Make-Believe Thinking About Drug Prices & Pharmaceutical Industry Economics

This posting responds to Steve Laffey's outlandish criticism last week of the pharmaceutical industry.

Originally part of an extended entry to this posting, the comments below - which represent counter-arguments to his suggestion that importing drugs from Canada would miraculously allow comparable patient care at radically reduced costs - were not sufficiently visible to readers. As a result, I am reposting a slightly modified version of my original comments here and deleting them from the original posting.

I have worked in the healthcare industry since 1983, spending most of my time since 1985 working in venture capital-financed startup companies. With that experience base, I found Laffey's words on drug prices - which you can read in the posting mentioned above - to be grossly misleading and grossly misinformed.

The Canadian Health System

The romantized - but fake - vision of simply importing inexpensive drugs from Canada in an effort to mimic their health system completely ignores the many grotesque failings of their socialist system discussed in an earlier posting entitled Canadian Supreme Court: "Access to a Waiting List is NOT Access to Health Care", including these highlights:

Canada is the only nation other than Cuba and North Korea that bans private health insurance...

"Access to a waiting list is not access to health care," wrote Chief Justice Beverly McLachlin for the 4-3 Court last week. Canadians wait an average of 17.9 weeks for surgery and other therapeutic treatments, according the Vancouver-based Fraser Institute. The waits would be even longer if Canadians didn't have access to the U.S. as a medical-care safety valve. Or, in the case of fortunate elites such as Prime Minister Paul Martin, if they didn't have access to a small private market in some non-core medical services...

The larger lesson here is that health care isn't immune from the laws of economics. Politicians can't wave a wand and provide equal coverage for all merely by declaring medical care to be a "right," in the word that is currently popular on the American left.

There are only two ways to allocate any good or service: through prices, as is done in a market economy, or lines dictated by government, as in Canada's system. The socialist claim is that a single-payer system is more equal than one based on prices, but last week's court decision reveals that as an illusion. Or, to put it another way, Canadian health care is equal only in its shared scarcity...

...in Canada you wait for everything. North of the 49th parallel, we accept that if you get something mildly semi-serious it drags on while you wait to be seen, wait to be diagnosed, wait to be treated. Meanwhile, you're working under par, and I doubt any economic impact accrued thereby is factored into those global health-care-as-a-proportion-of-GDP tables. The default mode of any government system is to "control health-care costs" by providing less health care. Once it becomes natural to wait six months for an MRI, it's not difficult to persuade you that it's natural to wait ten months, or fifteen. Acceptance of the initial concept of "waiting" is what matters...

...[for single-payer health insurance systems] rationing by waiting is pervasive, governments overspend for the healthy and deny care for specialist and life-saving medical technologies to the sick, and leave health-care choices to bureaucrats rather than patients. Single-payer systems, in other words, often deny choice and access to the sick.

This denial and limited access also exists in market-driven systems...but at least sick patients in market-driven systems can explore options outside of rigid federal bureaucracies, as many Canadians do by coming to their neighbor to the south for care. The Canadian court decision debunks the myths that government systems offer equal access to care, that they offer a higher quality of care to all, and that a paternalistic government can take care of all of the people all of the time...

Preventing citizens from purchasing as much health care as they want and can afford under the pretext that it "wastes" resources needed to fund "free" health care presupposes that the state is the rightful owner of all wealth...

Further examples of the failings of the Canadian healthcare system can be found in a report entitled What goes into the cost of prescription drugs?...and other questions:

In British Columbia, some Canadians being treated with one effective medicine are switched to a substitute simply because the government health system mandates it. This can result in patient confusion, greater noncompliance, and a worsening of symptoms.

Canadian patients are often denied easy access to certain medicines that, for them, would have minimal side effects, because the government requires that they must first endure therapy with the "cheaper," potentially less-effective medicines. Only when serious side effects appear - sometimes requiring hospitalization, for example - does the government allow the more efficacious drug to be prescribed.

Canadians wait, on average, seven months longer than Americans for new medicines to be approved by their government regulatory agency. Even after a medicine is approved, patients wait an average of five to 13 months longer before the medicine is put on and reimbursed by each province's formulary...

Canada ranks third-from-last in the developed world on the availability of medical technology, according to the OECD...

Is this the healthcare world we aspire to for all American citizens?

Adverse Macro Impact of Price Controls

In an article entitled The High Price of Cheap Drugs, John Calfee writes about the effect that price controls have had on innovative research, including the loss of jobs:

...Those price controls prevent innovative pharmaceutical firms from reaping free-market rewards anywhere but in the United States. That is one reason why the world pharmaceutical industry, which 20 years ago was mostly based in Europe, has largely relocated to the United States. American manufacturers now account for 7 of the top 10 worldwide best-selling medicines, and 15 of the top 20. This reflects a large and growing disparity in research and development expenditures. In 1990, European pharmaceutical firms outspent American firms on R&D by approximately 8billion euros to 5 billion euros ($7 billion to $4.3 billion). In 2000, U.S. firms outspent European firms by 24 billion euros to 17 billion euros ($20.9 billion to $14.8 billion). Even traditional European firms, notably GlaxoSmithKline and Novartis, have moved many of their most essential operations to the United States. After years of looking the other way, the European Commission is sufficiently alarmed by these trends to propose relaxing price controls in order to rejuvenate its pharmaceutical industry, especially the biotechnology sector...

Are we willing to pursue drug price controls in America and accept the resulting loss of jobs and innovation?

Drug Importation

As to the drug importation issue, David Frum frames the big-picture issue in this August 11, 2004 posting (no longer accessible on web) at his NRO blogsite:

...drug re-importation is a cheap and cynical non-solution to a real problem: the unfairness of asking Americans to pay the whole cost and more of new drugs while the rest of the world pays less. But it’s no kind of answer to cut prices in the US: In that case, innovation could disappear entirely. The answer is to share the cost more widely within the developed world – an answer that US trade negotiaters are beginning to press hard. So here’s the real question for [any politician] on drug prices: Will he stand up for American pharmaceutical-makers – and global pharmaceutical-users – by calling for a fair sharing through trade of the costs of innovation?...Or does he just want to score points now – at the price of denying Americans access to potential drugs of the future?

Are we going to hold our politicians accountable when they use cynical ploys to pander for votes? Are we willing to push for more equitable trade policies regarding drug pricing outside the United States?

Calfee adds his comments on drug importation from Canada:

...[Politicians] think this is competition and free trade at work. The fact that a group of Canadian or European bureaucrats would be setting drug prices for the entire U.S. economy seems to elude them. What would this law actually do? For one thing...might not get the low prices they want even if Congress passes their law. Prices won't drop in the United States unless foreign drugs really will be imported in large volumes. Importation from Canada alone won't do the trick because the Canadian market is tiny, about 5 percent of the U.S. market in terms of revenues. When Canadian pharmaceutical wholesalers ask Pfizer, Merck, and their competitors to ship them 10 times the usual volumes of Lipitor and Zocor and other blockbuster drugs, with the obvious intention of shipping them right back to the United States, any manufacturer with a decent regard for its shareholders will refuse. Why sacrifice billions of dollars in U.S. sales to maintain sales in a market one-twentieth the size? If that were the end of the story, events would follow a simple course. Canadian authorities, who understand the importation logic as well as anyone, would have to reassess their price ceilings or leave their citizens short of the best pharmaceuticals. At some point, it would become clear that Canadian drug importation would not bring the low U.S. prices its advocates want, although it might put a good number of patients at risk if importation--including importation of counterfeits--were to ramp up before prices adjusted. Prices in Canada, meanwhile, would rise...

Drug Safety

The second report referenced above includes these words:

...according to the Acting FDA Commissioner in July 2004, the FDA found evidence of a Canadian Web site advertising "Canadian generic" drugs, when in fact it was selling fake, contaminated and substandard versions of three commonly prescribed medicines. In addition, the FDA has identified drugs being imported into the U.S. arriving from unreliable sources in such places as the Bahamas and Pakistan. Media reports have found that some Canadian pharmacies are now shipping drugs from all over the world, including Belize, Israel, India, Chile, New Zealand, Ireland and Great Britian. So a drug that a consumer assumes is coming from Canada, may in fact originate anywhere in the world.

According to Canadian Health Minister Ujjal Dosanjh: "Canada cannot be the drug store of the United States."...Additionally, Diane Gorman, Assistant Deputy Minister, Health Canada, said "the Government of Canada has never stated that it would be responsible for the safety and quality of prescription drugs exported from Canada into the United States..."

Calfee also discusses the risk of increased importation of counterfeit drugs:

...pass a law so that drugs shipped to Canada or Europe or South Africa can be imported into the United States for sale at foreign prices. The law would leave the Food and Drug Administration with almost no authority to check the safety of these imports. Wholesalers would have to do their own testing, but pharmacies and "qualifying individuals" (who could resell to others) would face no such requirement. This bothers the FDA...

Are we willing as a society to tolerate the greater human risk and higher economic costs resulting from use of counterfeit drugs by patients?

Long-Term Impacts

Calfee then notes how there are two eventual scenarios that arise from price controls and importation issues:

Two scenarios could play out, one bad and the other worse.

In the first scenario, drug manufacturers would again simply refuse to ship huge volumes of drugs to small foreign countries in order for the drugs to be shipped back and cripple profits at home, where the drugs were invented. If that happened (and I think it would), our European friends would probably have a political fit. They would face the prospect of either going without American drugs or raising their own price ceilings--and with them the costs of their fiscally strapped socialist health care systems. From their point of view, the importation plan would be a clever way to force U.S. drug prices on Europeans. They would want very much to prevent that. An international demand for drug price controls in the United States (not just in Europe) would become a centerpiece of international diplomacy. And we might cave in, pushed by the same politicians who want importation.

In scenario two,...importation would rapidly escalate to massive volumes from Canada and Europe, maybe from South Africa and elsewhere. The process would resemble the "parallel trade" now engulfing European drug markets as products with Greek or Spanish labels flow to patients in Germany and Britain. Drug prices would drop here, limited only by fears of counterfeiting, dilution, or inadequate storage. Wholesalers, pharmacies, managed care organizations, and other large-volume dealers would feel intense price pressure from the imports, and the U.S. pricing structure would gradually collapse...

Either way, price controls would end up suppressing innovation here, just as they have done abroad. It is one thing for the Canadians and Europeans to free-ride on American R&D, but we can't free-ride on ourselves. The system that gave us the drugs the whole world wants would be hobbled...The market would understand with perfect clarity that the days of free-market rewards for high-risk-high-payoff research were over. The implications for future drug research are both obvious and depressing...

Are we willing to live with either of these outcomes in America?

Myths About Prescription Drugs

Robert Goldberg writes about Ten Myths about the Market for Prescriptions Drugs, including these excerpted thoughts:

Myth No. 1: American Spend Too Much on Prescription Drugs. Per dollar spent, drugs offer a better return on health care spending than virtually any other health care option. Using prescription drugs often reduces or eliminates the need for costlier health care services. One recent study found that every dollar spent on drugs is associated with a $4 decline in spending on hospitals...

Myth No. 4: Drug Prices Are Higher in the United States than in Other Developed Countries. Drug prices in the United States are not very different from prices in other developed countries. Using accurate pricing information, health economist Patricia Danzon has found that drug prices in Canada, Germany, Switzerland and Sweden are higher on average than prices in the United States. When "purchasing power parity," a means by which economists attempt to compare the price of goods in different countries, is considered, the Organization for Economic Cooperation and Development has found that Americans spend less per capita per year on drugs than do people in Germany or France and only slightly more than those in Canada and Italy - yet the other countries have controls. (Go here for another verification of this point.)

Myth No. 5: Americans Could Reduce Their Drug Costs If They Paid the Same Prices as People in Less-Developed Countries. Critics of the U.S. system complain that consumers can buy drugs in Mexico for less than half their cost in the United States. Prices for the same drugs do differ in different countries, but Americans cannot get the newest drugs at Mexican prices for a simple reason. The research and development required to ready a drug for production can cost millions of dollars and take many years, but the cost of actually manufacturing a drug is usually small. Because manufacturers have discretion about pricing, the price may be close to production costs in poorer countries, which could not otherwise afford the drug, and higher in wealthier countries - more accurately reflecting the drug's value to patients. If all patients paid the lower price, there would be no money for research and development and no new drugs...

Myth No. 7: Price Controls Can Reduce Drug Spending. Attempts to drive down drug costs through price controls have two unintended results: (1) they encourage increased consumption of drugs and (2) they lead to the consumption of inferior drugs. Many European health systems with price controls spend more on drugs per capita than the United States spends, but Americans use newer and more appropriate medications. That is one reason Americans spend less time in hospitals when they are sick and have a higher quality of life than do Europeans...

Myth No. 9: We Can Have Price Controls without Rationing Drugs. If federal price controls for pharmaceuticals were adopted, an increase in consumption of pharmaceuticals would be inevitable and the government would then try to control the increase. That is what happened with erythropoietin (EPO), which is used to reduce anemia in kidney dialysis patients. Medicare, which pays for drugs for kidney dialysis, put a price control on EPO in 1994, rationed the amount patients could get and refused to cover patients with healthy blood cells above a certain level...

Price controls represent not a mere extension of market pressure but a fundamental shift in values. Controls substitute a political process for the marketplace. For controls to work, individuals must be forced to adhere to governmental and bureaucratic decisions. This allows a few "experts" to decide what pharmaceuticals millions of physicians, pharmacists, medical researchers and patients "deserve" - and at what prices.

Finally, Did You Know?

That spending on drugs accounts for less than 11% of every healthcare dollar, of which branded drugs are about 7% and generic drugs are about 4%? That hospital care totals about 31% of every healthcare dollar, physician services about 22%, and nursing homes about 9%?

That studies show treating conditions with new medicines instead of older medicines increases drug costs but significantly lowers non-drug spending?

That developing a new drug takes 12-15 years and costs over $800 million?

That, on average, only five of every 10,000 compounds investigated are tested in clinical trials and, of those five, only one is ever approved for patient use?

That, on average, only three of every 10 prescription drugs available to treat Americans generate revenue that meet or exceed average R&D costs?

That pharmaceutical companies spend 20% of their revenue on research & development efforts for new drugs, equal to over $34 billion in 2003 alone and slightly over 10 times what they spent on direct-to-consumer advertising?

We need leaders who truly understand the economics of developing new drugs. If they stay ignorant, then we risk implementing policies which will lead to Americans losing access to innovative new drugs and losing the freedom we currently have to pursue the medical care we want.

And, if you needed any further evidence that the government is the last entity we want interfering with the marketplace, then reread this posting and share it with the next friend that whines about how the government should do something about the number of citizens lacking health insurance. Remind them that the government created the problem in the first place.

Our public debate and the ensuing public policies would improve if leaders did not go about promising economic benefits while simultaneously claiming the benefits can be realized without any costs.

Such suggestions are nothing less than a form of economic make-believe. In the end, if you won't deal with economic reality, then it will deal with you - on its own terms.