Patricia Danzon, a professor in Wharton’s health care department, has long studied prices in the pharmaceutical industry. Her study on "Price Comparisons for Pharmaceuticals: A Review of U.S. and Cross-National Studies" examined relative drug prices in the U.S. and other countries. In the following opinion piece, Danzon rebuts the logic underlying recent legislative moves to regulate drug prices.

In recent weeks, federal and state legislative attention has turned northward as attention has focused on the allegedly cheaper drug prices of Canada. Motivated by stories of busloads of seniors travelling across the border to buy cheap drugs, American politicians have unleashed legislative proposals aimed at securing these bargain pills without the bus ticket.

Some proposals would limit U.S. prices to no more than is charged in Canada or other nations. Others would accomplish this goal by lifting restrictions on importing medicines from outside the U.S. Still others would require that companies give their lowest price to all citizens, or at least to seniors.

The conventional wisdom on which these price control proposals is founded may be conventional but it is not wisdom. None of these proposals is based on a sound understanding of the facts, the economics, or their potential negative impact on patients both here and abroad. All are distractions from a real solution that would offer seniors drug coverage through a modernized Medicare program that gives them a choice of competing health plans.

First, the facts. It is undeniable that many brand name medicines are priced lower in Canada. This results from several factors, including federal government control over prices for brand name medicines; tight provincial government health budgets; former compulsory licensing provisions, and lower liability threats. But the perception that U.S. prices on average are much higher than other industrialized countries is based on inaccurate and biased comparisons. Many price comparisons use small, unrepresentative samples – typically, ten top branded products — and faulty methods that lead to biased conclusions.

Our analysis of 1992 data using a representative market basket of medicines purchased by U.S. consumers found that average manufacturer price levels of these drugs were comparable or higher in Canada, Germany, Sweden, and Switzerland. Costs were lower in France, Italy, Japan, and the UK. This analysis overstates U.S. prices because it omits rebates given to managed care and government purchasers. We also found that, in general, government price controls undermine price competition, particularly post-patent competition between generics and branded products. More than 42% of drug purchases in the U.S. are generics, yet these are omitted from most price comparisons.

Second, the economics. The regulatory alternatives proposed are bootstrap fixes without rational economic foundation. Price regulation creates perverse incentives familiar in other industries. Price controls based on costs are particularly inappropriate for pharmaceuticals because the common costs of R&D cannot be rationally allocated across different users or countries. Regulators in small countries – Canada’s entire population for instance is smaller than California’s – are tempted to pay only marginal costs. While this may not have a discernable effect on global revenue and hence on R&D, if no one pays for the common costs of R&D, new products will not be developed. If the U.S., which accounts for over one third of global pharmaceutical revenues, adopts such strategies, the effects on innovation would be significant.

Uniform prices are not uniformly low prices and are probably bad policy. Poorer nations, whose prices are referenced by rich nations, would inevitably see prices rise or drugs not launched at all. This clearly hurts patients in those nations but would also harm patients here. For each sale today, even at a price below a U.S. market price, revenues continue to exceed marginal production costs. Were these sales not made, overall revenues from these countries would decline, as would revenues in the US. And that will be precisely the impact of current proposals to cap U.S. prices at prices in other markets, either by direct comparison with Canada or Mexico, or by permitting importation of products from price-controlled countries.

The same kind of price differences that today exist between the U.S. and other nations also exist within the U.S. This is good news, not bad. The fact that today large managed care customers are able to negotiate price discounts confirms that competition can effectively work to restrain prices if given the chance. The real problem in U.S. pharmaceutical markets is distortions to competition, not any intrinsic market failure that could or should be "fixed" by regulation.

As in other industries, all health care providers and suppliers, including drug manufacturers, charge lower prices to more price sensitive customers — typically managed care buyers. Managed care’s ability to steer patients towards lower cost providers makes managed care demand more price sensitive. In the case of managed pharmacy benefits, formularies of preferred drugs and structured co-payments are used to shift market share to manufacturers that give discounts, just as physicians, pharmacists and hospitals give discounts in order to be in preferred provider networks. The rapid growth of managed pharmacy benefits suggests that patients view the minor restrictions on choice as well worth the savings.

The real problem that federal and state policymakers need to address is that seniors and others who do not participate in managed plans do not enjoy the same benefits of competition as those who do. The best solution is to deal with this as an insurance problem, enrolling Medicare and Medicaid beneficiaries in competing plans that manage their pharmacy benefits to take advantage of price competition. Since health plans must compete for consumers, formulary design cannot ignore consumer preferences, unlike regulatory alternatives. Social concerns can be addressed through risk-adjusted premiums, or tax credits to address equity and affordability concerns.

In recent days, we have seen partnering initiatives by two leading pharmacy benefit managers, Merck-Medco Managed Care/Reader’s Digest and PCS/AARP, to extend discount prices to consumers who are not enrolled in managed health plans. These and other competitive approaches, which are grounded in basic economics, are at least worth trying before turning to regulatory alternatives that could seriously distort the working of markets and undermine R&D, at high administrative expense.

If we want the level and type of R&D that consumers and taxpayers, on average, are willing to pay for, then the best approach is to permit market-determined prices within the context of competing health plans. Price controls in any form are ineffective and unsafe medicine, based on a misdiagnosis of the problem.