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Sally C. Pipes is President and CEO, Pacific Research Institute [go to Pipes index]

Where This Angell Should Have Feared to Tread
Drug reimportation is a bad idea...
[Sally C. Pipes and Benjamin Zycher] 10/4/04

No one would pay much attention to the views of an economist with respect, say, to the causes of heart disease. Why then are prominent physicians accorded prime-time attention when they pontificate on the economics of pharmaceutical development?

That question emerges front and center given the groundswell of political abuse now directed at pharmaceutical producers. The physician-as-economist now most prominent is Dr. Marcia Angell, the former editor-in-chief of the New England Journal of Medicine currently beginning a nationwide advertising campaign ("book tour") for her new tome attacking the practices and profitability of the drug companies. That much of her ire is directed at pharmaceutical advertising is only a minor example of the myriad ironies and errors in her arguments. To wit:

Profit Margins. Angell argues in The Truth About the Drug Companies that the pharmaceutical industry earns a "profit margin" of 17 percent, while the figure for the rest of the Fortune 500 firms was 3.1 percent. A very slippery term, "profit margin" bears only a tenuous relationship to the far more fundamental "return on investment" that investors ultimately pursue. In any event, that 3.1 percent figure is quite revealing, far more so about Angell than about the drug producers. Since U.S. government bonds earn a good deal more than 3.1 percent, one would conclude either that the rest of the Fortune 500 is going out of business, or that Angell's comparison is nonsensical. In particular, she apparently believes that the pharmaceutical firms are low risk investments in that they earn a higher profit margin than other industries year after year. Precisely the reverse is true: If pharmaceutical profits consistently are higher than found elsewhere, we can conclude that pharmaceutical investment indeed is riskier, unless we observe massive attempts to enter the business in quest of those higher returns. Suffice it to say that we do not. In other words, Angell's "evidence" demonstrates that the pharmaceutical industry consistently must earn higher returns in order to attract capital given the greater risks perceived by investors. This is hardly surprising: Investment in new drugs takes fifteen years or more to pay off, even in the relatively rare cases in which such efforts pay off at all.

Innovation and "Me-Too" Drugs. Angell defines "innovation" as the presence of "new active ingredients," and complains that several "me-too" drugs tend to appear on the market to treat identical conditions. These truly are strange arguments: "Old" active ingredients can be used in new ways for new conditions, and a definition of "innovation" that excludes such, well, innovation is wholly arbitrary. Moreover, different drugs -- even if they differ only slightly -- affect patients differently and so there may be important distinctions among them for individual patients even if the drugs' effects are comparable in the aggregate. In any event, in the rest of the private sector we usually define such "me-tooism" as "competition"; since Angell elsewhere complains about drug prices, perhaps she has a new economic theory that predicts higher drug prices as competitive pressures increase. In the larger context, drug producers begin the development of new pharmaceuticals many years before the products emerge from the development and regulatory process; that they tend to arrive in a staggered ("me-too") fashion is hardly detrimental to patients, who in consultation with their doctors can pick and choose. Patient welfare is, after all, the ultimate goal. Or has Angell forgotten that?

Industry Piggybacking on Government Research. Angell argues that pharmaceutical producers profit significantly from research conducted or financed by government and university laboratories. Even if true (which it is not), it is not clear why that would be a problem. Government provides the private sector with many things: national defense, roads, ad infinitum. So what? In any event, even the government refutes Angell's assertion: A 2001 study by the National Institutes of Health found that of 47 major drugs, four had been developed in part with NIH funding. Indeed, private-sector pharmaceutical R&D spending is about $32 billion per year, an amount greater than the entire NIH budget. More to the point, the riskiness of drug investment -- consuming fifteen years, at the end of which only a trivial percentage of the compounds developed actually are approved for the market and actually earn positive returns -- in substantial part stems from inefficient regulatory delay, due to biased political incentives confronting the FDA. Government funding of some basic scientific research is one indirect method with which to offset that bias and to improve the efficiency of investment incentives in the aggregate.

Research and Development. Angell complains that the drug producers spend less on R&D (she claims 14 percent of revenues) than on marketing, failing to notice that if pharmaceutical R&D investment is as profitable and low-risk as she claims, we would expect to see high levels of investment in drug R&D. Actually, pharmaceutical R&D spending as a proportion of revenue is far higher than in such other sectors as computers (12.8 percent), telecommunications (5.3 percent), or defense (3.8 percent). Moreover -- here is the doctor-as-economist problem again -- Angell seems to believe that "marketing" is wasteful, a view truly preposterous in a world in which information is not free. Are patients harmed when informed that a drug is available to treat a given condition, and that consultation with a physician might be useful? Not in our world. And, alternatively, if Angell believes that some (but not too much) marketing is a good thing, then she has provided no criterion at all with which to determine whether marketing should be less than, equal to, or greater than R&D spending. In any event, such marketing expenditures to a large degree take the form of free drugs given to physicians, who tend to use them to determine which drugs deliver the greatest benefits to given patients (see "me-tooism" above) and to give them to the uninsured. Is either of those practices a bad thing? And the "cost" of such "marketing" is substantially an arbitrary measure, in that it is unclear as to whether the retail, wholesale, or some other price ought to be assumed in order to determine "cost."

Regulation of Drug Costs. Apart from Angell's confusion between drug prices and total spending ("costs"), she complains that the U.S. is the only advanced nation that does not regulate drug costs, and that, accordingly, other nations spend far less on drugs than does the U.S. Angell forgets to mention that as a result of those foreign price controls, the foreign pharmaceutical sectors are in long-term decline, with diminishing investment, R&D spending, and therefore drug development. The ensuing implications for the future alleviation of human suffering are obvious, and Angell's silence on this score is loud indeed; so much for the children. Most amusing (to an economist) is the assertion that drug companies, not being charities, do not sell at a loss in foreign markets subject to price controls. Well, it is unclear as to how Angell is treating the historical R&D costs of bringing the drugs to market; if the cost of producing a pill is 25 cents ignoring all of the underlying investment costs that already have been borne, then a controlled price of 30 cents yields a "profit" of a nickel. That even Angell recognizes the fundamental silliness of that argument is implicit in her claim that "independent analysis" shows that the cost of bringing a drug to market is only a small fraction of the $800 million that the industry claims. Actually it is not the industry that claims that: It is a series of studies conducted at Tufts University. And her "independent analysis" -- which for example amusingly treats interest costs as irrelevant -- has been conducted by the lobbies promoting price controls on drugs, hardly a neutral source.

The Drug Industry As a Public Utility. What Angell ultimately seeks is the treatment of the pharmaceutical sector as a public utility, with cost controls, price regulation, the politicization of investment decisions, and all of the other perversities that have made the U.S. electric utility sector such a model of industrial resource waste. Since pharmaceutical development fundamentally is both a scientific and creative process extending over many years with enormous uncertainties, it is simply incompatible with a standard public utility regulatory process. Prices would be determined by costs incurred "prudently," with a "fair and reasonable" rate of return. Would the regulators actually allow the regulated rate of return on large investments or experiments that failed to pan out? If not -- and that is a virtual certainty as a matter of political reality -- then the industry could not earn even the allowed rate of return over time, since allowed profits on successful investments would be limited. Would there be political pressures affecting which diseases and conditions receive priority attention and investment? The question answers itself. Would we see a long-term decline in innovation and the actual alleviation of human suffering? That also is obvious: The destination toward which Angell's framework actually leads is a Soviet-style government takeover of the pharmaceutical sector. Will central planning work for drug development? The actual record of the federal government, and of the numerous governments overseas that have pursued this path, is not inspiring.

Has Angell actually thought seriously about any of this? Amid all the assertions, leaps of logic, and non sequiturs, that answer is clear. It is safe to ignore her nostrums. CRO

Sally C. Pipes and Benjamin Zycher are, respectively, President/CEO and senior fellow at the Pacific Research Institute for Public Policy. They can be reached at spipes@pacificresearch.org and bennyz@pacbell.net.

copyright 2004 Pacific Research Institute

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