Price Controls Are Hazardous to Your Health

T he new budget-reconciliation bill, just signed into law by President Biden, directs the executive branch to “negotiate” the prices of drugs purchased by Medicare. Those provisions of the new law will likely reduce patient access to prescription drugs both in the Medicare and commercial segments, which is contrary to what Democrats have claimed at least since President Clinton was in office.

It is widely understood that “negotiation” is a euphemism for government-set prices. Indeed, the statute prohibits the executive branch from accepting a price above those dictated in the statute, which are a fraction of the prices charged to commercial customers such as employer plans. The new law is purported to increase patient access by making drugs more affordable for participants in the Medicare program where the negotiated prices apply.

The increased-access prediction is contradicted by real-world experience in the pharmaceutical industry, where patent policy has repeatedly pushed drug prices lower without increasing utilization. When drug patents expire, the patent holder is subject to competition (to the extent that such competitors are not discouraged by other regulations). Although drug prices fall as new competitors enter, the lower prices do little if anything to increase total sales of the drug, as a combined total between the incumbent and the new competitors.

All else the same, lower prices encourage consumers to purchase. However, all else is not the same for the sellers of a unique prescription drug. While the drug is under patent, manufacturers have a strong financial incentive to widen the distribution of their product because each unit pays them the difference between the market price and the marginal cost. That distribution incentive is sharply reduced when patent expiration, or government price controls, slash the revenue that manufacturers get from each sale.

Selling through insurance plans is one way that pharmaceutical manufacturers increase the distribution of their products. In addition to informing plans, prescribers, and patients about the existence and utilization of a unique drug, manufacturers present the plans with financial incentives to increase plan-member access to it. Those “pharmacy benefit management” incentives will be reduced or disappear in the markets that fall under the new law.

The increased-access prediction also ignores the multiple financial incentives that price-regulated manufacturers will have to reduce sales under the new law. With drug development costing billions of dollars, discovery of new drugs will be retarded as companies find it more difficult to offset the costs of inevitable less-successful research projects with revenue from the blockbusters targeted by the new legislation. The law will also reduce the scope of the discoveries that do occur, because the price controls reduce the financial reward to conducting clinical trials on a wider range of patient demographics.

Because the law selects the highest-revenue drugs for regulation, a number of manufacturers are incentivized to increase their prices to further reduce their sales and revenues and thereby stay off the government’s target list. This is one reason why a law promised to reduce prices may actually increase them.

Because the statute directs government regulations to account for drugmakers’ costs, its price regulations have elements of the more familiar “cost-plus” price regulations that have long been imposed on public utilities such as residential electricity. The providers respond to cost-plus regulations by inflating costs at consumers’ expense.

With the drug-price controls, drugmakers will be limited in the amount of cost they can pass to the Medicare program because the statute sets a ceiling at a fixed fraction of commercial prices. In other words, drugmakers will be able to relax their Medicare price ceiling by increasing their commercial prices. The Medicaid program has employed a related “reference pricing” approach for several years, and the results clearly show the “incentive for [a drug] maker to increase prices for other health care consumers.” Now the reconciliation bill has Medicare doing something similar. The Medicaid studies help us know what to expect, which is higher commercial prices especially for drugs that are mainly selling through the program with the price controls.

Finally, the statute creates a punitive excise tax on the U.S. sales of any drug on which the manufacturer refuses to accept the government’s price. Excise taxes are well-known tools for increasing prices and reducing sales, which may be acceptable for cigarettes, but presumably not for life-saving pharmaceuticals.

The laws of economics do not disappear because politicians want to sound benevolent when talking about drug prices. Rather than increasing access to drugs, the reconciliation bill includes many incentives that will likely reduce access, both to currently existing drugs and drugs that will be invented in the future.