Are Drug Price Controls Good for Your Health?

Now that the Medicare Prescription Drug, Improvement and Modernization Act (MMA) of 2003 provides senior citizens with drug insurance coverage beginning in 2006, several political and special-interest groups have expressed the opinion that the Medicare program should use its immense bargaining power to negotiate prices directly with drug manufacturers. While the MMA, as enacted, forbids such direct negotiation, a modification allowing direct Medicare negotiation is now under consideration. Specifically, proponents such as the American Medical Association and the AARP want the government to reduce drug prices paid by Medicare to those purchased by the Department of Veterans Affairs in the U.S. or set by the Patented Medicines Price Review Board in Canada.

New drugs generate immense social benefits by saving, improving, and extending lives. Economic theory is clear in its prediction that price controls will reduce biotechnology and pharmaceutical research and development (R&D) by lowering expected revenues and through reduced cash flows.

By 2006, the federal government will be purchasing or paying for nearly 60 percent of all prescription drugs in the United States, making it the most important buyer of medicines in America. Hence, we might assume that federal price controls will reduce incentives to invest in new drug development. To determine how direct Medicare negotiation and formulary restrictions might affect pharmaceutical and biotechnology R&D, in this study we examine how government influence has historically affected pharmaceutical prices. Based upon this evidence from the past, we can infer, rather than speculate about, the impact of what happens to pharmaceutical and biotechnology prices and R&D in the future as government exerts more control over prices.

Collecting national data for the U.S. for 1960-2001 and using multiple regression analysis, we find that from 1992 to 2001 a 10 percent increase in the growth of government's share of total spending on pharmaceuticals was associated with a 6.7 percent annual reduction in the growth of pharmaceutical prices. Two new laws, OBRA of 1990 and the Veterans Act of 1992, aimed at controlling drug prices under public programs, account for much of this impact.

Using these regression results, we then simulate how the prices for medicines would have differed throughout the period from 1960 to 2001 in the absence of any government influence. The simulation implied that the ratio of the pharmaceutical price index to the general price index would have been 1.27 rather than 0.94 in 2001, suggesting that pharmaceutical prices would have been about 35 percent higher, on average, in the absence of this government influence.

Using the predicted trend in pharmaceutical prices without government influence and an established elasticity of R&D spending with respect to drug prices from prior research, we determined that the resulting government-induced loss of capitalized pharmaceutical R&D expenditures was $188 billion (in 2000 dollars) from 1960 to 2001. This "lost" R&D may be translated into human life years "lost"-literally, increased pain and suffering and shorter lives caused by the absence of new medicines and future research-by using results from recent econometric work on the productivity of pharmaceutical R&D in the U.S. over the same period. We conclude that the federal government's influence on real drug prices cost the U.S. economy approximately 140 million life years between 1960 and 2001.

Applying this same analysis to the future, we predict that the increased government influence on drug purchases under the MMA will dramatically reduce both real drug prices and R&D spending. We estimate that real drug prices will decline by 67.5 percent (or about 49 percent lower than pre-MMA levels) if purchases under the MMA are treated in the same manner as drug purchases under Medicaid and the VA have been treated historically. We further estimate that this decline will reduce R&D spending by 39.4 percent, or $372 billion over the lifetime of the act. This translates into a reduction of 277 million life years.

With the passing of the MMA, an additional 14 percent of the population and, more important, an additional 40 percent of all drug consumption, will fall under government's purview. Many wish to replace the noninterference clause presently contained in the MMA with some type of direct government price setting mechanism. The results of this study indicate that government's downward pressure on drug prices has historically generated sizable social costs during a forty-year period when only a relatively small percentage of pharmaceutical expenditures were directly controlled by the government.

This suggests that imposing price controls similar to those found in the VA, Canada, or Medicaid for 60 percent of all biotechnology and pharmaceutical use will reduce investment in R&D and lead to a loss of life and life expectancy of a greater magnitude than has been the case for the past half-century for these types of price controls. Consequently, our findings suggest that informed public policy debate should consider the trade-off between lower drug prices now and future health benefits lost because of lower R&D spending.

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