Regulation, Regulation, Regulationception

March 7, 2019

Regulators…mount up!

Inquisitions are nothing new in Washington, especially when it concerns healthcare, but rarely are they due to a problem coming full circle. Spearheading the latest probe into “skyrocketing” drug prices, Senator Chuck Grassley recently dragged executives from seven top pharmaceutical companies before a Senate Finance Committee hearing to clear the “great deal of secrecy” behind how companies set prices. Some lawmakers worried about drug prices, like Grassley, make vague calls for increased transparency and legislative oversight, while others propose solutions as radical as limiting price increases, capping prices, and even fining drug companies that raise prices. But a case of wrongful conviction is at the root of all these regulatory proposals, dooming them to failure. The sad irony is that it isn’t Gordon Gekko, greedy corporations, or a lack of regulations causing drug prices to spiral out of control: it is regulations themselves.

Like a pair of handcuffs without the key, regulations can only move in one direction. Also, like handcuffs, regulations constrain the cuffed party’s movement. Proponents argue such rules are necessary to prevent bad behavior. Of course, the Laws of Supply and Demand tell us prices rise as you constrain supply, and Cost Theory shows how prices are a function of a firm’s costs. Too often, lawmakers forget to consider these basic principles when deciding to regulate. Beyond the foundational considerations of whether a regulation will even accomplish its stated goal, even more rarely do lawmakers balance the “benefits” of regulations against the costs of undesired outcomes.

Pharmaceuticals are among the most regulated industries in the United States, with over 10,000 individual rules and restrictions, ostensibly in place to protect patients and consumers. Pharmaceutical companies shell out millions of dollars per year on the legal bureaucracy and necessary compliance manpower alone. When you factor in the Food and Drug Administration (FDA) rules on development, testing, efficacy, and certification of a new drug, costs reach the billions. Save the semiconductor technology industry, pharmaceutical companies spend the highest percentage of revenues on research development of any industry, at an average of 17%. It takes an average of 12 years and $4 billion to bring a new drug to market, with many costing more than $10 billion. Regulations and the associated bureaucracy directly contribute to these ballooning costs, and by extension, add to the final market price of a drug. It remains unclear if these higher costs and regulations provide any benefits to patient care or reducing the risk of a bad drug.

Beyond the effect regulations have on manufacturing costs and sale prices, they also create perverse incentives that limit consumer choice and delay innovation. By raising the cost of developing a new drug, regulations incentivize manufacturers to focus on developing drugs that will bring them the most bang for buck (a higher margin). Companies have little reason to focus on producing a drug that, while lifesaving or contributory to widespread wellbeing, has smaller margins. Think of it like what happened with airlines. In the time of the Civil Aeronautics Board (CAB), when airlines were regulated much the same way drug companies are today, airlines had little incentive to make economy seating. The cost of flying was out of reach for all but the wealthy. With the dissolution of the CAB and price controls, airlines could profitably have both premium and economy seating. In effect, the higher margins on premium seats subsidize the less profitable economy seats, allowing them to offer economy seats at prices almost anyone can afford.

The sad irony in Washington’s latest crusade against rising drug prices is that the bulk of the proposals are targeted at the consequences of previous regulations. Ayn Rand once said, “we can ignore reality, but we cannot ignore the consequences of reality.” She very presciently wrote in Atlas Shrugged of a future where, when regulations on businesses produced undesirable, unintended consequences, government passed more laws simply banning those unintended consequences. We can actively watch this sad game play out in New York City. Their new $15 per hour minimum wage is forcing businesses into the tight spot of laying off some workers to fund the higher wages for others. The situation even reached The New York Times, which reported fast food workers now face “unfair” firings. But these firings aren’t unfair or arbitrary – “they are the predictable consequence of a binding minimum wage in a competitive labor market.” Rather than reexamining the efficacy (or lack thereof) of a $15/hr minimum wage in making workers better off, the city is pursuing new regulations to “protect” workers from being fired (read: ban businesses from laying off unprofitable employees).

Fundamentally, regulations beget more regulations. If lawmakers are truly concerned with out of control drug prices, it isn’t price controls or fines on businesses that will lower them—it is a fundamental reform in the way we are currently regulating pharmaceutical companies.