NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

The Effect of Price Controls on Pharmaceutical Research

"...cutting prices by 40 to 50 percent in the United States will lead to between 30 and 60 percent fewer R and D projects being undertaken in the early stage of developing a new drug. Relatively modest price changes, such as 5 or 10 percent, are estimated to have relatively little impact on the incentives for product development - perhaps a negative 5 percent."

One of the main concerns of both business and Washington policymakers in recent years has been soaring health care costs. This was an issue behind the passage of the Medicare Modernization Act in 2003 and during the more recent debate on legislation dealing with the re-importation of drugs, from Canada or elsewhere. "It seems likely, therefore, that pharmaceutical price controls are just around the corner," Thomas Abbott and John Vernon write in The Cost of U. S. Pharmaceutical Price Reductions: A Financial Simulation Model of R&D Decisions (NBER Working Paper No. 11114). "Indeed, the U.S. pharmaceutical market is currently the only market in the world where drug prices remain largely unregulated. In every other major market, governments regulate drug prices either directly or indirectly."

Some critics of the drug companies assume that patent protection and the freedom to price drugs in the United States at market prices, along with an ability to exploit inefficiencies in the existing insurance system, actually encourages pharmaceutical firms to exploit consumers with high costs. However, numerous economic studies indicate that price controls, by cutting the return that pharmaceutical companies receive on the sale of their drugs, also would reduce the number of new drugs being brought to the market. So, a short-run benefit for consumers could lead to a long-run negative impact on social welfare. And, this damage wouldn't be fully felt for several decades because it takes so long to develop new drugs.

Abbott and Vernon apply a new technique to studying this question about research and development (R and D). They maintain that their approach is more closely aligned with the actual structure of R and D investment decisions by firms. They take account of the uncertainty around R and D research costs, the success rates for drug developments, and the financial returns to those products that are successfully launched onto the market.

Their basic finding is that cutting prices by 40 to 50 percent in the United States will lead to between 30 and 60 percent fewer R and D projects being undertaken in the early stage of developing a new drug. Relatively modest price changes, such as 5 or 10 percent, are estimated to have relatively little impact on the incentives for product development - perhaps a negative 5 percent.

For the pharmaceutical industry, one economic problem is that only 3 out of every 10 of their products generate after-tax returns (measured in present value terms) in excess of average, after-tax R and D costs. The scientific process is heavily regulated, and involves significant technical risk. Only one in several thousand compounds investigated ever makes it through the full development process to gain approval of the Food and Drug Administration. The vast majority of R and D projects fail for reasons related to safety, efficacy, or commercial viability, the authors note. For compounds that do gain FDA approval and are taken to market, the entire process from discovery to launch takes on average about 15 years.

Further, it's estimated that the pre-tax cost of a new drug runs around $802 million. The after-tax cost of an average drug is about $480 million, assuming the company has sufficient revenues to take advantage of the tax benefits or can somehow sell the tax benefits to another firm. The average net revenues for a new drug amount to about $525 million in present value. Thus at the time of a product launch, the drug company can foresee a potential average profit or economic value for their pharmaceutical R and D of about $45 million.

With this economic scene as background, a company must make a financial decision about whether to take an R and D project into clinical development. This step is called the Phase 1 Go/No-Go decision. Only one out of five projects that are given the "Go" signal into clinical development actually reach the market as a product. Factoring in this uncertainty, the authors write, is essential to understanding the behavior of the industry. This uncertainty factor may explain what critics say is a tendency of the pharmaceutical industry to focus on only minor innovations (me-too products) because of their greater probability of success, at the expense of conducting more revolutionary research that carries a higher risk of failure but also may yield greater health improvements

-- David R. Francis


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