Will reference pricing make US drugs affordable?

June 28, 2022 Health

Joe Biden’s Build Back Better Act is the latest in a long line of attempts by US administrations to make pharmaceutical drugs cheaper for its citizens, by capping US prices according to levels set in other countries. Analyzing the global impact of such policies, especially the tradeoffs between encouraging innovation and access to medicine, is a key research focus at the TSE Health Center. In a new paper coauthored with colleagues at UCLA and Stanford, Pierre Dubois demonstrates how international reference pricing rules may ultimately raise prices in referenced countries much more than it will decrease prices in the United States.

Why are policymakers often reluctant to push for lower drug prices?

Global pharmaceutical sales rose to $1.1 trillion in 2016 and have since grown by more than 30%. Given the scale of this spending, policymakers face political pressure to lower drug prices. But they must also balance the immediate benefits of reducing drug prices against the long-term benefits of incentivizing pharmaceutical R&D. Many expensive drugs represent important medical advances. The cost of bringing them to market includes not only the highly skilled labor, facilities, and materials needed to develop and test a single successful product, but also the costs of failures along the way. For such large investments to be worthwhile, pharmaceutical firms must expect to make a substantial profit on successful products. The patent system aims to shield new drugs from generic competition for a defined duration so that innovators may charge prices that are significantly above marginal cost.

How does the US approach differ from other countries?

While they recognize the benefits to incentivizing innovation, most developed countries negotiate or regulate drug prices. In the United States, however, pharmaceutical companies are allowed free reign to set prices: Americans spend twice as much per person as European countries, and account for 40% of total global expenditure. This has led many in US policy circles to advocate for price controls. Every US administration in the past three decades has proposed a flagship program to try to lower prices and shrink the gap. Most recently, the Lower Drug Costs Now Act of 2019 and the Build Back Better Act of 2021 proposed to do this by requiring that prices in both government and commercial markets not exceed 120% of prices for the same drugs in a set of reference countries.

How does your paper analyze the impact of such policies?

It is typically assumed that reference pricing would push US prices down to the prices that are currently observed in reference countries. These analyses ignore the possibility that pricing may adjust in reference countries as well, given that those prices will act as a price ceiling in the US. To predict these potential price adjustments, we develop a structural model of demand and supply for pharmaceuticals in the US and reference countries like Canada, where prices are negotiated between pharmaceutical firms and the government. In our simulations, negotiations are heavily influenced by the knowledge that lower prices in reference countries entail lower profits in the US, giving firms a credible threat of abandoning reference-country markets. Both sides recognize that firms are unlikely to sell in countries that insist on a price that significantly undermines their US profits.

The extent to which reference pricing would result in higher prices in reference countries rather than lower prices in the US depends on many factors, including the competitive structure and size of each market, its demand elasticities, and regulators’ bargaining power. Moreover, equilibrium price changes depend on the details of the reference pricing rule, such as the number of countries referenced, the amount of premium allowed in the US, and how US regulators respond to instances where firms exit reference countries.

What do your results suggest about the effectiveness of reference pricing?

We find that reference pricing on its own is unlikely to produce dramatic savings for US consumers. Overall, it induces a substantial increase in reference-country prices but only a modest decrease in US prices. Reference pricing works better when more countries are included in the reference index: US prices fall further, while prices in other countries increase by less. It is also more effective when reference countries have larger, more lucrative markets. However, the price reductions that result in the US are surprisingly small. This is because, even when reference countries have more leverage, profitability in the US still dominates negotiations due to the US market’s unrivaled size and the willingness of Americans to pay for new treatments. 

In contrast, we find that price-control policies that allow regulators to negotiate on behalf of US consumers would be far more successful. Requiring firms to continue selling in the reference country as a precondition to selling in the US is also very effective at lowering US prices. This type of rule dramatically strengthens the reference country’s bargaining position since firms know that failing to make an agreement will close the door to the lucrative US market. However, this type of agreement is not renegotiation proof and unlikely to be easily enforced.

Interestingly, we find that global pharmaceutical profits may increase slightly as a result of international reference pricing, as lost profits in the US are offset by increased profits in reference countries.

What are some of the potential impacts of this research?

While our work has implications for pharmaceutical policy design in the US, it also has possible applications in other contexts like the European one where external price referencing is widely used, or in contexts where parallel trade of drugs creates similar externality effects across markets. Allowing parallel imports of patented drugs to the US from other countries is another policy that could be modeled using our framework. Future research could examine the effects of such policies in dynamic contexts, taking into account product entry, delays, or long-term effects on innovation.


Pierre’s working paper ‘Bargaining and International Reference Pricing in the Pharmaceutical Industry’, coauthored by Ashvin Gandhi and Shoshana Vasserman, is available to read here

Article published in TSE Reflect, June 2022

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