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The myth of the big bad drug companies

They're not greedy, they're over-regulated. The result is fewer pills to cure our ills.

December 22, 2006|Richard A. Epstein | RICHARD A. EPSTEIN is a professor of law at the University of Chicago and a senior fellow at the Hoover Institution who has often consulted for the pharmaceutical industry. His recent book is "Overdose: How Excessive Government Regulation Stifles Pharmaceutical Innovation."

THE PHARMACEUTICAL industry is getting bad press. Recent books by Marcia Angell, the former editor of the New England Journal of Medicine, and Jerome Kassirer, another former editor of the journal, have harshly condemned the industry for recklessness, insensitivity and all-consuming greed. They gain sales by spicing up their titles with inflammatory phrases about "deception," "complicity" and how drug companies "endanger your health."

I take a different approach. I don't defend every business decision made by the great pharmaceutical research houses. To the contrary, much recent commentary suggests that many such companies have committed themselves to a blockbuster-drug model -- in which a company's success or failure depends on a few vital, high-selling drugs -- that may prove unsustainable over the long haul. If so, I believe that those firms should suffer the financial consequences of their mistaken business choices. Government bailouts are no more appropriate for Merck and Pfizer than they are for Chrysler or Ford.

Nonetheless, critics like Angell and Kassirer are absolutely wrong to portray the nation's big drug companies as heartless, avaricious behemoths that act in whatever manner they choose and always get their way. The truth is, the pharmaceutical industry is too heavily regulated. Its big problem today is not that it's free to run roughshod over the needs of consumers, but that it operates in a hostile and excessive regulatory environment that frustrates sound business decision-making and keeps down pharmaceutical company share prices in the stock market.

Consider the following: Ever-tougher conflict-of-interest rules in the National Institutes of Health and such academic medical centers as the University of Pennsylvania, Stanford and Yale have reduced opportunities for fruitful collaboration between industry, government and universities. More stringent requirements for clinical drug trials -- including rules that demand larger test populations and more extensive documentation -- have reduced the flow of new drugs to market. (Between 1996 and 2000, the FDA averaged about 153 new drug approvals. Between 2001 and 2005, the number was down to 55, with only 15 in 2005 and 29 in 2004.)

In addition, the industry faces major liability risks. Consumer fraud legislation adopted in many states has generated massive, often eye-popping claims for refunds of the original purchase price -- in some cases even for drugs that have worked as promised or on the part of people who have not taken the drugs at all.

All these developments spell higher costs for the companies. Simultaneously, regulatory attacks on the industry's pricing model, including recent proposals to have the government negotiate rates for all senior citizens covered under Medicare Part D, threaten its revenue stream. The pharmaceutical industry operates in a high-fixed-cost and low-margin environment. It costs, on average, more than a billion dollars to get the first pill to market. All subsequent pills, however, can be made and marketed for only a few additional dollars or cents. Of course, no user ever wants to pay the big bill for that first pill. Instead, each fervently hopes to pay as close to marginal cost for the subsequent pills.

The problem with that is that unless someone pays for developing that first pill, there's no second pill to take. The central challenge to drug pricing is to figure out, quite literally, who swallows (and in what proportions) that huge front-end cost. Unfortunately, no company has a precise method to fairly, reasonably and palatably allocate the cost of drug development among the varied classes of subsequent consumers -- large HMOs, hospitals, full-service pharmacies and Medicaid for starters. Each buyer has a strong incentive to push as many of those costs as possible onto someone else.

The upshot is a rough-and-tumble bargaining game in which drug prices vary substantially across different market segments. But the corner drugstore doesn't have the same leverage to play one drug manufacturer off against another, so it usually pays higher prices for its wares than a large HMO. The resulting confusion leads to loud calls for equitable, industrywide price controls. But price controls would have the same dire consequences as they would in any other industry. Investment dollars will quickly move elsewhere if the regulatory system does not allow manufacturers to maximize their revenues over the useful life of the drug (which, incidentally, never exceeds the 11 or so years of patent protection).

Repeated studies, both domestic and foreign, have shown that price controls dull the incentives of pharmaceutical companies to develop new drugs. Even talk of price controls depresses investment.

Because of its high-fixed, low-variable cost structure, the drug industry will never reach perfect competitive equilibrium. But in our second-best world, ponder carefully the different consequences of two strategies. The first seeks to expand supply by avoiding regulation and encouraging the entry of new companies into the business. The second seeks to hold down prices by direct controls.

The second approach leads to low prices today but systematic shortages tomorrow, while the first leads to greater innovation today and greater choice tomorrow. We must be careful not to mistake price controls for a cure when they are in fact a disease. Let our new reformist Congress beware.

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