In a recent Health Affairs Blog post, Nancy Yu, Zachary Helms, and Peter Bach note that prices for top-selling drugs are higher in the United States than in other countries. They conclude that “premium pricing [in the United States] exceeds what is needed to fund global R&D.” They further suggest that “lowering the magnitude of the US premium” would have saved $40 billion for US prescription drug purchasers in 2015.
Essentially, the authors imply that the US price premium could be significantly reduced without affecting research and development investments or having other adverse effects. This is a strikingly bold and unfounded conclusion. There is no sound economic rationale to suggest that price ratios across countries or revenue premiums in the United States should match current research and development spending. Hence, the fact that price differences and research and development spending levels fail this arbitrary test does not offer a basis for sound policy making.
The issue of drug prices is always controversial, but in today’s politically charged environment, it seems particularly important to carefully evaluate this post’s methods and conclusions—and to do so through the lens of the economic principles that drive companies to search for new medicines and set prices for them. Thought leaders and policy makers would be well advised to approach this issue with a clear-eyed view of facts and underlying principles that govern economic behavior.
The Authors Have A Fundamental Misunderstanding Of The Research And Development Investment Process
The research and development investment process in pharmaceuticals is long, costly, and risky. Only a small proportion of new drug candidates that enter clinical trials (around 10 percent) become new drug introductions. It generally takes more than a decade for the maker of a new drug to perform the costly trials and gain Food and Drug Administration approval, and there is uncertainty concerning a drug’s efficacy and safety at every stage of the process.
Economic models of investment behavior under uncertainty indicate that spending will be driven by the expected future gains from these investments. If US policy makers were to enact regulations that drive prices down significantly, as Yu and her colleagues suggest, many projects that now have positive expected returns would no longer be profitable. Current prices would be lower but so would the expected level of future innovation.
A recent analysis by Ernst R. Berndt and colleagues published in Health Affairs is instructive in this regard. The authors found that research and development investment in pharmaceuticals generally provides competitive returns historically commensurate with other risky investment activities, but there is high variability across products and over time. They also observed a downward trend in pharmaceutical industry returns for the most recent cohorts, a period when research and development investments have plateaued or even declined for many firms.
Another failing of the Yu and colleagues analysis is that they analyze research and development investment in isolation from all other activities and expenses associated with new product development and commercialization. These include the costs of production, management, distribution, and provision of information about clinical trial results to physicians and payers. When these other expenses are included along with research and development costs, taxes, and the need for risk-adjusted returns to investors, as in the Berndt and related studies, there is no “excess premium” beyond what is needed to maintain current research and development investment levels as implied by Yu and her colleagues.
Drug Price Determinations In The United States And The Other Benchmark Countries
The US Market-Based System
Ultimately, market-based drug prices will reflect the value and benefits they provide to patients. Drug manufacturers conduct pharmacoeconomic studies to demonstrate the cost-effectiveness of their new drug introductions. In the United States, insurance companies and other agents that administer private employer plans and government insurance plans such as Medicare Part D evaluate these studies and negotiate prices and access conditions. They use various market-oriented instruments in this process, including formulary placements and copayment tiers, rebates, prior authorizations, and step therapy.
In this market setting, a new medicine that solves health problems more effectively, or that solves a problem that previously could not be solved, will tend to command a higher price than its alternatives. This explains why new therapies, such as the recently launched hepatitis C drugs, are able to sell at a high price. The new hepatitis C drugs offer something important and valuable that existing therapies simply did not offer. The sellers of these drugs did not charge high prices because they had spent a lot on research and development; they were able to set high prices because the products generated remarkable new value to patients (and to the health care systems that would be less likely to have to pay for higher-cost medical interventions in the future).
It is important, but often ignored, that there were multiple contestants in the race to bring these new drugs to market. As succeeding companies have introduced competing hepatitis C drugs, prices have fallen because customers have alternatives to which they can turn if the sellers do not negotiate lower prices (typically in the form of discounts and rebates). The incentives of market-based prices drive invention, which in turn drives prices down. In the case of the first hepatitis C drug, Sovaldi, for example, average rebates to Medicaid and the Department of Veterans Affairs, which receive best-price discounts, resulted in price reductions of more than 50 percent when competitive therapies entered the market.
Monopoly Buyers Abroad
Regulators abroad also evaluate pharmacoeconomic studies in negotiating prices. However, they are essentially negotiating as monopoly buyers in most instances. Their governments impose various additional mandatory regulatory measures such as price and quantity controls, international reference pricing schemes, and expenditure caps that do not exist in market settings. As with all buyers, the objective generally of national purchasers abroad is to obtain new drug products as close as they can to the seller’s reservation price or marginal cost of supply, to minimize expected drug expenditures. The difference is that, when the negotiating regulator is the only customer, the ability of the seller to bargain or walk away is severely diminished because some returns are better than none. Refusing to sell medicines that stand to benefit patients in a country also presents reputational challenges for a company. For these reasons, regulators in other countries are able to employ mandatory constraints and controls that extract much lower prices than might be available in market settings.
However, if all countries, including the United States, behaved in this manner, manufacturers would be unable to cover the high fixed costs of research and development investment and earn a return to sustain future innovation. This is the sense in which price premiums in the United States provide most of the returns to sustain future innovation. Correspondingly, US policy measures to lower prices toward these international values would adversely affect current research and development commitments, in contradiction to the conclusions of Yu and her colleagues.
The authors’ approach also suffers from numerous biases and related methodological issues. In particular, several economic studies demonstrate that the outcomes of the research and development process in pharmaceuticals and other innovative industries are highly skewed, with a few high societal value “blockbuster” products accounting for a large share of company sales and returns. By considering only the biggest successes in this process, the authors bias their analysis in favor of finding high US price premiums, particularly in view of the relatively unique market-based price setting process in this country.
One would also expect higher market premiums in the United States based on higher incomes and a greater demand for health inputs. Market prices respond to customer incomes; prices are typically lower for customers with less buying power (subject to certain conditions). Thus, many goods and services cost less in countries where incomes are lower. Prescription drugs are no exception. Average US income levels are substantially higher than incomes in all but one of the countries (Ireland) in the Yu and colleagues analysis, so even in a setting where regulators abroad did not regulate prices, one would expect prices to be higher in the United States on the basis of economic analysis. This would suggest nothing about the appropriate allocation of the revenue contributions to research and development.
The Particular Danger To Start-Ups If The United States Moves Toward International Prices
It is also important to recognize that over the past several decades, hundreds of start-ups have emerged in the biopharmaceutical industry, backed by venture capital firms and other early investors that are concentrated in the United States. A few of these start-up companies have evolved into significant entities based on the development of important new therapies, while many others have disappeared given the high failure rate of new drug candidates. A number of the companies on Yu, Helms, and Bach’s list are relatively young companies that illustrate this phenomenon; for example, Amgen, Biogen, Celgene, Gilead Sciences, and Cephalon (now a division of Teva) were start-ups in the recent past.
Obviously, a new start-up company has no revenues to use for research and development spending, so it must entice investors to support its research and development efforts. US policies designed to decrease prices toward those that prevail abroad would have particularly adverse consequences for young start-ups that invest in uncertain early-stage research. Venture capital firms do not restrict their activities to investments in new drugs and medical technologies, but also invest in web-based applications, new and improved energy sources, advanced scientific instruments, and many other competing opportunities. If expected returns in start-up biopharmaceutical companies are reduced, early-stage investors will look elsewhere for returns.
Established companies also respond to these same pressures. If the return to pharmaceutical research and development is reduced, they will be led to seek other investments by reducing pharmaceutical research and development spending or will return money to shareholders (through higher dividends or share repurchases) so that the shareholders can invest their money elsewhere.
In summary, the authors fail to address the dynamic nature of research and development investments and the expected consequences for future global drug innovation that would occur from downward pressures on US drug prices to levels prevalent abroad. Rather, the authors look at the geographic distribution of revenue from products already on the market and ask whether the domestic revenues from the US price premiums exceed global research and development investments. This is a meaningless exercise from the perspective of assessing policy issues relating to drug prices, research and development investments, and future global biopharmaceutical innovation.
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