Solving the Drug Dilemma

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Solving the Drug Dilemma

By Burton A. Weisbrod

Washington Post, August 22, 2003

The House and Senate are struggling over what to do about the cost of pharmaceuticals under Medicare. Whatever the outcome -- whether, for example, consumers are allowed to import drugs from Canada or anywhere else, and whether government should negotiate with manufacturers over drug prices -- it will be no more than a short-term solution. It will miss entirely the long-term problem: how to harmonize the two conflicting social goals of making drugs affordable and stimulating the advance of medical technology.

Scarcely any of today's pharmaceuticals existed even 25 years ago. Fifteen percent of the 200 largest-selling pharmaceuticals are new every year. The next 25 years can be even more productive because of the magnificent advances in basic scientific knowledge. But there will be little new technological advance without the lure of profit. We need to set out on a new path that separates the rewards for new drug development from the pricing of the resulting drugs.

The dilemma of pharmaceutical prices is how to balance consumers' demands for low prices for existing drugs with producers' demands for higher prices and greater incentives to develop new and better products. Lower prices increase consumer access to vital drugs already developed, tested and FDA-approved: antiretroviral AIDS drugs, cholesterol-fighting drugs, antidepressants. But lower prices also reduce profitability and thus discourage development of new products.

Economists have long recognized similar dilemmas when start-up costs are very high but marginal production costs are low. Pharmaceuticals are a clear example, as are telephone and electricity distribution. In all these cases, the economically efficient solution is two-part pricing -- a flat charge for access plus a variable charge that depends on level of usage.

Drug companies have two distinct outcomes but only one instrument for pricing them. They develop new drugs and they manufacture the actual pills or products consumed by individual patients, but they can price only the pills. The patent system is the root problem. It encourages innovation by granting a monopoly and then allowing the owner to set prices for the resulting product. Thus the only way that R&D, including clinical testing, costs can be covered is through high prices for the resulting pills.

When R&D costs are small, there is no serious problem. But when R&D costs are very large relative to production costs -- as is the case for pharmaceuticals -- using price for pills as the only mechanism for rewarding the product developer drives price upward. Prices become far higher than they should be, far higher than the cost of producing the pills, and far higher than is economically efficient.

The solution: Two prices -- one for the R&D, another for the resulting pills. This solution is not painless, but neither is the course that public policy is now on.

My plan has two components. First, massive awards would be made to the developers of safe and effective new patented pharmaceuticals. In effect, government would purchase drug patents; developers of successful new drugs would be rewarded for successful R&D. Second, use of the patents would be freely offered to any firms wishing to produce the pills. This would ensure active competition among generic producers and low prices, as competition forced prices down toward their low marginal production cost.

The two elements of the process, R&D and pill production, would be separated. Consumers would get low prices, and innovators would get financial awards.

Such a plan could not be implemented overnight. The most critical element is the setting of the awards or "prizes." Note, though, that there are precedents. Awards of millions of dollars, in terms of today's price levels, have provided incentives to search for innovations in other industries, with results that include the invention of a mechanism for measuring longitude on the high seas, a non-air-polluting refrigerant and solutions to major mathematical problems.

In the drug industry, awards of billions of dollars could well be appropriate for blockbuster drugs. With health care expenditures approaching $1.5 trillion per year, an innovative drug that substantially reduced the need for costly surgery and enhanced quality and length of life for large numbers of people could justify vast awards.

To be sure, there are challenges: We would have to develop a mechanism for establishing the size of an award for a specific new drug. But market size for a new drug can be estimated meaningfully, though imperfectly, as can patient demand. Possibilities should be explored for using auctions to gain information for determining awards. As any procedure for establishing awards would involve a political mechanism, there would have to be accountability and transparency, so as to prevent undue influence by industry.

The awards would have to be financed through taxation, but with Medicare expenditures alone exceeding $219 billion annually, even a multibillion-dollar award would not be a serious budgetary obstacle, especially in light of the favorable effects on health, longevity and other health care costs.

Public policy toward pharmaceutical prices is now on a dead-end path. A two-part pricing model that rewards innovation but also ensures lower prices to consumers could be a way out.