Medical Progress Report 3 | The Human Cost of Federal Price Negotiations: The Medicare Prescription Drug Benefit and Pharmaceutical Innovation

The Human Cost of Federal Price Negotiations:
The Medicare Prescription Drug Benefit and Pharmaceutical Innovation

Abbott, Thomas A., and John A. Vernon. “The Cost of U.S. Pharmaceutical Price Regulation: A Financial Simulation Model of R&D Decisions.” Managerial and Decision Economics, forthcoming.

Bender, Bruce, and John R. Lott, Jr. “Legislator Voting and Shirking: A Critical Review of the Literature.” Public Choice 87, nos. 1–2 (April 1996): 67–100.

Bowman, Lee. “Democrats vs. Bush on Medicare Drug Plans.” Scripps Howard News Service, February 20, 2004.

Calfee, John E., Mario Villarreal, and Elizabeth Dupré. “Biotechnology Drugs, Traditional Pharmaceuticals, and Price Controls.” Manuscript, American Enterprise Institute, June 3, 2006.

Dimasi, J. A., R. W. Hansen, and H. G. Grabowski. “The Price of Innovation: New Estimates of Drug Development Costs.” Journal of Health Economics 22 (2003): 151–85.

Executive Office of the President. Annual Report of the Council of Economic Advisers. February 2006.

Filson, Darren. “The Impacts of Price Controls on the Performance of the Research-Based Pharmaceutical Industry.” Manuscript, Claremont Graduate University, May 23, 2006.

Filson, Darren, and Neal Masia. “The Effects of Profit-Reducing Policies on Firm Survival, Financial Performance, and New Drug Introductions in the Research-Based Pharmaceutical Industry.” Manuscript, Claremont Graduate University, May 4, 2005.

Freking, Kevin. “Democrats to Unveil Drug Benefit Changes.” Seattle Post-Intelligencer, June 26, 2006.

Giaccotto, C., R. E. Santerre, and J. A. Vernon. “Pharmaceutical Pricing and R&D Growth Rates,” Journal of Law and Economics 48, no. 1 (2005): 195–214.

Golec, Joseph, Shantaram Hegde, and John Vernon. “Pharmaceutical Stock Price Reactions to Price Constraint Threats and Firm-Level R&D Spending,” NBER Working Paper 11229, 2005.

Hahn, Jim. “The Pros and Cons of Allowing the Federal Government to Negotiate Prescription Drug Prices.” CRS Report for Congress, February 18, 2005.

Helms, Robert B. “The Impact of Pharmaceutical Price Controls on R&D.” AEI-Brookings Joint Center briefing, May 16, 2005.

Hirshleifer, J. Investment, Interest, and Capital. Englewood Cliffs, N.J.: Prentice-Hall, 1970.

Institute of Medicine of the National Academy of Sciences. Financing Vaccines in the 21st Century. Washington, D.C.: National Academies Press, 2004.

Kaiser Commission on Medicaid and the Uninsured. “The Medicaid Program at a Glance.” May 2006.

Kaiser Daily Health Policy Report. “Group of Democrats to Introduce Legislation Overhauling Medicare Drug Benefit.” June 27, 2006.
———. “House Members Seek Vote on Bill to Revise Medicare Prescription Drug Benefit.” July 21, 2006.

Lichtenberg, Frank R. “Older Drugs, Shorter Lives? An Examination of the Health Effects of the Veterans Health Administration Formulary.” Medical Progress Report No. 2, Manhattan Institute for Policy Research, October 2005.

———. “Sources of U.S. Longevity Increase, 1960–1997.” NBER Working Paper No. 8755, 2002.

Murphy, Kevin M. and Robert H. Topel, eds. Measuring the Gains from Medical Research. Chicago: University of Chicago Press, 2003.

National Science Foundation. “Comparability of PhRMA Survey with NSF Survey of Industrial Research and Development.” Unpublished manuscript, July 1, 2004.
———. IRIS database, at www.nsf.gov/statistics/iris.
———. National Patterns of Research Development Resources. 2003.
———. Research and Development in Industry.
———. Survey of Industrial Research and Development. 2001.

Organisation for Economic Co-operation and Development. STAN database, at www.oecd.org/sti/stan.

Pharmaceutical Research and Manufacturers of America. Industry Profile, 2006.

Santerre, Rexford E., John A. Vernon, and Carmelo Giaccotto. “The Impact of Indirect Government Controls on U.S. Drug Prices and R&D.” The Cato Journal 26, no. 1 (winter 2006): 143–58.

Scherer, F. M. Industry Structure, Strategy, and Public Policy. Boston: Addison-Wesley, 1996.

United Nations Industrial Development Organization. Industrial Statistics Database, INDSTAT4, 2003, ISIC Revisions 2 and 3.

U.S. Department of Commerce, International Trade Administration. Pharmaceutical Price Controls in OECD Countries. December 2004.

U.S. Department of Health and Human Services. “Prescription Drugs: Spending Controls in Four European Countries.” 1994.
———. “Secretary’s Progress Report IV on the Medicare Prescription Drug Benefit.” Prepared by Mike Leavitt, secretary of Health and Human Services, June 14, 2006.

Vernon, John A. “Drug Research and Price Controls.” Regulation 25, no. 4 (winter 2002–03): 22–25.
———. “Examining the Link between Price Regulation and Pharmaceutical R&D Investment.” Health Economics 14, no. 1 (January 2005): p. 1–16.
———. “New Evidence on Drug Price Controls.” Regulation 27, no. 3 (fall 2004): 13–14.

Vernon, John A., Joseph H. Golec, and W. Keener Hughen. “The Economics of Pharmaceutical Price Regulation and Importation: Refocusing the Debate.” American Journal of Law & Medicine 32 (forthcoming in 2006).

Vernon, John A., Rexford E. Santerre, and Carmelo Giaccotto. “Are Drug Price Controls Good for Your Health?” Medical Progress Report No. 1, Manhattan Institute for Policy Research, December 2004.

Wolf, Charles, Jr., and Benjamin Zycher. European Military Prospects, Economic Constraints, and the Rapid Reaction Force. RAND Corporation MR-1416-OSD/SRF, 2001.

Zycher, Benjamin. “Healthy Profits Have Healing Powers.” Los Angeles Times, October 25, 2005.
———. “Pharmaceutical Importation, Price Controls, Federal Price Negotiations, and the Interests of Consumers.” Prepared statement before the Committee on Health, Education, Labor, and Pensions, U.S. Senate, February 17, 2005.
———. “A Preliminary Benefit-Cost Framework for Counterterrorism Public Expenditures.” RAND Corporation MR-1693-RC, May 2003.

See Lee Bowman, “Democrats vs. Bush on Medicare Drug Plans,” Scripps Howard News Service, February 20, 2004.
Ibid. See also Kevin Freking, “Democrats to Unveil Drug Benefit Changes,” Seattle Post-Intelligencer, June 26, 2006. Net federal spending on the new Medicare drug benefit is now estimated by the Centers for Medicare and Medicaid Services (CMS) at $746 billion over the period 2006–16. See U.S. Department of Health and Human Services, “Secretary’s Progress Report IV on the Medicare Prescription Drug Benefit,” prepared by Mike Leavitt, secretary of Health and Human Services, June 14, 2006. See also Kaiser Daily Health Policy Report, “Group of Democrats to Introduce Legislation Overhauling Medicare Drug Benefit,” June 27, 2006; and idem, “House Members Seek Vote on Bill to Revise Medicare Prescription Drug Benefit,” July 21, 2006.
Strictly speaking, the implicit “revenue” stream is the perceived greater total net value of drugs — total drug value minus total drug spending — but that is a minor complication ignored here, in part because lower prices might yield higher consumer spending under some demand conditions.
The measurement of this monopsonistic pricing power of the federal government as a drug purchaser lies beyond the scope of this paper; but it is useful to bear in mind that quite apart from the mere magnitude of its purchases, the federal government has the power to threaten actions affecting the profitability of ongoing pharmaceutical investments, as well as the power to threaten the imposition of price controls in various forms. For summary spending data, see Kaiser Commission on Medicaid and the Uninsured, “The Medicaid Program at a Glance,” May 2006. For more detailed tables, see U.S. Department of Health and Human Services, at http://www.cms.hhs.gov/NationalHealthExpendData.
See unpublished spreadsheet projections from the CMS, available from the author upon request.
For a discussion of the formulary restrictions imposed upon the Veterans Health Administration pharmacy program, see Frank R. Lichtenberg, “Older Drugs, Shorter Lives? An Examination of the Health Effects of the Veterans Health Administration Formulary,” Medical Progress Report No. 2, Manhattan Institute for Policy Research, October 2005.
The U.S. Postal Service, Amtrak, and other such federal agencies are a partial exception to this generalization. Most federal agencies in effect offer to Congress an aggregated basket of services in exchange for a lump-sum budget, even in such cases as entitlement programs for which the annual budgets cannot be determined precisely in advance.
See John A. Vernon, Rexford E. Santerre, and Carmelo Giaccotto, “Are Drug Price Controls Good for Your Health?” Medical Progress Report No. 1, Manhattan Institute for Policy Research, December 2004.
These private incentives to invest in research and development are powerful in the absence of expected price controls and similar disincentives, in that the market value (“market capitalization”) of the firms incorporates the present value of the capital created by research and development investments.
For most drugs, fixed costs are large while marginal production costs are low. So, pushed to the extreme, drug producers would be willing in the short run to accept very low prices for given drugs — even if those prices do not cover the associated fixed costs — as long as the negotiated price is greater than the marginal production cost. This effect might be tempered by the realization that acceptance of a very low price for one drug might make negotiations over other drugs more difficult; in any event, the greater willingness of the federal government to exclude given drugs from formularies, because of its weaker incentives to satisfy its “customers,” implies automatically that prices negotiated with the federal government will be lower than those negotiated with large private buyers, ceteris paribus. Note that the Bush administration disputes this effect, citing a 2005 memo from Richard Foster, chief actuary of the CMS, arguing: “We believe that direct price negotiation by the secretary would be unlikely to achieve prescription drug discounts of greater magnitude than those negotiated by [private] Medicare prescription drug plans responding to competitive forces.” See Kaiser Daily Health Policy Report, June 27, 2006. That assertion is inconsistent with the experience in 2001 with the drug Cipro, produced by Bayer Pharmaceuticals; for a brief summary of that episode, see Benjamin Zycher, “Healthy Profits Have Healing Powers,” Los Angeles Times, October 25, 2005. Nor is it consistent with the experience of the federal child vaccine program; see the Institute of Medicine of the National Academy of Sciences, Financing Vaccines in the 21st Century (Washington, D.C.: National Academies Press, 2004), chapter 5. In a larger context, it is not clear why the Bush administration would oppose such federal price negotiations merely because they would have no net price effect; what, then, would be the harm?
This discussion of federal incentives is developed further in Appendix A.
Producers are required also to participate in the Veterans Health Administration pharmacy program in order to have drugs included in Medicaid formularies.
There is a further geographic adjustment determined by the Consumer Price Index (CPI-U).
Note that reimbursement for the actual price paid by the provider yields no compensation to the provider for the direct medical services associated with administration of the drugs (e.g., an injection, or patient monitoring), unless reimbursement for the direct medical services “incident to” the drugs (e.g., cancer treatment) is sufficient to compensate the providers for those services. This lack of compensation for narrowly defined medical services related to the administration of the drugs is, in effect, a tax on the drug-related medical services, which in principle is borne by both the providers and the drug producers in some proportion determined by demand and supply conditions.
The requirement that price discounts negotiated with private-sector buyers be given to federal programs, whether directly or indirectly, may have the effect of limiting the discounts negotiated privately, in that the total cost of a given discount is greater than the narrow cost of giving it to the private buyer. But this must make both the private buyer and the drug producer worse off, in that the latter is constrained from offering a (larger) discount to which it otherwise would agree. Another way to see this is to recognize that under most conditions, differential pricing — different prices for different consumer subclasses — moves the drug market toward efficient levels of output and greater utilization of drugs; most-favored-nation types of required discounts are inconsistent with that goal.
Thus do so-called me-too drugs yield competition rather than a waste of investment resources, as some observers have argued, even apart from the differential medical benefits of alternative drugs in a class for individual patients. Even in the absence of competition, a drug with full patent protection can yield returns above, equal to, or below competitive levels, depending upon past costs, current production costs defined broadly, and market prices.
The interest rate in this context is the market rate for the relevant risk class of investments.
If this were not the case — if the average expected return systematically is higher than the market rate of interest — new producers would enter the market, increasing competition, thus driving down future expected prices and the expected returns to investment.
In the extreme case, the upper end of the statistical distribution of expected returns simply would be truncated.
That is, producers can restore (imperfectly) the mean expected return at the market rate of interest by truncating the lower end of the statistical distribution.
See Rexford E. Santerre, John A. Vernon, and Carmelo Giaccotto, “The Impact of Indirect Government Controls on U.S. Drug Prices and R&D,” The Cato Journal 26, no. 1 (winter 2006): 143–58. See also Section VI below for a discussion of related literature.
An earlier paper found that more than one-third of the new drugs introduced between 1980 and 2001 would not have been developed had the rate of pharmaceutical price increases been limited to that of the consumer price index. See C. Giaccotto, R. E. Santerre, and J. A. Vernon, “Pharmaceutical Pricing and R&D Growth Rates,” Journal of Law and Economics 48, no. 1 (2005): 195–214.
Santerre et al., pp. 151–52. The authors are careful to note that other market and policy shifts beginning in the early 1990s may account for part of the larger post-1992 decline in the real growth rate of drug prices. Their elasticity estimate is consistent with those reported in other empirical research: 0.58, 0.61, and 0.54–0.68, respectively, in Giaccotto et al.; F. M. Scherer, Industry Structure, Strategy, and Public Policy (Boston: Addison-Wesley, 1996), chapter 9; and U.S. Department of Health and Human Services, “Prescription Drugs: Spending Controls in Four European Countries,” 1994.
Frank R. Lichtenberg, “Sources of U.S. Longevity Increase, 1960–1997,” NBER Working Paper No. 8755, 2002.
The deflator used was the chained GDP deflator for private equipment and software investment; see Annual Report of the Council of Economic Advisers, Table B-7, February 2006. See National Science Foundation, IRIS database, at www.nsf.gov/statistics/iris; idem, Research and Development in Industry, various annual issues; idem, National Patterns of Research Development Resources, 2003; idem, Survey of Industrial Research and Development, 2001; United Nations Industrial Development Organization, Industrial Statistics Database, INDSTAT4, 2003, ISIC Revisions 2 and 3; Organisation for Economic Co-operation and Development, STAN Database, at www.oecd.org/sti/stan; and Pharmaceutical Research and Manufacturers of America, Industry Profile 2006.
See. e.g., Charles Wolf, Jr., and Benjamin Zycher, European Military Prospects, Economic Constraints, and the Rapid Reaction Force, RAND Corporation MR-1416-OSD/SRF, 2001. Because one central question addressed in this paper is the effect of the implicit federal negotiation tax upon the projected pharmaceutical research and development capital stock for 2007–25, the initial capital stock assumed for 1985 is far less important than may seem to be the case, in that under an assumed annual depreciation rate of 8 percent, only about 18 percent of the 1985 capital stock would remain in 2007, and less than 5 percent would remain in 2025.
At an annual depreciation rate of 8 percent, about 21 percent of the capital from a given research and development project would remain at the end of the 20-year patent period. This is consistent with the general observation that drug prices tend to fall about 80 percent with the introduction of generic competition at the end of the patent period, in that the value of the remaining capital at any given point is the present value of the remaining net revenue stream, itself a function of generic competition and other market factors.
See above, n. 5.
Note that all of these assumptions are highly conservative. The available empirical analysis shows that existing public-sector drug programs depress prices by far more than 5 percent, that the federal spending share is certain to increase after 2006 because of the growing Medicare population, and that the 1.2 percent tax assumption is the compound tax rate before 1992 estimated by the Santerre et al. analysis, which is far lower than the compound tax rate (5.3 percent) estimated for the period after 1992. Even without any further increase in the total government spending share after 2006, and even assuming only a 1.2 percent implicit price tax per 10 percent federal spending share, compounded annually, the price effect by 2025 would be over 35 percent.
The negotiation tax does not affect the fixed cost — estimated by Dimasi et al. at about $800 million for the year 2000 — of bringing a new drug to market, and we assume for simplicity that it does not affect expected future prices after the patent period. It may reduce competition (and thus increase prices) during the patent period, but that is a complication beyond the scope of this paper. See J. A. Dimasi, R. W. Hansen, and H. G. Grabowski, “The Price of Innovation: New Estimates of Drug Development Costs,” Journal of Health Economics 22 (2003): 151–85.
Consider an investment expected to cost C, after which expected revenues during the patent period are PQ, where P is price, and Q is quantity sold. The patent period is g years, after which expected revenues are pq, where p and q are the parameters analogous to P and Q. The market interest rate is r. An unbiased first approximation of the present value of expected profit p in the absence of federal negotiation is
π = [(PQ/r)-(PQ/(r(1+r)^g)) + pq/r(1+r)^g] – C.
Since C, p, q, g, and r by assumption are unaffected by federal price negotiations, they can be ignored. If PQ is reduced by some percentage, p declines by that same percentage. Again, this is independent of the interest rate r and the patent period g. Q might change disproportionately with P, but even the direction of the change in Q is unclear, as formulary restrictions might reduce Q even as P is reduced through negotiations.
In other words, the assumed elasticity of research and development investment with respect to price is 1. This is a conservative assumption because implicitly it assumes away the possibility that a given negotiation tax will reduce investment to zero. For a classic discussion of the marginal efficiency of investment, see J. Hirshleifer, Investment, Interest, and Capital (Englewood Cliffs, N.J.: Prentice-Hall, 1970), chapters 3 and 6.
Above, n. 21.
See Pharmaceutical Research and Manufacturers of America, above, n. 25. These investment data generally are larger than the NSF data, particularly after 1990; the source of the differences is beyond the scope of this paper, although it is likely to be some combination of definitions and inclusions and exclusions. Note also that the PhRMA data are for domestic members of PhRMA only.
Above, n. 24.
See Kevin M. Murphy and Robert H. Topel, “The Economic Value of Medical Research,” in Measuring the Gains from Medical Research, ed. Kevin M. Murphy and Robert H. Topel (Chicago: University of Chicago Press, 2003). The Murphy/Topel estimate of the value of a life-year is $160,000.
The CMS projects total U.S. drug spending in 2015 at about $450 billion in nominal (then-year) dollars. If we assume an annual inflation rate of 2 percent, that amount is about $369 billion in year 2005 dollars. We ignore here the marginal economic cost (“deadweight loss”) caused by the federal tax system; even if we assume it to double the economic cost of federal spending (by another $160 billion in year 2005 dollars), the value of the life-years lost is still about the same as total national resource consumption for drugs. See Benjamin Zycher, “A Preliminary Benefit-Cost Framework for Counterterrorism Public Expenditures,” RAND Corporation MR-1693-RC, May 2003.
Above, n. 29.
Note that the earlier part of the 1995–2005 period coincided with the implementation of the Prescription Drug User Fee Act, which may account in part for the relatively large number of approvals in 1996–2002.
John A. Vernon, “Drug Research and Price Controls,” Regulation 25, no. 4 (winter 2002–03): p. 22–25. Vernon notes clearly that price-control regimes vary substantially across Europe, that substantial uncertainty afflicts the econometric findings, and that the estimates are crude.
Joseph Golec, Shantaram Hegde, and John Vernon, “Pharmaceutical R & D Spending and Threats of Price Regulation,” NBER Working Paper, 2006. The estimated decline in research and development spending is 12 percent if we use the data from PhRMA. See Pharmaceutical Research and Manufacturers of America, above, n. 25.
Thomas A. Abbott and John A. Vernon, “The Cost of U.S. Pharmaceutical Price Regulation: A Financial Simulation Model of R & D Decisions,” Managerial and Decision Economics, forthcoming.
Above, n. 21.
U.S. Department of Commerce, International Trade Administration, Pharmaceutical Price Controls in OECD Countries, December 2004, pp. 25–31.
Giaccotto et al., above, n. 22.
John A. Vernon, “Examining the Link between Price Regulation and Pharmaceutical R & D Investment,” Health Economics 14, no. 1 (January 2005): p.1–16.
Above, n. 8.
For a more detailed discussion of this issue, see John A. Vernon, Joseph H. Golec, and W. Keener Hughen, “The Economics of Pharmaceutical Price Regulation and Importation: Refocusing the Debate,” American Journal of Law & Medicine 32 (forthcoming in 2006).
See John E. Calfee, Mario Villarreal, and Elizabeth Dupré, “Biotechnology Drugs, Traditional Pharmaceuticals, and Price Controls,” manuscript, American Enterprise Institute, June 3, 2006.

a1. For states implicitly purchasing drugs under Medicaid rebate requirements, this incentive may be weaker in that states receive marginal subsidies between 50 percent and, as an upper limit, 83 percent from the federal government. The average in FY 2004 was 60.2 percent; the highest was 77.08 percent for Mississippi.

a2. See above, n. 8.

a3. In simple terms, “efficient” in this context is the investment flow that yields an expected economic return for the “marginal” (last) investment equal to the market rate of interest.

a4. Because, broadly, the drug producers must produce goods valued by patients, and because, more narrowly, differential pricing (crudely, high prices for those willing to pay them and low prices for others) in the context of low marginal costs enables the firms to expand sales and increase profits by reducing prices for some consumers, the interests of drug producers and current patients to a substantial degree are aligned even in the short run.

a5. Note that P* is not necessarily the economically efficient price, which is a marginal price equal to marginal cost.

a6. The magnitude of the price discount affects the magnitude of the implicit stream of savings for consumers, but not proportionately: A discount of zero would yield no savings for consumers, while a price of zero also would yield no savings for consumers since drug producers would refuse to include those drugs in formularies. Therefore, bigger discounts are not necessarily better for consumers even in the short run. This is analogous to the “Laffer Curve” effect, much derided but in reality completely correct over some range of tax rates. In any event, if the drug producer could make more money by reducing the price, it would do so unilaterally.

a7. Prices lower than P* yield larger consumer savings on drugs included in formularies but consumer losses on drugs excluded from formularies; P* is defined to be the price that maximizes the flow of price savings.

a8. Again, these taxes and expenditures can be implicit, as in the case of discounted pharmaceutical prices yielding savings for drug consumers or spending increases for the beneficiaries of other spending programs.

a9. For example, a very low price in the immediate term might drive the given pharmaceutical producer to cease production of the drug in question, possibly yielding very high prices soon thereafter. This sort of “present value” calculation is inherent in this discussion but will be avoided for purposes of simplicity.

a10. This should make intuitive sense: As long as current policymakers can continue to obtain “cheap” medicine, and as long as future patients’ medical interests are not reflected in current voting, it is rational for current policymakers to favor policies transferring additional wealth to their constituencies.

a11. Evidence of such “shirking” behavior is weak. See Bruce Bender and John R. Lott, Jr., “Legislator Voting and Shirking: A Critical Review of the Literature,” Public Choice 87, nos. 1–2 (April 1996): 67–100.

a12. The technical analysis yielding this conclusion is available from the author upon request.

d1. Jim Hahn, “The Pros and Cons of Allowing the Federal Government to Negotiate Prescription Drug Prices,” CRS Report for Congress, February 18, 2005.

d2. Consider the ways in which theaters, restaurants, and myriad other sellers find ways to charge different prices to various consumer groups.