Confronted by the government's plan to impose price controls on hundreds of medicines, Indian pharmaceutical producers recently chose instead to cap the profit margins they make on many commonly used drugs. The government calls it a useful compromise to keep vital medicines affordable, good for Indian consumers and ultimately good for the Indian economy, as well.

However, before the government commits to the new policy, which promises to be extremely complex and difficult to administer—it should consider carefully the disastrous consequences that drug price controls have had for pharmaceutical innovation in Europe. In the decade that ended in 2002, Europe's pharmaceutical R&D spending growth barely doubled, to $21 billion, while the US expenditures nearly tripled, to $26 billion. If current trends continue, the US drug makers will spend twice as much on innovation as Europe by 2012.

At first glance, Europeans seem to be in an enviable position, spending about 60% less per capita on pharmaceuticals than Americans do. Yet, lower drug prices for Europeans entail other costs, which are harder to quantify but equally real. At the heart of Europe's competitive decline in pharma is the dramatic shift in pharmaceutical innovation from Europe to the US. Simply put, innovation has "followed the money."

To get a return on the $1.7 billion currently required to bring a new drug to market, according to Bain analysis, pharmaceutical companies increasingly focus on the US market, which represents the largest and fastest-growing share of the global "profit pool," around 62%. At the same time, the EU has declined in importance, falling to roughly one-third of the global profit pool, despite having a larger population than the US. Pharmaceutical companies now depend on the US as their key source of returns on R&D investments.

Innovation isn't tethered to the economies where products cost the most. So why has the deep US profit pool caused such a significant shift of R&D to the US? First, the US profit pool has been created not only by higher prices and per-capita drug utilisation, but also by government and capital market support of R&D and new drug company formation. Second, major R&D investments tend to be located near to clinical trials, which play a key role as the first step in successful commercialisation.

That makes it appealing to companies to work with key US opinion leaders as they put together trials. Finally, there's a broad symbiosis between US scientists, labs, universities and R&D suppliers that compounds companies' innovation investments when they're made in the US.

The high cost of Europe's approach will be difficult to sustain over the next decade. If current trends hold, Americans will spend four times as much on drugs per capita as Europeans by 2012, a sharp increase from twice as much today and equal spending historically. The same spending patterns will likely cause a further shift in new drug launches. From 1993 to 1997, Europe accounted for 81 unique new drugs, compared with 48 launched in the US. But the situation reversed during the following five years, with the US outpacing EU two-to-one in new drug launches.

Reduced access to new drugs in Europe may be reflected in higher morbidity and mortality from diseases that are responsive to innovative drugs. Europeans are experiencing slower improvements in health outcomes in some disease areas than Americans. In Germany, for instance, 74% of eligible German patients through 2002 were not receiving statins, a key preventive treatment for coronary artery disease. In the US, the figure was 44%. German cardiac mortality declined 8% from 1990 to 2000, while in the US it dropped by 13%.

Breast cancer is another case in point. In 2002, 41% of German physicians treated early-stage breast cancer patients with taxanes—key drugs that target tumor cells. Compare that rate to the US, where 60% of doctors used the drugs in early-stage patients. German breast cancer mortality decreased by 9% from 1990 to 1998, while in the US, mortality dropped by 19% - a striking contrast. In fact, studies suggest that mortality rates correlate strongly with the total rate of introduction of new drug therapies, country by country.

Even without being able to fully quantify the health impacts of lesser and slower rates of introduction of innovative medicines, Germany has paid a price as a result of the innovation imbalance in pharma. Germany gained an annual benefit of $19 billion from lower drug spending, according to our analysis. But the benefit is offset by $22 billion in hidden costs—more than the $3 billion R&D dollars that would have been invested if it kept pace with that in the US; $3 billion in wages; $1 billion in income taxes; $1 billion in taxes from lost corporate centres; and nearly $4 billion in jobs that surround R&D spending - yielding a net loss of $3 billion through 2002.

The calculus will differ for other European countries. But we argue that, in most if not all cases, countries are bound to score a loss, particularly when the full health impacts are taken into account.

Germany's experience illustrates the importance of understanding the full costs of such regulations. Price and margin controls can destroy the ability of Indian pharma companies to invest in essential R&D and remain competitive, particularly as the generic drug business comes under increasing pressure.

The government has proposed a 10-year exemption from price controls for any drug developed by indigenous R&D. But Indian pharma executives are right to question whether this can effectively offset the chilling effect that government intervention has on innovation—and many are sceptical.

Clearly, India needs a mechanism to keep vital medicines available to lower-income citizens. But a policy built around profit margin controls is likely to create more problems than it solves. What's needed is a scalpel, not the blunt axe that the government is swinging today.

(The authors are partners at Bain & Company, and leaders of Bain's Healthcare Practice in New Delhi and Boston)