Drug Research and Price Controls: What Would Happen If the United States Adopted Other Countries' Drug Price Regulations? (Health & Medicine)

By Vernon, John A. | Regulation, Winter 2002 | Go to article overview
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Drug Research and Price Controls: What Would Happen If the United States Adopted Other Countries' Drug Price Regulations? (Health & Medicine)


Vernon, John A., Regulation


IN THE UNITED STATES, PRESCRIPTION DRUG prices are largely unregulated. That differs from most other countries, where drug prices are regulated either directly through price controls (e.g., France and Italy), indirectly through limits on reimbursement under social insurance schemes (e.g., Germany and Japan), or indirectly through profit controls (e.g., the United Kingdom). For a detailed listing of those controls, see Table 1.

That striking difference has given rise to one of the most contentious public policy issues in recent years: whether or not the U.S. government should join most of the rest of the world in regulating drug prices. In general, supporters of pharmaceutical price controls argue that drug prices in the United States are excessive and that price controls would ensure affordable health care for all Americans. Opponents of price regulation argue that price controls would significantly diminish incentives to invest in pharmaceutical research and development, which would harm medical advances in the future. Are those opponents of regulation correct?

PHARMACEUTICAL R&D INVESTMENT

Basic economic theory predicts that firms invest in capital up to the point where the expected marginal efficiency of investment (MEI) is equal to the marginal cost of capital (MCC). That equilibrium may be thought of in the classic way as the intersection of a demand (for investment) and supply curve (investment funds). Specifically, the firm's MEI schedule is derived by arranging potential investment projects in a decreasing order with respect to each project's risk-adjusted expected rate of return. Firms will undertake the most profitable projects first and will continue to undertake additional projects so long as the expected rate of return from the next project exceeds the firm's marginal cost of capital. The classic supply and demand framework for capital investment may be applied directly to investment in pharmaceutical research and development.

In a neoclassical world, with perfect information and well-functioning capital markets, the MCC schedule would simply be constant at the real market rate of interest. The firm will be indifferent about the source of investment finance. However, recent work -- both theoretical and empirical -- has demonstrated that the source of finance does matter. Cash flows, because they have a lower cost of capital relative to external debt and equity, exert a positive influence on firm investment spending. That has been particularly true for empirical studies of pharmaceutical R&D investment.

The effect of price controls and other equivalent regulations is to reduce the expected return on investment in R&D (and therefore the demand for R&D). Thus, for firms whose pharmaceutical sales come primarily from markets outside the United States, the expected returns to R&D are likely to be lower (all things considered) than the expected returns to R&D for firms whose market is predominantly the U.S. pharmaceutical market.

Data and model design To begin my research, I collected data for the world's 20 largest pharmaceutical firms (as ranked by 1999 world pharmaceutical sales) for the period from 1988- 1999 through IMS America, Standard and Poor's Compustat files, and Scrip Company League Tables. (I ignored firms that ranked between 20 and 50 because many of those are generic drug manufacturers without the same emphasis on R&D as "brand name" drug makers.) Of the top 20 firms for which IMS data were collected, 15 also had data available from both Compustat files and Scrip. Those 15 firms became the sample for my study.

Ranked in order of sales, those firms are: Pfizer, Merck & Co., AstraZeneca, Aventis, Bristol-Myers Squibb, Glaxo Well-come, Pharmacia, Roche, Johnson & Johnson, American Home Products, Eli Lilly, SmithKline Beecham, Abbott Laboratories, Bayer, and Amgen.

I then estimated the following regression model of the determinants of R&D investment intensity:

[RDS.

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