The day after the Democrats took both the House and Senate in November, the stock market was up. The share prices of the big pharmaceutical firms—Merck, Schering Plough, Pfizer, and Johnson & Johnson—dropped significantly, however. One explanation is Democrats’ big plans for Big Pharma. Citing high drug company profits, they’ve promised to make way for the federal government to negotiate pharmaceutical prices for Medicare recipients. Also brewing is legislation that would allow imports of drugs from Canada and possibly other countries.
It’s timely, then, that law professor Richard Epstein of the University of Chicago denounces exactly these kinds of proposals in his new book Overdose: How Excessive Government Regulation Stifles Pharmaceutical Innovation. Epstein argues that a laissez-faire approach—minimal government intervention and strong intellectual property rights—is the best way to encourage the big pharmaceutical companies to develop new therapies. He doesn’t prove, though, that the proposals the Democrats are currently floating will do much damage to drug innovation.
Epstein lays out the basic trade-off inherent in the patent system, and that’s useful for understanding why he thinks congressional efforts to lower pharmaceutical prices will ultimately backfire. New drug development is a very expensive gamble; companies invest a lot of money in pharmaceutical projects and only a minority of those projects result in viable drugs. It’s the highly profitable drugs that make the search worthwhile. If drug companies can’t charge high prices, they have little incentive to invent drugs in the first place. This is the Epstein trade-off: To induce a lot of innovation, we have to put up with high prices. Conversely, if we insist on lower prices, we have to expect less innovation.
Medicare drug price negotiation and reimportation of drugs from Canada are tactics designed to lower the prices that U.S. consumers pay for drugs. Indeed, the Republicans have argued that federal negotiation of Medicare drug prices is tantamount to price regulation. If that’s true, then Epstein is right. By lowering the prices that U.S. consumers pay for drugs, the incentive to invest in creating new drugs is lowered. But this leaves out an important piece of story. In fact, it is not at all clear that either Medicare price negotiation or Canadian reimportation would have a large effect on American pharmaceutical prices.
At first glance, it might seem otherwise. Supporters of Medicare price negotiation point to the government’s existing scheme for reducing drug prices for Medicaid participants. For Medicaid’s prescription benefit for poor people, the government rules dictate drug prices at 85 percent of the lowest price charged to a private buyer. The problem is that with many drugs, Medicaid is such a big buyer that the pharmaceutical companies keep an eye on the effect on Medicaid when they negotiate prices with anyone else. In a paper forthcoming in the Quarterly Journal of Economics, Mark Duggan and Fiona Scott Morton show that drug makers charge higher prices overall for drugs for which a large share of sales go to Medicaid, to lessen the pain of the 85 percent hit. If the Feds were to adopt a scheme for Medicare like the one for Medicaid, there is a good chance that drug makers would raise the prices they negotiate with private buyers on medication used largely by older people in order to ensure a healthy profit on Medicare sales.
A similar argument applies to reimportation. The United States represents more than half of the world drug market. Canada, by contrast, represents about 4 percent. Drug makers are willing to sell their product cheaply in the regulated Canadian market only because very few of the drugs leak back into the United States. If drug companies were forced to sell to American consumers at whatever price they charged in Canada, to preserve U.S. profits they would raise prices in Canada, or, if that was not feasible, cut the Canadians off. That might not be entirely bad. Right now, the Canadians are freeloading off American consumers who foot the bills for pharmaceutical innovations. The main point, though, is that unless reimportation extends to many countries that constitute a large fraction of world pharmaceutical sales, it likely won’t have a large effect on the prices paid by U.S. consumers.
So, none of the proposals currently on the table are very likely to much effect prices, and thus, they aren’t likely to have much effect on innovation. Of course, if the government were to develop a greater appetite for price interventions—putting price caps on pharmaceuticals, for example, or allowing widespread reimportation, then Epstein is right, incentives for innovation would fall.
But even that does not mean that all efforts to push down prices are wrongheaded. Epstein opposes efforts to lower drug prices because he views the resulting loss in innovation as unacceptable. But, here, we shift from an explanation of economic theory to a statement of Epstein’s preferences. Lowering drug costs at the expense of reducing future innovation is a trade-off that some consumers—particularly lower income ones—may well be willing to make. Sure, moving in this direction would reduce drug company profits. It misses the point, however, to frame the choice as drug company stockholders versus drug company consumers. A lot of people, including me, are both. Rather, the real debate is between consumers who want price relief today and consumers like Epstein who want the maximal number of new therapies tomorrow.
