Monday, October 25, 2004

The Bush Health Care Plan

Having concluded that Kerry's plan is at best a shifting of health care costs from the poor to the wealthy, with no reduction in the cost structure, and at worst, a costly mistake that will increase both the budget deficit and the cost of health care, the question turns to the Bush plan. Does the President's plan succeed where Kerry's fails? Let us start by examining what the Republican Congress has and has not already done.

As the Democrats have delighted in pointing out this campaign season, the Republican Medicare prescription drug benefit contains a "doughnut hole" which provides no coverage between $2500 and $5100 in prescription drug costs. This is partly a cost-control measure, as to fill this gap would cost hundreds of billions of dollars above and beyond the initial $410 billion price tag over the next 10 years. But the second, and perhaps more important reason for the gap is control of demand.

Professional sports have often imposed a luxury tax on salaries over a certain threshold, as a means of reducing incentive to overspend. By doing so, the marginal cost of each additional player added beyond this threshold rises, while the marginal improvement to the team remains the same. In essence, the luxury tax makes owners think twice about whether a player is worth 1.25-1.5 times the cost to a team under the cap. Sometime the answer is yes, and the team makes the signing anyway. Sometimes the answer is no, and the team must either rearrange its existing personnel to make room under the cap, or do without that player.

A similar force is at work under the Medicare prescription drug benefit. The new system has provided a powerful economic incentive for seniors to keep their prescription drug costs to $210/month or less. Those who are unwilling or unable to do so will have to choose between paying addtional costs (i.e. full price drugs), or purchasing secondary insurance to bridge the gap.

Some will see in this a new tragedy: the senior forced to choose Zocor instead of Lipitor in order to reduce drug costs. But is this a new tragedy, or merely a more humane reworking of the old one, in which the senior had to choose between Lipitor and groceries? And is it such a tragedy that seniors should, like all Americans, have to take into account for the expenses associated with their medicines? As a taxpayer who has no expectation that Medicare and Social Security will be solvent in its current form when I retire (assuming that the U.S. doesn't impose sweeping tax increases of the like never seen in this country), I say the answer is a resounding no.

Then there is the reimportation issue. The fundamental reason that this is an issue is the unfairnesses inherent in a system in which many industrialized nations (Canada, New Zealand, most of western Europe) have imposed price controls, while the U.S. has not. Effectively, United States consumers subsidize the costs of medicines exported to other countries. This might make sense with respect to the developing world, but from nations like Canada, with whom we have a free trade agreement, such legislation is deeply disappointing and unfair.

Some would suggest that the solution is to impose controls of our own. However, as any Intro to Economics student can tell you, depressing prices merely results in reduced supply. In the case of pharmaceutical products, that depressed supply will come in the form of reduced research and development, not reduced sales of existing products, so we won't actually know what we are missing, specifically, but what we will be missing is nothing less than the next generation of "wonder drugs" that have improved and extended our lives again and again over the last 50 years.

But what if America were to legalize reimportation? The immediate impact would be to reduce prescription drug supplies in Canada, as drug companies would doubtless choose not to increase exports to Canada to meet rising demand. Canadian voters would respond with outrage to American "poaching" of their needed medicines. (Excuse me for saying so, but this is hardly the kind of move that will make us well-liked in the rest of the world.)

Adding New Zealand and Western Europe to the list does nothing to change the basic structural problem with this plan: pharmaceutical companies will refuse to increase exports to countries with price controls. Allowing reimportation would briefly give these price-controlling countries a taste of their own medicine (excuse the pun) and a glimpse of the true costs of their price controls, up to this point disproportionately borne by the United States. For this reason alone, it might be worth legalizing reimportation.

Perhaps some of these counties, reaping the famine their policies have sown, might reconsider the wisdom of such controls, and the market would be allowed to right itself, to the point of equitable treatment for all. But the most likely result of reimportation legislation would be a unilaterally reimposed prohibition from the Canadian side, which would be much more difficult to circumvent for American consumers, after which we'd quickly return to our current equilibrium, with little or no impact on drug prices. In short, passing a law allowing reimportation of drugs is largely symbolic, and would have little practical value, as the countries adversely impacted by shortages would almost certainly change their laws to ensure that cheap drugs only flow into the country, not out.

Now that we've laid this groundwork, we can examine the plans of President Bush for lowering healthcare costs in their appropriate context. Bush's plan consists of four parts: first, reduce the duration of exclusive patent rights by closing the loopholes that allow pharmaceutical companies to keep generics off the market, second, encourage tax-free health care savings plans, third, improve the ability small businesses to collectively bargain for reduced health insurance rates similar to those available to large corporations, and fourth, reform a legal system that adds tremendously to the costs of doing business in healthcare. Let's begin with drug patent rights.

A company's exclusive patent rights on prescription drugs are among its most valuable possessions. Once generics enter the market, costs quickly approach "ideal" profit/cost ratios. That is, a company is forced to charge a price close to the production costs summed with distribution and other overhead costs, with the addition of a small percentage profit. This shift in price structure is driven by the competition of generics, which attempt to profit through scale of operation and market share, not through higher margins. A "brand name" will still cost extra, but the replacement good in the form of generics places an upper limit on the price a drug company can charge within the market.

For example, if a company has exclusive patent rights to a drug that is proven to stop the spread of stomach cancer, with more manageable side effects than its competitors, it can charge practically any price it wants, because there is no price (within reason) that a patient with stomach cancer is not willing to pay for such a product. However, once a generic equivalent of that product emerges, the patient may still be willing to pay a small premium for the familiar name, but as price diverges from the "ideal", the generic will take a larger and larger share of the market. Thus, the typical drug company makes perhaps 90-95% of its profits on drugs for which it holds exclusive patents.

Patent durations, unlike the products themselves, are not protected property under the Constitution. The Constitution allows the Congress the right to grant exclusive licenses of a limited duration, but gives neither an upper nor a lower limit to that duration. Thus, pharmaceutical companies are subject to the needs of the marketplace in the duration of their patents. If it is deemed to the benefit of society to do so, patents can be limited to one week or extended to 100 years. Bush states that in his second term, he would reduce the length of patents in order to increase the flow of generic drugs, thereby lowering prices through competition. But what hidden impact could we expect in the aftermath of such a change?

First, reducing the length of patents (or at least limiting the patents to their intended lengths), will force drug companies to reevaluate the rewards of research. Suppose that it costs a given company $10 billion dollars in research & development, production & distribution, and advertising to develop and sell products that produce $40 billion dollars in sales over 15 years of exclusive patent rights. That represents approximately 10% Return on Investment (ROI), assuming that profits and research and development costs are distributed over that timeframe at a roughly proportionate rate. (Side note: In reality, sales slowly increase over the product lifecycle, while the costs are bunched at the beginning and middle, so that the rate of return would be somewhat lower, taking into account the opportunity costs associated with investment.) At a rate of 10% ROI, profitable pharmaceutical companies have investors lining up around the block.

Let's imagine that patent rights are reduce to 10 years. R&D costs will remain fixed, distribution costs will be reduced proportionately to the reduction in sales, which I will assume to be about 30%, and advertising costs will be reduced by approximately 20% (as rollout composes the largest proportion of advertising costs, ending the patent early should not reduce these costs proportionately). Assuming that $3 billion goes to R&D, $2 billion goes to production & distribution, and $5 billion goes to advertising, that means the costs will decrease by approximately $1.6 billion (16%). However, sales were reduced by 30%, and that means profits will drop from $30 billion over 15 years ($40 bil - $10 bil) to $19.6 billion over 10 years ($28 bil - $8.4 bil). On a yearly basis, this is a slight decrease in profit margin, but not substantial enough to change the face of the investment market. However, this analysis ignores an important factor: development time.

If development and approval time for medicines exceeds product life, then a company will have fewer and fewer exclusive patents on the market at any given time, thus reducing the overall profits, though not substantially impacting the profit margins of those products. In other words, the supply of new drugs will be smaller, as the industry is less able to profitably absorb new investment.

A reduced supply would also imply that the cost of new "wonder drugs" would increase, assuming constant demand, in order to maintain the profit margins for pharmaceutical companies. More money would be shifted toward advertising over R&D, as the timescale necessary to develop new drugs would become more of a limiting factor upon profitability, and the need for immediate sales became all the more pressing. The shorter patent rights would encourage companies to flog their current products rather than develop new ones.

However, there is a second factor at work here: modern pharmaceutical development techniques. In the "ancient" times (say, 1975), a pharmaceutical company might generate drugs by mixing up chemicals in the lab, subjecting them to heat and pressure that would force them to combine into new compounds, then testing those compounds on animals for pharmacological effect. In other words, pharmacology was a science of trial and error, with more error than trial. It is no accident that many of the great advances in medicine (penicillin, quinine, smallpox vaccination) were largely the result of accidents.

Today's pharmacology is a greatly different science, as different from the methods used 30 years ago as the methods of the 1970s differ from those used in the 1900s. Today's pharmacologist is able to model countless molecules before so much as entering the lab. And by the time she picks up a test tube, today's pharmacologist often knows what molecule she is trying to create, and what general purpose it should serve. The contribution of computer modelling in today's golden age of medicine cannot be overstated.

What this means, in practical terms, is that pharmaceutical companies, if properly motivated, can improve their products repeatedly within the lifecycle of their patent. Only the inertia generated by steady profits prevents innovation in this regard. Thus, by shortening the lifecycle of drugs, pharmaceutical companies will not experience reduced cash flow, but will deal with an increased sense of urgency in bringing new drugs to market, and improving upon old formulae.

However, there is a risk inherent in this urgency, as shown most recently by Vioxx, and most horrifically by Thalidomide . However, it is worth noting that Vioxx is the first drug withdrawn from the US market since 2001. At least one other famous drug recall, Phen-Fen, was actually the result of uncommon and difficult to spot side-effects that came to light due to massively widespread use of drugs whose safety had been "established" by the FDA many years ago. What seems clear is that when the FDA does its job properly, simple urgency on the part of pharmaceutical companies is not enough to endanger consumers.

To summarize, shortened patent durations will mean increased incentive for pharmaceutical companies to improve their products (thereby lengthening their exclusive patents), and cheaper prices for consumers (due to greater access to generic equivalents). This is ultimately a supply-side solution, which allows additional competition into the marketplace, thereby lowering prices and improving product. The possible downside is that entirely new drugs may be slower to develop, but this risk is mitigated by the speed and cost advantages generated by leveraging modern technology.

However, supply of prescription drugs is not the only factor driving up the costs of healthcare. In my next post, I will examine the impact of health savings plans on demand for medical care.

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