The dark side of drug price controls

The perception that major, multinational pharmaceutical firms gouge the ill and are the cause of the explosion in drug expenses is widespread. Drug costs have undeniably risen more quickly than other health-care costs—from 10.8% in 1988 to 15.7% in 2001 of overall Canadian health-care spending—but this is not due to price increases imposed by pharmaceutical companies. Other factors explain the growth in drug spending, including more frequent use of drugs (more prescriptions per patient per year and the fact a growing number of people are on medications) as well as higher mark-ups at the wholesale and retail levels.

In reality, pharmaceutical prices are anything but rising quickly. Since 1987, the Patented Medicine Prices Review Board (PMPRB), the quasi-judicial Canadian federal body, has controlled the prices of patented drugs from their launch, with increases tied to the consumer price index. Over and above this, the provincial governments of Ontario and Quebec have imposed price freezes for several years on the drugs they buy for their health-care systems. Contrary to public belief, real patented drug prices—with inflation taken into account—have been falling, between 1998 and 2002, by an annual average of 1.9%.

One might think this is good news for drug consumers and for the government’s finances. But this policy, like all forms of price controls, has adverse effects on pharmaceutical innovation—a threat not only to patients’ well-being, but also to Montreal’s economy.

Rising research costs

The costs—and risks—of discovering and launching a new drug have risen sharply in recent years. After adjusting for inflation, the average R&D cost of a new drug went from $318 million US in 1991 to $802 million US in 2001 (in 2000 dollars). The entire R&D process can last 10 to 15 years. At the same time, R&D productivity is declining because it has become harder to find new molecules; the easier-to-find ones have mostly already been discovered. For each 10,000 molecules at the pre-clinical testing stage, only one will obtain approval and go on commercial sale.

Because of this, merely maintaining the current pace of pharmaceutical innovation requires spending a greater share of resources on R&D. In Canada, however, R&D spending in relation to revenues from drug sales is not only lower than in other developed countries but has fallen sharply since 1997. In fact, the ratio at companies reporting to the PMPRB went from 11.32% in 1997 to 9.24% in 2002.

With the costs and risks involved in developing new drugs continuing to rise, price controls make investing in R&D less attractive. They add extra risks and uncertainties, with companies never being sure of the selling prices of their future drugs. Companies may even find themselves having to reimburse sizable sums. For example, Schering Canada Inc. had to reimburse $7.8 million in 2003 because it charged a price judged as excessive for its infliximab (Remicade) drug.

Who would be tempted to invest under these conditions? It is hardly a surprise that investors are pulling out a growing portion of their funds. National subsidiaries of pharmaceutical companies compete for R&D budgets, which are managed centrally and their allocation is based on revenues and cash flow in each country.

Price controls cause a direct reduction in volume. Thus, Canadian subsidiaries are getting a declining number of R&D missions. At the end of the road, this leads inevitably to slower pharmaceutical innovation. Canada seems to be on the same track as Europe, where there has been a notable drop in pharmaceutical R&D.

But there are other major costs linked to drug price controls. These include losses of highly skilled jobs, corporate research centres and jobs foregone in the subcontracting of goods and services and in industries associated with R&D. Another result is lower performance in health-care procedures. A recent study by the international consulting firm Bain & Co. provides an example: Drug price controls saved Germany $19 billion US in 2002, but the negative consequences cost $22 billion US, for an overall loss of $3 billion US.

The same phenomenon poses a threat to Canada and in particular to Quebec, home to Canada’s largest concentration of pharmaceutical R&D, with 42.3% of total spending in 2002. Most of these big pharmaceuticals are located in Montreal’s West Island. A decline of pharmaceutical research in Canada would hit Quebec hardest.

A price explosion?

If there were no controls, would we have to fear a sudden rise in prices toward levels observed in the U.S.? It is clear abandoning controls would mean the prices of some innovative drugs would be higher at their launch. But general price levels could be expected to remain more or less unchanged.

Between one-third and one-half of the difference between Canadian and U.S. prices may be due to lawsuits in the U.S. A major part of the remaining difference is due to the gap in living standards and incomes between Canada and the U.S. Companies adjust their prices based on purchasing power in specific markets where they sell their products. Second, the provincial governments have considerable negotiating power in obtaining price reductions, equivalent to medium-size health maintenance organizations (HMOs) in the U.S.

Finally, there would be downward pressure on the prices of older patented drugs and non-patented drugs since distortions caused by price controls would cease to exist. At the moment, some generic drugs are paradoxically more expensive in Canada than in the U.S. This is because price controls eliminate incentives for pharmaceutical firms to lower the prices of drugs already on the market, since the PMPRB uses them for comparative purposes. Companies prefer to keep these prices higher so they can launch new drugs at prices providing for fuller recovery of R&D, launch and marketing costs. This situation also leads generic drug producers to sell their goods at higher prices.

A more economically rational price structure would again reward pharmaceutical innovation and provide an invaluable service by saving patients and sometimes replacing more expensive hospital care. It would also contribute to economic dynamism in Montreal and across Canada. In contrast, maintaining administrative price controls over drugs seriously compromises the longer-term preservation of these beneficial effects on our quality of life.

Valentin Petkantchin is MEI’s Research Director and author of the Economic Note entitled Drug Price Controls and Pharmaceutical Innovation.

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