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Price Controls on Pharmaceuticals
Frank Lichtenberg uses a novel strategy to estimate the effect of price controls on innovation. Simplifying (see the paper for details) Lichtenberg argues that the profit from a pharmaceutical is essentially P*Q-FC where P is price, Q is quantity and FC is fixed cost. Most of the fixed cost is due to research and development and getting through FDA hurdles.
The key to Lichtenberg's strategy is to note that changes in Q have the same effect on profit and thus on the incentive to innovate as changes in P (this is not really true since changes in P also influence Q but Lichtenberg adjusts for the elasticity of demand). Moreover we can estimate the effect of changes in Q on innovation by looking at how the incidence of a disease influences innovation. Lichtenberg finds, for example, that pharmaceutical innovation is higher among cancers with greater incidence (e.g. lung versus pancreatic cancer). Using the Q to innovation relationship he estimates that a 10% reduction in price would reduce pharmaceutical innovation by 5%.
We know that pharmaceutical innovation saves lives and has a very high benefit to cost ratio. Thus, price controls or other restrictions that reduce prices are almost certainly a bad idea.
Indeed, as I have argued before, health care spending on the margin has very low value. We know, for example, that Medicare regions that spend twice as much on patients have no better outcomes. Spending on health care research and development, however, has very high value. Thus price controls would be a disaster - reducing high value R&D and replacing it with low value current spending.
I fear that short-term thinking by politicians and the public will destroy the US pharmaceutical industry.
Posted by Alex Tabarrok on February 2, 2007 at 07:12 AM in Economics | Permalink
Comments
It's popular in some circles to demonize U.S. efforts to export its intellectual property regime overseas, but if those efforts were more successful, it might have the effect of reducing U.S. drug prices. If U.S. drug companies could benefit more from overseas sales of drugs still covered by patents, it would better defray R&D, marketing, and other costs, and U.S. drug prices might fall (and overall R&D spending might increase). Maybe we should be encouraging other countries to tighten their IP regimes rather than seeking to control prices domestically.
Posted by: Andrew at Feb 2, 2007 7:22:28 AM
I fear that short-term thinking by politicians and the public will destroy the US pharmaceutical industry.
From here (Ann Arbor, MI) it appears the process has already started as Pfizer has just decided to shutter a major research lab (the lab that invented Lipitor). Obviously, Pfizer's present financial troubles were a major factor in this decision but so, too, I think was the prospect that forthcoming price-controls will make pharma research a much less profitable business in the years to come.
Posted by: Slocum at Feb 2, 2007 7:38:26 AM
I agree that it is not a good idea to regulate pharmaceutical prices.
However, the best place to invest in medical research is the National Institutes of Health.
Posted by: Bill Gardner at Feb 2, 2007 8:10:50 AM
Bullshit. Major pharmaceutical companies are rarely more than a marketing and distribution arm for small ventures focused on one or two medicines initially funded by capital markets and for government research, an arm that nevertheless takes most of the money. They are to medicine what the RIAA is to music. Medicine should be funded by international government-funded prizes for medicines, with capital markets providing the research and initial testing money, with the patents released freely for generics companies to compete making. Lipitor was totally unnecessary, by the way.
Posted by: bhauth at Feb 2, 2007 8:38:38 AM
What percentage of drugs that would be "price-controlled" (accepting for the moment this not-quite-accurate description of what Congress is talking about) actually "save lives"? Lichtenbeg's study demonstrating the "very high benefit-to-cost ratio" uses as evidence drgus that extend life, so Propecia, Viagra, etc., are not relevant. More important, as Bhauth says, there's little evidence that the proliferation of drugs that all attempt to solve the same problem has improve the benefit-to-cost ratio of drug purchasing.
I find it bizarre that you argue that "health care spending on the margin" has very low value, and yet you want to insist that the government spend tens of billions of dollars a year extra on drugs that precisely constitute "health care spending on the margin," becasue they offer only marginal improvement over existing drugs or generics while conferring very little additional benefit.
Posted by: K. Williams at Feb 2, 2007 9:21:42 AM
I keep hearing the argument that price controls lead to reduce investment and output. But when I look at the data on domestic oil exploration and production, for example, the only time since 1969 that oil exploration and output expanded was during the late 1970s era of price controls and windfall profits taxes. As soon as Reagan removed them exploration and production collapsed.
New drug development has been retreating for a decade while the industry was one of the most profitable in the economy. From 2002 to the end of 2005 the relative performance of the S&P index of Drug stocks fell 40% in an era when Washington was acting in many ways to improve drug company profits and drug profits were soaring. Drug stocks have been market performers over the past year. It appears that the situation may be a little more complex then the introductory economics supply and demand curves imply. There appears to be some structural and/or scientific factors behind the poor performance of drug companies that has little to do with your worries about hypothetical price controls.
Posted by: spencer at Feb 2, 2007 9:28:36 AM
Eliminate the government monopoly drug patents and create prizes for drug research, (Alex seems found of for Goldcorp). It would be a much more efficient system.
Posted by: theCoach at Feb 2, 2007 9:35:07 AM
Again, what price controls? When the Defense dept. bargains with Lockheed Martin over the price of a submarine, is that a price control? Does the DD farm out the bargaining power to a million different contractors, who then bargain with Lockheed Martin? Of course not. I love it when libertarians start arguing for industrial policy on the basis of what is "Beneficial to Society."
Posted by: bjkasd at Feb 2, 2007 10:22:00 AM
Major pharmaceutical companies are rarely more than a marketing and distribution arm
Hmmm. Those 180 acres of soon-to-be-empty laboratories on the NE side here must be a figment of our collective imagination, then. But I'm puzzled -- if Pfizer is no more than marketing and distribution, how is it that they're managing to cut back on the R&D that they don't actually do?
Lipitor was totally unnecessary, by the way.
Right. Because one drug in any given category is all that is ever needed. No improvements will ever be made and there is no variation in patients so that a drug that works for one patient will work equally well for all (and will produce exactly the same mild side-effects).
Posted by: Slocum at Feb 2, 2007 10:55:18 AM
--Lipitor was totally unnecessary, by the way.--
Knocked my cholesterol down over 100 points on the lowest dosage (not normal, I know).
Mine is partially genetic on both sides, but I still like milk and cheese.
Oh, and if any of you are milk drinkers, Costco has 0% cholesterol milk.
If only they could cut the cheese.....
Posted by: Sandy P at Feb 2, 2007 10:57:09 AM
The private attempt to map the human genome cost a fraction of the gov't attempt and achieved the goal quicker. The NIH simply does not have the proper incentives to focus and economize on research, and if we were to make a collective decision to put all of our eggs in that basket, there would be a greater politicization of the process than there already is. Whoever has the best public pressure tactics will get the research (remember AIDS demonstrations in the 80s, when AIDS was still quite minor and preventable compared to more serious diseases such as breast cancer and heart problems among older women, which remain underfunded). Golden Carrot funding, however, has its merits (see Alex' next post on gold prospecting).
Spencer, if oil exploration "collapsed" after Reagan removed price controls, it was because the price of oil collapsed soon thereafter. It was well known at the time that oil prices were artificially inflated, not due to actual scarcity, and as far as I know, exploration did not collapse, it simply moved offshore to the Gulf of Mexico and North Sea, with a good deal of success.
Regarding R&D by pharmaceuticals, we would all benefit from the dissolution of the FDA and its replacement by third party certifiers (UL and Consumer Reports, for example, though I think more specific certifiers would appear) to reduce the costs imposed by an overly risk-averse bureaucracy that prevents the distribution of knowledge and useful drugs. I have no problem leaving the FDA in place as an "honest broker" with no enforcement power, consistent with the Constitutional authority to establish weights and measures. In 2005, according to an IEEE article on the top 100 R&D spenders worldwide, pharmaceuticals spent over $52 B on R&D (of which over 57% was by American companies - that's not bad for 4% of the world's population and a heck of a free ride by the other 96%). As far as their advertising budgets, it should be noted that a significant portion is donation or subsidization to lower income patients, something not generally recognized as supplemental to public support programs. The IEEE article started off with a naive statement: although the funding for the National Institutes of Health doubled between 1998 and 2003 from $13.1 to $26.4 B, they ask, "Why hasn't all this government largesse motivated the private sector to spend more of its own money on life sciences R&D?"
Three responses come to mind. First, duh! -- it's called "corporate welfare". Why would they spend more on R&D when a well-placed lobbyist is a better investment? Second, they already outspend the public sector 2:1 without having the benefit of the IRS. Third, how do they know the current amount (at any time) is not the correct amount? There is an assumption that more, now, is better, no matter what the current level is, without analysis of how the research is distributed or whether there are distortions or inefficiencies.
I'm not defending the industry as it exists - it could stand a lot less government protection (perhaps even in the IP area) and corporate welfare. But has anyone ever read the story of the Golden Goose?
Posted by: Eric H at Feb 2, 2007 11:15:43 AM
Alex's point is well taken, as far as I'm concerned.
The problem with the debate over drug prices is the agency issue that it hinges upon: the firms say, give us money so we can do research. People say, how do we know you will use it for research? Two answers are commonly given: 1. trust us, we will, or 2. don't worry, it's in our interest to do so. Neither of these claims is particularly credible with the public, in part because of the way firms in this sector conduct themselves (and have, historically, conducted themselves -- see John Braithwaite's study
http://www.anu.edu.au/fellows/jbraithwaite/_documents/Manuscripts/Corporate_Crime.pdf).
Of course, the fact that a claim is not credible, when uttered by a particular speaker, does not mean that it is false.
An anecdotal point: I happen to be married to a doctor, who works at a major academic hospital, so I've seen the amount of money that pharmaceutial companies throw around. Unless you've seen it up close, it's hard to believe. I know doctors who haven't paid for their own lunch in over five years. My office is full of drug company swag. My favorite episode was when a local drug rep took a dozen doctors to the casino, and gave them each $200 cash on the way in (not a kickback, just an entertainment expense!) It seems to me that using a casino to launder dirty money, apart from being a tired old trick, should be beneath the dignity of a Forture 100 firm.
Of course, the amount of money that actually gets wasted in this way is minor in the grand scheme of things. But I think pharmaceutial companies underestimate the extent to which their political troubles are a consequence of their own behavior. (For instance, I think that fact that these firms are allowed to advertise in the United States has done an enormous amount to damage their credibility -- I say that as an observed in Canada, where such ads are more or less prohibited.)
Posted by: Joseph Heath at Feb 2, 2007 11:40:19 AM
Let me state the my mother became a type 1 diabetic about 2 yrs ago, so I do equate my arguement with some emotional attachment. Having said that, I think that diabetes is something that far and wide is under control. In business, there are limited inputs such as land, labor, and materials. These companies are researching drugs according to the market demand for them. Although some don't see it, these companies are trying hard to develop drugs for more serious diseases and cancers but along the way, this research allows them to stumble upon medicines and treatments for ailments that have much less complex make-ups and along the way, through the sale of these drugs, allow them to fund themselves by making a profit.
This is also why I completely agree with the use of the patents. It breeds competition. Everyone knows that the first one to develop a new, and effective drug for say, treatment of AIDS, stand to gain financially, which will give them more income to spend on R&D, and so on and so on.
Posted by: Johnny at Feb 2, 2007 11:55:49 AM
If the problem is that drug companies don't innovate enough, seems the solution would be to examine why their incentives are so out of whack. In almost every other industry innovation is frequent and necessary for a profit. Why is the pharma industry different? We should be answering that question and solving it, not trying to restrict their profits.
Maybe you don't think Microsoft innovates enough - is the solution to institute price caps on all computer software?
Posted by: bob montgomery at Feb 2, 2007 12:17:02 PM
Lipitor was totally unnecessary, by the way
Even if there was no statistically significant benefit at all from drug A over drug B
-the side effects may be different/better
-as mentioned, drug A may work for 80% of sick people, but what if you are among the 20%? Maybe drug B will work for you.
-all research, even if it leads to a dead-end, is probably a net positive. Something was learned, anyway; the process of elimination and all that.
Now if there was a benefit, even if small, all of the above apply, and
-it's easy to dismiss small benefits. But to sick people it might make a huge difference.
-a 5% improvement now, a 3% improvement on that in 3 years, a 2% improvement on that in another 5 years...a series of small improvements will add up.
Posted by: bob montgomery at Feb 2, 2007 12:26:34 PM
"Again, what price controls? When the Defense dept. bargains with Lockheed Martin over the price of a submarine, is that a price control?"
Creating monopolies is the whole point behind patent system. Having the government essentially act as a monopsonist to counteract the effect of those monopolies may not entirely defeat the purpose, but it risks taking a pretty big whack at it.
Posted by: Scott Wood at Feb 2, 2007 12:33:56 PM
What percentage of new drugs-that-save-lives are initially developed by drug companies, and what percentage are initially developed by government-financed spending?
I get the impression that private drug companies are spending much of their research effort on lifestyle drugs like V**gra and me-too drugs like C**lis. OK, fine, there's a business there, but if they're spending more money marketing than researching, and their research money goes to dick drugs, then they don't get to claim the halo of innovation of lifesaving drugs.
Posted by: Cardinal Fang at Feb 2, 2007 12:47:57 PM
Why not use contests to encourage pharmaceutical development? A board of medical experts could decide how much a cure/vaccine/improved drug should be rewarded. Discovers get the prize, the public gets the patent.
Posted by: vc at Feb 2, 2007 12:58:30 PM
Didn't the Saudis also help in the oil collapse of the 80s??? They opened the spigots to stop us.
Posted by: Sandy P at Feb 2, 2007 2:48:01 PM
New drugs have to go through very expensive clinical trials.
Taking away patent protection would result in generic producers making a generic version of a new product the instant it gained FDA approval.
End result no more research and development because no company would spend money on a clinical trial if they could not have a chance of recouping their investment.
Posted by: TJIT at Feb 2, 2007 6:51:41 PM
bjkasd,
Again, what price controls? When the Defense dept. bargains with Lockheed Martin over the price of a submarine, is that a price control?Oftentimes for government contracts a request for proposals with specifications is let and companies bid on supplying the equipment and supplies. That is a world away from how drug R&D works and makes comparing drug R&D to defense procurement less then useful.
Posted by: TJIT at Feb 2, 2007 6:59:10 PM
Spencer,
But when I look at the data on domestic oil exploration and production, for example, the only time since 1969 that oil exploration and output expanded was during the late 1970s era of price controls and windfall profits taxes.The story is lots more complicated. The link goes to a paper that reviews the impacts of the windfall profits tax and price controls. Because price controls and profit taxes can be levied only by the U.S. government on U.S.-based companies, such policies also increase the economic attractiveness of foreign relative to domestic oil. The U.S. experience with price controls from 1971 to 1980 and the Crude Oil Windfall Profit Tax from 1980 to 1988 amply demonstrates the problems.
Furthermore the price of oil collapsed in 1986 dropping more then 60% in less then 12 months. That is why exploration and production collapsed, not the end of windfall profits.The link below discusses the collapse
By 1987, only a year after the price collapse, 175,000 of those jobs had vanished.
Posted by: TJIT at Feb 2, 2007 7:17:30 PM
It is worth noting that Viagra was originally intended as a hypertensive medication; the unusual side effects were noted in Phase 1 trials.
Presumably, it was research into the enzyme target of Viagra that produced its cousin Cialis. Not sure who to blame for that. I can tell you that Pfizer Sandwich did not intend to synthesize 'dick drugs'. I think Icos (maker of Cialis) probably did.
I'll be blunt: there's a great deal of ignorance about the inner workings of the pharmaceutical industry here, starting with bhauth's laughable RIAA crack.
Posted by: Klug at Feb 2, 2007 9:06:28 PM
Fallaces a-go-go to clean up:
1) Pharmaceutical marketing expenditures, assuming that the companies are run by greedy profit-seeking bastards, do not "crowd out" R&D. You spend marketing dollars because they increase revenue by more than a dollar for each dollar spent (until diminishing returns equates them and they stop). The profit pool of the company is where R&D budgets come from.
2) As mentioned by a number of posters, the elimination of price controls on oil coincided with a world collapse in oil prices, explaining why domestic production dropped.
3) NIH and small biotechs have developed, to a first-order approximation, zero percent of the patented drugs prescribed, if we use "developed" in the sense of "created the exact molecule, tested it on animals, figured out how to make it, and got it through three phases of FDA review at the expeniture of hundreds of millions of dollars."
Posted by: srp at Feb 2, 2007 9:08:21 PM
I would have no problem with the FDA acting only in an advisory role, given its history.
No, those big labs aren't imaginary, but given their incompetence and marketing driven nature, they might as well be. Cardinal Fang has a good point.
TJIT, the idea is that governments then fund that by paying for successful development.
I'm holding my ground on the advantages of Lipitor lying mostly in glossy magazines and the RIAA analogy. bob, there may be some small benefits to having it but it's indisputable that it was not an efficient use of research.
srp, that's because the business model of both university and startup research is to do the real work (including some amount of animal testing) and then sell to the major pharmaceuticals who act as marketing and distribution. Sure, they figure out how to make the drugs, but generics companies have managed to do that very cheap and very fast compared to the cost of the development. And some amount of expensive testing is necessary, but we don't need big pharma for that. Look, if government provides prize money as a motive, saying "we need to make sure they have money to fund research" is stupid because if it's worthwhile then capital markets can provide it.
Yes, marketing returns a little money to companies, but it costs the consumers a lot of money. That's the point, isn't it? To make medicines cheaper without stopping their availability?
Posted by: bhauth at Feb 2, 2007 9:52:57 PM
