The Key to Cheap Drugs: Pay Research Costs Upfront

We face a bizarre situation where policy experts, advocacy groups, and politicians struggle to find ways to bring down drug prices. The situation is bizarre because drug prices would be low in a free market; it is only government policy that makes them expensive.

It is the government-granted patent monopolies that create the problem of high drug prices, not the market. The government gives drug companies patent monopolies that make it illegal for competitors to sell the same drug. These patent monopolies allow companies to charge prices that are a hundred or even a thousand times the free market price.

Drugs are almost invariably cheap to manufacture. But, if a drug company has a monopoly on a drug that can save a person from cancer or some other deadly or debilitating disease, it will be able to charge a very high price for it. Patients or their families will pay hundreds of thousands of dollars, or more typically, get an insurance company or the government to pick up most of the bill. While there are instances where companies producing generic drugs can gain monopoly power and jack up their prices, this is a relatively small part of the story of high drug prices.

Drugs produced by the brand drug sector account for roughly 75 percent of drug costs, even though they are just 11 percent of sales. This means that generic drugs account for only one-quarter of drug spending despite being almost 90 percent of sales. Even these numbers understate the role of patent and related protections. Some generic drugs also benefit from government-imposed protections, such as a six-month period of exclusivity for the first generic to enter a market.

We are on a path to spend more than $450 billion (2.2 percent of GDP) on prescription drugs this year. We would likely be spending less than $80 billion, a savings of $370 billion annually, if all drugs were sold in a free market without patents or related protections.

The justification for patent monopolies is that it gives drug companies the incentive to research and develop new drugs. While the drug companies hugely exaggerate the cost of developing drugs, there is no doubt that it is expensive and they would not be able to recover their research costs if their newly developed drugs were sold in a free market without protection.

But, we don’t have to rely on patent monopolies to pay for drug research. We could, for example, pay for the research costs upfront. In fact, the government already does this to a substantial extent. It spends close to $40 billion a year financing biomedical research through the National Institutes of Health and other government agencies. There is bipartisan agreement that this is money that is very well spent.

However, as it stands, most of this funding is for basic research. It is essentially a gift to the pharmaceutical industry, which does the additional research needed to develop and test drugs and bring them through the Food and Drug Administration’s approval process.

There is no reason that federal funding has to be restricted to more basic research, rather than supporting the development and testing of new drugs. If the federal government were to pay for the later stages of drug development and testing, and bring drugs through the FDA approval process, then newly developed drugs could all be sold as generics. This could mean that the next big cancer drug might sell for a few hundred dollars a year rather than a few hundred thousand.

This doesn’t mean we would have the government directly taking responsibility for developing new drugs. It could have long-term contracts with private companies, much as the Defense Department does. While there are abuses in defense contracting, these companies do develop state of the art military systems. (That is not an endorsement of how they are used.) Contracts can be renewed and expanded, or terminated, depending on a company’s effectiveness with the money it received.

One big advantage of contracting biomedical research over military research is that there is no reason for secrecy. We really don’t want the blueprints for weapon systems posted on the web where any terrorist group can download them, but there is no reason not to post developments in the treatment of cancer or heart disease.

In fact, web posting of all results in a timely manner should be an absolute requirement for any company doing publicly funded research. This was the practice in the mapping of the human genome, where the Bermuda Principles required that results be posted nightly. This should allow other scientists to both learn from advances made elsewhere and to correct mistakes where they see them.

We also don’t have to look to replace patent financed research all at once. The government could focus its support on two or three major health areas, like cancer and diabetes. The industry does a bit less than $70 billion a year in research. If we added another $15 to $20 billion to what the NIH now spends, federal-financed research should be able to replace a substantial portion of the research now done by the industry.

Even in the areas chosen for funding by the government, the industry would still be free to compete, doing patent-supported research. However, in addition to the risk of not developing an effective drug, the companies relying on patent monopolies could face competition from a publicly funded drug that is as good or better, and selling at generic prices.

Our current system of financing drug research is like paying firefighters when they show up at our burning house with a family inside and then asking what it is worth to save them. It makes zero sense to have a patient suffering from a serious illness, or their family, to cough up the money to pay for research that has already been done.

Patent monopolies also give huge incentives for all sorts of corrupt behavior by drug companies, including pushing their drugs in contexts where they are not appropriate. The marketing of OxyContin is a recent example of this sort of abuse.

Conservative economists have a point when they tout the virtues of a free market. It would be great to have a free market for prescription drugs.