The Price of Lower Drug Prices

The United States has been rethinking the long-standing market design that has governed how it pays for branded prescription drugs. With the drug pricing provisions in the Inflation Reduction Act (IRA) and continued interest in Most Favored Nation (MFN) pricing, the U.S. is testing forms of government intervention in the pricing of branded prescription drugs that fundamentally disrupt the market-based norms that have guided drug pricing, the incentives for drug development, and the incentives for generic drug entry. As these policies and proposals take shape, it is worth considering the market design that governed branded drug pricing before these shifts and what we may be leaving behind.

Pharmaceutical Market Design Before IRA and MFN

Historically, the U.S. pharmaceutical market has followed a market-driven, two-part design shaped largely by the Hatch-Waxman Act. Enacted in 1984, the Hatch-Waxman Act strengthened incentives for novel drug development through patent protections and exclusivities (part 1) and created the legal framework that encouraged timely generic entry once these protections expired (part 2). This two-part design provided innovators and investors with a reliable period of time to attempt to generate a return on their investment at market-based prices and provided a reliable pathway for low-cost generics to enter afterward so generic competition could work to sharply decrease prices.

This market design is widely credited with supporting the United States’ global leadership in biopharmaceutical innovation while also producing one of the world’s highest generic dispensing rates because it balances the incentives for novel innovation with the need for affordability over time. On the innovation side, Hatch-Waxman strengthened the effective period of market-based pricing through regulatory exclusivities and restoring some of the patent term lost for certain patents due to clinical trials and the regulatory review process, allowing up to 14 years of effective patent life for that patent after approval. These incentives have spurred investments in both new and improved biopharmaceutical innovations for decades. Periods of protection incentivize innovators to continue to invest in the research and development required to bring new medicines to market which, in turn, produces new medicines for society and yields low-cost generics that can continue to improve health over the long term.

On the affordability side, it created a streamlined, low-cost pathway for generics to seek FDA approval and a process for challenging patents in federal court prior to expiration without risking liability for patent infringement damages. Importantly, it also further incentivized competition by encouraging generics to be the first applicant to challenge an innovator’s patents, granting them a 180-day market exclusivity period during which later filed generics cannot launch. This first-to-file incentive is often underappreciated. Although it limits the number of generic competitors for 180 days, it offers these first generic filers a temporary period during which prices typically remain above the marginal cost of production and thus can earn substantial profits. The prospect of this higher-profit window motivates multiple generic manufacturers to attempt to be the first-to-file, which positions the market for rapid multi-entrant competition over time. It is this multi-entrant generic competition that works to drive prices toward the marginal costs of production and promote long-term affordability.

How the IRA and MFN Disrupt the Pharmaceutical Market Design

The drug pricing provisions in the IRA and proposals like MFN represent a fundamental shift in the long-standing design of the U.S. pharmaceutical market. These policies and proposals now involve government price intervention during the period when innovators and investors have historically counted on market-based pricing. Although these market disruptions might result in lower branded drug prices for a period of time and for a portion of the population, they alter the incentive structure that has supported both novel innovation and timely generic entry.

There is already extensive analysis around how the IRA affects the incentives for new medicines. Research has already shown a decrease in the development of novel medicines targeting Medicare-aged individuals and a decrease in post-approval research to study medicines for new uses and populations. Analyses have already quantified how shortening the effective period of market-based pricing reduces the expected net present value of investments in drug development, which subsequently impacts investor decision-making. While the evidence around MFN-type policies is less developed, the negative impact of MFN proposals is likely to be even greater if MFN-type policies apply earlier in a drug’s lifecycle, extend beyond high-spend products, and reach payer types outside of Medicare. Collectively, these would likely amplify the effect on revenue and potential returns and thus incentives for novel innovation.

But incentivizing novel innovation is only the first part of the pharmaceutical market design. The second part—timely and robust generic entry—is also essential. And now there is growing concern on how these policies may weaken the incentives for generic and biosimilar manufacturers to enter the market. If generic entrants now must compete with a government-regulated price that is lower than the historical market-based price, the potential return for being the first to file could diminish. And even if generics enter, their ability to gain market share is critical for lowering prices and sustaining future generic investment. Yet the IRA requires Medicare Part D plans to cover branded drugs with a maximum fair price in effect, which could limit the market share capture of the first generic to enter and further erode the returns and incentives for the first filer. Generic entrants are almost always covered on a generic tier and preferred over the branded version, but the presence of the branded drug at a maximum fair price could disrupt this long-standing dynamic. If the incentives for being the first to file diminish, the competitive race that drives multi‑entrant generic competition could slow.

How the IRA and MFN Could Reduce Generic Entry

Research has shown that products with higher branded sales attract more generic competitors. Using data from 1995 to 2019 reported in Figure 2 of this published article, I estimated a linear relationship between the branded sales in the year prior to first generic entry and the number of generic entrants within the first year of generic competition. I estimated that for every additional $140 million in branded sales the year prior to generic entry, there is approximately one more generic entrant. The sales of the branded market is a predictor of how many generic firms are willing to invest in entering.

I acknowledge that the precise magnitude of how generic entry might fall if pre‑entry branded revenues decline is uncertain, but the direction of the effect is likely not. Policies like the IRA and MFN are designed to reduce branded drug spending, which will shrink the annual revenue pool that generic manufacturers use to inform if entry is financially viable. Similar to the well-studied relationship between revenues and novel pharmaceutical innovation, the relationship between branded revenues and generic entrants is neither zero nor inverse. Any push to reduce branded drug revenues should also consider the tradeoff of reduced generic entry.

Why should we care?

Policies that alter the design of the pharmaceutical market risk weakening the incentives that sustain both novel innovation and generic competition. If the incentives for generic entry are weakened, so could the long-term engine of affordability. Generic drugs have delivered enormous societal value: they intensify price competition, build supply chain resilience that reduces the risk of shortages, and increase access to people who could benefit from them. They are also responsible for making the innovation cycle turn. As pharmaceutical products lose exclusivity and generics enter, not only do prices fall through competition but biopharmaceutical companies must then develop new medicines to replace their lost revenue. Society benefits twice—first through affordable access after exclusivity, and again with the arrival of new medicines.

Generic competition and new medicines can impact the entire population, and thus the consequences of weakening these incentives extend beyond the specific population groups that may be targeted by certain policies and proposals (such as people enrolled in Medicare or Medicaid). Short‑term savings for a subset of the population may come at the expense of long‑term losses in both novel innovation and generic entrants which could impact a much larger population.

Although the precise degree to which policies like the IRA or MFN could weaken the incentives for generic competition is not yet known, that uncertainty should give policy makers pause. Before adopting policies that could alter the incentives in the pharmaceutical market, we need clear evidence that any immediate reductions in branded drug spending outweigh the broader, longer‑term costs to affordability, competition, and medical progress.