Will your medicine cost $150 or $150,000? If it costs $150,000, does that mean that the pharma company is making more money? Does it mean that they are making too much money? Pharmaceutical pricing in the United States is a notorious “black box.” Few understand why prices are so high, and how biotech companies arrive at these prices. But there is more rhyme and reason to the pricing process than most people realize. Healthcare analyst John Kehoe explains…
The high prices of drugs and medicine has become an increasingly contentious topic in the United States as prices have continued to rise over the past decade. Healthcare in the United States operates under a free market economy, so the prices of these medicines are dictated by numerous different factors that are not easily manipulated. Nonetheless, these questions remain uncomfortable and difficult. Why must I pay thousands of dollars out of pocket in order to receive treatment for my illness? Why is medicine so expensive? It becomes easy to blame this phenomenon on corporate greed, but for the most part companies are simply keeping their shareholder’s best interests in mind in order to further the future of their company and their research. The process that goes into developing new medicines is painstakingly thorough and expensive. This process also holds a substantial amount of risk for the company and its investors. Depending on the size and opportunity within the market, a medicine must be priced at a point where both the company and investors can feel comfortable that they will see returns on their product.
There are other arguments that lowering the prices of these medicines would diminish potential enthusiasm and innovation within the field, but the majority of the reasoning behind these high prices are the market forces in action and the need to create returns for shareholders. Much of this pricing is dependent on the size of the vulnerable markets for each particular medicine. The total addressable market (TAM) of a product helps a company pinpoint the correct pricing strategy that can allow for their product to cover the investments that have been made for the product’s development.
What is TAM and how is it calculated?
One of the most important factors that is taken into consideration when arriving at the price of medicine is the drug’s total addressable market (TAM) and how much potential money there is to be made. TAM can be looked at as the amount of revenue that can be achieved if a company were to sell its services to every available customer within its market. There are a few different ways to calculate TAM, but the most intuitive and easily understood is the top-down approach. For example, imagine a company produces a software that is geared to help basketball coaches analyze team footage. This company has determined that there are 20,000 basketball teams (high school, college, amateur and professional) that have a need or even a potential need for their product. If their product sells for $1,500, their TAM would be $30,000,000 (20,000 x 1,500). The calculation of this TAM can then be used as a figure to attract investors and help the company understand how much of this market they have at their fingertips while selling their products. If their TAM appears to be too low, they may have to consider raising the price of their product in order to cover the costs and expenses associated with their business and eventually find profits.
How does TAM affect the price of medicine?
While medicine and drugs are certainly different from basketball analytics computer software, in our current economic situation they are treated as a product like any other item in the market. Although, unlike most other products, medicine can cost hundreds of millions of dollars to produce and can take decades to be developed. This creates a large amount of risk for any potential investors in these types of medicine. In this same vein, a drug with a small TAM must adjust its price to a higher level in order to compensate for its price of development and other costs that it has incurred. A drug that is working to remedy or cure a rare disease will have a very small population of its potential customers but can still require a substantial amount of investment and research.
An example of this high pricing for drugs with a small TAM can be found in the drug Sovaldi which is used to treat the virus known as hepatitis C. Approximately 55,000 cases of hepatitis C occur in the United States per year with less than 5,000 being treated. This obviously leads to a relatively small TAM and very few potential customers. The development and production of this drug remains as exhaustive as all of its competitors who are marketing to a much larger TAM. This drug is priced at $28,000 for a month of treatment which makes it one of the most expensive prescription drugs in the country. This price is used as a means to compete with the profits of other medicines that are marketed to a much larger consumer base.
The correlation of TAM and the expenses of cancer treatment
The treatment of cancer is difficult and grueling for the patient, which is made even worse by its extravagant price. This massive price seems to conflict with the previous statement about TAM and its correlation to the cost of medicine. Cancer affects approximately 20 million people per year, a number that is steadily growing as time passes. With this many potential “clients”, pharmaceutical companies should hypothetically be able to offer drugs at an affordable price but sadly this is not the case. Each individual cancer patient has a unique reaction to different cancer treatments. Cancer treatment is not a “one size fits all” situation. Therefore, cancer research and development are never ending, and it must act similarly to other rare diseases. Different cancer drugs must target specific types and aspects of cancer, drastically decreasing their TAM. Cancer treatment also usually lasts less than 1.5 years, meaning the drug will only be purchased for a short period of time per patient.
In 2006, a drug named Revlimid was approved for use by the FDA for use with dexamethasone in patients with multiple myeloma who received at least one prior therapy. Since then it has been approved for even more use with less restrictions and has seen great success in its treatment of multiple myeloma (a disease with a previously poor survival rate). The TAM for multiple myeloma is quite small with an estimated 35,000 cases per year in the United States. Revlimid’s production costs were also very pricey as the company Celgene spent $800 million and 14 years developing the drug. These factors have led this drug to be priced at $16,000 for a month of treatment. This analysis is not meant to diminish the fact that Revlimid is one of the most profitable cancer drugs in the market and could be currently overpriced, but it demystifies the reasons for the high base prices of these drugs. Companies are given the liberty to determine the price they believe will provide them with the most profit, but in order to account for the risks and price of developing a drug for a small TAM the price must begin at a lofty benchmark.
Putting It All Together
Like all products in the current United States economy, medicine must act as a revenue generator for its company. The high costs that go into the research, development, and distribution of medicine create a unique dilemma when pricing this medicine for the public. While it may seem odd that companies are maximizing their profits in relation to sickness and suffering, this is necessary in order to satisfy the needs of their company’s future endeavors and expectations of their investors. There is an extensive list of detailed reasons why certain medicines are more expensive than others and why medicine is costly in the first place, but a simple explanation can be found by looking at the TAM of some of the most expensive medicines in the world. A look at the equation and the math behind each drug’s total addressable market can help determine why some companies must set its price high in order to delve into their small customer base.