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The Human Cost of Drug Price Negotiations

By Benjamin Zycher

Lowering prices for prescription drugs for the elderly is a politically attractive idea. So it is hardly surprising that incoming House Speaker Nancy Pelosi has announced that in the first 100 hours of the new Congress she will seek to empower the federal government to negotiate drug prices directly with pharmaceutical companies providing medicines for the new Medicare prescription drug benefit. She believes, with good reason, that the massive size and buying power of the federal government would drive those prices down to unprecedented levels.

She is right that prices would come down, but she is wrong that using the power of the federal government would come without a high cost: a reduction in the creation of new and improved medicines that would lessen future human suffering. The development of fewer new medicines would be the collateral damage inflicted by government negotiations that would lower industry returns and reduce R&D spending. My own estimate, based on existing government data, would be that almost 200 new drugs would go undiscovered over the next two decades as an indirect result of federal price negotiations.

To understand why this is true, it is instructive to review the actual experience of the drug purchasing program administered by the Department of Veterans Affairs, cited by many as a "negotiating" model for Medicare Part D. In order to reduce budget costs, the VA excludes newer and more expensive medicines. The VA "formulary", a list of covered medicines, includes about 1400 drugs; virtually all of the existing Part D formularies, currently negotiated by private purchasers, have about 4300 drugs.

What is more striking is that drugs covered by the VA formulary are significantly older than those covered by Medicare Part D or by private health insurance plans. The VA formulary includes only 38 percent of the drugs approved by the FDA during the 1990s, only 19 percent of the drugs approved since 2000, and only 22 percent of the drugs given priority review approval since 1997. VA prescriptions systematically are for drugs older than those specified in non-VA prescriptions, and new drugs as a matter of VA policy are not considered for the VA formulary for three years, regardless of improved effectiveness or reduced side effects. A third of VA seniors prefers to switch to Part D, but cannot because they would lose other VA benefits.

Government negotiators - at the VA and elsewhere - have very different incentives than private firms, which have to balance the preferences of consumers for both newer, more innovative products and low prices. This leads them, in order to satisfy their customers, to offer broad formularies that have a wide selection of both new medicines and generics. In contrast, the federal government faces intense political pressures to control costs, but does not have customers. Therefore, political incentives to achieve budget savings are powerful, while incentives to satisfy consumer preferences for more-inclusive formularies are relatively weak. The dissatisfaction of some patients who lose access to their preferred drugs would be offset by the support of other constituencies concerned more about lower prices, or that would benefit from increased spending in their favored programs.

Accordingly the most likely outcome we can expect from adopting the VA model for Medicare would be the following: substantially lower prices, smaller formularies, and reduced revenues from pharmaceutical sales. The capital market would view investment in pharmaceutical research and development less favorably, and fewer new medicines would be developed.

Based on a review of existing government purchasing programs, new research from the Manhattan Institute provides specific estimates of these effects: Prices would be driven down by over 35 percent by 2025. The cumulative decline in drug R&D for 2007-2025 would be about $196 billion in year 2005 dollars, or $10.3 billion per year. Because R&D costs for new medicines are about $1 billion, the loss would be about 196 new drugs. Other published research reports findings that each pharmaceutical R&D investment of roughly $2000 yields an expected gain of one life-year. Accordingly, an annual R&D decline of $10 billion would result in an expected loss of 5 million life-years each year. If we assume, again conservatively, the value of a life-year at $100,000, the economic cost of this effect would be about $500 billion per year, far in excess of total U.S. spending on pharmaceuticals.

It is difficult to predict which drugs will fail to be developed as a result of government price negotiations, but it seems clear that Congress is wading into dangerous waters. As the experience in Canada and Europe shows, government mandated drug formularies and interference in drug pricing leads to substantially less drug innovation and rationing of access to the new medicines that do come to market. Thus would Ms. Pelosi's politically attractive but ill-considered idea have as its unintended consequence an increase in future human suffering.

Benjamin Zycher is a senior fellow at the Manhattan Institute for Policy Research. Email: He is the author of a forthcoming Manhattan Institute study, The Human Cost of Federal Price Negotiations: The Medicare Prescription Drug Benefit and Pharmaceutical Innovation.

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