The Pharmaceutical Industry: Problem of Solution?; D. Bandow

including charging thousands of dollars a year for some drug therapies. Worried one industry lobbyist, "administration officials Doug Bandow is a Senior Fellow at the Cato Institute and this mo~th' s guest editor of The Freeman. 55 have made a political calculation that they need to go to war with us." Task-force members responded to ana lysts who spoke of market-oriented health care reforms by arguing that the market place 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 per cent (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 "reasonable ness" of drug prices, and the.overall health care 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 56 THE FREEMAN • FEBRUARY 1994 instance, Senator David Pryor (D-Ark.), chairman of the Special Committee on Ag ing 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 "manufac turers 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 acknowl edged, but' 'that does not mean-as a matter of public policy-that the manufacturer should be able to charge whatever the mar ket will bear." Indeed, he argues, the com panies 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 in stance, Representative Montgomery has proposed limiting the prices of drugs pur chased by Veterans hospitals. Representa tive Stark, supported by the American As sociation of Retired Persons, has suggested creating aU. 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 pharma ceutical prices are too high. Columbia Uni versity'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 some one 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 na tions.

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, giventheir relatively small role in the health care 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 coun tries. 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 com plain 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" phar maceuticals, 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 mar keted worldwide during the 1970sand 1980s.

According to the General Accounting Of fice, 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." Be tween 1973 and 1986, American firms ac counted 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 spend ing 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 THE PHARMACEUTICAL INDUSTRY: PROBLEM OR SOLUTION? 57 operations and treatments. Actigall dis solves gallstones, for instance, and thereby saves an estimated $2 billion annually pre cisely because 350,000 patients Use it. Sur gery 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 incapac itated 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 sec ond heart attacks by 16 percent and saves about $2 billion every year. The Battelle Institute estimates that for just eight leading diseases between 1968and 1989drugs 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 actu ally increase total medical expenses. A 1988 Louisiana State University study, for in stance, warned that if Medicaid, the joint federal-state program for lower-income peo pie, 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 prescrip tions for Medicaid recipients caused an upsurge in doctors' visits, hospitalizations, and nursing home admissions. The legisla ture 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 Pub lic Policy Center, the Bureau of Labor Statistics has failed to incorporate such changes as the greater availability of gener ics 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 re mained below the overall inflation rate, as well as the cost of medical care. As inflation waned in the 1980sdrug prices followed the overall trends but fell less quickly.

Moreover, by the mid-1980sgeneric sub stitutes 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 1980sare not carrying over into the 1990s as compe tition has intensified. "The market for drugs has changed dramatically since 1981, par ticularly in the last three years," reports Robert Goldberg. According to the Boston Consulting Group, industry-wide average discounts had quadrupled to 16 percent in 1992over 1987. New drug prices in 1991 and 1992were 14 percent lower than comparable products in the past. Some of the cuts were drastic-36 percent for new heart drugs, for instance. HMOs, hospitals, and drug mail order firms were also gaining an increasing 58 THE FREEMAN • FEBRUARY 1994 share of drug sales and simultaneously win ning 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. Gold berg, "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 "reason able" prices for any number of goods and services. Prices respond to supply and de mand, not moral fervor. There is no objec tive 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 partic ipants the power to "price-gouge."

Mter 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 regula tory 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," re ports 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 As sessment (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 prod ucts are not only safe but effective; separate applications, which typically run 100,000 pages long, are required for different treat ments 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 ex tending drug patent lives, but that step only ameliorated, rather than solved, the prob lem. The costs of a process that averages 12 years would be high enough for any indus try. But, notes Michael Ward, staff econo mist 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 per cent of new drugs that reach the market are estimated to lose money. Most never get beyond the research stage. There are typi cally 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 1962amendments have had little impact on the introduction of ineffective drugs-companies don't like duds because they don't make money iftheir 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 tight ened 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 THE PHARMACEUTICAL INDUSTRY: PROBLEM OR SOLUTION? 59 widely cited OTA study contended that "returns to the pharmaceutical industry as a whole over the 12-year period from 1976to 1987were higher by 2 to 3 percentage points per year than returns to nonpharma ceutical firms, after adjusting for differ ences in risk." Average industry profits ranged between 13 and 14 percent during the 1980s.

This rate of return hardly seems unrea sonable given the very· high risks of both failure and regulation, which Robert Gold berg believes the OTA has underestimated. In any case, this level of return is probably not sustainable, given the increasing com petition within the industry and cost con sciousness of consumers. In particular, OTA's future estimates overlook how dra matically generic products have been erod ing brand-name drug prices over the last decade. Moreover, Dr. Steve Wiggins, an eco nomics 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 fig ures are "unreliable because accounting con ventions require the expensing of research and development." Wiggins contends that compared to the cost of capital, drug company returns look far from impressive. He com pares 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, indi/ cates "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 60 THE FREEMAN • FEBRUARY 1994 sales industry, R&D approaches 17 per cent, nearly twice that for the rest of the health-care industry and treble that for the electronics industry. Even the OTA acknowl edged that its "findings on returns to phar maceutical 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. Gold berg, 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, Alz heimer's, asthma, arthritis, cancer, depres sion, diabetes, glaucoma, herpes, hyperten sion, obesity, strokes, and many more diseases. With these conditions costing un told lives and an estimated $400 billion a year, it seems foolish to begrudge the phar maceutical 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 market ing, 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 ap pearing. 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 con trast, createdjust three. The most important difference between the two nations is gov ernment policy. Observes P.E. Barral, "In France, the calibre of pharmaceutical re search is seen as having deteriorated, be cause 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.

Healthcare 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 pro portion of total medical expenditures than in socialized systems, while at the same time helping to hold down overall medical ex penses. 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. D THEFREEMAN IDEASON LIBERTY ENVIRONMENT AND FREE TRADE by Jo Kwong E nvironmental activists, who typically take a unified stance on major issues ranging from global warming to endangered species protection, experienced an unusual split with regard to the North American Free Trade Agreement (NAFTA). Generally speaking, environmentalists divided be tween those who were convinced that free trade would lead to greater damage to the environment, and those who believed that freer trade would stimulate national econo mies, ultimately creating more resources to help protect the environment.