It is a bedrock principle of capitalism that as competition erodes profits on established products, enterprises will invest in innovation to earn higher profits from new products. US law governing prescription pharmaceutical markets abandons that principle and gives every new drug a long-term monopoly that prohibits competition. It also discourages competition between medicines based on comparative price or effectiveness. High prices and slow innovation cycles are the inevitable result and will remain so unless Congress makes fundamental changes in existing law.

According to the Pharmaceutical Manufacturers Association, it takes at least 10 years to develop a new drug. It is no surprise that the typical monopoly period on an existing drug is also 10-12 years. Why rush to bring a new product to market when a monopoly makes it possible to raise the price of the old one with impunity?

Patents covering products other than drugs rarely provide the ability to charge any price. They are normally limited to a specific innovation and do not prevent competition from similar products. There are always many computers, TVs, and smartphones to choose between. Patent litigation also takes years to complete and the vast majority of cases are ultimately settled because the pace of new innovations is often faster than the time it takes to acquire or enforce a patent on an existing innovation. The iPhone supplanted the Blackberry in far less than the 20 year life of Blackberry’s patents.

In contrast, Federal law prohibits the Food and Drug Administration (FDA) from approving a copy of a new drug for a period of seven to 12 years even if there are no patents. The FDA is also prohibited from approving a generic drug anytime a claim of patent infringement is alleged — a policy that has encouraged many frivolous patent claims just to delay competition. Drug patents also get extensions of up to five years and then an additional six-month extension for conducting studies of the new drug’s suitability for use in children. Collectively, all of these special monopolies prevent competition and keep prices high.

Market Distortion

Competition between the many medicines that are usually available to treat the same medical condition could help bring down the price of a new drug that has insignificant value over an old one. A rational consumer would not pay $10 for a medication when their affliction could be relieved for 10 cents. Unfortunately, once a medication is prescribed by a physician, only that medication or an approved generic copy can be legally dispensed even if a lower cost alternative medicine exists.

In a 1979 study recommending that States enact generic drug substitution laws as a means of lowering prescription drug costs, the Federal Trade Commission stated “the forces of competition do not work well in a market where the consumer who pays does not choose and the physician who chooses does not pay.” The situation is worse today because most patients have drug insurance that pays.

The pharmaceutical industry exploits this market distortion to avoid price competition, spending tens of billions every year on promotions and payments to physicians to convince them that minor differences between drugs are clinically significant. And it spends billions more in direct-to-consumer advertising and on coupons that cover copays, to stoke demand for high-priced, low-value drugs. Medicare wasted over $4 billion in 2013 on Nexium and Crestor for which equivalent therapeutic alternatives are available at a tiny fraction of their cost.

Ultimately, it is the payer and not the patient who must negotiate the price it is willing to pay and most countries actually do so. To get the best price, many rely on rigorous scientific studies that examine the comparative clinical and cost effectiveness of new drugs and will simply refuse to purchase a new drug that is not fairly priced relative to its value.

In other cases health systems may limit insurance reimbursement to a reference price that reflects such value leaving patients to pay the difference when they choose a high-priced, low-value medicine. European health systems have prescription drug costs that are as much as 50 percent lower than the $1,000 per capita cost incurred in the US by using their purchasing power to extract value. In stark contrast, US lawmakers have succumbed to the absurd argument that direct price negotiations by the government is akin to price controls and have prohibited Medicare from directly negotiating prices.

US government efforts to conduct and use comparative effectiveness research to hold down drug costs have been a failure. Patient groups, largely financed by the pharmaceutical industry, persistently lobby against restricted formularies that could limit the use of high-priced, low-value medicines by falsely claiming that the government is trying to ration health care to save money at the expense of health outcomes.

As a result, the Patient Centered Outcomes Research Institute (PCORI), created by the Affordable Care Act to conduct studies comparing two or more existing treatments, has not yet completed a single such study after five years and the commitment of over a billion dollars. Pharmacy benefit managers use comparative effectiveness research to extract rebates from drug manufacturers but due to a lack of transparency regarding drug prices appear to keep a sizeable share of any savings as profit.

Why does Congress, in the face of outrageous drug prices, continue to advance laws like the 21st Century Cures Act which bestow even more monopolies on the pharmaceutical industry? Quite simply, the pharmaceutical lobby has used its money and influence to sell the false notion that high drug prices and monopolies are necessary to support the high cost of research. Yet public financial data shows that high drug prices simply produce high profits!

For decades, the pharmaceutical industry has been one of the most profitable industries in America enjoying a median return on assets which is two to three times higher than the median return for all Fortune 500 companies. In 1984, when the Hatch-Waxman Act enabled an expedited FDA approval process for generic drugs, the market capitalizations of Merck & Pfizer were each less than $7 billion-$16 billion in 2015 inflation-adjusted dollars. Their market capitalizations are now more than 10 times that amount.

Where Does Industry Invest?

Annual industry expenditures on research have averaged less than 15 percent of sales and have less impact than that on profit because of the tax benefits associated with research spending. The industry’s enormous profits are what remains after all of its research and marketing expenses which is why the industry is awash in cash.

Pfizer now holds $74 billion in unrepatriated profits overseas and Merck holds $60 billion — enough to fund their respective annual research budgets for 10 years. Meanwhile, taxpayers are spending $30 billion a year on basic biomedical research the benefit from which flows to the pharmaceutical industry free of charge.

Under current law, ownership of the patents on drugs discovered with taxpayer money is given away to the academic institutions that discover them. They license those patents to the pharmaceutical industry in exchange for the payment of a royalty which the public actually pays since the royalty increases the price charged for a drug. Federal law essentially socializes the cost of drug discovery while privatizing the profits since it does nothing to limit the prices that can be charged or the profits that can be earned from drugs discovered at public expense.

In 1984, I represented the Generic Pharmaceutical Industry Association in the negotiations with Congress and PhRMA which sought to strike a balance between the pharmaceutical industry’s demand for greater incentives to invest in innovation and the public’s need for low-cost medicines. The deal which was struck then has not withstood the test of time. The monopolies created by Hatch-Waxman and subsequent legislation providing 12 years of exclusivity for biologic drugs clearly went too far in compensating the pharmaceutical industry at the public’s expense.

For decades, Congress has simply been transferring wealth from ordinary citizens to the pharmaceutical industry. While claiming to believe in free market capitalism, it has created a web of monopolies which cause the United States to pay the world’s highest prices for drugs even though it is the largest purchaser. The US would save $80 billion annually if its per capita drug costs were only 50 percent higher ($750 per capita), rather than 100 percent higher, than those of other developed countries. Investing some of those savings to accelerate the development of cures for our most costly diseases could eventually reduce health care costs and justify a high price for life-saving medicines.

Looking Ahead

What specific changes to US law could create that virtuous cycle? Here are some specific recommendations:

Reduce The Scope And Length Of Monopolies

Granting special monopolies to pharmaceutical companies that are not based on the patent law is a costly and inefficient way to induce investment in research. The five year exclusivity for small molecules; 12 year exclusivity for biologics; six-month pediatric exclusivity and all other similar non-patent monopolies are now being granted without any regard for the investment required or value produced.

A drug which provides little or no incremental value over existing products gets the same ability to charge a monopoly price for an extended period of time as a life-saving breakthrough that required 10 times the risk and investment to discover. The current system of exclusivities should be repealed and replaced by a system which reasonably rewards research that produces drugs of high therapeutic value and little or no reward to low-risk research that produces “me too” drugs.

Paying For Value

As the largest payer for prescription drugs, the US government is entitled to the best price. It can achieve that price in one of two ways.

It can modify existing law to assure that Medicare, Medicaid, and other public programs utilize the full array of tools for evaluating the value of each new drug and allow government programs to directly negotiate drug prices using those tools, including restricted formularies, reference pricing, and the like, just as it is now done by other developed nations and by pharmacy benefit managers.

In the short term, it can modify existing rebate laws so as to base rebates on the lowest price being charged for a drug in one or more OECD countries having a comparable standard of living rather than basing it on the inflated price charged in the US market.

Get A Better Return On Public Investment In Biomedical Research

The pharmaceutical industry is becoming more and more dependent on the US to conduct and pay for the basic biomedical research as the starting point for its investment in the development of new drugs. The government must stop the practice of giving away the patents resulting from that research and mange those rights in a manner that assures that drugs developed with public support produce public economic benefit and not just private profits. That benefit should take the form of reasonable prices, shorter monopoly periods, or both.