As regards drug development or anything else.
"The money was NOT spent all on day the drug was approved"
"And that you have overestimated the costs is obvious from simple inspection, even assuming opportunity costs to be an actual expense rather than a potential bookeeping entry."
"Do you really think you would have doubled your money…if you had the money up front…had you made some investment other than the development of a new drug?"
It isn't something that costs you money. It is a way of talking about who chooses to invest in what. If I invest in something I know is going to lose money, I am an idiot unless I'm running some sort of tax scheme. If I invest in something that will definitely make 3% a year (a CD perhaps) I'm much smarter. If I invest in something that will have an imprecise percentage chance of making money and an imprecise percentage chance of losing money it is a wise decision based on how much money I can make compared with what the chances are that I will make or lose money. If, on average, the best this imprecise investment will make is less than 3%, I'm still an idiot for investing in it because I had a safe 3% available to me with the CD. The gap between the average return of the safe investment and the risky investment is called the opportunity cost. If the risky generally underperforms the safe, no one would invest in the risky. In fact if the risky cannot dramatically outperform the safe (when the risky doesn't go bankrupt) very few people would invest in the risky.
Pharamaceutical research is risky.
"The money was NOT spent all on day the drug was approved"You are right. The fact that it is spent BEFORE the approval is what makes sunk costs amenable to an opportunity cost analysis. In fact that is a pre-condition to talking about opportunity costs.
Your whole bank analysis is completely nonsensical once you realize that opportunity cost analysis is how one chooses between investments. It isn't expensable, but if the pharma profits drop anywhere near the safe investment level, everyone will pull out of pharma research because such research has a high chance of giving you NOTHING. If your return is 4% when positive with a 75% chance of getting nothing, you would be a fool to invest in such a thing when you could get 3% in a CD and the only risk you would take is the vanishingly small chance that the entire world economy implodes. Opportunity analysis is a selection mechanism.
- Sebastian Holsclaw
Note: "It isn't something that costs you money. It is a way of talking about who chooses to invest in what."
Since it isn't something that costs you money, including it in one's costs is…inaccurate.
Posted by P6 at February 22, 2004 09:16 PM
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Ok. And who exactly was suggesting that you ought to put it on your balance sheet? Lowe was saying that you have to keep it in mind or else investment in pharmaceutical research will dramatically decrease. He may have used 'costs' in a mildly imprecise way, but it is certainly true that if you can't make the opportunity cost pay for pharamaceuticals, you won't have much research. Therefore it is not at all wrong to suggest that 'opportunity cost' or whatever you want to call it to avoid using the word 'cost' in a way you don't like, has to be an issue when talking about drug company profit levels.
Which is exactly what he was talking about.
Posted by Sebastian Holsclaw at February 23, 2004 01:10 AMsigh
And who exactly was suggesting that you ought to put it on your balance sheet?
Let's see, Here's Derek in the very first sentances in the very first post you linked to:
I wanted to pass along a couple of recent articles that address drug pricing and research costs. It's a subject that attracts nonsense like a cloud of gnats; every so often you have to shoo them off.
Research costs. Not investment decisions.
Okay, let's look at what Alex Tabarrok says in the post Derek says is "fine."
Firms spend on R&D from the day the development process begins up until the day the drug is approved for marketing which may be a decade or more later. But a dollar spent early in the process could have been earning interest in the bank for years before marketing approval is achieved. Recognizing this, DiMasi et al. calculate the cost of the drug as if all the money had been spent on the day the drug was approved.Is this unreasonable? Well, suppose you lend me $5000 - how much would you want back in a year, in 2 years, in 10 years? The longer the loan period the more you would expect back when the loan came due, right? This is exactly the same calculation performed by DiMasi et al.
I challenge anyone who thinks this is imaginary money to lend me $5000. I guarantee to repay them the same return as they recognize as legitimate for the pharmaceutical companies.
Alex claims these are real costs, Sebastian. And you accuse ME of not understanding opportunity costs when it's the boys on your side of the discussion who are confused. That confusion is what draws nonsense like gnats.
Finally, though I could point to a post or two arond here by folks who want to factor opportunity costs into profit calculations DogofFlanders, let's look at the abstract from the paper published by the highly-regarded Journal of Health Economics:
The research and development costs of 68 randomly selected new drugs were obtained from a survey of 10 pharmaceutical firms. These data were used to estimate the average pre-tax cost of newdrug development. The costs of compounds abandoned during testing were linked to the costs of compounds that obtained marketing approval. The estimated average out-of-pocket cost per new drug is US$ 403 million (2000 dollars). Capitalizing out-of-pocket costs to the point of marketing approval at a real discount rate of 11% yields a total pre-approval cost estimate of US$ 802 million (2000 dollars).
This explains why the Journal is highly regarded. They didn't discuss opportunity costs at all. I still have issues with an 11% rate of return being used to calculate capitalization cost but had that been the discussion much wear and tear on our keyboards could have been avoided.
Lowe was saying that you have to keep it in mind or else investment in pharmaceutical research will dramatically decrease. He may have used 'costs' in a mildly imprecise way
This was not mildly imprecise. This was, intentionally or no, misleading.
Sebastian, you are one of the few who I've linked to out of pure respect for your rationality and reasonablility. Don't blow it. You know damn well that using words imprecisely means you aren't saying what you intend to.
but it is certainly true that if you can't make the opportunity cost pay for pharamaceuticals, you won't have much research.
"Opportunity costs pay for pharmaceutics"? You want to be less mildly imprecise? Don't you mean "if you don't see a reasonable chance to achieve a profit that exceeds opportunity costs"?
It's not hard to be correct. And I'll not be joining you in your apparent respect for a lack of precision as long as you're on my side.
Now, if you just want to justify the current prices of prescription drugs as an article of faith, that's fine. But we got a thing going on around P6…we put forth both arguments and rhetoric, and everyone is pretty clear on which is which because we tend to blow off the rhetoric. When we get caught out there, we admit it or let it go (and I don't run around harrassing the folks that let go either). We do not spin, though.
Posted by P6 at February 23, 2004 06:14 AMI'm really trying to see it, but I can't understand what you are objecting to. Take the part where you are quoting Derek: "I wanted to pass along a couple of recent articles that address drug pricing and research costs. It's a subject that attracts nonsense like a cloud of gnats; every so often you have to shoo them off."
You say: "Research costs. Not investment decisions."
But you fail to see the phrase pefore the 'and'. That phrase is 'drug pricing'. And opportunity cost is intimately related to drug pricing because if you can't make more money than a safe CD by charging enough in drug pricing to make a large profit, no one would invest in your company.
You have an extensive quote of Tabarrok which includes: "But a dollar spent early in the process could have been earning interest in the bank for years before marketing approval is achieved." He doesn't explicitly say so, because he thinks it is obvious, but the point of that sentence is that if you earn less than that you don't get investment. He isn't saying that it is a cost in the outlay sense, he is saying that it is a huge factor in pricing. It is a cost which would have to be covered or it would be impossible to get adequate investment. I really think the problem is that 'opportunity cost' is a term of art in economics and you don't like the word 'cost' to be associated with it. It isn't Tabarrok's fault that some now-dead economist coined a term which you think is a misdescription.
I guess I don't think it is misleading to note (under some label) that one of the reasons why return on pharma investment has to be so high is because it is so risky. I don't think Derek Lowe and others can be blamed for using the economics term which covers that concept. If you attempt to get financing for a risky product, you have to have a high return potential. You have to well outperform safe investments because there is a much higher chance that you are going to end up with nothing at the end. This higher rate of return has to be paid for out of revenues--which is to say out of drug prices. This high rate of return (when it pays off) spurs investment in drug research which is exactly what we want to happen.
Posted by Sebastian Holsclaw at February 23, 2004 05:54 PMThe problems isn't the term of art. The problem is saying "this is what it costs to bring a drug to market," when (as you said) we're not discussing something that costs you money.
Posted by P6 at February 23, 2004 06:01 PMOkay, let's try that again, with a little more patience this time.
When someone is trying to make a point, it is up to that person to be clear. You know all terms of art are non-standard usage which are guaranteed to be misunderstood by outsiders. A marvelous example goes back to the run-up to the Iraq invasion. Colin Powell spoke of "poison factories" in Iraq, but when challenged because no poison was found by inspectors, he said it was a term of art and that no one expected to see tanker trucks of poison laying around (http://www.iht.com/articles/86134.html, but you have to go to the second page).
By now I hope it's clear I understand what "opportunity costs" are. What I've been doing is getting really clear and specific, in terms people use every day.
I almost said "that's the only way to get real agreement," but of course that's not the case. It IS the only way to keep people from feeling they're being lied to and jerked. Let's face it, I had to HAMMER at this to get anyone to state the simple fact that opportunity costs do not represent cash coming out of your pocket, nor does it represent capitalization costs. And you will never, ever, ever get the person on the street to accept that it's an out of pocket cost…which is what the words used by Alex etc. imply. You will never, ever, ever convince the person on the street that pretending you spent all the money in one day is valid.
And being a person who wants to see drug prices come down significantly I probably shouldn't say this, but if you read what I've written in the discussions attached to the posts you'll see I've explained how to put your point across such that you wouldn't catch this sort of grief. In our society (in which profit is the sacrement of the religion Capitalism), being seen as a profiteer is much easier to get around than being seen as a liar. Look at Cheney. No one gave him grief over all that Halliburton stuff until they stopped believing him.
Again, the point is not the specific choice of words. It's clarity of exposition.
Posted by P6 at February 23, 2004 06:30 PMOk, but now that we have gone through all that, do you understand why the subject was broached? The topic was high drug prices. Whatever you want to call it, the idea that risky investments have to have higher returns than safe investments, and that pharma research is a risky investment, is intimately tied to the reason why drug prices are higher than we might like.
I guess I don't even understand your problem with : "this is what it costs to bring a drug to market". You are using the word cost to mean 'immediate cash expenditure to buy stuff'. They are using it to mean 'things which must be covered with actual money in order to fund research'.
I'm not trying to be difficult, but both are costs in the general sense of 'things which must be paid out of the drug selling price'.
Posted by Sebastian Holsclaw at February 23, 2004 08:04 PMI've always undestood why it was broached.
As for the cost thing, my problem is, when are you adding the money to the mix?
DiMasi et al. calculate the cost of the drug as if all the money had been spent on the day the drug was approved.
You can't deny that this process will create a greater cost figure than if you calculated the interest based on when the expenditure actually occurred. Your estimate is higher, you're more selective about the drugs you develop, and someone is sick uneccessarily.
And my problem with what you just wrote is you flipped from "opportunity costs," which as you said doesn't actually come out of your pocket, to (oh, let's call it)eventual costs, which do.
Two different things, guy. Way too easy for me to keep and consider seperately for me not to notice the meanings slipping as you write.
Posted by P6 at February 23, 2004 08:44 PM"And my problem with what you just wrote is you flipped from "opportunity costs," which as you said doesn't actually come out of your pocket, to (oh, let's call it)eventual costs, which do."
I don't get it. Seriously. If in order to get investment you have to have a higher rate of return because you have a risky venture, where do you think the money comes from? If you have to pay it to keep your industry afloat doesn't it 'actually come out of your pocket' at some point?
Posted by Sebastian Holsclaw at February 23, 2004 11:13 PMI don't get it. Seriously. If in order to get investment you have to have a higher rate of return because you have a risky venture, where do you think the money comes from?
It comes from the opportunity costs?
Do me a favor. Stop playing ignorant. I'm still pissed at Phelps.
Posted by P6 at February 24, 2004 12:18 AM