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Call in the Economists!

Stephen Maurer, Adj. Em. Prof. of Public Policy | December 17, 2009

The health care debate has so far produced remarkably little in the way of cost-saving strategies.  Instead, there has been a kind of placeholder claim that “single payer” will do the job.  Certainly, it is not hard to see how “single payer” will cut prices for some people.  After all, when hospitals treat the uninsured gratis someone else (usually insured patients) has to pay.  But however desirable, fixing the current robbing Peter to pay Paul system isn’t  the same thing as cost-containment. If the country is going to buy health care for everyone, transfers between individuals will wash out long before the bottom line. And it’s hard to see how “single payer” can contain costs for the country as a whole.

This is not for lack of ideas.  Economists, after all, spend enormous amounts of time thinking about ways to organize markets so that consumers get the lowest price.  But this sort of thinking has only very occasionally permeated Congress’s healthcare debate – mostly in talk about letting insurance companies compete across state lines.  Unfortunately, that suggestion barely  scratched the surface, and nobody has talked about it for months.

The other day, though, the Democrats suggested (and almost immediately dropped) a genuine market intervention  — Letting Americans buy their medicines from countries where drug prices are lower. Superficially, this idea is so wrongheaded that it looks like the worst kind of political pandering.  After all, the patent system is supposed to give innovators a profit and this can only be done if they are allowed to charge much higher prices than their manufacturing costs. The fact that Europeans routinely demand that Big Pharma sell them drugs at prices that barely cover manufacturing costs subverts this model. Letting Americans buy their drugs from Europe would make things worse by driving our prices down too.  At that point, the argument goes, the US patent system wouldn’t provide any R&D incentive at all.

Look at the argument more closely, though, and you start to see a loophole. Ten years ago, the average per-drug cost of discovery was estimated at $800 million.  If US prices fall, it’s pretty clear that Big Pharma will stop funding discovery at that level.  But does this mean that drug discovery will stop entirely?  Probably not. The $800 million figure is surely one possible level of investment, but it’s not the only one.  Biologists with sharp pencils routinely estimate that it would be possible to fund a bare bones drug discovery program for much less  — typically $200 to $300 million. Why, then, does Big Pharma insist on paying more?  Because current patent rewards are so large that companies race each other to see who can develop drugs first.  The $800 figure, in other words, is not some immutable number fixed by biology.  Congress set these rules and, if it wants to, Congress can change them.  If Congress really wants, say, a $600 million per pill all it has to do is change the law.

There would, of course, be a tradeoff.  Our world of $800 million pills may be deep into diminishing returns, but it does deliver drugs (slightly) faster and (a little) more reliably.  Dialing back patent incentives would give up those benefits.  Would this qualify as (gasp) rationing?  I don’t see how. After all, Congress could also increase current patent rewards if it chose to.  Does that mean that the current, $800 million level of effort qualifies as “rationing?”  Perhaps.  But if so, what number would not?

The obvious way for Congress to fix patent incentives is to rewrite patent law or, more precisely, the Hatch-Waxman Act that fine-tunes US drug discovery incentives.  On the other hand, rewiting the law to reduce drug discovery incentives poses obvious political dangers.  And 2010 is an election year.

Could buying drugs from Europe achieve the same result?  Not if US prices fell and Europe’s stayed where they are.  But there is hardly any chance that this would happen.  Notoriously, Europe likes the current system because it gets the best of both worlds — low drug prices and intensive US-fueled drug discovery.  Let the US buy drugs from Europe, though, and Europe will have to stop free-riding on America’s high prices.  Then Europeans who want continued drug discovery will have to pay higher prices themselves.  Here the political good news is that — unlike their US cousins — Europe’s politicians already have plenty of practice debating health care tradeoffs.  “Rationing” accusations don’t play well in Brussels.

Readers should rightly worry that this kind of political misdirection – allowing Americans to import drugs instead of simply rewriting Hatch-Waxman — too often ends in a plumber’s nightmare of unintended consequences.  And it’s true that the scheme would force the US to play  chicken with Europe over how much profit drug companies should earn.  Based on Washington’s recent suggestions for health care legislation, though, this particular detour is hardly “messy” at all. Not that it’s a panacea.  High pharmaceutical prices account only account for about ten percent of the gap  between what that Americans pay for health care and the world average.  Still, if Congress really does mean to contain costs this would be as good a place to start as any.

I don’t mean to be naive about these things, and it’s easy to find press reports which claim that Congress doesn’t want to contain costs — if they did, who would buy off the drug companies and the doctors and other groups whose support is needed to pass a bill?  On the other hand, I’m not a Beltway insider so I can’t really say what Congress is thinking.   What I do know is that if Congress wants to squeeze the drug companies (and then the doctors, and then the insurers …) there are plenty of similar marketplace strategies it ought to consider.  If Congress is serious, it needs to start tapping what economists know about markets and procurement.

Comments to “Call in the Economists!

  1. That is pretty interesting comparing health care with what an Economist would do. I agree in a lot of aspects, however I do think that the pharmaceutical companies are making pleanty of money with all these drugs they are creating. Although I do believe medicine to be of value to us, sometimes I question why some of these drugs are legal on the market when they cause so many side effects.

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