American Journal of Law & Medicine

The economics of pharmaceutical price regulation and importation: refocusing the debate.(Globalization of Pharmaceuticals: International Regulatory Issues)

I. INTRODUCTION

There is a great deal of misinformation surrounding the economics of pharmaceutical importation and price regulation. Among economists, the principles governing the relationships between prices, innovation, and pharmaceutical research and development (R&D) investment are incontrovertible. (1) Unfortunately, faulty, non-economic analyses abound on these fundamental relationships, (2) reinforcing economic illiteracy and leading to unfounded U.S. public policy.

Effective public policy debate requires that all parties to the debate be informed and aware of the potential costs and benefits associated with new policies, or changes in existing policies. This has not yet occurred for pharmaceutical importation and price regulation policy. Therefore, the purpose of this paper is to provide a positive (in contrast to a normative) economic analysis of pharmaceutical importation and price regulation.

This paper will not answer the question of whether or not regulated drug prices in the U.S. (achieved either through direct price controls or indirectly through importation) will, on net, improve social welfare. Nor will it draw conclusions about the social welfare effects of non-U.S. price regulation. Quantitative analyses of this nature are beyond the scope of the paper. Instead, the objectives of the paper are to dispel the flawed logic advocated by some non-economists, and to place the issues firmly within a rational, incontrovertible, economic framework. The reader is then free to make her own judgment with knowledge of the economic facts and realities surrounding public policy towards price regulation and importation.

This paper will proceed as follows. Section II will use standard economic tools and models to place the issues of price regulation and importation into context. Specifically, the links between prices, profits and R&D investment will be demonstrated. Economic logic will frame the issues and draw several irrefutable, qualitative conclusions. Prior to this, however, this paper provides a brief overview of the various forms of price regulation used around the world. Finally, to demonstrate the economic illiteracy surrounding these very important public policy issues, this paper will briefly discuss several examples of high-profile flawed economic logic. Overcoming bad "economic reasoning" is a critical first step to making sound public policy decisions in the U.S.

Section III will report and discuss several empirical estimates on the relationship between drug prices, profits and R&D investment. This section will also undertake multiple policy simulations designed to partially answer important questions surrounding the tradeoffs between drug prices, profits, and innovation. Having a quantitative approximation of these links may help inform future policy debates. Several caveats regarding both the empirical analyses and simulations will be emphasized. While quantitative and statistical measures are important considerations when debating policy issues, it is equally important that they be viewed with caution and only within the context of the sample studied and assumptions employed. This section will conclude by considering the "forced-sale" provision contained in a recent importation bill (the Dorgan bill) (3) and illustrate why it will be ineffective in achieving its objective. Section IV will conclude the paper.

II. PHARMACEUTICAL PRICE REGULATION, PROFITS, AND R&D INVESTMENT

A. A BRIEF OVERVIEW OF PHARMACEUTICAL PRICE REGULATION

The United States is the only major industrialized country in the world that does not currently regulate prescription drug prices. (4) In the United States, prescription drug prices are determined, for the most part, in a free market system. In direct contrast with this, practically every other country, either directly or indirectly, imposes one form of price controls on pharmaceuticals. (5) For example, France and Italy regulate pharmaceutical prices directly through price controls, Germany and Japan regulate drug prices indirectly, through limits on reimbursement under various social insurance schemes, and the United Kingdom employs profit controls to indirectly regulate prices. (6) Therefore, to set the stage for the forthcoming analyses in this paper, it will be instructive to briefly review the predominant pricing and cost containment methods utilized by these and other major non-U.S, governments. Because the empirical analyses will be based on data covering the 1994-1997 time period, we review the regulatory landscape that characterized the industry during this period. However, it should be noted that the regulatory environment with respect to pricing has not changed greatly. (7) Because the returns from pharmaceutical R&D come largely in the form of revenues generated by recently launched, patented new drugs, we focus on the price regulation of these newly-launched drugs.

To control public spending on newly introduced/launched pharmaceutical products, some governments opt to focus on the supply side of the market (the manufacturer and pharmacists), while others focus on the demand side of the market (the patient and the physician). (8) In regulating pharmaceutical pricing on the supply side, the most common methods include controls over individual product prices, reference pricing (which establishes a price based upon the price of the same or similar drugs in other countries), average pricing, constraints on wholesalers and pharmacists, and positive and negative product listings for reimbursement (which are lists of drugs that the government decides it will and will not pay for, respectively). (9)

Alternatively, for countries that emphasize the regulation of pharmaceuticals on the demand side, frequently used methods include government regulated patient co-payments, advice, guidelines and/or budgets for physicians, parallel imports, and even the transfer of products from prescription-only to over-the-counter (OTC) status. (10) However, no country relies on a single method, but rather a combination of different methods. (11)

Table 1 summarizes the different methods that major non-U.S. governments use to regulate the prices of newly launched prescription pharmaceuticals.

It should be noted that the countries listed in Table 1 accounted for roughly 70% of all non-U.S. pharmaceutical sales in 1998. (12) Hence, Table 1 provides a good profile of the industry's regulatory landscape (with respect to pricing) outside the U.S. market our sample period. (13)

Table 1 demonstrates the vastly different types of health care systems that exist in Europe and Japan. However, all of the countries listed in Table 1 (indeed, practically all ex-U.S. markets, including Asia, Australia, Canada, South America, etc.) do have one thing in common: one form of pharmaceutical price controls. Many countries strive to keep pharmaceutical prices from rising faster than average consumer goods prices. (14) This, as was stated earlier, is not the case with the U.S. health care system. (15) In the United States, the government does not regulate prescription drug prices. Of course, this may change soon. This fact is germane to the following sections of our paper and the development of a variable that will enable us to empirically estimate the impact pharmaceutical price controls have on firm R&D investment.

B. THE FIRM R&D INVESTMENT DECISION

Basic economic theory predicts that firms invest in capital up to the point where the expected marginal efficiency of investment in R&D (MER) is just equal to the firm's marginal cost of capital (MCC). (16) This equilibrium may be thought of in the classic way: as the intersection of a demand (for investment) and supply curve (investment funds). The firm's MER schedule is derived by arranging potential investment projects in a decreasing order with respect to each project's risk-adjusted expected rate of return. (17) This implies that firms will undertake the most profitable investment projects first--those offering the highest risk-adjusted expected rate of return--and continue to undertake additional investment projects so long as the expected rate of return from the next project exceeds the firm's marginal cost of capital. As has been argued in the recent literature, (18) this classic supply and demand framework for capital investment may be applied directly to investment in pharmaceutical R&D.

The firm's MCC equation reflects the cost of capital incurred through investing in R&D projects on the margin. (19) It reflects the opportunity cost of alternative investments for the firm. (20) In a neoclassical world, with perfect information and well functioning capital markets, the MCC schedule would simply be constant at the real market rate of interest. (21) This neoclassical assumption implies that the firm will consider the source of investment finance irrelevant. However, recent research has shown that the source of finance does matter, and cash flows, because they have a lower cost of capital relative to external debt and equity, exert a positive influence on firm investment spending. …

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