If drug companies earned the same rate of return as on government bonds, no one would invest in … More
President Trump thinks Americans pay too much for brand drugs. Under his proposal, the U.S. would pay the lowest price for American-made drugs sold to other developed countries.
Right now, Americans pay about three times more than the average price paid in OECD countries. So even if we merely matched the average price other countries pay, that would be a substantial reduction.
More than one critic has noted that if you limit drug company income, we will get fewer new drugs. But the converse is also true. If we do things to increase drug company profits, we will get more new drugs. The right question is: what is the optimal policy?
My approach to this subject is the same one economists take toward most public policies. It is an approach introduced by Adam Smith, the father of economics. We begin by asking what would happen in a completely free market. Then, we ask whether government intervention of some sort would improve social welfare.
By a free market, I mean a market in which companies are free to develop drugs and (once they are found to be safe and effective) charge whatever price the market will bear for the life of a patent. When the patent expires, others are free to produce identical drugs (generics) and charge what is likely to become a competitive market price.
Let’s think through this sector by sector.
Drug company behavior
Like any monopolist, drug companies have an incentive to charge a monopoly price—the price that maximizes profits. If they can segregate markets (and prevent buyers from reselling to each other), they will price-discriminate—charging more to those willing and able to pay more. That’s why there are different prices in different countries.
Sometimes it is said that drug companies need to charge a high price to recoup the cost of development, which these days averages about $2.6 billion per new drug. But that gets the cart before the horse.
Our Constitution gives the government the power to create patents and copyrights, and the reason is obvious. These short-term grants of monopoly power allow inventors and innovators to get a return on new ideas that have the potential to benefit the public as a whole. However, once the product is invented, development costs are sunk costs. The only thing that matters at that point is the value of the product to people who need it and want it.
Bottom line: there is no relationship at all between drug development costs and the price charged to consumers.
Sometimes it is argued that since government funding is involved in the initial phases of scientific discovery, the price charged to the public should be very low. But this is just a variation on the same confusion. Regardless of the government’s role, drug companies are willing to buy the right to produce and sell a drug (from universities and research institutes) precisely because they can charge a monopoly price.
Once the patent expires and many competitors can produce generic versions of the drug, we expect free market competition to bring the price down to the marginal cost of production. Today, more than 90 percent of all drugs purchased in the U.S. today are generic, and their average price is $17.90 per dose.
Public policy implications
From this short overview, there are six things to note.
First, the manufacturers of drugs never get the full social value of their creations.
The typical drug patent lasts 20 years. However, it takes many years from the time a patent is granted until a drug actually appears on the market. On average, a new drug gets patent protection in the market for only 8 years. There are circumstances under which short extensions are possible. But remember, a life-saving drug might go 20 or 30 years before it is replaced by a better drug.
What is true of drugs is true of all innovations and inventions. Economist William Nordhaus has estimated that innovators (including drug developers, tech companies, etc.) capture only about 2.2% of the total social value created by their innovations.
Arguably, we should be thinking about how to increase the rewards for innovation and discovery—not only for pharmaceuticals but in many other areas as well.
Second, the rate of return in the pharmaceutical industry has to be higher than in other industries.
Critics sometimes argue that the high rate of return earned by drug companies means that consumers are being ripped off. However, bringing a drug to market is not only very expensive with a very lengthy payoff period, the business is also very risky. About 90% of all drugs that enter a clinical trial never make it to the market.
If drug companies earned a rate of return no larger than the return on government bonds, no one would invest in pharmaceuticals.
Third, price discrimination in the market for drugs helps improve social welfare.
In Part II we will show that the value of a drug (as measured by people’s willingness to pay for it) in different countries depends on their average income. If government were not involved at all, we would expect to find that different prices for a brand drug in different countries almost exactly reflect differences in income.
President Trump seems to think that if drug companies were forced to charge the same price in international markets, the U.S. price would be a lot lower. But drug companies might raise the price they charge other countries and keep the U.S. price where it is. Likely something in between would happen, and that would mean that many patients would be priced out of the market.
The same principle also applies within countries. If a drug company is able, it will charge higher-income patients a higher price and lower-income patients a lower price. If it is prohibited from such price discrimination, lower-income patients will fail to get a drug that could have helped them.
This is a good way to understand the next thought.
Fourth, monopoly pricing potentially leaves many needs unmet.
Suppose a new cancer drug is selling for $1,000 a month, but the actual production cost is only $20, Then all of the patients who are willing to pay between $20 and $1,000 will be excluded from the market. That leaves us with unmet social benefits that are well above the social cost of meeting them.
This is probably the strongest argument for government intervention. For example, some economists have advocated replacing the patent system with a system of monetary prizes—under which the government would pay manufacturers for new discoveries and then make the drugs available to the public for prices equal to their marginal cost of production
However, our experience with government regulation should cause everyone to be skeptical. Plus, drug companies have discovered enough ways to price-discriminate to greatly reduce the size of the problem (including copay cards to reduce a patient’s out-of-pocket expenses for those with no insurance or limited insurance). You almost never see a headline about a cancer victim dying because she couldn’t afford the price of her drug.
Fifth, price discrimination creates strong incentives to resell drugs across markets.
It should surprise no one that Americans sometimes buy their drugs in Mexico or mail-order them from Canada. Nor should anyone be surprised when U.S. drug companies warn that Canadian drugs might be unsafe—even though we don’t see Canadians dropping dead after consuming them.
Sixth, other countries are hypocritical.
Outside the U.S., virtually every developed country negotiates the prices of brand drugs with the manufacturers. You might suppose this is out of concern for the health and welfare of their own citizens. Yet when it comes to generic drugs produced in these same countries, they tend to be very protectionist—shielding their generic producers from international competition.
Americans pay the highest prices in the world for brand drugs and some of the lowest prices for generic drugs.
In Part II, we will look at the decisions made by the buyers of brand drugs.