A renewed debate over health care and pharmaceutical prices flared up in 2016. The Obama White House, dismayed about rising prescription drug costs since the passing of the Affordable Care Act (ACA), wants new powers to regulate the industry. Republicans, industry operatives and free market advocates stand in opposition to the president's plans, claiming the proposed changes will do more harm than good.

The debate may determine the future of health care policy in the United States. Nevertheless, pharmaceutical investors should be alert to potential downward price pressure, no matter the outcome on Capitol Hill.

Argument in Favor of Government Intervention

The Obama administration signed an executive order in January to limit the amount pharmaceutical companies can charge for drugs. By May, Congress began hearings on an overhaul of Medicare Part B to allow greater government control over pricing mechanisms. This would amount to a price ceiling on pharmaceutical products.

The turning point in the drug debate may have been the sudden spike in prices for Daraprim, a treatment for parasite infections, and cycloserine, which is designed to battle tuberculosis. The cost of Daraprim rose from $13.50 to $750 per tablet after being acquired by Turing Pharmaceuticals. Cycloserine jumped from $16.67 per tablet to $360 per tablet once Rodelis Therapeutics purchased its rights. Several other drugs, notably the antibiotic doxycycline, have experienced similar price increases since 2013.

Major news outlets, particularly the New York Times, expressed outrage at pharmaceutical companies and hedge fund financiers for exploiting sick people. Public outcry followed, and Congress spearheaded several investigations into corporate practices. There are legitimate concerns about whether pharmaceutical companies operate as de facto monopolies and are able to restrict supply to drive up prices.

Argument in Favor of Free-Market Principles

It is very difficult to prove the net effect of regulations. Economists cannot run trials before policy experiments. The best economics can do is highlight the most likely outcomes and then look for supporting evidence.

Fortunately, when viewed through this prism, the obvious conclusion – regulations and restrictions limit competition and harm consumers – receives support from the historical results. Using this logic, the government should do less to help lower drug costs, not more. Dean Baker, economist and the co-director of the Center for Economic and Policy Research, says the pharma industry "has all of the problems economics predicts when government interferes with the market."

The U.S. health care cost crisis did not exist before 1965. Until 1964, health care costs rose at nearly identical rates to the Consumer Price Index (CPI), according to U.S. Census Bureau data. Pharmaceutical research costs and drug prices rose an average of 3% between 1935 and 1965, barely above the 2.8% CPI for the same period.

Medicare and Medicaid were enacted in 1965, further removing consumers from the cost of their medications. Thereafter, doctors and hospitals were increasingly reimbursed through cost formulas and received fees for service instead of receiving income based on quality and results. This crippled the vital role of consumer discrimination against high costs or ineffective treatment.

Extreme limits on pharmaceutical competition make matters worse. in 1962 the Food and Drug Administration (FDA) enacted the Kefauver-Harris Amendment, making it much more difficult to receive approval for a new drug. In 1972, the Nixon administration passed laws forbidding the construction of new hospitals without a federal certificate of need. Research from RAND showed the cost of a day in the hospital increased approximately 1,000% between 1972 and 2012.

Prices Would Go Down If Competition Were Legal

It is practically impossible for new entrants to compete in the pharmaceutical industry. In 2003, the Tufts Center for the Study of Drug Development published a study in the Journal of Health Economics titled "The price of innovation: new estimates of drug development costs." It estimated the average cost of bringing a single new drug to market was $1 billion in 2000.

Tufts performed another study in 2014 and found costs were up more than 250%; the cost of introducing a new drug was nearly $2.6 billion. If you include post-approval development expenses, such as indications and dosage strength studies, the actual life-cycle cost was $2.9 billion. The study found an "intense effort by companies to increase efficiency in R&D," but those were more than offset due to the increased complexity of trials and regulatory controls.

The $3 billion it takes to introduce a drug is only the beginning. New companies need a good relationship with the FDA and the U.S. patent office to have any chance at approval. Drug patents are extremely generous, especially after the Reagan administration granted 20-year extensions in the 1980s. The limits on competition strangle innovation. Baker says this government-protected monopoly "allows drug companies to sell their drugs at prices that can be hundreds of time the free market price."

Health care and pharmaceutical costs keep rising thanks to these structural challenges and protected profits. As Game Show Network president and medical author David Goldhill explains, "Accidentally, but relentlessly, America has built a health care system with incentives that inexorably generate terrible and perverse results."

Prices Might Go Down Anyway in the Short Run

The NASDAQ Biotechnology Index fell from above 3,600 to below 2,900 between October 2015 and May 2016. This is more than a 20% decline. Angry consumers and fear of extra innovation may be key drivers of price pressure on pharmaceutical stocks.

In response, health insurers have pushed for so-called "value-based" deals to get price discounts from drug manufacturers. PricewaterhouseCoopers reported that drug prices "reached a boiling point" in the U.S. thanks to pressure from insurers and patients, and that insurance companies can use unfavorable sentiment and declining pharmaceutical equity performance to negotiate lower costs.