The Pharmaceutical Industry: Problem or Solution?

Doug Bandow is a Senior Fellow at the Cato Institute and this month’s guest editor of The Freeman.

In his State of the Union speech President Bill Clinton warned that his entire economic program could fail if Congress did not approve serious health-care reform. Alas, his economic program could also fail if Congress approves the wrong sort of health-care reform. The result could be a simultaneous medical failure and fiscal disaster.

Unfortunately, the administration is moving in the wrong direction with a tax- and regulation-heavy reform proposal. One of the reasons that it is more likely to hurt than help is the fact that its proponents seem as interested in punishing supposed villains as in improving the lives of patients. Doctors and insurance companies have long been popular targets of populist wrath; so, too, have been pharmaceutical companies. For instance, during the 1992 presidential campaign President Clinton promised to “stop drug price gouging.” His wife’s task force had little more regard for the drugmakers, complaining of their “sins of the past,” including charging thousands of dollars a year for some drug therapies. Worried one industry lobbyist, “administration officials have made a political calculation that they need to go to war with us.”

Task-force members responded to analysts who spoke of market-oriented healthcare reforms by arguing that the marketplace would not limit prices “of single-source drugs for which there is no therapeutic equivalent,” as if the purpose of patents was something other than allowing inventors to earn a generous reward for their labors. But the President apparently shied away from formal price controls because of opposition from even liberal Democratic legislators. Still, his program would hit the industry with measures very much like price controls: Medicare would demand a 17 percent (up from 15 percent in the initial draft) rebate on prescribed drugs, the Secretary of Health and Human Services could further bargain down prices and refuse to allow the purchase of drugs deemed to be overpriced, an “Advisory Committee on Breakthrough Drugs” would collect confidential industry information and assess the “reasonableness” of drug prices, and the overall healthcare plan would press people into managed-care insurance plans that would limit access to pharmaceuticals.

Congressmen, too, have been pressing for controls over prescriptions and prices. For instance, Senator David Pryor (D-Ark.), chairman of the Special Committee on Aging and a close friend of President Clinton, has long used his committee to demand limits on pharmaceutical prices. He testified before the President’s Task Force on Health Care Reform, complaining that “manufacturers can essentially set the launch price, without the health care system having any idea of whether the price is ‘fair’ or even ‘reasonable’.” Yes, continued research and development is important, he acknowledged, but “that does not mean—as a matter of public policy—that the manufacturer should be able to charge whatever the market will bear.” Indeed, he argues, the companies will gain an unwarranted windfall from the Clinton program’s inclusion of pharmaceuticals, which, in his view, alone warrants regulating the industry.

Other Congressional critics of the drug industry include Representatives Sonny Montgomery (D-Miss.) and Pete Stark (D-Cal.), and Senators Byron Dorgan (D-N.D.) and Edward Kennedy (D-Mass.). For instance, Representative Montgomery has proposed limiting the prices of drugs purchased by Veterans hospitals. Representative Stark, supported by the American Association of Retired Persons, has suggested creating a U.S. equivalent of the Canadian Patented Medicine Prices Review Board to slow drug price increases. Senator Dorgan wants to cut pharmaceutical tax credits and create a Prescription Drug Policy Review Commission. Senator Kennedy hopes to force drugmakers to provide their products for lower prices to entities funded under the Public Health Service Act.

Even some doctors contend that pharmaceutical prices are too high. Columbia University’s Paul Meier, a consultant to the Food and Drug Administration, says that “There’s a limit to how much we should play the market.” As he explains, “If someone who finds a pill that would save babies from some dreadful fate says, ‘I’m charging an outrageous amount but it’s worth it,’ I would say that’s morally corrupt.” How to set a “fair” price? Dr. Peter Arno of New York City’ s Montefiore Medical Center proposes establishing prices based on those of comparable products or drugs in other nations.

In short, the average American could be forgiven for thinking that the drugmakers deserve to be damned. Yet all the attention being given to pharmaceuticals seems odd, given their relatively small role in the healthcare crisis. Prescription drugs account for roughly eight percent of total health-care expenditures, half that of three decades ago and far lower than in most European countries. The average consumer doesn’t know that, however, because the government covers a smaller share of drug costs in America, meaning that consumers pay more of the expense directly and therefore complain more vociferously to their elected officials. In fact, this goes a long way to explaining why President Clinton and many Congressmen are so busy attempting to develop well-publicized “solutions” to the nonproblems in this area.

A Successful Industry

Before the government “reforms” pharmaceuticals, it needs to recognize that drug-makers constitute one of America’s most successful economic industries: U.S. firms developed roughly half of the drugs marketed worldwide during the 1970s and 1980s. According to the General Accounting Office, pharmaceutical companies are only one of the 11 high-tech industries that it studied which did not lose ground internationally during the 1980s, but rather “maintained their strong position over the decade.” Between 1973 and 1986, American firms accounted for ten times as many drug patents as Germany and Japan, 16 times as many as Great Britain, and 20 times as many as France. Research and development spending has grown fifteen-fold from 1970, to more than $9 billion. R & D also rose significantly as a percentage of revenues during the 1980s—at a time when companies are being accused of price-gouging.

Moreover, while drugs may be expensive, the lack of drugs is also expensive. That is, drugs often replace higher-priced medical operations and treatments. Actigall dissolves gallstones, for instance, and thereby saves an estimated $2 billion annually precisely because 350,000 patients use it. Surgery for ulcers usually runs more than $25,000, while taking medication may run just $1,000 annually; the resulting savings totals at least $3 billion, even more including the economic gain of workers not incapacitated by surgery. Medicine for arthritis and osteoporosis permits some elderly patients to avoid institutionalization. Patients who spend $300 a year on drugs to treat angina can thereby avoid coronary bypass surgery running $40,000 or $50,000. The beta-blocker Timolol reduces the number of second heart attacks by 16 percent and saves about $2 billion every year. The Battelle Institute estimates that for just eight leading diseases between 1968 and 1989 drugs saved 671,000 lives and $83.8 billion.

Thus, a drug’s price tells us nothing about its value. Explains Dr. Herbert Gladen at the Baltimore VA Medical Center, “higher-priced drugs may actually be more cost-effective if they have greater efficacy, wider therapeutic range and are less costly to prepare and administer.” Indeed, because even expensive prescription drugs are so cost-effective, limitations on their use actually increase total medical expenses. A 1988 Louisiana State University study, for instance, warned that if Medicaid, the joint federal-state program for lower-income people, restricted drug coverage, overall costs were likely to rise between 4.1 and 15.5 percent. Just such an attempt by New Hampshire to limit the number of prescriptions for Medicaid recipients caused an upsurge in doctors’ visits, hospitalizations, and nursing home admissions. The legislature dropped the ill-considered regulations within a year.

Are Drug Prices too High?

Are drug prices nevertheless too high? Senator Pryor, for instance, complains that pharmaceutical prices rose far more swiftly than the general inflation rate during the 1980s. Drug prices are higher here than in other nations, he contends, and new drugs are extraordinarily expensive. “While these new drugs helped to reduce hospital stays, and in many cases avoided more costly medical interventions,” he acknowledges, “there was no indication that the prices for these drugs had any relationship to their costs of production and development, or were priced reasonably.”

However, one should always be skeptical of the partisan use of statistics, since, when tortured, they will confess to anything. Warns Robert Goldberg of the Gordon Public Policy Center, the Bureau of Labor Statistics has failed to incorporate such changes as the greater availability of generics into its figures, meaning that the reported drug-price index may be inflated by as much as 50 percent. In any case, for most of the 1960s and 1970s drug-price increases remained below the overall inflation rate, as well as the cost of medical care. As inflation waned in the 1980s drug prices followed the overall trends but fell less quickly.

Moreover, by the mid-1980s generic substitutes for brand-name drugs were entering the market more quickly as a result of legislation passed in 1984 speeding the FDA approval process. While this step reduced the cost of older medications, it had the opposite effect on new releases. Firms found the effective life span of their brand name products to be shorter, forcing them to focus more on the introduction of new products, which typically cost the most, and charge more when the drug was released in order to recoup development costs.

Moreover, the price hikes of the 1980s are not carrying over into the 1990s as competition has intensified. “The market for drugs has changed dramatically since 1981, particularly in the last three years,” reports Robert Goldberg. According to the Boston Consulting Group, industry-wide average discounts had quadrupled to 16 percent in 1992 over 1987. New drug prices in 1991 and 1992 were 14 percent lower than comparable products in the past. Some of the cuts were drasticre36 percent for new heart drugs, for instance. HMOs, hospitals, and drug mail-order firms were also gaining an increasing share of drug sales and simultaneously winning discounts of up to 30 percent from list prices. And the pressure for price-cutting will increase as larger number of drugs lose their patent protection. Observes Dr. Goldberg, “by 2000, 200 drugs with $22 billion in sales will be off patent.”

In any case, politicians today are likely to do no better than those who tried over the past several thousand years to set “reasonable” prices for any number of goods and services. Prices respond to supply and demand, not moral fervor. There is no objective standard by which Senator Pryor or anyone else can call one price reasonable and another unreasonable. Nor is there anything about the market that gives participants the power to “price-gouge.”

After all, the market is competitive—there are some 22 major drug firms, and no company has more than a 7.2 percent share. (The industry was even more fragmented in 1962, before more stringent federal regulatory standards, passed in the aftermath of thalidomide-induced birth defects, drove smaller companies out of business. The new FDA “regulations created pronounced economies of scale for drug innovation, which steadily increased over time,” reports author Terree Wasley.) The only way a firm can gain “monopoly” power is by developing a good product protected by a patent. Patents, however, are required to induce firms to spend money on research and development. After all, the average cost of developing a drug runs $359 million, according to the Office of Technology Assessment (OTA).

High Costs of Federal Approval

Much of this expense is due to the federal drug approval process. Companies must convince the FDA that prospective products are not only safe but effective; separate applications, which typically run 100,000 pages long, are required for different treatments by the same drug. Since 1962 both the total cost of bringing drugs to market, and the length of time devoted to testing and review, effectively cutting a product’s patent protection, have more than doubled. In 1984 Congress passed a measure extending drug patent lives, but that step only ameliorated, rather than solved, the problem.

The costs of a process that averages 12 years would be high enough for any industry. But, notes Michael Ward, staff economist at the Federal Trade Commission, “the very nature of the lengthy drug development process makes the pharmaceutical industry susceptible to harm from unnecessarily stringent regulations.”

Most importantly, the risks involved are enormous. Pharmaceutical companies find many more dry holes than gushers: 70 percent of new drugs that reach the market are estimated to lose money. Most never get beyond the research stage. There are typically 30,000 to 45,000 medical articles on drug therapies a year. Government patent grants for drugs usually range between 2,000 and 4,200 a year; companies list about half that number as investigational new drugs with the FDA. Another half fall out by Phase Three of the testing process and companies end up filing applications for barely 80 to 250. The FDA then approves between 20 and 60. Concludes Ward, “In all, firms will market about one out of a hundred of the products for which they have developed patents.”

Studies suggest that the 1962 amendments have had little impact on the introduction of ineffective drugs—companies don’t like duds because they don’t make money if their products don’t work—but have reduced the rate of introduction of new drugs by two-thirds and the speed with which they enter the market by one-half. The United States has also lost some of its edge over other industrialized states, which permit the sale of safe and effective drugs still prohibited by Washington. Because patients suffer when they receive no medicine as well as when they receive bad medicine, on net the tightened federal controls have made more Americans sicker and allowed others to die.

Even so, some critics argue that the drug companies are making too much money. A widely cited OTA study contended that “returns to the pharmaceutical industry as a whole over the 12-year period from 1976 to 1987 were higher by 2 to 3 percentage points per year than returns to nonpharmaceutical firms, after adjusting for differences in risk.” Average industry profits ranged between 13 and 14 percent during the 1980s.

This rate of return hardly seems unreasonable given the very high risks of both failure and regulation, which Robert Goldberg believes the OTA has underestimated. In any case, this level of return is probably not sustainable, given the increasing competition within the industry and cost consciousness of consumers. In particular, OTA’s future estimates overlook how dramatically generic products have been eroding brand-name drug prices over the last decade.

Moreover, Dr. Steve Wiggins, an economics professor at Texas A & M University, suggests that “a common misstep by industry critics is to rely on accounting data to measure industry returns” when such figures are “unreliable because accounting conventions require the expensing of research and development.” Wiggins contends that compared to the cost of capital, drug company returns look far from impressive. He compares the industry’s capital costs, which ran from 15.1 to 17.2 percent between 1980 to 1990, with an estimated return of between 13.5 and 16 percent, which, he says, indicates “competitive returns.”

Research and Development

It is also important to recognize that the industry’s profits were largely channeled into research. Last year the drugmakers spent more on R & D, $12.6 billion, than they earned in profit, $10 billion. Industry R & D grew by a 15 percent compound annual rate in the 1980s. As a percentage of sales industry, R & D approaches 17 percent, nearly twice that for the rest of the health-care industry and treble that for the electronics industry. Even the OTA acknowledged that its “findings on returns to pharmaceutical R & D and to the industry as a whole explain why R & D expenditures have risen so fast throughout the 1980s. Investors followed the promise of high returns on future innovations.” But ignored by the OTA is the fact that a lot of this money, as much as one-third, according to Dr. Goldberg, is going into biotechnology, which is riskier than traditional drug research.

What does all this money produce? The Boston Consulting Group points to a score of new drugs expected to be approved later this decade to combat AIDS, allergies, Alzheimer’s, asthma, arthritis, cancer, depression, diabetes, glaucoma, herpes, hypertension, obesity, strokes, and many more diseases. With these conditions costing untold lives and an estimated $400 billion a year, it seems foolish to begrudge the pharmaceutical industry a healthy return on its investment. Critics should be celebrating the industry’s success rather than carping about an allegedly “excessive” percentage or two of profits.

Unfortunately, new federal restrictions would simultaneously raise the industry’s cost of capital and reduce its rate of return, forcing firms both to cut R & D and distort their research efforts. Companies would skew their efforts to products that would more easily win regulators’ approval for price increases and also shift money to unregulated investments, such as marketing, that would involve less risk and a better return.

The form of price controls wouldn’t matter. All would hurt patients not by denying them access to current therapies, since those drugs are already on the market, but by discouraging new treatments from appearing. The cost to patients of losing new medicines could be staggering. Between 1975 and 1989 American firms developed half of the 66 top drugs introduced in the marketplace. French enterprises, in contrast, created just three. The most important difference between the two nations is government policy. Observes P.E. Barral, “In France, the calibre of pharmaceutical research is seen as having deteriorated, because severe price control has encouraged French companies to give priority to small therapeutic improvements which are useful in price negotiations. Such systems tend to stifle originality and induce risk aversion.” At the same time, drugs accounted for 16.7 percent of French health expenditures, twice America’s level. Moreover, per capita spending on drugs is almost three times as high in France.

Health-care reform should involve a search for answers, not villains. In the case of pharmaceuticals, the system is working: A highly competitive industry is leading the world in the discovery and marketing of new treatments and cures. Although drugmakers have an incentive to invest heavily in R & D, pharmaceuticals account for a lower proportion of total medical expenditures than in socialized systems, while at the same time helping to hold down overall medical expenses. If the administration and Congress nevertheless put ideology before prudence and tighten controls over the drug industry, they risk killing the golden goose that has provided so many benefits for so many patients.