When was the last time you saw a news headline announcing that a cancer patient died because she couldn’t afford a drug that could have saved her life? I bet you haven’t. Why? Because it doesn’t happen. At least not in this country. President Trump doesn’t understand the market for drugs. He is not alone. Most people don’t understand it. Here is John Goodman’s contribution to clear thinking:
Part 1
President Trump thinks Americans pay too much for brand drugs. Under his proposal, the U.S. would pay the lowest price for American-made drugs sold to other developed countries. Right now, Americans pay about three times more than the average price paid in OECD countries. So even if we merely matched the average price other countries pay, that would be a substantial reduction. More than one critic has noted that if you limit drug company income, we will get fewer new drugs. But the converse is also true. If we do things to increase drug company profits, we will get more new drugs. The right question is: what is the optimal policy?
My approach to this subject is the same one economists take toward most public policies. It is an approach introduced by Adam Smith, the father of economics. We begin by asking what would happen in a completely free market. Then, we ask whether government intervention of some sort would improve social welfare. By a free market, I mean a market in which companies are free to develop drugs and (once they are found to be safe and effective) charge whatever price the market will bear for the life of a patent. When the patent expires, others are free to produce identical drugs (generics) and charge what is likely to become a competitive market price. Let’s think through this sector by sector.
Drug company behavior
Like any monopolist, drug companies have an incentive to charge a monopoly price—the price that maximizes profits. If they can segregate markets (and prevent buyers from reselling to each other), they will price-discriminate—charging more to those willing and able to pay more. That’s why there are different prices in different countries. Sometimes it is said that drug companies need to charge a high price to recoup the cost of development, which these days averages about $2.6 billion per new drug. But that gets the cart before the horse.
Our Constitution gives the government the power to create patents and copyrights, and the reason is obvious. These short-term grants of monopoly power allow inventors and innovators to get a return on new ideas that have the potential to benefit the public as a whole. However, once the product is invented, development costs are sunk costs. The only thing that matters at that point is the value of the product to people who need it and want it.
Bottom line: there is no relationship at all between drug development costs and the price charged to consumers. Sometimes it is argued that since government funding is involved in the initial phases of scientific discovery, the price charged to the public should be very low. But this is just a variation on the same confusion. Regardless of the government’s role, drug companies are willing to buy the right to produce and sell a drug (from universities and research institutes) precisely because they can charge a monopoly price.
Once the patent expires and many competitors can produce generic versions of the drug, we expect free market competition to bring the price down to the marginal cost of production. Today, more than 90 percent of all drugs purchased in the U.S. today are generic, and their average price is $17.90 per dose.
Public policy implications
From this short overview, there are six things to note.
First, the manufacturers of drugs never get the full social value of their creations.
The typical drug patent lasts 20 years. However, it takes many years from the time a patent is granted until a drug actually appears on the market. On average, a new drug gets patent protection in the market for only 8 years. There are circumstances under which short extensions are possible. But remember, a life-saving drug might go 20 or 30 years before it is replaced by a better drug. What is true of drugs is true of all innovations and inventions. Economist William Nordhaus has estimated that innovators (including drug developers, tech companies, etc.) capture only about 2.2% of the total social value created by their innovations. Arguably, we should be thinking about how to increase the rewards for innovation and discovery—not only for pharmaceuticals but in many other areas as well.
Second, the rate of return in the pharmaceutical industry has to be higher than in other industries.
Critics sometimes argue that the high rate of return earned by drug companies means that consumers are being ripped off. However, bringing a drug to market is not only very expensive with a very lengthy payoff period, the business is also very risky. About 90% of all drugs that enter a clinical trial never make it to the market. If drug companies earned a rate of return no larger than the return on government bonds, no one would invest in pharmaceuticals.
Third, price discrimination in the market for drugs helps improve social welfare.
In Part II we will show that the value of a drug (as measured by people’s willingness to pay for it) in different countries depends on their average income. If government were not involved at all, we would expect to find that different prices for a brand drug in different countries almost exactly reflect differences in income. President Trump seems to think that if drug companies were forced to charge the same price in international markets, the U.S. price would be a lot lower. But drug companies might raise the price they charge other countries and keep the U.S. price where it is. Likely something in between would happen, and that would mean that many patients would be priced out of the market.
The same principle also applies within countries. If a drug company is able, it will charge higher-income patients a higher price and lower-income patients a lower price. If it is prohibited from such price discrimination, lower-income patients will fail to get a drug that could have helped them. This is a good way to understand the next thought.
Fourth, monopoly pricing potentially leaves many needs unmet.
Suppose a new cancer drug is selling for $1,000 a month, but the actual production cost is only $20, Then all of the patients who are willing to pay between $20 and $1,000 will be excluded from the market. That leaves us with unmet social benefits that are well above the social cost of meeting them.
This is probably the strongest argument for government intervention. For example, some economists have advocated replacing the patent system with a system of monetary prizes—under which the government would pay manufacturers for new discoveries and then make the drugs available to the public for prices equal to their marginal cost of production. However, our experience with government regulation should cause everyone to be skeptical. Plus, drug companies have discovered enough ways to price-discriminate to greatly reduce the size of the problem (including copay cards to reduce a patient’s out-of-pocket expenses for those with no insurance or limited insurance). You almost never see a headline about a cancer victim dying because she couldn’t afford the price of her drug.
Fifth, price discrimination creates strong incentives to resell drugs across markets.
It should surprise no one that Americans sometimes buy their drugs in Mexico or mail-order them from Canada. Nor should anyone be surprised when U.S. drug companies warn that Canadian drugs might be unsafe—even though we don’t see Canadians dropping dead after consuming them.
Sixth, other countries are hypocritical.
Outside the U.S., virtually every developed country negotiates the prices of brand drugs with the manufacturers. You might suppose this is out of concern for the health and welfare of their own citizens. Yet when it comes to generic drugs produced in these same countries, they tend to be very protectionist—shielding their generic producers from international competition. Americans pay the highest prices in the world for brand drugs and some of the lowest prices for generic drugs.
In Part II, we look at the decisions made by the buyers of brand drugs.
Part 2
In response to Donald Trump’s invitation to a national discussion on how much we should pay for drugs, I proposed in Part I to take the same approach economists take toward most public policies. That is, we begin by asking what would happen in a completely free market. Then, we ask whether government intervention of some sort would improve social welfare. In Part I, I surveyed the seller side of the market. Let’s now turn to the buyer side.
Buyer behavior
How would people make decisions about whether to purchase drugs and which drugs to purchase in a free market? For low-cost drugs (which includes most generics), they would likely pay directly—probably from a Health Savings Account. Their decisions would be based on a physician’s advice and personal experience.Individuals have different biological makeups. A drug that works for one person may not work for another. How long a drug is needed is also likely to be personal. So, people would purchase drugs the way they purchase any other product. They would rely on experience and engage in personal cost-benefit analysis, occasionally aided by professional advice.
For expensive drugs, people would almost certainly turn to third-party health insurance. In doing so, they would have to rely on the insurer to make collective decisions about which drugs to cover and how much to pay for them. In doing that, the insurer would be doing cost-benefit analysis for the enrollees as a group.
How is that possible?
From the medical research, the insurers would have estimates of the health value of a drug—how many additional years of life it promises, for example. From the economics literature, they would have estimates of the value people place on additional years of life—based on decisions they make in everyday life.
Some readers may object that life is priceless. It may be, but we don’t act like it is. In driving a car, crossing a street, playing sports and in many other activities, all of us take small risks in return for small rewards. Economists have measured these tradeoffs—mainly by looking at behavior in the job market. For example, jobs that have higher death and injury rates pay higher wages. By measuring how much more people have to be paid to take additional risks, economists are able to estimate what is called the “value of a statistical life year,” or VSLY.
Space does not permit a full discussion of all the issues involved (including adjustments for the “quality” of life), but a common estimate is in the range of $150,000 to $200,000 per year of life saved. If a drug promises to save a year of life and its annual cost is less than $150,000 it is said to be cost- effective, or worth what it costs. If it costs more than $200,000, it is said to be not cost-effective.
Note: this is not the same thing as saying that a person’s life is worth no more than $200,000. Instead, it is saying that when everyone is healthy and we all know that we face low probabilities of many different future risks, how much money are we willing to commit today to avoid (or reduce) those risks? Based on decisions people make with respect to other risks in life, it looks like the cutoff point is around $200,000.
This exercise isn’t theoretical. It is already being done by our federal regulatory agencies, including the Department of Transportation (DOT), the Environmental Protection Agency (EPA) and the Food and Drug Administration (FDA). Each of these agencies must make many decisions involving tradeoffs between money and improvements in the health and safety of the public. They can’t make consistent decisions without a standard.
Right now, no health insurer in the US (public or private) uses the VSLY for decision-making. But the British National Health Service does—for drugs and other interventions. The cut-off point for the British is between $25,000 and $37,500 per quality adjusted life-year—a much lower value than American agencies are making for regulatory decisions. Critics argue that these limits are too low. Yet it is interesting that the British government has a standard and that it is very public about it.
Public policy implications
From this brief overview of the buyer’s side of a free market for prescription drugs, we can note five important things.
First, private insurers should be able to adopt the same cost-benefit standard the federal government uses.
Because of perverse regulations, private insurers can’t be counted on to adopt the socially optimal cost-benefit tests. (I’ll address this in Part III.) But there is no reason why they shouldn’t be able to use the same cut-off criteria the federal government uses. Drug manufacturers would know that if the price they are asking can’t meet this criterion, private insurance probably won’t cover their drug.
Second, if private insurers were allowed to use the federal cost-benefit criteria, many state and federal health insurance mandates would have to be repealed.
It is not just drugs that might fail the cost-benefit standard. State governments for years have mandated heath insurance benefits that are not cost-effective. The Affordable Care Act (Obamacare) did the same thing under federal law. An annual cervical cancer screening in low-risk populations, for example, costs more than $1 million per year of life saved. Yet Obamcare requires that it be covered. It is doubtful that Obamacare’s mandated annual wellness exam has saved any lives.
Third, individuals should be able to make private provision for items not covered by their health plan.
Women at low risk should be able to pay out-of-pocket for an annual cervical screening— even if their health plan doesn’t pay for it. But people may also want to buy a separate insurance policy for expensive uncovered services.
This, for example, would be a possible solution for the problems faced by British cancer patients. According to one study, as many as 25,000 British cancer patients die every year because (1) they don’t have access to drugs that are available in other countries and (2) they don’t have access to other complementary care.
Of course, in many cases we may be talking about only a few months of additional life. But different people have different preferences. So why not let them buy “top up” insurance, which would pay for the drugs and also for private care, should the occasion arise? Because the likelihood that it would be used is very small, this type of insurance would probably be very inexpensive.
Fourth, if the private insurance plan is large enough, insurers would be able to negotiate prices.
In a free insurance market, a garden-variety health plan would be a price taker in the market for prescription drugs. That is, manufacturers would quote a price, and the plan would take it or leave it. However, if the plan were large enough, it might be able to achieve bargaining power. For example, if a drug company faced the possibility of losing every one of the people insured by UnitedHealthcare, it almost certainly would be willing to discuss a lower price at the bargaining table.
Fifth, if we allow monopoly on the seller side, we should be open to allowing monopsony on the buyer side.
If a group of businesses got together and as a group tried to force sellers to lower their selling price this would ordinarily be a violation of the antitrust law. However, in the market for drugs, we have explicitly created monopoly. It seems reasonable, therefore, to let buyers be free to combine and form a countervailing force.
In Part III, I will explain why private negotiations will almost always be better than government price negotiations.
Part 3
In the previous two columns, we saw how a free health care market would arrive at prices for brand drugs. In this column I will briefly discuss what the federal government is now doing, why political decision-making faces perverse incentives, why private insurers also face perverse incentives and how we can move in the direction of free market reforms.
Medicare negotiated prices: offers that can’t be refused
Some time ago, the Congressional Budget Office (CBO) investigated whether the federal government could save significant money by negotiating with drug manufacturers over the price of drugs covered by Medicare. The CBO concluded that the government would be unlikely to do much better than private negotiators as long as Medicare covers every drug. In other words, without the ability to walk away from the bargaining table and refuse to buy the drug at all, there is only so much that negotiation can accomplish.
With the passage of the Inflation Reduction Act (IRA), the word “negotiation” becomes little more than a euphemism for price controls. The “negotiated” prices under the IRA are not the result of typical free-market negotiations. The federal government—through the Department of Health and Human Services (HHS)—sets a “maximum fair price” for selected drugs. Any company that refuses to comply with the negotiation process will be hit with an excise tax that starts at 65% of a product’s sales in the U.S. and increases by 10% every quarter, to a maximum of 95%.
As an alternative to paying the tax, manufacturers can choose to withdraw all of their drugs from coverage under Medicare and Medicaid. (This would be like giving up from 40% to 45% of all the manufacturer’s sales.) Also, drug manufacturers are required to pay rebates to Medicare if they increase prices for certain drugs faster than the rate of inflation.
Bad as all this is from the industry’s point of view, the picture could be worse. Under Canada’s compulsory licensing law, the Canadian government asserts the right to produce patented drugs without the permission of the patent holder—and selling the same drug at a lower price. Although this isn’t done very often, the threat must surely be in the back of the minds of industry representatives when price negotiations take place.
The politics of medicine: perverse incentives
In all government-run health care systems all over the world, politicians face perverse incentives to favor the healthy over the sick.The reason: In any given year, in any health insurance pool, about 5 percent of the enrollees will account for about half of the spending. Yet in a democracy it is hard to expect public officials to spend half the health care budget on 5 percent of the voters. In our analysis of foreign health care systems, my colleagues and I found that in country after country a persistent pattern emerged: over-provision to the healthy and under-provision to the sick.
You can see the same pattern in our Medicare system. From its beginning in 1965, Medicare paid for small expenses that relatively healthy people could easily pay from their own resources, while leaving those with serious medical problems exposed for thousands of dollars of out-of-pocket expenses.
This pattern was also repeated in Medicare Part D (drug coverage), which started in 2003. Seniorshad first-dollar coverage for inexpensive drugs, while being exposed to catastrophic expenses if they incurred serious medical problems.
In 2022 the IRA law did provide extra protection for the sickest enrollees. But in deciding which drugs to include in the initial price “negotiations,” the government chose those drugs that were costing Medicare the most money, not the drugs that placed the greatest financial burden on the enrollees.
Private insurance: perverse incentives
Because of unwise regulations, private insurers also face perverse incentives. With one exception described below, no insurer in our health care system wants to enroll a sick person. No employer. No commercial insurer in the marketplace. No Medicaid managed-care plan. And no safety net institution.
Every time someone with an expensive medical problem enters one of these plans, the organization loses money. If the patient leaves the plan (for whatever reason), the plan makes money. If the plan develops a reputation for being really good at handling serious medical problems, it will attract more sick people and incur more losses.
Given the horrible economic incentives that government regulation has created, the surprise is not that some patients experience mistreatment. The surprise is how few there are.
One notable exception to these observations is the Medicare Advantage program.
More than half of Medicare enrollees are now in private health insurance plans. Like everyone else in the country, they pay community-rated premiums that are independent of their health status. But unlike everyone else, their premiums are topped up by Medicare based on individual risk assessments.
As a result, the total premium that the plans receive makes the healthy and the sick equally attractive from a financial point of view.
Free market reforms
As noted in Part II, in a free market for health insurance, companies would use objective data to determine whether a drug was cost-effective. They would publish the standard they use to make these determinations (how much to spend per year of life saved, e.g.). People who are more risk- averse than average could purchase “top up” insurance that pays for drugs not covered by their health plan. Also, different plans could have different cost-benefit standards, provided that these are fully disclosed.
We could do this right now with the Medicare Advantage (MA) program. As suggested in Part II, we could also consider setting aside the antitrust law and allowing the MA insurers to bargain collectively with drug companies as a group. That would allow monopsony on the buyer side to bargain with monopoly on the seller side.
What about traditional Medicare? In addition to the perverse political incentives discussed above, there is another problem: Medicare’s drug coverage and its medical coverage are the responsibility of different insurers with conflicting interests. If a chronic patient doesn’t take his medications, the company insuring the drug gains financially, because it avoids the medication costs. But if the patient shows up in an emergency room because he hasn’t taken the medications, that cost is covered by the insurer of medical care.
This problem doesn’t arise in the Medicare Advantage program because a single insurer is covering all costs. That is why some MA plans make maintenance drugs available to chronic enrollees free of charge. The plans believe that the cost of the drugs is lower than the cost of ER visits and hospital admissions that might occur with noncompliant patients.
One answer to the dysfunctional arrangement in traditional Medicare is to encourage MA enrollment by (1) deregulating and making these plans more attractive, and (2) making MA enrollment the default choice for new Medicare enrollees. Since the MA program has lower costs and higher quality than traditional Medicare, these would be good things to do in any event. A final step is to let traditional Medicare pay the drug prices that are negotiated by the MA plans instead of government negotiation and government-imposed price controls.
Then, we could reform the individual market (where people not on Medicare buy their own insurance) along the lines of Medicare Advantage— a reform Prof. Lawrence Kotlikoff and I suggested several years ago. Something similar could be done with Medicaid managed care.
That leaves the employer market. Space does not permit a lengthy discussion of how to reform it, but Stanford economist John Cochrane has shown how the market for private insurance could function in a way so that insurers do not have perverse incentives to attract the healthy and avoid the sick. In fact, without unwise government interference, that type of insurance would have evolved naturally through free market competition.
Read the original articles on Forbes.com
- In Part I, he asks readers to imagine a free market for drugs, in which drug manufacturers are given a patent for a certain length of time. The patent allows drug companies to charge a monopoly price. But by price discriminating, they insure that almost no one goes without a lifesaving drug.
- In Part II, he asks how free market health insurance would cover expensive drugs. People who are more risk averse would purchase “top up” plans to pay for drugs conventional insurance finds not cost effective.
- In Part III, he shows that both public insurance and unwisely-regulated private health insurance face perverse incentives to favor the healthy over the sick. Reforms are suggested.
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