Prices, Profits and Prescriptions:
The Pharmatech Industry in the New Economy
December 2001
Given the widespread apprehension over anthrax and other potentially deadly biological acts of terrorism, America's pharmaceutical industry is more important to preserving our health than ever before. Effective treatments like Cipro (ciprofloxacin) and doxycycline require years and millions of dollars to develop. Without an active and inventive prescription drug industry we would not have the drugs we need when we need them. Developing any new idea takes risk, enterprise and investment.
Today there is genuine concern that increased government controls will smother the bold innovation that makes new drug treatments possible. For that reason it is all the more worrisome that some policymakers in our state are calling for price controls, heavier regulation and, in some cases, a take-over of the pharmaceutical industry as part of a state-run single-payer system.
Nationally, there are proposals to take the intellectual property of pharmaceutical companies by arbitrarily ending their patent protections. Any effort by the government to willfully appropriate private property is a matter of the gravest concern for all citizens. Patent infringement, whether by a rival company or by the government, is theft. Not only is such a move wrong on its face, it is the surest way to end the development of new treatments for currently incurable diseases like AIDS, cancer and Alzheimer's.
Washington's medical technology and pharmaceutical industry
Much is at stake for Washington in this policy debate. Our state is one of the fastest-growing centers of medical research in the world. Biotechnology and medical technology in Washington comprise almost 170 companies employing nearly 16,000 people. Since 1980 the industry has attracted more than $17 billion in federal research and health sciences training money to the state. Last year alone, private firms headquartered here invested more than $476 million in research and development of new medical products and technologies. Washington companies such as Immunex and Cell Therapeutics invest hundreds of millions of dollars in search of treatments for painful afflictions like arthritis and leukemia.
The pharmaceutical industry itself would be most heavily impacted by any adverse action by the state government. A $896 million industry in 1998, drug-making companies provide some 2,950 jobs in Washington, while suppliers and distributors contribute another 34,000 jobs. In addition to economic benefits, the industry annually pays more than $149.5 million in taxes to state and local coffers.
Price controls and heavy regulation would stifle the industry and make the problem of drug availability, and the general economy, worse. As we have seen with the aerospace industry, biotech and pharmaceutical activities could easily shift to other states. Even if current activities are not shifted, policymakers risk causing the industry to stagnate, as future medical research and distribution activities migrate to other parts of the country.
A failed attempt at price controls
One attempt at imposing price controls on prescription drugs has already failed. Last year Governor Gary Locke created by executive order the AWARDS program (A Washington Alliance to Reduce prescription-Drug Spending). The plan required the state's benefits manager to negotiate discounts with drug manufacturers. If patients ordered the same drugs through local drug stores, pharmacists were required to provide the discounted price, even though pharmacists had to absorb the cost themselves. The price control operated by requiring local pharmacists to accept state-imposed prices that had been negotiated between other parties.
In May, Superior Court Judge Richard Strophy ruled the program illegal, saying the state did not have the authority to force local pharmacists to offer their products at the discounted price. Some independent pharmacists had expressed concern that the program would put them out of business. Policymakers are often tempted to provide a popular benefit while shifting the cost to a few private citizens - it is always easy to be generous with other people's money - but such an approach is shortsighted because over the long term price controls never work.
Why price controls never work
From the days of ancient kings to Richard Nixon's "Whip Inflation Now" initiative, political leaders have tried to use price controls to make popular products more widely available at the expense of producers. But the law of supply and demand is not so easily repealed. Artificially capping the price of a commodity only causes demand to soar while inducing supply to dry up. The inevitable results are shortages and rationing.
Should Washington policy makers impose price controls on prescription drugs, they would be encouraging a number of harmful effects. Price controls tend to:
Health care is already one of the most heavily regulated sector of the state economy. Yet when regulations fail to deliver promised results, the market is blamed. This misleading analysis is then used to argue for more regulation and control, to address the failures caused by past regulations.
Myth: price controls are justified because they are an "essential of life"
While some would accept that price controls have a harmful economic impact for most products, they would argue that controls on prescription drugs are justified because medicines are an "essential of life." This claim is false on two counts.
First, the realities of the economy make no distinction between products deemed "essentials of life" and other products. The harmful impact of price controls on both is the same. Prescription drugs are no different in kind than any other product in our economy, and the supply and price are determined by the same forces. In fact, the more essential a product is to meeting basic human needs, the more urgent it is not to impose controls on it.
Second, the "essentials of life" argument overlooks the even more fundamental needs of life that are adequately provided through vigorous competition in the free market. Food, clothing and housing are immediate human needs. For the vast majority of citizens these needs are met through a vibrant system of private buying and selling, with the government's role limited to protecting public safety and assisting the needy. Daily experience shows that when the market is free to operate under minimal government oversight, the result is abundance, quality service and low price.
An in-depth look at the prescription drug market is especially relevant now
Merrill Matthews' study is especially relevant now that Washington has joined with six other states to create a drug purchasing pool to press for lower prices. A nationally recognized health care policy expert, Dr. Matthews builds on his in-depth knowledge of how the market for medicine works. He addresses why some drugs are expensive while others are not, reviews the growth of research and development costs in the U.S. pharmaceutical industry, and examines the level of drug company profits in relation to other major industries. He also explores how the benefits of competition can be increased through reduced regulation.
Policymakers will find this study to be a valuable guide in considering ways to make health care more accessible while preserving innovation and availability. Citizens will find it useful in learning about practical ways to reform our health care system without turning to price controls and increased regulation. As important medical innovations continue to emerge in our state, it is vital for Washington residents to be informed about effective prescription drug policies that will help patients and doctors who treat them, now and in the future.
There have been many complaints about prescription drug prices lately; critics seem to think they are too high, and point to drug company profits as proof. But would imposing price controls on drugs be good policy for the public, states and the nation? Would such policies reduce or eliminate drug manufacturers' research and development efforts? Are there deadly or debilitating diseases that won't be treated or cured if price controls are implemented? How many people would die for lack of a new drug that might have been developed had price controls never been adopted?
While price-control advocates are good at recognizing the high cost of a drug, they never take time to count the high cost of not having it. A government decision to make prescription drugs more "affordable" by imposing price controls would mean less money available for research and development. Money will be saved, but lives will be lost.
Some drugs are very expensive, others aren't. What's the difference? Research and development. As Figure 1 shows, pharmaceutical companies will spend about $22.4 billion in 2000 developing and testing new drugs, as compared to about $4 billion for all other countries combined.
Not all drugs are expensive; most over-the-counter drugs are very affordable, which highlights an important distinction. There are really two pharmaceutical industries: one that mass produces aspirin, cold medicines, ointments and other over-the-counter (OTC) drugs and one that spends billions of dollars each year creating and developing new prescription drugs that relieve pain, cure disease and save lives. The OTC market fits nicely in an Old Economy model where there are some research costs, but competition is high and prices are low.
The other pharmaceutical industry - the "pharmatech" industry - is a New Economy industry, where initial costs to create and test a patentable item are very high, but once achieved the reproduction costs are usually minimal.
For a New Economy company, the primary barrier is the cost of developing the intellectual property, which may be patented in order to protect the monopoly.
In a speech delivered in May in San Francisco, former Treasury Secretary Lawrence Summers said that at the heart of this thing called the New Economy "must be the move from an economy based on the production of physical goods to an economy based on the production and application of knowledge" - or what he calls "knowledge goods." Thus, "An information-based world is one in which more of the goods that are produced will have the character of pharmaceuticals or books or records, in that they involve very large fixed costs and much smaller marginal costs." And that change bears significantly on the nature of economic incentives. According to Summers, in an information-based economy, "the only incentive to produce anything is possession of temporary monopoly power - because without that power the price will be bid down to the marginal cost, and the high initial fixed costs cannot be recouped."
It is true that most pharmaceutical companies are profitable - with profits averaging about 18 percent of revenue in 1999, according to Fortune magazine. Some critics cite those profits as evidence that drug companies are price gouging. The real issue is whether drug company profits are comparable with other New Economy, or even some Old Economy, companies.
Table 1 tracks profits as a percent of revenues for several companies over the past decade as compared to the average profit ranges of several pharmaceutical companies. According to the table:
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Coca-Cola frequently showed higher profits than the pharmatech industry average.
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And Microsoft had significantly higher profits, while Oracle was only slightly below the pharmatech average.
Moreover, as shown in Figure 2, a number of industries had average annual profits very close to the pharmaceutical industries.
So, while it is true that many prescription drug manufacturers are profitable, and several have been consistently profitable over the years, those profits are not out of line with other successful New Economy companies and industries, and even some Old Economy companies, that deal in intellectual property or other patentable or copyrighted products.
Which brings us to an important point: drug companies are not profitable because they charge so much for many prescriptions; they are profitable because they produce products that doctors and their patients want. However, while a company like Coca-Cola stays profitable by promoting the same product year after year, pharmaceutical and computer software companies make their money by continually releasing new or upgraded products.
As a result, while total spending on pharmaceuticals has been growing rapidly - averaging a 13.7 annual increase between 1995 and 1999 - most of that spending is due to increased volume of sales, not higher prices. For example, while prescription drug sales grew by 18.8 percent in 1999, 14.6 percentage points of that growth was due to increased volume and new products, while only 4.2 percentage points of the increase was due to higher prices (see Table 2).
Drug company profits have become a political issue as both Democrats and Republicans look for a way to provide seniors with a prescription drug benefit. However, it is not clear there is a problem.
Currently, 65 percent of seniors already have some type of coverage for prescription drugs. Of the 35 percent who do not have coverage, many of them are healthy and face relatively low expenses. Most have made a conscious decision - which may be reasonable given the fact that they are healthy - not to purchase drug coverage. In other words, just because 35 percent of seniors don't have supplemental coverage doesn't mean they have serious health care problems or high drug expenses.
The drug industry is already very competitive, with no drug company having more than 7.2 percent of the market. And changes in the health care system and patients' ability to access information are making the market even more competitive.
Take direct-to-consumer (DTC) advertising, for example. Congress has already adopted some policies that have enhanced competition among drug companies, which explains their heightened visibility. In just 10 years DTC advertising has increased from $55 million (1991) to an estimated $1.8 billion this year. However, most of that growth came after 1997, when the Food and Drug Administration (FDA) loosened some of the restrictions on DTC ads. For example:
And those ads have had an impact on consumer behavior. Prior to the change in guidelines, 41 percent of the physicians surveyed by IMS Health said they had observed an increase in patients' requests for brand name drugs. After the change, 65 percent of the physicians surveyed noticed an increase in brand-name requests.
While increased advertising expands information and enhances brand recognition, it doesn't necessarily increase competition. If there is only one product treating a specific illness or medical condition, the manufacturer can still make monopoly profits. Fortunately, many medical conditions are being treated with a growing number of products.
True, the prescription drug market doesn't work exactly like a normal market for three reasons:
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Nevertheless, the prescription drug market could be more competitive than it is now.
If Congress is concerned about drug company prices and profits, the proper response is to adopt policies that encourage competition, not restrict it as price controls would do.
Indeed, some steps in this direction have already been taken. For example, in 1991 the FDA published regulations intended to accelerate the review of drugs targeting -life-threatening illnesses. And the faster a drug can move through the process and hit the pharmacies, the more competitive the market will be.
In addition, 1997 legislation attempting to speed up the drug approval process and loosen restrictions for advertising has played a dramatic role in increasing advertising over radio and television. Consumers are increasingly becoming familiar with prescription drug products and what they do. That's important since a knowledgeable consumer and brand identification are necessary to a competitive market.
True, the pharmaceutical industry will likely never be as competitive as some industries. Several factors, such as patent protection and the price insulation for consumers, will necessarily limit the industry's ability to act like a real market. However, steps such as reforming Medical Savings Accounts that would reduce insulation from the cost of health care or eliminating the FDA's "efficacy" requirement would go a long way in making the industry more competitive. And with that competition would come more choice and lower costs. And if drugs are available and easily affordable, who cares how much money drug companies make?
Merrill Matthews Jr., Ph.D., is a visiting scholar with the Institute for Policy Innovation and an adjunct scholar with the Washington Policy Center. He is policy director of the American Conservative Network, a project of the American Conservative Union. He is a public policy analyst specializing in health care, Social Security, welfare and Internet issues, and is the author of numerous studies in health policy, as well as other public policy issues. He is past president of the Health Economics Roundtable for the National Association for Business Economics, the largest trade association of business economists, and a health policy advisor to the American Legislative Exchange Council, a bipartisan association of state legislators.
Since 1992, Dr. Matthews has served as the medical ethicist for the University of Texas Southwestern Medical Center's Institutional Review Board for Human Experimentation, and has contributed chapters to two recently published books: Physician Assisted Suicide: Expanding the Debate (Routledge, 1998) and The 21st Century Health Care Leader (Josey-Bass, 1998).