(by Farasat Bokhari) On Monday morning, the New York Times broke the story about a price hike in the USA from $13.50 to $750 per pill for Turing Pharmaceuticals’ drug Daraprim. Hillary Clinton tweeted, “Price gouging like this in the specialty drug market is outrageous. Tomorrow I’ll lay out a plan to take it on. –H”. Since Clinton’s plan is likely to include negotiated prices between pharma and Medicare, this in turn sent the Nasdaq Biotechnology Index down by 4.7% within the next two hours (see the Bloomberg graph below). Beyond the political repercussions, how can it suddenly be profitable to impose such an enormous price rise for an out-of-patent drug?

First, a bit of background. The price hike was in August, when Turing Pharmaceuticals bought the rights to market this drug in the US from Impax for $55 million. Prior to that, it was owned by CorePharma, who in turn had increased its price from $1 to $13.50 in 2010 when it purchased it from GlaxoSmithKline (GSK). While Turing is receiving much loathing for its price hike, it is probably fair to mention that they are also giving the drug away for $1 per pill (or even free) to those who can’t afford it.

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High priced drugs are not a new phenomenon. We protect new drugs via patents and market exclusivity periods and allow them to charge monopoly prices for some time. The justification is that research and development is costly and risky – one often cited study from 2003 estimates it costs about $800 million to successfully bring a new drug to the market (the figure has recently been updated to $2.6 billion) – and hence we need to give an innovator a chance to recoup this cost else new drugs will never be developed. However, once the patent and/or market exclusivity period is over, we expect other manufacturers to enter the market and offer generic replicas of the original drug. Since the cost of manufacturing an additional pill is usually very low – perhaps just a few cents per pill – and these drugs are otherwise identical, competition will force prices all the way down to the cost of producing an additional pill, at least for the generic drugs even if the branded firm continues to charge a higher price to its brand loyal segment.

The puzzle is that Daraprim is not a new drug. It has been around since the 1950s and there is no patent protecting this drug, nor is there any data or marketing exclusivity associated with it to keep other generic manufacturers out of the market. Yet there are no generics of this drug in the market. This raises some interesting questions. If there is no patent protection, why are there no generic copies of this drug on the market? If there are no generics, why was the drug historically priced at only $1 per pill and not something much higher? Thirdly, if Turing has set the new price to $750, won’t another manufacturer enter the market and knock the prices back down to marginal cost? In other words, why worry?

The answer to the first question is that the size of the market may not allow for multiple firms when there are significant entry costs. The potential market for Daraprim is small. It is a speciality drug and typically used to treat toxoplasmosis, a disease that affects pregnant women as well as AIDS and cancer patients with compromised immune system. According to one estimate there were roughly 12,000 prescriptions written in 2010 in the US. This makes it a de facto orphan drug — drugs that service diseases that have small markets (typically less than 200,000 patients) and as such firms have little incentive to invest in drug development since there may not be much of a return. The small size of the market, combined with entry costs, imply room for only a handful or perhaps just one firm to operate in this market, thus making the issue of patent expiration a moot point. We return to the second question at the end of this blog.

Regarding the third question, Turing knows that it will take a significant investment by a competitor to enter the market, as they will have to establish bio-equivalence of their generic with the branded reference drug (i.e., with Daraprim) to establish safety and efficacy of the new generic. This in turn requires access to the original drug and/or its data. The distribution of Daraparim is reported to be tightly controlled, and so it may not be as easy to get access to samples if that is in fact needed to establish bioequivalence. Thus, developing a generic and obtaining a marketing approval can take several months, and in the meantime Daraparim can be sold at the monopoly price allowing the firm to recoup its investment of $55 million, and exit or resell the product line (if need be) after that.

As for the cheap/free distribution to those who can’t afford the drug, this is neither necessarily philanthropy nor good old fashioned price discrimination. In fact, it may be a signal to the potential entrants: if they were to develop a generic, Turing would/could drop the price to $1 per pill and still be profitable while the new entrant may not recover development costs. So should we worry? Yes, as Turing’s philanthropy could further delay or deter generic entry in this small market, and in the meantime, short of a Congressional or some other governmental intervention, it will continue to charge $750 per pill to pregnant women.

One final issue: why did GSK not adopt Turing’s high price strategy? Note that Turing Pharmaceuticals is a start-up headed by a hedge fund manager. It is not an established pharmaceutical firm with multiple product lines. Hence, unlike GSK, it may be undeterred by reputational effects on other products. For GSK, a one-time hit and run strategy on a drug that represents a minor share of its portfolio may not be worthwhile, risking the wrath of authorities that are sure to intervene at some point. Thus GSK may have kept the price close to the marginal cost (one dollar per pill), as opposed to a monopoly price, so as to discourage generic entry.