January 22, 2005
'Negotiated' Drug Prices Are Really Just Price Controls
By Benjamin Zycher

Advocates of cheaper drug prices like to talk about federal "negotiation" of prices with pharmaceutical companies. And when they do, they almost always point to the Department of Veterans Affairs, which they say has used its size to "bargain" for better deals on prices for years. Why, they want to know, can't Medicare do the same thing?

"The Veterans Affairs system … negotiates lower prescription drug prices," Sen. Dianne Feinstein (D-Calif.) said last year. "Why should we prevent the secretary of [Health and Human Services] from doing the same on behalf of our 41 million Medicare recipients?"

But Feinstein and her colleagues know full well that although "negotiation" has a nice ring to it, that's not really what is going on. What's actually happening is something that does not sound quite as appealing: price controls.

Under the 1992 Veterans Health Care Act, two price constraints are imposed upon pharmaceutical manufacturers in dealing with the VA: There is a minimum 24% discount off the "non-federal average manufacturer price." And there also is the Federal Supply Schedule, or FSS, requirement that the pharmaceutical producers sell drugs to the VA at the "best price" offered to private-sector buyers.

The VA is entitled under the law to receive either the minimum 24% discounted price or the "best price," whichever is lower. These "best prices" are not just for the VA; many healthcare programs receiving federal funding also are entitled to them. That is how the federal government, state Medicaid programs and others receive the benefits of private-sector negotiations without actually having to undertake negotiations themselves.

And if drug companies refuse to play by these rules? They then would be precluded from selling any of their products to the VA and other healthcare programs operating under the FSS system, and in all likelihood to the Medicaid system as well, thus shutting them out of a market accounting for roughly 10% to 15% of their sales.

Now consider the economics of drug development. Despite many casual assertions about "huge profits," the truth is that pharmaceutical companies face enormous research-and-development costs — about $800 million per drug — as well as increasing regulatory burdens, a growing squeeze on patent protections, a 15-year period of development uncertainty and huge potential litigation risks.

Pharmaceutical prices include a significant markup over the low cost of production because drug companies have to recoup their large R&D costs. And drug companies play by the government's rules because they can't afford the loss of a significant portion of their sales, even at controlled prices.

The "negotiation" argument obscures the harsh reality that price controls are being sought and shunts aside the adverse long-term consequences of such policies. Of course we want our medicines to be affordable. But we also want them to be available.

That AIDS now is a manageable chronic disease rather than a death sentence is not the result of a price-control regime; it is the result of ongoing research and development undertaken because there was a financial incentive to do so. The same is true for other recent advances, such as Rituxan for non-Hodgkins lymphoma and Herceptin for breast cancer.

From the standpoint of public officials driven by the imperatives of the next election, price controls on drugs have little downside. Current medicines will continue to be produced because even controlled prices will cover ongoing production costs. So voters will get the cheap medicine they need. Other than the pharmaceutical sector, the losers will be those in the future who will suffer because of the drugs that will not be researched or developed.

But so what? For the most part they will not know about the drugs that failed to be developed. And in any event, many of them do not vote today.

Here is something more effective that Congress could be doing to reform pharmaceutical pricing: Policies must be developed to end the free ride that foreign pharmaceutical consumers — particularly in wealthy economies like those of Canada and Europe — now receive. Consumers in these countries pay artificially low prices because of foreign price controls, forcing Americans to pay higher prices to support R&D. But price controls masquerading as "negotiated" prices will do nothing to solve this problem.

Most voters are in the middle class; the cost of medicine is not a huge burden for them, but neither are they immune to the appeal of cheaper drugs. The competition for their votes will mortgage the future in favor of the present, with greater human suffering the inexorable outcome. So much for the children.

Benjamin Zycher is a senior fellow in economics at the Pacific Research Institute. This article first appeared in the LA Times.

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