If you’re looking for market failures, look no further than the way pharmaceuticals are priced — the most recent example being the case of Remdesivir. Remdesivir is the prescription drug developed for treatment of Covid 19 by Gilead Sciences, Inc. It’s not a cure, but it has been shown to reduce recuperation times.

In virtually all markets, suppliers naturally seek to maximize profits, which they strive to do by setting the profit-maximizing price. In purely competitive markets, firms actually don’t have any discretion in this area. The competition effectively forces suppliers to accept the widely recognized competitive market price. At the other extreme, a monopolist operating in an unregulated environment can set the price with total discretion. Gilead would be more like the monopolist, but their pricing decision clearly takes into consideration public sentiment. They want to be seen as good corporate citizens and not gougers taking advantage of their unique market authority.

Their capacity to set the price is also somewhat constrained by the fact that the US government will ultimately be a major purchaser, and Gilead needs to be cautious about setting a price that will precipitate a Federal effort to impose too onerous price controls. My sense is that Gilead is trying to thread that needle.

The announced pricing will be differentiated for patients of private insurance ($3,120 per treatment course) verses those on government-sponsored insurance ($2,340 per treatment course). According to the NY Times, many experts appear to have opined that this pricing isn’t excessive, but I’m unconvinced. That assessment seems to rely on evaluating the price in relation to a reference price, where that reference price is calculated by applying a multiplier to the price of similar drugs. The multiplier is designed to reward innovation. In this case, it seems like the “competitor” drugs are other antiviral drugs. The Innovation adjustments depends on the when the competitor drug came into being. Innovation over older competitors would deserve a higher premium than would be innovation over newer competitors.

As reasonable as that reference pricing model may seem, this approach ignores the concept of return on investment. Drug companies are like venture capital firms in that they typically manage a portfolio of products, generally with more losers than winners. Given that structure, the returns on the winners have to be large enough to cover the losses on the losers, but still, shouldn’t there be some limits?

It seems reasonable to me for the company to set a price that would be expected to generate some threshold rate of return over some anticipated sales horizon, but once realized revenues surpass an amount sufficient to generously reward the associated research and development costs, the pricing of these drugs should be reduced dramatically. The adjusted price should assure a reasonable markup over production costs, but no more. Given the public health aspect of the pharmaceutical industry, a constraint of this type is deserving of consideration.

You’d think the CEO of Gilead Scientific, Daniel O’Day, who had a total compensation of $29.1 million in 2019, ought to be able to accommodate to that.

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