to work out these issues. But I think some people would say that in this area, the markets are not always perfect. We often have payers or manufacturers that have some amount of market power. How do we know that we would get a better outcome through market transactions than just through expert assessment of value?

Part of the answer is that we intentionally give firms market exclusivity on their drugs. It’s how we incentivize further development. But that does bring up a question about how much and what type of market power we want firms to have. What’s the optimal policy for this kind of innovation?

It’s important to remember that our policies don’t just reflect market operations. A lot of them reflect societal preferences and norms. Think about the formulary of covered drugs under Medicare Part D. Everyone has to have access to oncology products in that formulary. That’s not just because oncology manufacturers petitioned for them to be there. It’s because society doesn’t want people who have cancer not to get access to that drug.

Then the question for us as a society becomes: How much are we willing to pay so that you can get access to every product? And how much are we willing to walk away from products if a manufacturer demands too much money?

I think it’s important to remember that, anytime we’re discussing market signals and innovation policy, we’re not just talking about a single public health event, even one as massive as the coronavirus. We’re also talking about the next such event to occur.

Right. This will not be our last pandemic – I think we all agree on that. It might be an infectious viral disease like this, or it might be a disease-resistant bacteria for which we need antibiotics that don’t yet exist. But we will need to do more going forward to think about paying in advance and developing systems that allow us to express the value of the drug and allow innovators to capture the value that they create. And I think that if there’s one thing I hope we take away from this pandemic, it’s that we understand the inherent value that the biotechnology sector can provide to the market. ■