October 13, 2006 | Volume 3, Issue 2

Price Controls on U.S. Pharmaceuticals

Is this Good Public Policy?

by Nathan Gannon, Karen Sheng, and Delal Ismail

Introduction

“The debate over prescription drug prices in the United States is both contentious and longstanding” (Abbott and Vernon 2005). Public perception of the U.S. pharmaceutical industry is divided. Detractors of the pharmaceutical industry label these companies villains who soak the public with the high prices they charge; others view them as protagonists for the overall “good” provided by their new medical innovations. Due to this domestic friction between the public and the pharmaceutical industry, elected officials have proposed some skeptical policy alternatives in order to level the access to prescription drugs.

The United States remains largely unregulated when it comes to pharmaceutical pricing. This lack of regulation has given drug manufactures legal monopoly power on patented drugs and, as a result, some government officials have recommended policies that mirror price regulations found in other industrialized nations. For instance, France and Italy have direct price controls on pharmaceuticals, allowing their citizens access to cheaper prescription drugs. The recent political debate regarding the re-importation of drugs from other countries (i.e., Canada) can be seen as an imported price control on U.S. pharmaceuticals. Although the issue has been rather quiet since the 2004 Presidential election, the discussion of re-importation, or price regulation, points to an unsettling direction in which the federal government is heading—pharmaceutical policies based more on politics rather than sound economics.

Direct price regulation on U.S. pharmaceuticals is an ineffective tool in curbing the high prices of prescription drugs. Although static efficiency (innovation in the short-run) benefits under a price control, it does so at the expense of dynamic efficiency. The question at hand, then, is whether or not policy makers ought pursue static efficiency over dynamic efficiency.

Patents

Patents are the cornerstone for financing the pharmaceutical industry. There is little doubt that new medications have benefited the public greatly. Advances in new pharmaceuticals have prolonged the life expectancy of many patients suffering from a variety of diseases (Kremer 2002). Patent protections drive the innovations that allow for new medicines to be developed. However, the flip side to these protections is the monopoly power granted to drug companies. The debate today revolves around the issue of whether prices and in turn, profits, of drug companies seem excessively high.

Patents allow pharmaceutical companies to establish legal monopoly protection against competitors for a period of 17 years. Under the U.S. Constitution (Article 1, Section 8) the law states that the overall goal of patents is to ‘promote the progress of science and the useful arts by securing, for limited times, to inventors the exclusive right to their respective discoveries’ (Phelps 2003). Considering the ease with which chemical compounds can be reversed engineered, patents provide key incentives for firms to take on the high risks and costs associated with research and development. Without patent protection, competitors could save millions of dollars by waiting for a new drug to go to market, reverse engineer the process and profit on the research of other companies. Protections allow pharmaceutical companies to continue to innovate and absorb the high costs of research. Nevertheless, they are not without their drawbacks.

One of the major drawbacks of patent protection is the emergence of monopoly pricing power by the firm. Under perfect competition, prices and quantity are usually set at an optimal level where a firm would not charge a price above what is offered in the competitive market. If a firm decides to charge a price higher than the market equilibrium, other firms are able to bid down the price (for the same good) and consumers will thus move towards the lower price. Thus, competition is the key to lowering prices. Please see Figure 1 below.

With perfect competition, a firm will not charge a price above the equilibrium point, which is where marginal cost (MC) curve intersects the demand curve (D). Consumer and producer surpluses are labeled in the triangular (1) and rectangular regions (2). It is important to note that long run profits are nonexistent. Firms that are able to freely enter and exit the market push down price and drown out the chance for long run economic profits. In other words, whenever there is an opportunity to make a profit, other firms will notice and enter this particular market. As a result, there are a number of firms now present, resulting in firms constantly innovating and competing based on price.

Due to the existence of patents, competition is by definition absent. This leads firms to charge a higher price (above marginal cost) than would otherwise be offered in a competitive market. Furthermore, monopoly pricing leads to a deadweight loss of consumer surplus to consumers who value or would pay “more” for the drug under perfect competition and in turn, are phased out and unable (or unwilling) to purchase the drug at the monopoly price (Figure 2). This societal loss is important because with competitive pricing the deadweight loss would be absent. For example, individuals who would be willing to pay a little more than the market price (deadweight loss region, Figure 2) lose out due to the monopoly price. In other words, the individuals in this region of Figure 2 would have paid more for a drug under perfect competition; however, now, the new monopoly price is above their willingness to pay. Thus, society would have been better off under perfect competition. This highlights one of the basic inefficiencies of a monopoly—innovating as little as possible while charging a high price.

As Figure 2 illustrates, firms that have monopoly power will place a price (Pm) above what would be offered in the competitive market (P*). The deadweight loss (loss to consumer surplus) is located in the triangle region between Pm and P*. Also, the societal loss (deadweight loss) is another major consequence of monopoly pricing. Under perfect competition, consumers (or patients) who valued the drug above its equilibrium level were willing to pay more for the good. However, with monopoly pricing consumers that previously valued the good (drug) more than its competitive equilibrium level now become priced out of the market. In other words, consumers who valued the drug more under perfect competition lose out completely with monopoly pricing. Again, society (the market) loses out on these consumers highlighting one of the more important implications of monopoly pricing.

Price Controls

Price controls are the populist remedy for excessive monopoly power (Guell and Fischbaum 1995). In general, the government imposes a price “ceiling” below what is offered on the market under the auspice that price competition is weak. In turn, this price ceiling artificially lowers the price of a good. Consumers in the past who could not previously afford the product are able to do so at this price, causing the demand for the product to increase. Under traditional supply and demand, when the demand for a particular good increases, the price of a good along with its quantity goes up as well. However, with a price ceiling, the quantity demanded still goes up, but the price is capped and therefore cannot rise above its restricted level. The price ceiling therefore generates a shortage for the particular good.

The consequence of a price ceiling induces buyers and sellers to use non-price rationing mechanisms to allocate a good. Theoretically, if this type of control were enacted on pharmaceuticals, there could be a rationing of particular drugs even though more people—who now can afford the drug—demand it. Long waiting lists for drugs might form, allowing for patients to miss out on valuable treatment time.

Although economic theory provides a pretty solid guide to the consequences of price controls, public officials seem inclined towards price controls as public policy . For example, in the 1970’s the federal government instituted a price ceiling after the Organization of Petroleum Exporting Countries (OPEC) restricted the supply of oil to the United States. The oil supply restriction caused the price to rise drastically so the U.S. government decided to impose a price ceiling on how much oil could be charged. This policy turned out to be disastrous when long lines began forming at the gas pumps. Other types of rationing also took place, such as restricting the purchase of gas on odd days with cars that license plates ending in an odd number.

In a monopoly, however, a price control could have the advantage of actually increasing output or capturing some of the deadweight loss that comes about due to monopoly pricing. It could be theorized that a price control could bring down the price from its monopoly level to a more competitive level, which would cause output to increase. The size of the deadweight loss would decrease by the amount of the proposed control. In Figure 2, if the price control were to be lowered to the perfectly competitive level, prices go down from Pm to Pcontrol and output increases from Qm to Qcontrol. Also, the deadweight loss found in Figure 2 could be erased.

Figure 3 illustrates that when a price control is enacted against a monopoly not only do prices lower, but output increases as well. The static efficiency gain is that those consumers who where unable to afford the good before the control are now able to have access to it. Also, long run profits are eliminated. Dynamic efficiency is important for long run R&D. Without it, pharmaceutical firms might become reluctant to take on expensive research for fear they will not recuperate these expenses.

International Price Controls

During the past two decades, all advanced economies except the United States have implemented comprehensive controls over pharmaceutical prices, either directly or indirectly. In practice, the structure of pharmaceutical price and reimbursement regulations differs across countries and continually evolves (ITA 2004). This section will focus on the main prototypes.

Direct Price Limit

Under direct price regulation, as used in France, Italy, Spain and Japan, the initial launch price and any subsequent price increases must be approved as a condition of reimbursement. Sometimes price decreases are mandated. Most countries use one or both of two criteria in setting prices. (1) Internal benchmarking. Price of new drugs is set in comparison with established competitor drugs in the same therapeutic class. Mark-ups are allowed on the basis of improved efficacy, better side effect profile and local production (Danzon and Keuffel, 2005). If post-launch price increases are prohibited, a drug’s real price declines over its life-cycle. As a result, if follow-on products are benchmarked to an old drug, the real launch price declines for successive entrants in a class. (2) External benchmarking, which is sometimes known as international reference pricing. The comparison is set as the mean, median or minimum price of the same drug in a designated set of countries (Danzon et al, 2005). For instance, Italy uses an average European price; Canada uses the median price in 5 European countries plus the U.S. and Japan. External benchmarking limits manufacturers’ ability to price discriminate across countries. It is predictable that manufacturers’ launch prices would converge across linked markets. Consequently, launch delays and non-launch become an optimal strategy in low-price countries.

Reference Price Reimbursement Limits:

Some countries, including Germany, the Netherlands and New Zealand, have established reference price reimbursement systems for drugs in designated groups. Under reference price, products are clustered for reimbursement based on either the same compound (generic referencing) or different compounds with similar mode of action, for the same indication etc (therapeutic referencing). All products in a group are reimbursed the same price per daily dose –the reference price (RP). The RP is usually set at the price of the cheapest (or the median, the 13th percentile, etc) of drugs in the group. The reference price becomes the de facto market price for drugs in the same group, because mark-ups above the reference price can be justified only when consumers are convinced of the superior therapeutic benefits (Danzon et al., 2005).

RP reimbursement resembles direct price limit with internal benchmarking to competitor products, but with critical differences that make RP potentially more constraining. If a reference pricing class includes a drug with generic equivalents, all brands are reimbursed at the rate for the cheapest drug in the class. This effectively truncates the patent life for the newer products in the group.

Profit or Rate-of-Return Controls:

The UK is unique among industrialized countries for regulating the rate of return on capital, leaving manufacturers relatively free to set prices for individual drugs. There is a limit on each company’s revenues from sales to the UK National Health Services as a percentage of their capital investment in the UK. The allowed rate of return is around 17–21%; excesses can be repaid directly or through lower prices the following year (Danzon et al., 2005).

International Price Disparities:

The variety of price control policies reflects the fact that no single conceptual foundation for price controls has yet to be advanced and explored. What is of more importance is whether these price control policies have affected the inherent price disparity across countries, which is supposed to be proportional to per capita GDP in each country. It is not easy to study the impact of price controls within the U.S. pharmaceutical market, as the market is relatively free from government intervention all the time. International comparison therefore provides an appropriate basis for evaluating price disparities and impacts of price controls.

Table One (Calfee, Villarreal and DuPre 2006) summarizes several recent studies that explore price disparities between the U.S. and other OECD countries and prices that would prevail in the absence of price controls. A key assumption these studies share is that U.S. prices offer the closest approximation of deregulated prices available for use as a benchmark for comparison with government-mandated prices among other OECD countries.

A common methodology used in this line of studies is to construct aggregate price indices for patented pharmaceuticals in other economies relative to U.S. prices for the same medicine. These aggregate price indices are contrasted against relative levels of per capita GDP across the same group of countries. An adjustment factor, if any, can be calculated to estimate what prices would prevail in each country without price controls. This adjustment factor is shown as ‘ratio of Laspeyres to relative per capita GDP’ in the table. Adjustment multipliers greater than one indicate that prices are below what would have been expected in an unregulated market. Results from these studies are slightly different from each other, due to the year of data they each employ and what drugs they have excluded from their data set.

On the whole, these research studies reveal large international price disparities, with average prices in large developed countries about 30 to 50 percent lower than American prices. Moreover, these disparities have grown over the past 15 years and have come to substantially exceed disparities in per capita GDP (Calfee, Villarreal and DuPre 2006).

		Australia	Canada	France	Germany
Calfree, Villarreal & DuPre (2006)
Relative per capita GDP (2004)		0.79	0.79	0.75	0.72
Laspeyres index		0.52	0.61	0.58	0.53
Ratio of Laspeyres to relative p.c. GDP		0.66	0.77	0.77	0.74
ITA (2004)
Relative per capita GDP (2004)		0.80	0.81	0.74	0.72
Laspeyres index (2003)		0.65	0.57	0.55	0.55
Ratio of Laspeyres to relative p.c. GDP		0.81	0.70	0.74	0.76
HHS (2004)
Laspeyres index (2003)		0.67	0.57	0.53	0.57
Ratio of Laspeyres to relative p.c. GDP		0.84	0.70	0.72	0.79
Danzon and Furukawa (2003)
Relative per capita GDP (1999)		0.77	0.81	0.73	0.73
Laspeyres index (1999)			0.64	0.61	0.73
Ratio of Laspeyres to relative p.c. GDP			0.79	0.84	1.00

Parentheses indicate the year of the data. The results from Calfee et al are for year 2004 prices; ITA(2004) and HHS (2004) are for 2003 prices; Danzon et al (2003) is for year 1999 prices. Per Capita GDP data using PPP comparisons are from OECD Factbook 2005, reported at current prices in U.S. dollars on current purchasing power.

Cost-Benefit Analysis

As mentioned before, prescription drug prices are largely unregulated in the United States. This has resulted in criticism by those who believe that not having price controls is a direct cause of the large price disparities between the U.S. market and comparable international markets that do have price controls. These critics argue that price controls, or even indirect means of regulating drug prices such as reimbursement under social insurance plans, would be a positive solution to ensuring all consumers receive the prescription drugs they need for better health care.

However, despite the short term benefits of drug price controls, which would enable consumers to have more access to the drugs they need, the long term shortcomings of such a plan have much higher stakes in the pharmaceutical industry. These long term effects would inevitably lead to lower consumer or social welfare. Long terms price controls would lower incentives for future research and development (R&D), which would harm future medical advances necessary to improve health care. For example, according to recent study by James Hughes, Michael Moore and Edward Snyder, there would be a loss of 3 dollars in benefits from innovative pharmaceutical drug innovations for every one dollar gained from better access of drugs as a result of price controls in (present value terms). Also, according to the 1996 Medical Expenditure Panel Survey, which has patient data on medical conditions, the replacement of newer drugs for older ones led to significant decreases in patient mortality (Hughes, Moore and Snyder 2002). These studies support the idea that price controls, while improving public access to current medications and generating cost savings and improved consumer health, would also cause a reduction in R&D and result in worse outcomes in the future. The benefits of price controls are measured in this section in terms of consumer surplus while the costs are measured in forgone pharmaceutical drug innovations mainly using a simulated study by authors Rexford Santerre and John Vernon (Santerre and Vernon 2004).

Authors Rexford Santerre and John Vernon constructed an economic model to prove that a policy of drug price controls would lead to higher social cost through time. Through using a first partial derivative to represent the marginal utility of positive health as well as the marginal productivity of drugs on positive health, it is found that the consumer would equate marginal benefit of the final drug used (marginal benefit of the consumer’s value of good health) with the marginal cost (marginal cost of one more drug on good health). As the model suggests, the price paid for an additional drug in the market captures the consumer’s willingness to pay for a minor reduction in the probability of morbidity.

In using these economic techniques to derive willingness to pay for any advancement in health care, it is assumed that prescription drugs are a normal good. When this is given as the assumption, real income will directly affect the quantity demanded of drugs. Furthering the study, out-of-pocket real price of health care was found using the consumer price index along with statistics from the Bureau of Labor Statistics. Real income is measured in GDP. After taking multiple regression analyses and uncovering price inelasticity assumptions, the main conclusion is that an increase in real out-of-pocket expenses leads to a decrease in demand of prescription drugs. In the end, medical care and prescription drugs are found to be substitute goods; therefore, an increase in expenditures on prescription drugs means less expenditures on other health care services such as hospitalizations, etc.

With a drug control policy in place, consumer surplus actually increases through time as prescription drug prices increase. Evidence can be seen by the chart taken from Santerre and Vernon, Exhibit 3; by the year 2000, consumer surplus increased to $33,969,669,938 from $234,008,952 in 1981 (future value of consumer surplus (invested at 7% until the end of the year 2000) (Santerre and Vernon 2004).

In using this same model, it is estimated that the price control policy would also decrease the incentive of firms to continue with research and development by anywhere from $264.5 to $293.1 billion. In essence, profit expectations lower when price protection is implemented over time. Further, the reduced R&D investment leads to an estimation of about 38% fewer new drugs put on the national and international market. Now in terms of using the Federal Drug Administration’s figure of new drugs placed on the market between the years 1980 and 2000, and applying the Santerre and Vernon figure mentioned above, about 198 new drugs would not have been developed as a result of price controls along with an estimated $1.6 billion loss in consumer surplus per each new drug created (Santerre and Vernon 2004).

Frank Lichtenberg’s 2002 study estimated that every $1,345 used for R&D actually increased one U.S. life year. Studies have also found that the amount of compounds used in human trials from the laboratory would decrease by about 50 percent. This means that fewer new drugs would be discovered if the trials are not there to cement the results. These effects, as suggested by the data above, are long term. These figures prove that price controls commit worse outcomes in terms of social welfare than the current policy of the U.S. to not have price controls on pharmaceutical drugs as evidenced in the table below. By the year 2001, there would be an estimated $251 to $256 billion loss in R&D (Santerre, Vernon and Giacotto 2006).

In furthering the argument against price controls on pharmaceutical drugs, there is strong evidence to suggest that even indirect price controls will cause a loss of R&D and have a negative effect on the U.S. economy. The following table provides evidence of the consequences of indirect drug price controls. Indirect price regulations, as suggested by various state policy makers, use techniques like moral suasion or threats to convince drug companies to decrease their prices.

From this table, the authors suggest an estimated $186 to $190 million loss in life years with indirect price regulations enacted (Santerre, Vernon and Giaccotto 2006). In all of the above analyses, it is clear that the future costs of direct and indirect price controls, such as losses in R&D and social welfare, exceed the benefits of implementing price controls.

Conclusion and Other Alternatives

Price controls are, in general, not a good solution in leveling the price of expensive prescription drugs. Dynamic efficiency suffers as a result of firms not taking on the risks associated with new research and development. Static efficiency, on the other hand, is benefited through price controls, thereby giving access to those who need the drug in the short run. But the tradeoff of dynamic efficiency is larger in the sense that riskier research will not be conducted for fear that firms will not recuperate their research and development costs. In the end, this results in greater costs than benefits.

Price discrimination and patent buyouts would offer better solutions in facilitating both dynamic and static efficiency. Price discrimination would allow for firms to target different level of consumers with different prices. Meaning, those that value the drug more will pay the price above marginal costs while those who cannot afford the drug at its marginal costs will be charged a lower price, thereby granting wider access to the drug. Theoretically, price discrimination works; however in practice, price discrimination is very difficult to accomplish.

Patent buyouts are another tool for stimulating dynamic efficiency (Kremer 1998). In a buyout the government could use an auction to estimate the private value of the patent and then offer to buy the patent at its private value . Furthermore, patent buyouts could potentially eliminate monopoly price differentials and raise private incentives to have research closer to its social value (Kremer). In other words, patent buyouts would help eliminate the deadweight loss associated with monopoly pricing.

Both perfect price discrimination and patent buyouts are theoretically better at stimulating dynamic efficiency than the patent system. Thus, the patent system can be viewed as the second “best” solution for firms to recuperate expensive R&D costs. However, when compared to the political proposal of re-importing drugs from other countries, the patent system is by far a much more reliable option. If the U.S. allowed for the re-importation of drugs, the short term benefits could be highly beneficial—those sick today, particularly the elderly population, could have greater access to newer drugs. But another question arises: should the government support the elderly today at the expense of the elderly tomorrow? This is both an ethical and economic scenario that should be debated vigorously by elected officials and economists.

References

Abbott, T. A. and J. A. Vernon, 2005, “The Cost of US Pharmaceutical Price Reductions: A Financial Simulation Model of R&D Decisions.” National Bureau of Economic Research. Autumn.

Calfee, John E, Mario Villarreal and Elizabeth DuPre, “An Exploratory Analysis of Pharmaceutical Price Disparities and Their Implications Among Six Developed Nations”. AEI-Brookings Joint Center for Regulatory Studies, Working Paper, April 2006.

Danzon, Patricia M and Eric Keuffel, “Regulation of the Pharmaceutical Industry”, NBER Working Paper, September 2005.

Guell, R. and F. Marvin, 1995, “Toward Allocative Efficiency in the Prescription Drug Industry,” The Milbank Quarterly, 73, 213–230.

Hughes, James W., Michael J. Moore and Edward A. Snyder 2002. Napsterizing Pharmaceuticals: Access, Innovation, and Consumer Welfare. National Bureau of Economic Research. http://www.nber.org/papers/w9229 (accessed May 2006).

Kremer, M., 2002, “Pharmaceuticals and the Developing World,” The Journal of Economic Perspectives, 16, 67–90.

Kremer, Michael, 1998, “Patent Buyouts: A Mechanism for encouraging Innovation,” The Quarterly Journal of Economic Perspectives, 113, 1137–1167.

Phelps, C. E., 2003, Health Economics, 3rd ed, Boston, MA, Addison Wesley.

Santerre, Rexford E. and John A.Vernon 2004. A Cost-Benefit Analysis of Drug Price Controls in the U.S. AEI-Brookings Joint Center for Regulatory Studies. http://www.aei.brookings.org/publications/abstract.php?pid=872 (accessed May 2006).

Santerre, Rexford, John Vernon and Carmelo Giacotto 2006. The Impact of Indirect Government Controls on U.S. Drug Prices and R&D. Cato Journal, Vol. 26. No. 1. http://www.cato.org/pubs/journal/cj26n1/cj26n1.html (accessed May 2006).

U.S Department of Commerce, International Trade Administration, “Pharmaceutical Price Controls in OECD countries: Implications for U.S. Consumers, Pricing, Research and Development and Innovation”. 2004.

Endnotes

¹ Average estimates to bring a new drug to market tend to be around $250 to $400 million.

² Please note there are some important instances where price controls might be effective, such as a large scale war.

³ Kremer posits that the government could buy the patent at its private value, plus a fixed mark up.

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