Tufts Hangs Tough on Opportunity Cost Analysis

Last week I questioned the $800 million quoted in the press and other blogs as the cost of Pfizer's torcetrapib failure (see torcetrapib: "$800 Million" Failure but Kindler Safe). I doubted this was the real cost and suggested that Pfizer was just quoting the results of a 2001 study by the Tufts Center for the Study of Drug Development.

Mostly, I was upset that journalists would just accept this number at face value as the actual loss due to torcetrapib's failure. I suggested that this was an "estimate" that the industry trots out whenever it wants to argue how expensive it is to develop new drugs.

In my post, I mentioned that the Tufts' estimate was disputed because of the inclusion of "opportunity cost of capital" in the calculation. Apparently, I misunderstood the economics, because the lead author of the study, Joseph A. DiMasi, PhD, Tufts CSDD Director of Economic Analysis, submitted the following tough, no holds barred, comment to this blog in defense of the estimate:

I don't read your blog, so I don't know all that you may have written about R&D costs, but someone forwarded this particular blog entry to me. I won't comment about torcetrapib because I don't know (nor do you) what their actual or projected costs were or what they included (i.e., discovery costs, preclinical development, chemistry, manufacturing and controls R&D throughout the process, all clinical trials for all indications, infrastructure costs for an ongoing concern, interaction with regulatory authorities and preparation of regulatory submissions, etc.). I doubt, given in particular statements that I recall from Pfizer people about what they think average costs are for a more recent period than we analyzed, that they simply took $800 million from our (Tufts) study (which included the costs of failures and what may be called time or financing costs).

I will, however, correct you on what you have written in this blog entry about our study and its methodology. For your information, PhRMA did not, as you wrote, sponsor the study (nor, for that matter, did pharma). You write that the study is disputed. That's true, but, as far as I can see, the ultimate sources of that criticism are those with obvious political agendas and who lack appropriate expertise. I have never seen a criticism of the methodology from a bona fide economist. The paper and its predecessor were published in the most methodologically rigorous journal in the field of health economics. Anonymous referees and the editors of the journal, who are among world's leading health economists, reviewed the methodology.

What you call financing costs were clearly quantified in these papers and distinguished from actual cash outlays. [my emphasis] Economists do not dispute the relevance of the time, or financing, costs. You wrote: "It's like me saying that the cost of my BMW equals the actual $50,000 I spent on it plus the money I didn't earn by failing to invest the $50,000 elsewhere. Well, actually no. It's nothing at all like that. You have confused a consumption good with an investment good. That makes it impossible to present a realistic analogy, but keeping to your context an appropriate analogy would go as follows. It's rather like you paying $50,000 for your BMW in cash today, but dealer won't deliver the car to you for ten years.

If you still doubt this logic, then I have a proposition for you. The next time that you want to buy a BMW send me a $50,000 check instead. I promise to pay you back exactly $50,000 ten years from now. By your logic you should be OK with that. Both possibilities should be equally valuable to you. In fact, I would sweeten the pot and pay you an extra dollar ten years from now so that, by your logic, you would actually be better off by sending me the $50,000 check.

My main takeaway from Dr. DiMasi's comment is that he's trying to scam me out of $50,000! Of course, I refused his offer ("Too bad," he said, "I was hoping you would take me up on my offer.") .

If Dr. DiMasi didn't like my analogy (confusing a "consumption good" with an "investment good"), then he surely won't like this analogy presented by my friend Matthew Holt resident maven on The Health Care Blog:

To illustrate, Lets say me and a friend have drunk 3 beers a day for two years at $10 a day. Let's say instead of drinking for the first three months, I'd invested that money in Google stock instead. Now I spent $6,000 on beer and $1,000 on Google stock. My friend spent $7,000 on beer. But at the end of the 2 years my Google stock made me a profit of roughly $6000. By Tufts' accounting logic my friend spent $13,000 on beer--the $7,0000 he spent and the $6,000 he didn’t make on the Google stock because he spent the first $1000 on beer.

The problem with their logic is that it ignores the expected returns -- his hangover and my expected financial reward. My financial reward is of course analogous to the money pharma makes when its products are successful (which is a hell of a lot more than 1.2bn over 10 years!)

Matthew uses both a consumption good (beer) and Google stock (an investment good) in his analogy! I love his creativity, however, and urge readers to submit other examples illustrating the concept of opportunity cost to help us non-bona fide economists understand.

More Examples
To get you started, here are some more examples I found:

"An example of opportunity cost would be going to the movies. The cost of going to the movie is $9.00 or whatever ridiculous amount of money your movie theater charges. The opportunity cost would be something else you could have done with that time, such as studying." [This from the Teenanalyst.com, a site advising teenagers about investments. I'm sure studying is an opportunity cost uppermost in the minds of teenagers!]

"If a shipwrecked sailor on a desert island is capable of catching 10 fish or harvesting 5 coconuts in one day, then the opportunity cost of producing one coconut is two fish (10 fish / 5 coconuts)." [That's just weird!]

"The opportunity cost of buying a box of Cracklin Oat Bran is one-and-a half boxes of Wheat Chex, if that's your second favorite cereal."

Here's one I just thought of:

Assuming it takes my son only 4 years to complete his undergraduate study at Penn State, I will have spent over $100,000 on tuition, room, board, books, wine-in-a-box, transportation, etc. A college education is clearly an investment good -- there's no payback until 2009 at least, when my son is scheduled to get his degree (a college education isn't worth anything without the degree!). Sure, some of you might say wine-in-a-box shouldn't be considered in the calculation, but then I'd say you are not a bona fide expert (ie, a parent of a college student)!

But wait! I forgot my lost opportunity to invest that $100,000 in the next best thing (whatever that is). I could have made another $100,000 with a better investment. So, I will really be spending $200,000 on my investment in my son's degree. I'll have to factor that in on my next IRS return!

But wait! Suppose my son, God forbid!, quit college in his junior year and never earned his BS degree? Did I actually spend $200,000 on his failed attempt? I mean, could I go around to my friends and relatives and say, it was a $200,000 failure? I don't think so. But, IMHO, that's what Pfizer did with torcetrapib -- it spent something, probably a great deal, but the development of torcetrapib was cut short before approval. The $800 million Tufts estimate doesn't apply to that situation.

However, as Dr. DiMasi says, we don't know what Pfizer actually spent, so it's a moot point.

Anyway, I thought readers (and Dr. DiMasi, if "someone" should happen to forward this blog entry to him) might be interested in what a few other people had to say on this topic. The following is a recent thread from the Pharma Marketing Online Discussion Forum (not all members of this forum have "obvious political agendas" and I doubt there's a bona fide economist among them):

Tufts pegs the cost of developing a biotechnology drug at an even higher $1.2 B in the following release: http://csdd.tufts.edu/NewsEvents/NewsArticle.asp?newsid=69

Do these claims of extremely high drug development costs help pharmas justify the high price tags for their products?

--David Jastrow

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People are considering torcetrapib a major loss. And while it's true that the $1 billion loss is a large onetime loss. You must consider the amount of derivative research data that is now available to Pfizer. I believe Pfizer has a secondary HDL drug in the pipe. How much cross pollination do you think there will be from the data collected from the torcetrapib trial?

--Laurent Laor

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While Tufts includes the projected cost of projects that never make it to market (perhaps those that never get past Phase 1), let's not forget that 55% of their funding comes from "unrestricted" grants and commissioned projects from the pharmaceutical industry.

I personally do not doubt that when you figure in the cost of salaries, benefits, overhead, legal services, attending conferences, publishing study reports, etc., these costs are realistic.

--Michael Altmann

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From a clinical point of view, it is interesting that I can accomplish the same objective with soy, exercise and niacin. Didn't cost $1.2 billion to figure it out, and I don't have the problem of killing off my patients.

--Avery L. Jenkins

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The Tufts studies are certainly very high estimates of drug development costs.
I'd suggest that interested readers check out Public Citizen's critique of the Tufts studies prior to accepting their results. Link here: http://www.citizen.org/pressroom/release.cfm?ID=954

So, yes, the Tufts studies help the drug industry make claims as to why it needs to keep prices high, but the costs of drug development in the Tufts studies are not accurate, thus making the argument for high prices less compelling. And when making a me-too drug or altering the molecule of one's own existing product just enough to market it as new, that certainly costs much less than a billion bucks. Switching a drug to extended release format is also not likely to run anywhere near a billion dollars.

--CP, Clinical Psych Blog

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Does it cost that much to discover and develop innovative products? Yes, if you consider the costs ploughed into all the investigational drugs that fail in each Phase of testing, not to mention those such as torcetrapib that have cost a boatload of money that will never be recouped. BUT, that still doesn't justify the fact that clear profits for Pharma average about 17%-20% when the clear profit margin for most other innovation-based industries is about 12%. The first company to swallow the short-term losses, tell Wall Street to piss-off with the quarterly pressure, and lower their prices just a little will be the winner.

--Siobhán NíBhuachalla, M.P.H.

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The major problem with the Tufts studies (other than their propaganda use) is that the "opportunity cost of capital" is a huge part of the number. I cant think of any reason to count that, as it has a return at the end.

But no problem--the $800m/$1.2 bn number makes the industry feel good. Who cares how it came about?

--Matthew Holt

That's enough on this subject from me -- discuss!

I'm off to Washington, DC, where I am participating in the Healthcare Blogging Summit. Hopefully, I'll have a report on that for Tuesday's posting.