Governments are trying to remain competitive in an increasingly global economy. To do so, they must control their overall expenditures, including spending on health care and thus on pharmaceuticals. As a result, pharmaceutical price regulation has become endemic in virtually every country, and price controls are getting broader and tougher. This trend has significant implications not only for the future of the pharmaceutical industry and its spending on research and development, but on the health of patients worldwide.

The pharmaceutical industry, more than most other industries, is particularly vulnerable to regulation because research and development (R&D) is an unusually large component of its total costs. Pharmaceutical spending on R&D is approximately 13 to 20 percent of current sales. However, the R&D for drugs being sold today occurred 12 to 15 years ago. To appropriately calculate the percentage of the total costs of bringing those drugs to market, the time value of money must be included (that is, the interest foregone on that R&D spending between the time it is invested and the time the revenues come in). Once we take this opportunity cost of funds into account, R&D accounts for over 30 percent of total costs on a discounted present value basis.

It costs over US$400 million per new drug launched. Factored into this are the many failures for every success, and the opportunity cost of funds. More innovative drugs tend to cost more than more imitative ones because of longer delays, larger and longer clinical trials, and because of greater failure rates. If the expected return on R&D decreases, then there will be a shift toward the more imitative rather than innovative drugs.

Pharmaceutical R&D is a joint cost in the sense that one cannot easily attribute that cost to patients in any particular country. So, whereas one could say that the costs of distributing drugs in Canada are a marginal cost of serving Canadians, the costs of R&D are a global cost that once incurred serves all patients worldwide. This is good in that we all benefit from pharmaceutical R&D, but it is difficult in that there is the question of who pays for the joint costs. As well, there are usually one or two plants worldwide that supply a number of drugs to all countries. The capital of these plants is another global joint cost, and again the issue is how that cost is divided up among patients in different countries.

This is where we get into the problem of free-riding for pharmaceuticals. R&D costs are largely sunk by the time the drugs are launched; these costs have already been incurred. The costs that remain to be incurred by the time a product is brought to market—and the company negotiates the price with the regulators—is the marginal cost. These costs account for approximately 25 to 50 percent of the total cost, and can be attributed to specific countries. Each country's regulator would like to only pay the marginal cost of serving the patients in that country, and indeed a manufacturer will be willing to supply a product as long as the price covers marginal cost because the sunk costs are gone—the money is spent. However, if everyone pays only the marginal cost, then 30 to 50 percent of the costs will not be covered.

Differential pricing

How are we going to allocate this cost among different consumer groups? Social welfare, or the welfare of consumers, is maximized if prices to different consumer groups are based on price-sensitivity, with more price-sensitive groups being charged lower prices, and less price-sensitive groups being charged higher prices. If you charge the same price to everybody, the people who are most price-sensitive will cut back most on their consumption, and suffer the largest welfare loss. So, in order to get the maximum social welfare, it is best to permit differential pricing. This form of pricing is commonly used in other industries where there are important joint costs, such as airlines or utilities. Peak-load pricing is common, and business passengers pay a lot more than coach-class passengers on airlines.

Differential pricing is the way that pharmaceutical manufacturers have traditionally covered their joint costs. Even as recently as the 1980s, there were significant price differentials across world markets, with relatively high prices in the US, Germany, Japan, and Canada, and lower prices in France, New Zealand, and Australia, and, of course, the lower income countries of the world. This system worked reasonably well in funding R&D.

However, the system is breaking down because of two types of policies that are becoming more important internationally. The first is the use of regulation based on foreign price comparisons. This system is used in Canada, Italy, and informally in Japan. Regulators in a country set the price they will pay for a pharmaceutical based on the prices at which that product is sold in different countries. This system was proposed as part of the Health Security Act in the US health care reform debate of 1993. The US would have paid a price that was the lowest price paid for a drug among 22 countries, including countries such as New Zealand, whose prices are about 50 percent of the OECD average. The bill did not pass, but the idea is not dead. There are several bills in state legislatures in the US that would cap the prices in the US at the price in Canada. For example, Massachusetts has such a bill in its legislature. If this bill passes, Canadian prices will become the effective price cap in Massachusetts for Medicaid.

Parallel trade

The other policy adversely affecting prices for drugs globally is parallel trade: a drug put on the market in one country is shipped to another, usually by wholesalers or retail pharmacists, and sold at the higher price in that other country. So the same product may be shipped from Spain or Italy into the UK to take advantage of the price differential between these countries. There has been parallel trade in Europe since the Treaty of Rome, however it has become more common recently because the European Medicines Evaluation Agency (EMEA) permits a drug to go through one single registration process, one safety, efficacy, and labelling review. Once approved by the EMEA, the product can be put on the market in all of the European countries, with standardized labelling, dosage, etc. This greatly reduces the cost to the parallel wholesalers because they don't have to repackage and relabel the product.

In the North American free trade association there is not yet a problem of parallel trade. Drugs do not come up to the US from Mexico because, when NAFTA was created, traditional patent rights were preserved. A patent-holder in the US, for example, still has the right to pre-empt anyone from shipping that product from another country into the US, whereas when Europe set up the common market, patent rights within the EU were modified. You can still stop unauthorized imports from outside the EU, but if you put your product on the market anywhere in the EU, your patent rights are exhausted. So far, NAFTA does not have this problem, but it is a concern in any trade agreement.

In response to the globalization of markets, manufacturers are doing exactly what economic theory would predict. If a manufacturer cannot segment markets, the optimal pricing strategy is to charge a price that will give the highest revenue looking across all markets, and that means charging a single, relatively high price at launch. In most countries where drug prices are regulated, the manufacturer has significant control at launch because they can withhold a drug if the price is not adequate. Once the drug is on the market, however, the price is largely beyond their control. Manufacturers are now trying to launch drugs at either a single price, or within a very narrow band worldwide in order to eliminate the incentives for parallel trade or for regulation based on price comparisons.

The problem is that from the consumer's standpoint, having a uniform drug price is bad public policy. Uniform pricing for pharmaceuticals is inequitable and inefficient. If there is a single price worldwide, that price will be too high for some low-income countries. They will no longer have access to the most expensive new medicines, and will reduce their use, even though they may be able and willing to pay a price that would cover the marginal cost of the drugs. Low-income countries are clearly worse off. However, because uniform pricing reduces revenues to manufacturers, all consumers are worse off because there are less revenues available for R&D. Some drugs that would have had a positive net social benefit will not be developed, and this means a loss of well-being to patients in all countries.

The EU favours parallel trade on the principles that trade is good. Trade usually benefits consumers because it occurs when one country is more efficient or has lower costs of producing a product. However, in the case of pharmaceuticals, parallel trade is occurring not because particular countries are more efficient producers, but because their governments are more aggressive regulators. The trans-shipping occurs from countries with aggressive regulation to countries with less aggressive regulation. In this case, parallel trade does not benefit consumers. Thus, in the case of R&D-intensive products that have patents, such as drugs, there is not an economic case for free trade.

Regulation and innovation

Countries that have freer pricing for pharmaceuticals have companies that are more innovative. The countries that are clear leaders in innovation are the US and the UK (as defined by the number of new chemical entities they have produced that have become global products, and are recognized as being medically innovative). The US has free pricing except for the Medicaid program, and in the UK new drug pricing is relatively free from regulation, although there are some controls. A company's R&D is recognized as being a legitimate cost on which a return is permitted.

By contrast, Japan, which is usually considered a leader in innovation in high-tech industries, has produced many new compounds but very few truly innovative compounds, at least until recently. There is evidence that this is related to the Japanese system of price control, the effect of which is to give manufacturers a strong incentive to introduce a lot of minor innovations in order to get a new, higher price. In Japan, the interaction of regulation and competition lead to sharp post-launch price declines. If you want a new price, you introduce a new version of your drug. Japanese companies had not developed many innovative drugs until they became global companies and had access to other markets. France and Italy, which also have very strict price control systems, have lagged in terms of innovation in this industry, although they have performed well in other industries.

Reference price systems regulate reimbursement. The manufacturer can still, in theory, charge a higher price, and the consumer is free to pay it. But in practice, in countries like Germany, New Zealand, or the Netherlands, manufacturers generally drop their prices to the reference price, so the reference price becomes a cap. Reference pricing is fairly benign if confined to generic substitutes because then it only applies to products that are off-patent. However, when applied to therapeutic substitutes that include fairly broadly defined groups, there is no incentive for a manufacturer to develop an improved version of a product for an existing therapeutic group. It will simply be classified in with the existing product, and no additional price margin will be allowed, so you cannot recoup the returns on that investment. Companies will tend not to put drugs onto these markets for fear of what that lower price will do in other world markets. A company cannot afford to have that low price in a country like New Zealand because it may diffuse to other countries through the international comparison system of regulation.

Some of these same regulatory techniques are being used in managed care in the US. Managed care entities use formularies, which are similar to reference pricing. The formulary only pays the generic price for a particular molecule, or in some cases, therapeutic substitution. However, generic substitution exists in approximately 80 percent of health maintenance organizations (HMOs), while therapeutic substitution is less common. One reason is that competing plans have to satisfy doctors and patients, so a plan that has very aggressive therapeutic substitution may be unappealing to patients. Therefore, managed care plans are willing to pay for innovative drugs. Truly innovative drugs are on the formularies of most major managed care plans. Managed care appears to provide a system subject to more market constraints, and seems to be able, from the evidence so far, to preserve incentives for innovation.

Conclusion

Price control for pharmaceuticals and other forms of medical services is only appropriate when there is extensive insurance, because insurance protects patients from the cost of medical services, and protecting people from the cost tends to make them indifferent to cost. The consequence can be overuse of care and excessive prices, so insurance appropriately includes some sorts of controls or possibly co-payments. However, cost controls imposed by government become regulation, and this becomes particularly pernicious when it is done by a government that is the only player in town.

Governments control the manufacturer's price either directly or indirectly through such policies as reference pricing. However, price controls do not control total expenditures because total expenditures depend on price, volume, and on the mix of drugs. Consequently, countries committed to controlling expenditures have had to add other controls. For instance, Germany, after introducing reference pricing, introduced direct price controls, then a national limit on total expenditure for pharmaceuticals, with physicians responsible for any budget overruns.

One thing the pharmaceutical industry can do is try to use evidence-based medicine to show that pharmaceuticals, although sometimes relatively high-priced themselves, can reduce total health care costs because of savings in other areas such as hospitalization. The other important strategy is to try to get countries away from what is called silo-based budgeting, with one budget for drugs, one for hospitals, one for physicians; where the focus is just on the drug budget, with no thought about the efficient substitution between different services. Once you have cost control systems that look at value for money from the total mix of medical services, then there is a chance of showing that pharmaceuticals can be good value for money, and cost-effective for the system as a whole.

Footnotes

Patricia Danzon gave a more detailed version of this speech at "Patients First," a Fraser Institute conference on health care reform held in Toronto and Vancouver on November 3rd and 4th, 1997, respectively.  

This theory was developed in the 1920s by economist Frank Ramsay (and is hence called Ramsay pricing), to address the question, What is the best way of charging prices to different consumers when there is a joint cost?  

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Last Modified: Wednesday, October 20, 1999.