Price Controls on Pharmaceuticals

by on February 2, 2007 at 7:12 am in Economics | Permalink

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. 

1 Andrew February 2, 2007 at 7:22 am

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.

2 Bill Gardner February 2, 2007 at 8:10 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.

3 K. Williams February 2, 2007 at 9:21 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.

4 theCoach February 2, 2007 at 9:35 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.

5 Slocum February 2, 2007 at 10:55 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).

6 Eric H February 2, 2007 at 11:15 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?

7 Johnny February 2, 2007 at 11:55 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.

8 bob montgomery February 2, 2007 at 12:26 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.

9 Cardinal Fang February 2, 2007 at 12:47 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.

10 Sandy P February 2, 2007 at 2:48 pm

Didn’t the Saudis also help in the oil collapse of the 80s??? They opened the spigots to stop us.

11 TJIT February 2, 2007 at 6:59 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.

12 Klug February 2, 2007 at 9:06 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.

13 bhauth February 2, 2007 at 9:52 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?

14 Brian February 2, 2007 at 10:36 pm

If Wal-Mart goes forward with its plans to drastically lower the price of some drugs, what do you think will happen? I know it may not be for all drugs, but still, less money is less money. Why would the effect with Wal-Mart, to pick one example, be that much different than if some government agency negotiated? If we are being told the best way to run government, if at ll, is like a business, why would it be bad to run it like a business?

15 Xmas February 2, 2007 at 11:10 pm

I’m sorry, I guess that Merck vaccine for HPV and the resultant cervical cancer is just a lifestyle drug.

I highly recommend reading the Corante Pipeline blog. It’s all about drug discovery.

http://www.corante.com/pipeline/

16 bhauth February 3, 2007 at 4:48 am

Xmas, guilty as charged of slight hyperbole but my point stands.

Klug, generics companies have shown that the production is done incompetently by big pharma, and the testing, firstly the FDA system is a bad one and secondly doing the testing is a commodity good.

17 bhauth February 3, 2007 at 5:04 am

And no, I’m not saying the scriptwriters do all the work. I’m saying that Hollywood itself has become unnecessary – an opinion I hold literally too, actually.

18 Klug February 3, 2007 at 1:40 pm

I’m sorry, bhauth, you and I are in complete disagreement.
1. Patents are NOT infinitely extendable. The courts (even after the pleading of BigPharma lawyers) are letting generics in sooner and sooner. Copyright is 3 times as long. What is your basis for your RIAA comment?

2. You still haven’t answered my question: What, in the process of drug development, do you consider the ‘real work’?

3. I am gathering that you think major pharma is incompetent. Why do you think generic drug companies will do better? Is it purely that they charge less for the drug?

4. We (I) weren’t talking about “the FDA system”. I was talking about pre-clinical drug development. We haven’t gotten to the clinic yet — the FDA doesn’t know what we’re up to. Or is it your assertion that pre-clinical testing regimes are also unnecessary? Pre-clinical testing is NOT a commodity good. The assays need to be designed to accurately assess the individual enzyme or cell line and the class of molecules. That’s not freely interchangeable (and can be a trade secret.)

5. Drug formulation is NOT, as you assert, “cheap and well-understood mass production and engineering nowadays.” Having participated in the process, it is essentially an art more than a science. It isn’t well-understood: solid-phase chemistry and physics is a relatively new field. It certainly is not cheap (Your team consists of pharmacists and chemical engineers — can you think of a smaller and more expensive pool of experts?)

19 TJIT February 4, 2007 at 3:10 pm

Bhauth,

the idea is that governments then fund that by paying for successful development.

I have to assume your joking. Congressional spending has produced widespread abuse of earmarks, pork boondoggles, and nice little items like political actions forcing the pentagon to buy things they don’t want or need because of political pressure.

A reasonable person would look at that and reach the conclusion that inevitably drug research would be funded based on what congressional district the developing company was located in. The second alternative would be the program would not be funded at all because it was more beneficial politically to spend money on something like ethanol subsidies.

Sure they figure out how to make the drug, but generic companies have managed to do that very fast and cheap compared to the cost of development.

Well no s**t Sherlock, generic companies have the published data on the drug, they have the results from the clinical trials and they have the drug itself to reverse engineer. None of that was available when the drug was first developed.

Here is the flowchart for your glorius ideas in drug development

1.Researcher finds an potentially useful target for a drug
2.
3.Brand new wonder drug hits the market

Drug development is a life and death matter, you appear to be operating under the sadly mistaken belief that Harry Reid and Trent Lott would be better at it then Pfizer or Merck are.

20 TJIT February 4, 2007 at 3:13 pm

Bjask,

I said oftentimes a request for proposals is given and bids accepted.

There is a world of difference between weapons systems procurement and drug development. The pentagon and the bidding company can agree on a price and delivery date. That does not mean that will be the final price and delivery date will be what was agreed to or that the weapons system will even be delivered.

I’m sure you have heard the term cost overrun and delayed delivery. Take a look at the C-17, the crusader artillery project, the Osprey tilt rotor aircraft, etc for good examples of this. The idea that emulating the pentagon procurement system will improve drug development is laughable.

21 Derek Lowe February 5, 2007 at 10:05 am

Klug’s comments have done all the work for me here. I do drug discovery for a living, and bhauth, in large part I’m afraid that you do not know what you are talking about.

22 Brian February 6, 2007 at 9:45 am

“walmart is lowering the price on generic drugs that are off patent. Not that relevant to the drug development discussion we are having.”

Ah, okay.

23 bhauth February 7, 2007 at 9:17 am

Well, it looks like this discussion would take much longer to resolve than this post falling to the archives will.

My view is this: Large pharmaceutical companies develop drugs by throwing large amounts of money at problems. Some problems cannot be solved by throwing large amounts of money at them – these fall under the category of development of new and useful drugs. The result is that a lot of the good pharmaceutical research big pharma comes out with, they buy from somewhere else. Some problems can be solved to a large extent by throwing money at them. These include clinical trials, marketing, and to a fair extent manufacturing. So, the first kind of problem, big pharma is not good at solving, and the second kind of problem, big pharma is earning more money than it should.

As far as generics and manufacturing processes go, let me put it this way. Generics companies have consistently been able to outcompete big pharma on price of production. This holds when they, due to the patent structures, come up with completely new methods of manufacturing drugs. This happens fairly often. Since they are unable to use the most obvious methods of production, while big pharma can, and they are still able to make these drugs at a lower cost and make a profit even though big pharma has already bought the relevant equipment for a given drug, they must be better at manufacturing.

I think we both agree that the research and development is done inefficiently by large pharmaceutical companies, though to different degrees. If an international prize fund is established like I described, and the governments can pull out and lose the right to drugs from this after 10 years or something, and the money is kept in competitive investments, and accurate values for the development of drugs are used by the economists determining prize values, and people must sign away patent rights when starting research to receive prizes, then if big pharma is good, it will outcompete the prize system, and if it is not, then drugs will be developed more efficiently. Yes? So, the risk is small and, in my opinion, the possible gains in efficiency are large. That is a point I don’t want to get lost in out argument about just how good or bad the pharmaceutical industry is.

24 spencer February 14, 2007 at 11:38 am

TJIT — interesting paper — I need to look at it a little more.

But nothing in the paper negates the analysis that during the period of price controls / windfall profits tax in the 1970s that the oil companies were spending every cent they could beg, borrow or steal on exploration. The only constraint on oil exploration was the ability of the oil service firms to expand capacity.

I also want to look at the cited econometric study that found that price controls restricted oil exploration. I will find it interesting to find how the paper handled the issue of oil exploration capacity.

25 Bush June 2, 2007 at 6:09 am

Lucky to find you, keep on the good workk guys! Best of luck./

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28 Lily May 30, 2008 at 2:58 pm

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29 Sherry August 21, 2008 at 8:40 pm

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Google these things and you will learn how to truly heal and regain good health. The problem with our health care system, put in place by the Rockefellers through their seats on the board of the AMA, is that natural products and proceedures that don’t require pharmaceutical products aren’t allowed. If the pharmaceutical industry suffers from price drops, that would be OK with me.

30 Anonymous October 25, 2008 at 5:04 am
31 likaida March 18, 2009 at 6:42 am
32 likaida March 18, 2009 at 6:43 am
33 likaida March 18, 2009 at 6:54 am
34 likaida March 18, 2009 at 6:56 am

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