Pharma Companies Argue That Lower Drug Prices Would Mean Fewer Breakthrough Drugs. Is That True?
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Healthcare Policy Sep 2, 2020

Pharma Companies Argue That Lower Drug Prices Would Mean Fewer Breakthrough Drugs. Is That True?

Probably not, a new study suggests—as long as the price decreases are modest.

Drug innovation at a pharmaceutical company

Michael Meier

Based on the research of

David Dranove

Craig Garthwaite

Manuel I. Hermosilla

Remdesivir, the antiviral drug that’s shown promising results in treating COVID-19, costs $3,120 for a five-day regimen.

As eye-popping as that number is, it pales in comparison to many other drugs on the market, some of which have price tags that reach up to seven figures for a typical treatment course.

In the U.S., such high drug prices can limit access for many and drive up insurance costs, spurring ongoing debate: Do biopharma companies really need to charge as much as they do?

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“The industry’s response has been just as constant as the complaints,” says David Dranove, a strategy professor at Kellogg. “They say they have to cover their research costs, and if they don’t, they’ll have to cut back on research.”

In general, developing truly innovative drugs requires more research dollars than developing more incremental ones. It’s also riskier, because the odds of success are unknown. Without sufficient financial incentive, pharmaceutical companies argue, they will deliver fewer innovative drugs, which ultimately means worse health outcomes.

But is this really the case? Does less money-making potential truly lead pharma firms to cut back on innovation? It’s a critical question, given that the U.S. government leaves drug pricing largely to market forces.

“We do that as a country because we’re interested in promoting future innovation,” says Craig Garthwaite, a professor of strategy at Kellogg. Effectively, the U.S. is willing to trade off some access to drugs—due to high pricing—to secure more innovative drugs in the future.

To investigate the connection between profit and research, Dranove and Garthwaite teamed up with Manuel Hermosilla at Johns Hopkins. But instead of looking at whether reduced money-making potential prompts firms to cut back on innovation, they studied the opposite: Does the promise of higher profits lead companies to plow more money into innovative research?

Specifically, they explored how biopharma research changed following the creation of Medicare Part D, which increased prescription-drug coverage for Americans over age 65. Part D resulted in new coverage of about 5 million seniors, meaning more purchases of prescription drugs and more pharma-company profits.

While 5 million people may sound like a lot, in the context of the $400 billion U.S. pharmaceutical market, this was a “relatively modest shock,” as the researchers write. Still, the impact allowed for an effective research experiment.

They wanted to see if the expected boost in drug-manufacturer profitability resulted in truly novel therapies aimed at older patients. Or would companies play it safe by focusing development efforts on copycat versions of drugs already targeting this population, such as those treating high cholesterol?

The researchers found evidence of the latter: post-Medicare Part D, drugmakers overwhelmingly pursued new versions of existing drugs, rather than innovative products. However, this implies that converse is also true: incremental price reductions may not stifle innovation.

“When the biopharma industry says that any change to drug pricing is going to destroy the innovation engine, that’s not really true,” Garthwaite says. “Our study puts some bounds on that.”

Defining Drug Novelty

It is well established that pharmaceutical firms focus on products that they perceive as lucrative.

“Drug companies invest in areas where they think there’s demand for their developments, like any profit-maximizing firm,” Dranove says.

But critics have argued that this process doesn’t necessarily result in innovative drugs that improve social welfare. Money-making potential, the critics claim, typically pushes drugmakers to bring the third or fourth version of a drug to market rather than seek a cure for a disease we can’t currently treat, like pancreatic cancer.

To test this claim, the Kellogg researchers first had to define what counts as a pharmaceutical “novelty”—that is, what makes a drug truly innovative.

The researchers settled on a definition: “Do drugs represent new options for patients that might not otherwise exist?” Garthwaite says. Based on that line of thinking, they then examined whether clinical trials for a given drug fit the bill.

Specifically, they looked at “target-based actions” (TBAs), or what a prospective drug product actually did in the body—what biologic entity it targeted, and with what function, such as blocking a specific lipid to reduce cholesterol. More novel drugs tend either to focus on a new TBA or to use a largely unprecedented combination of multiple TBAs.

Expected Profits and Innovation

The study used pharmaceutical research data from 1997 through 2018 on over 70,000 molecules developed globally by over 4,300 biopharma companies. This time period spanned the advent of Medicare Part D, which was created as part of the Medicare Modernization Act of 2003, and became effective in 2006.

This made possible a “natural experiment” on the relationship between expected profits and innovation. Starting in 2006, pharmaceutical companies would have expected an increase in profits for drugs targeting older patients, due to the increased prescription-drug coverage for this population.

The question, then, was whether that increased expected profit would yield greater innovation in drugs targeting seniors—or would companies play it safe by focusing on copycat versions of existing drugs?

The Choice: Playing It Safe

The study showed little change in research on scientifically novel drugs for seniors in response to Medicare Part D.

“We saw an increase in drug research targeting seniors after the expansion of Medicare Part D,” Dranove says, “but it was largely for drugs with the same target-based actions as previous ones—addressing essentially the same condition in the body.”

“When the biopharma industry says that any change to drug pricing is going to destroy the innovation engine, that’s not really true.”

— Craig Garthwaite

From 2012 to 2018, there was an increase of 106 percent in the number of clinical trials for less-novel drugs targeting seniors, but only a 14 percent increase in trials for the most novel pharmaceuticals.

That means that in response to the new financial incentives, drug companies focused largely on copycat versions of drugs rather than truly novel products.

“What the new Medicare Part D was affecting are drugs that are only valuable at the margin,” Garthwaite says.

A Green Light for Pricing Regulation

The main practical implication of the finding is that incremental changes to drug profits probably won’t affect innovation in a noticeable way.

On one hand, this is discouraging news for healthcare professionals and policymakers who might otherwise champion incremental incentives in order to boost innovation. But on the other, it also suggests that policies that slightly lower drug prices won’t stifle pursuit of novel drugs. In short, the researchers argue that minor changes to drug-company profits will neither encourage nor discourage innovation.

“Increasing competition or decreasing returns from developing products won’t kill the biopharma industry,” Garthwaite says.

That means Americans could potentially enjoy lower drug prices—and the access that goes with these—without suffering a costly loss of biopharma innovation.

“That social impact is ultimately what we care about,” Garthwaite says.

The researchers also point out that copycat drugs developed in response to Medicare Part D did represent some value to patients—Lipitor was far from the first cholesterol-reducing drug to market, for example, but it improved upon existing ones and became a high-grossing product for Pfizer, a win–win.

“The fifth [copycat] drug brought to market may have the fewest side effects,” Dranove says. “Or it may be the one that drives prices down.”

Implications for COVID-19 Research

So what incentives would encourage biopharma firms to develop a truly innovative drug?

For an answer, look at the hundreds of firms that have joined the global hunt for COVID-19 treatments and vaccines. Welfare gains from even the greatest copycat drug “pale in comparison to the first drug that truly cures COVID,” Dranove says. “That’s the game-changer.”

And, of course, the expected profits from a COVID treatment are far higher than those introduced by Medicare Part D.

“True drug breakthroughs are really hard, and incremental changes in profitability aren’t the main reason why those things come along,” Dranove says.

Featured Faculty

Walter J. McNerney Professor of Health Industry Management; Faculty Director of PhD Program; Professor of Strategy

Associate Professor of Strategy; Herman Smith Research Professor in Hospital and Health Services Management; Director of Healthcare at Kellogg

About the Writer

Sachin Waikar is a freelance writer based in Evanston, Illinois.

About the Research

David Dranove, Craig Garthwaite, and Manuel I. Hermosilla. “Expected Profits and the Scientific Novelty of Innovation.” NBER Working Paper 27093.

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