Drug pricing conversations must take the cost of innovation into consideration

Midterm elections have ushered in a decidedly split 116th Congress. Yet the desire to lower U.S. pharmaceutical spending, which now exceeds $450 billion a year and dwarfs that of any other developed nation, is likely to continue uniting some strange bedfellows. Lawmakers from both side of the aisle are doing a disservice to Americans by uniting behind populist drug pricing proposals that ignore the harsh realities of drug development in favor of simplicity and sloganeering.

Consider the unlikely coalition of Sen. Bernie Sanders (I-Vt.), Rep. Ro Khanna (D-Calif.), Rep. Elijah Cummings (D-Md.), and President Donald Trump calling to tie U.S. drug prices to those of our international peers.

Just Thursday, Sanders, Cummings, and Khanna proposed legislation aimed at drugs that are considered “excessively priced” — those whose U.S. price exceeds the average amount paid by five other developed countries. The secretary of health and human services would be charged with ending patent protection for such drugs, opening them up to generic competition and likely price reductions.

This proposal is aligned with an earlier one announced by HHS. It would base Medicare prices for some drugs on the median amount paid in a set of developed countries. Because international prices for branded drugs are typically below U.S. prices, both proposals would likely generate considerably lower prices.

Such bipartisan consensus is often a sign of serious policymaking that should be supported in these contentious times. Not so in this case: By focusing solely on today’s high prices of drugs, these proposals intentionally ignore the more important conversation of how drug prices, while undesirably high, provide the necessary incentives for private companies to invest in developing tomorrow’s innovative products. This focus is sadly understandable, since we can see and hear the victims of high prices today — after all, they are real people who cannot afford to take an existing drug. In contrast, the potentially far more numerous victims of a lack of innovation are future patients who can’t show up in photo opportunities.

The economic reality of drug development

Discussing the trade-off between drug prices and innovation requires an accurate understanding of the nature of early-stage drug development and the mobility of investment capital.

Many people think of pharmaceutical research and development as the sole purview of “Big Pharma,” firms such as Pfizer and Merck. But an increasing fraction of early-stage research is now undertaken by small biotech firms and startups. Their primary goal is to demonstrate the success of their products in order to be purchased by larger and more established firms. The price of this acquisition is determined by the expected profits for the product.

This efficient evolution of the sector allows small biotechnology firms to confront the increasingly difficult world of drug development while allowing larger companies to undertake later-stage development as well as regulatory and commercialization activities. This means that a considerable amount of the funds for risky, early drug investments don’t come from the internal profits of existing pharmaceutical firms. Instead, they come from venture capital firms.

Keep in mind that venture capital funds are not restricted to pharmaceutical investments. Speaking with the Wall Street Journal earlier this year, Food and Drug Administration Commissioner Scott Gottlieb emphasized that these firms are “looking across a whole portfolio and comparing returns in one segment versus returns in another segment. It’s very easy for them to shift more capital into one segment of their portfolio than another.”

While this is technically true even for internal research and development funded by pharmaceutical firms’ profits, venture capital funds face far fewer frictions and can mercilessly chase maximum profits. As a result, if or when expected profits decline — the only reasonable expectation of the Sanders-Cummings-Khanna-Trump administration policies — capital will move out of the pharmaceutical sector.

The extent to which pharmaceutical investments respond to profit expectations is not merely the domain of economic theory.

Consider the case of two diseases, malaria and gout. Malaria, a mosquito-borne illness, afflicted more than 200 million people in 2016, resulting in nearly 450,000 deaths. Gout, a buildup of uric acid in the joints, causes exceptionally painful swelling. Made worse by the consumption of fatty foods and alcohol, gout has been called the “disease of kings.” While painful, gout is not fatal.

From a global welfare perspective, we arguably should be investing massive resources into a cure for malaria. Yet between 2004 and 2016, only nine clinical trials for malaria were publicly registered, compared to 239 for gout. The reason for this is obvious — the average per capita gross domestic product of countries where malaria is endemic is less than $2,000, while gout is more common in countries with populations of relatively affluent and insured individuals.

Beyond this simple example, this price-innovation trade-off is well established in the economics literature. Put simply, we can lower current drug prices but we’ll get fewer new drugs. That is good if you suffer from hepatitis C, but it’s not so good if you are waiting for a cure for Alzheimer’s disease or glioblastoma.

The folly of recent proposals

To avoid confronting difficult trade-offs, Sanders, Cummings, Khanna, and the Trump administration are trying to hide behind the policy decisions of other developed countries. But the simple fact that the U.S. pays more for drugs than other countries does not prove that our prices are too high, nor should we implicitly assume that international prices represent the appropriate balance of tradeoffs.

Many of these countries have long had the luxury of enjoying innovations made possible by U.S. profits. If the Sanders-Cummings-Khanna-Trump administration proposals became law, other countries would ideally respond by increasing spending on drugs, thus blunting the potential decline in innovation. Yet few believe that international prices would rise enough to offset the decline in profits earned from U.S. customers.

Earlier legislation announced by Sanders and Khanna contains another worrisome element. It would grant the secretary of HHS authority to revoke patent protection on branded drugs for any “other factors the Secretary determines appropriate.”

Giving the head of HHS the power to end patent protection essentially at will would expose pharmaceutical investors to idiosyncratic political risk in which profits would be at the discretion of the whims of a small number of future regulators. This would be particularly alarming for companies developing products that are disproportionately sold to populations with government insurance, such as the poor, elderly, and disabled. Gilead Sciences has already faced threats to its intellectual property for its hepatitis C treatment because of the burden its curative therapy places on government spending.

Having the adult conversation about drug prices

The economics of drug development argue for targeted regulatory intervention that explicitly acknowledges where lower prices justify foregone investment. Policies should also be designed with the understanding that uncertainty raises the costs of drug development and decreases investment in future innovations. Particularly in the case of the Sanders-Khanna plan, neither condition is met.

We are not arguing that the price-innovation tradeoff is never worth making. It is quite possible that our current policies provide incentives to overproduce low-value drugs. Medicare, for example, pays for all new cancer drugs regardless of their effectiveness or their similarity to existing products. As a result, even marginally better therapies generate spending that likely outstrips any social value. This potential overinvestment in low-value drugs represents a ripe area for policy changes aimed at lowering prices and, in turn, curtailing new drug development.

Instead of proposing simplistic policies that outsource difficult policy conversations to foreign governments, policymakers must immediately engage in the difficult and adult conversation about the important issues related to drug pricing and innovation. These include, but are not limited to, ensuring that markets allow for robust competition between brand name products, developing solutions for the lack of competition for generic products treating relatively uncommon diseases, and creating robust pathways for biosimilar products to compete with biologics. Such policies would allow us to provide returns for high-value drugs that meaningfully improve health.

Even after those important issues are addressed, we must ultimately tackle the fundamental question of how much innovation we are willing to pay for. This conversation must be informed by the economic realities underpinning the business model of how new drugs are developed, not with invectives about the greed of drug companies or hopes that breakthrough drugs will materialize out of thin air. Policymakers cannot promise, either explicitly or implicitly, that it is possible to strip profits out of the system while still getting the same pipeline of innovative drugs we currently enjoy.

It is time to start focusing on balancing access to pharmaceuticals today with access to new drugs in the future. Patients with conditions that are treatable by existing drugs have the relative luxury of being able to negotiate prices. That same luxury isn’t afforded to those suffering from conditions without existing treatments.

Craig Garthwaite, Ph.D., is a strategy professor and director of the Healthcare Program at Northwestern University’s Kellogg School of Management. Benedic Ippolito, Ph.D., is a research fellow at the American Enterprise Institute.