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No free ride on U.S. innovation.
Pharmaceutical price controls hurt Euro zone competitiveness.

Joseph H. Golec, John Vernon
Medical Progress Today
July 20, 2007

The typical U.S. consumer is willing to pay up for superior–quality high–technology products, e.g., Blackberry Smartphones®, because they understand that such products provide value for the money. Furthermore, they understand that paying a higher price provides an incentive to successful, innovative companies to spend on research and development that leads to new innovative products and increased competition—witness Apple's iPhone.

All of this changes, however, when the product happens to be patented brand–name pharmaceuticals. Consumers often complain about high drug costs (even though most have medical insurance to cover most of the cost) because they know that consumers in price–controlled countries, like EU countries, pay less for the same drugs. As U.S. consumers see it, they end up funding the lion's share of the R&D that goes into new breakthrough drugs. Understandably, U.S. consumers and policymakers resent the apparent free–ride taken by EU consumers at their expense.

In our recent research, we show that the ride is not completely free after all. We show that EU consumers paid progressively less for drugs than U.S. consumers between 1986 and 2004 as more EU countries adopted or tightened their pharmaceutical price controls. But we also show that pharmaceutical R&D spending in the EU has come to a near standstill, while U.S. pharmaceutical R&D spending remains relatively robust.

Part of this robust spending can be traced to EU pharmaceutical firms growing their U.S.–based R&lD faster, and their EU-based R&D slower. In 1986, EU–based pharmaceutical R&D spending exceeded U.S. spending by about 24 percent. By 2004, EU spending trailed U.S. spending by about 15 percent.

In 1993, the total value of assets of EU pharmaceutical firms and U.S. pharmaceutical firms was about equal. By 2004, U.S. firms had twice as much assets. And U.S. firms earned about five percentage points more profit on their assets than EU firms did during the period. This is because EU firms sell proportionately more of their products in the EU at low prices and profits. Conversely, U.S. firms sell more in the U.S. at higher prices and profits

Clearly, low–profit EU firms have less incentive to spend on R&D. In terms of innovative activity during our sample period, we estimate that reduced R&D from price controls led to about 50 fewer new drugs originated in the EU, and about 1700 fewer scientists employed. The difference between U.S. and EU R&D spending growth has been very stable at about 3.5 percent during the period. If this continues into the foreseeable future, we estimate that EU firms will produce over 500 fewer new medicines than they would have if they were subject to the same pricing environment as U.S. firms. They will also hire about 170,000 fewer scientists.

U.S. firms are not fully free of implicit price constraints. Some drugs are reimported illegally from price–regulated countries, Medicaid requires 15 percent discounts, California requires discounts for certain low–income people, etc., but these have minor effects compared to EU price regulations. Although EU countries have adopted different price control mechanisms, they all state that their goal is to keep drug price inflation at the level of average consumer price inflation, and they have done so. This is the same goal proposed by President Clinton in 1993 in his Health Security Act, which Congress rejected.

If the U.S. were to adopt the same goal of zero real price increases, we estimate that the costs to the U.S. would be nearly twice those of the EU, because the U.S. pharmaceutical industry is now about twice the size of the EU's. These cost estimates ignore all of the high paying jobs that support the scientists at the new U.S. R&D facilities. It also ignores all of the jobs created in support industries from chemicals to local services for pharmaceutical workers. (Pharmaceutical and biotechnology research businesses happen to create a relatively large employment multiplier effect—over five times the number of R&D employees.)

Some researchers have argued that it does not matter where R&D facilities are located because companies can do the research anywhere and then simply sell the product in the U.S. at a high price. Hence, high prices should not attract R&D. For some industries, this may be true, but not for pharmaceuticals.

First, new pharmaceuticals sold in the U.S. must pass FDA–approved clinical trials, and this is easier when there is close contact and under conditions familiar to the FDA. This increases the probability of FDA approval and speed–to–market. But perhaps more important, U.S.–based clinical trials offer a marketing advantage when well–know U.S. specialist direct the trials and stand behind the results. This can be crucial to capture market share in the earlier years of a new drug's marketing when it must displace an old treatment and before it faces new competitors. After all, setting a high U.S. price is meaningless if few patients use the drug.

Indeed, several major EU firms have moved their research or operational headquarters to the U.S. during our sample period, including Pharmacia, Aventis, GlaxoSmithKline, and Novartis to be close to their top market. And the U.S. has become their most profitable market because it does not closely control prices.

A second reason why firms locate R&D facilities in the U.S. is that firms' property (e.g. patent) rights are better protected in the U.S. by U.S. law, and overseas by the U.S. trade representative. One example of how the EU comes up short here involves Bayer. In the early 1990's, Spain and France set a price for Bayer's second best–selling drug (Adalat) 40 percent below its price in England. Bayer then restricted supply to French and Spanish wholesalers who were reselling their supplies in England. In 1996, the European Commission fined Bayer 3 million Euros and ordered them to stop restricting supply to French and Spanish wholesalers. World–wide sales of Adalat, which had been growing strongly, decreased in 1998 and 1999 due to low–priced French and Spanish resellers. In response, Bayer decreased its EU pharmaceutical R&D spending in 1998 and 1999. At the same time, Bayer increased its U.S. R&D spending in 1998 and 1999.

Of course, EU price controls affect all firms that sell in the EU, including U.S. firms. And threats of EU–type regulations in the U.S., particularly in recent presidential election years, has made planning for long–term pharmaceutical R&D much more uncertain. The combined effects appear to have reduced the growth of U.S. pharmaceutical R&D spending, although it remains robust compared to EU spending.

U.S. consumers resent having to shoulder more of the R&D funding burden than EU consumers, but we show that there are substantial benefits for doing so. U.S. consumers enjoy more new pharmaceutical advances because they bear this burden. Of course, the rest of the world including the EU, also enjoys the therapeutic benefits of these U.S. advances while taking what appears to be a free ride.

But we also show that U.S. workers benefit directly from substantial growth in pharmaceutical employment and the spillover support employment that those jobs create. Hopefully, U.S. voters will resist price control policies that have pernicious effects on long term innovation and employment. Otherwise, if the U.S. adopts EU style price controls, we will likely experience the same stagnation in innovation and employment observed for the EU.

Joseph H. Golec, Ph.D. is an Associate Professor of Finance at the University of Connecticut School of Business. John A. Vernon, Ph.D., is an Assistant Professor of Health Care Management, Finance & Insurance at the University of Connecticut, Center for Healthcare and Insurance Studies, also in the School of Business. This op-ed is based on their working paper entitled, "European Pharmaceutical Price Regulation, Firm Profitability, and R&D Spending. You can download a copy of the paper at
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