Just Say No to . . . Drug Companies?

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Update:  Once published, I realized that the tone was a little snottier than I meant it to be.  So apologies to both Ezra and Dr. Avorn, assuming that they read this, for my over-the-top sarcasm.  I don't retract any of the arguments, but I wish I'd made them a little more temperately.

Speaking of Ezra Klein's obsession with experts, I'd like to suggest another class of experts he may not have considered:  people who run companies.  I know, I know--it feels too much like conceding to the kind of annoying right wing ideologues who think that the market is so perfect that if anything good is possible, a company will do it--indeed, will already have done it.  Believe it or not, those people annoy me too.

But while it is certainly true that companies don't know everything . . . that they are merely a part of the vibrant web of different institutions that makes up this America of ours . . . you do not have to be a lunatic free-marketer to acknowledge that companies might be good at a few things that other institutions don't do so well.  You just have to visit the former Soviet Union and ask around.

Of course, I don't know that Ezra has not actually spoken to many people who run companies, and particularly not companies which don't support the current progressive agenda.  But that suspicion is the only way I can explain this very, very strange interview, in which Jerry Avorn, chief of the division of pharmacoepidemiology and pharmacoeconomics at Brigham and Women's Hospital, announces that companies don't do anything.  It's no mystery how Dr. Avorn formed this belief:  he pretty clearly has absolutely no idea what companies do.  But the fact that he mistakes his ignorance for a fact about the universe makes me wonder if pharmacoeconomics is what my college boyfriend's roommate used to do with a few grams of cocaine and a copy of Mankiw's Principles

For example, Avorn says:

My view is that the translation of an important scientific breakthrough -- let's say the discovery of tumor angiogenosis, which a lot of drugs were based on -- it's not implausible to say the translation of those basic science findings into a marketable product is something that could be done in university settings, and many university groups are moving towards doing their own licensing. It requires capital, but as you see with biotech start-ups, they can often get it.

So once you raise capital to form a biotech startup, you can often develop a drug, which proves that we don't need companies to develop drugs.  Huh?  Is Dr. Avorn under the impression that biotech startups are some sort of extension campus of the University?  They're drug companies.  They're just in the larval stage.

Ezra leaps in:

Some people have said to me that a lot of the pharmaceutical industry's really innovative work is coming not from inside large companies, but from the acquisition of start-ups.

Exactly. If you look at where their new drugs are coming from an awful lot is coming from buying a biotech company run by real start-ups

So if we just got rid of big pharma, the real innovators would . . .

Well, actually, they wouldn't do anything, because they wouldn't exist.  If we just got rid of big pharma, all the capital that the biotech startups raised in the previous question wouldn't be so easy to raise.  Venture capitalists have longer investment time horizons than retail investors or say, mutual fund managers, but those horizons are not indefinite.  They need to have a way to get their money back out.  That usually happens in one of two ways:  the company goes public, or it gets acquired.

Moreover, biotech firms often lack the assets they need to monetize their drugs:  things like the research capability to take a drug through trials, or even more commonly, the production, distribution, or marketing capacity to actually mass produce the thing and sell it.  These are boring divisions, usually led by people who didn't even go to a decent graduate school, which is why professors of pharmacoeconomics don't know a lot of district sales managers or operations chiefs socially.  But without them, the company goes broke.  If too many companies go broke, there's no new capital for those academics who want to found an exciting new biotech startup, and they have to go back to begging the government for money.

Once you've conceded that drug discovery needs capital, you've conceded that you need a pharmaceutical industry.  The rest, as Shaw said, is just haggling.  But Avorn sails on, apparently blissfully unaware that raising capital is something that is usually done by, er, capitalists.

Dr. Avorn seems  to think that companies are some sort of giant black box to him--the operations are impossible to see, so all you can do is measure inputs and outcomes on a pie chart.  If only there were whole big areas of social science, not to mention the pop business section at your local Barnes and Noble, devoted to describing how companies work for people who might like to know.  But alas, there are not, so medical doctors who want to spout off about pharmaceutical firms are forced to do so with no actual knowledge, nor even an educated guess, about how they might work:

Virtually every progressive recommendation about health policy for the last 20 or 30 years that the drug industry felt might harm its bottom line has been met by the threat that if they don't make as much money before, innovation will cease and there will be no cures for new diseases. It came up around Medicare drug pricing and generic drugs. It's not a surprise to see it come up around health-care reform.

There are a couple reasons that this is a specious argument. One is that according to their filings with the SEC, the drug companies only spend about 15 cents of every dollar on research and development. That's compared to more than 30 cents in administration and marketing and more than 20 cents on shareholder equity. As an investment in R&D, I think any venture capitalist would say a company spending 15 percent on research is not a robust innovation engine.

This makes about as much sense as saying that Dr. Jerry Avorn cannot be that smart because his brain only weighs about three pounds.  Presumably, you can't be really smart--really innovative--unless your brain is at least 30 percent of your body weight! 

This is obviously ludicrous--so why would Dr. Avorn say it about an R&D department?  Like your brain, the R&D department is part of a complex system that does a lot of important stuff.  You can argue that the R&D department is the most important part of a company, not least because it couldn't survive long without it.  I think the same thing about my brain--but I'd still be just as dead without my liver.  You certainly can't prove anything about my effectiveness as a journalist by pointing out that it weighs less than my bones.

So how big should a "brain" be?  Hard to say.  But let's look at some companies that are generally recognized as pretty innovative, and their R&D as a percentage of revenue:

Apple:  three cents out of every dollar

Google:  ten cents out of every dollar

Intel:  fifteen cents out of every dollar

Genzyme (innovative biotech startup!):  sixteen cents of every dollar

US Government:  three cents out of every dollar

I can assure Dr. Avorn that any venture capitalist would be happy to invest in these hidebound laggards who haven't had a new idea in centuries. The first few, anyway.

I'll tell you what else venture capitalists like:  they like to make money when they lock it up in a very risky venture for a long time.  That's that "shareholder's equity" line that Dr. Avorn thinks is a huge waste.

His most fundamental error is treating company size as static, and then acting as if the money is being divided among begging divisions.  If there were only some social science, some bookstore section, that could have explained the difference between a stock and a flow, an investment cost and an operating cost, a balance sheet and an income statement . . . but no, that is not the world we live in.  In this world, Jerry Avorn's world, a pharma industry that makes $1 million and spends $500,000 on R&D is not only better for all of us, but more innovative, than a firm that makes $100 million and spends $15 million on R&D.   

You could argue that since most of the drugs people take are wasted, we'd be better off with the former world than the latter.  But that isn't really the argument he's making, and it's pretty clear that he doesn't understand the industry well enough to make it if he wanted to.  Rather, he seems to view marketing expenses as . . . I don't know, an elaborate way for pharmaceutical executives to funnel money to their favorite college cheerleaders.  In reality, of course, marketing is presumed to increase total revenue by more than is spent on the marketing budget.  That means more money available for R&D.  It also means more capitalists are willing to invest in the inherently risky drug discovery process. 

Maybe we'd all be better off taking fewer brand-name drugs.  But we wouldn't have more innovation or more research if we eliminated the marketing budget, unless Dr. Avorn has evidence that a substantial part of that budget is wasted and doesn't result in higher drug sales.  That could well be the case--as I've said elsewhere, I'm under no illusion that what companies do is always optimal.  But Dr. Avorn has evidenced none of the basic business knowledge that would enable him to make that judgement.  I am completely unsurprised to find out that Dr. Jerry Avorn has completed no work in economics, and indeed, so far as I can tell, no work in anything except being a professor of medicine?  I'm sure he's a very good researcher on how patients use drugs.  But he's pretty clearly no sort of expert at all on how companies actually make them--or anything else gracing our store shelves.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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