Pharmaceuticals: Economics and Regulation

by Charles L. Hooper
About the Author
Pharmaceuticals are unique in their combination of extensive government control and extreme economics, that is, high fixed costs of development and relatively low incremental costs of production.

Regulation

The Food and Drug Administration (FDA) is the U.S. government agency charged with ensuring the safety and efficacy of the medicines available to Americans. The government’s control over medicines has grown in the last hundred years from literally nothing to far-reaching, and now pharmaceuticals are among the most-regulated products in this country. The two legislative acts that are the main source of the FDA’s powers both followed significant tragedies.

In 1937, to make a palatable liquid version of its new antibiotic drug sulfanilamide, the Massengill Company carelessly used the solvent diethylene glycol, which is also used as an antifreeze.1 Elixir Sulfanilamide killed 107 people, mostly children, before it was quickly recalled; Massengill was successfully sued and the chemist responsible committed suicide. This tragedy led to the Food, Drug, and Cosmetic Act of 1938, which required that drugs be proven safe prior to marketing.2 In the next infamous tragedy, more than ten thousand European babies were born deformed after their mothers took thalidomide as a tranquilizer to alleviate morning sickness.3 This led to the Kefauver-Harris Amendments of 1962, which required that efficacy be proven prior to marketing. Note that even though thalidomide’s problem was clearly one of safety, an issue for which the FDA already had regulations, the laws were changed to add proof of efficacy.

Many people are unaware that most of the drugs, foods, herbs, and dietary supplements that Americans consume have been neither assessed nor approved by the FDA. Some are beyond the scope of the FDA’s regulatory authority—if no specific health claims are made—and some are simply approved drugs being used in ways the FDA has not approved. Such “off-label” uses by physicians are widespread and can reach up to 90 percent in some therapeutic areas.4 Although the FDA tolerates off-label usage, it forbids pharmaceutical companies from promoting such applications of their products.

Problems, sometimes serious, can arise even after FDA approval. Baycol (cerivastatin), Seldane (terfenadine), Vioxx (rofecoxib), and “Fen Phen” (fenfluramine and phentermine) are well-known examples of FDA-approved drugs that their manufacturers voluntarily withdrew after the drugs were found to be dangerous to some patients. Xalatan (latanoprost) for glaucoma caused 3–10 percent of users’ blue eyes to turn permanently brown. This amazing side effect was uncovered only after the drug was approved as “safe and effective.” One group of researchers estimated that 106,000 people died in 1994 alone from adverse reactions to drugs the FDA deemed “safe.”5

One problem with the 1962 Kefauver-Harris Amendments was the additional decade of regulatory delay they created for new drugs. For example, one researcher estimated that ten thousand people died unnecessarily each year while beta blockers languished at the FDA, even though they had already been approved in Europe. The FDA has taken a “guilty until proven innocent” approach rather than weighing the costs and benefits of such delays. Just how cautious should the FDA be? Thalidomide and sulfanilamide demonstrate the potential benefit of delays, while a disease such as lung cancer, which kills an American every three minutes, highlights the costs.

In 1973, economist Sam Peltzman examined the pre- and post-1962 market to estimate the effect of the FDA’s new powers and found that the number of new drugs had been reduced by 60 percent. He also found little evidence to suggest a decline in the proportion of inefficacious drugs reaching the market.6 From 1963 through 2003, the number of new drugs approved each year approximately doubled, but pharmaceutical R&D expenditures grew by a factor of twenty.7

One result of the FDA approach is the very high, perhaps excessive, level of evidence required before drugs can be marketed legally. In December 2003, an FDA advisory committee declined to endorse the use of aspirin for preventing initial myocardial infarctions (MIs), or heart attacks.8 Does this mean that aspirin, which is approved for prevention of second heart attacks, does not work to prevent first heart attacks? No. One of the panelists, Dr. Joseph Knapka, stated: “As a scientist, I vote no. As a heart patient, I would probably say yes.” In other words, he had two standards. One standard is the scientific proof that aspirin works beyond any reasonable doubt. By this standard, the data on fifty-five thousand patients fall short.9 The other standard is measured by our choices in the real world. By this standard, aspirin passes easily. “The question today isn’t, does aspirin work? We know it works, and we certainly know it works in a net benefit to risk positive sense in the secondary prevention setting,” said panelist Thomas Fleming, chairman and professor of the Department of Biostatistics at the University of Washington, who also voted no.10

When our medical options are left to the scientific experts at a government agency, that agency has a bias toward conservatism. The FDA is acutely aware that of the two ways it can fail, approving a bad drug is significantly worse for its employees than failing to approve a good drug. Approving a bad drug may kill or otherwise harm patients, and an investigation of the approval process will lead to finger pointing. As former FDA employee Henry Miller put it, “This kind of mistake is highly visible and has immediate consequences—the media pounces, the public denounces, and Congress pronounces.”11 Such an outcome is highly emotional and concrete, while not approving a good drug is intellectual and abstract. Who would have benefited and by how much? Who will know enough to complain that she was victimized by being denied such a medicine?

The FDA’s approach also curtails people’s freedom. The available medicines are what the FDA experts think we should have, not what we think we should have. It is common to picture uneducated patients blindly stumbling about the complexities of medical technology. While this certainly happens, it is mitigated by the expertise of caregivers (such as physicians), advisers (such as medical thought leaders), and watchdogs (such as the media), which comprise a surprisingly large support group. Of course, not all patients make competent decisions at all times, but FDA regulation treats all patients as incompetent.

A medicine that may work for one person at a certain dose at a certain time for a given disease may not work if any of the variables changes. Thalidomide, though unsafe for fetuses, is currently being studied for a wide range of important diseases and was even approved by the FDA in 1998, after four decades of being banned, for a painful skin condition of leprosy.12 Similarly, finasteride is used in men to shrink enlarged prostate glands and to prevent baldness, but women are forbidden even to work in the finasteride factory due to the risk to fetuses. Also, the FDA pulled Propulsid (cisapride), a heartburn drug, from the market in March 2000 after eighty people who took it died from an irregular heartbeat. But for patients with cerebral palsy Propulsid is a miracle drug that allows them to digest food without extreme pain.13 What is a poison for one person may be a lifesaver for another.

Economists have long recognized that good decisions cannot be made without considering the affected person’s unique characteristics. But the FDA has little knowledge of a given individual’s tolerance for pain, fear of death, or health status. So the decisions the FDA makes on behalf of individuals are imperfect because the agency lacks fundamental information (see information and prices). Economist Ludwig von Mises made this same argument in its universal form when he identified the Achilles’ heel of socialism: centralized governments are usually incapable of making good decisions for their citizens because they lack most of the relevant information.

Some economists have proposed that the FDA continue to evaluate and approve new drugs, but that the drugs be made available—if the manufacturer wishes—during the approval process.14 The FDA could rate or grade drugs and put stern warnings on unapproved drugs and drugs that appear to be riskier. Economists expect that cautious drug companies and patients would simply wait for FDA approval, while some patients would take their chances. Such a solution is pareto optimal, in that everyone is at least as satisfied as under the current system. Cautious patients get the safety of FDA approval while patients who do not want to wait don’t have to.

Economics

A study by Joseph DiMasi, an economist at the Tufts Center for the Study of Drug Development in Boston, found that the cost of getting one new drug approved was $802 million in 2000 U.S. dollars.15 Most new drugs cost much less, but his figure adds in each successful drug’s prorated share of failures. Only one out of fifty drugs eventually reaches the market.

Why are drugs so expensive to develop? The main reason for the high cost is the aforementioned high level of proof required by the Food and Drug Administration. Before it will approve a new drug, the FDA requires pharmaceutical companies to carefully test it in animals and then humans in the standard phases 0, I, II, and III process. The path through the FDA’s review process is slow and expensive. The ten to fifteen years required to get a drug through the testing and approval process leaves little remaining time on a twenty-year patent.

Although new medicines are hugely expensive to bring to market, they are cheap to manufacture. In this sense, they are like DVD movies and computer software. This means that a drug company, to be profitable or simply to break even, must price its drugs well above its production costs. The company that wishes to maximize profits will set high prices for those who are willing to pay a lot and low prices that at least cover production costs for those willing to pay a little. That is why, for example, Merck priced its anti-AIDS drug, Crixivan, to poor countries in Africa and Latin America at $600 while charging relatively affluent Americans $6,099 for a year’s supply.

This type of customer segmentation—similar to that of airlines—is part of the profit-maximizing strategy for medicines. In general, good customer segmentation is difficult to accomplish. Therefore, the most common type of pharmaceutical segmentation is charging a lower price in poorer countries and giving the product free to poor people in the United States through patient assistance programs.

What complicates the picture is socialized medicine, which exists in almost every country outside the United States—and even, with Medicare and Medicaid, in the United States. Because governments in countries with socialized medicine tend to be the sole bargaining agent in dealing with drug companies, these governments often set prices that are low by U.S. standards. To some extent, this comes about because these governments have monopsony power—that is, monopoly power on the buyer’s side—and they use this power to get good deals. These governments are, in effect, saying that if they cannot buy it cheaply, their citizens cannot get it.

These low prices also come about because governments sometimes threaten drug companies with compulsory licensing (breaking a patent) to get a low price. This has happened most recently in South Africa and Brazil with AIDS drugs. This violation of intellectual property rights can bring a seemingly powerful drug company into quick compliance. When faced with a choice between earning nothing and earning something, most drug companies choose the latter.

The situation is a prisoners’ dilemma. Everyone’s interest is in giving drug companies an adequate incentive to invest in new drugs. To do so, drug companies must be able to price their drugs well above production costs to a large segment of the population. But each individual government’s narrow self-interest is to set a low price on drugs and let people in other countries pay the high prices that generate the return on R&D investments. Each government, in other words, has an incentive to be a free rider. And that is what many governments are doing. The temptation is to cease having Americans bear more than their share of drug development by having the U.S. government set low prices also. But if Americans also try to free ride, there may not be a ride.

Governments are not the only bulk purchasers. The majority of pharmaceuticals in the United States are purchased by managed-care organizations (MCOs), hospitals, and governments, which use their market power to negotiate better prices. These organizations often do not take physical possession of the drugs; most pills never pass through the MCO’s hands, but instead go from manufacturer to wholesaler to pharmacy to patient. Therefore, manufacturers rebate money—billions of dollars—to compensate for purchases made at list prices. Managed-care rebates are given with consideration; they are the result of contracts that require performance. For example, a manufacturer will pay an HMO a rebate if it can keep a drug’s prescription market share above the national level. These rebates average 10–40 percent of sales. The net result is that the neediest Americans, frequently those without insurance, pay the highest prices, while the most powerful health plans and government agencies pay the lowest.

Pharmaceutical companies would like to help poor people in the United States, but the federal government and, to a much lesser extent, health plans have tied their hands. Drug companies can and do give drugs away free through patient assistance programs, but they cannot sell them at very low prices because the federal government requires drug companies to give the huge Medicaid program their “best prices.” If a drug company sells to even one customer at a very low price, it also has to sell at the same price to the 5–40 percent of its customers covered by Medicaid.

Drug prices are regularly attacked as “too high.” Yet, cheaper over-the-counter drugs, natural medicines, and generic versions of off-patent drugs are ubiquitous, and many health plans steer patients toward them. Economic studies have shown that even the newer, more expensive drugs are usually worth their price and are frequently cheaper than other alternatives. One study showed that each dollar spent on vaccines reduced other health care costs by $10. Another study showed that for each dollar spent on newer drugs, $6.17 was saved.16 Therefore, health plans that aggressively limited their drug spending ended up spending more over all.

Most patients do not pay retail prices because they have some form of insurance. In 2003, before a law was passed that subsidizes drugs for seniors, 75–80 percent of seniors had prescription drug insurance. Insured people pay either a flat copayment, often based on tiers (copayment levels set by managed-care providers that involve a low payment for generic drugs and a higher payment for brand-name drugs) or a percentage of the prescription cost. On average, seniors spend more on entertainment than they do on drugs and medical supplies combined. But for the uninsured who are also poor and sick, drug prices can be a devastating burden. The overlap of the 20–25 percent who lack drug insurance and the 10 percent who pay more than five thousand dollars per year—approximately 2 percent are in both groups—is where we find the stories of people skimping on food to afford their medications. The number of people in both groups is actually lower than 2 percent because of the numerous patient assistance programs offered by pharmaceutical companies. For all the talk of lower drug prices, what people really want is lower risk through good insurance.

Insurance lowers an individual’s risk and, consequently, increases the demand for pharmaceuticals. By spending someone else’s money for a good chunk of every pharmaceutical purchase, individuals become less price sensitive. A two-hundred-dollar prescription for a new medicine is forty times as expensive as a five-dollar generic, but its copay may be only three times the generic’s copay. The marginal cost to patients of choosing the expensive product is reduced, both in absolute and relative terms, and patients are thus more likely to purchase the expensive drug and make purchases they otherwise would have skipped. The data show that those with insurance consume 40–100 percent more than those without insurance.

Drugs account for a small percentage of overall health-care spending. In fact, branded pharmaceuticals are about 7 percent and generics 3 percent of total U.S. health-care costs.17 The tremendous costs involved with illnesses—even if they are not directly measured—are the economic and human costs of the diseases themselves, not the drugs.


About the Author

Charles L. Hooper is president of Objective Insights, a company that consults for pharmaceutical and biotech companies. He is a visiting fellow with the Hoover Institution.


Further Reading

Bast, Joseph L., Richard C. Rue, and Stuart A. Wesbury Jr. Why We Spend Too Much on Health Care and What We Can Do About It. Chicago: Heartland Institute, 1993.
DiMasi, Joseph A., Ronald W. Hansen, and Henry G. Grabowski. “The Price of Innovation: New Estimates of Drug Development Costs.” Journal of Health Economics 22, no. 2 (2003): 151–185.
Higgs, Robert, ed. Hazardous to Our Health? FDA Regulation of Health Care Products. Oakland, Calif.: Independent Institute, 1995.
Hilts, Philip J. Protecting America’s Health: The FDA, Business, and One Hundred Years of Regulation. New York: Alfred A. Knopf, 2003.
Klein, Daniel B., and Alexander Tabarrok. FDAReview.org. Oakland, Calif.: Independent Institute. Online at: http://www.fdareview.org/.
Miller, Henry I. To America’s Health: A Proposal to Reform the Food and Drug Administration. Stanford, Calif.: Hoover Institution Press, 2000.

Footnotes

Philip J. Hilts, Protecting America’s Health: The FDA, Business, and One Hundred Years of Regulation (New York: Alfred A. Knopf, 2003), pp. 89–90.

Daniel B. Klein and Alexander Tabarrok, FDAReview.org, Independent Institute, online under “History” at: http://www.FDAReview.org/history.shtml#fifth.

“THALOMID (Thalidomide): Balancing the Benefits and the Risks,” Celgene Corporation, p. 2, online at: www.sanmateo.org/rimm/Tali_benefits_risks_celgene.pdf.

Alexander Tabarrok, “The Anomaly of Off-Label Drug Prescriptions,” Independent Institute Working Paper no. 10, December 1999.

Lazarov, Jason, et al. “Incidence of Adverse Drug Reactions in Hospitalized Patients.” Journal of the American Medical Association 279, no. 15 (1998): 1200–1205.

Peltzman, Sam. An Evaluation of Consumer Protection Legislation: The 1962 Drug Amendments. Journal of Political Economy 81, no. 5 (1973): 1049–1091.

Parexel’s Pharmaceutical R&D Statistical Sourcebook 2004–2005 (Waltham, Mass.: Parexel International Corporation, 2004), p. 9.

“Broader Use for Aspirin Fails to Win Backing,” Wall Street Journal, December 9, 2003, p. D9.

This 55,000 is the total number of patients tested in five published clinical trials of the use of aspirin to prevent initial non-fatal myocardial infraction.

Food and Drug Administration, Center for Drug Evaluation and Research, Cardiovascular and Renal Drugs Advisory Committee meeting, Monday, December 8, 2003, Gaithersburg, Md.

Henry I. Miller, M.D., To America’s Health: A Proposal to Reform the Food and Drug Administration (Stanford, Calif.: Hoover Institution Press, 2000), p. 42.

“FDA Gives Restricted Approval to Thalidomide,” CNN News, July 16, 1998.

“Drug Ban Brings Misery to Patient,” Associated Press, November 11, 2000.

Klein and Tabarrok, FDAReview.org, online under “Reform Options” at http://www.fdareview.org/reform.shtml#5; David R. Henderson, The Joy of Freedom: An Economist’s Odyssey (New York: Prentice Hall, 2002), pp. 206–207, 278–279.

Joseph A. DiMasi, Ronald W. Hansen, and Henry G. Grabowski, “The Price of Innovation: New Estimates of Drug Development Costs,” Journal of Health Economics 22 (2003): 151–185.

Frank R. Lichtenberg, “Benefits and Costs of Newer Drugs: An Update,” NBER Working Paper no. 8996, National Bureau of Economic Research, Cambridge, Mass., 2002.

The Centers for Medicare and Medicaid Services (CMS), January 8, 2004.


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