Why Are Drug Prices in the United States So High?

The Hatch–Waxman Act encourages both pharmaceutical innovation and price competition, complicating straightforward pricing comparisons between the United States and other countries.

On policy or political concerns, former President Donald Trump and House Speaker Nancy Pelosi have rarely agreed. I can only think of one big area where they did: the practically unanimous belief that medicine costs in the United States are excessively high. Trump released two executive orders aimed at decreasing prescription medication prices that affect Medicare recipients as one of his final major policy measures as president. Pelosi was a vocal supporter of the "Cummings Lower Drug Costs Now Act," which passed the House of Representatives in 2019 but stalled in the Senate. (A new version has been presented in the House of Representatives in the current Congress.) She argued after its passing that "prescription medicine prices are out of control," and that the proposed legislation will lower them.

More recently, President Joe Biden has joined the chorus. He is quoted as saying that “all of us … could agree that prescription drug prices are outrageously priced in America.”

This viewpoint differs from that of Trump, Pelosi, and Biden. The National Academy of Sciences issued "Making Medicines Affordable: A National Imperative" in 2017, with the underlying conclusion that Americans overspend on prescription pharmaceuticals. "Annual expenditures... now approach a half trillion dollars and account for about 17 percent of the nation's personal health care cost," according to the research. The US spends "almost twice as much on health care as a fraction of gross domestic product as the average of the other nine" nations considered for comparison, according to the report. That conclusion, by inference, applies to medications. It is now widely acknowledged that medicine costs in the United States are excessively expensive, and that we spend much too much money on them.

The main evidence for this conclusion is that overseas costs for the identical pharmaceuticals are frequently significantly lower than those in the United States. That mere observation is enough to conclude that pharmaceutical prices in the United States are high.

Complications, to be sure, may throw that conclusion off. Most comparisons ignore the reality that various countries may use different amounts of the same medicine. Smaller amounts of high-priced "brand name" pharmaceuticals and greater quantities of lower-priced "generic" equivalents might be used in the United States, making simple price comparisons of brand names deceptive. That problem is crucial for U.S.–international comparisons, as mentioned below.

Because price comparisons of a small number of pharmaceuticals are insufficient to determine total comparable pricing, the ideal way is to generate price indices that are confined to drugs available in various countries. This is the technique followed in a recent report by the RAND Corporation, a respected research institution, titled "International Prescription Drug Price Comparisons." Prices in one of the two comparison nations are weighted (multiplied) by their stated amounts. Because our emphasis is centered on U.S. pricing, the RAND research uses U.S. quantity weights correctly. Furthermore, because the pharmaceutical industry generates and sells thousands of therapeutic compounds, the RAND authors are right that calculating price indices for the present collection of overlapping goods is the optimum strategy.

The U.S. Pharmaceutical Sector

Before we look at the RAND report's medication pricing comparisons, it's important to understand certain key aspects of the pharmaceutical supply chain in the United States, many of which are fundamentally different from those seen abroad. "Nearly all of the nations [included in his discussion] either establish pharmaceutical pricing levels or participate in formal discussions with manufacturers," Tom Rice writes in his 2021 book Health Insurance Systems: An International Comparison. "None of these actions are carried out by the United States federal government," says the report. Instead, "current US policy... precludes government negotiation and instead depends on competition," according to the report.

The United States' approach of depending on competition is sound and has been in place for a long time. This strategic direction has been developed since the Hatch–Waxman Act was passed in 1984. In contrast to other nations, politicians in the United States place a premium on the social benefits of pharmaceutical innovation, encouraging a high pace of new product debuts as well as the benefits of achieving low, competitive costs. The Hatch–Waxman framers were aware of the tension between these two policy goals.

With these goals in mind, the Hatch–Waxman founders established a new pharmaceutical sector that had never been before. Indeed, in the history of the United States, this bill was the most dramatic example of industrial strategy implemented through regulatory reform. And it happened because Orrin Hatch, a conservative Republican senator from Utah, and Henry Waxman, a liberal Democratic congressman from West Los Angeles, collaborated. The bill effectively launched the generic pharmaceutical business in the United States by altering the regulatory system enforced by the Food and Drug Administration.

As a result of the Act, the United States now has two independent pharmaceutical businesses, each with its own set of goals. The branded industry, which included "Big Pharma" drug firms and — subsequently — innovation startups, was charged with pushing a quick pace of new product releases to meet the country's and world's health demands. The Hatch–Waxman framers recognized that high costs for novel therapeutic medicines may be charged, but that they would be more effectively confined to the term of the accompanying drug patents. The rule would enable and even encourage generic businesses to join the market with competing low-cost variants of the established medicine once those patents expired.

Potential entrants are no longer required to show the safety and efficacy of already existing drugs through costly and socially wasteful duplicative testing, as was formerly the case. A rival just has to show bioequivalence, or that its version of the medicine elicits a biological reaction identical to the copyrighted drug, to get FDA marketing clearance. The cost of entrance was significantly decreased as a result of this provision. While Big Pharma companies may set high prices for new pharmaceuticals while their patents are valid, the Hatch–Waxman architects expected dramatically lower costs once generic entrants arrived and price competition became effective.

The then‐​fledgling generic industry was designed to assure low prices for drugs for which patent protection had expired. This objective would be achieved not through price regulation or government intervention into the price‐​setting process, but through competition. Where branded prices exceeded production costs, the framers believed, a bevy of new firms would flock to the industry, attracted by the prospect of undercutting the high prices charged for therapeutically effective pharmaceuticals. If there were profits to be made, the Hatch–Waxman framers presumed that generic producers would appear.

To make this program work, doctors and patients must believe that generic drugs are of equivalent quality to their branded counterparts. Arguments were raised at the time the Act was being considered that "knock off" medications, despite FDA certification of their bioequivalence, would not be believed. Overall, there were substantial doubts about whether the new strategy of two different United States drug sectors, unique in the world, would function. But that was 37 years ago, and we now know what happened.

Table 1, which reports data for 2019, tells the story. When the Hatch–Waxman Act was passed in 1984, generic prescriptions accounted for merely 14% of total prescriptions. By 2019, they dominated the pharmaceutical sector and represented fully 90% of all dispensed prescriptions. Generics achieved that result by continually reducing prices such that they now represent only 29% of total spending on pharmaceuticals after accounting for discounts, rebates, and other price concessions.

Regulation - v44n4 - Article 2 - Table 1

In contrast, the branded industry receives more than 70% of aggregate net revenues even while providing only 10% of dispensed prescriptions. This disconnect is striking and associated, of course, with major differences in the average price per prescription between the two industries: over $600 for branded drugs but only $26.89 for generics. Based on these data, an appropriate response to the question of whether average U.S. drug prices are high or low is both. By regulatory design, there are two pharmaceutical industries: one with high prices and the other with low ones. And this result is just what the Hatch–Waxman framers had in mind.

International Price Comparisons and the RAND Report

The RAND authors were tasked by the U.S. Department of Health and Human Services with “understanding the extent to which drug prices are higher in the United States than in other countries.” To this end, they explain and then derive “price indices as a tool to compare drug prices between countries.” However, the authors pay little attention to the presence of two distinct U.S. pharmaceutical industries. In effect, they compute a “fruit” index containing “apples” and “oranges” with little concern paid to the striking price differences between them.

In the following discussion, I will mainly ignore the authors' overall index, which combines branded and generic medicine costs. Instead, I concentrate on their distinct pricing indexes for branded and generic medications, which are where they contribute the most. Instead of dealing with their whole sample of 32 comparator nations, I just analyze Japan, Germany, and the United Kingdom, which are the next three largest pharmaceutical users by volume after the United States. As seen in the first section of Table 2, total branded and generic medicine sales in the United States are far higher than in any of the following biggest nations.

The data presented in the second part of Table 2 describe the different compositions of U.S. pharmaceutical sales as compared with its largest rivals. Consistent with the data presented earlier on prescriptions, the physical volume of U.S. generic sales was 84% of the country’s total in 2018, although its sales revenue was only 12% of the total. The next largest countries all had smaller shares of physical units accounted for by unbranded generics but larger shares of sales revenue. These data indicate the very different pharmaceutical supply structures in the United States and elsewhere.

Table 3 reports the RAND report’s major findings. Consistent with the data provided earlier, and after making the appropriate net price correction, U.S. branded drug prices are more than double their foreign counterparts in Japan and the UK and just under that level in Germany. However, these averages apply to only 16% of the pharmaceutical physical units sold in the United States.

In contrast, as shown in Table 3, the RAND analysis indicates that average generic medicine prices in the United States are significantly lower than those in the three major comparator countries: just 43% for Japan, 62 percent for Germany, and 68 percent for the United Kingdom. These averages apply to 84% of all pharmaceutical standard units supplied in the US. Pharmaceutical costs in the United States differ between the branded and generic marketplaces to a significantly higher extent than they do abroad. In generic markets, pricing outcomes are determined by competition, but not so much in branded pharmaceutical markets, which are generally dominated by patent-protected product monopolies.

Regulation - v44n4 - Article 2 - Table 2
Regulation - v44n4 - Article 2 - Table 3

While the RAND report provides a useful discussion of price index economics and also valuable price indices concerning U.S. pharmaceuticals, it suffers from a lack of connection to the underlying market conditions. Its concluding statement makes that disconnect clear:

We found that 2018 drug prices in the United States were substantially higher than those in other countries. The magnitude of this difference between prices in the United States and other countries was substantial.… Only unbranded generics had lower prices than in most comparator countries.

What is missing from the statement is that, by their own reported data, fully 84% of total pharmaceutical quantities are represented by unbranded generics. That category of pharmaceuticals hardly represents an exception to a larger conclusion put forth in the report.

Policy Conclusions

The RAND report confirms the common notion that U.S. consumers pay high branded drug prices as compared to other developed nations. It also confirms the less recognized fact that U.S. consumers pay lower generic prices than elsewhere. This division reflects U.S. policymakers' dual goals of promoting pharmaceutical innovation while also reducing the prices of long-established drugs. To gain the benefits of therapeutically advanced new drugs, the Hatch–Waxman policymakers willingly tolerated high branded prices. Whether those prices are excessive or not turns on whether they exceed levels required to achieve the drug innovation policy objective and not on whether they are higher than elsewhere.

There is empirical evidence in a study by F.M. Scherer that drug companies' net revenues are an important predictor of pharmaceutical company ratios of research and development expenditures to sales. There is also evidence that larger therapeutic markets, which promise greater revenues, directly entice the entry of new medications and new molecular entities. The point here is that pharmaceutical innovation is an economic activity that is pursued, like other economic activities, for financial gain.

Even when new pharmaceuticals build upon basic scientific discoveries made in government and university facilities, company resources are required. On this point, an empirical study by Andrew Toole estimated that for every public dollar allocated to basic biopharmaceutical research, an additional $8.38 is spent on pharmaceutical R&D. In a recent report, the Congressional Budget Office emphasized

the complementary relationship between public and private R&D spending [which] arises mainly because NIH funding focuses on basic research that leads to the discovery of new drugs, whereas private spending focuses on applications of such research.

A major factor in private R&D spending is the cost of the extensive clinical trials required before the Food and Drug Administration grants marketing approval. These trials can cost upward of $100 million per drug according to estimates by Joseph DiMasi and colleagues. The point here is not to diminish the importance of public research but rather to note its complementarity to industry research in circumstances where both efforts are essential.

To be sure, pharmaceutical R&D is inherently uncertain. While not all research programs lead to therapeutically important new drugs, many do. A striking example is the development of pharmaceutical treatments to combat the virulent AIDS epidemic. An empirical study by Tomas Philipson and Anupam Jena of the comparative aggregate treatment costs and social benefits reported that the survival gains associated with the new AIDS treatments were conservatively valued at 20 times the observed treatment costs.

While the AIDS example may be atypical, Philipson and Jena also noted that for a larger sample of 200 branded pharmaceuticals, societal values exceed treatment costs by as much as 10 times. Moreover, for new drugs that are no better than existing ones, these pharmaceuticals are generally priced at about the same level as their established rivals, according to my research with John Lu. For the most part, and with some exceptions, the prices charged for branded drugs lie well below the social value of their therapeutic contributions, as explained in a forthcoming paper by Mark Pauly et al.

Between 1990 and 2015, life expectancy in the United States grew by 3.3 years, according to a recent research by Jason Buxbaum et al., which attributed the increase to several key contributory causes. The authors underlined that the 12 most important parameters collectively accounted for 85 percent of the total increase (2.9 years). Pharmaceuticals were the second most important influence, behind public health efforts. Drugs were responsible for 44% of the overall reduction in death rates, albeit this was somewhat offset by a 9% drop in survival rates, mostly due to the opioid epidemic. Nonetheless, medicines contributed 35% of the entire increase. These findings "underscore the important importance of drugs in explaining lower mortality," the scientists write.

Another report by the Congressional Budget Office examined the connection between pharmaceutical prices and innovation. When bills are offered or passed in either chamber of Congress, they are commonly "scored" by this impartial office to describe the implications of the proposed legislation. For the most part, the CBO provides budgetary implications but sometimes also offers additional non-budgetary effects. The CBO "scored" the 2019 Cummings legislation mentioned earlier.

The bill's goal was to lower medication prices by directing the secretary of health and human services to negotiate the pricing of "chosen pharmaceuticals" so that they do not exceed 120 percent of the average price charged in a group of nations. In such a scenario, the CBO forecasted a $456 billion reduction in federal expenditure over a ten-year period. The CBO also predicted that due to lower earnings from newly patented pharmaceuticals, eight fewer drugs would be launched between 2020 and 2029, and 30 fewer drugs in the decade after that. A subsequent CBO staff report reduced those figures to two fewer drugs in the current decade and 23 fewer in the next decade, but also estimated there would be 34 fewer drugs in the following decade. The report explained, "The change would be small for the first few years … [but] would increase substantially as decisions in earlier phases of development affect later phases."

The clear tradeoff between pricing and innovation begs the policy question of why, despite possessing similar menus of modern medications, other industrialized countries have imposed significantly lower prices. Isn't it true that if they make less money, they'll make fewer new drugs? The solution rests in the fact that other nations are not as affected by the tradeoff between branded prices and innovation as the United States is.

According to the RAND analysis, the United States accounts for 58 percent of total pharmaceutical sales income among countries in the Organization for Economic Cooperation and Development, while Japan and Germany, respectively, account for 9 percent and 5%. Moreover, because U.S. branded prices are higher than elsewhere, the United States accounts for approximately 78% of worldwide industry profits. All other countries, in aggregate, account for less than one-third of that amount. Put simply, U.S. profits incentivize global innovation.

Whether this striking imbalance resulting from high U.S. branded drug prices is "excessive" or not depends on policy objectives pertaining specifically to the branded industry. As emphasized in a 2018 report by the President's Council of Economic Advisers, "worldwide profits drive innovation incentives," which in turn depend at least partially on the prices paid by government health insurance programs. The report continues, "Providing innovative returns is a global public goods problem that leads to classic under-provision through government free-riding." Because advanced new pharmaceuticals benefit all countries, each has an incentive to free ride off the high prices and resulting incentive effects of others. While this incentive applies particularly to smaller countries that contribute little to overall innovative returns, it is least applicable to the United States, which in effect has no one to free ride on. In a sense, the United States is captive to its overwhelming position in the worldwide pharmaceutical marketplace.

The social benefits from therapeutically improved new goods are represented in the costs that knowledgeable collective consumers are ready to pay, which is why branded medicine prices in the United States are so high. While most other nations may assume that their price policies have little impact on pharmaceutical innovation, the United States cannot. This prestigious position has perks, such as sophisticated new medications being launched first in the United States. However, there are apparent drawbacks, one of which is that policymakers, such as the Hatch–Waxman framers, cannot avoid accounting for impacts on new product introduction when establishing price policies. That stunning piece of legislation's compromise solution will not be replicated elsewhere.

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