Basic, applied research, and price negotiation for new drugs

Transcription

1 Basic, applied research, and price negotiation for new drugs Francesca Barigozzi and Izabela Jelovac y This version: 9th May 2018 Preliminary bstract. Pharmaceutical innovations result from the successful achievement of basic research, produced by an upstream lab, and applied research, produced by a downstream lab. In this note, the regulator and the rm producing applied research negotiate the nal price of the drug and they can nance basic research with negotiated grants. We show that the interest of the regulator and of the downstream lab are perfectly aligned and even more strongly so when the lab producing basic research has high bargaining power. Under reasonable conditions, the public/private integration with the upstream lab provides bene ts to the rival negotiator and impairs the merging agents. Public integration of basic research generates the lowest public expenditures and the largest consumers surplus. This result is not driven by e ciency but depends on the appropriate reduction of the two labs monopolistic rents. Keywords. Pharmaceutical innovation, drug prices, negotiation, basic research, applied research. JEL codes. D8. 1. Introduction Pharmaceutical innovations result from the successful achievement of basic and applied research. Basic research generally precedes applied research, which makes use of the fundamentals from basic research to develop tradable innovations and, doing so, translates basic research into operational medical knowledge. pplied research mostly lies in the hands of private companies, precisely because they lead to tradable innovations, while basic research is traditionally nanced by the government or is developed in the public sector. ghion et al. (2008) provides a powerful argument to justify public early-stage research and private applied research. They show that, by serving as a pre-commitment mechanism that allows scientists to freely pursue their own interests, academia can be indispensable for early-stage research. t the same time, the private sector s ability to direct scientists towards higher-payo activities makes it more attractive for later-stage University of Bologna. francesca.barigozzi@unibo.it. y CNRS, University of Lyon, GTE Lyon-St Etienne. izabela.jelovac@cnrs.fr. 2

2 Drug prices, private and public research 3 research. Gonzalez et al. (2016) provide another interesting argument to discuss the pros and cons of private research. They distinguish between breakthrough and incremental innovations. They show that pharmaceutical rms incentives for conducting R&D activities searching for breakthrough drugs are inferior to those socially optimal and that rms devote too many resources to R&D activities that lead to incremental innovations. But the authors disregard the di erent roles played by basic and applied research labs. Nowadays, private forms of basic research are emerging so that basic research takes place no more only in public universities and institutes. In the United States, for example, where basic research was funded mainly by federal government and done mainly at universities and institutes, the government funding has diminished in the 2010s and private funding is increasingly important (see Wikipedia, de nition of Basic science). Independent spin-o s, start-ups, joint ventures appear and independent basic research labs are sometimes integrated in the research department of big private corporations such as pharmaceutical rms (see Versaevel and Billette de Villemeur??, among others). The changing organization of basic research is concomitant with the public debate about the fast raising prices of innovative drugs. In 2015, 118 US cancer physicians co-signed a commentary in Mayo Clinic Proceedings (Te eri, yalev et al. 2015) to raise concerns about fast-increasing prices of innovative cancer drugs. They report the following: In 2014, all new US Food and Drug dministration (FD) approved cancer drugs were priced above $120,000 per year of use. The average annual household gross income in the United States is about $52,000. For a patient with cancer who needs one cancer drug that costs $120,000 per year, the out-of-pocket expenses could be as high as $25,000 to $30,000 more than half the average household income and possibly more than the median take-home pay for a year. They advocate, among other actions, to allow Medicare to negotiate drug prices. Recently, the US administration has adopted the Medicare Prescription Drug Price Negotiation ct of 2017, which amends title XVIII (Medicare) of the Social Security ct to require the Centers for Medicare and Medicaid Services (CMS) to negotiate with pharmaceutical companies regarding prices for drugs covered under the Medicare prescription drug bene t. Until then, the law prohibits CMS from doing so. In France, cancer physicians led by Maraninci and Vernant (2016) have followed their US pairs by launching a petition against rising cancer drug prices. Even if in France, drug prices are negotiated and patients are protected against catastrophic out-of-pocket expenses, prices of innovative drugs are high and increasing. The Cour des Comptes (2017), a French administrative court charged with conducting nancial and legislative audits of most public institutions, recommends to provide the Comité Économique des Produits de Santé, which is the public authority in charge of drug price negotiations, with increased nancial and legal resources to raise its negotiation power. On top of this, Maraninci and Vernant (2016) recommend to take into account not only private R&D expenses when negotiating drug prices, but also the costs of public R&D that contributed to the production of such drugs. In di erent words, in countries with public provision of health insurance, one should avoid that taxpayers rst pay basic research for the development of a new drug and then pay the full price of the new drugs by nancing the health authority when the latter purchase the drug from the pharmaceutical rm. We o er a contribution to this debate by proposing a very simple three-side negotiation model where the health authority, the lab producing basic research and the one producing applied research interact and agree on the investments in basic and applied research and on the nal price of the drug. In our interpretation, basic research represents an

3 4 F. Barigozzi and I. Jelovac intermediate input necessary to nalize a new drug so that it is produced upstream. pplied research is instead produced downstream. This implies that the decision about the amount invested in basic research is always made before the decision about the amount invested in applied research. In addition, the downstream lab negotiates with the health authority the price of the drug. The collectivity attaches some social value to the innovation that enters the payo of the health authority. The monopoly power of the unique pharmaceutical rm is justi ed by some guaranteed protection (patent) of the innovation. Our setting is suited to describe the current situation in many NS-type countries: the public sector can actually in uence drug prices because it partially or totally pays these prices to the pharmaceutical rms. 1 In our model, if price setting was not regulated, the pharmaceutical rm, owner of a patent for the nal innovation, would set a price close to the social value of the innovation net of the public investment in research, so as to fully extract the surplus from pharmaceutical consumption. If instead, the health authority is the unique price decision maker, it would set a price that compensates the pharmaceutical rm for its research investment but leave to the rm only limited pro ts. s expected, we show that the negotiated price lies between the before mentioned two extreme values, at a level that depends on the respective negotiation powers of both negotiating parties. More interestingly, when we analyze the funding of basic research, we consider both public and private research grants, which are also negotiated. The health authority negotiates public grants with the basic research lab and the pharmaceutical rm negotiates private grants with the same lab. We also investigate integration, either private or public, as an alternative to research grants. Private integration re ects the possibility of a merger between the basic research lab and the rm. Public integration illustrates the case of basic research within the public sector. Surprisingly, we nd that the interest of the regulator and of the downstream lab are aligned: both agents are better o when the one with the higher bargaining power is the unique founder of basic research. s an intuition, the timing of the game favors both the health authority and the downstream rm (i.e. the nal negotiators), at the expense of the upstream research lab that would prefer to negotiate a grant with the least powerful negotiator. The alignment of the regulator and the downstream lab s payo s is even stronger when the upstream lab is the agent with the highest bargaining power. In this case, when basic research is nanced by the downstream rm, the health authority bene ts from an increase in the negotiation power of the downstream lab, provided that the latter remains low relative to the negotiating power of the upstream lab. Results from integration complement the previous ones. In the plausible situation in which the bargaining power does not display very important increasing return to merger, the integration with the upstream lab impairs the merging decision makers and bene ts the rival decision maker. The integration between the health authority and the upstream lab generates the lowest expenditures and the largest share of the total surplus for the health authority (which translates in the highest consumers surplus) and is thus desirable. owever the upstream lab, unless incentivated, will prefer not to integrate 1 The recent legislative change in the US in favor of drug price negotiation is likely to in uence prices downwards. This e ect would be even stronger with higher Medicare reimbursements. Indeed, considering that drugs are listed for insurance reimbursement only if prices are negotiated, the (public) health insurer and a drug producer would negotiate lower prices the higher the health insurance reimbursements (Jelovac, 2015). Moreover, as mentioned above, the drug price should not only compensate for the applied research undertaken by the pharmaceutical rm itself, but it should also be discounted for all of the basic research outside the rm.

4 Drug prices, private and public research 5 because integration is not pro table from its perspective. The remaining of the note is organized as follows. The next section describes our theoretical setting. Section 3 shows the general case where drug price, private and public grants for basic research are negotiated. Section 4 introduces the possibility of integrating basic research into either the public sector or the private pharmaceutical rm. Section 5 concludes. 2. The Model Consider three decision makers: public health authority, ; a laboratory B producing basic research b; and a rm producing applied research a. In our interpretation, basic research b represents an intermediate input necessary to nalize a new drug (see also ghion et al. 2008). Thus, lab B produces upstream whereas lab produces downstream. This implies that the decision about the amount b invested in basic research is always made before the decision about the amount a invested in applied research. In addition, rm commercializes the new drug. ence, it negotiates with the health authority the nal price of the drug P, which the public health authority pays to the lab. The basic research lab can negotiate some compensation, X, with the public health agency, which corresponds to a public research grant. Lab B can also negotiate some compensation X from the pharmaceutical rm, which is equivalent to a private grant or to outsourcing of basic research. We assume that a and b represent research activities as well as their costs. The value of innovation to the public health authority depends on the investments in both basic and applied research and we denote it V (a; b). We reasonably assume that the variable cost of producing the pharmaceutical innovation is null and the demand for it is part of its social value. The monopoly power of the unique pharmaceutical rm is justi ed by some guaranteed protection (patent) of the innovation. The objectives of the health authority, the lab and the rm are as follows: U = V (a; b) X P ; (2.1) U B = X + X b; (2.2) U = P X a: (2.3) where X ; X 0 and at least one of the two payments is positive, meaning that basic research must be nanced. We de ne ; B and the negotiation power of the three decision makers. In any bargaining stage, the relative negotiation powers of any two bargaining decision makers must sum at one. The total surplus is thus T S = V (a; b) a b. The resulting e cient investment in basic and applied research maximizes this total surplus by equating marginal cost and marginal bene t : V 1 (a; b) = V 2 (a; b) = 1. We consider that payments P, X and X are negotiated after the investments a and b. This guarantees that all participants choose only the e cient investments in basic and applied research. This is easy to show along the whole analysis and we decide to skip these steps.

5 6 F. Barigozzi and I. Jelovac 3. ow is basic research financed? The timing of the game is as follows. The research lab B rst plans her investment in basic research b. Then, lab B simultaneously negotiates a transfer X with the public health authority and a transfer X with the downstream lab to nance basic research. In a third step, the downstream lab decides to invest a in applied research. Last, and negotiate the nal price, P. Solving the game backwards, we start deriving the nal negotiated price, which is the solution to the following Nash Bargaining Program. max ln(v (a; b) X P ) + ln(p X a): (3.1) P The Nash Bargaining Solution provides the following negotiated nal price: P = (a + X ) + (V (a; b) X ) + : (3.2) The negotiated price thus positively depends on the private contribution to innovation, a and X, and it negatively depends on the public contribution, X. The total surplus from this transaction is shared between the regulator and the downstream research lab according to their respective negotiation power: U = + (V (a; b) X X a); (3.3) U = + (V (a; b) X X a): (3.4) The total surplus so far still depends on the grants X and X, decided two step backwards. In the meanwhile, the downstream pharmaceutical rm decides its investment in applied research a so as to maximize its pro t and the resulting private investment equates marginal cost and marginal bene ts: V 1 (a; b) = 1. In the preceding step, the upstream research lab and the downstream pharmaceutical rm negotiate their transfer X according to the following Nash Bargaining Program: max X ln (V (a; b) X X a) + + B ln(x + X b): (3.5) The resulting best-reply private transfer is: X = b + B (V (a; b) a) X : (3.6) B + B + Simultaneously, the upstream research lab and the public health authority negotiate their transfer X according to the following Nash Bargaining Program: max X ln (V (a; b) X X a) + + B ln(x + X b): (3.7)

6 Drug prices, private and public research 7 The resulting best-reply private transfer is: X = b + B (V (a; b) a) X : (3.8) B + B + Solving the system of equations given by (3.6) and (3.8) for the transfers X and X, we have either X = 0 or X = 0. Speci cally: Lemma 1 (Exclusive nancing of basic research). If the health authority has a larger bargaining power than the downstream lab ( > ), then X = 0, i.e., basic research is exclusively nanced with public research grants. If the health authority has a lower bargaining power than the downstream lab ( > ), then X = 0, i.e., basic research is nanced by the downstream lab only. Given quasilinear payo functions, we obtain a corner solution: the agent with the largest bargaining power is the only one to nance basic research. If the health authority has a comparative advantage in negotiating with the upstream lab, then basic research is nanced by the public body; otherwise basic research is nanced by the downstream rm. This depends on the fact that the health authority and the downstream lab negotiate the price P in the last stage of the game and basic research is an intermediate input in the innovation process. We are now going to study the two possible situations in turn Basic research nanced by the public sector ere the basic research lab receives a grant from the public health authority only. Given that > and X = 0; the decision makers payo functions simplify to: U = V (a; b) X P ; (3.9) U B = X b; (3.10) U = P a: (3.11) Now the payo functions of the two labs are similar, however the distinction between basic and applied research is still captured by the timing: the decision about the amount b invested in basic research is always made before the decision about the amount a invested in applied research. In addition, rm commercializes the new drug and negotiates with the health authority the nal price of the drug P. Substituting X = 0; into (3.2) and (3.8), then solving for drug price P and public grant X, we obtain the following solution: When >, P (1) = a + (V (a; b) a b): (3.12) ( + )( + B ) X (1) = b + B (V (a; b) a): (3.13) B + B + X (1) = 0: (3.14) Subscript (1) refers to the solution to the present case where the basic research lab receives a grant from the public health authority only.

7 8 F. Barigozzi and I. Jelovac The resulting total expenses for the health authority are: P (1) + X (1) = V (a; b) ( ) 2 (V (a; b) a b): (3.15) ( + )( + B ) Each participant then obtain, respectively: U (1) = ( ) 2 (V (a; b) a b); (3.16) ( + )( + B ) U (1) B = B + B (V (a; b) a b); (3.17) U (1) = (V (a; b) a b): (3.18) ( + )( + B ) The comparative statics show very intuitive relationships between solution and parameters. The only unexpected relationship relates to the role of the health authority negotiation power with regards to the payo of the pharmaceutical rm. Indeed, we can show (1) > 0 () ) 2 < B : (3.19) Recalling that this case 1 occurs when > > 0 implies that the following chain of inequalities holds: ( ) 2 < B < B : ence, for U (1) to be increasing in it must be: ( ) 2 < B or B > : To sum up, a necessary but not su cient condition for U (1) to be increasing in is that negotiating powers are such that B > > : We can thus state the following remark: Lemma 2. When the upstream lab has the highest negotiating power and the downstream rm the lowest one ( B > > ), then the payo of the downstream rm can increase with the bargaining power of the health authority. When instead > and ( ) 2 > B, then we are in the intuitive case in which the payo of the downstream rm decreases with the bargaining power of the health authority Basic research nanced by the pharmaceutical rm ere basic research is funded by the downstream rm only. Given that < and X = 0; the decision makers payo functions simplify to: U = V (a; b) P ; (3.20) U B = X b; (3.21) U = P X a: (3.22) Substituting X = 0, into (3.2) and (3.6), then solving for drug price and private funding of basic research, we obtain the following solution: When >, P (2) = V (a; b) (V (a; b) a b): (3.23) ( + )( B + )

8 Drug prices, private and public research 9 X (2) = b + B (V (a; b) a): (3.24) B + B + X (2) = 0: (3.25) The subscript (2) refers to the solution to the present case where basic research is exclusively nanced by the downstream rm. The total expenses for the regulator are given by the nal negotiated price, P (2) in (3.23). Each participant then obtain, respectively: U (2) = (V (a; b) a b); (3.26) ( + )( B + ) U (2) B = B B + (V (a; b) a b); (3.27) U (2) = ( ) 2 (V (a; b) a b): (3.28) ( + )( B + ) gain, comparative statics show intuitive relationships between solution and parameters except for the e ect of the downstream lab s negotiation power on the health authority payo U (2). We can show > 0 () ( ) 2 < B : (3.29) Recalling that this case (2) occurs when < 2 > 0 implies the chain of inequalities: ( ) 2 < B < B : ence, ( ) 2 < B or < B : To sum up, < < B is a necessary but not su cient condition 2 > 0. We can state the following remark: Lemma 3. When the upstream lab has the highest negotiating power and the health authority the lowest one ( < < B ), then the payo of the health authority can increase with the bargaining power of the downstream rm. When instead ( ) 2 > B and <, then we are in the intuitive case in which the payo of the health authority decreases with the bargaining power of the downstream rm. ence, a strong lab producing basic research has unexpected e ects on the negotiation between the health authority and the downstream rm, irrespective of whether the former or the latter decision maker nances basic research. Interestingly, when basic research is nanced by the downstream rm, the health authority bene ts from an increase in the negotiation power of the downstream rm, provided that the latter remains low relative to the negotiating power of the upstream lab. Comparing health expenditures of the public agency in the two scenarios we observe that pays P (1) + X (1) when it nances basic research, while it pays P (2) when basic research is nanced by the downstream rm. Comparing public expenses using (3.15) and (3.23), we show that: P (1) + X (1) 7 P (2) ()? L ; (3.30)

9 10 F. Barigozzi and I. Jelovac which is precisely the case. We can generalize the comparison as follows: P (1) + X (1) 7 P (2) () U (1) 7 U (2) (1) () U B? U (2) (1) B () U 7 U (2) ()? : (3.31) The previous chain of inequalities shows that the downstream lab is better o when the health authority has high bargaining power and funds basic research. In the same way, the health authority is better o when the downstream lab is strong and negotiates with the upstream lab. From the discussions above we conclude that: Proposition 1. (i) The payo s of the health authority and the downstream lab are perfectly aligned: the two agents are better o when the one with the higher bargaining power is the unique founder of basic research. (ii) This outcome is exacerbated when the upstream lab is the "strongest" among the three agents. Part (ii) of the proposition is a direct consequence of Lemmas 2 and 3. The intuition of this result follows. The nal negotiators (the health authority and the downstream lab) are determinant as to how basic research is funded, at the expense of the independent upstream research lab. Indeed, when >, then both the health authority and the pharmaceutical rm are better o with public nancing of basic research, while the basic research lab would prefer to negotiate a grant with the least powerful negotiator, i.e., the downstream rm in this case. On the opposite, when <, then the basic research lab would prefer to negotiate with the public health authority. owever, the latter and the downstream rm prefer to have exclusive private funding of basic research. The outcome from the three negotiations favors both the health authority and the downstream rm, because of the timing of negotiations. 4. Integration of basic research In this section, we analyze whether integration can o er some advantages to any of the three parties involved in the funding and the development of a pharmaceutical innovation. Recall that nancing is always e cient in our model so that integration is not e ciency enhancing, it just a ects the negotiation process. Integration can be of two di erent kinds, either public or private. Public integration represents the case in which basic research takes place in a public lab or in a public funded research center. ccording to our results in the previous section, we expect integration to be public when > ; or when the health authority nances basic research by exclusively negotiating with the upstream lab. Private integration instead, illustrates a situation in which the rm merges with or acquire the basic research lab. In our model, this is relevant when < ; or when the downstream lab nances basic research Public integration of basic research Suppose that > so that, absent integration, the health authority nances basic research by exclusively negotiating with the upstream lab. We ask the following question. Is integration between the health authority and the basic research lab desirable from the perspective of the three decision makers? When the public health authority and the basic research lab are integrated, they jointly decide on the investment in basic research and on its internal compensation (that

10 Drug prices, private and public research 11 will be such that X = b). They also negotiate the nal price, P, net of the private payment for basic research, X, with the pharmaceutical lab. Therefore, the objectives of the integrated public body and of the downstream lab are as follows: U B = V (a; b) P + X b; (4.1) U = P X a: (4.2) The timing of the game is as follows. The integrated public research entity, B, decides its investment in public basic research, b. Then, the pharmaceutical rm,, decides on her investment in applied research, a. Last, the integrated public research entity B and the downstream lab negotiate the nal net price of the drug, P X. Solving the game backwards, we start deriving the nal negotiated net price, which is the solution to the following Nash Bargaining Program, where B is the negotiation power of the integrated public research entity, and is the negotiation power of the pharmaceutical rm: max B ln(v (a; b) P + X b) + ln(p X a): (4.3) P X When and R are integrated, their joint negotiation power is at least as high as their individual negotiation powers: B Max( ; B ). The Nash Bargaining Solution provides the following negotiated net nal price: P (3) X (3) = Ba + (V (a; b) b) B + : (4.4) That is, the higher the public agency s negotiation power, the smallest the di erence between nal price and private research costs. Conversely, the higher the pharmaceutical rm negotiation power, the lower the di erence between the nal price and the value of the innovation net of the public research investment. The total surplus is split between the integrated public research entity and the pharmaceutical lab according to their respective negotiation powers: U (3) B = B B + (V (a; b) a b); (4.5) U (3) = B + (V (a; b) a b): (4.6) In the preceding steps, the public integrated agency and the pharmaceutical lab e - ciently decide on their investment, as described at the end of Section 2. The resulting total expenses for the public integrated body are: P (3) X (3) + b = V (a; b) B B + (V (a; b) a b): (4.7) By comparing the decision makers payo without integration when > (or the payo s denoted with superscript (1) in Section 3.1) with the payo s derived above we nd that: Lemma 4. Suppose that > so that, without integration, we would observe exclusive nancing of basic research by the health authority. (i) Integration always implies lower (total) public expenditures; however: (ii) if B < + B + B, integration decreases

11 12 F. Barigozzi and I. Jelovac the joint pro t of and B and increases the payo of. (iii) if B > + B + B ; then the opposite holds. Point (i) of the previous proposition is not surprising and depends on the fact that no surplus is obtained by the basic research lab when it integrates with the health authority ( X = b). Point (ii) and (iii) show instead that integration a ects the payo s of the decision makers according to whether the bargaining power of the new public body displays decreasing or increasing return to merger. Decreasing return to merger ( B < + B ) is more likely to occur in the real world, implying that case (ii) represents the situation most relevant empirically: the downstream lab is better o after the integration of the health authority with the basic research lab. s an explanation for this counterintuitive result consider that integration reduces the number of negotiations to one, instead of the two negotiations occurring in the case of independent basic research lab. The total surplus is unchanged because e ciency is granted anyway thanks to the nal price negotiation. The only di erence is the sharing of the total surplus among two entities, i.e., the integrated public body and the downstream rm, instead of three. s a result, it is the downstream pharmaceutical rm that gains from the integration between the health authority and the basic research lab if the bargain power of the integrated body is not too high. The public integrated body thus obtains a lower share of the total surplus than if basic research was independent. Recall that integration is not e ciency enhancing in the model and it only a ects the negotiation process. Our objective in this section was to understand whether integration between the health authority and the basic research lab is desirable from the perspective of the three decision makers. To this respect Lemma 4 shows that, unless the increase in the bargaining power displays larger than increasing return to merger (or unless B > + B + B ), integration with the upstream research lab makes the health authority and the upstream lab jointly worse o and the downstream lab better o Private integration of basic research Suppose now that > so that, absent integration, the downstream lab nances basic research by exclusively negotiating with the upstream lab. Is integration between the applied and the basic research labs desirable from the perspective of the three decision makers? When both upstream and downstream labs are integrated, the objectives of the regulator and of the integrated labs are as follows: U = V (a; b) X P ; (4.8) U B = P + X a b: The labs and B jointly decide their investments in upstream basic research X = b rst, and then in downstream applied research a. Last, and B jointly negotiate with the nal price, P and the public grant, X. Solving the game backwards, we start deriving the nal negotiated price and public grant, P + X, which is the solution to the following Nash Bargaining Program. max ln(v (a; b) P X ) + B ln(p + X a b): (4.9) P +X

12 Drug prices, private and public research 13 gain, and R 0 s joint negotiation power is at least as high as their individual negotiation powers: B Max( ; B ). The Nash Bargaining Solution provides any nal price and public grant summing as follows: P (4) + X (4) = V (a; b) + B (V (a; b) a b): (4.10) The total surplus is shared between the health authority and the integrated research rm according to their respective negotiation power: U (4) = + B (V (a; b) a b); (4.11) U (4) B = B + B (V (a; b) a b): (4.12) One step backwards, the integrated rm decides its investment in applied research a so as to maximize its pro ts and the resulting investment equates marginal cost and marginal bene ts. nother step backwards, it decides b e ciently too. By comparing the decision makers payo without integration when > (or the payo s denoted with superscript (2) in Section 3.2) with the payo s derived above we nd that: Lemma 5. Suppose that > so that, without integration, we would observe exclusive nancing of basic research by the downstream lab. (i) Integration always implies lower (total) public expenditures; however: (ii) if B < + B + B, integration decreases the joint pro t of and B and increases the payo of. (iii) if B > + B + B ; then the opposite holds. Point (i) again depends on the fact that no surplus is obtained by the basic research lab when it integrates with the health authority (X = b) and this decreases the health authority s total expenditures. Point (ii) and (iii) show that integration a ects the payo s of the decision makers according to whether the bargaining power of the integrated private lab displays decreasing or increasing return to merger. gain, decreasing return to merger ( B < + B ) is more likely to occur implying that case (ii) is probably the instance more relevant empirically: the health authority is better o after the integration between the two labs. The intuition is the same as before: integration reduces the number of negotiations. The total surplus is unchanged because e ciency is granted anyway, the only di erence is the sharing of the total surplus between the health authority and the integrated labs. s a result, the health authority gains from the integration between the two labs if the bargaining power of the integrated pharmaceutical rm is not too high. The integrated lab instead is worse o. s before, given that integration is not e ciency enhancing, we can conclude that the health authority is better o with integration between the two labs, unless the increase in the bargaining power of the integrated lab displays important increasing return to merger. Combining our results about vertical integration: Proposition 2. (i) In the plausible situation in which the bargaining power does not display very important increasing return to merger, the integration with the upstream

13 14 F. Barigozzi and I. Jelovac lab impairs the merging decision makers and bene ts the rival decision maker. (ii) The integration between the health authority and the basic-research lab generates the lowest expenditures and the largest consumers surplus. Notice that, in this model, the surplus appropriated by the health authority corresponds to the consumers surplus while the surplus appropriated by the private lab(s) corresponds to the producers surplus (and it re ects monopolistic rents). This explains point (ii) of Proposition 2 where we compared the surplus obtained by the public sector and its total expenditures in the two possible types of integration. Speci cally, by comparing (4.7) and (4.10), we obtain that: P (3) X (3) + b < P (4) + X (4) () B > ; B which is always satis ed. The same condition also assures that the public sector receives the higher share of the total surplus (U (3) B > U (4) ), implying the higher consumers surplus. ence, point (ii) in Proposition 2 states that the integration between the health authority and the lab producing basic research maximizes consumers welfare. Part (i) of Proposition 2 complements and extends Proposition 1. From the point of view of the health authority and the downstream lab, the situation in which the rival negotiator interacts and/or merges with the upstream lab is desirable, provided that the integrated agent does not increase its bargaining power too much. More importantly, part (ii) of Proposition 2 provides a new rationale for the public nancing of basic research. It shows that, even in the absence of e ciency gains, in order to increase consumers surplus and reduce negotiated prices for new drugs, the health authority should merge with the upstream lab. Our argument focuses on the negotiation process to set public and private grants for basic research and to agree on the nal price of a new drug. From the perspective of the health authority (representing the interest of taxpayers and consumers) the most pro table sharing of the surplus is obtained under exclusive nancing of basic research and, when the health authority is su ciently strong, integration with the producer of basic research. 5. Conclusion We presented an extremely simple and parsimonious model of price and research grant negotiations. We disregarded e ciency motives and focused on the bargaining process between the health authority and the downstream lab when basic research is produced by an upstream lab. We show that basic research is nanced with public (private) grants if the health authority has more (less) negotiation power than the pharmaceutical rm and that the exclusive nancing of basic research bene ts both the health authority and the downstream lab. Surprisingly, when the upstream lab is very strong, it is even possible that the bargaining power of the health authority (downstream lab) positively a ects the payo of the downstream lab (health authority). Overall this shows that, in the three-side negotiation analyzed in this note, the intermediate negotiator (i.e. the upstream lab) is always worse o while the payo of the extreme negotiators (i.e. the health authority and the downstream lab) are fully aligned. The disadvantaged position of the upstream lab is con rmed in the case of vertical integration. Speci cally, the upstream lab looses from integration (either upstream or downstream), unless the bargaining power after integration displays very high increasing

14 Drug prices, private and public research 15 return to integration. From the point of view of the regulator, the integration with the lab producing basic research is desirable: it reduces public nancing of the innovation and negotiated prices. ence, it increases consumers welfare. But it also decreases the producers joint surplus, so that the upstream lab will not voluntarily opt for vertical integration. Our results are speci c to the use of negotiations to determine pharmaceutical prices and the grants to nance basic research. In the real world we observe di erent possible arrangements as for the nancing and the production of basic research; however, basic research is mainly nanced by the government in many countries or is directly developed in the public sector. Our model suggests that this arrangement increases consumers surplus and reduce negotiated prices for new drugs, provided the public contribution to basic research is appropriately accounted for. Unfortunately, the latter condition does not seem satis ed in the real world, which could explain the dramatic increase in drug prices in past decades. 2 The model also highlights some unexpected complementarities between the payo of the extreme negotiators (i.e. the health authority and the downstream lab) in the negotiation process. Drug price negotiations have been adopted in many countries and the US has just started expanding their use. Given the dominant position of the US in the international pharmaceutical market, the impact of negotiations on the price of drugs may become more relevant in a near future. The setting we propose in this note o ers an appropriate framework to study the e ects of di erent arrangements in the nancing of basic research on negotiated prices for new drugs. It shows how public contributions to basic research should be properly taken into account by the regulator when negotiating prices with the downstream lab. References [1] ghion, Dewatripont, Stein (2008). cademic freedom, private-sector focus, and the process of innovation, RND Journal of Economics 39(3), [2] Cour des Comptes (2017). La sécurité sociale. Rapport sur l application des lois de nancement de la sécurité sociale. Septembre les/ / rapport-securitesociale-2017_1.pdf [3] Gonzalez, Macho-Stadler, Perez-Castrillo (2016). Private versus Social Incentives for Pharmaceutical Innovation, Journal of ealth Economics 50, [4] Jelovac (2015). On the relationship between negotiated prices of pharmaceuticals and the patients co-payment.economics Bulletin 35(1), [5] Maraninci, Vernant (2016). L urgence de maîtriser les prix des nouveaux medicaments contre le cancer. Le Figaro garo.fr/actualite/2016/03/14/24739-lurgence-maitriser-prixnouveaux-medicaments-contre-cancer [6] Medicare Prescription Drug Price Negotiation ct of 2017, S.41, 115th Congress ( ). 2 In practice, the regulator seems to behave according to a model in which, when the negotiation for the nal price of the drug is tackled, the payment X is fully disregarded.

15 16 F. Barigozzi and I. Jelovac [7] Te eri, yalew et al. (2015), In Support of a Patient-Driven Initiative and Petition to Lower the igh Price of Cancer Drugs. Mayo Clinic proceedings 90.8: