Policy Options for the Drug Pricing Conundrum

What is it about?

Policy changes to reduce U.S. pharmaceutical prices have broad political support. They include expanded requirements for manufacturers to negotiate Medicare drug prices centrally with the Centers for Medicare and Medicaid Services (CMS), and states choosing to import pharmaceuticals from Canada at Canadian prices. Their rational is that high drug prices are reducing our ability to provide needed health care, particularly to the elder and lower income populations.The short run impacts of these policies would be to reduce health care costs, but since they also are likely to reduce pharmaceutical investment in R&D, they will have a longer term impact on new drug innovations. This longer-term loss may far outweigh the benefit of price reductions. Pharmaceutical innovation have decreased mortality by .46 years over the last decade and increased morbidity-free life years for the over 65 population markedly. A conservative estimate of the social benefits to the U.S. population of just these two contributions of pharmaceutical R&D is over 3.25 trillion dollars, while total R&D costs over the decade were about 900 million. That is the social benefit to cost ratio of pharmaceutical R&D has been extremely high. So though we would like to reduce the cost os supplying pharmaceutical products to the U.S. population, we would also like to maintain current levels of R&D investment. About 80% of the costs of pharmaceutical R&D are borne by private companies, so if we want to maintain the current sources and levels of pharmaceutical investment, we need to be careful to maintain private firm profit margins. The size of the U.S. market implies that policies that reduce U.S. prices will have large effects on global profit margins. Our analysis shows that, under conservative assumptions, if current price reduction policies were adopted the profit margins of the top fifteen pharmaceutical manufacturers would fall by at least 20%. This is large enough to cause a notable fall in research investment. We ask whether there is a mechanism we could use to decrease U.S. pharmaceutical prices while maintaining current levels of private firms’ incentives for research in pharmaceuticals. The benefits of pharmaceutical innovation do not have national boundaries: a cure for a particular type of cancer will benefit Europeans in the same way as it benefits U.S. citizens. Yet it has long been recognized that U.S. prescription pharmaceutical prices are higher than in other developed economies. We quantified just how different by asking: what would prices be in each of twenty one OECD countries with incomes above fifty thousand dollars per capita, if individual drug prices were harmonized across those countries and the U.S., and we kept those prices high enough to maintain current R&D incentives. The weighted average of the harmonized prices (weighted by U.S. quantity shares) would have every country except the U.S. increase their drug prices. U.S. prices would fall to 43 cents for every dollar we now spend. Canadian prices would increase to $1.28 for every current dollar and the rest of the countries would pay between $1.50 to $3.50 per current dollar. We note that OECD countries are also expending a lower fraction of their GDP on publicly funded pharmaceutical research than does the U.S. We spend .21% of GDP on pharmaceutical research, the twenty one EU member states spend .07% of GDP, and the other OECD members spend an even lower percentage. So U.S. consumers are both paying notably more for their drugs and shouldering a proportionally higher fraction of the social costs of drug development.. Are the European countries likely to increase prices in the future without some inducement to do so? The European Parliament’s Pharmaceutical Proposal that was adopted in April 2024 (but needs to be approved by the Council before it is enforced) would create a single market for medicines for all countries across the EU. This would concentrate pharmaceutical purchases for all of Europe in a single purchasing agent. The single purchaser would likely have higher bargaining leverage in negotiations with the pharmaceutical companies than any 1 single member state. As a result we should expect that, if adopted, the proposal would result in lower European prices, increasing the inequity compared to the U.S. rather than reducing it. Can we induce these countries to increase the share of the cost of drug development they pay for? Pharmaceutical prices in other high income countries are set in agreements between governmental (or quasi governmental) institutions and the pharmaceutical firms, in a manner similar to how the U.S. prices for the drugs specified in the Inflation Reduction Act 2022 (IRA) are determined. Under that legislation, manufacturers are required to negotiate Medicare prices centrally with CMS for each of a number of drugs chosen by the federal government.. The outcome of such negotiations depends very much on each participant’s “outside option”: how it would fair if no agreement was reached and no trade occurred. The more a participant has to lose, the smaller the share of the gains from trade they capture. Recognizing this fact, the IRA threatens firms who do not abide by the prices that are approved by the government with discontinuing Medicare purchases from the firm. That same threat could be used to affect the results of the manufacturers’ negotiations with foreign governments. To judge the likely impact of the threat, we compared Medicare to total European revenues for the twelve of our fifteen firms for which the needed data were available. The size of the Medicare market when combined with U.S. prices would cause a remarkable increase in the leverage of the pharmaceutical companies in their negotiations with the European authorities. Eight of the twelve firms obtain more revenues from their Medicare sales than from all of Europe, and one of the four remaining (Merck) only has higher European sales because one of its drugs is not sold to those over sixty-five. Moreover the other three have the lowest share of Medicare sales. This is not the only way to influence the pharmaceutical price negotiations with foreign governments: one suggestion from one of our colleagues is to charge a tax on the price differential between drugs sold in the foreign country and the U.S. That too is an idea worth consideration. Our point is simply that, rather than solely cutting U.S. prices, we should also consider how best to influence pharmaceutical companies’ negotiations with other-countries, as this might allow us to decrease our health care costs without sacrificing pharmaceutical R&D investment.

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Why is it important?

Proposed U.S. policies to reduce pharmaceutical prices, though particularly beneficial for low-income and elderly populations, could reduce firms’ investment in R&D. Social benefit cost ratios from pharmaceutical R&D are high, and the likely effect of the policies on profit margins are large. Higher U.S. prices subsidize the worldwide pharmaceutical market; if each drug had a single international price across high-income countries, and pharmaceutical profits were held fixed, U.S. prices would fall by half and every other country’s prices would increase (by 28 to over 300%). We outline a policy that would generate a more equitable distribution of benefits and costs across high-income countries.

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