The cost of losing R&D

The Economist carried a comparison of US and European pharmaceuticals industries (based on a Bain study) a while back. In their analysis, they debunk the idea that Europe is benefiting from a free ride. Government pricing regimes may be keeping drug prices low, leaving American patients and insurers to pick up the tab of ever more expensive drug development. However, they are losing out overall - the policy is currently incurring a net loss in Germany for one.

As Europe becomes a less attractive market and red tape further hinders innovation, R&D (and the jobs that go with it) and cutting edge health care are moving to the United States.

IN THE drug industry, they call it “Europe's free ride”. Government pricing regimes mean that prescription drugs cost far less in Europe than in America, where a growing proportion of new drugs are developed—presumably because Americans are willing to bear the lion's share of development costs. On the face of it, Europe reaps big rewards. It spends 60% per head less on drugs than America. In 1992, the gap was 30%. Had spending kept pace with America, last year alone Europe would have shelled out an extra $160 billion. The cumulative “saving” since 1992 is approaching $1 trillion—quite some free ride.

But is the saving from cheap drugs more apparent than real? And are Europe's drug firms in fact struggling to keep up with more dynamic American competitors? A new study by Bain, a consultant, argues that the existing pricing regimes are bad for everyone, including patients. “The free ride is not free,” argues Paul Rosenburg, a co-author. “If governments and drug companies begin to accept this, then future policy on health-care innovation and spending can be far more rational.”

On the other hand, America gains from its growing dominance of drug research and development (R&D). A decade ago, Europe and America each spent roughly $10 billion a year on drug R&D. Now, America spends almost $30 billion annually, and Europe a little more than $20 billion. A growing number of firms now base their R&D efforts in America. Drugs R&D in Germany fell by 3% in 1992-2002.

One result is a striking decline in European drug innovation. Bain examined how many so-called new molecular entities (NMEs) have been produced in recent years. In 1993-97, Europe launched 81 NMEs and America 48. But in 1998-2002, the respective figures were 44 and 85, almost an exact reversal.

Exactly how drug-pricing regimes influence innovation is complex—and much debated. According to Bain, research shows that the main economic factor driving where firms locate their R&D is how big, and quick, are the potential profits. That gives America an advantage over Europe, where price controls slow down profit-taking. True, early-stage research can take place anywhere in the world—and big drug firms are increasingly looking to shift this to lower-cost places. (GSK recently linked up to do research with Ranbaxy, a leading Indian drug firm.) But the bulk of costs are incurred in the development phase between early-stage and market. And the process of drug approval remains very much a national, as opposed to global, activity. So it makes sense for firms to put promising drugs on trial in the market where there is most to gain—namely, for now, America.

According to Bain, a proper accounting for Germany's spending on drugs produces an alarming result. In 2002, Germany saved $19 billion because it spent much less per head than America on drugs. On the other hand, says Bain, in the same year, Germany lost out on $4 billion from R&D, patents and related benefits that went elsewhere. It lost $8 billion because high-value jobs went somewhere else—plus the benefits of those jobs from the “multiplier effect”. German drug firms would have made $3 billion more profit if they had kept pace with rivals elsewhere. A further $2 billion was lost as the country shed corporate headquarters and the benefits they bring. The cost of poorer-than-necessary health was $5 billion.

Of course, these calculations rely on some rough and ready assumptions. Even so, Bain arguably errs on the side of caution. It plays down, rather than up, the multiplier benefits of jobs in the drug industry, for instance. In sum, it reckons that Germany's $19 billion saving is in fact a $3 billion net loss. “When you add up all of the costs, the free rider model is actually quite expensive,” argues Mr Rosenburg.