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Introduction
The unmitigated increase in expenditures for prescriptions drugs has become both a budgetary problem and a contentious political issue. Intensifying public outrage and criticism of the drug industry have brought the debate over pharmaceutical prices and access to the fore. An obvious tension exists between meeting shareholder expectations and fulfilling public health objectives, a challenge that often stems from differences in public health policy and economic policy.
Given that the industry’s existing operating model appears to be unsustainable, scholars are reexamining the patent system and searching for alternative mechanisms for encouraging pharmaceutical innovation and drug development while ensuring access. In contrast to the theoretical monopoly power currently granted for pharmaceutical innovations, a socially preferable mechanism would provide a reward to the innovator proportional to the social value of the innovation, and simultaneously enhance access through marginal cost pricing.
In this spirit, we introduce an alternative mechanism: extending tax incentives to the innovating firm in the form of direct tax credits equal to the social value of the innovation in return for marginal cost pricing. While preserving the incentive to innovate, price disparities between customer segments would be eliminated and drug prices to individuals and third-party payers could fall dramatically. Moreover, consumer surplus and access would increase through the elimination of any monopoly pricing.
The article is written from the initial perspective of developed countries in general and the US in particular. Its consideration will have to begin at this level because of inequities in national income, disease impact, and the necessity to remedy inefficiencies in research and development priorities, price discrimination, and global access. Without initial consideration by these countries the proposal cannot go forward. Admittedly, implementation will require international cooperation through trade agreements and bilateral negotiations on pricing and reimbursement policy, since current WTO negotiations are at an impasse over compulsory licensing provisions for developing countries facing public health crises. Further, pricing and reimbursement policies are national decisions and not determined by treaties.
The remainder of the paper is structured as follows. Section 2 considers the current policy environment. Section 3 describes the proposal. Section 4 develops the details of the policy mechanism. Sections 5 and 6 consider the advantages and limitations of the proposal. Section 7 concludes.
Current policy environment
The combination of rising pharmaceutical prices and growing demand for more effective, innovative medicines is increasing drug expenditures and challenging health policymaking. Three principal factors are driving the rising expenditures for prescription drugs in the United States: (1) increased aggregate utilization rates associated with an aging population, (2) the introduction and adoption of newer therapies that have higher prices than older patented drugs or generic drugs and (3) annual price increases across all products and therapeutic areas (Copeland, Reference Copeland1999; Berndt, Reference Berndt.2002).
The issue is further complicated by price discrimination across geographic markets, which draws greater attention to prices perceived to be unfairly high. The price differentials stem from different forms of price regulation and other institutional constraints, in addition to Ramsey pricing, which is utilized by most pharmaceutical manufacturers (Danzon and Towse, Reference Danzon and A.2003). In an attempt to maximize social welfare while recovering the high costs of research and development, the industry charges different customer segments different prices based on their price sensitivity and ability to pay. Ramsey pricing amounts to the set of prices that produces the highest level of consumer welfare subject to generating sufficient revenue to cover the shared global development cost.
The pharmaceutical industry relies heavily on the protection that patents provide their innovations, especially in the free market economy of the United States. For pharmaceutical innovations, the existing patent system provides 20 years of patent protection. Inherent in the traditional patent system is a tension between the incentive to innovate and far-reaching access. Dynamically, this provides firms with the incentives to bear the cost of research and development. At the same time, the system results in allocative inefficiency. Consumer surplus and access are reduced since some individuals able to pay the marginal cost of production are unable to pay the monopoly price.Footnote 1 A socially preferable system would ensure financial incentives for the innovator, proportional to the social value of the innovation, while simultaneously facilitating access through marginal cost pricing. Preserving the incentive to invest in research and development, while enhancing access, would eliminate several of the distortions of the patent system without interrupting the flow of new innovative medicines.
In the context of growing public outrage over high drug prices, a variety of policy changes have been proposed. On the political stage, the majority of proposals entail some form of direct price controls or a measure of reimbursement control. The price problem is perceived to be the ‘easiest’ to fix but in reality imposes complex and often contradictory administrative procedures and does not accomplish policy objectives. While addressing the budgetary pressures of public programs, these price control solutions discount the importance of current profitability in funding the pipeline of new therapeutic agents.Footnote 2
In the academic arena, a selection of more creative solutions has been developed. These proposals principally focus on three objectives: improving access and affordability, reducing deadweight loss, and furthering research into neglected diseases.Footnote 3 Utilizing a variety of methods, from an auction to a tiered patent system for ‘global’ vs. diseases of developing countries, they differ in their means for rewarding pharmaceutical innovation. However, the limitations of the proposals are strikingly similar: significant administrative oversight, large informational requirements, and a lack of details. While a comprehensive evaluation of the advantages and disadvantages of other proposals is beyond the scope of this work, we draw on them to introduce our own proposal, which builds on many of the best characteristics of these alternatives.
Description of the policy proposal
This policy proposal rewards pharmaceutical innovation based on its social value. As an alternative to patent exclusivity and monopoly pricing, under this proposal the innovator would receive direct tax credits in exchange for pricing the innovation at the marginal cost of production and distribution (henceforth ‘marginal cost’). In essence, we propose transferring the risk inherent in pharmaceutical research from the market system to the taxpayer, through tax policy. While the government would obviously be involved in the process, the valuation of the innovation will be directed by the forces of the market. The objective is to provide a system of direct tax credits approximating the social value of a specific innovation in exchange for marginal cost pricing.
The patent holder will receive direct tax credits approximating the social value of the innovation, which will be defined as the sum of consumer surplus and producer surplus. The calculation of social value will be a function of one year of ‘benchmark’ sales at market prices which reflect the private value of the innovation. With participation, the patent holder agrees to marginal cost pricing, or to license the patent for generic production. Nations that elect to participate and ‘buy in’ to the system receive marginal cost pricing. Nations that elect not to ‘buy in’ would negotiate price or reimbursement levels with the innovator subject to national regulations and pricing policies. Participant nations provide a share of the financing, which will be a function of the disease burden borne by the country and per capita GDP. The negotiation process would be voluntary for both the patent holder and individual nations.
The proposal is intended initially for consideration by developed countries and will require ongoing international governmental consideration, agreement, and formalization as a policy initiative. The US market is the world’s largest as measured by sales, profits, and level percentage of the world’s R&D spending (IMS, 2007). Consequently, the initial presentation of the concept is prepared from its market and policy environment. At a future point, the perspective could be expanded to other developed and developing countries under the auspices of existing international governmental organizations.
The welfare gains available through this proposal will be greatest in policy environments lacking universal health insurance or government-funded prescription programs. Accordingly, the mechanism would provide limited welfare gains under systems in which the state pays for medicines out of tax funds. The discussion of welfare gains is focused on the US market, due to its significance as a starting point, and developing country markets, due to their need for increased access to medicines.Footnote 4
This proposal is structured around tax credits rather than direct payments or subsidies because there is little empiric evidence to suggest that direct government payments are efficient in increasing the output of pharmaceutical R&D, viz., the successful launch of new chemical entities (NCEs). Although governmental grants have certainly contributed to scientific and clinical progress, the transition from discovery platforms to NCEs involves highly specialized skills and resources that are better concentrated in private industry. For instance, even in highly regulated markets such as France and Japan, their pharmaceutical industries are characterized by for-profit corporations that pursue proprietary R&D programs. Also, concern over budget deficits and the political processes thereof suggest that sustained, multi-year grant initiatives in targeted therapeutic pharmaceutical R&D would be difficult to construct, implement, and sustain financially.
Development of the proposed mechanism
Determination of social value and tax credits
Given that pharmaceuticals are global social goods, the patent holder’s compensation should be tied to the social value of the innovation as determined by market forces. In the same vein as Guell and Fischbaum (Reference Guell and M.1995), we propose a benchmark year to determine the social value of the innovation. A single year of monopoly power will be used as a benchmark for the value of the innovation. If the innovation offers a therapeutic benefit, a market will emerge for the drug. Alternatively, given limited incremental benefit over existing therapies, patients will wait until the price drops to marginal cost in the second year. At the end of the benchmark year, a calculation will be made using the year’s sales data to estimate the private value of the innovation.
In the formulation of the mechanism, consensus must be reached on the social value of the innovation. Under the existing patent regime, Kremer (Reference Kremer1998) estimates that the social value of a pharmaceutical innovation will be 2.5 times the private value. Under the mechanism described here, utilizing year 1 sales as the benchmark, Kremer’s method may provide an underestimation. Given that peak sales are reached three to five years post-launch, a multiple of three may provide a more accurate estimate of the social value of the innovation. The innovative firm would receive this compensation through direct tax credits for 12 years, and generic competition would then start as is now the situation after patent expiry. As noted by Hollis (Reference Hollis2005), 12 years is approximately equivalent to the average effective patent life of pharmaceutical innovations.Footnote 5
In calculating the social value of the innovation, data on benchmark year sales may be supplemented by expert opinions. To incorporate additional information, patent holders could obtain a value estimate from internally derived estimates that are vetted by an external expert. Alternatively, outside experts may conduct the seminal research. This process would be facilitated by the wealth of information generated by clinical trials and the FDA approval process. As suggested by Kremer (Reference Kremer1998), the expert’s compensation could be calibrated according to the accuracy of their estimate. This approach may be particularly appropriate for small market drugs developed to treat the diseases of developing countries or neglected diseases, drugs for which establishing the market valuation may be particularly difficult.
This mechanism proposes using tax credits as an incentive. In a review of the economic evidence of fiscal incentives for research and development, Hall and van Reenan (Reference Hall and J.2000) found support for the use of tax credits, concluding that every dollar in tax credits for R&D is associated with a one dollar increase in R&D expenditure at the margin.Footnote 6 Based on our own observations we favor tax credits because we believe they are more politically feasible than are direct tax payments to pharmaceutical firms. Given the constraints imposed by OBRA in the US and the anti-tax sentiment of the American public, it is unlikely that US tax policy would be changed to compensate pharmaceutical companies’ R&D expenditures by patent buy-outs or direct grants approximating social value. The public criticism over the industry’s profit margins is a major barrier. Tax credits have become a convenient vehicle for economic stimulation of targeted sectors and are far more acceptable politically than tax increases. We also note similarities in the EU, where countries’ pressures to reduce debt as a percentage of GDP limit their abilities to increase direct spending. The impact on a firm’s tax rate in a specific country has not been addressed. Since firms use a complex tax minimization strategy of transfer pricing and profit repatriation, the effect is unknown and beyond the scope of this proposal. We do not have a priori evidence to form a tentative hypothesis of the proposal’s impact on country-specific marginal tax rates.
Incremental and breakthrough innovation
This proposal is designed for application to both incremental and breakthrough innovations. Most obviously the calculation of product-specific social value will differ based on the extent of the innovation. Incremental innovations and ‘me too’ drugs will contribute less to social welfare than innovations that are both first-in-class and best-in-class. An effective measure of social value will account for the significance of breakthrough therapies. Since duplicative innovations will capture a smaller market share and generate fewer sales than breakthrough innovations, the differential will be reflected in benchmark sales. Undoubtedly some firms will dispute the calculation of the social value of their innovation. These firms may elect not to participate, relying instead on traditional sales and marketing efforts, charging whatever the market will bear. This option may be more attractive than participation for incremental innovations and lifestyle drugs, products that generate less social welfare and are accorded lesser tax credits.
Adverse reactions and additional indications post-launch
The need to address potential post-launch discovery of dangerous side effects is strikingly illustrated by the recent Vioxx withdrawal. Alternatively, additional indications may be discovered post-launch. Both possibilities should be addressed ex-ante contractually. In the case of adverse reactions, the innovator would be penalized and surrender a share of the compensation. In the case of additional indications, supplemental rewards would be appropriate. Under these terms, the firm has the incentive to pursue sufficient safety testing and fully disclose any potential risks to avoid the penalty, and to complete more comprehensive development pre-launch to maximize sales during the benchmark year.
Marginal cost pricing
In joint production facilities, marginal cost is exceedingly difficult to estimate. Moreover, in the pharmaceutical industry, the firm’s cost structure is considered a competitive secret. These factors will complicate marginal cost pricing. Marginal cost can be estimated in the US by using wholesaler acquisition costs or average wholesaler price for specific products within therapeutic classes. In therapeutic classes where both patented and off-patented products exist, marginal cost would likely be the transaction price (maximum allowable cost) of the lowest-price, commonly available generic product. In the case of therapeutic classes comprised of patented drugs only, marginal cost can be approximated by the lowest price patented product, either list price (less accurate since volume/time and other trade discounts are ignored) or estimated acquisition price. Given the difficulties involved in determining marginal cost, licensing for generic production may be an alternative. With participation, firms would agree to freely license the patent to generic firms, generating competition which should bring prices down to levels approximating marginal cost.Footnote 7
Global participation
While applicable to the US market in isolation, this proposal is also well suited to the global market and multinational participation. Nations that elect to participate will ‘buy in’ by providing a share of the patent-holder’s compensation and, in exchange, receive marginal cost pricing. Nations that elect not to participate will continue to operate under their existing systems, negotiating access with the patent holder (who retains ownership of the patent) subject to national regulatory and pricing controls.Footnote 8 With the exception of cases of global participation, supply controls will be needed to ensure that drugs are not transshipped to non-participating nations.
The share of compensation to be financed by each participating nation will be a function of their proportional disease burden and per capita GDP. This ensures that financing balances both the prevalence of disease as well as ability-to-pay. The disease burden will be calculated as the fraction of the afflicted population of participating nations living in a particular country.Footnote 9 For global diseases this fraction will be small for developing nations and their corresponding share of the funding will also be small. For diseases endemic to developing nations, their fraction of the disease burden will be more significant, though lessened by the weight of per capita income.
Consensus on the precise mechanism for calculating the national shares must be reached by all stakeholders. The following is suggested as a starting point: multiply each nation’s share of the disease burden (of the participating countries) by their per capita income; sum across all countries, then calculate each nation’s share of this total. That fraction is the percentage of the financing to be paid by each nation.
The innovator’s compensation, k, will be jointly financed by all participating nations. It will be a function of benchmark year sales and the social value multiplier. Each nation is expenditure will take the following form
![$$E_i=\bigg[d_{i}g_{i}/\sum_{\limits {i}} d_{i} g_{i}\bigg]\bullet k$$](https://static.cambridge.org/binary/version/id/?pub-status=live)
where E i = expenditure by nation i
d i = proportional disease burden of nation i
c i = disease incidence (number of cases) in nation i
g i = per capita GDP in nation i
k = innovator’s compensation
Tables 1 and 2 are offered as simplified representations to illustrate the calculations of compensation and national contributions under this proposal. In Table 1 the disease burdens of HIV/AIDS and malaria are presented for comparison. HIV/AIDS appears as a global disease, while malaria illustrates the calculation for a disease most prevalent in developing countries. In the case of HIV/AIDS it is worth noting that of the participating nations,Footnote 10 the largest disease burden is borne by the nation with the highest per capita income, the United States. While Ghanaians represent 16% of the disease burden, the national share to be contributed is only 1.69%. This contrasts with the figures for malaria for which the largest disease burden is born by the poorest of the participating nations. In this case, Yemen bears 68% of the disease burden and close to 64% of the financing.
Contrasting the disease burden of HIV/AIDS and malaria
Note:
Data on Disease Incidence and GDP are for 2004.
aSource: World Health Organization (2004), www.who.org
bSource: CIA, The World Factbook (2004), www.cia.gov
Contrasting the number of participating nations
Note:
Data on Disease Incidence and GDP are for 2004.
aSource: World Health Organization (2004), www.who.org
bSource: CIA, The World Factbook (2005), www.cia.gov
Alternatively, Table 2 describes how the calculation of national contributions evolves as additional nations elect to participate. The table first illustrates the mechanism under the participation of three nations. This is then expanded to six nations for comparison. Initially, the US bears the largest share of the disease burden (44%) as well as the lion’s share of the financing (80.4%). With the participation of three additional nations, the disease burden share of the US drops to 16%, though the share of financing remains high at 74.1%. This striking result stems from the low per capita income of the new participants. While Nigeria bears almost 61% of the disease burden, among participating countries, the extremely low levels of per capita GDP results in the national share of financing of only 7%. As the number of participating nations increases, the share of financing falls for each country, attracting the participation of additional nations. Consequently, nations will have the incentive to recruit additional participants.
The social value of the innovation is the last piece of information needed in order to calculate the financing provided by participating nations. Referencing Table 1, if firm compensation for an HIV/AIDS treatment is calculated to be $1 million, Ghana would be required to contribute $16,900 (1.69%). Alternatively, if the firm compensation were calculated to be $500 million, Ghana would contribute $8.45 million. Depending on the size of the national contribution, there may be drugs for which developing nations will not be able to afford their share of the financing. If so, international organizations and aid agencies might ‘buy them in’ by providing the financing as a form of foreign aid for investment in public health.
Marketing and promotion
It is essential to consider the implications of this proposal for marketing and promotion. Firms currently make the majority of their marketing expenditures in the two years pre-launch and the two years post-launch. However, under this mechanism the firm will set price to marginal cost following the benchmark year and have no further incentive to market the innovation. This proposal intensifies the incentives for marketing in the years before launch and in the benchmark year. Accordingly, marketing practices would likely mirror existing patterns.Footnote 11
This is clearly visible in Table 3 (below), particularly in the case of Pfizer’s Viagra [sildenafil]. Viagra generated the highest level of sales in the benchmark year and is also shown to generate the highest level of proposed compensation under the mechanism. This also results in the largest difference between (actual) market sales and the proposed compensation. In essence, the greatest reward goes to one of the most innovative products in the table.
Comparison of sales and compensation under the proposed mechanism (in millions of US dollars)
Notes:
*IMS Health data.
♣Data on Gleevac are available for only 35 months of sales instead of the full 60 months. The figures presented here use that number ($804,038,229) to extrapolate to 5 years. Admittedly, this may be an underestimation of 5 year sales.
Data: the mechanism in retrospect
In an attempt to demonstrate the impact of this mechanism, we present calculations in Table 3 on 20 drugs launched between November 1991 and May 2001.Footnote 12 The drugs included are produced by a variety of manufacturers. Several would be considered ‘blockbusters’ (Lipitor [lovastatin], Viagra [sildenafil]), while others attained sales of much more modest levels (Accolate [zafirlucast], Effexor [venlafixine]).
Data on firm profits at the product level are not publicly available, nor are data on the cost of production. The data that are available come from IMS Health, which collects data on pharmaceutical sales and on prices. We acknowledge that in order to truly gage the impact of this mechanism, and certainly to operationalize it, cost data are essential. Without cost data, the challenge of estimating profit from revenues is difficult and controversial. We do not attempt to make this estimation. As such, Table 3 presents calculations based on revenues, not on profit. The calculations based on profit would be smaller than, though proportional to, the figures presented here. The results provide a glimpse of how the mechanism would operate and a retrospective view of how the numbers compare: actual sales over five years versus the amount provided by the mechanism.
The third column shows Year 1 Sales, what would have been the product’s benchmark year. This number is then used to calculate the compensation that the innovator would receive under the mechanism described here. The fourth column shows cumulative sales over five years. This should be compared with the fifth column, the firm’s compensation (k) over five years under the proposed mechanism.Footnote 13 The difference between these two is presented in the sixth column. The last column calculates the equivalence multiplier, the annual multiplier necessary to equate actual sales to those determined by the mechanism.
Utilizing a multiplier of three, as described earlier, Table 3 shows that for nine of the 20 drugs, the payoff under the mechanism is greater than actual sales, while for 11 of the 20 drugs, actual sales exceed the payoff provided by the mechanism. An examination of the equivalence multipliers reveals the largest to be 12.17 (Remicade [inflixmab]) and the smallest to be 1.17 (Viagra [sildenafil]), which corresponds to the low level of Remicade sales in the benchmark year and the high level of year 1 sales for Viagra. The average of the equivalence multipliers is 3.80. If the average is recalculated without Remicade (a significant outlier), the average equivalence multiplier is 3.36, more in line with the proposed multiplier of three. Overall, the proposed mechanism provides somewhat less compensation than the market, though the difference is relatively small, approximately 7%. The proposed mechanism provides a total of $55.41 billion to firms, while the market generated $59.27 billion. Again, excluding Remicade from this calculation, the market generates $50.77 billion, while the proposed compensation totals $50.64. Strikingly, the difference amounts to less than 0.26%.
Proposal advantages
In its current form, the patent system seeks to balance the static inefficiency of monopoly power in return for the dynamic benefits of knowledge spillovers. Above all, this proposal aims to correct the allocative inefficiencies of the existing patent system, while preserving the dynamic incentives to innovate. Our mechanism provides the firm with direct tax credits proportional to the social value, while marginal cost pricing ensures gains in efficiency and equity.Footnote 14 The incentive to innovate is preserved and consumers able to pay the marginal cost of production are able to attain the good. Although this may be the most significant benefit of the proposal, several other significant benefits do result. This section discusses each of the following in turn: equity gains, global access, stable funding, reduction of duplicative R&D, reliance on market forces, and scale trial.
As currently envisioned, this proposal transfers the burden of R&D financing from the sick, those afflicted with a particular disease, to all tax payers. In addition, with global adoption, American consumers would cease to subsidize pharmaceutical research and development for the rest of the world. Both more equitably distribute the R&D expense.
This mechanism benefits the global community, especially developing countries, in several ways. Under the existing patent system, access is hindered by high prices and launch delays. Both are addressed by the framework introduced here. Marginal cost pricing will prevail in participating countries, increasing the affordability of included drugs. Moreover, Lanjouw (Reference Lanjouw, J.2005) argues that absent price controls, launch times should improve and global product dissemination should be more rapid.
In addition, this proposal eliminates the need for a ‘single global price’, a strategy that has been discussed in the context of increasing parallel importation and price variations among nations. Arguably, a global price would raise prices in developing nations without reducing prices in the profitable markets of industrialized countries. Such a policy would certainly exacerbate the access problems of the world’s poorest nations. Removing the need for a single global price protects the interests of the most vulnerable populations. Finally, this framework has the potential to improve global access through third party ‘buy ins’. International aid agencies and development organizations could provide the financing to ensure the participation of poor nations.
It is recognized that for some of the least developed counties marginal cost pricing is more than the countries can afford to pay. Consequently, it is important to note that participation is voluntary. Nations would elect to participate only when it benefited them, presumably in cases in which medicines are not available to them at marginal cost. Moreover, governmental participation is also voluntary. As such, international participation through international governmental and international non-governmental organizations would likely continue on a voluntary basis.
Firms also benefit from this proposal in two significant ways. First, the mechanism provides a predictable and stable source of funding. This is particularly important during drug discovery and early development stages. Secondly, the mechanism should reduce the amount of duplicative research and development.Footnote 15 Firms will have less incentive to create ‘me too’ products and invent around existing patents. Under marginal cost pricing, second-comers will be unable to capture significant market share and profitably compete. ‘Me too’ products will see smaller profits in the benchmark year, reducing the incentive for duplicative R&D. While the rewards from this proposal will be greatest for breakthrough innovations, incremental advances that offer some therapeutic benefit should be pursued though the social value (and compensation) will be less. A smaller multiplier could be applied to tax credits for incremental innovations. Accordingly, this mechanism should provide greater incentives for breakthrough and lesser incentives for incremental innovation.Footnote 16
A significant advantage of this framework is the reliance on market forces. This mechanism purposefully links the patent holder’s compensation to sales in the benchmark year, providing incentives for research on drugs with strong consumer demand. To the greatest extent possible, valuation by market forces is preserved. The mechanism also provides incentives for correcting the informational asymmetries in the market for pharmaceuticals since greater transparency will generate more accurate estimates of social value. In addition, participating nations have an incentive to increase the participation to all nations, including poor nations, since it would reduce their share of the financing.
In terms of implementation, this proposal could be tested on a small scale with application to a single innovation. The application could be implemented on a national or regional basis to establish the feasibility and efficiency of the proposal. If the reduction of deadweight loss from monopoly pricing exceeds the welfare losses from raising the required tax revenue, social welfare gains result. Given these efficiency gains, the trial could be expanded.
Proposal limitations
The most significant challenge to this proposal will be working through the details of the calculations and contractual terms. Reaching consensus among all stakeholders is critical to the success of the mechanism. In addition to teasing out the details, several other limitations and challenges deserve discussion. This section addresses the issues of bureaucratic administration, sequential innovation, neglected diseases, excessive marketing, and parallel importation.
The bureaucracy required to implement and administer this proposal is largely unknown but recognized as a significant determinant of the proposal’s feasibility. All trade agreements and negotiations, however, require not only national bureaucracies’ participation but also international cooperation to prevent trade inequities and ensure transparent and equitable applications. At this point, a bureaucratic mechanism is not put forward. By avoiding the sale or auctioning of patents to governments, we avoid the inherent problems associated with ‘gaming’ the system by patent holders as well as inefficiencies of governments assuming the role of drug developers and purchasers. While this mechanism avoids these limitations, it admittedly engenders others.
Sequential innovation is inevitable, especially in the case of breakthrough technologies. It is important that any departure from the traditional patent system be structured to encourage, balance and reward innovations built on earlier patents. Two concerns emerge: providing sufficient incentives for ‘first generation’ innovations and avoiding holdup. Incentives for first-generation innovators are only sufficient when they receive a share of the social surplus generated by the subsequent innovations that build upon their patents. At the same time, first-generation innovators may have an incentive to holdup subsequent technologies by refusing to license their patents or demanding excessive compensation for their use. Since this mechanism preserves the rights of the patent holder, the potential for both problems remains and should be addressed contractually.
One of the greatest challenges to global public health is securing treatments for neglected diseases and those endemic to poor nations. Unfortunately, this proposal does not provide additional incentives for research on these diseases. Since ability-to-pay is low in poor nations, tying the innovator’s compensation to benchmark year sales results in low powered incentives for work on ‘unprofitable’ diseases. While marginal cost pricing would increase access for poor populations, this mechanism does not attract the additional research funding needed in these areas. Sustainable intergovernmental initiatives will remain necessary to address access issues to the poorest countries, as will innovative partnerships between non-governmental organizations and the private sector.
In like manner, this proposal does not provide a remedy to excessive marketing expenditures. Since this mechanism relies on benchmark year sales, firms will have an incentive to promote and market their drug to increase these numbers. The potential for exaggerated expenditures still exists, though it is unclear how it would compare to current levels of promotion. Given that the innovator’s compensation is provided by the taxpayer, the government has an incentive to promote participating drugs and increase utilization.
The pharmaceutical industry currently relies on price discrimination across national markets. This practice has been widely criticized and simultaneously threatened by parallel importation.Parallel trade occurs whenever the price differential between two markets is sufficiently large to make trade profitable. Although empirical evidence is lacking, a price differential of as little as 8% for a ‘blockbuster’ drug like Lipitor [atorvastatin] may be sufficient to stimulate trade. For products with lower market shares, the margin may have to reach 15–16%. (Anonymous, 2007). Regardless, parallel trade, whether it be legal as within the EU or illegal or ‘grey’, is an opportunistic trade practice that will likely continue. Our proposal, while eliminating some of the price differentials among countries and thus the incentive for parallel trade, will likely not represent a significant barrier to parallel trade. While this proposal addresses the equity concerns that generated the criticism, the threat of parallel importation is likely to continue via both legal and illegal channels.The drugs available at marginal cost in participating nations will be considerably less expensive than the same drugs in non-participating nations.Supply controls such as electronic pedigrees and secure supply chain management practices will be essential to ensure that smugglers do not move drugs across national boundaries.
Conclusions
The current policy debate over rising drug expenditures is focused almost exclusively on price controls, ignoring the importance of R&D funding to a healthy pipeline of new compounds and therapeutic agents. As an alternative, the proposal presented here seeks to lower prescription drug prices by granting the pharmaceutical industry direct federal tax credits approximating the social value of the innovation in return for marginal cost pricing. This concept is based on the fundamental assumption that innovation that benefits society at large may be financed publicly. This mechanism is especially well-suited to the pharmaceutical industry and others that produce social goods and whose cost functions are characterized by high information and regulatory costs, high fixed and/or sunk costs, and relatively low marginal costs.
We posit that consumers would benefit from lower drug prices, increased access, and a continued stream of innovative medicines. Pharmaceutical manufacturers would have a more reliable source of funding and realize increased incentives to pursue breakthrough innovations. While the advantageous of the proposal are significant, it is not without its limitations and many of the details remain to be assessed. Nevertheless, in light of continued criticism of the industry and the pressure on pharmaceutical prices, alternatives such as this mechanism are certainly worth exploring.
