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The Lion and the Lambs Laying Down Together
Why the federal government shouldn't "negotiate drug prices"

Benjamin Zycher, Ph.D.
Medical Progress Today
October 27, 2005

Wal-Mart does it. Big pharmacy chains do it. Insurance companies and HMOs do it. And for all I know, the birds and the bees do it too.

Fear not, dear reader: Medical Progress Today remains a family-safe journal of analysis and commentary. “It” in this context refers to price negotiations between major buyers and producers of pharmaceuticals. And with the Medicare drug benefit soon to deliver big bills to the taxpayers, many ask: Why should the federal government not do it also so as to obtain bigger price discounts on drugs?

Well. Ask not what our country can do for us. Ask instead what our policy goals are. We want to help those less fortunate obtain needed medicines at prices that they can afford. But we also want those needed medicines to be available in the respective Medicare formularies, and we want to preserve efficient financial incentives for the ongoing research and development yielding new and improved medicines reducing future human suffering.

And so we must confront the reality that the federal government - a big, powerful, coercive, lumbering, and almost irresistible force - is not like Wal-Mart, and certainly not like those charming birds and bees. Consider first the degree to which the federal government can exercise economic purchasing (“monopsony”) power in negotiations. Yes, Wal-Mart is big. But the federal government is really, really big, a reality made obvious by the federal purchasing program for childhood vaccines, and by the pharmaceutical price “negotiations” conducted by the Department of Veterans Affairs (DVA).

The federal government now purchases almost two-thirds of the childhood vaccines used in America, at a mandated discount of 50 percent. This pricing “system” simply does not qualify as a “negotiation,” whether between equals or not; it is a system of price controls. And so the National Academy of Sciences has concluded, unsurprisingly, that the result is “declining financial incentives to develop and produce vaccines.” Combined with the liability/litigation problem, the result has been a decline in the number of vaccine producers from twenty-five in the mid-1970s to five today.

And then there is the pharmaceutical price “negotiation” system overseen by the DVA. Under the 1992 Veterans Health Care Act, two price constraints are imposed: There is a minimum 24 percent discount off of the “non-Federal Average Manufacturer Price” (the Federal Ceiling Price). And there also is the Federal Supply Schedule requirement that the pharmaceutical producers sell drugs to the VA at the “best price” offered private sector buyers. These FSS “best prices” must be offered as well to many health care programs receiving federal funding; thus does the FSS “best price” requirement allow other federal agencies and many others to receive the benefits of private sector negotiations without actually undertaking any negotiations themselves. The VA is entitled under the law to receive the lower of the FCS and FSS prices.

And if the drug producers refuse to play by these rules? They then would be precluded from selling their products both to the DVA through the FSS system and to Medicaid, thus shutting themselves out of 10-15 percent of their sales.

Consider the economics of drug development. The pharmaceutical firms find themselves whipsawed between enormous research and development costs - over $800 million per drug - increasing regulatory burdens, a growing squeeze on patent protections, a fifteen-year period of development uncertainty, and huge potential litigation risks. For most pharmaceuticals, narrow production costs per pill are small, so that a loss of so significant a portion of sales - combined with a fixed period of patent protection - can wreak havoc with sales strategies designed to recoup large R&D costs.

The basic problem is that bureaucrats and politicians have powerful incentives differing sharply in two important ways from those confronting large private-sector purchasers of pharmaceuticals. First, there is the time horizon issue, that is, the tradeoff between achievement of short-term and long-term goals. Because there never can be enough budget dollars available to satisfy every interest-group demand, and because interest-group demands expand as spending grows, the political incentives to reduce “costs” (explicit budget spending) on any given program are powerful. This means that federal decisionmakers are confronted with enormous pressure to put the squeeze on suppliers; and the ensuing supply/production/investment problems created by price controls will be left to future officials to confront.

This is a particularly serious problem in the case of pharmaceuticals because of the relatively small production costs noted above. Unlike the imposition of price controls on, say, gasoline, yielding queues, chaos, and political blowback almost immediately, price controls (“negotiation”) on most pharmaceuticals would have little immediate effect on drug supplies, and thus little downside from the standpoint of public officials driven by the imperatives of the next election. Current medicines will continue to be produced; current voters will get cheap medicine. But research and development investment in new and improved medicines will slow, perhaps dramatically. Other than the pharmaceutical sector itself, the losers will be those in the future who will suffer more than otherwise would have been the case, and for the most part they will not know who they are because they will not know about the drugs that will have failed to have been developed. And in any event, many of them do not vote today. So much for the children.

Second, there is the further matter that unlike Wal-Mart and the others, the federal government does not have “customers.” It has interest groups, the demands and preferences of which are satisfied in greater and lesser degrees; and it has voters, the happiness of whom is registered not in dollars spent every day, but instead in votes delivered every two or four or six years.

Yes, Wal-Mart seeks low prices, always; but it also wants to be able to obtain for its formularies the drugs that its customers need. The federal government on the other hand has powerful incentives to reduce budget costs, as noted above; but if given drugs drop out of government program formularies, well, patients are unlikely to move to Brazil as a result. Voting is influenced by a myriad of issues and factors; federal incentives to satisfy the pharmaceutical preferences of patients are weak. In no other context does the admonition “Write your Congressman” fall quite so flat.

There is no need to speculate about this. Frank R. Lichtenberg of Columbia University reports that “the drugs used in the [DVA] health system from 1999 to 2002 were older than the drugs used in the rest of the U.S. health-care system.” Lichtenberg estimates that the effect of this federal attempt to reduce costs by limiting access has reduced the mean age at death of the DVA patients by about two months.

Of course we want our medicines to be affordable. We also want them to be available when needed. That AIDS now is a manageable chronic disease rather than a death sentence is not the result of a negotiation/price control regime. Nor are such other recent advances as Rituxan for non-Hodgkins lymphoma or Herceptin for breast cancer. Price negotiations visited upon the drug producers’ heads by the federal government promise to reduce both the research and development investments needed for the future alleviation of human suffering and the ability of patients in government programs to receive the benefits of the latest medicines. No one ever has accused Wal-Mart of engendering such outcomes.

Benjamin Zycher is a senior fellow in economics at the Pacific Research Institute. Email:

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