How Drug Price Controls Hurt Consumers

Published July 1, 2001

Maine is at the forefront of efforts to regulate the price of prescription drugs. Last spring, the Pine Tree State passed the Prescription Drug Price Reduction Act, which directs state officials to negotiate lower prescription drug prices with pharmaceutical companies or, if unsuccessful in that effort, to impose price controls on pharmaceuticals.

In October 2000, a federal judge put the law on hold until a constitutional challenge raised by pharmaceutical companies is resolved.

Not to be deterred by the judge’s injunction, Maine officials asked for and received from the Clinton administration a last-minute waiver that allows the state to expand eligibility for discounted prescription drugs under the Medicaid program. The waiver allows individuals with incomes up to 300 percent of the federal poverty level, who do not have prescription drug insurance and are not currently eligible for Medicaid, to buy prescription drugs at a 25 percent discount.

Because Medicaid requires the pharmaceutical companies to pay rebates, the waiver will extend the Medicaid price controls on prescription drugs to a much wider segment of the population. Further, Maine congressman Tom Allen recently introduced a bill in Congress to require pharmaceutical companies to sell prescription drugs at the average price the drugs sell for in six foreign countries.

The proponents of these regulatory measures argue they are necessary because prescription drug treatments can be expensive and many seniors, as well as other individuals living close to the poverty line, do not have insurance coverage for pharmaceutical drugs. Although the goal of providing seniors and low-income individuals with access to prescription drugs at an affordable cost is admirable, price controls are bad public policy that, in the long run, will increase the cost of prescription drugs to all citizens, including seniors and the poor.

The Essence of Price Controls

To understand why price controls are bad policy, it is important to carefully examine the cost structure of pharmaceutical companies and the pricing strategies they use to recover their costs.

The cost of discovering and developing a new prescription drug can run into the hundreds of millions of dollars. Despite these large expenditures on research and development, many new prescription drugs never make it into the marketplace, largely because of the enormously costly eight- to 10-year delays caused by the Food and Drug Administration’s review process.

Investments in research and development must be made before the drug reaches the market, so these costs become fixed once they have been incurred. By contrast, the actual cost of manufacturing and marketing a successful prescription drug is quite small.

Pharmaceutical companies will continue to invest large sums in discovering and developing new prescription drugs only if they expect to recover their fixed cost, as well as their production and marketing cost. This means the pharmaceutical companies must set prices significantly above the low cost of producing and marketing a unit of prescription drugs.

However, when the price is significantly higher than the cost of manufacturing a unit of prescription drugs, it becomes profitable for drug-makers to discriminate among customer groups, charging a lower price to some groups and a higher price to others. So long as the lower price generates additional sales and covers the cost of manufacturing a unit of drugs, it is profitable to sell to the new consumers at the lower price.

The fact that some consumer groups pay a lower price for the same prescription drug than others may seem unfair. However, the consumer groups that pay the higher price may actually benefit from the lower price charged to others. If the lower price to the favored group is greater than the cost of manufacturing the drug for them, the additional sales will generate extra revenues that can be used to cover some of the fixed research and development cost.

Most of the proposals to regulate prescription drug prices mandate that the pharmaceutical companies charge all consumers the same price. Unfortunately, these proposals are likely to harm all consumers, even the consumers they intend to help.

Negative Consequence of Artificial Pricing

If pharmaceutical companies are forced to charge a lower single price to all consumers, they may not be able to generate enough revenue to cover their fixed research and development costs, including the costs of creating the vast majority of drugs that fail in the research and development stage.

In this case, the pharmaceutical companies may continue to produce existing drugs if they can cover their production cost, but they will cut back on their investments in research and development. What company can invest hundreds of millions of dollars to develop a new path-breaking drug treatment when the government can force them to charge prices that do not recover all of their expected cost, including the cost of research and development for drugs that fail? Many of these lost drug treatments would have benefitted the elderly and the poor.

If prescription drug price regulations are not the answer, what should the government do? Targeted subsidies to low-income seniors and other low-income individuals would give them access to private prescription drug insurance plans, without skewing the economics of the prescription drug marketplace.

James W. Meehan Jr. is the Herbert E. Wadsworth Professor in the Department of Economics at Colby College in Waterville, Maine. Along with more than 500 economist colleagues, Meehan has signed an open letter organized by The Independent Institute opposing price controls in health care reforms.

For more information . . .

The Independent Institute’s open letter is available on the group’s Web site at