How should we pay for medical research ?

In reading the discussion on pharmaceuticals and the US-Australia Free Trade Agreement, I thought it might be useful to look at the more fundamental question – how should we pay for medical research ? In the framework of neoclassical economics, it’s natural to start by looking at the free-market solution. In the absence of government intervention, firms innovate in the hope of securing above-normal profits by offering a superior product. They discourage imitators using a variety of methods such as branding and trade secrets. While these methods don’t work forever, in some cases they deliver enough profits to finance a satisfactory rate of innovation. But, as far as I know, no-one seriously suggests this is the case in relation to medical research. To finance adequate levels of medical research, we need some form of government intervention. There are three main options

* Patents

* Research grants

* Research rewards

Of these options, patents involve the most intrusive government intervention and the largest welfare costs.

A patent is a temporary grant of monopoly rights[1], imposing civil and criminal penalties on those who produce and market goods that are inconsistent with the terms of the patent. Moreover, since a monopoly is analogous to a narrowly-based consumption tax, it has higher welfare costs than an equivalent sum raised from general taxes. On the other hand, if the product market in question functions well in other respects (in particular, if consumers are well-informed and there are no cross-subsidies), the profit from the monopoly is a good measure of the social value of the innovation, eliminating the need for governments to make judgements on this issue. The problem in the case of pharmaceuticals is that the conditions for an efficient product market are not met. Consumers are largely reliant on the advice of doctors, who face a range of incentives that don’t align well with cost and benefit criteria. In addition, markets are generally riddled with cross-subsidies of various kinds, for example arising from public and private insurance.

Research grants of various kinds are the basis of most fundamental research. This category includes both project-based grants of the kind funded by national medical research agencies and the funding of universities and research institutes to undertake research without specific directions as to the content of that research. In the pure model of grant-based research, the products of research are freely usable public goods. In recent times, it has become common for grant-funded researchers and institutions to seek a second bite at the cherry through patents, though the amount actually raised in this way is much smaller than is commonly imagined.

The least familiar category is that of rewards for successful research. A famous historical instance is that of the Longitude prize. Explicit prizes of this kind are rare nowadays and are mostly privately funded. But in practice, research grants are awarded, at least in part, as a reward for past successes. More importantly, for the purposes of the present argument, the Australian system of purchasing pharmaceuticals is, in essence, a reward-based system. Pharmaceutical companies with new and innovative products offer them to the Australian government, which accepts them if the estimated social benefit of the drug exceeds the price demanded. For a bargain to be struck, the price must be somewhere between the company’s marginal cost and the net benefit to Australia. Where there is a wide gap, a standard bargaining problem arises, with the buyer seeking a price near the lower bound and the seller a price near the upper bound.

Because Australia is a small market, companies can cover most of their fixed costs in other markets such as the US, so that the marginal cost may be quite low. This strengthens Australia’s bargaining position. It is this aspect of the scheme that has attracted most attention in public discussion. If the US followed the Australian example, the resulting price (for both Australia and the US) would be higher. But it seems likely that the average price would be well below that prevailing at present and that the allocation of research effort would be more socially beneficial.

fn1. Historically, the grant of patents on items such as salt and playing cards first emerged as a device for raising revenue and rewarding favourites under the Tudor and Stuart monarchies. The award of patents as a reward for inventors came much later.

33 thoughts on “How should we pay for medical research ?

  1. Brilliant post, John. It is important to note, I think, that the PBS system results in us paying a fair price rather than the lowest possible price.

  2. Information leading to medical innovations and new drugs is obviously partly a public good that calls for public funding. Private incentives can also be fostered with the prospect of monopoly profits. In relation to anti-AIDS drugs a few years ago the Economist magazine suggested that governments might buy out the expected future profit streams of private suppliers and then supplying the drugs at marginal cost. You then give big transfers to the private firms but reduce the monopoly deadweight losses. There are a host of practical issues (international issues as markets are global, eliciting estimates of future profits and the real transfers that occur) but this scheme seems an option,particularly with respect to crucial life-saving drugs.

  3. Doesn’t the US military use Research rewards with respect to malaria and other tropical diseases?

  4. The patent system exists for other innovations. Use it and regulate patent misuse through competition laws. A mixture of all these approaches would be optimal though fundamental research will still need government funding.

  5. I watched the Four Corners program on Monday and one thing that really struck me was that Australians are unwilling to pay for innovation. I’ve often wondered why, with so many talented people, Australia punches below its weight in innovative industries. I think this may be why.

    In the program, we were hit over the head that big pharma were the baddies and the PBS the goodies. From a simple viewpoint, this seems obvious – getting drugs at lower cost is good.

    However, this isn’t the whole story. One thing that wasn’t made clear is that the PBS has never invented a single drug and never will. The only reason the argument exists is because big pharma made the investment to create new drugs. No useful drugs = no benefits = no reason to argue over cost.

    This is relatively unimportant if your view is that medical research won’t create many new useful drugs, but few people argue with this. This kind of research costs big bucks, most of which are wasted on red herrings. If we want the benefits, we have to be willing to pay companies good profits for their research risks.

    What is of more value to customers? Cheaper inferior drugs today or the possiblility of much better but more expensive drugs tommorow. If I was dying of cancer or AIDs, I’d want the better drugs, but the government seems to have defaulted to the former position that I’d want the cheaper ones.

    In the case of the PBS, there’s an argument to be made that we get the best of both worlds. The benefits of innovation spending without the costs. We get a free ride from the Americans.

    However, this kind of thinking has implications for our own innovative industries. If we’re unwilling to pay the price for innovation here (or abroad), we won’t reap the benefits of new, lucrative companies.

    I think this goes a long way towards explaining why Australia doesn’t now and probably never will have a lot of large, dynamic, innovative companies.

  6. The PBS isn’t designed to invent innovative drugs just that we pay a fair price. Drug companies are in the business to make money. A lot of the tactics they have used have been unethical. They have hidden important information about dnagerous side-effects, made sure researchers didn’t tell anyone etc etc.
    There have been some important innovations that have come from Australian researchers. Universities need money to support their work, from the basic sciences up. The population of Australia does mean that some trials are more difficult to conduct but it is WRONG to say that because drug companies are profitable that means they are innovative, except perhaps in marketing in which they excel

  7. sp

    I’m not saying that drug companies aren’t in business to make money. Just that they are an important source of innovation. Nobody is going to invest private money into risky research without the possibility of big rewards. Why would they?

    I know the PBS isn’t designed to create drugs. It’s designed to make them cheaper. You can’t have both though – cheaper drugs and more research dollars (unless you take a free ride from other countries).

    I’ve got no problem with funding government research. Why deny the possibility of private research as well though by artificial price constraints?

    The point is that universal appreciation of the PBS says a lot about Australia’s cultural attitude to innovation. That is – we’re unwilling to pay for it. This seems to be true of both public and private innovation.

  8. And it’s not wrong to say profitable drug companies are innovative. They are, plain and simple. That’s why we want their products. If we didn’t, there’d be no purpose for the PBS.

    “A lot of the tactics they have used have been unethical.”

    Perhaps, but a lot of their products save lives. What has this got to do with prices anyway? If they’re doing something illegal, prosecute them.

  9. There an aweful lot more to producing a new drug than research, eg manufacturing, clinical trials, quality assurance, testing. These other things are most of the expense. Government funding doesnt seem the best way to deal with these other things.

  10. Most of the “innovation” by drug companies is about getting round each other’s patents – the huge majority of new drugs are variants of each other with arguable benefits.

    The “wellness” research on preventative health is fundamentally important and driven by government, universities and foundations because there ain’t no money in it. Although CSIRO has found a handy private enterprise source in food companies, fuelled by important research into areas like cruciate vegetables, fibre, cholesterol, exercise and Omega 3 fish oil, carried out by a chain of institutions around the world which publish and share in the good old scientific tradition because there’s no profit in secrecy.

    Just ask yourself which research dollars will actually lead us to lead longer healthier lives… the prevention or the cure?

    I think the Australian medical research community would become very angry at the idea we are punching beneath our weight, or that we lack innovation. Ironically, one reason why we don’t do tablets is that the US FDA accreditation system is slow, cumbersome and expensive.

    And let’s not forget lithium. And spina bifida. And malaria. And surgical techniques. And our public health activity to limit the spread of AIDS. And even the evolution of casemix.

  11. David. You seem to be arguing a different thing, which is that the patent system is broken. I’d tend to agree, but this is the government’s fault, not companies, who have a responsibility to shareholders to maximise their investment.

    Australia does punch below its weight in innovative industries, not innovation. This isn’t only true in medical science but most industries.

    Australian researchers seem to agree, as they often complain they have to take their research overseas. Why? Because Australians are unwilling to pay for innovation. The PBS is a perfect example.

  12. PK,

    Whether or not Australians are willing to pay for innovation is debateable, and furthermore not relevant to the PBS.

    Australian pharma companies do not develop drugs to sell into the Australian marketplace alone. If they did, you would be correct in asserting that the PBS restricts the returns to R&D, thus stifling innovation.

    HOWEVER, pharma companies operate in global markets, of which the biggest (by far) is the USA. All of our nascent pharma companies direct their research to meeting US FDA (Food & Drug Administration) requirements and obtaining US patents. The Australian market is incidental to most pharma companies, including the AUSTRALIAN ones, therefore the PBS is largely a side issue of limited relevance in the fostering of Australian innovation.

    The crux of the issue is that Australia is a marginal buyer of drugs, produced largely by US and European companies, and via trade restrictions (i.e. the PBS) we reduce the marginal revenue available to US and European companies. They still sell us drugs, however, because the marginal cost of supplying us is well beneath the marginal revenue. Why? Because they spend vast sunk costs on R&D and marketing to get products into their core markets, and the size of those markets enables them to spread the development costs over large populations.

    Australia is a free rider in this situation, as we refuse to pay the average cost plus (exceedingly remunerative) profit markup. We pay something closer to marginal cost, which still leaves the drup producers with plenty of profit…just not as much as the greedy blighters would like to get.

    Is this fair? No, but what’s fair about the vast array of tariffs and subsidies the US uses to protect its farmers from our guys? Furthermore, given we have a largely government-run health system (including the PBS), why shouldn’t our government, in effect, demand a “volume discount” from foreign drug companies? The PBS has proved to be enormously efficient at supplying Australians with cheap drugs, and we should demand considerable compensation to dismantle it. We’re not getting that from the FTA, so stuff it.

  13. There are some repeated bits of tunnel vision around here. Look at these examples:-

    “…it’s natural to start by looking at the free-market solution… as far as I know, no-one seriously suggests this is the case in relation to medical research. To finance adequate levels of medical research, we need some form of government intervention.”

    “a public good … calls for public funding”

    It’s a social democrat prejudice that governments are the, rather than a, solution in such areas. Sometimes they are even the best solution, but they are rarely the only solution. All that is needed is a non-market solution – but that does not imply a role for government.

    I won’t offer the whole range of non-government, non-market alternatives here, but I will point out that where JQ states that “… patents involve the most intrusive government intervention and the largest welfare costs”, he is mistaken on the first point. It is only our current implementation that requires government involvement, and that only to maintain government monopolies of policing – the point I brought out in the different languages entry. Think back to the Elizabethan/Jacobean revenue raising; this involved turning the patent holders loose on the public, with the right to do their own collection (objectors to over-reaching could in theory go to the courts, which were user pays in those days). Patents do not actually require government involvement at all, let alone intrusively, once they are issued. The cost comes from using them in a framework that is now quite different, so we end up with more not less policing.

    (Oh, look at the parallels with how Stamp Acts were enforced; nobody went out there and policed them, it was just that if the parties to a contract didn’t have the Stamps, they could never get it enforced at law if they wanted it – the sanction was of being excluded, made into a debt of honour like a gambling debt. Access to the legal system was necessary, not policing of law; it was self policing.)

  14. Fyodor

    Most big companies start off small servicing their home market. They then expand. Very few companies in any industry would aim to immediately service huge foreign markets.

    The PBS is more a symptom of an underlying reluctance to fund innovation in this country. I agree that it’s not worth dismantling now.

    Who’d be willing to invest large amounts in a country with an attitude that it’s okay to use legislation to restrict profits from innovation? No me, that’s for sure.

  15. PK,

    Selling intellectual property isn’t like selling widgets. You don’t “start small” then go big. What actually happens is that companies spend millions of dollars developing knowledge that has global application. Speak to any pharma company in Australia, and they’re all paranoid about securing patents for their products in OTHER markets, principally the USA. The PBS is of marginal importance to them, and has no material impact on what and where they decide to develop technology, because the big bucks are in the USA and Europe.

    Let me repeat that point: the PBS is irrelevant to the innovativeness of Australian pharma companies.

    Your argument is really that the SPIRIT of the PBS is anti-innovation, but only in one specific industry. I can’t think of another industry in Australia being stifled by Australian patent restrictions. Maybe there are government and cultural problems with Australian innovation, but the PBS isn’t a big deal in this respect.

  16. Its an interesting empirical question why the large pharmaceutical companies have not been very good at innovation. Most of the drugs on the market are me-too drugs ie there is the original breakthrough and then the pharmaceutical industry develops different chemicals which use the same clincal principle. eg drugs to increase serotonin in the case of depression. The original breakthroughs have usually come from publicly funded research.
    An interesting example where they retarded innovation was with regard to treatment of ulcers. A publicy funded researcher — Barry Marshall in WA — discovered the real cause of stomach ulcer was the bacterium H. pylori. Thus the appropriate treatment was antibiotics. This insight rendered irrelevant all the acid suppressing drugs that were on the market to ameliorate the symptoms of ulcers. This was a multibillion dollar market, so the companies fought tooth and nail against Barry Marshall’s idea. Their actions delayed the widespread use of antibiotics to treat ulcers by 10 to 20 years.

    But to get back to the original point, in theory the drug companies should be major sources of innovation in pharmaceuticals, but in practice they are not. They do some innovation but nowhere near what one would expect given they spend $US50 billion a year on research. Why?

  17. Harry Clarke writes:
    “Information leading to medical innovations and new drugs is obviously partly a public good that calls for public funding.”

    This is incorrect. If it is a public good, it must be non-excludable and non-rivalrous in consumption. Non-excludability means that it is automatically provided to everyone and consumed by them in the same amounts once it is produced. This is obviously not true of information leading to new drugs.

  18. George

    Some information does leak from research into developing new drugs and medical technologies and patenting is imperfect because of reverse engineeruing and imitation possibilities. Note I said that these items were ‘partly a public good’. and of course I went on to discuss the role of private firms. I stick with my remarks.

    If your view is that these are pure private goods then half of John’s posting becomes irrelevant — what role for public funding and research grants?

  19. Fyodor

    Actually most IP companies do start small and local. Software being a good example. Pharma cos are probably aiming at foreign markets initially because the PBS makes ours not worth the bother. We’re digressing though.

    You’re right that my argument is with the spirit. Not just of the PBS, but the public reaction to the debate, exemplified by the 4 corners program.

    The very notion that a private interest should make big profits from a useful innovation appears detestable to the general Australian public, the media and many politicians.

    In America, Switzerland and Taiwan, for example, they have a different view. Which is why they have profitable innovative industries and we don’t.

  20. The Economist had an article considering the possibility of an open-source model for medical research. It would certainly be worth trying given that the existing privately oriented, patent based system seems to be inefficient.

    An open-source shot in the arm?

    Jun 10th 2004
    From The Economist print edition

    Medicine: The open-source model is a good way to produce software, as the example of Linux shows. Could the same collaborative approach now revitalise medical research too?

  21. PK,

    Pharma companies follow Willie Sutton’s maxim: they target foreign markets because that’s where the money is. The Australian market pales into insignificance when compared to Europe and North America. The PBS does not discourage innovation by Australian companies, because the Australian market is not important in the scheme of things.

    You’ve generalised from the 4 Corners programme to the “Australian public”, but I think 4 Corners was spot on in questioning why we are giving up a price control WHICH WORKS IN OUR FAVOUR. It does not suppress innovation in Australia, but does ensure that Australians pay less for drugs than they would otherwise. If we can get away with it, why not do it?

    On your last point, “innovation” is influenced by a wide variety of factors. It’s simplistic (and unproven) to attribute Australia’s (perceived) lack of innovation just to public and government attitudes.

    It’s also questionable whether Switzerland itself is that innovative just because a couple of multinational corps have HQs there. Likewise, Taiwan is an odd choice – it’s a country I associate with IT production, but not necessarily much innovation.

  22. PK, what kind of drugs have you been smoking?

    If you’re trying to produce a new drug, you have to do extensive clinical trials to show it’s safe and that it’s effective. You have to do that, and I believe that it costs about one billion US dollars to do so, regardless of whether you try to sell it in one country or worldwide. You’ve got a fixed period to do so, worldwide, before the generic drug makers get their crack. Are you really going to try and make your billion dollars back exclusively in the Australian market?

  23. Merkel and Fyodor

    You appear to be saying it’s fine for Australia to get away with not paying for innovation because, well, we can.


    You also seem to believe that local market conditions have no effect whatsoever on a company’s prospects. Funny, but businesspeople

  24. PK is wrong in everything he has said about the cost of getting new drugs to market. It’s not the research costs that are prohibitive but the commercialisation costs. And it’s the over regulation of the FDA and the TGA which causes these costs to spiral out of the reach of all but the largest pharma companies.

    In order to reclaim the huge commercialisation costs, the big pharmas require enormous margins during the patent period. Australia is not getting a free ride from so called US innovation, our biotechnology industry is at the bleeding edge of innovation, but we dont have the capital to be able to carry out the clinical trials and other hurdles constructed by the FDA.

    The best way to reduce the cost of drugs is to reduce regulation, get past the horrors of thalidomide and introduce protocols that encourage the rapid uptake of new inventions and treat more diseases, especially those in the third world.

  25. I actually tend to agree woodsy. Not with your analysis of the costs, but with your solution.

    Then on top of that we have the same old geniuses claiming that the price mechanism doesn’t count in this case. You can ignore it with zero consequences, apparently.

    Sure, the price mechanism generally works, but not when it comes to drugs in the Australian market, because that’s different blah, blah, blah.

    We’ve seen the same story before a thousand times before with predictable consequences.

  26. Just to add a bit to John G (and thanks for the ulcer example) –

    There is a very good reason why most drug companies concentrate on imitation rather than innovation. Finding a new mechanism in the human body by which an introduced and patentable chemical not only makes a difference but goes past the body’s defences and has manageable side effects is very hard, and very risky.

    As I understand the general explanation by Australian researchers to civilian writers like me, the big companies, particularly in the US, tend to use a systematic and industrial approach to innovation. Just keep synthesising the chemicals and finding out if they work on anything.

    Very small players like CSIRO can’t use this harvesting model; instead researchers work by hypothesising a mechanism and looking for the chemical to do it. Basic science, in other words.

    I think there’s also a problem with patents for Australian drug companies – they can’t just develop locally because anything useful is noted by our competitors who do what they can to take over the international patent space, and to develop analogues. You have to come out quickly, at a large scale.

    The software market is not a very good comparison. A large number of innovative ideas fail because of production and distribution problems; software minimises these.

  27. 1. It’s in big pharma’s interest that the cost of commercialisation is so high.

    2. Arguing that we have a bad scheme because it takes advantage of overseas research implies that research can’t occur under the conditions of the PBS. This claim needs to be backed up with some sort of evidence.

    3. Lack of capital and other support for innovation in Australia is so well documented over the last 50 years that unless the PBS can be shown to be some peculiarly toxic manifestation of good old ozzie comprador apathy it seems a bit unfair to blame it all on the PBS.

    4. Anyway, medicine is not the only cure. I don’t know how the PBS evaluates drug versus non drug therapies but I’m sure they’ve thought about it. The advantage of a system of rewards based upon comparative price advantage is that apples can be compared to pears and drugs can be compared to acupuncture(etc.). Such a system encourages innovation, not only by not limiting the scope of a healer’s imagination but by setting clear goals early on in terms of the actual price that should be aimed for.

    5. Nobodies mentioned it yet – but the drugs that really make a killing are the ones that you have to/can take all the time. Then we get scandals llike HRT which has left more than a few women injured and confused in spite of the PBS.

  28. Another point to note is that stressing “innovation” is a bait and switch, focussing on what is basically a marketing thing instead of the underlying substantive thing it rests on, in this case discovery, invention, and productive engineering. It’s a bit like the way the ALP started stressing “leadership” around the time Paul Keating ran out of ideas (apart from big vision stuff that didn’t connect to anything on the ground).

    Here, “innovation” actualy takes away from things like indigenous peoples’ age-long use of remedies by making that not count until it has been run in and out of the framework foisted on it. It’s a close analogue of the way peasants lost rights when their land was switched to enclosed (private) ownership from being handled through commoners’ rights. While it doesn’t cover all cases of medical innovation, enough is spurious appropriation to undercut the the concept that not contributing to other people’s appropriation is somehow expropriating from them.

  29. P.S. How could I have forgotten Bill Gates when commenting on innovation? He seems to have taken it up as a bait and switch to distract attention away from the fact that Microsoft’s successful efforts are not directed at inventing or providing but at making available – and in such a way as to thwart much better things that didn’t have marketing clout behind them (pie menus, anybody?). In answer to the question “do you want it right or do you want it now?”, he has chosen the only correct marketing answer.

  30. Patents and copyright have an important role as selectors for innovation, when compared against research grants. With patents and copyright, the market decides what’s useful. With research grants, a considerable apparatus is needed to decide who gets the grants, and it’s subject to many irrelevant pressures.

    Consider for example if all our software development or medical research was funded by a body like the Australia Council.

  31. “Patents and copyright have an important role as selectors for innovation, when compared against research grants. With patents and copyright, the market decides what’s useful”

    Exactly. On the other hand, as John notes, the demand side of the market is also imperfect because of imperfect information on the consumer’s side (including principal-agent problems – doctors may be overly influenced by pharma companies to prescribe certain medicines over others), externalities in consumption decisions (private priorities on what conditions should be most urgently treated don’t take full account of impacts on health of 3rd parties, reinforced by a subsidised health system), etc, etc. This may then lead to the diversion of scarce research resources into areas that do not properly reflect social marginal costs and benefits. On the other hand as Tony points out, a fully publicly funded pharma system also has its own imperfections and ignore research into certain areas which may yield net benefits simply because they aren;t favoured byt whatever elite is put in charge of deciding priorities (e.g. not prestigious enough or too ‘trivial’). Therefore the optimal policy is to have a mixture of both public grants and a patent system, one to produce ‘social priorities’ research and the other to produce products of immediate consumer demand, one as a corrective to the other since in practice neither the fully public or private model can get the mix of goods right.

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