The Dynamics of Pharmaceutical Regulation and R&D Investments

• Author: MICHELE MORETTO,ROSELLA LEVAGGI,PAOLO PERTILE
• DOI: http://doi.org/10.1111/jpet.12195
• Date: 01 February 2017
• Published date: 01 February 2017

THE DYNAMICS OF PHARMACEUTICAL REGULATION

AND R&D INVESTMENTS

ROSELLA LEVAGGI

University of Brescia

MICHELE MORETTO

University of Padova and FEEM

PAOLO PERTILE

University of Verona

Abstract

The paper uses a real option approach to investigate the properties

of two widely used schemes of regulating the reimbursement of new

pharmaceutical products: standard cost-effectiveness thresholds and

performance-based risk-sharing agreements. The use of the latter has

been quickly spreading and often criticized in recent times. The re-

sults show that the exact definition of the risk-sharing agreement is

key in determining its economic effects. In particular, despite the con-

cerns expressed by some authors, the incentive for a firm to invest in

R&D may be the same or even greater than under cost-effectiveness

thresholds. The greater flexibility on the timing of commercialization

allowed by risk-sharing schemes plays a key role, by increasing the value

of the option to invest in R&D under uncertainty. Under this scheme, a

higher value for the firm is associated with earlier access to innovations

for patients. The price for this is less value for money for the insurer at

the time of adoption of the innovation.

1. Introduction

Total pharmaceutical expenditure across OECD countries was estimated at over USD

700 billion in 2009, accounting for around 19% of total health expenditure. Between

2000 and 2009, average spending on pharmaceuticals rose by almost 50% in real terms

Rosella Levaggi, Dip. di Economia e Management, University of Brescia, Italy (rosella.levaggi@unibs.it).

Michele Moretto, Dip. di Scienze Economiche, University of Padova and FEEM (michele.moretto@

unipd.it). Paolo Pertile, Dip. di Scienze Economiche, University of Verona, Italy (paolo.pertile@

univr.it).

We thank two anonymous referees for their valuable comments. We are grateful to Gijsbert Zwart

for excellent comments on an earlier version of the paper. We also thank other participants at the

13th European Health Economics Workshop, MMRG seminar series at Catholic University, Milan, and

EARIE 2012 conference.

Received February 10, 2014; Accepted May 11, 2015.

C2016 Wiley Periodicals, Inc.

Journal of Public Economic Theory, 19 (1), 2017, pp. 121–141.

121

122 Journal of Public Economic Theory

(OECD 2011).1Although in several countries this is not the most rapidly growing com-

ponent of health care expenditure, its regulation is receiving particular attention. Mo-

tivations for such pervasive regulation include market failures at several levels and the

need to manage a complex trade-off between incentives to R&D investments for the

industry, access to pharmaceuticals for patients, and value for money of public expen-

diture. Identification of the ideal equilibrium is widely debated. Opponents of strict

regulation argue that, by reducing expected profits, it may adversely affect incentives to

develop new and better products, and possibly cause crowding-out of price competition

(Danzon and Chao 2000). There is a growing empirical literature reporting a negative

trend in productivity of the industry’s R&D spending. Pharmaceutical R&D has seen

some major advances, both scientific and technological, over the past 60 years. Despite

this, Munos (2009) reports that the rates of production of new drugs in recent years

have been similar to those of the 1950s. A closer look into the data shows a slightly pos-

itive trend for the period between 1980 and 1996, which has been reversed since then,

bringing the number of new drugs approved back to the levels of the period 1950–

1980. However, the steady increase in R&D investment by the pharmaceutical industry

implies that the number of new drugs approved per billion U.S. dollars spent on R&D

fell around 80-fold times in inflation-adjusted terms between 1950 and 2010 (Scannell

et al. 2012). DiMasi, Hansen, and Grabowski (2003) report evidence of an increasing

trend in the average R&D cost of new drugs. More recently, Pammolli, Magazzini, and

Riccaboni (2011) have shown that the R&D productivity of the pharmaceutical industry

has been falling since 1990. If productivity is actually falling, no matter what the de-

terminants are, understanding the link between regulation and R&D investment is of

paramount importance, because regulation could be an essential policy tool to ensure

the availability of innovations in the future.

Although most of the research on pharmaceutical regulation has explored the

welfare properties of alternative solutions focusing on the use of new drugs, some con-

tributions have gone further, studying its impact on the industry’s propensity to invest

in R&D. Regulation of prices has received the greatest attention in this literature. The

key trade-off is between static efficiency—making drugs accessible to all those who need

them—and dynamic efficiency—ensuring that firms’ profits are robust enough to sus-

tain R&D investments. Filson (2012) investigates the welfare properties of pharmaceuti-

cal price regulation and concludes that consumers in the United States tend to be better

off with market prices: long-term losses in dynamic efficiency due to regulation outweigh

short-term gains in static efficiency. Danzon, Towse, and Mestre-Ferrandiz (2015) show

that with universal insurance, value-based prices can be second-best static and dynamic

efficient within and across countries. Insurance is obviously crucial, because static ef-

ficiency depends on consumer prices. Lakdawalla and Sood (2009) show that public

sector insurance can enhance welfare by mitigating the trade-off between static and dy-

namic efficiency. Garber, Jones, and Romer (2006) study the optimal coinsurance rate

in a framework where patent-owning firms fix monopoly prices. We depart from this

literature in both the regulatory policy we focus on and the methodology we adopt.

Our interest is not in price setting regulation, but in the rules that define under

what conditions an insurer reimburses a new drug. In particular, we compare a well-

established type of regulation based on a maximum threshold for the incremental cost-

effectiveness ratio (ICER), with a performance-based risk-sharing agreement.Underthe

1In the two following years, expenditure was reduced by 0.9% on average (OECD 2013). However, this

is more likely to be due to the global economic crisis rather than to a structural change in the trend.