Pharmaceutical Pricing: The Case of Combivir

**IMPORTANT: This article contains mentions of HIV/AIDS. If you feel uncomfortable with these topics, please refrain from reading.

On June 5, 1981, the US Center for Disease Control (CDC) reported cases of pneumonia affecting otherwise healthy gay men living in major urban centers including Los Angeles, New York, and Boston. (Cowen/Tabarrok, Modern Principles of Economics 5e) The human immunodeficiency virus (HIV) results in the disease AIDS (acquired immunodeficiency syndrome) which makes dangerous illness more likely. Many individuals with AIDS suffer from pneumonia and because their bodies are unable to mount an effective immune response, ultimately pass away from the illness.

Since 1981, AIDS/pneumonia has killed over 36 million people and while there is no single cure to the disease, combination antiretroviral therapies have proven to be effective in reducing mortality. Combination antiretrovirals are groups of different drugs designed to prevent HIV virus replication within the body; these therapies have resulted in drastic decreases in AIDS-related mortality, which fell by about 50% between 1995 and 1997. (1)

The therapy I will focus on in this article is Combivir. While I will write later about the global HIV-AIDS response, I want to focus on drug pricing and how prices are set by innovative pharmaceutical firms.

Before I begin, let me summarize an economic model of profit maximization. I will draw your attention to a few parts of this graph:

1. Firm Costs: ATC represents the average total cost (the total cost to produce a certain number of goods divided by the number of goods created). MC represents marginal cost (the cost associated with producing one more good).

2. Firm Returns: MR represents marginal revenue (the revenue associated with producing one more good). Demand represents the amount of goods consumers demand at any given price.

3. If a firm produces where the marginal cost equals the price that consumers demand for that quantity, the production is “efficient.”

4. A firm profits when it sells its goods at a higher price or markup. This occurs when the marginal cost to produce the next good is less than what consumers demand for it. Graphically, profit is a box found by multiplying the quantity produced by the difference between consumer demand and firm costs.

5. If a firm profits, it sets its price higher than what some customers may be willing to pay. Thus, profits inherently result in unfilled wants which are visualized between Qm (the quantity the firm produces to earn a profit) and the quantity produced when the production is efficient.

Let’s discuss how the Combivir drug market works: a single Combivir pill costs $12.50 (totalling roughly $9,200 per year for a patient taking two pills per day). The problem is that most HIV patients live in developing nations and do not have the money to spend on HIV treatment. (2)

This seems like a stereotypical issue of patient access versus big pharma profit. In many cases, it is. The cost to produce one pill of Combivir is roughly 50 cents. Think of this as the marginal cost. If you remember, one pill of Combivir is sold in the US for $12.50 (a 2500% markup). The firm that owns Combivir is UK-based pharmaceutical firm GlaxoSmithKline (GSK). (3) Because the firm owns a patent on the therapy, other firms cannot produce the same product without facing legal consequences. Thus, we say that GSK has a monopoly/near total market power over Combivir.

The interesting thing with this issue is that in India, where the government does not recognize the GSK patent, Combivir is sold for 50 cents ($365 per year if taken twice a day). It seems that the efficient price (P* = MC) to sell the drug is 50 cents while the $12.50 in the US is the profit-maximizing price. There are probably thousands of patients around the world that can afford the 50 cent price but not the $12.50 price. These patients are represented graphically in the gray triangle representing Deadweight Loss (DWL), or the lost value to the sellers and buyers from the transaction. I argue that it is the government’s role to reduce deadweight loss for consumers as much as possible, especially for products that have the capacity to improve health.

Drugs like Combivir are some of the best examples of monopoly firms’ power to influence prices. Because pharmaceutical drugs are a necessity for patients and because drugs are the product of innovation (meaning that only one or two firms will have the ability to produce them), monopoly firms can charge a large markup and still earn significant profit. To explain this, I have included a pair of graphs below.

On the right, we see the case for the average good. Demand is elastic (if price rises, you will conceivably purchase less) and when a firm tries to charge you more for the same good, the firm’s revenue does not increase significantly. On the left, we see the case for a pharmaceutical drug or necessity good. Demand is inelastic (if price rises, you are still obliged to purchase a similar amount) and when a firm raises their prices, that firm earns more profit.

Before I discuss what I believe is the best solution to this issue, I want to briefly mention price controls. When we think of improving access to drugs, we often think about limiting how much a firm can raise their prices above the cost to produce the drug. This is an effective profit ceiling, a form of price control. While price controls do force pharmaceutical firms to produce drugs at a price affordable to most patients, it discourages innovation which is crucial to drug development. Before a pharmaceutical firm can sell an innovative drug, it must invest millions if not billions into creating and testing the drug and most drugs that are in development never even reach the market. (4)

Remember the way I framed my previous article: firms exist to make profit. (5) The goal of pharmaceutical firms is to innovate, earn profit, and deal with emerging disease threats, not to ensure everyone has access. Without the incentive to produce, pharmaceutical firms would not have developed many of the lifesaving therapies we have today.

As I conclude this article, I want to discuss one solution that I believe holds the most promise in solving this issue. This theory is known as the patent buyout and was first proposed by Michael Kremer who in 2019 won the Nobel Prize in Economics for helping develop a new approach to alleviate poverty. (6) The idea is that when a pharmaceutical firm patents a drug, governments may buy it, generating profit for the pharmaceutical firm and encouraging innovation. The government can then terminate the patent, so that generic brands can produce drugs, increasing competition and driving down prices.

What are generic drugs? After a firm’s patent expires, other (generic) firms can produce similar drugs without repeating the same research and testing process. (7) When many firms attempt to replicate the original drug, competition to increase sales decreases prices for consumers, resulting in the 50 cent Combivir we see in India. This strategy reduces the price of new drugs without reducing the incentive for further research and development. While national governments may be forced to raise taxes to pay for this patent buyout, the tax is offset over the entire population (resulting in a nominal increase) rather than on the smaller patient population. However, while this idea holds promise, it has never been tested in the real world; the point is that, by using an economic systems approach, we can understand what drives drug prices much more effectively so that in the long term, we can maintain a robust healthcare system while increasing affordability. Ultimately, we must remain mindful about the long-term consequences of any policy that reduces drug prices; it is the role of the government to establish an agenda that prioritizes pharmaceutical innovation while also protecting individual health.