Hangover without the Party: The Impact of Threatened Drug Price Controls on Pharmaceutical Investment

Article excerpt

Specialization and investment are the engines of economic growth and the economics profession spends considerable energy towards promoting these activities and defending them against perverse policies. Although price controls are perennially popular with policymakers who confuse price with cost, they are almost universally panned by professional economists. The economist's analysis of price controls typically focuses on the harmful effects of thwarting specialization and exchange. This typical analysis describes how the controls distort the price signals that coordinate specialization and exchange, and thus hobble markets, reducing efficiency while creating shortages and queues. Price controls also reduce the profitability of providing a service or product.

Since profits are the reward that motivates the investment that generates economic growth, price controls can reduce the investment necessary for this economic growth. An interesting difference in the case of investment effects is that current investment can be affected not only by current price controls but by future price controls as well. The prudent investor would try to anticipate price controls in making the investment. This leads to a possibility that investment could be reduced by threatened price controls even if they are ultimately rejected.

An example of just such a scenario occurred in the pharmaceutical industry in the mid-1990s. From 1980 to 1992 the nominal annual growth of domestic research and development expenditures for the research-based pharmaceutical companies varied from 13 percent to more than 20 percent. In the two years following President Clinton's 1992 election, the health-care task force headed by First Lady Hillary Rodham Clinton generated a serious threat of stringent price controls for many health-care products and services. This threat receded after the 1994 mid-term electoral gains by Republicans in the House and Senate.

During the period when the threat was most credible, the growth rate of expenditure on research and development dropped to the 6-7 percent range (Figure 1). After the threat receded, growth in R«SdD returned to its double-digit levels. Had R&D growth remained at least 12 percent during the threat period, cumulative investment for the years 1994-1998 would have been nearly $7 billion greater. Figure 2 shows how real R&D flattened out during the period of the threat.

Development costs and lags

It takes more than a decade to develop and bring a new drug to market..1 Figure 3 shows that time from start to market has grown to over 14 years. In addition to the long delay before any revenues are generated, most of the drugs fail to cover their development costs, with many washing out along the way (PhRMA, 1998). These costs are far from trivial. The Boston Consulting Group estimated that the pre-tax cost of developing a new drug was $500 million for drugs introduced in 1990 (PhRMA, 1998, p. 20). The rewards can be significant for investment in drug research, but drug development requires a firm belief by investors that they will reap the rewards of their patience and their capital.

A static monopolistic competition model suggests an attractive, but deceptive, case for price controls. The monopolistic competition model would seem to apply because products are differentiated, not homogeneous, and marginal cost is below price. Whether it is due to differentiated products or to the economies of scale caused by the very large R&D costs, the fact that drug prices are above marginal cost can have an important effect on the short-run impact that price controls might have.

In the short run, price ceilings below average total cost but above marginal cost can lead to larger output. Any time there is a downward-sloping firm demand curve, marginal revenue will be below price. A binding price ceiling will make the firm's demand perfectly elastic at the ceiling price. This, of course, means that marginal revenue will now be whatever is the ceiling price. …