The myth of the big bad drug companies

Thanks to Richard Epstein for stating the obvious. Are things in the pharma world perfect? Far from it, but the cures some people would like to put in place would make things much worse. But then you get lots of political mileage from painting horns and a tail on someone easy to hate.

Critics like Angell and Kassirer are absolutely wrong to portray the nation's big drug companies as heartless, avaricious behemoths that act in whatever manner they choose and always get their way. The truth is, the pharmaceutical industry is too heavily regulated. Its big problem today is not that it's free to run roughshod over the needs of consumers, but that it operates in a hostile and excessive regulatory environment that frustrates sound business decision-making and keeps down pharmaceutical company share prices in the stock market. ...

All these developments spell higher costs for the companies. Simultaneously, regulatory attacks on the industry's pricing model, including recent proposals to have the government negotiate rates for all senior citizens covered under Medicare Part D, threaten its revenue stream. The pharmaceutical industry operates in a high-fixed-cost and low-margin environment. It costs, on average, more than a billion dollars to get the first pill to market. All subsequent pills, however, can be made and marketed for only a few additional dollars or cents. Of course, no user ever wants to pay the big bill for that first pill. Instead, each fervently hopes to pay as close to marginal cost for the subsequent pills.

The problem with that is that unless someone pays for developing that first pill, there's no second pill to take. The central challenge to drug pricing is to figure out, quite literally, who swallows (and in what proportions) that huge front-end cost. Unfortunately, no company has a precise method to fairly, reasonably and palatably allocate the cost of drug development among the varied classes of subsequent consumers — large HMOs, hospitals, full-service pharmacies and Medicaid for starters. Each buyer has a strong incentive to push as many of those costs as possible onto someone else.

The upshot is a rough-and-tumble bargaining game in which drug prices vary substantially across different market segments. But the corner drugstore doesn't have the same leverage to play one drug manufacturer off against another, so it usually pays higher prices for its wares than a large HMO. The resulting confusion leads to loud calls for equitable, industrywide price controls. But price controls would have the same dire consequences as they would in any other industry. Investment dollars will quickly move elsewhere if the regulatory system does not allow manufacturers to maximize their revenues over the useful life of the drug (which, incidentally, never exceeds the 11 or so years of patent protection).

Repeated studies, both domestic and foreign, have shown that price controls dull the incentives of pharmaceutical companies to develop new drugs. Even talk of price controls depresses investment.

Because of its high-fixed, low-variable cost structure, the drug industry will never reach perfect competitive equilibrium. But in our second-best world, ponder carefully the different consequences of two strategies. The first seeks to expand supply by avoiding regulation and encouraging the entry of new companies into the business. The second seeks to hold down prices by direct controls.

The second approach leads to low prices today but systematic shortages tomorrow, while the first leads to greater innovation today and greater choice tomorrow. We must be careful not to mistake price controls for a cure when they are in fact a disease. Let our new reformist Congress beware.

For those that were decrying the lack of vaccines last year, they need to review their history of how we got in this mess and re-read what the second approach gets you.