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The Curious Case of Martin Shkreli

February 29, 2016

Martin Shkrell is most famous for increasing the price of Daraprim, a generic drug, by around 5000% to $750 a dose. He’s currently under investigation for securities fraud as well, but most of the attention he gets is because of his unsavory business model.

How Normal markets Work
“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages”” – Adam Smith

Consumer demand limits prices. A demand curve is a list of everyone in the economy’s willingness to pay for a good. As the price falls, more and more people are willing and able to buy the good.

A firm’s profit is the price minus costs times the quantity. For example, if they sell 100 goods at $100 each, and their costs are $50 each, profit is $5000 [(100-50) x 100). If they raise prices to $125, but sales fall to 50, total profit will be lower.
price quantity profit

Every firm has a price point where profit is maximized. The more competitive a market is, the more options customers have, and the less willing they will be to pay high prices. Instead of a slow drop in demand as prices go up, firms in competitive industries will face sharply lower sales if they raise prices above their competitors’ prices. Markets don’t have to be perfectly competitive for prices to be fairly close to costs – as long as firms know if they raise prices, they will lose sales to their competition.

How do drug markets work?
Drugs are like software; extremely cheap to produce, but have very high and very risky development costs. It costs around $1.3 billion to bring a drug to market, and even when you do, there is no guarantee of profit.

If society allowed full competition immediately, with no compensation for research and development, no one would create new drugs. Even the most altruistic generous person in the world isn’t going to throw that kind of money at developing a drug, unless maybe they’d save a few million lives doing so. You can’t rely on charity to run the entire drug industry, because there simply isn’t enough money to cure all the diseases out there without some profit. For some perspective, if St. Jude’s Children’s Research Hospital spent their entire annual budget, they could get one drug approved. That’s it. There are thousands of diseases out there that need curing.

Total average per-drug profit needs to be at least 1.3 billion to ensure new drugs get developed in significant numbers. That means either high volume at moderate prices or high prices at low volume. If 10 million people have a disease, you can charge them each $130 and make your drug trial costs back. However, if only 100,000 people have that disease, you need to charge a whopping $13,000 per treatment. Pharmaceutical companies used to look for blockbusters – drugs that lots of people wanted so they could make their money back in bulk. These days, those sorts of drugs are hard to come by, and so instead they have to make more expensive drugs for smaller markets.

This tradeoff wouldn’t be quite so harsh if the drug approval process were cheaper. There is a tradeoff between safety and efficacy. Obviously, we don’t want experimental drugs killing a lot of people, but at the same time delays and drugs never brought to market at all cost lives too. The FDA could also leave efficacy to separate trials and only worry about safety before it clears use for humans, or allow drugs that are approved by the EU or other first world countries to be used in the U.S. without redundant trials. There are many options.

However, in Shkreli’s case, the drug was a generic, and so was off patent. Generally speaking, generic drug prices are falling. Turing Pharmaceuticals never should’ve been able to raise its price without inviting serious competition. Companies need manufacturing licences from the FDA to make drugs, and setting up new operation can be costly. If someone went through the trouble of getting one, Turing could just lower the price and destroy any profit opportunity. But in the end, someone did end up undercutting them.

Laws and Norms
On February 4th, Shkreli testified before Congress on the drug pricing change. He plead the 5th in response to nearly all questions put to him. The hearing was mostly grandstanding nonsense. Of course he isn’t going to give a speech about how evil he is or whatever. I spent a few hours looking up the records of the congresspeople on that committee and couldn’t find anything in their careers that actually addressed the problem of high priced drugs. If you want lower drug prices, you need lower costs and more competition. You get that by changing the law. If you think you can change the way a whole industry acts by dragging one guy in to testify, I got bad news for you.

If Shkreli didn’t exist, there would be 100 other guys just like them looking to exploit the system. Capitalism has virtues which are required for it to function, but if you create a system where it’s extremely profitable to break those norms, those norms are gonna get broken. At least Shkreli brought some much needed attention to drug market reform.

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