Right Diagnosis, Wrong Cure: Examining the True Cost of Drug Price Controls

Healthcare affordability remains a prominent issue in Washington, with many policymakers looking for ways to lower patented drug prices, such as Most-Favored-Nation drug pricing and other sanctions.

During this webinar,  Professor Tomas Philipson, former Acting Chair of the Council of Economic Advisers, and Mercatus Research Fellow Satya Marar, author of Right Diagnosis, Wrong Cure, examine what the evidence shows about the impact of drug price controls on healthcare affordability, medicinal R&D, and innovation.

Transcript

SATYA MARAR: Greetings everyone and welcome. Cost of living and affordability are high on most Americans' list of concerns. Prescription drugs are no exception. Americans are rightly frustrated and confused about why we pay two to three times the price for the same patent drugs that citizens of other developed nations pay. But what's missing from this conversation is the reality that it takes billions of dollars in upfront investment to discover, research, develop, and bring new drugs to the market. And the ability to recoup that revenue through a temporary period of monopoly over the drug is the high-powered incentive needed for that investment. It's no surprise, then, that less expected future revenue means less investment in R&D, and the high sunk cost of failed projects and trials before a blockbuster drugs are discovered mean that companies must make a 60% profit on their commercially successful drugs to get just a 4% return on their overall assets, according to the Congressional Budget Office.

Americans might pay more for patented drugs, with prescription drugs accounting for 9% of the federal health budget, but being the source of a disproportionate amount of global revenue means that we can access the most and newest drugs before citizens of other countries. America also witnesses faster entry of generic drugs than other countries, and this puts downward pressure on prices, but there will be nothing for generic manufacturers to replicate if it wasn't for the commercial incentive to discover and bring new drugs out in the first place. Despite all this, Democratic and Republican administrations alike have tried to replicate some of the tactics that other governments and their single-payer healthcare systems use to keep prices low. Under the Biden administration's Inflation Reduction Act, makers of some patented drugs must enter into negotiations with the government to set a so-called maximum fair price for their drugs, and failure to sell at that price means incurring financial penalties.

This effectively reduces the exclusivity period for a small molecule drug to just eight years after FDA approval and a biologic to about 13 years, shifting incentives to fund research between projects based on things other than what is most useful and valued by the public. More recently, the second Trump administration introduced an executive order on most-favored-nation drug prices that threatens manufacturers who don't lower their prices to the prices they charge in other countries with targeted lawsuits, antitrust investigations, tariffs, and even revocation of the approval for their drugs if they don't comply. The legal authority of the administration to do this is questionable, and it will likely be as challenged as the first administration was when it tried doing something similar. However, a number of companies have still entered into voluntary agreements with the government to lower their prices, most notably makers of GLP-1 drugs. This might seem like a great win right now, but it remains to be seen how this will affect research and development for such new drugs in the future, especially considering that many of these cures help keep Americans out of the hospital, and hospitalizations remain one of the biggest costs that our public healthcare system incurs.

To unpack all of this, I'm joined by Professor Tomas Philipson of U Chicago, who is also a senior economic advisor of the first Trump administration. Welcome, Tomas.

TOMAS PHILIPSON: Morning.

MARAR: All right, so help set the scene for us. Why are American patented medicines so much cheaper in other countries, and why can't we just do what they do? Why do we pay so much more?

PHILIPSON: So the first thing I want to argue is that essentially [the] US is paying less than other countries for prescription drugs. And that sounds strange to many people who are in the policy circle, so let me explain where I'm coming from on that argument, which I think is definitely true. The reason is that about 93% of prescription drugs in the US are generic, generics of patent drugs, essentially. And [the] US is roughly benchmarked paying half the price of generics relative to other countries, particularly in Europe. So more than nine out of 10 times you go to the pharmacy, you're paying half of what other countries pay in the US.

Obviously, we're paying more for brand name drugs on patent drugs. And essentially that order of magnitude is roughly 3X relative to other countries, and it varies a lot across those countries. But if you look at the average prescription price, therefore—which we usually weigh volume when we take average prices—our prices are actually, for the government—Medicaid and Medicare—about 18% below the average price of a prescription abroad in Europe. I think that's very important for several reasons. And this is all on our center webpage, by the way, if you're interested in the exact sources, they're all on the Initiative for Choice of Competition in Healthcare, which is at the University of Chicago Department of Economics. The reason why this is important is that essentially people will argue, “but wait a minute, Thomas, spending is much higher on brand name drugs. In fact, 80% of spending roughly is on brand name drugs compared to generics.”

The way that's misleading is because the reason spending is so high on brand name drugs in the US is because generics are so cheap. If generics were free, then we would have 100% of spending being on brand name drugs, essentially. And presumably all the patients would be better off who got 93% of their prescriptions for free, even though 100% in that case would be spent on brand name drugs. So, the fact is that we have this system in the US where we have a more than 90% generic market share relative to Europe, which has many times, 70 or 75%, market share of generics. And also, in addition, they pay more for generics, so they have lower penetration or lower volume potentially due to the fact that they pay essentially more for generics. It's not surprising that they therefore potentially have lower volumes relative to the US. But because they have lower volume and pay more, essentially, their spending on generics as the share of spending is much, much higher.

So I think that's important to recognize. We have the Hatch–Waxman system in the US, which has fierce competition for generics. And generics is by far the most common form: Nine out of 10 prescriptions are generics. So we're actually living in a world where we're the most favored nation for prescription drug prices in the US.

MARAR: Great. I think that's something that a lot of people end up missing out on. The fact that we are such a huge market for drugs means that we do get access, even to generics, a lot faster than other countries do. And also, as you pointed out, we have those regulatory settings, including the Hatch–Waxman Act, that foster a generic entry.

You mentioned your study, which found that US public sector prices for prescription drugs are 18% lower than comparable PR nations like France, Germany, Canada, and Japan. What does the data then say about private sector prices, what our insurance plans pay?

PHILIPSON: We have actually replicated that. We're in the process of trying to extend the study to commercial plans. Obviously, commercial plans pay above Medicare, and particularly Medicaid that has a 23% discount relative to commercial plans. But it's still true because of the high penetration of generics in commercial plans, because they are obviously into the cost savings of generics, and many states therefore mandated, even for both public and private payers, essentially, to have generic penetration that is very high. So even though the numbers are not as stark, it's still true that average prescription drug prices, even when you include the commercial sector in the US, is lower in the US relative to abroad.

MARAR: Great, cool. I'm definitely looking forward to seeing that study. So why does the media and policy debate almost exclusively focus on brand name list prices? And what are the consequences of policymakers designing price controls based on this sort of incomplete data that doesn't look at what people actually pay?

PHILIPSON: There's a very important point here that we are also in the process of analyzing, and this will come out in a couple of weeks, which is if you only focus on brand name prices, you will basically have very adverse effects many times on price controls on those brand name drugs. So, if you take IRA, the Inflation Reduction Act, which controls prices at the last three or four years of your exclusivity period, they only come in at the end of the exclusivity period with the negotiations. The problem with that is that you basically are interfering with generic entry after the patent expires. Generic manufacturers, the Association of Affordable Medicine, raised this issue very quickly after the IRA was implemented, that you're now basically limiting competition in the generic market after the molecule expires. That's a major issue. There are two issues there. The generic manufacturers don't know exactly what drugs are going to be negotiated, so they don't know.

It takes a year or two to prepare to hit a target that is expiring. But if the public sector through negotiations comes in first, all their investments are in vain. So there's a lot of uncertainty for them. Which is the target that we're actually going to attack with price competition when the patent expires? That's one issue. But even if you have that being clear, the fact that the government lowers the revenue of these companies dramatically with negotiations makes them less of a useful target for generics. They want to come in and get the first guy to get the 180 days where they're alone and then get more and more entrance coming in. That whole process, the manufacturing association of generics has now been upended, according to them. And therefore, competition is not as fierce after the patent expires, meaning prices are not going down as much as they otherwise would when a big brand name drug goes off patent.

Remember, IRA goes after the highest spending brand name drugs. So those are the ones where the generics have the fiercest competition coming in after the patent. So here's the bottom line of this, which is very important. You may lower brand name prices at the last end of the exclusivity period, but if you raise prices after that exclusivity period, it may turn out that's more important, because the three or four years of production may be dominated by 20 years of generic prices being higher than they should be after the patent expires. So, it may be that for some drugs we're finding that these price controls increase the lifetime price of the molecule as opposed to decreasing it because you don't make up the brand savings with generic, or you basically have offsetting generic effects after the patent expires that dominate the savings of the brands before the exclusivity runs out.

MARAR: That's really interesting. And I think we all know that in theory price controls lead to shortages, but they also create this sort of significant uncertainty, and it clearly seems like that's a huge issue in these sectors, which are characterized by huge upfront investments and expectations about future revenue. 

You've established that for every 1% cut to pharmaceutical revenue, there would be a roughly 1.5% drop in pharma R&D. How would this decline affect other costs in the healthcare system in the long run?

PHILIPSON: Well, that actually is not our finding. We have used that finding to study the effects of if IRA reduces revenue, how much does R&D get cut, and therefore how many fewer drugs get introduced. But that number comes actually from an average of the entire economic literature on this, which is studied quite extensively. There are about 15 papers in that literature on estimating the elasticity of R&D to revenues—ust to make clear that that's not our number, that comes from a broader economic literature. That's an important caveat to that. But how do drugs essentially affect the rest of healthcare? It depends on the drug class. So, in certain drug classes, certainly drug spending raises total healthcare spending. But in many drug classes, the increase in drug spending is more than offset in future reductions of other forms of spending. Other forms of spending go down more than drug spending goes up.

Think of SSRIs replacing the manual labor costs of shrinks. Think of GLP-1s having offsetting effects on diabetic care or heart disease care, et cetera. And similar with statins in heart disease having offsetting effects on surgical expenditures at hospitals. These are usually called cost offsets. And many times it is the case that the increased drug spending, even for the big sort of poster child when people thought drug spending was getting too high, which was Sovaldi for Gilead for hepatitis C, it turned out that the increase on Sovaldi spending for curing hepatitis C was dominated by the reduction in future cost of liver transplants, et cetera, that were saved from people not having more severe liver disease. It's many times the case that future healthcare spending more than offsets drug spending. Now the CBO doesn't score it that way when they do federal impact analysis because they basically take a very biased stand on the literature. So they only say for every $1 increase in drug spending, you only save 20 cents. But that's a very strange take on the literature that we have summarized in other papers.

MARAR: Great. And I think that's just so important because hospitalizations alone account for about 30% of federal healthcare budget, and that's more than three times what the federal budget is spending on drugs.

This year you pointed out that nearly 60% of cancer drug improvements between 2000 and 2024 focus on treating the disease earlier in its course. So why are price controls uniquely destructive for these earlier stage innovations? And what does a patient lose when we disincentivize drugs that prevent long-term complications rather than just treating the late-stage symptoms?

PHILIPSON: The oncologist is a very important case because about half the pipeline, almost half if not all of FDA drugs is oncology. It's a very, very large drug class, the largest drug class. If you look at oncology, how it was impacted from IRA, particularly in small molecules, the problem is that essentially when you have new indications—if you have an oncology drug that works for breast cancer, but you want to extend it to liver cancer or what have you, another new indication—they don't let you get a new extension in exclusivity on the IRA. So you're still under the nine-year or 13-year time clock during IRA. What that means is that many times these new drugs that come out after the first drug that are follow-on drugs on the initial innovation are much more productive because they hit lower, earlier stages of the cancer.

So instead of treating a metastatic stage four cancer, the next drug follow-on drug to the same molecule is treating it in stage two or stage one, ideally. So what we found is essentially that follow-on innovation hits much earlier stages of cancer. And therefore, when you hit much earlier stages of cancer, you're basically getting much larger treatment effects of these drugs because you're not at the last step of the cancer where it's gone metastatic across several organs. I think that's very important because many times the follow-on innovations are the real valuable ones relative to the initial molecule. It's essentially saying that once you get a new cancer drug approved, that's just the start of a set of new drugs that can actually be even more beneficial than the initial one. And that's what's being limited by these time clocks not adjusting to new indications.

MARAR: I think that's a really important point. And I've also heard that it's leading to great delays, even if this follow-on innovation eventually happens—delays in them being introduced to the population because these exclusivity periods cut out a certain number of years after the initial approval. I think that's another important thing.

The Congressional Budget Office—and you mentioned some of the issues that they have with how they score costs—they projected that the IRA would only result in a tiny handful of lost drugs, whereas your research shows that it will likely result in 135 fewer new approvals. Could you elaborate a little bit more on why there was such a big gap between your economic modeling and the government's projections?

PHILIPSON: That's a very good question. So let me start with why we got our numbers, and then I can speculate what CBO is doing. Again, this was not really our analysis. We basically took the CBO's number on revenue reductions from IRA, which they said would be 12%. We then took that to the economic literature and just said, What is the R&D reduction associated with a 12% revenue reduction, according to this literature I mentioned before, that measures how much R&D gets reduced when revenue gets reduced? We took an average of that literature and said, here's how much less R&D is done. And then we have also an existing literature—What does that mean for the new number of drugs coming on the market? So we are basically taking several literatures and just putting them to CBO's revenue reductions and coming up with those numbers. Now CBO said that we will lose five drugs in 30 years or some incredibly low number, which has already been rejected.

If you look at earnings calls of public companies who have to report what they're doing to their investors and also can go to jail if they do lie to their investors on these earnings calls,  they’re pretty disciplined discussions. In those earnings calls, there was much more pulling of drugs in the pipeline due to IRA than we estimated. So we are basically too low relative to the flow of new drugs being pulled by the companies. Now that's an underestimate of the total effect because some drugs will never be started because of IRA, and we certainly don't see those on the earnings calls. So I think we essentially have underestimated the total effect, and CBO has drastically underestimated. They then released a call for sort of a request for information on how they want to revise their estimates of drug introductions in responding to price controls, which is a positive sign.

On their side, though, is that this is not really their business. CBO is set up to just score budget effects. Implicit though in that effort, they must score essentially future spending, which is also dependent on innovation, obviously. So they're kind of forced to take a stand on this, but they did not. They certainly did not successfully take a stand on the IRA.

MARAR: Thomas Sowell once said that you shouldn't trust people who have nothing to lose by what they say, and you can probably better trust people who have a lot to lose. I think that's also quite important. 

I want to move on to the MFN executive order. I seems to me that the rationale behind that proposal and a similar one by Senator Josh Hawley from Missouri is that if we try to force drug makers to sell their drugs at the same price they sell the same drugs overseas to foreign governments that use their buyer monopsony power or price controls to keep the prices low, in theory that would result in these companies simply raising the price they charge in those countries, maybe achieving some kind of parity and in theory leading to those countries paying whatever the alleged fair market value is for those drugs. Is this likely to be the actual result? And who, if anyone, is likely to step in to fund the sort of R&D if the US contributions decline?

PHILIPSON: Well, it is true, I believe, that if you have to have the same price in the US and many other countries who have price controls, you will eventually, if the US price comes—let's say we take Canada just for the sake of argument. Canada is about 5% of our sales in drugs. If you were to lower the US price to Canadian levels, you would most likely face a shareholder lawsuit, I would assume, because that's basically suicidal. About 75% of global earnings in biopharma occur in the US because the US is the largest market and the richest market, but also because we don't have price controls. So it's an enormous disproportionate share of funding R&D returns across the world. Novo Nordisk is a Danish company. They don't innovate for five million potentially obese gains. They innovate for Medicare and the US market. So the whole world R&D spending depends on the 75% of earnings coming from the US market.

If you were to threaten that by trying to mimic the lower price in a smaller country or in Europe, I mean there's a strong case that your shareholders would do something to you. So the question then becomes, if then you go and try to have upward pressure on foreign countries’ pricing, they will tell you, thank you very much, but we can't afford your prices. That is actually not true in general because of the argument I gave in the beginning that, it turns out, like I said, that we have cheaper prescription drugs than abroad. So if they reallocated their generic spending to innovative spending, they could actually do two things at once. One is have our prices for brand name drugs. Second, spend less in total on drugs because they're basically offsetting that by lower generic spending essentially if they mimicked our Hatch–Waxman pricing of generic and brand name drugs.

Obviously that's not going to take place overnight, but it is a case that can be made that Europeans can essentially spend less total on drugs and stimulate innovation more like the US. But that's not going to happen in the near term. So in the near term, they will say, "Thank you very much, we can't afford your prices,” and therefore may potentially either walk, not buy the drug at all, or compulsory-license the drug in their country because the manufacturer refuses to lower the US price to accommodate the price in the foreign country. And if that's the case, then MFN leads to more free riding as opposed to less, because then US in the extreme case paying for 100% of the return to innovation if the foreign country either steals the patent or doesn't buy the drug, just waits it out to become generic.

I think that the tying prices across countries—not a good idea to attack this. I think the president was right with what he did in the UK–US trade deal, which is to have bilateral deals, where US has a lot more power in bilateral deals than multilateral deals to force these countries up in their pricing, which they did with the UK. If they can do that with the five largest countries—Germany, they now have a 301 investigation of Germany, that's obviously the largest European country—they can do it with France and Italy and Japan. They're well on their way of getting something through trade negotiations, which I think is a much more productive way than tying prices across countries.

MARAR: Absolutely. I'm also weighing on the side of this being more of a trade issue certainly than it is an issue for some kind of technocratic pricing. And there's been plenty of good research from Professor Lichtenberg and others looking into how price discrimination between geographic markets promotes actually better outcomes, and preventing it or constraining it will probably result in shortages across the board because you can't allocate those resources efficiently.

I'm a bit curious about why it is that there's maybe this reluctance in... I mean, I can understand why foreign developed countries don't want to shoulder their citizens with higher taxes or higher prices in the short term because of the political incentive there. But why have they not decided to go for something like the Hatch–Waxman Act, the settings on making generic entry more fast and easy?

PHILIPSON: Well, I think some of the countries like Spain or Canada, they have very strong generic manufacturers also, so they are very reluctant to go after their own industries in that regard. But also we have much more fierce private competition in those countries in general. It's not just for generics, but it's true across many, many industries. But I've been in discussions with several European countries, and there is some potential momentum of getting them to move in this direction essentially. They realize that, Why are we spending money on the copycats as opposed to the guys who came up with this stuff? And if they did, they could potentially lower their total bill for prescription drugs on average. If that becomes clearer, and if that actually has some momentum, which I hope it will, it will still take a lot of time for those reforms. Maybe one country will do it and then other countries see the value of it, but it's still very far a long time away, put it that way.

MARAR: Because maybe we could use our trade leverage to nudge them perhaps in the right direction.

Well, thanks so much for that. It seems to me that a big takeaway from all this is that we often hear about the trade-off between incentives to innovate and make new drugs and then paying lower prices. But I think clearly what the evidence is showing is that these policies, these price control policies will also likely fail to achieve the very thing that they want to achieve, which is lower prices, which is lower taxpayer spending while depriving tons of people of potentially new cures by limiting that competition. So thank you so much for joining us, Professor Philipson, and look forward to seeing and reading more of your research as it comes out.

PHILIPSON: Great. Thanks for having me. Appreciate it.