Regulating the price of drugs can be dangerous

To spotlight drug firms that increase prices excessively, the state of Vermont has enacted a law requiring drug companies that increase prices by 15 percent or more to justify them.

 

Regulators ask manufacturers to identify all factors (such as wages and supplies) whose price changes contributed to drug price increases, and calculate the percentage of the price increase that was because of the factor’s increase.

But what is the ultimate purpose of the reporting program? Note that no penalties are imposed if the firm’s increases exceed the 15 percent cutoff. And they are only fined if they fail to file the report.

Advocates say the report adds transparency to the pricing process which, they expect, will put pressure on companies to soften price increases. And this reason is cited by California legislators who are developing similar legislation. The same reasoning is behind Sens. John McCain’s and Tammy Baldwin’s legislation to offer a similar proposal at the federal level.

But for reasons developed below, there are valid arguments for drug price increases. And the compliance costs for these reporting plans, especially for small firms, promise to be huge relative to the dubious benefits. Finally, President-elect Donald Trump has indicated that he does not like drug price increases.

Since time immemorial, humans have disliked price increases. That is always the case. But to plunge headlong into controlling the price of drugs is dangerous. Consumers want, and expect, from this industry a constant flow of lifesaving developments – new drugs, new treatments and exciting discoveries.

For the innovative, dynamic manufacturer, today’s supply of drugs is directly related to tomorrow’s supply of new drugs. But how can this be? The law of demand states that an increase in the price of a product generally will be followed by a reduction in the supply offered. According to the law, today’s supply offering will be reduced by a price increase.

After defining adjusted cash flows (ACF) as gross profit after cash costs, taxes, interest and dividends, we note that this higher ACF earned today enables a manufacturer to finance, either directly or indirectly, an increase in tomorrow’s output, including breakthrough drugs.

To further explain, if this innovative drug manufacturer is to remain innovative, it will need new drugs to offer. It can get the required financing either through retaining current ACF, or by selling debt, and/or new shares of stock. To retain current ACF, it must be profitable. If it is not profitable, it must increase its prices, or forego this dream of developing new drugs.

On the other hand, if it opts instead to sell debt or stock, it must demonstrate to a skeptical investing public adequate current ACF. Investors look at current ACF as a base for generating expected future earnings. This brings us to a very important conclusion: Whether the firm chooses to finance the new drug with retained ACF, or by sale of debt/stock securities, it must show adequate current ACF.

But this is only part of the story. The increased ACF earned by the manufacturer today provides incentive for another visionary who is, say, a medical school doctor developing an idea he or she has been nurturing in their research. From society’s point of view, this development supplements existing firms as a source of tomorrow’s new and better drugs.

This highlights the overwhelming importance of personal incentives in our economy, especially in the high-risk area of new drugs. It is vital for public policy makers to cultivate an environment in which incentives can flourish.

And this means adequate personal rewards for those who save (sacrifice personal consumption), take the risk of investing their money, their time, their weekends, to achieve their dreams.

When legislators muse about methods for denying price increases, they should consider that the cost and supply of future drugs – including the miracle successes – may be of equal, if not more importance than prices of current drugs.

And how should Vermont firms report research and development costs? If they aim to finance new drugs, absolutely they should report current R&D costs as factors behind current drug price increases. This conclusion will annoy regulatory advocates, but it is implied by long-run competitive firm-survival conditions, including pressure from incentive-reward relationships.

This private-sector model relating current ACF to new drugs should not be overlooked by regulatory advocates. We stress that incentives and rewards drive the creation of drugs – our lifesavers.

(The writer is a professor emeritus of financial economics at the University of Georgia. He lives in Aiken, S.C.)

 

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