The pharmaceutical industry: The trouble with cheap drugs

Date: 31/01/04

Europe pays a lot less for its drugs than America. But do hidden costs mean that Europeans are actually worse off?

IN THE drug industry, they call it “Europe's free ride”. Government pricing regimes mean that prescription drugs cost far less in Europe than in America, where a growing proportion of new drugs are developed - presumably because Americans are willing to bear the lion's share of development costs. On the face of it, Europe reaps big rewards. It spends 60% per head less on drugs than America. In 1992, the gap was 30%. Had spending kept pace with America, last year alone Europe would have shelled out an extra $160 billion. The cumulative “saving” since 1992 is approaching $1 trillion - quite some free ride.

Europe's drug firms do not appear to suffer unduly as a result. On January 26th, Sanofi-Synthélabo made a €48 billion ($60 billion) hostile bid for Aventis, a larger French group. The combined entity would be the industry's third-biggest firm, behind Pfizer of America and Britain's GlaxoSmithKline (GSK). A combination of cheap drugs and successful big drug firms would seem to suggest that Europe is doing something right.

But is the saving from cheap drugs more apparent than real? And are Europe's drug firms in fact struggling to keep up with more dynamic American competitors? A new study by Bain, a consultant, argues that the existing pricing regimes are bad for everyone, including patients. “The free ride is not free,” argues Paul Rosenburg, a co-author. “If governments and drug companies begin to accept this, then future policy on health-care innovation and spending can be far more rational.”

America certainly resents European meddling with prices, blaming it for higher drug prices at home. Mark McClennan, head of the Food & Drug Administration (FDA), which oversees America's drug industry, said recently: “The main reason [American drug] prices are higher is that our country is paying the bulk of the costs of developing new treatments. That's got many Americans angry.”

Prozac needed?

But should Americans be angry? And should they force down drug prices at home? True, a few big firms, such as Pfizer, the global leader, feel that in Europe they lose profits that could otherwise fund new research (or go to shareholders). True, also, America suffers from large “grey” import markets in both Canada and Mexico, as canny consumers cross the border into cheaper markets to buy otherwise costly drugs.

On the other hand, America gains from its growing dominance of drug research and development (R&D). A decade ago, Europe and America each spent roughly $10 billion a year on drug R&D. Now, America spends almost $30 billion annually, and Europe a little more than $20 billion. A growing number of firms now base their R&D efforts in America. Drugs R&D in Germany fell by 3% in 1992-2002.

One result is a striking decline in European drug innovation. Bain examined how many so-called new molecular entities (NMEs) have been produced in recent years. In 1993-97, Europe launched 81 NMEs and America 48. But in 1998-2002, the respective figures were 44 and 85, almost an exact reversal.

With the transatlantic shift in R&D goes many high-value jobs, as well as a greater share of the industry's profits. According to Bain, America created 42% more high-value pharmaceutical jobs in 1999-2001, and the trend is continuing. In 1992 the global drugs industry made profits of $60 billion, less than half of which were in America. In 2002, industry profits were $121 billion - 60% generated in America.

European drug executives are increasingly concerned. On January 26th, for instance, Jean-Pierre Garnier, boss of GSK, spoke out against the loss of jobs, arguing that Europe's love of red tape is throttling innovation. Maybe so. But the thrust of Bain's study is that the main reason for America's growing dominance of drug R&D is not the red tape so much as Europe's tougher price controls on drugs, particularly new drugs.

Exactly how drug-pricing regimes influence innovation is complex - and much debated. According to Bain, research shows that the main economic factor driving where firms locate their R&D is how big, and quick, are the potential profits. That gives America an advantage over Europe, where price controls slow down profit-taking. True, early-stage research can take place anywhere in the world - and big drug firms are increasingly looking to shift this to lower-cost places. (GSK recently linked up to do research with Ranbaxy, a leading Indian drug firm.) But the bulk of costs are incurred in the development phase between early-stage and market. And the process of drug approval remains very much a national, as opposed to global, activity. So it makes sense for firms to put promising drugs on trial in the market where there is most to gain - namely, for now, America.

That could change, of course - particularly given the continuing attempts to reduce drug prices in America. Although the Bain study suggests that a big divide occurred between Europe and America over the past decade, and that the gap is likely to continue to grow, policy shifts in either place could profoundly alter the picture.

Also typically ignored when assessing the overall drug-pricing regime is how patients fare. In America, despite what often seems a lack of urgency at the FDA, new drugs get to market relatively quickly, and so can begin to improve the quality of life of patients. By contrast, the approval process in Europe can drag. It is on average one-third slower. Negotiating with governments to allow access to expensive new treatments is a big hurdle in Europe.

Bain looked closely at Germany, Europe's biggest drugs market - accounting for one-fifth of total spending and of the industry's European jobs. Germans have relatively high life expectancy, but get access to new drugs relatively slowly and by many measures their overall health standards are worse than those in America. Germans spend more time in hospital and lose far more working days to sickness than Americans. Germans suffering from heart disease and breast cancer have worse mortality rates, thanks to the unwillingness or inability of doctors to prescribe the newest, most effective - and most expensive - drugs.

A decade ago, Germany boasted two of the world's top ten drug firms - Bayer and Hoechst. Now it has none. Hoechst, for instance, merged with France's Rhone-Poulenc to form Aventis, which itself might now disappear, either in a merger with Sanofi or into the arms of a white knight.

According to Bain, a proper accounting for Germany's spending on drugs produces an alarming result. In 2002, Germany saved $19 billion because it spent much less per head than America on drugs. On the other hand, says Bain, in the same year, Germany lost out on $4 billion from R&D, patents and related benefits that went elsewhere. It lost $8 billion because high-value jobs went somewhere else - plus the benefits of those jobs from the “multiplier effect”. German drug firms would have made $3 billion more profit if they had kept pace with rivals elsewhere. A further $2 billion was lost as the country shed corporate headquarters and the benefits they bring. The cost of poorer-than-necessary health was $5 billion.

Of course, these calculations rely on some rough and ready assumptions. Even so, Bain arguably errs on the side of caution. It plays down, rather than up, the multiplier benefits of jobs in the drug industry, for instance. In sum, it reckons that Germany's $19 billion saving is in fact a $3 billion net loss. “When you add up all of the costs, the free rider model is actually quite expensive,” argues Mr Rosenburg.

Even if Europe's governments accept the logic of the Bain study, it seems unlikely that they will abandon price controls, not least because of short-term budget constraints for publicly financed health care. (More likely, America will impose its own tougher price controls.) A more typical, though less effective, European response would be to strive harder to attract, or at least keep, drugs R&D by offering a mix of tax relief and subsidy. And Mr Garnier might get some help with red tape. Faster drug launches, fewer restrictions on access to consumers, even faster price negotiations, would all make the pill easier to swallow. But it remains a bitter and, despite appearances, expensive one.

Europe pays a lot less for its drugs than America. But do hidden costs mean that European are actually worse off?

• Primary Source