HMGT 435 WEEK 3 PRO 3

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455

THE PHARMACEUTICAL INDUSTRY: A PUBLIC POLICY DILEMMA

The pharmaceutical industry is subject to a great deal of criticism regarding the high prices charged for its drugs, its large (some would say “waste- ful”) marketing expenditures, and its emphasis on “lifestyle” and “me-

too” drugs over drugs to treat infectious diseases and chronic conditions. However, the industry has developed important drugs that have saved lives, reduced pain, and improved the lives of many. Public policy that attempts to respond to industry critics may at the same time change the industry’s incen- tives for research and development (R&D), thereby reducing the number of potentially blockbuster drugs. To evaluate the criticisms of this profitable indus- try and the consequences of public policy directed toward it, an understanding of the structure of the pharmaceutical industry is needed.

The pharmaceutical industry is made up of two distinct types of drug manufacturers: (1) pharmaceutical manufacturers, which engage in R&D (or buy newly developed drugs from small R&D firms) and market brand-name drugs, and (2) generic manufacturers. Pharmaceutical manufacturers invest large sums in R&D, whereas generic manufacturers do not. Consequently, the former group develops innovative branded drugs for new therapeutic uses, while generic firms sell copies of branded drugs (when their patents expire) at greatly reduced prices. These two types of manufacturers differ in their economic performance and in the public policies directed toward them. Most public policy is directed at pharmaceutical manufacturers.

Understanding the distribution channel for prescription drugs is also essential in understanding the structure of the industry. Manufacturers produce the drugs and, for the most part, sell them to wholesalers, which then sell them to pharmacies, where the drugs are purchased by patients; manufacturers also sell to pharmacy benefit managers (PBMs), who manage prescriptions for insur- ers and employers. Pharmacies can take many forms and are found in various places, including chain drugstores such as Walgreens, mass merchandisers such as Walmart and Target, grocery store pharmacies such as Kroger, mail-order and retail pharmacies, and pharmacy websites. Over time, the number of inde- pendent retail pharmacies has declined. Wholesalers and retail pharmacies are each competitive industries.

28

C o p y r i g h t 2 0 1 9 . H e a l t h A d m i n i s t r a t i o n P r e s s .

A l l r i g h t s r e s e r v e d . M a y n o t b e r e p r o d u c e d i n a n y f o r m w i t h o u t p e r m i s s i o n f r o m t h e p u b l i s h e r , e x c e p t f a i r u s e s p e r m i t t e d u n d e r U . S . o r a p p l i c a b l e c o p y r i g h t l a w .

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Health Pol icy Issues: An Economic Perspect ive456

Public Policy Dilemma

An important characteristic of the drug industry is the low cost of actually pro- ducing a drug once it has been discovered. Very large costs are incurred by the pharmaceutical manufacturer in the R&D phase and in marketing the new drug once it has been approved by the Food and Drug Administration (FDA). A new drug’s price is not determined by its R&D costs, however, because these costs have already been incurred. Instead, the price is based on the demand for that drug, which is determined by its therapeutic value and whether it has close substitutes. Because the production costs of a drug (marginal costs) are low, a drug with great therapeutic value and few, if any, substitutes will command a high price. The result- ing markup of price over production costs will therefore be high, leading to criti- cism of the drug company that the drug is priced too high for those who need it.

Grabowski and colleagues (2012) estimated the economic value of statins, a breakthrough drug used for the treatment of cardiovascular disease. The authors estimated that between 1987 and 2008, the economic value was $1.25 trillion. The use of statins resulted in fewer deaths, and it reduced heart attacks and strokes and their associated costs. Subtracting the actual payments made for the drug, $300 billion, over that period from the economic benefits results in a net benefit (social value) to society of about $950 billion. The social value (which economists refer to as “consumer surplus”) represents the amount people who benefited would have been willing to pay, but did not, to receive the benefits of statin drugs. The net benefits of statins would have been much greater if the analysis had been extended for more years, if all those in the United States who could have benefited from the drug actually took it, and if the analysis were extended to other countries.

The public policy dilemma is that if the high price markups over cost are decreased so that more people can buy the drug, profits will also be lowered, thereby reducing future R&D investment and the discovery of new drugs with great therapeutic value.

Structure of the Pharmaceutical Industry

The structure of the pharmaceutical industry, together with regulatory restraints and government payment policies, affects drug prices and the rate of investment in innovative drugs. Industry performance is generally measured by the number of blockbuster drugs produced. High price markups for innovative, high-value drugs with no existing substitutes appear justified; high price markups on older drugs are simply an indication of the lack of price competition, because the industry is unable (or lacks the incentive) to produce innovative drugs to take their place. Industry performance is also affected by regulations that raise the cost of developing new drugs, the time it takes for a new drug to receive FDA

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 457

approval, and whether the government establishes the prices it will pay for new drugs; each of these government policies affects the profitability of new drugs and, hence, incentives for R&D investment.

The growth in regulatory requirements over the past several decades has adversely affected the discovery of new drugs by increasing the cost of develop- ing them. The costs of enrolling patients in phase 3 clinical trials (representing about 90 percent of the total cost of clinical trials), as well as the length of time spent in clinical trials, have been increasing; bringing a new drug to market can take about 12 years and cost as much as $2.5 billion (in 2013 dollars) (DiMasi, Grabowski, and Hansen 2016). Given the time to bring the drug to market and the size of the investment required, little time is available to recoup the investment because the patent expires in 20 years.

Drug firms are also experiencing a more difficult reimbursement climate. The patent periods on several blockbuster drugs (e.g., Lipitor) have expired, and the drugs have been replaced by generic substitutes. Medicare Part D drug plans use formularies, forcing drug firms to compete on price to have their drug included in the formulary. Managed care plans use similar approaches to reduce their enrollees’ pharmacy costs.

Mergers and Acquisitions Since the mid-1990s, many mergers have taken place among pharmaceutical companies. These mergers have been of two types.

The first type is a vertical merger, whereby a firm diversifies into another product line. The growth of managed care and the greater importance of PBMs led several large drug manufacturers to spend many billions of dollars to buy PBMs in the early 1990s. (Merck, for example, paid $6.6 billion for the PBM Medco in 1993.) These drug firms believed that, by buying PBMs, they could gain more control over the market for their drugs; the PBMs would presumably substitute their drugs for those of their competitors, increasing their market share and drug sales. PBMs, however, were unable to simply include their owners’ drugs to the exclusion of others because their credibility in serving health plans would have been adversely affected.

The drug firms’ PBM strategy does not appear to have been worthwhile. Pharmaceutical companies that did not buy PBMs were also able to increase drug sales, and some companies that bought PBMs sold them. The growth of managed care turned out to be a benefit rather than a threat to drug manufacturers. As more people enrolled in managed care, they received prescription drug cover- age, use of prescription drugs grew, and sales at all drug firms sharply increased.

The second type is horizontal merger, in which one drug manufacturer purchases another. There are several reasons for horizontal mergers. First, by becoming larger, firms expect that economies of scale will increase efficiency and decrease costs. Merging two companies can lower administrative costs and raise the efficiency of the two companies’ sales forces, which is critical to the

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Health Pol icy Issues: An Economic Perspect ive458

success of any drug firm. Drug firms with distinctive products are able to use a single distribution system and sales force when they merge, which results in significant cost savings. Consolidating research units can eliminate competing efforts, and mergers can reduce duplicative manufacturing costs.

Second, for some large firms, mergers are a response to patent expira- tions and gaps in a firm’s product pipeline (Danzon, Epstein, and Nicholson 2007). A wider array of prescription drugs diversifies the financial risk of a firm that produces only a few best-selling drugs. Third, for small pharmaceutical firms, mergers are primarily an exit strategy, an indication of financial trouble. Fourth, horizontal mergers can improve the combined drug firms’ market power. However, few mergers have occurred between firms with drugs in the same therapeutic category. Instead, the drugs offered by the combined drug firms are in different therapeutic categories, offering a broader range of pre- scription drugs across many therapeutic categories to large purchasers.

Pharmaceutical Firms’ New Research Strategy The pharmaceutical industry has undergone major changes in the past several decades. Previously, most pharmaceutical firms were large, able to take advan- tage of economies of scale, and vertically integrated—that is, most activities were performed in-house, from drug discovery to clinical trials to regulatory approval processes to marketing. The firm’s investments in R&D were financed by internally generated funds. Large drug firms’ drug development relied on having very large research staffs to screen millions of compounds to discover the next blockbuster drug that would be used by large population groups. This strategy, however, resulted in finding very few new blockbuster drugs.

Revolutionary discoveries in biologic sciences in the 1970s changed the structure of the industry. Thousands of new biotechnology firms emerged. Venture capital funded many of these startups, which were not expected to be profitable for a number of years. Although the risk was high, the profit potential from new drug discoveries was believed to be so high that investors were willing to risk substantial sums on these new firms. The biotechnology industry became a major source of drug innovation (Cockburn, Stern, and Zausner 2011).

Scientific advances in genetics and biology enabled drug discovery to become more focused, targeting the particular pathway that causes a disease in relatively small population groups. Biotechnology firms attempt to discover genetically targeted drugs that treat relatively small populations, but because of the effectiveness of these new drugs, the drug’s price can be as high as $100,000 a year. Because there are no close substitutes, insurers are willing to pay higher prices compared with what they would pay for drugs for common diseases, such as high cholesterol, for which there are many generic substitutes. These specialty drugs are generally able to receive regulatory approval in a shorter period; the time required to bring a new drug to market is reduced from 12 years to about 6 years.

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 459

Large drug firms were concerned that they had fallen behind small bio- technology firms in their ability to develop innovative drugs. Small companies were more likely to take greater scientific risks and devote a greater number of researchers to a particular idea, whereas large companies became more bureau- cratic in their scientific decision making. Large drug firms began to depend on small biotechnology firms to fill their drug pipelines.

The new approach to drug discovery also changed the size of a drug manufacturer’s research efforts. Large research staffs have been downsized and reorganized. The firm’s research team has been greatly reduced to only 20 to 40 focused teams. Drug companies believe that smaller research units may be willing to take greater risks and be more innovative than large bureaucracies.

Another major change in drug firms’ research strategy has been to become venture capitalists. Rather than investing $1 billion to find the next blockbuster drug, large drug firms are minimizing their financial risks by devel- oping contractual relationships with and investing in a number of small bio- technology companies to find promising new drugs (Walker and Loftus 2013).

Most of the small, new biotechnology firms did not possess the large drug firms’ capabilities to bring a new product to market. At the same time, large drug firms recognized the profit potential of the drug research being undertaken by these small firms. Both types of firms realized that developing relationships would enable them to capitalize on each other’s strengths. These small firms face large risks and huge investment costs before their products can be marketed. The process of discovery, clinical trials, and drug approval is lengthy and costs several billion dollars. Larger firms are able to bear these costs and have the expertise to navigate the drug-approval process. Greater risk pooling also occurs when many drugs are in the discovery and development phase, as only a few of the many drugs developed will be successful. Only a large firm can afford to undertake these large research efforts. Small firms may not have the financial resources to complete the long drug-approval process or the expertise to perform all of the steps required (Golec and Vernon 2009; Lazonick and Tulum 2011).

Although the research innovation is being generated by small firms, large firms have an advantage when it comes to marketing and selling their drugs. They are able to offer drugs to health plans and PBMs (which contract with large employers and medical plans) for almost all therapeutic categories at a package discount. Providing a full line of drugs for different therapeutic areas at a discount lowers the cost to the PBM by removing the need to negotiate with multiple firms, while enabling the large pharmaceutical firm to include drugs in its package that the PBM might not otherwise select. The Medicare Part D drug benefit reinforces these marketing advantages for the large firm; they are better able to provide the range of drugs in the restricted formularies used by the drug plans offering the Part D benefit to Medicare beneficiaries.

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Health Pol icy Issues: An Economic Perspect ive460

Scientific advances have changed the structure of the pharmaceutical industry by stimulating the growth of many small biotechnology firms, shifting the direction of drug research, downsizing research teams, and creating a new role for large drug firms as venture capitalists.

Industry Competitiveness The pharmaceutical industry appears to be relatively competitive, as measured by the degree of market concentration. Concentration—which is measured by the combined market share of the top four firms—was only about 21 percent in 2016, based on data from PAREXEL International (2017, 36). However, when therapeutic categories are used, the degree of market concentration is much higher (in some cases, 100 percent) as a therapeutic category may include only one drug. Thus, the competitiveness of the pharmaceutical industry depends on the definition of the market.

Markets that are less concentrated (i.e., have more competitors) are typically more price competitive. The higher the degree of market concentra- tion and the fewer the substitutes available for a particular drug, the greater the firm’s market power—that is, the ability to raise the price without losing sales. Thus, the manufacturer of the first breakthrough drug in a therapeutic category has a great deal of market power. As additional branded drugs are developed in that therapeutic category, substitutes become available and price competition increases. When the patents on those drugs expire and generic versions are introduced, a great deal of price competition occurs. At each of these stages, purchasers are able to buy the prescription drug at a lower price.

Development of New Drugs by the US Pharmaceutical Industry

Several measures are used to indicate the productivity of the US pharma- ceutical industry. One measure is designation as a global new chemical entity (NCE), a drug that is marketed to a majority of the world’s leading purchas- ers of drugs; this designation is preferred over total NCEs as an indicator of a drug’s commercial and therapeutic importance. First in (a therapeutic) class is another designation that reveals the innovativeness of a drug. In addition, the introduction of biotechnology and orphan drugs is examined, as both are major sources of industry growth and innovation.

Grabowski and Wang (2006) analyzed all NCEs introduced worldwide between 1982 and 2003. During that period, 919 NCEs were introduced; 42 percent were global NCEs, 13 percent were first in class, 10 percent were bio- technology drugs, and 8 percent were orphan drugs. Over this period, the total number of NCEs introduced each year exhibited a downward trend. However, measures of the drugs’ importance (global NCEs, first in class, biotechnology

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 461

drugs, and orphan drugs) increased during the same period. Grabowski and Wang (2006) concluded that although the trend in total NCEs declined, the relative quality of new drugs increased, and most of the biotechnology and orphan drugs were introduced from 1993 to 2003. The number of NCEs con- sidered global or first in class varied by therapeutic category, with the highest number being oncology drugs, which are emphasized by the biotechnology industry. (The United States is the dominant source of biotechnology drugs.)

When Grabowski and Wang (2006) analyzed the introduction of drugs by country, the United States was found to be a leader in the development of innovative drugs, particularly from 1993 to 2003. As shown in exhibit 28.1, 30 of 62 first-in-class drugs (48 percent), 37 of 71 biotechnology products (52 percent), and 27 of 49 orphan drugs (55 percent) are manufactured in the United States. Further, when these authors examined the countries in which important new drugs were first introduced (as opposed to developed), the United States was again a strong leader compared with the rest of the world in the most recent period for which data are available (i.e., 1993 to 2003). Both foreign and domestic drug firms preferred to introduce their important new drugs first in the US market. US patients benefit from having earlier access to important new drugs (although there is an associated risk with being the first users of such drugs).

Country

All NCEs Global NCEs First-in-Class

NCEs Biotech NCEs Orphan NCEs

82–92 93–03 82–92 93–03 82–92 93–03 82–92 93–03 82–92 93–03

EU total 230 183 99 112 23 27 6 23 9 20

France 35 18 9 11 2 3 0 3 0 4

Germany 53 42 21 27 5 5 2 6 2 5

Italy 29 14 4 1 1 0 0 0 0 0

Switzerland 42 41 26 30 8 11 3 8 1 8

U.K. 34 36 23 27 6 7 0 3 5 2

Others 38 33 17 16 2 2 1 3 1 2

Japan 125 88 12 12 5 3 5 9 1 0

U.S. 120 152 66 81 24 30 9 37 10 27

ROW 7 13 3 1 0 2 0 2 0 2

Total 482 437 179 206 53 62 19 71 20 49

Notes: EU is European Union. ROW is rest of world.

Source: Reprinted with permission as it appeared in Henry G. Grabowski and Y. Richard Wang, “The Quantity and Quality of Worldwide New Drug Introductions, 1982–2003,” Health Affairs, 25 (2), March/April 2006: 425–60, Exhibit 4. © 2006 Project HOPE-The People-to-People Health Founda- tion, Inc.

EXHIBIT 28.1 Country-Level Output of New Chemical Entities (NCEs) by Category and Time Period, 1982–1992 and 1993–2003

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Health Pol icy Issues: An Economic Perspect ive462

Unfortunately, no updates to these figures are available. However, although the data in exhibit 28.2 are not comparable to those in exhibit 28.1, they are more recent and indicate that the United States still leads in the dis- covery of new chemical or biological entities. Biotechnology drugs, in which the United States is a leader, have been a source of important new drugs and industry productivity growth.

The US market provides greater incentives to drug firms than do other countries for developing important new drugs and for first introducing innova- tive drugs. Whether the predominance of the United States in drug innovation and in being the first place of introduction will continue depends on govern- ment payment policies to reduce the costs of new drugs.

The Political Attractiveness of Price Controls on Prescription Drugs

For many years, the high price of prescription drugs was a major concern of the elderly. When Medicare was enacted in 1965, prescription drugs were not included as a benefit. Many elderly beneficiaries, who are the highest users of prescription drugs, could not afford to buy needed drugs; attaining a prescrip- tion drug benefit became their highest political priority. In 2003, the Medicare Modernization Act was enacted. It included a new voluntary Medicare Part D prescription drug benefit, which became effective in 2006 (see chapter 8).

Part D increased seniors’ demand for prescription drugs, and pharma- ceutical manufacturers benefited from higher revenues. However, increased revenues to the pharmaceutical companies meant higher federal expenditures for prescription drugs. Part D, similar to Medicare Part B, became another unfunded federal entitlement; no matter how much was spent on drugs by the elderly, Medicare was committed to paying 75 percent of those expenditures. (As part of the 2010 Affordable Care Act [ACA], Part D beneficiaries’ cost sharing for prescription drugs is reduced over time, leading to greater use of prescription drugs and higher drug expenditures.)

Region 1997–2001 2002–2006 2007–2011 2012–2016

Europe 79 46 52 75

United States 84 67 65 88

Japan 29 21 20 32

Other 4 14 12 38

Source: Data from STATISTA (2017).

EXHIBIT 28.2 Output of New

Chemical or Biological

Entities by Region of Origin and Time Period

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 463

The Medicare Modernization Act and the ACA prohibited the federal government from negotiating drug prices with pharmaceutical firms. Elderly individuals enroll in a private drug plan, which then negotiates prices with the drug manufacturer. The cost of the Medicare drug benefits has been much less than expected, which generally has been attributed to the use of formularies by competing drug plans, which enable them to negotiate lower prices from pharmaceutical firms. Pharmaceutical companies are, however, concerned that Congress will change the law and have the government regulate drug prices because of the high prices of specialty drugs, which can exceed $100,000 a year. (Several legislators have proposed changing the law to allow the federal government to negotiate directly with pharmaceutical companies.) As long as the government is ultimately responsible for paying for the drug expenses of Part D enrollees, regardless of who administers the benefit, there is concern that drug expenditures will eventually be regulated, as the government cur- rently regulates payment for each type of provider participating in Medicare.

Proponents of government regulation of drug prices claim that in addi- tion to reducing federal expenditures, the aged would also benefit by lower- ing their out-of-pocket drug expenses and their premium for the Medicare drug benefit, which equals 25 percent of total Medicare drug expenditures. As evidence of the benefits of price controls, proponents claim that prices on branded drugs are as much as 30 percent higher in the United States than they are in Canada, which uses price controls.

Price controls on new breakthrough drugs are politically attractive. Politicians try to provide their constituents with short-term visible benefits, seemingly at no cost. In the short run, drug prices would be reduced and there would be no decrease in access to drugs currently on the market. Because the costs of R&D have already been incurred, the only cost to produce an existing drug is its relatively small variable cost. As long as the regulated drug price is greater than the drug’s variable costs, the firm will continue selling the drug. Profits from that drug will be lower, but the firm will make more money by continuing to sell the drug, even at the regulated price, than by not selling it.

Consequences of Price Controls on Prescription Drugs

Price controls would not decrease access to innovative drugs currently on the market or even to those currently in the drug-approval process. Those who would benefit include patients who cannot afford expensive drugs, states with rapidly increasing Medicaid expenditures, and the federal government, which is responsible for bearing 75 percent of the cost of the prescription drug ben- efit. The aged (who have the highest voting-participation rate), state Medicaid programs, and legislators interested in decreasing federal drug expenditures

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Health Pol icy Issues: An Economic Perspect ive464

are likely to favor legislation to reduce drug prices. The only apparent loser would be drug companies.

The real problem with price controls is their effect not on current drugs but on R&D for future drugs. Price controls reduce the profitability of new drugs. With lower expected profits, drug companies will be less willing to risk hundreds of millions of dollars on R&D. Most new drugs (70 to 80 percent) are not therapeutic breakthroughs and, although their price may exceed their variable costs, do not generate sufficient profit to cover their R&D investments. Thus, the drug company loses money on these drugs (see exhibit 26.4).

The small percentage of drugs that are considered blockbuster drugs have high price markups over their variable costs. The large profits generated by these blockbuster drugs provide the funding for the drugs that lose money. Although there is a short-term visible benefit to price controls, they impose a long-term cost on patients. This long-term cost is not obvious because it occurs in the future, and the public would be unaware of breakthrough drugs that were never developed.

Blockbuster drugs, with their high price markups, would be targeted by price controls. With price controls, profit would be insufficient to provide R&D funding for new drugs. Fewer breakthrough drugs would lead to more costly treatment for a disease, whereas such drugs might make surgical intervention unnecessary or even prevent the disease from developing. Through R&D and the development of new drugs, the total cost of medical treatment is lowered, such as has occurred with Sovaldi (sofosbuvir) for treatment of hepatitis C. With price controls, R&D investments would decline. Drug companies would also redirect their R&D efforts away from diseases affecting the elderly (where price controls limit profits) and toward diseases affecting other population groups (where profits are not limited).

Exhibits 28.3 and 28.4 illustrate the effects of price controls on the product life cycle of a blockbuster drug (Helms 2004). During the beginning phases of R&D, including clinical trials, the company incurs a negative cash flow. Once the FDA approves the drug and the drug company markets the drug, the cash flow is positive—until other branded drugs (substitutes) enter the market, and eventually the patent expires and generics enter the market.

If price controls are imposed on a drug after it is approved by the FDA and marketed, the positive cash flow from the new drug is greatly diminished, as shown by the black, dotted curve in exhibit 28.4. To illustrate the financial effects of imposing price controls in the previous example, one would have to examine the present value of both the cash outlay and the positive cash return.

Money received in the future is worth less than the same amount of money received today. These money outflows (before the drug is sold) and inflows occur at different times. The cost of developing a new drug includes all the costs of bringing it to market, such as research expenditures, the cost of clinical trials, the cost of having the drug approved by the FDA, and marketing

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 465

– Cash flow

– $20 million

R&D

Clinical trials

Promotion Competition

Approval

0 5 10 15 20 30

Years

40

0

+ Cash flow

+ $20 million

N et

R ev

en ue

( $,

in M

il li

on s)

Expected net returns on a new drug

Note: R&D = research and development.

Source: Helms (2004).

EXHIBIT 28.3 Life Cycle of a New Drug

– Cash flow

R&D

Clinical trials

Promotion Competition

Approval

0 5 10 15 20 30

Years

40

0

+ Cash flow

N et

R ev

en ue

( $,

in M

il li

on s)

Expected net returns on a new drug

Expected net returns on a new drug if price controls are imposed

Note: R&D = research and development.

Source: Helms (2004).

EXHIBIT 28.4 Effect of Price Controls on Drug Returns

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Health Pol icy Issues: An Economic Perspect ive466

costs once it is approved. A company would calculate what it could have earned on that investment if the funds were instead invested in a corporate bond and gained interest. For example, if $10 were invested today and earned 6 percent interest per year, in five years that initial investment would grow to $13.38. Thus, in calculating the cost of developing a new drug, the firm calculates both its cash outlay and what it could have earned on that money (the opportunity cost). Similarly, in calculating the return received from that new drug, which generates a positive cash flow in the future, it is necessary to discount (using the same interest rate) the positive cash flow and determine what the money received in the future is worth in today’s dollars (the present value).

Using the example shown in exhibits 28.3 and 28.4, if a firm invests $20 million in year 5, the present value of that investment equals $14.95 million. (In other words, $14.95 million invested today would be worth $20 million in five years.) If, after 15 years, a new drug earns $20 million, the present value of that return is only $8.35 million. Clearly, the $20 million spent and the $20 million earned are not equal. In this example, the drug firm would lose $6.6 million on its investment. Thus, the longer it takes to bring a drug to market, the longer the negative cash flow and the smaller the present value of the positive cash flow once the drug is marketed.

If price controls are imposed on a drug once it is marketed, as shown by the dotted line in exhibit 28.4, both its positive cash flow and the present value of that reduced cash flow will be lower. Thus, if the firm earns only $10 million in year 15, the present value equals only $4.17 million. The present value of the cash outflow remains at $14.95 million (Helms 2004).

In the previous example, a drug firm would change its investment strat- egy. It would decrease its overall investment in R&D, invest in drugs with a quicker payoff, seek drugs with less risky profitability outcomes, and invest in drugs whose market potential is very large and profitable, thereby abandoning research on drugs for diseases affecting relatively few people.

Examples of Price Controls on US Prescription Drugs The debate over President Clinton’s health plan, introduced in the fall of 1993, provides an indication of the likely effect of price controls on prescription drugs. Included in the plan was the Advisory Council on Breakthrough Drugs, whose purpose was to review prices of new drugs. If the proposed council believed that a new drug’s price was excessive, it would try to have it reduced or, failing that, have the drug excluded from health insurance payment. The targeted drugs were those that were the most profitable and had high price markups—namely breakthrough drugs.

The pharmaceutical industry was concerned that if the plan were enacted, price controls would be imposed on prescription drugs and the profitability of new drugs would be decreased. As a result, the annual rate of increase in

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 467

R&D expenditures declined sharply, falling from 18.2 percent in 1992 to 5.6 percent by 1994, the smallest annual rate of increase in 30 years (see exhibit 28.5). Once it became clear that the Clinton health plan would be defeated and price controls would not be imposed on new drugs, the annual rate of increase in pharmaceutical R&D spending rose again.

The next threat to the drug companies occurred in 2002 when the firms believed Congress was going to legalize reimportation of drugs from Canada and Europe (without the approval of the secretary of the US Department of Health and Human Services). As a result, in 2002 R&D expenditures grew by only 4.2 percent, after having increased by 14.4 percent in 2001. Once the threat of reimportation did not materialize, R&D expenditures again rose—to 11.1 percent in 2003.

In 2008 and 2009, R&D expenditures sharply decreased over concerns that the newly elected Democratic president and large Democratic majorities in Congress would pass legislation that adversely affected the industry by requiring reductions in Medicare and Medicaid prescription drug prices. In the fee-for-service section of Medicaid, drug firms pay a rebate to Medicaid for each drug the program purchases on behalf of its beneficiaries. President Obama’s 2010 budget proposed an increase in that rebate (ultimately lower- ing the price that drug firms charged). Proposals were also made to require a rebate on drugs purchased by Medicare Part D beneficiaries. As the data indicate, R&D expenditures are sensitive to possible legislative changes that would reduce drug firms’ profits (Congressional Budget Office 2009).

History does not offer much hope for drug manufacturers evading price controls. Governments in other countries have used various approaches to lower their drug expenditures. In a study of 19 OECD (Organisation for Economic Co-operation and Development) countries, Sood and colleagues (2008) found various forms of regulation that decreased pharmaceutical revenues. The types of controls used by these countries included fixing the price of drugs, delaying approval for expensive new drugs for several years, restricting the use of a drug once it has been approved, establishing global (country) budget caps, setting annual budget limits for physicians’ prescriptions, applying profit controls, and setting the price of all drugs within a specific therapeutic category at the cost of the lowest-priced drug. While a majority of the regulations decrease pharmaceutical revenues, direct price controls have the largest negative effect on revenues. If similar price controls were imposed in the United States, phar- maceutical revenues would fall as much as 20 percent. Further, the longer the regulations are in place, the greater their impact on revenues.

Several approaches have already been used in the United States to reduce government expenditures for prescription drugs (Vernon and Golec 2009). Because of their tight budgets, state Medicaid programs have more restrictive formularies than do managed care plans. Newer drugs that are more expensive

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Health Pol icy Issues: An Economic Perspect ive468

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 469

but more effective are more likely to be excluded in favor of less expensive generics. Further, Medicaid programs delay inclusion of expensive innovative drugs in their formularies for several years. Studies have shown that the effect of limiting access to preferred drugs results in a shift toward more costly set- tings, higher nursing home admissions, and greater risk of hospitalization among Medicaid populations (Soumerai 2004). Further, the savings in drug costs were offset by increases in the costs of hospitalization and emergency department care (Hsu et al. 2006).

A price-control approach that has been used by the federal government requires the drug manufacturer to sell the drug to the government at its “best” price. In the 1980s, as a result of price competition among drug companies to persuade health maintenance organizations (HMOs) and group purchasing organizations (GPOs) to include their drugs in HMO and GPO drug formular- ies, drug manufacturers gave large price discounts to certain HMOs and GPOs. In 1990, the federal government, in an attempt to reduce Medicaid expendi- tures, enacted a law that required drug manufacturers to give state Medicaid programs the same discounts they gave their best customers. Consequently, the drug companies gave smaller discounts to HMOs and GPOs. A study by the Congressional Budget Office (1996) found that the best (largest) price discount given to HMOs and GPOs declined from 24 percent and 28 percent, respectively, in 1991 to 14 percent and 15 percent, respectively, in 1994, the minimum amount required by the government.

The study concluded that drug companies were much less willing to give steep discounts to large purchasers when they had to give the same discounts to Medicaid. Drug prices and expenditures consequently increased for many private buyers.

Summary

Two important characteristics of the pharmaceutical industry are (1) the low costs of actually producing a drug and (2) the high cost of developing a new drug. The price at which a new drug is sold is determined not by its cost of production or the R&D investment in that drug, but by its value to purchasers and whether any close substitutes to that drug are available. Valuable drugs that have no close substitutes (blockbuster drugs) will be priced high relative to their costs of production. Lowering the price of these blockbuster drugs to make them more affordable will decrease pharmaceutical companies’ incentive to invest hundreds of millions of dollars in drugs that may have great value to society. That is the public policy dilemma.

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Health Pol icy Issues: An Economic Perspect ive470

The pharmaceutical industry has been changing over time from large, vertically integrated organizations to an industry that still consists of large firms but also has many small biotechnology firms (funded by venture capital) that are engaged in developing new blockbuster drugs. A great deal of private money is invested in these highly risky ventures in the hope of developing a valuable (and profitable) new drug.

Compared with the rest of the world, the United States has been a leader in developing important new drugs, and it is the country of first choice for introducing innovative drugs. Government payment policies to reduce drug expenditures threaten both the US industry’s leadership and patients’ access to innovative drugs.

A growing concern is that the federal government, which has become a large indirect purchaser of prescription drugs as a result of including Part D in Medicare, will attempt to lower its drug expenses by “negotiating” the price of prescription drugs. Direct government negotiations with drug companies over the price of their drugs will be tantamount to the government fixing the price of drugs.

Implementing price controls will not have any immediate effect on seniors’ access to drugs. However, over time, drug companies will invest less in R&D and redirect their R&D toward population groups and diseases that offer greater profitability.

In coming years, enormous scientific progress is likely. The mapping of the human genome and advances in molecular biology are expected to lead to drug solutions for many diseases. Drug prices and expenditures will also likely be higher to reflect the increased willingness of people to pay for these new discoveries. It would be unfortunate if the desire to reduce the cost of drugs through price controls decreased the availability of breakthrough drugs.

Any public policy must deal with trade-offs: reducing the high price markup of breakthrough drugs versus maintaining incentives for investing in R&D. It is important to distinguish between the short- and long-term effects of public policy. Using price controls to lower drug prices results in a visible short-term benefit, but it comes at a less visible longer-term cost of fewer breakthrough drugs. Patients in the future would be willing to pay for lifesaving breakthrough drugs that were not developed because the government removed the incentives to do so. Given the trade-off between instituting regulation to reduce the cost of drugs and having innovative drugs to cure disease, reduce mortality, and lower the overall cost of medical treatment, society would likely choose the full benefits that scientific discovery will offer.

Discussion Questions

1. How has the structure of the pharmaceutical industry changed over time?

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Chapter 28: The Pharmaceutical Industry: A Publ ic Pol icy Di lemma 471

2. What are alternative ways of judging whether the pharmaceutical industry is competitive?

3. Why are price controls on prescription drugs politically attractive? 4. Why would price controls not limit access to blockbuster drugs that

are either currently on the market or have almost completed the FDA approval process?

5. What are the expected long-term consequences of price controls on R&D investments, quality of life, mortality rates, and the cost of medical care?

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