Government Demand for Drugs and Drug Prices-Becker

In determining whether governments should use their monopsony power-defined well by Posner- to reduce drug prices, it is essential to distinguish between generics and drugs that are still protected by patents. Generics are produced under competitive conditions because they typically become available only after patents on drugs expire. The production of generics would be inefficiently low if the government used its buying power to force down prices to the government, and to patients, to levels where demand for drugs by patients exceeded the supply of these generics.

Even a government monopsonist can avoid causing such an inefficiently low output of generics if it bought generics at competitive prices, but required generic drug producers to give them upfront payments in order to get their business. This is called two-part pricing in the literature on monopoly pricing, and applies fully not only to government monopsonists, but also to unions that set wages along with employment of their members. However, successful two-part pricing is delicate to achieve, and if used unwisely on generic producers it could force some of them out of business in the long run because they cannot obtain a decent return on their capital investment.

The wisdom of the government’s using its economic power to lower the prices of drugs it buys is even more questionable for drugs under patent protection. The whole purpose of patent laws is to give drug innovators monopoly power for a period of time in pricing their drugs in order to encourage the R&D research that leads to these innovations. The government would be taking away with one hand what it gave with another hand if it then used its buying power to take back some of this pricing power.

A different version of two-part pricing might help even with patented drugs. The government could arrange to pay producers of patented drugs a certain amount upfront if they sold units of the drugs to them at the cost of producing these drugs. Such upfront payments would help offset the large spending on R&D required to discover successful drugs. The major difficulty in this approach is in determining the size of these upfront payments to drug companies, especially when the media and members of Congress would be quick to claim a sell out to powerful drug lobbies.

One reason why companies and researchers in the United States are greatly overrepresented in the development of new diagnostic and therapeutic drugs compared to say Europe (see, for example, the paper by Whitman and Raad “ Bending the Productivity Curve: Why America Leads the World in Medical Innovation”, November 2009, Cato Institute) is that prescription drug prices are about 50% higher in the United States than in Europe. Another factor is that almost half of all pharmaceutical sales are in the US.

Posner recognizes that especially persons under government Medicare and Medicaid are encouraged to buy an excessive amount of drugs relative to their medical needs because their co-payment rates are only a fraction of the total cost to the government. Posner also believes that advertising and other promotion of drugs induce consumers to buy more drugs than they really “need”. Perhaps that is true, although I am doubtful. Stil, both these considerations suggest that the government should force consumers to pay more for drugs under Medicaid and Medicare. Higher consumer prices could induce consumers to eliminate any “excessive” use of drugs. Whether the government could politically get lower prices from pharmaceuticals and yet force many consumers to pay more is surely questionable.

A different reason why investments in developing new drugs may be excessive is that it is hard to deny the use of new drugs once they are developed, even when new drugs are only slight improvements over existing drugs. The difficulty in denying their use may arise from political pressure by the elderly and others who benefit, even if only by a little, from the new drugs. In addition, children who help their elderly parents pay for their medical care may feel “guilty” in not allowing them to consume the latest drugs, even when they add little to their parents health and longevity.

Other considerations, on the other hand, suggest that drug companies may not spend enough on developing new drugs. One is that even elderly people appear to be willing to pay a lot of their own resources for small extensions in their life- see the various Rand experiments on demand for medical care. Persons with serious diseases believe or hope that if they can extend their lives even for a short while, new drugs will come along that will greatly improve their life prospects. This happened during the 1990s for persons with Aids since Aids cocktails developed then that greatly extended lives of persons with Aids. Very sick patients with these expectations would be willing to spend a lot for relatively small initial extensions in their life expectancy.

Another reason why too little may be spent on developing new drugs is that companies with blockbuster patented drugs collect only a fraction of the total benefits to patients, despite the high prices they charge. This is partly because similar drugs are often developed prior to the expiration of the patents of the original drugs.

The net outcome of all these forces is that the American government would be unwise to use its economic power to force down drug prices, unless it used sophisticated forms of two-part pricing of drugs. I believe that in the long run major drug discoveries lower rather than raise medical spending by reducing the need to rely on lengthy hospital stays and expensive surgeries to treat serious diseases.

Comments

[Brian Stone]

Mr. Becker,

Can we use the economic models of other countries which currently exercise this practice as an example? Generic vs. Patent-protected drugs could be looked at individually in this case, I would imagine. It would seem that this would point to the long term success or failure of such a policy.

However, if only "some" countries are exercising their respective monopsony power to drive down the cost for drugs to their nations, as with textbooks, are Americans not actually overpaying above what would otherwise be an economically efficient price?

Lastly, re: advertising, would not the existence of such a prolific amount of drug advertising suggest that demand is highly sensitive to it? I would surmise that this would, at least somewhat, substantiate Mr. Posner's claim that advertising causes consumers to buy drugs that they don't "need." If it doesn't, I would think it would then suggest that Dr's overall have been remiss in adequately caring for their patients (unless we assume that only doctors are receptive to such advertisements; we cannot).

Thank you both for the excellent and thought-provoking analysis.

[Paul H. Rubin]

Posner argues that the purpose of direct-to-consumer (DTC) advertising of drugs is to induce patients to go "over the heads of physicians." But there are substantial health benefits of DTC advertising. Patients may have information about diseases or symptoms that is not available to physicians. They may also have treatable conditions that they do not know are treatable, and so for which they will not consult a physician. There are numerous other possibilities as well. In a recent review, Adam Atherly and I found that the best evidence to date is that this advertising is in fact cost effective: Adam Atherly and Paul H. Rubin, The Cost-Effectiveness of Direct-to-Consumer Advertising for Prescription Drugs, Medical Care Research and Review, December 2009; 66; 639.
http://mcr.sagepub.com/cgi/content/abstract/66/6/639

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[Jack]

The case our proffs make for just paying the rack rate for prescription drugs and extending them government protection from virtually any competition has me reflecting on the time when we had only the Big Three auto companies and at great cost Ma Bell supplied us with clunky black dial telephones and would not even allow us to connect other products to "their" lines.

Had we not broken ATT's choke hold on telecomm where would we be today in terms of either tech improvements or the cost of communicating?

Do we even know what is going on in the economics of drug sales? If, say Canada employs its "monopsony" power in buying drugs from a US company for one third the cost to the US provider, I'd assume that the negotiated price covers at least the marginal cost of providing product to Canada, while as Brian points out we overpay.

The question comes up as to whether we lose our "trust in both capitalism and what appears to be a highly selective "globalism". For example from a technical standpoint the computer chip and software biz seems much like that of the drug industry. Both spend billions before making a dime on a new product and the profits are made in serving the widest possible consumer base before something better comes along.

Becker seems to depict a scarcity model in refs to the "very sick.... being willing to pay" etc. Interesting. In the computer biz model the "need" and profitability of a computer might be great for Google or another big business, but the price paid is much the same as it is for a teen for whom it may be nothing more than a toy.

(I understand some drugs may be costly even when produced in the millions but most do fall in cost as we see once the generic comes out.)

Currently the VA is "allowed" to price shop (I believe only within the US for most drugs) and pays less than half what the price-fixed deal for Medicare costs. So what would happen were Medicare allowed a similar freedom? Surely they'd pay somewhat less and squeeze the mfg somewhat. But, assuming that the monopsony power of other nations was not absolute wouldn't the drug company offset their lower margins on Medicare with a somewhat higher (than today) price in Canada and other nations much as would Microsoft or Intel?

Any discussion of "markets" are completely confused in the US by "insurance" companies and Medicare/VA etc paying most of the bills. But the matter of US citizens paying a LOT more than those in other nations is not trivial. Increasingly out medical care dollar goes to prescription drugs and as our overall H/C costs are half again higher than Germany and nearly double that of some other nations the costs have become a problem affecting our ability to compete in a global system we designed and promote.

Domestically perhaps it's even worse. Becker and Posner both wrote on "job creation" of further pounding down wages (at the lowest rungs of course) so the employer could "afford" to hire more workers. Leaving out for now the silliness of $7 jobs that pay less than half of a basic std of living for one person, the ability of the low income worker to pay inflated costs of drugs becomes impossible by any scheme other than yet another direct subsidy.

[Brian Davis, Austin, TX]

I do NOT understand why Republicans have failed to make it THEIR issue. It's like what Ronald Reagan said about the cigarette companies after he was out of office, that if he'd had it to do over he'd have called in Big T's execs and told them they had X years to deliver a cure for nicotine addiction or they'd be taken apart. 100% T.R. Rooseveltish conservative as far as I'm concerned.

[blake]

I really think that the subsidies we agree that pharmaceutical companies should get for developing new drugs should be overhauled from start to finish. They are in the same boat as the creative content producers in that they are currently rewarded with a monopoly over their product. When marginal cost per consumer was relatively high this model worked well, it's a hard system to game if no one wants your product. But The System Is Not Working Well Now. The price points monopolies set if they are maximizing profits are nowhere near the resources the marginal user consumes. Rational monopolists price a lot of people out of the market. And where pricing poor people out of music is just kind of a crappy thing to do, pricing people out of the best drug for them is... suboptimal at best. Not what government subsidies should be designed to do. Enforcement of monopoly rights is a subsidy, and one that is getting more and more expensive and complex every day.
A whole separate issue is raised by the fact that consumers in these markets often want the best product with not much regard to price(a problem especially bad if insurance is footing the bill). This means that companies tend to over-invest in products only marginally better than their near competitors, and under-invest in smaller markets where they would really make a big difference. And differences in marketing can sway the scales, leading to almost comic over-marketing in both fields.
These are all pointless market distortions, and I think it unlikely that any sensibly designed alternative subsidy would be worse than the status quo. I would recommend some kind of review process for how good a product is relative to competitors, multiply that by it's market share and give the producer that share of the pot of money provided by the government. I'd say a carbon tax to provide the pot, and all content goes free and all drugs are at cost to produce. It's a bit extreme, and it would need to be watched for corruption, but I bet it would work better than what we have now. It's not like that's not corrupt.
Blake

[Pentagron]

(1) There is not a free market in generic drugs (that is, the pricing of generic drugs is no longer typical of other commodity products). Generic companies price their products only slightly below branded competitor products. Because of the price sensitivity of buyers, they are able to capture substantial market share even with minimal underpricing. Given the enormous margins, the generic pharmaceutical business is highly profitable. Teva, the largest generic manufacturer, reported profit of $1.1 billion in 2005 and $2.5 billion in 2008. The recent quarterly numbers indicating that this rapid growth in earnings is accelerating.

(2) I disagree with the assertion that the U.S. Government would be unwise to force drug prices down. The current arrangement where U.S. consumers fund the bulk of drug research and development because the U.S. is virtually the only unregulated market in the developed world is clearly unsustainable. Like every bubble it will correct and it is better that it corrects sooner rather than later (if only because the current arrangement is grossly unfair to U.S consumers). When it corrects, drug innovation will not stop. There will no doubt be continued global demand for new medicines. If the U.S. Government were to level the playing field by instituting price controls as in other developed countries, this would hasten the development of sustainable financing models where the cost of drug development is distributed more fairly across the global population. It seems highly likely that this will lead to more not less *real* innovation. Marcia Angell has argued that much of what is touted as innovation by U.S. drug companies, such as the development of me-too drugs, adds virtually no value for patients. When different economic conditions apply, pharmaceutical companies will adapt. Governments will be able to change the rules of the game to insure read advances for patients.

(3) It is illogical to assert that higher prescription drug prices and greater per capita pharmaceutical sales in the U.S. than in Europe are the reasons behind the purported greater productivity of U.S. drug companies and researchers. Actually, European (and indeed global) pharmaceutical innovation is largely driven by the profit opportunity in the U.S. The U.S. market should have the same influence on European companies as it does on U.S. companies. While it is true that academic biomedical research productivity is far greater in the U.S. than in Europe because the U.S. NIH spends vastly more on biomedical research than do EU countries, it is doubtful that U.S. pharmaceutical companies are truly more innovative.

[Jack]

Pentagon..... Amen! I was just mulling over the problem of a pharma model that would tend to find the sweet spot of enough profits to fund adequate (and productive) research while not unduly burdening a population much of which has no wage growth with few having wage increases on par with escalation drug and H/C costs.

Some of this "research" is targeted more to income generation than the welfare of the patient, as in re-patenting a once a day pill as the twice a day pill becomes generic.

Becker suggests higher copays for those on Medicare/Medicaid to "lower costs". Interesting. To further a scarcity model on the backs of those in their declining or low income years? And apparently trying to justify the lobbyist and political arm twisting model of locking in full retail for all the drugs purchased by Medicare?

Isn't there likely to be a sweeter equilibrium spot further to the right on a supply demand chart that gins up more volume for the drug company, with lower cost per unit for the consumer and the taxpayer who funds Medicare? Going back to my Intel argument, where would we be today if government purchases of computers had been price fixed at full retail?

The sum of their essays seems that of heavily favoring the "needs" and "wants" of the drug companies at excessive costs (and most likely inefficiency) to the consumer and taxpayer.

Lastly, Ha! for now! I found the following "interesting":

Becker:
"Another reason why too little may be spent on developing new drugs is that companies with blockbuster patented drugs collect only a fraction of the total benefits to patients, despite the high prices they charge. This is partly because similar drugs are often developed prior to the expiration of the patents of the original drugs."

............. Isn't that progress and the purpose of capitalism? Arguably every product sold is of more benefit to the consumer than the price paid, otherwise the sale would not take place. But more to the point, does Intel, MSFT, GM, or Campbell Soup expect to collect a price related to the total benefit to the "patient?"

Well, we know we've no functioning "market" in either H/C or prescription drugs which means that WE will have to seek the "sweet spot" by other means. Admittedly a risky game considering what happened in Congress at 3:00 AM at the hands of legions of money laden lobbyists representing, not the public at large, but narrow special interests with much to gain and price-fixing ALL of the drugs sold to Medicare to be paid for by the taxpayers.

[Gordon Longhouse]

Australia has a monoposonistic pharmaceutical benefits program whereby the government negotiates a (significantly lower) price for prescription drugs on behalf of the public. Drug companies may sell outside the scheme for a higher price to those willing to pay but as a practical matter seldom do so.
The major complaint that big pharma seems to have with the program is that access to it is limited by the government only offering to buy one drug of any given category, only adding a drug to the program where the manufacturer is able to demonstrate that the drug brings additional benefits to patients over those currently in the market. The drug companies want access to the program for drugs similar to those on the market but that are judged insufficiently innovative.
Brand name advertising of prescription drugs is prohibited though "awareness campaigns" along the lines of "ask your doctor about new treatments for arthritis" are permitted. They mustn't be very effective as they are not nearly so widespread as prescription drug advertising in the US.

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We know we've no functioning "market" in either H/C or prescription drugs which means that WE will have to seek the "sweet spot" by other means. Admittedly a risky game considering what happened in Congress at 3:00 AM at the hands of legions of money laden lobbyists representing, not the public at large, but narrow special interests with much to gain and price-fixing ALL of the drugs sold to Medicare to be paid for by the taxpayers.

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