An Economic Assessment of the Relationship between Price Regulation and Incentives to Innovate in the Pharmaceutical Industry

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In the context of healthcare cost-containment efforts, pharmaceutical products are increasingly subject to strict pricing and reimbursement conditions in many European countries and it is widely believed that the U.S. are following suit. However, little attention has been paid to the adverse consequences that pricing and reimbursement regulation may have on pharmaceutical innovation, by reducing the value of pharmaceutical projects and by curtailing the resources available to carry them out. Furthermore, because pharmaceutical discovery and development is a long-lasting process, the adverse consequences of the pricing and reimbursement regulation that are introduced today will be observed in the number and characteristics of the drugs that will be launched in the market only in the future.


In this report we set out to analyze the effect of pricing and reimbursement regulation on innovation in the pharmaceutical industry by:

  • first, qualitatively exploring how a pharmaceutical firm is likely to strategically respond in its R&D activities to pricing and reimbursement regulation;
  • then, quantitatively evaluating this effect in the context of a calibrated decision-theoretic model of drug development in which a pharmaceutical firm is forward-looking and takes future pricing regulation into account in making current development decisions.

The point of view that we take throughout this report is that of a representative pharmaceutical firm which, when taking development decisions, optimally reacts to the incentives provided by the pricing and reimbursement regulatory environment. It is beyond the scope of this report to evaluate the net effect of pricing and reimbursement regulation on the welfare of patients and society at large by comparing the potential welfare benefits of lower drug prices and the potential welfare costs of fewer drugs being developed and launched in the market.

The innovation process and how it interacts with the commercial environment

The pharmaceutical innovation process is a long, costly, and risky process that is paced by rigorous marketing authorization rules ensuring that marketed drugs are safe and effective.

From an economist’s perspective the pharmaceutical innovation process is characterized by two key decision stages. First, a decision on the overall R&D budget is taken. Arguably because of the presence of asymmetric information between pharmaceutical firms and outside investors, R&D projects are primarily financed by current cash flows, resulting in a relatively stable ratio between R&D expenditures and sales over time. Second, once an R&D budget is allocated, a variety of decisions must be taken regarding which projects to accelerate, which projects to delay, and for what therapeutic indications to perform clinical trials.

The later part of the process can be characterized as a time-phased process during which go/no go decisions, as well as a variety of “softer” decisions, are taken. While in the past these decisions were based primarily on scientific and technological grounds, in the recent years—and arguably because of the stricter cost-containment policies implemented—there has been an increase in the importance assigned to commercial factors, including considerations about potential pricing and reimbursement regulation outcomes. This is reflected in the early stages of the development process in a careful, but not necessarily quantitative, meditation on the unmet medical need that a drug candidate would fill and its degree of differentiation relative to other drug (candidates). Then, especially later on in the development process, these reflections find their way into Expected Net Present Value calculations. These calculations—which explicitly take into account development costs, risks, and the life cycle of expected future sales—allow decision-makers to rank their projects and make better resourceallocation decisions.