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Perspectives on the Pharmaceutical Industry C o s t s I n C o n t e x t Perspectives On The Pharmaceutical Industry Granting all Americans access to prescription drugs that work should be a trivial economic challenge for this wealthy nation. by Uwe E. Reinhardt ABSTRACT: This paper seeks to provide an economic perspective on the phar- maceutical industry, which has come under increasing criticism on a number of issues. In the main, that criticism amounts to a rather ineffective flailing at the supply side of the market for pharmaceutical products—much of it based on inaccurate perceptions—when a more productive policy would be to strengthen the hitherto weak and poorly informed demand side of the market. mbival ent social ethics and inconsistent goals have long been the hallmark of U.S. health policy, and nowhere Amore so than in the nation’s attitude toward its pharmaceuti- 136 DRUG cal industry. On the one hand, Americans look to that industry for INDUSTRY rescue from life-threatening infectious diseases, mental illness, and other chronic illnesses that impair quality of life. Writing in the New York Times Magazine, Andrew Salomon goes so far as to argue that psychopharmaceutical intervention could be a major armament in a war on poverty.1 On the other hand, however, the industry is increas- ingly viewed as a major burden on the economy, even though per capita spending on alcohol and tobacco combined have only recently been surpassed by per capita spending on prescription drugs, and less than a quarter of the current double-digit increases in private health insur- ance premiums can be attributed to increases in drug spending.2 The public’s ambivalence toward the pharmaceutical industry may be shaped in part by the industry’s hybrid nature. On the gen- eral theory that capitalism is most likely to bestow on society the richest flow of innovative products, Americans have preferred to structure the industry as a set of investor-owned, profit-seeking firms, rather than as rate-regulated utilities or nonprofit enterprises. More so than most other investor-owned industries, however, the drug industry is a creature of government, because it cannot exist for long without government protection of its economic turf. The most important form of that protection is patents, which grant pharmaceutical firms temporary monopolistic market power Uwe Reinhardt is the James Madison Professor of Political Economy and professor of eco- nomics and public affairs at Princeton University, where he has been teaching since 1968. H E A L T H A F F A I R S ~ V o l u m e 2 0 , N u m b e r 5 ©2001 Project HOPE–ThePeople-to-PeopleHealth Foundation, Inc. D R U G I N D U S T R Y for their products. A less well understood but very important sec- ond form of protection is laws that restrict the resale of drugs among the industry’s domestic customers and that erect sundry barriers to the importation of drugs, including U.S.-produced drugs sold abroad at lower prices. These laws allow pharmaceutical firms to segment the markets for their products by customer class—each class with its own price-sensitivity—and to charge different classes of customers different prices for the same product, a practice econo- mists call “price discrimination.” As I explain further on, some price discrimination on the part of producers is the sine qua non of eco- nomic efficiency in the pharmaceutical market. The general public, however, may view that practice as inherently “unfair.” Perhaps because of the pharmaceutical industry’s hybrid nature, society posits for the industry inconsistent standards of behavior. On some occasions, lawmakers and the general public seem to ex- pect pharmaceutical firms to behave as if they were community- owned, nonprofit entities. At the same time, the firms’ own- ers—among them the mutual and pension funds that help to manage the savings of Americans—always expect the firms to use their market power and political muscle to maximize the owners’ wealth. Caught between these inconsistent standards of behavior is COSTS IN 137 an industry that naturally will never get it quite right. CONTEXT The remainder of this commentary is intended as an exploration of several issues that seem to trouble the industry’s critics. To that end, I do not focus on a single point but examine several distinct facets of the market for pharmaceuticals. The discussion begins with the question of whether spending on prescription drugs represents an intolerable burden on the U.S. economy. That proposition is sometimes made to warn against es- tablishing additional entitlements to prescription drugs—for exam- ple, for elderly Americans. I argue that spending on pharmaceutical products is not now and is unlikely ever to be a significant macro- economic burden. It would be a burden only if such spending were patently wasteful, as all waste is a burden on the economy. To be sure, spending on these products can be a problem for individual households, but the proper social response to this microeconomic problem is adequate insurance coverage, rather than regulations aimed at the supply side of the market. The focus of the paper shifts next to the industry’s cost structure; to the practice of price discrimination, which is rooted in that cost structure; and to the profits earned by drug firms, which are often decried as excessive. I contend that relative to those of other indus- tries, the pharmaceutical industry’s profits may be on the high side, but in the absolute they are not large enough to offer much relief for H E A L T H A F F A I R S ~ S e p t e m b e r / O c t o b e r 2 0 0 1 C o s t s I n C o n t e x t any cost containment effort, as they constitute only a minute frac- tion of total national health spending. Finally, I argue that the incessant focus of the industry’s critics on the supply side of the market for pharmaceuticals is misplaced. A more fruitful effort would be measures to shore up the demand side. The paper ends with some policy recommendations to that end. Prescription Drugs As A Macroeconomic Burden n Current and projected drug spending. Is it easy to understand the growing concern over spending on prescription drugs (Exhibit 1). While in 1999 prescription drugs accounted for 8.2 percent of total national health spending, that share is expected to reach 14 percent by 2010.3 It is generally agreed that these spending increases have been driven much more by increases in volume and switching from older to newer, more expensive drugs than by annual price increases on existing drugs.4 The increased volume has been driven in part by the greater availability of a stream of new products, especially antihista- mines, antidepressants, cholesterol reducers, and anti-ulcerants.5 Another driver undoubtedly has been the expansion of health insur- 138 DRUG ance coverage for prescription drugs during the 1990s. In 1990 about INDUSTRY two-thirds of all prescription drugs were still paid for by patients at the pharmacy, out of pocket, as for any other consumer good. By 1999 only about one-third of total national spending on prescription drugs was paid for out of pocket.6 Most of the extended coverage for drugs during the decade was offered by employer-based insurance rather than by public insurance programs. EXHIBIT 1 Actual And Projected Annual Percentage Growth In Prescription Drug Spending And In Total National Health Spending, Selected Calendar Years 1993–2010 Percent Drugs Total NHE 16 12 8 4 0 1993 1997 1998 1999 2000 2002 2010 SOURCE: S. Heffler et al., “Health Spending Growth Up in 1999: Faster Growth Expected in the Future,” Health Affairs (Mar/ Apr 2001): Exhibit 1. NOTE: NHE is national health expenditures. H E A L T H A F F A I R S ~ V o l u m e 2 0 , N u m b e r 5 D R U G I N D U S T R Y n Drug spending as a percentage of GDP. As a percentage of gross domestic product (GDP)—a commonsense measure of a na- tion’s “ability to pay” for particular items—the United States does not stand out as a heavy spender on prescription drugs. According to Organization for Economic Cooperation and Development (OECD) data, in 1997 the United States spent only about 1.4 percent of GDP on prescription drugs. A number of European nations and Japan spent more.7 If by 2010 the United States actually spent the roughly 16 percent of GDP on health care now projected by the actuaries at the Centers for Medicare and Medicaid Services (CMS, formerly HCFA), and if prescription drugs then were to account for the roughly 14 percent of total national health spending also pro- jected by these actuaries, total U.S. drug spending in 2010 would still be only about 2.2 percent of GDP.8 To be sure, the percentage of GDP devoted to prescription drugs is apt to increase more rapidly after the baby boomers begin to retire in 2011. This is so because the number of prescriptions per American is more than three times as high for the elderly as it is for those under age sixty-five.9 Even then, however, outlays on prescription drugs are unlikely to represent an intolerable aggregate burden on the U.S. economy. After all, that economy can be expected to grow. COSTS IN 139 During the roughly two decades from 1980 to 1998 real GDP per CONTEXT capita rose at an average annual compound rate of 1.86 percent.10 If that rate persists over the next several decades, GDP per capita in 2025 will be 59 percent higher than it was in 2000.
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