Regulation and Innovation

Ian McCarthy | Emory University

Outline for today

  1. Innovation and R&D decisions
    • MEI, dynamic efficiency, and what gets researched
  2. Prices, competition, and high drug spending
    • U.S. vs peers, brand vs generic, limited competition
  3. Policy responses and global equity
    • Price regulation, push vs pull incentives, global public good

Innovation and R&D Decisions

What is innovation?

How would you define “innovation” in pharma?

  • Should not just mean a new drug, but a new drug that is better than existing treatments
  • Not clear this is always the argument made in the media

Inducing Innovation

  • Governments often care not just about using existing technologies efficiently, but about creating new ones
  • Classic example: British Parliament’s 1714 Longitude Prize, which paid for a method to determine longitude at sea
  • The prize worked: it induced decades of R&D by clockmakers, eventually yielding highly accurate marine chronometers
  • Question for today: what “prizes” or incentives are we implicitly setting for pharma R&D?

What governs innovation?

  • Strong empirical evidence that firms internalize future profits of a drug when making R&D decisions
  • Investment decision can be modeled as:
    1. Ranking of expected returns to potential new drugs, including costs of manufacturing, packaging, marketing, and distribution. This is the Marginal Efficiency of Investment (MEI)
    2. Comparison of MEI to cost of capital
    3. Investment in the drugs to the point where MEI=cost of capital

MEI and the Cost of Capital

 

  • Downward-sloping MEI: diminishing returns to additional R&D projects
  • Horizontal line: cost of capital
  • A leftward shift of MEI (e.g., from lower prices) reduces the profit-maximizing R&D level

Dynamic Efficiency

  • Policies that lower drug prices today reduce current spending but also reduce expected future profits
  • If firms internalize these future profits, lower prices → lower MEI → less R&D and fewer future drugs
  • Dynamic efficiency tradeoff:
    • Static gain: lower prices and better access for today’s patients
    • Dynamic cost: potential reduction in future innovation
  • Example: debates around Medicare drug price negotiation and the Inflation Reduction Act can be viewed through this lens

What Gets Researched? Preventives vs Treatments

  • Even holding total market size fixed, incentives can differ sharply between:
    • Preventive products (e.g., vaccines)
    • Treatments after disease onset
  • Kremer & Snyder show that with heterogeneous risk, firms may earn more from treatments than preventives, even when preventives generate more social surplus
  • Intuition: high-risk patients are easier to identify and treat; low-risk individuals may not buy prevention at a price that fully reflects its social value

Kremer–Snyder Stylized Example

  • Suppose:
    • Some consumers have a high probability of getting the disease; others have low risk
    • A preventive reduces risk; a treatment cures the disease after it appears
  • With the same underlying health risk and willingness-to-pay:
    • Treatment can yield higher firm revenue than prevention because only high-risk consumers are willing to pay high prices for the preventive
  • Takeaway: private R&D may tilt toward treatments over preventives, even when prevention is socially preferable

Stage of Disease and Trial Length

  • Firms also choose which stage of disease to target
  • Shorter clinical trials mean:
    • Faster time to approval
    • Longer period of effective market exclusivity
  • Empirically, cancer R&D is heavily concentrated in late-stage and recurrent disease, with far fewer trials on prevention or very early-stage disease
  • This suggests underinvestment in long-term, prevention-oriented projects relative to social value

Evidence: Cancer Trials by Stage

  • Data on cancer clinical trials show:
    • Very high numbers of trials for recurrent and metastatic disease
    • Much smaller numbers for in situ cancers and especially for prevention trials
  • Interpretation:
    • Market incentives favor drugs with shorter, cheaper trials and quicker payoffs
    • Long-horizon prevention may be dynamically underprovided

Prices, Competition, and High Drug Spending

Paper Discussion 1

The High Cost of Prescription Drugs in the United States: Origins and Prospects for Reform

1. High Spending

 

 

  • Higher spending in the U.S. compared to peer countries
  • Faster spending growth in the U.S. compared to peer countries

But…

  • Spending on even very high cost drugs can still be cost-effective
  • Sovaldi (hepatitis C) found to be cost-effective despite $84,000 per 12-week course

Research Questions

  • What factors seem to contribute to pharma price increases?
  • What policies can help ensure prices match value and that drugs are available in an equitable way?

Brand name vs generic

  • Annual cost of highly specialized brand name drugs exceeds $250,000 per patient!
  • High brand-name prices now extend to drugs with some substitutes (not just rare conditions)
  • Generic drugs generally lower priced, but some examples of high price increases
    • Daraprim, 63-year old treatment for toxoplasmosis, increases 5500% (from $13.50 to $750) in 2015
    • A few hundred generic drugs experienced price increases of more than 1000% from 2008 to 2015
    • Why? Monopoly products, despite no patent protection

Why such high prices?

  • Prices set by manufacturers, PBMs, insurers, and pharmacies
  • Little direct price regulation
  • Conversely, the UK specifically requires cost-effectiveness thresholds before allowing coverage

Case Study: Avastin and Price Discrimination

  • Avastin was approved for certain cancers and priced accordingly
  • Physicians later discovered that very small doses were also effective for treating macular degeneration
  • At the cancer price, the implied price per eye injection for ophthalmology was extremely high
  • Regulatory and reimbursement rules limited Genentech’s ability to charge very different prices across indications, creating tensions around off-label use and follow-on products
  • Example of how indication, dosing, and pricing regulations interact with firms’ incentives

Drug Life Cycle and Patent Clock

 

  • Legal patent term starts before approval; effective market exclusivity is shorter
  • Shorter clinical trials bring approval earlier and lengthen effective exclusivity
  • R&D incentives are shaped by where projects sit on this timeline

Competition

  • Patent protection usually lasts around 20 years (starts before drug is officially approved)
  • Companies can apply for extended patent protection for 5 years (max of 14 years in the market)
  • Additional 6 months if testing products in children
  • On average, 12.5 years of post-market exclusivity for widely used drugs and 14.5 years for highly innovative drugs (first-in-class)

Limited competition even for brand name drugs with some substitutes. Why?

  • Fragmentation
  • Information problems
  • Physician agency

Firms can also deter generic entry, via:

  • Additional patents on coating, method of administration, etc.
    • Example: Nexium is derivative of Prilosec (omeprazole), sold for 600% markup over generic omeprazole
  • Significant settlements to generic drug companies
  • Delays in approval for generic drugs (FDA delays of 3-4 years, now closer to 1-2 years)

Barriers to substituting brand name drugs with generic drugs even after generic entry:

  • Drug product selection laws in 30 states that allow but do not require pharmacists to substitute generics
  • 26 states that require patient consent when replacing brand name with generic drugs
  • All states allow “dispense-as-written”, which restricts pharmacists’ ability to substitute brand name drugs

Drug Pricing Supply Chain

  • Already discussed…
    • Manufacturers set list prices and negotiate rebates with PBMs
    • Insurers reimburse pharmacies; patients face cost sharing at the pharmacy
    • PBM payment structures can weaken incentives to push aggressively for lower net prices

Other barriers to competition among generics and brand name:

  • PBMs often paid based on insurer spending on specific drugs, therefore little incentive to intensely negotiate prices
  • From US House Committee on Oversight and Government reform:

“The investigation revealed, for example, that Turing received ‘no pushback from payors’ when it increased ‘Chenodal price 5x… [Thiola] price 21x… [and Daraprim] price 43x.’

Justification for high prices

Industry argument that significant R&D costs necessitate higher prices

But…

  • Half of the “most transformative drugs” developed (or started) in academic centers
  • Many drugs also started in small companies later acquired by larger manufacturer
  • “Innovation” means more than just another drug
  • Current price growth simply not sustainable

Policy Responses and Global Equity

Price regulation and innovation

  • Price regulation (reference pricing, direct price caps, etc.)
  • In general, lower prices discourages innovation by shifting MEI inward
  • How much? Some estimates of price elasticity of R&D at 0.6
    • 10% price cut reduces R&D by 6%
  • But what innovations are “lost”? Hard to say

How to influence innovation?

  • If firms are maximizing profits, then the only way to influence innovation is to change the MEI or the cost of capital
  • Shift MEI outward via:
    • Changing marketing regulations (DTC advertising)
    • Increasing demand for a drug (market exclusivity, coverage under public insurance)
  • Shift cost of capital down via:
    • Easier access to funding (tax credits, grants, etc.)

How to influence innovation?

  • Which approach is “best”?
  • Politically, these are NOT identical policies
    • Pull incentives require no up-front costs
    • Pull incentives tend to place R&D burden onto pharma customers
    • Push incentives require up-front government investment
    • Push incentives place burden on taxpayers

What can we do?

Federal Policies:

  • Limit secondary patents for minor changes
  • Combat anticompetitive practices like pay-for-delay
  • Allow negotiation of prices and formulary exclusions by Medicare
  • Faster time to market for generics

State Policies:

  • Drug product selection laws
  • Allow negotiation of prices and formulary exclusions by Medicaid

Advanced Market Commitments (AMCs)

  • Governments or donors commit in advance to buy a specified quantity of a vaccine or drug at a pre-set price
  • Goal: create a credible, profitable market for products that primarily benefit low-income countries
  • Example: AMC for pneumococcal vaccines in low-income countries
  • AMCs act like:
    • A pull incentive (payment conditional on success)
    • Targeted at areas where standard patent-based returns would be too low

Patent Buyouts and Delinking

  • Patent buyouts:
    • Government buys the patent at an auction-based price plus a markup
    • Drug is then placed in the public domain (generic competition; low prices)
  • Broader “delinkage” proposals:
    • Replace or reduce reliance on monopoly pricing
    • Reward firms through prizes or lump-sum payments tied to clinical and social value
  • These ideas aim to preserve dynamic incentives for R&D while reducing static monopoly distortions in prices

Paper Discussion 2

PHARMACEUTICAL PRICING AND R&D AS A GLOBAL PUBLIC GOOD

Who Pays for Pharma R&D?

 

  • The U.S. accounts for a disproportionate share of global pharmaceutical sales (stylized)
  • Other high-income regions also contribute, but to a lesser extent
  • Sets up the question of whether the U.S. is over-contributing to global R&D incentives

US Subsidizing ROW

  • US clearly pays higher prices than other countries
  • Strong evidence that US contribution to profit for future innovation is higher than it should be
  • That said, the ROW contribution is meaningful (all other countries do not force prices to marginal costs)
  • Authors urge a more international view of spending, suggesting better policy is to advocate for higher prices elsewhere rather than directly for lower prices in the US

Pulling It Together: Designing R&D Incentives

  • Standard patent system: strong dynamic incentives but high prices and uneven R&D portfolio
  • Distortions:
    • Treatments vs preventives
    • Short- vs long-horizon projects
    • Diseases of rich vs poor countries
  • Policy menu:
    • Adjust prices and coverage (Medicare/Medicaid negotiations, global pricing)
    • Add targeted push and pull incentives (NIH funding, AMCs, prizes, buyouts)
  • Open question: what mix best balances current access, future innovation, and global equity?