TCS Daily

The Drug War

By Laurence J. Kotlikoff - October 21, 2004 12:00 AM

These days beating up on America's drug companies is PC, de rigueur, a national pastime -- you name it. Americans of all political stripes view the pharmaceutical industry as greedy, corpulent, and corrupt. They're mad as hell and aren't going to take it anymore. Everyone, they say. is either struggling to pay prescription drug bills or knows someone who is.

Senator Lott's 90-year old mother is an example. Her drug bills are so high that Senator Lott just plain got fed up, he says. He switched sides on the drug re-importation bill, stating that he can no longer abide by his mom's high prescription costs. He also issued a warning to the pharmaceutical companies "to address the overall rising cost of their products or the federal government will, and it won't be pretty."

Democrats are threatening the drug companies as well. Here's a typical statement from Congresswoman Rosa DeLauro (D., Conn.): "It is time that this Congress stop acting as a wholly owned subsidiary of the pharmaceutical companies and step up to its responsibility to the consumers of this nation."

Some docs are also upset with the drug companies. According to Dr. Marcia Angell, former editor of the New England Journal of Medicine and Senior Lecturer at Harvard Medical School, the pharmaceutical industry is "primarily a marketing machine to sell drugs of dubious benefit, (which) uses its wealth and power to co-opt every institution that might stand in its way, including the US Congress, the FDA, academic medical centers, and the medical profession itself."

As a myopic consumer, I'm all for beating up on the drug companies and forcing them to lower their prices -- in the short term. But as an economist trained to appreciate scarcity and the need to finance research and development, the public pillaring of the drug companies gives me lots of pause.

Yes, drugs are expensive. But so are lots of goods and services. Where I live, three bedroom homes cost an outrageous amount. Gasoline has gone through the roof. College tuition is stratospheric. And consuming double espresso latte frappe mocha grande supremos or whatever they call a cup of coffee at Starbucks can bust your budget in no time flat.

Funny, isn't it, that no one is accusing Starbucks of price gouging even though millions of Americans are addicted to the place and can't afford it. But who knows, Starbucks may be next on the hit list, particularly if Senator Lott's mom is a Frappucino junkie.

The drug companies get our gall because their products are so tiny, yet still cost so much. Take the new purple pill, Nexium. Depending on where and how you shop, each pill costs about 4 bucks - $4.63 on for each 40 mg dose, for instance, or $3.23 using the best discount from the new Medicare cards. At one level, this just seems amazing. But spend a day suffering with acid reflux, and you'll view it as a bargain. Also think of the millions upon millions of dollars that went into researching, developing, testing, and marketing those little purple pills and all the other little pills that didn't pan out or, like the arthritis drug Vioxx, were introduced to the market only to be recalled.

Of course no one is forced to buy coffee, let alone coffee from Starbucks, whereas we all need to fill our prescriptions. And for those drugs that we buy that are still protected by patents, there aren't a lot of substitutes. Consequently, drug companies are free to charge what the market will bear, which is typically a high price. Is this immoral? No, it's exactly what we established our patent system to produce. We want drug companies to charge high prices and reap high profits from new drugs that they discover and/or help bring to market so they'll have the incentive to keep developing new medications. We also want the business to be profitable so that the industry will experience lots of new entry.

Dr. Angell would have us believe this virtue is a vice. In a nutshell, she claims the drug companies are super profitable, don't spend enough on R&D, waste money on marketing and advertising, don't generate enough new discoveries, and free-ride on government research support. Rather than debate these dubious propositions, let's assume, for argument's sake, that they are all true. In this case, Dr. Angell should set up a new drug company or engineer the buyout of an existing company. With her new company, she can choose to spend more on R&D, make more discoveries, bring more drugs to market, cut back, if not eliminate, marketing and advertising, benefit from government research support, and end up with higher profits than current drug companies. That's the nice thing about an open market. You're free to invest your time and money where your mouth is.

As far as I know, Dr. Angell is not setting up her own drug company. Nor are new entrants to the drug industry popping up every day. Nor is there a plethora of pending takeovers of existing drug companies. These facts suggest that the market is properly pricing these companies, that the risk-adjusted expected return available to pharmaceuticals on marginal investments is not supernormal, and that the industry isn't acting stupidly when it comes to deciding how much to spend on R&D, marketing, advertising, etc.

This doesn't mean that all is fine in drug land. Dr. Angell offers a number of timely and important suggestions for improving the objectivity of drug testing, protecting the independence of academic research, and ensuring that doctors aren't rewarded for prescribing particular drugs. But where I get nervous is when she and others start advocating price controls. Price controls would be the death knell of pharmaceutical R&D in the U.S. just like it has been in Europe, Canada, and Japan.

Dr. Angell should be careful what she wishes for. And Congress should be careful what it votes for. As I understand it, the drug re-importation legislation now pending before Congress would effectively impose Canadian pharmaceutical price controls on the U.S. market. Here's how. The legislation requires U.S. companies to sell to Canadian pharmacies as much product as they demand and then permits these pharmacies to sell the same drugs back to the U.S. market at the Canadian price; i.e., the price set and controlled by the Canadian government. If this law passes, essentially all our prescription drugs will be shipped out of the country and then back into the country to be sold to us at prices set in Ottawa. Since the Canadian prices are typically 20 to 40 percent lower than the U.S. prices, we're talking here about wiping out most of the U.S. industry's profit margin and with it most of the U.S. industry's incentive to find and develop new medications.

Major threats to the U.S. drug industry come from other quarters as well. Wholesale violation of patents is occurring in large parts of the developing world. And the World Health Organization's recently established Commission on Intellectual Property Rights, Innovation, and Public Health seems eager to water down current U.S. patent protection and provide a green light to patent infringements that it deems are "justifiable."

U.S. drug companies aren't paternal organizations. They aren't our friends. And like all other businesses, their sole goal is making money. But the drug companies are also our best and, indeed, our only hope for curing hundreds of horrible and often deadly diseases. Consequently, we can complain, swear, and beat our breasts about the high costs of drugs. But killing this critically important golden goose -- the pharmaceutical industry -- is the last thing we want to do.

The author is Chair, Department of Economics, Boston University and a TCS contributor.


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