What does it cost to develop a drug and should we really care?

How much does it cost to develop a new drug? The Tufts Center for Drug Developing periodically produces estimates for drugs that actually make it to market. Predictably, those estimates consistently generate a storm of criticism that the methodology behind them is opaque, and that they are, nevertheless, too high. The newest number is $2.6 billion (for 2013) - triple the estimate in 2003.

One of the less frenetic critiques of the Tufts estimates comes from Harvard Medical School professor Jerry Avorn. In an article in the New England Journal of Medicine, he points out some of the issues in developing these estimates.

However, a more interesting question is why Avorn and so many others care about these numbers in the first place. He says it is because they are used to "justify the cost of several expensive medications and to support longer periods of market exclusivity for new products." But what is the connection between the estimates and the justification or support for anything?

Suppose, for example, that a research assistant at Tufts discovered a mistake in the calculations, and the correct number was really $2.0 billion. It is hard to believe that such a change would materially affect anything. The link, if there is one, between drug pricing and development cost should be based on the revenues an average new drug will produce. However, the Tufts Center does not produce revenue estimates.

Avorn and other critics must be assuming that the revenue from new drugs is also too high and is increasing along with the costs. If it is, then we need to make an economic value judgment of whether the profit from producing a new drug was "too high" or just about right. Data on profit margins for new drugs eventually becomes available after a drug reaches the market—and that is what we should be fussing about.

The cost of developing a drug without reference to the revenues it produces doesn't tell us much. Even prices (like the now-fabled $1000 per pill for Gilead's hepatitis C drug Sovaldi, which Avorn mentions) are not important. Revenues are what matters, and it should be noted that they could be enormous even if the per pill price was set low for a high volume product (for example, the long-hoped-for Alzheimer's treatment).

There is considerable research on the rate of return to the pharmaceutical industry on new drugs, taking into account the extremely common failures of many expensive development projects. Those estimates are themselves somewhat controversial, but the general conclusion is that the return in this sector—especially in the last decade when there has been a success drought—appears to be on par with returns for similarly risky investments elsewhere in the economy.

Time will tell whether the market will return revenues large enough to cover the cost and a competitive return on a $2.6 billion dollar investment. But it is not obvious that this number alone calls for much if any policy change or even much emotion. If firms cannot recoup this investment given the current period of patent protection, they will lose money, as would any investor who made a bad bet, and that is the way capitalism is supposed to work.

If that happens, one would predict that in the future investors will be more discriminating in choosing which drugs to push forward—and so spend less on the smaller number of drugs that will make it to market. Indeed, a major reason for the growth in research and development costs that firms chose to incur (assuming the Tufts numbers are correct) must reflect the market's willingness to pay more and more for new products.

One final point on the cost of Sovaldi, since Avorn brought it up. He notes that Gilead did not invent the compound but bought the company, Pharmasset, which had the rights to it based in part on federally funded research at Emory University—and then made back its $11 billion purchase price in one year of revenues. But he does not note that, at the time of the acquisition, according to The New York Times, "investors balked at the deal," pushing down Gilead's share price.

Of course, Gilead ended up hitting the jackpot, as did the millions of patients with hepatitis C, when the drug turned out to be very effective. But it is just this kind of unpredictability that makes it a risky proposition to draw any inference about reasonable prices for innovative drugs from the Tufts estimates.

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