How odd. Drum wrote
Andrew Sullivan returns to the Big Pharma debate today, stepping back a bit from yesterday's claim that European pharma companies have been "decimated" by Europe's widespread adoption of universal healthcare. And a good thing too. After all, the market for pharmaceuticals is global. Every pharmaceutical company, no matter where it's based or where it conducts R&D, sells into the exact same market. If European national healthcare had really decimated European pharma companies, it would have decimated American companies too.
But it hasn't. So today Andrew moves on to a different, and more common, conservative claim. With some coaching from Mark Kleiman, he argues that the real issue is drug innovation, which he thinks is driven largely by profits from U.S. sales. If we introduce national healthcare in American and start bargaining down the price of drugs, Big Pharma will no longer have an incentive to invest lots of money in R&D. Result: no new drugs.
On its face this sounds reasonable. Pharma companies are like anyone else: they invest in R&D to the extent that they can earn a return from the drugs they develop. If drug company profits are driven mostly by high-priced U.S. sales, then the rest of the world is getting a free R&D ride on our backs.
But I don't think that's quite what's happening. There's a free ride happening, but it's not a free ride on innovation. It's a free ride on pricing.
As Mark points out, pharma companies have to raise capital in the same markets as everyone else, and that means their overall pricing has to be high enough to provide them with the risk-adjusted returns on equity that the market demands. So what happens if prices in America are gradually pushed down? Answer: prices everywhere else will be gradually pushed up. Americans will pay a bit less and Europeans will pay a bit more — which suits me just fine — and both profit levels and risk-adjusted returns will remain constant, just as basic economics demands. The only difference is that Europeans will be forced to pay their fair share of pharma R&D budgets. No more free ride on pricing.
This reassoning seems to me to be very very odd. A standard simple model of pharmaceutical company managers would have them sell for the highest price they can get. This would suggest that they are squeazing all of the money out of Europe that they can already. It is not clear how a decline in profits earned in the US would change the game played by the pharmaceutical companies and European states. Now I don't believe in standard simple models of firms (or anything) especially since I mean models which have been proven false decades ago. However, I don't see how a more sophisticated model would imply that prices in Europe go up as prices in the USA go down.
Before going on, I have to distinguish two kinds of risk adjusted returns. One would be risk adjusted returns to investments in the shares of pharmaceutical companies. It is very easy for these to remain the same (after a period of adjustment) even if the USA begins bargaining seriously about drug prices. A surprising discovery of a federal spine (plus a federal pair and other anatomical metaphors) would cause a drop in share prices. That would imply higher returns for a given path of dividends or, in a simple model, equal returns given lower dividends due to lower drug prices and profits. No problem there. In particular appropriate risk adjusted returns on shares can be achieved via changes in share prices no matter what firms' R&D (or any other) policy is.
On the other hand, it might be that MK and KD think shareholders will demand a given risk adjusted return on investments included investments in R&D.
Now if the required return on an investment stays the same, the pharmaceutical companies can manage that by investing only in projects which currently pay higher than the required return. That is by investing in fewer projects. In other words via a reduction in R&D as argued by Sullivan.
But how do investors demand such returns ? The return on investment in the pharmaceutical industry is very high compared to other sectors (also adjusting for risk that is their Q even including R&D investment in the denominator is very high). How and why do investors manage to make managers earn such high returns. In the simple model (which I don't believe) managers act in shareholders' interests. Ha. Back to seriousness. Investors can demand a high return on investments by only buying new shares issued by firms if the firms have high enough returns. Pharmaceutical companies are not issuing new shares, so this is not a factor.
Basically the way that investors can force managers to act in their interests is via the threat of takeovers, that is, if the current management doesn't maximize shareholder value, someone can make a lot of money buy quietly buying 5% minus one of the shares then taking over the firm. In other words managers are forced to make the highest return possible. There is nothing that implies that this return must be constant.
My guess is that if the US got tough on drug prices, the price of pharmaceutical companies shares would fall as would the value of those companies to predators. Managers' incentives would not change. I would guess R&D would remain about the same.
The reason pharmaceutical companies must earn huge returns on capital is that they can and if current management won't someone else will. If the environment changes so that they can't make such returns, they won't be forced to make such returns.