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The pharmaceutical industry is increasingly multinational in scope. Most major research-based companies market products throughout the world. Historically, the centers of global research have been in large countries that foster free markets and thus innovation. Approximately 36 percent of pharmaceutical R&D conducted by companies worldwide is performed in the United States, followed by Japan with 19 percent of global R&D [Figure 7-1]. The United States is also the largest market for pharmaceuticals. The U.S. accounts for one-third of global pharmaceutical sales [Figure 7-2].

U.S. LEADERSHIP

Of 152 major global drugs developed between 1975 and 1994, 45 percent were of U.S. origin, 14 percent originated in the U.K., and 9 percent were of Swiss origin [Figure 7-3]. During 1980-1995, innovative U.S. firms were able to globalize (launch in the U.S., Europe, and Japan) their new drug products at a rate more than double that of European companies [Figure 7-4]. In the rapidly growing field of biotechnology, U.S. firms have a commanding lead in patenting their innovations. Of the 150 genetic engineering health care patents issued by the U.S. Patent and Trademark Office in 1995, U.S. applicants received 122 [Figure 7-5].

PHARMACEUTICAL EXPENDITURES ACCROSS COUNTRIES

Although the United States is the world's largest pharmaceutical market, it spends less on pharmaceuticals as a share of total health care expenditures than most industrialized countries [Figure 7-6]. U.S. spending per capita on prescription drugs ranks fourth among industrialized countries, behind Japan, France and Belgium [Figure 7-7].

PRICE CONTROLS AND COST CONTAINMENT ABROAD

Competitive market forces, which promote innovation and help to control expenditures for pharmaceutical products in the U.S., have never been allowed to operate freely in most other parts of the world. In most European countries and Japan, the government is the largest purchaser of pharmaceuticals. Governments use their power to negotiate directly or to indirectly control the prices of pharmaceutical products; in some cases, they also compel companies to make investments in their country. While the mechanics of each price-control system differ widely from country to country, the end result is the same. Research-based pharmaceutical companies are prohibited from charging a free-market price for the products they discover and develop. These price controls distort the market for pharmaceuticals and undermine the vitality of the European and Japanese pharmaceutical industries.

Price- and cost-control mechanisms also often delay a product from being marketed once it is approved. Complex regulations and price and reimbursement negotiations play a major role. In Europe, delays between drug approval and market availability can be as long as 12 months [Figure 7-8].

Specific government market interventions practiced outside the U.S. include:

• Delisting: Delisting generally takes three forms: (1) disallowing reimbursement for products; (2) disallowing over-the-counter products that otherwise could be prescribed and reimbursed; and (3) switching prescription drugs to over-the-counter status. Often delisting is used to shift medical costs to consumers by requiring them to pay for products that treat minor illnesses or elective therapies (e.g., vitamins, oral contraceptives). If focused on specific products rather than therapeutic categories, delisting can distort the market by spurring doctors and patients to seek reimbursable products in the same therapeutic category. If price controls are imposed on delisted products, market conditions are further distorted.

• Local Performance Requirements: Local performance requirements are imposed by countries seeking to stimulate private investment in their own markets. Because international treaties prohibit many forms of direct-investment incentives, some countries instead require companies to manufacture products locally, conduct R&D locally, co-market or co-develop products with a local partner, and/or license their products to a local manufacturer. These practices violate intellectual property rights and seriously distort the marketplace. Performance requirements also have led to a worldwide overcapacity in manufacturing facilities, a waste of resources.

• Medical Needs: Medical-needs criteria are regulatory requirements beyond the three universally recognized criteria for marketing approval: safety, efficacy, and quality. Proponents of this approach assume that it is possible to reach a definitive judgment on the relative therapeutic value of a new product before it is marketed. Marketing approval is reserved only for a new product that offers a "breakthrough," "significant" therapeutic improvement, or cost benefit over existing products. The product might be required to undergo a social, economic, and environmental impact assessment before marketing approval is granted. Medical-needs criteria restrict drug availability and have a negative effect on the quality of health care and development of new therapies. The full therapeutic, social, and economic value of a product often becomes apparent only after it has been on the market for some time.

• Prescribing Controls: The imposition of controls over the prescribing practices of physicians has steadily increased in recent years as budget-cutters have sought to contain costs by slowing the use of pharmaceutical products. The result has been a disturbing trend toward shifting the responsibility for prescribing decisions from physicians to other health professionals (such as pharmacists) and to administrative staffs in governments, sick funds, and health facilities whose primary concern is cost. Undue pressure on physicians undermines their ability to prescribe the best possible treatment for their patients.

• Price Controls: Price controls are the severest market-distorting measures mandated by governments. They are imposed on manufacturers regardless of changes in the cost of research, development, and production. The specifics of each price-control system differ widely from country to country. Methods of price control include price freezes; across-the-board price reductions; government determination of the initial price of a new product; government approval required for price increases; price reductions for exceeding agreed-upon unit sales; price review based on "basket comparisons;" and limitation of price increases to cost-of-living increases.

• Profit Controls: Profit controls limit prices indirectly by arbitrarily capping the profits that pharmaceutical companies make on the capital they invest in plants for research, development, and manufacturing. The most prominent example of profit control is the Pharmaceutical Price Regulation Scheme in the United Kingdom. While this scheme is nonstatutory, companies comply because they know that their operations in the U.K. otherwise could be more adversely affected. Profit controls dampen innovation and efficiency by introducing nonmarket considerations into capital-investment decisions.

• Mandatory Rebates/Discounts: Under rebate/discount systems, centralized purchasing entities, drawing on their considerable buying power and high-volume sales, elicit price concessions from pharmaceutical manufacturers. These concessions can take the form of rebates (under which a pharmaceutical supplier pays back to the purchasing agency a set percentage of sales) or discounts (under which high-volume purchasers are awarded an upfront percentage reduction in the reimbursed price of a pharmaceutical product). Recent experience (with rebates in the U.S. and discounts in Japan) indicates that these market-driven reductions can easily become government-mandated price reductions, which are not related to the purchasing power of the government because they are not freely negotiated.

• Reference Prices: Reference prices are fixed amounts at which national health authorities will reimburse the purchase of a pharmaceutical product. Any amount above or beyond the fixed amount is paid by private insurers or a patient. Reference prices are established by dividing reimbursable products into clusters or groups of drugs that have similar chemical characteristics or are considered to be therapeutically equivalent when prescribed for a particular medical condition. Each cluster of products is given a "reference" price that becomes the maximum price at which all products in the cluster are reimbursed. Clusters may combine patented and off-patent products, leading to reference prices set far below levels at which patented products will be able to recoup their R&D costs. Reference-price systems have not had a discernible impact on the rate of expenditure growth for drugs in any country that has implemented such a system. Moreover, reference-price systems have added substantial administrative costs to health care systems because of their complexity, and have had negative impacts on the quality of care for patients and had a negative impact on R & D investment.

A 1993 study by Heinz Redwood¹ and a 1994 study by David Gross² comparing international pharmaceutical-spending controls across countries found that while price controls produce lower prices, they do not reduce pharmaceutical expenditures (price times volume) or contain health care costs.

In fact, the growth in pharmaceutical expenditures was greater in countries with price controls than in the United States. By focusing specifically on pharmaceuticals, government price- and cost-control mechanisms also do not address systemwide costs. Costs may be shifted from prescription drugs to other more costly forms of health care intervention such as hospitalization, physician care, and nursing-home care.

Price and volume controls also provide few incentives for pharmaceutical research and development. Patented, innovative pharmaceuticals, which are among the most cost-effective forms of medical care, are frequent targets of government cost-cutting efforts. Yet any short-run "savings" purported to be generated by controlling the price of patented drug products are minimal at best. In the European Union, drugs under patent account for an average of 22 percent of sales of drug products eligible for reimbursement by national health authorities [Figure 7-9]. As government reimbursement authorities continue to focus only on the relatively small, short-run "savings" of controls on innovative drugs, without regard to the costs of such controls, less money will be available for future research and development of new life-saving, cost-effective medicines.

PARALLEL TRADE

Price controls are creating another serious problem—the parallel importation of prescription medicines from a country with such controls into another country that does not have the controls and in which the products remain under patent. The patchwork of administered price schemes for drugs establishes an economic environment that enables middlemen to operate by exploiting legislated price differentials.

This situation is exacerbated under a unified market structure such as the European Union, which facilitates the movement of goods across the borders of member states. In some European countries, as well as in other parts of the world, national health authorities are exploiting administered drug price differences between countries by actively encouraging parallel imports to obtain lower-cost drugs.

Thus, the competitive distortion created by the administrators who mandate below-fair-market prices is transmitted throughout the trading system through parallel trade. Pharmaceutical trade is therefore distorted twice: first, through the imposition of price controls, and, second, through the loss of revenue in higher-priced markets from involuntary competition with oneself in the parallel market. Parallel trade, arising in this context, distorts trade patterns, artificially suppresses revenue, and undermines the incentives for research and development of new medicines.

A similar and equally serious situation is created when laws governing intellectual property protection for pharmaceuticals are inconsistently and inadequately applied. Since patent protection occurs at the national level, inadequate and uneven protection of patent rights also results in price distortions across markets. When the value of intellectual property is seriously undercut, the resulting price erosion creates another economic opportunity to foster parallel trade. Research-based pharmaceutical companies are thus injured twice again: first, through the erosion of the value of their patents in one market, and, second, through the loss of sales revenue from parallel trade in those markets where their patents are inadequately protected.

In general, patented products, including pharmaceuticals, are protected against parallel importation, although there are important exceptions in some major countries. The international standard is that the exclusive rights of a patent holder to control the use of a specific patented product are "exhausted," or relinquished, only in the country where the product is sold.

But the exhaustion of a patent in one market, such as Australia, does not affect a patent holder's rights for the same product in another market, such as the U.S. Under the doctrine of national exhaustion, the rights of a patent holder extend to the exclusive right of importation of the patented article. When pharmaceutical trade conforms to this doctrine, the value of a patent is protected from erosion through parallel trade.

The principle of national exhaustion is confirmed and strengthened by both the 1995 World Trade Organization's Agreement on Trade-Related Aspects of Intellectual Property (TRIPS) and the 1993 North American Free Trade Agreement (NAFTA), although the principle sometimes is challenged. TRIPS Article 28 specifically classifies importation as one of the exclusive rights enjoyed by a patent holder, which is confirmed by Chapter 17 of NAFTA. Nevertheless, the principles and practice of national exhaustion of patent rights for pharmaceuticals are being threatened in such places as South Africa, Singapore, and Israel.

The need for strong intellectual property protection for pharmaceuticals is discussed in the following chapter.

ENCOURAGING MARKET FORCES

The more effective means of controlling spending on pharmaceutical products, while at the same time providing incentives for truly innovative pharmaceutical research, is to foster competitive market forces in health care. Possible market-oriented reforms for the European, Japanese, and other health systems include:

• Promoting innovation (through market pricing, strengthened intellectual property protection, and appropriate fiscal policies).

• Encouraging market competition (through market pricing and enhanced price sensitivity).

• Providing unrestricted access to drugs (through prescribing freedom, timely approval of new drugs, and prompt reimbursement decisions).

• Encouraging patient responsibility (through cost sharing, improving patient information, and promoting patient-compliance and wellness programs).

• Adopting a systemwide approach to health care budgeting (through outcomes assessments).

• Separating pricing from reimbursement decisions as a first step in the deregulation of pharmaceutical prices.

Endnotes

1. Redwood, Heinz, Price Regulation and Pharmaceutical Research, Oldwicks Press, Suffolk, England, 1993.

2. Gross, David, et al., "International Spending Controls: France, Germany, Sweden and the United Kingdom," Health Care Financing Review, Vol. 15, No. 3, pp. 127-140, 1994.