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U.S. drug pricing is in the crosshairs. Mar-tin Shkreli, formerly of Turing pharma-ceuticals and KaloBios, made headlineslast fall after he hiked the price for the1950s-era drug Daraprim (pyrimeth-amine) nearly 5,500 percent. Throw insome supersized price increases by Vale-

ant pharmaceuticals, condemnations by presidential candidatesHillary Clinton, Bernie Sanders, and Donald Trump, Wall StreetJournal articles about high American drug prices, U.S. Senate andHouse committee hearings on drug pricing, and a comprehensivereport on government spending on prescription drugs that isbeing prepared by the U.S. Department of Health and HumanServices, and we have one pharmaceutical industry–sized black eye.

Every imaginable product and service has a price, and yetthere is something different about pricing prescription medi-cines. The unique characteristics of this industry should beunderstood, lest politicians—eager to be seen addressing a “cri-sis”—severely damage an industry that has restored health andeased pain for hundreds of millions of Americans. To “fix” drugpricing, we need more competition, more cost sharing, and theliberalization of some regulations.

Odd Market

Medicines prevent and cure debilitating and deadly diseases, andpeople place a high value on health. That’s one reason drugs areexpensive. But there are more reasons. physicians prescribe drugs,but they don’t personally pay—and often don’t know—the pricesof drugs. pharmacists know the prices, but don’t have muchcontrol over the prescribing decision. patients are the primarybeneficiaries of prescription drugs, but they pay only 22 percent

Charles l. hOOper is president of Objective Insights, a consultancy for pharma-ceutical and biotech companies. davId r. hendersOn is professor of economicsat the naval postgraduate school and a research fellow with the hoover Institution.he was senior economist for health policy with president ronald reagan’s Council ofeconomic advisers.

Want CheaperDrugs?

More competition, not more government coercion, would greatly benefit consumers.✒ By Charles l. hOOper and davId r. hendersOn

of the cost, typically through their copays. And notice our use ofthe word “copays.” insured patients typically pay a fixed dollaramount—a copay—rather than a percentage of the drug’s price,so for a drug with a copay of $20, patients do not have an incen-tive to care whether the drug is priced at $100 or $500. Third-party payers, both commercial and governmental, pay most ofthe cost, but they generally use a broad brush to put prescriptiondrugs into copayment categories and apply restrictions. Theresult of all this is relatively muted demand-side pressure forlower drug prices.

patients are heavily insulated from the costs of their carepartly because of long-term efforts by policymakers and advo-cates on the political left. The Affordable Care Act was a notableexception to this trend and, according to the Kaiser FamilyFoundation, following the legislation’s passage, patients’ insur-ance deductibles have increased six times as fast as averagewages. presidential aspirant Hillary Clinton would insulatethose patients more; her “solution” to the current drug priceproblem is to limit consumers’ monthly out-of-pocket costs formedications. This would counteract one desired effect of theAffordable Care Act—encouraging drug consumers to econo-mize—and would ultimately lead to higher drug prices. patients’insulation from costs makes them less sensitive to all medicalprices, and this lack of sensitivity encourages companies tocharge higher prices. if patients paid a larger share of prices (oreven knew the prices), then health care costs—including drugprices—would increase more slowly or even fall.

FDA testing / The U.S. Food and Drug Administration contrib-utes to high drug prices. its costly approval process makes it hardfor new drugs to reach the market, which keeps price competi-tion between drug makers to a minimum. Economists JosephDiMasi, Henry grabowski, and ronald Hansen at the TuftsCenter for the Study of Drug Development have estimated thatthe costs behind adding one new drug to the market total nearly

H E A LT H & M E D I C I N E

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$2.6 billion. Why so high? Because so much of r&D is spenton drugs that fail along the way. This figure accounts for those

“dry holes.” DiMasi et al. estimate these costs have increased at 7percent per year in real terms: $179 million in the 1970s, $413million in the 1980s, $1 billion in the 1990s through early 2000s,and now $2.6 billion. if this 7 percent annual growth rate persists,costs can be expected to double every 10 years.

This imposing cost means that far fewer drugs are discovered,developed, and marketed, which means less competition, lessoverall pricing pressures, and higher drug prices. This is quiteapparent to drug pricers. The ninth statin drug to enter a marketcompetes against the previous eight, perhaps with improvedefficacy and a similar price, or perhaps with similar efficacyand a lower price. Competition in that market keeps prices

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down because customers have good alternatives. The first andonly drug for a particular type of cancer, conversely, competesonly with whatever archaic and ineffective therapies were usedpreviously; competition is minimal and prices can be higher.

But wouldn’t clinical trials still be needed absent FDA regula-tion, in order for the drug to earn consumer acceptance? Theyusually would. But even if doctors and patients would always beas cautious about new drugs as the FDA is, there would likelybe more efficient ways of getting the same information about adrug’s safety and efficacy. For example, the FDA required roxropharma to run clinical trials for its Sprix (intranasal ketorolactromethamine) nasal spray, a non-steroidal anti-inflammatorydrug. That might have been reasonable had the active ingredientin Sprix not had two decades of real-world experience. it wasclear that ketorolac worked; the only remaining questions werespecific to the intranasal delivery system. What the FDA requiredfor approval made no sense but cost millions of dollars andtook two years. Moreover, doctors and patients show by theirbehavior with off-label uses that they are willing to consumedrugs that have not been tested specifically, or approved by theFDA, for those uses.

FOreIgn Markets

it’s often noted that drugs are much cheaper in other countriesthat have more socialized health care systems. While that is true,the disparity isn’t quite as large as is claimed; for instance, U.S.consumers make much greater use of generic drugs, and gener-ics are cheaper here than in Canada or Europe. Still, there is asignificant price difference.

There are three principle reasons for this difference. First, mostpeople around the world are poorer than Americans. pricing basedon value—economists call this “market segmentation” or “price

discrimination”—means setting lower prices where incomes arelower. A Wharton Business School analysis showed that pricedifferences across countries were somewhat consistent with per-capita income differences. in some cases, people are so poor thatdrug companies simply provide the medicines for free.

Second, most governments negotiate drug prices. While somemay cheer this, it involves the exercise of monopsony power—mar-ket power on the buyer’s side. These governments are saying, in

effect, that under normal circumstances, if they can’t buy a drugcheaply, their citizens won’t get it. As a result, their populationsdo without some breakthrough medicines.

Drug companies would likely extend price discriminationto poorer Americans if not for a perverse incentive in thenation’s Medicaid program. Medicaid requires drug compa-nies to charge it the lowest domestic price offered on everydrug. That unintentionally dissuades drug companies fromoffering lower prices to low-income Americans who aren’tenrolled in Medicaid. Those same low prices would then haveto be offered to the huge Medicaid program and the smaller340B program, lowering overall company profits. it is wrongto prevent drug companies from making mutually agreeabledeals with these patients.

The third reason branded drugs are cheaper in other countriesis that some governments threaten to invalidate a drug’s patents ifthe (typically foreign) drug maker charges a price that governmentofficials deem “too high.” Thus, so-called compulsory licensingis really just a violation of intellectual property rights. Whenfaced with a choice between making no money or some money,most drug companies choose the latter. That outcome does notlegitimize the process.

The result is that Americans subsidize global drug research anddevelopment costs because Europeans and Canadians pay so littlefor drugs. in essence, new drugs are developed for the U.S. market,with its large, wealthy population and generally less-regulateddrug pricing. Many breakthrough drugs would never have beendeveloped given, say, English pricing levels. Once drugs are devel-oped for the American market, other countries effectively hitcha free—or at least cheap—ride, relying on Americans to subsidizethe r&D costs. The problem is, if we Americans also try to freeride, there may not be many new rides.

pushIng prICes dOwn

Once a drug is approved, the $2.6 billiondevelopment and approval cost is “sunk.”A clear-thinking company will ignore itwhen setting a price based on what themarket will bear; the company need onlyrecover manufacturing, marketing, anddistribution costs in order to make pro-duction of the already-invented drugfinancially worthwhile. But at some point,all companies need to consider a price

high enough to make the whole venture profitable from theoutset; the sunk costs were not always sunk and must be paidsomehow. Otherwise, why would drug companies embark ona money-losing venture?

How much lower would drug prices be if not for the FDA’smandated approval costs and the subsequent damping of com-petition? We don’t know, but some analysts have suggested a fullorder of magnitude less, based on observations of markets with

Once drugs are developed for the American market, othercountries hitch a free—or cheap—ride, relying onAmericans to subsidize the research costs. If we Americanslikewise try to free ride, there may not be many new rides.

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lots of competition and those with little. Occasionally we do get tosee particular drugs that enter a market where similar drugs weremarketed without FDA approval. The new drugs, which receivedFDA approval and marketing exclusivity, are always priced muchhigher. One such drug, Makena, which helps prevent prematurebirths, was priced at 100 times the price of existing non-approveddrugs for the same purpose.

The reason that drug companies evenconsider large price increases for theirproducts is a perception that their drugsare currently underpriced relative totheir value. in 2003, Abbott Laboratoriesraised the price of norvir, an HiV drugintroduced in 1996, from $54 to $265a month. Abbott received widespreadcriticism for the decision, partly as aresult of internal memos that exposedthe decision as a tactic to help anotherAbbott HiV drug, Kaletra, which is a combination of norvirand another drug. As offensive as the price increase was tosome, Abbott believed that the price of norvir was far belowits value. The protease inhibitor had serious side effects thatprevented its stand-alone use. However, Abbott had discov-ered that in small doses, norvir boosted the effectiveness ofother protease inhibitors; it soon enjoyed widespread use as acomponent in the drug cocktails taken by AiDS patients. Onits own, norvir has a low value; in combinations with otherdrugs, it has a high value.

With little holding them back, why don’t manufacturers ofdrugs facing minimal competition set outlandish prices like $1million per dose? The simple answer is they can’t; even monopo-lies are bounded by what consumers are willing and able tospend. preventing pre-term births, curing hepatitis C, treatingHiV, limiting the effects of parkinson’s disease, and giving cancerpatients another year to live are truly valuable outcomes, butthe economic value is still capped and must meet the implicitapproval of health plans, physicians, and patients. After all, if anyof the three balk, the sale is lost. So at least two market mecha-nisms limit drug prices.

Two other remedies that the federal government could useto keep pharmaceutical costs down are the approval of moreover-the-counter (OTC) drugs and allowing drug reimportation.

OTC status can lead to strong price competition. For instance,OTC proton pump inhibitors and H2 antagonists are priced atabout 10 percent of the prices of their prescription versions. Whywould OTC drugs be so much cheaper? patients who pay 100percent of the cost—as they do with OTC drugs—are far moreprice sensitive, and companies price accordingly.

Drug reimportation—allowing patients to import drugs thathave been sold in other countries—would circumvent both theFDA’s high-cost approval process and Medicaid’s “best price”requirement. The only requirement is that these sales should

be voluntary for all parties; U.S. drug makers should not becoerced to sell to foreign countries that then sell the drugs backinto U.S. markets. Some have argued that these “re-imports”should not be allowed because the drugs are sold to wholesal-ers on the condition that they not be sold back to buyers in theUnited States. if this is the contractual arrangement with foreign

wholesalers, then they certainly are breaching their contract,and that shouldn’t be allowed. But enforcing contracts is notthe job of U.S. Customs, the FDA, or the Department of Healthand Human Services.

COnClusIOn

it should be noted that misbehaving drug companies like Tur-ing and Valeant have been punished heavily for their dramaticprice increases. Valeant lost 70 percent of its market share bynovember 2015 and Turing posted a $15 million third-quarterloss. (And Shkreli, it should be added, was arrested for securi-ties fraud.) A generic competitor announced that it would beginselling a version of Daraprim for 0.1 percent of Turing’s price.Already facing lawsuits and government investigations, thesecompanies have been ostracized by the rest of the pharmaceuticalindustry; the industry organization, BiO, even took the unusualstep of expelling Turing.

Those developments underscore that the best long-termsolution for keeping a lid on drug prices is good old-fashionedcompetition from more new drug approvals and more prescrip-tion-to-OTC approvals, combined with cost sharing and theelimination of the Medicaid “best price” regulation. Cost shar-ing gives patients an incentive to use medicines only when thebenefits are greater than their share of the drug’s price, whichwill put further downward pressure on prices. not only willfurther competition hold down prices, but also the concomitantincreased supply of good medicines will help Americans livebetter and longer lives.

Outrage over drug prices may someday be a historical curiosity.Until then, the industry will face periodic black eyes and politi-cians who, through the unintended consequences of their actions,may make matters worse. The best solution isn’t one of clampingdown on industry, but of relaxing some rules and unleashing aflood of new therapies.

Drug reimportation—allowing patients to import drugsthat have been sold in other countries—would circum-vent both the FDA’s high-cost approval process and Med-icaid’s “best price” requirement.