Economists have often found that attempts to centrally control markets lead to wildly suboptimal outcomes. Central planners have yet to discover an information revelation mechanism that can rival that of price in a free market. The world pharmaceutical industry is perhaps the most striking current test of this observation. Intrusive and aggressive price regulation by governments exists in almost every developed country other than the United States. The large difference in policies affords researchers the opportunity to investigate the impact of price controls on the evolution and organization of markets.
The pharmaceutical industry is an especially interesting test case for price controls because so much of the profit and improvements in social welfare associated with the industry depends on the success of risky research and development efforts. Recent examples of pharmaceutical innovation are impressive, with advances in medical oncology providing cancer patients with increased survival rates[1] and new cholesterol-lowering treatments providing encouraging outcomes for patients with heart disease.[2] While the science and research behind these innovations is complex, the mechanism by which they were developed is not random. In the context of pharmaceutical advancement, investment in research and development drives innovation.
Accordingly, one might expect that government intervention in pharmaceutical markets could have an unusually large impact on the pharmaceutical industry because of the extraordinary dynamism associated with rapid technological change. The evidence suggests that the different regulatory climates have led to massive changes in the world pharmaceutical industry. Conceptually, one could think of the U.S. as an island ecosystem that has survived the ravages of some global ecological disaster. Indeed Europe has lost the leadership it had just a few years ago. A recent Ernst and Young study reports that in the biotechnology sector alone, the U.S. employed 142,900 workers. The total in Europe was only 33,304. The total in Canada was 7,785, and the total in all of Asia only 9,764.[3] (Of course, total employment in the U.S. pharmaceutical sector industry is far larger than in the biotechnology sector alone.) Indeed, large foreign firms have begun locating their research activities in the U.S., with Novartis and GSK as two recent examples.
Across the Organisation for Economic Co-operation and Development (OECD) there exists a broad and highly diverse range of mechanisms employed by countries to control the cost of pharmaceuticals.[4] While the United States employs mostly market-oriented institutions to determine prices and value, other OECD governments tend to intervene more directly in the pharmaceutical industry to control costs. With state-run national health systems, these governments can effectively act like monopoly buyers (monopsonists) to reduce pharmaceutical prices to their national health budgets by implementing pharmaceutical price controls.
The most obvious net effect of price controls is to provide price-control country (hereinafter PCCs) patients with drugs at much lower prices than prevail in the U.S. A recent Australian government report found that prices in the U.S. are about double those in France and Australia.[5] Complementary findings were recently reported in a PPRS study, which found that prices for 60 drugs launched between 1995 and 2000 were often about 40 percent lower than prices that prevail in the U.S.[6]
Introducing a new drug has many regulatory costs. To the extent that cross-border trade leads to exports from low price countries, firms may also face a pecuniary cost to introducing a new drug in a PCC. Higher sales there may undercut revenues elsewhere.
From the trade perspective, it is important to note that a country may face protectionist pressures to avoid the significant adoption of a new drug as well. Many countries produce generic drugs domestically, and the emergence of a new patented drug could significantly undermine the profitability of a domestic generic manufacturer. Accordingly, one might expect that adoption patterns might vary significantly across countries, and be correlated with the pricing and trade policies of those countries. As discussed in Kessler (2004), there is a relatively large body of work documenting that this is this case. For example, Danzon, Wang, and Wang (2003) find that the expected profit in a specific country has a large and statistically significant effect on the diffusion of new drugs into a country. Kyle (2003) also found significant launch delays into price-controlled countries.
The U.S. market-based system both rewards innovation through market prices for brand innovation and promotes widespread use of unbranded generics (leading the OECD in the use of such drugs). The flip side of the slow adoption of new drugs in the non-US OECD is that PCCs provide larger rewards for treatments that are older and often off-patent. Since off-patent drugs can be produced by domestic generic manufacturers, there is a key trade aspect to health practice. The German generic market for example, considered the largest such market in Europe, is dominated by German generic manufacturers: Ratiopharm, Hexal, and Stada. The market prevalence of domestic manufacturers, however, is not limited to Germany, with this regime also seen in France, and, presumably, other countries not yet studied.[7] The data suggest that there is a very high correlation between pharmaceutical use and trade factors. For example, Silverstein, Brouwers, and Wolff (2004) found that the share of drug volume in PCCs that is attributed to branded generics, which compete partly by promoting brand image in contrast to competing strictly on the basis of price[8] (and which often have an inefficiently high price) is often above 50 percent. In Germany, it is about 65 percent. Thus, the government intervention affects not only the total outlays on pharmaceuticals, but also the mix. PCCs could save about 20 percent of total annual pharmaceutical spending if they simply reduced their reliance on branded generics to levels equal to those in the U.S. These savings could then be reallocated to provide greater access to newer, innovative, patented products rather than to domestic branded generic producers.
Given a desire to minimize social expenditures on drugs, it is nonetheless the case that expenditure should have an optimal mix given the constraint. It is a serious indictment of the trade practices of the PCCs that they rely so little on the best and newest therapies while inefficiently managing crucial health care dollars by encouraging the use of branded generics. Unless, of course, the case can be made that their practices do not sacrifice the health of their constituents. The literature, however, suggests the practice does affect the health of citizens of PCCs.
As far as the economics of drug development is concerned, the key observation is that foreign governments significantly reduce both the price and the volume of patented drug use. Accordingly, it follows that revenues from PCC's are significantly lower than would likely be achieved in a free market. The economics linking revenue to development is straightforward.
Economists and policymakers have long recognized that research and development activity suffers from a severe free-rider problem. If there are no enforceable property rights for a discovery, then there will be little incentive for firms to invest in the up-front costs. The patent system emerged for this reason, allowing those who make discoveries to exercise "monopoly" rights (or exclusive rights to a product) for those discoveries (but not for non-infringing discoveries that compete in the same market) for a specific amount of time. While there are many theoretical concerns about patent design, and a great deal of disagreement about the appropriate length of patents, econometric work has identified a number of positive and significant effects of patents on research activity and economic growth. In an exhaustive work exploring the 150 year history of patents, Lerner (2000) found that relatively wealthier countries are more likely to have patent systems, to give longer patents, and to enter into cooperative agreements with other countries to respect each other's patent rules. However, Lerner found significant variance across countries in the respect for each other's property rights. Notably, he found that many European countries have a long history of ignoring the rights of others. For example, "French family countries, while early to adopt patent protection, have consistently discriminated against foreign patentees."[9]
The foreign price controls for drugs appear to have had a dramatic effect on the structure of international industry and activity. First, lower revenues abroad have significantly eroded the resources available to U.S. firms for R & D investment. As Scherer (2000) has documented, and as is illustrated by 
Figure 1, taken from Silverstein, Brouwers, and Wolff (2004), pharmaceutical firms have historically poured a significant fraction of their free cash flow back into research and development activity. Numerous studies have found a significant link between profitability and research and development activity.[10] There is also a significant link between R&D expenditures and new discoveries, with the seminal work in the area being Jenson (1987), who documented a positive link between R&D and the discovery of new compounds.
These studies collectively confirm ample research into the behavior of firms more generally. For example, Hassett and Hubbard (2002) review the literature on the determinants of business fixed investment and find that there is consistent evidence that firm investment responds, as economic theory suggests it should, to key marginal cost and profit variables.
Accordingly, the free riding of foreign nations likely carries significant external costs. Research is diminished, and the discovery of new treatments is slowed, harming the U.S. economy and consumers. Silverstein, Brouwers, and Wolff (2004) attempt to assess the net impact of foreign price controls on the number of compounds available in the market place, utilizing the literature that links free cash flow to future investment, and investment to future discoveries. They concluded that revenues would increase by 35-45 percent if PCC's removed their price controls, and that R&D expenditure would rise by $17 to 22 billion. This extra research would, they estimate, lead to between 10 and 13 new compounds a year. This analysis is conservative compared to that of Acemoglu and Linn (2003) who predicted enormous responsiveness of drug development to revenue changes. They found that a 1 percent increase in the potential market size for a drug category would lead to a 4 to 6 percent increase in the number of new drugs in that category. While their study was concerned more with the location of research across different sized patient pools, a simple application of their results suggests that a 35-45 percent increase in revenues might lead to more than a doubling of the number of new compounds available. In light of the value of new medicines as discussed above and in greater detail later in the paper, the negative consequences for the U.S. of OECD price controls that suppress R&D investment are evident.
The positive health effects of new and innovative pharmaceuticals on the population at large have been well documented. A number of recent studies have found that increases in the overall stock of pharmaceuticals and the development of newer, more innovative medications have reduced morbidity, the number of hospital stays, and have increased longevity. Moreover, these improved health outcomes translate into significant economic benefits realized through decreased hospital stays, fewer workdays missed, and lives saved.
Gains made by pharmaceuticals against heart disease and cancer are compelling, but the scale of these conditions is such that every marginal advance can have a dramatic effect. Murphy and Topel (2003) cite that a 10 percent permanent reduction in death rates for heart disease would yield $5.1 trillion in prospective gains and the same reduction in death rates for cancers would yield $4.4 trillion in prospective gains. Clearly, the cost of pharmaceutical development and innovation is vastly outweighed by benefits that are objectively health related, in terms of lives saved or improved, and by the economic gains realized by such advancements.
Given these results, then, it is evident that the differences in drug use between the U.S. and PCCs cannot be explained by assuming that the U.S. uses too many patented drugs. The positive impact of the new drugs used has been extensively documented. Indeed, in the instance of statins, Lewin Group (2000) estimates that significant gains could be achieved in the U.S. if all relevant patients received recommended treatments.
Addressing these widespread patterns of underuse of needed, effective medicines can lead to better health outcomes and lower health care costs.
Similarly, other studies[11] demonstrate that lower use of needed medicines can increase consumption of other health care services and increase other health care cost. Figure 2, for example, documents that while the U.S. use of statins is more than double that in the average PCC, the U.S. only successfully provides statins to 56 percent of the eligible patient population.[12] Italy, in contrast, provides statins to only 17 percent of the relevant patient population. Given the link between statins and heart disease, this practice difference is likely to produce striking differences in outcomes. As can be seen in the second panel of Figure 2, the total number of preventable deaths that will occur because of too little statin use is quite high. For example, the United States would experience 19,000 fewer deaths if everyone were optimally treated, compared with 26,000 preventable deaths in Italy, over 5 years.
The literature, therefore, suggests a number of conclusions:
- Price controls significantly reduce revenue for patented products.
- Lower revenue generally results in lower R&D investment, delaying the introduction of new drugs.
- Patents provide essential protections to costly research and development initiatives.
- Lack of access to new drugs likely has significant negative health effects in PCC countries.
- Lower R&D reduces the rate at which new compounds are discovered.
- Price controls often appear to be part of a protectionist strategy by PCC countries.
- Price controls appear have contributed to an economic environment in PCC countries that has undermined pharmaceutical research to a startling degree.
Moreover, disregard for the patent rights of U.S. firms appears to be part of a more general historical pattern. European countries have often been highly parochial in their devotion to intellectual property, to the detriment of consumer welfare.
In the past, the U.S. market has been large enough relative to the rest of the world that it has been able to support research despite these intrusions. The evidence reviewed here suggests that there could be devastating effects should our policy environment change.
Appendix
References
Acemoglu, Daron, and Joshua Linn, "Market Size in Innovation: Theory and Evidence from the Pharmaceutical Industry," NBER Working Paper 10038(2003)
The Boston Consulting Group, "Ensuring Cost-Effective Access to Innovative Pharmaceuticals Do Market Interventions Work?" April 1999
Brouwers, Charles-André, Martin B. Silverstein, and Tory Wolff, "Adverse Consequences of OECD Government Interventions in Pharmaceutical Markets on the U.S. Economy and Consumer," The Boston Consulting Group Inc., July 2004
Danzon, Patricia M, and Michael F. Furukawa, "Prices and Availability of Pharmaceuticals: Evidence From Nine Countries," Health Affairs Web Exclusive. October 2003
Danzon, Patricia M., Y. Richard Wang, and Liang Wang, "The Impact of Price Regulation on the Launch Delay of New Drugs - Evidence from Twenty-five Major Markets in the 1990s," NBER Working Paper 9874 (2003).
Department of Health and the Association of the British Pharmaceutical Industry, "PPRS: The Study into the Extent of Competition in the Supply of Branded Medicines to the NHS," December 2002
Dor, Avi and William Encinosa. "Cost-Sharing and Non-Compliance with Prescription Drugs," NBER working paper, March 12, 2003.
Ernst and Young, "Beyond Borders: The Global Biotechnology Report 2003," July 2003
Gambardella, Alfonso, Science and Innovation: The US Pharmaceutical Industry During the 1980s, Cambridge University Press (1995).
Giaccotto, Carmelo, Rexford Santerre, and John Vernon, "Explaining Pharmaceutical R&D Growth Rates at the Industry Level: New Perspectives and Insights," AEIBrookings Joint Center for Regulatory Studies 03-31 (2003).
Hassett, Kevin A., and R. Glenn Hubbard "Tax Policy and Business Investment," Handbook of Public Economics Vol. III, Auerbach and Feldstein eds, Elsevier Science B.V., 2002.
Hassett, Kevin A., "Price Controls and the Evolution of Pharmaceutical Markets," mimeo July 2004; http://www.aei.org/publications/pubID.20971/pub_detail.asp
Heisler, et al. "The Health Effect of Restricting Prescription Medication Use Because of Cost," Medical Care, Volume 42, Number 7, July 2004.
IMS, "IMS Generic Focus 2003-2007," IMSworld Publications, June 2003
Jensen, Elizabeth J., "Research Expenditures and the Discovery of New Drugs," Journal of Industrial Economics 36 (1987): 83-95.
Kessler, Daniel P., "The Effects of Pharmaceutical Price Controls on the Cost and Quality of Medical Care: A Review of the Empirical Literature," June, 2004
Kyle, Margaret K., "Pharmaceutical Price Controls and Entry Strategies," Carnegie-Mellon University Working Paper (2003).
Lerner, Josh, "150 Years of Patent Protection," NBER Working Paper 7478 (2000)
Lewin Group, "Diffusion of Treatments Study: Statin Use for Hypercholesterolemia, Cross-Country Report," 2000
Lichtenberg, Frank R., "Public Policy and Innovation in the US Pharmaceutical Industry," in Doug Holtz-Eakin, ed., Entrepreneurship and Public Policy, MIT Press (2004c).
Murphy, Kevin M. and Robert H. Topel (editors), Measuring the Gains from Medical Research: An Economic Approach (Chicago, IL: The University of Chicago Press, 2003).
Productivity Commission, "International Pharmaceutical Price Differences" (July 2001). Productivity Commission Paper No. 1670. http://ssrn.com/abstract=277602.
Scherer, F.M., "The Link Between Gross Profitability And Pharmaceutical R&D Spending," Health Affairs 20 (2001): 216-20
Notes
1 For example, the U.S. Center for Disease Control recently reported a dramatic increase in cancer survivorship,(link: http://www.cdc.gov/cancer/survivorship/#science).
2 Lewin Group (2000)
3 Ernst and Young, "Beyond Borders: The Global Biotechnology Report 2003," July 2003
4 The primary source for this review is a 1999 Boston Consulting Group review.
5 Commission, Productivity, "International Pharmaceutical Price Differences" (July 2001). Productivity Commission Paper No. 1670. http://ssrn.com/abstract=277602.
6 Health, Department of and the Association of the British Pharmaceutical Industry, "PPRS: The Study into the Extent of Competition in the Supply of Branded Medicines to the NHS," December 2002
7 IMS, "IMS Generic Focus 2003-2007," IMSworld Publications, June 2003
8 Danzon, Patricia M, and Michael F. Furukawa, "Prices and Availability of Pharmaceuticals: Evidence From Nine Countries," Health Affairs Web Exclusive. October 2003
9 Lerner (2000), p. 2.
10 These include Gambardella (1995), Giacotta, Santerre, and Vernon (2003), Grabowski and Vernon (2000) and Lichtenberg (2004c).
11 For further studies see Dor and Encinosa (2003) and Heisler et al. (2004)
12 Lewin Group (2000)
Kevin A. Hassett is director of economic policy studies at the American Enterprise Institute. The above testimony draws heavily from Hassett (2004); see "References" above.
