Contra Yglesias on Pharmaceutical Profits

Or how I learned to stop worrying and love pharmaceutical profits

I did a type of debate called Public Forum in 9th grade. The first Public Forum topic I ever debated was about whether there should be price controls on the pharmaceutical industry. I was quite thoroughly obsessed—I did about 5 hours of research per day for two months, reading everything I could find about price controls. I’ve forgotten much of what I learned then, but my conclusion hasn’t changed: price controls in the pharmaceutical industry would be a disastrous, innovation-wrecking idea. Given that Matt Yglesias recently released an article arguing for price controls on the pharmaceutical industry, I thought it would be worth revisiting the topic.

I’ve already written about another, much better proposal but have yet to describe why the pharmaceutical price controls proposal would be so bad. The basic reason is that it would wreck innovation. About half of generic drugs already don’t make a profit and that’s of the ones that make it to market. The vast majority of drugs that are tested don’t end up going to market. The industry is thus only profitable because they make ridiculous sums of money from a small number of drugs.

Price controls make it so that the industry does not make as much profit, thus destroying innovation. This is why, as of 2017, of the new drugs that were genuinely novel, 78% come from the U.S. first. The U.S. is responsible overall for about half of new drugs, but of the new novel drugs, the vast majority come from the U.S.. Price controls especially depress the best kind of innovation—innovation of important drugs—because those drugs are the riskiest but have the highest payouts. Limiting the payouts reduces incentives to make them and encourages making more small tweaks, of the type that is typical of new drugs, rather than major reforms. As Wayne Winegarten notes:

The competitive environment that generic medicines enable also means that these firms will typically operate with very small profit margins. Due to these thin profit margins, HB 4900’s price controls are particularly damaging for these manufacturers. Consequently, HB 4900 could have the perverse impact of driving out manufacturers. This would worsen the competitive environment and (ironically) lead to higher cost pressures.

New drugs have lead to dramatically longer lives. That’s why studies of the impact of price controls on the pharmaceutical industry tend to find they’d make the average age of death go down by years. A helpful summary of various studies comes from Scott Alexander:

1. Golec & Vernon (2006) say that as a result of European drug price regulation, “EU consumers enjoyed much lower pharmaceutical price inflation, however, at a cost of 46 fewer new medicines introduced by EU firms.”

2. Eger and Mahlich (2014) find that among pharmaceutical companies, “a higher presence in Europe is associated with lower R&D investments. The results can be interpreted as further evidence of the deteriorating effect of regulation on firm’s incentives to invest in R&D.”

3. Kutyavina (2010) finds that “brand-name pharmaceutical firms characterized by large R&D expenditures decreased their R&D efforts post 1993 threat [to regulate drug prices] relative to firms that did not engage in as much innovative R&D”.

4. Acemoglu and Linn (2004) find that “We find a large effect of potential market size on the entry of nongeneric drugs and new molecular entities”, which I think is supposed to generalize to mean that the more money they expect to make the more research they do. I will count this as half a study since the connection is not explicit.

5. Danzon & Epstein (2008) analyze price regulations and new drugs invented in 15 countries and 12 drug classes, and find that “If price regulation reduces drug prices, it contributes to launch delay in the home country.

6. Troyer & Krasnikov (2002) find that “the empirical relationship between pharmaceutical industry revenues and pharmaceutical industry innovation is estimated, allowing for an exploration of the impact of the Medicaid rebate program [which regulated drug prices somewhat]. Using the empirical results, the opportunity cost of the Medicaid rebate program is found to be as high as four new drug approvals annually. Given the increased interest in a Medicare drug benefit, regulators should be aware of the hidden cost of price regulation for pharmaceuticals.”

7. Vernon (2005) finds that “I simulate how a new policy regulating pharmaceutical prices in the US will affect R&D investment. I find that such a policy will lead to a decline in industry R&D by between 23.4% and 32.7%. This prediction, however, is accompanied by several caveats.”

8. Golec, Hegde, and Vernon (2009) find that “Results show that the HSA [a bill to regulate drug spending in the US] had significant negative effects on stock prices and firm-level R&D spending. Conservatively, the HSA reduced R&D spending by about $1 billion even though it never became law.”

9. Santerre and Vernon (2006) use drug demand data to simulate various regulatory regimes, and find that a certain price regulation policy they test, continued over twenty years, would have cost gains of $472 billion (!) but also “have led to 198 new drugs being brought to the US market” (!!). They note that “Therefore, the average social opportunity cost per drug developed during this period was approximately $2.4 billion. Research on the value of pharmaceuticals suggests that the social benefits of a new drug are far greater than this estimate. Hence, drug price controls could do more harm than good.”

10. Keyhani, Carpenter, et al (2010) find that “The United States accounted for 42% of prescription drug spending and 40% of the total GDP among innovator countries and was responsible for the development of 43.7% of the NMEs [ie new drugs invented]. The United Kingdom, Switzerland, and a few other countries innovated proportionally more than their contribution to GDP or prescription drug spending, whereas Japan, South Korea, and a few other countries innovated less…higher prescription drug spending in the US does not disproportionately privilege domestic innovation, and many countries with drug price regulation were significant contributors to pharmaceutical innovation.” This study does not attempt to address the effects of price regulation, only to say that European countries seem to do pretty well at innovation despite price regulation, which is suggestive that price regulation does not hurt drug innovation but not really scientific evidence for it. I’m going to count this one as half a study too.

Scott cites a particularly good study by the Rand Corporation that finds that the average age of death in the U.S. and Europe would be .7 years shorter if there were price controls in the pharmaceutical industry. He notes that this would be really bad:

All of this sounds sort of boring and economics-y when you read it like this, and maybe your eyes are glazing over. So let me put this in context. In 2060 there will probably be 420 million Americans and 523 million Europeans. And suppose that whatever changes we make in drug regulations today last for one human lifespan, so that everybody has a chance to be 55-60. So about a billion people each losing about 0.7 years of their life equals 700 million life-years. Since some people live in countries outside the US and Europe [citation needed] and they also benefit from First-World-invented medications, let’s round this up to about a billion life-years lost.

What was the worst thing that ever happened? One strong contender is Mao’s Great Leap Forward, in which ineffective agricultural reforms and very effective purges killed 45 million people. Most of these people were probably already adults, and lifespan in Mao’s China wasn’t too high, so let’s say that each death from the Great Leap Forward cost what would otherwise be twenty healthy life years. In that case, the worst thing that has ever happened until now cost 45 million * 20 = 900 million life-years.

Once again, RAND’s calculations plus my own Fermi estimate suggest that prescription drug price regulation would cost one billion life-years, which would very slightly edge out Communist China for the title of Worst Thing Ever.

And Rand’s study is pretty conservative. One study which I remember but now cannot find concluded it would reduce average lifespan by 2 years. Another study that’s quite good was a meta-analysis that remarkably concluded that price controls wouldn’t even produce price savings (given how bad they’d be for innovation and delays):

Forty-seven out of 3787 initial studies were included. Price caps and price reductions were most commonly studied in the literature, followed by reference pricing and price freezes. The evidence indicates that price controls reduce company profits and have a detrimental effect on pharmaceutical research and development, pipeline productivity and investment. They may also inhibit, reduce or delay new product launches, increase parallel exports and diminish availability of generics due to disincentives and, hence, may reduce product availability, increase withdrawals and shortages. In terms of public expenditure about half of the studies indicate realized savings, but the other half indicate no effect or even increases in expenditure. In terms of effects on patients, studies indicate in the short term welfare gains due to lower cost and better access, but also losses due to drug shortages and availability issues. Long-term effects appear to be welfare losses due to reductions of discoveries, resulting from the disinvestment associated with the lower revenues.

Yglesias’s piece is mostly about alternative ways to boost innovation which I basically agree with. But his reasons for supporting price controls strike me as confused. Yglesias says:

I also have to say that I find the innovation-based argument against price negotiation to be a little underwhelming. Federal employees who travel for work need to follow specific guidelines on things like paying for a hotel room. But precisely because the federal government is such a large employer, they leverage the size of the market to secure a discount price for reimbursed travel from most hotel chains. Obviously it would be better for the hotel industry if the fed didn’t do that. But would it be better for society? It would lead to more investment in the hotel sector, but that’s neither here nor there to the extent that it just directs capital away from other uses.

This seems like a remarkably terrible argument for a guy as smart and consistently correct as Yglesias. Hotels are not public goods. Most of the benefits of having a hotel are captured by the hotelgoers. In contrast, pharmaceutical firms only soak up a very small percent of the total public goods brought about by their innovation. Huge amounts of the benefit of innovation come from consumer surplus and benefits of the drugs once there’s no longer a patent. For this reason, pharmaceutical companies make much less profit than is the social benefit of their product. When a pharmaceutical company makes a new drug that saves 100,000 lives, they do not get rewarded for the benefit of saving 100,000 lives. As a result, they innovate much less than is ideal.

There’s a reason it makes sense to have patents on pharmaceutical companies but not hotels. Hotels don’t produce public goods!

Yglesias spends the rest of the article arguing for other ways of boosting innovation which seem good! I’m all for more pharmaceutical innovation. In fact, I think the absence of innovation is one of the biggest and most neglected problems. But he frames this as a reason we should have price controls, saying, “If we want to see more pharmacological intervention, we should directly address the barriers to bringing new medicine to market.”

But why not both? This is a bit like arguing “if you want people not to be shot, don’t focus on keeping guns out of the hands of toddlers, focus on keeping guns out of the hands of criminals.” Both are good ideas!

Now maybe the idea is that we should do Yglesias’s ideas and price controls. Perhaps Yglesias would claim that once we did these things there would be the optimal level of innovation so price controls would be fine. But I think this underestimates the truly staggering benefits of innovation. Saving lives produces truly immense degrees of consumer surplus, especially given that those benefits stay along for long after the monopoly has expired. I wouldn’t be surprised if the optimal level of pharmaceutical profits was over ten times what they make now.

When seen this way, Yglesias’s proposals alone seem much better than Yglesias’s proposals plus price controls. Given that patents expire after around 12 years and then go down to market prices, after which the companies that made the drug no longer make much profit from them, it’s unbelievably important that pharma companies can soak up huge amounts of profits in those 12 years. Contrary to popular belief, pharmaceutical companies, like most innovative industries, should make far, far more profits!