Market Factors Are Best Regulator of Drug Prices

Published March 1, 2007

A timely question, given the new Medicare drug benefit launched last year, is how increasing insurance coverage is likely to affect innovation in the pharmaceutical industry.

We believe the answer is not as straightforward as one might expect, and depends on whether the insurance is privately or publicly produced and funded.

Insurance’s natural risk-sharing features generate additional demand for expensive breakthrough products. Clearly, more people can afford premiums for insurance covering expensive drugs than can afford their full out-of-pocket cost. Therefore, insurance coverage stimulates the demand for the latest and newest pharmaceuticals.

A more relevant question is whether switching from private to public insurance will affect the level of pharmaceutical research and development (R&D) and the provision of new medicines.

The new public Medicare drug coverage likely has two offsetting effects: First, more Americans over age 65 who could not afford private insurance premiums can afford publicly subsidized Medicare premiums. Second, many who previously bought private insurance, or received it as a benefit from their current or former employer, now are covered by public insurance.

Falling Expenditures

A 2002 study shows the percentage of outpatient drug expenditures paid out-of-pocket fell from about 70 percent in 1980 to 60 percent in 1990 and 33 percent in 1999, as pharmaceutical insurance coverage grew nationwide. During this period, many employers started offering their employees private drug-insurance benefits.

Spending on outpatient drugs was growing at an annual pace of 1 percent in 1980, but accelerated to 8 percent by 1990 and 17 percent by 1999. For comparison, total health care spending was increasing 6 percent annually in 1980, remained at 6 percent in 1990, and slowed to 3 percent by 1999.

The increase in drug spending outstripped the general increase in health care spending. The authors of the 2002 study estimate at least 25 percent of the pharmaceutical spending growth was due to increased insurance coverage.

Using data from this period, we found that pharmaceutical firms increased their R&D spending as sales and cash flows increased. Since new medicines follow about 15 years after discovery, it is difficult to link the increase in insurance coverage to specific new medicines that would otherwise not have been developed. Nevertheless, we believe the effect is likely to be substantial.

Switching to Public Insurance

In light of this research, what effects can we expect from switching from private to public insurance? The switch is mostly for individuals age 65 and older, but this age group also consumes the most pharmaceuticals. We suspect the short-run effects will be modestly positive at best.

The positive effect of more individuals covered by insurance could be partly or completely offset by the negative effects of less-generous coverage for those who were previously covered by employers.

But the long-run impact could be large, and negative, if public coverage leads to future direct or indirect pharmaceutical price controls.

European Decline

Consider the effects observed in Europe, where drug insurance is mostly publicly funded. As total pharmaceutical expenditures have increased and government budgets have been squeezed, European countries have adopted tighter price controls. The stated regulatory goal of most European countries is to keep pharmaceutical price inflation at the same level as average consumer price inflation.

However, a 2005 study shows constrained pricing and sales lead to lower R&D spending.

Preliminary results from our 2006 study comparing Europe with the United States from 1986 to 2004 show that European pharmaceutical price inflation has never exceeded that of average consumer prices by more than several percentage points. Cumulative real pharmaceutical prices over the period have actually declined slightly.

Conversely, U.S. pharmaceutical prices have increased annually between 2 and 3 percent faster than average consumer prices during the period. Consequently, real pharmaceutical R&D spending in the United States has grown about twice as fast as in Europe.

European pharmaceutical R&D spending substantially exceeded U.S. spending in 1986, but by 2004 it fell substantially behind.

No Vicious Cycle

We estimate that if European R&D spending had grown at the same rate as that in the United States from 1986 to 2004, Europe would have produced about 100 more new medicines and employed about 4,000 more research scientists than it did.

But are U.S. pharmaceutical prices and R&D at optimal levels, at least compared to European levels? Some suggest private U.S. pharmaceutical insurance causes individuals to overspend on drugs because they make small co-payments and don’t see the full cost of prescriptions.

Firms might then over-invest in R&D to discover new, high-priced breakthroughs. Individuals do not weigh the additional benefits of high-priced drugs against the additional costs of somewhat less effective, but much cheaper, generics.

Without the government to regulate prices, the argument goes, insurance leads to a vicious cost-inflation cycle as too much demand for high-cost drugs increases spending, which encourages more investment in R&D, which leads to more new, high-priced drugs, and so on.

Market Solution

An effective market-based solution to this problem would likely involve significant increases in insurance deductibles and co-payments. Indeed, many private policies are adopting them. Medicare insurance has them, but they are relatively small, so the insurance program must still rely on government subsidy.

We believe private U.S. insurance probably has not led to too much R&D spending. Most major pharmaceutical firms sell in both the United States and Europe. Consequently, public insurance in Europe discourages R&D, while private insurance in the United States encourages it.

We find that pharmaceutical firms selling proportionately more in Europe spend relatively less on R&D and that firms selling proportionately more in the United States spend relatively more on R&D. On balance, the realized aggregate level of pharmaceutical R&D may be close to optimal, although there is no way to be sure.

Our best guess is that global R&D spending is too low because U.S. pharmaceutical prices are restrained by political, if not regulatory forces.

Our work clearly shows U.S. pharmaceutical prices were constrained for years when the Clinton administration proposed price controls as part of its Health Security Act. Many firms voluntarily constrained their prices starting in 1992. We observe weaker but similar price moderations around presidential elections.

Proper Pricing

Some have suggested that R&D spent to develop very similar or “me too” drugs is wasted, a sign that pharmaceutical firms spend too much on R&D. On the contrary, we believe this is an effective, market-based method of price control. Price competition for market share within a drug class helps ensure proper pricing.

Overall, we believe market share competition on the supply side, and properly structured private insurance on the demand side, are the best means of establishing the optimal level of pharmaceutical pricing and R&D–not public insurance and government-enforced price regulations.

Joseph Golec ([email protected]) is an associate professor and John Vernon ([email protected]) is an assistant professor at the University of Connecticut School of Business Finance Department. This article originally appeared in the November 2006 issue of The Fraser Forum and is reprinted with permission.