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.

Saturday, October 23, 2004

The Kerry Health Plan

When a person has no information but a politician's word, accurate conclusions are difficult, if not impossible to draw. This is the reason why so many Americans vote according to party, character, or so-called "wedge issues". Because while a politician will say almost anything to get elected, you can be fairly sure that Republican will vote like a Republican, and a Democrat like a Democrat. You can count on a leader to remain a leader, and a follower to remain a follower. And you can assume that when a politician chooses to highlight a wedge issue, it is because he genuinely believes there is a difference between his position and that of his opponent. One such issue which has gained great currency in this election is that of the national health care plan.

Kerry proposes a system in which catastrophic health care costs are assumed by the government. On the other hand, Bush counters that catastrophic health care costs are precisely the reason insurance exists in the first place, and that it is not these extreme costs, but the steady drip of shots, doctor's visits, medicines, and other basic needs that drives up the cost of insurance. Thus, the candidates look at the same problem and draw opposite conclusions.

Kerry, working from the assumption that health insurance costs would be dramatically reduced were the insurers themselves insured against extreme payouts, such as those related to cancer and other debilitating diseases and injuries, offers a plan in which the Federal government takes on responsibility for these health care costs. One could examine the details of his plan, but to do so is pointless, given that any such plan must be radically altered in order to pass congressional muster. Instead, let us examine the principles which lead to such a plan.

Medicine is a market, like any other, controlled by supply and demand, costs and profits, production and consumption. Hence, in order to change the cost structure of health care, one must act to increase supply or reduce demand, to increase production or reduce consumption. How will increasing the government's role in paying for health care alter these factors?

It would seem obvious that shifting the costs of health care off of individuals and onto the government should increase demand. After all, if water is free, people use more water. If gas is cheap, people use more gas. And if health care is free (even if only at a very high expenditure level), people will use more health care. It is equally obvious that our health care system is already stretched by an imbalance in supply and demand. It is not the greed of health insurance companies and doctors that drives up the costs of medical care, any more than it is the greed of oil refiners that drives up gas prices. Instead, it is the insatiable thirst of the consumer that drives up costs for both these products.

Every time you go to the doctor when you could stay at home and take Nyquil, you drive up healthcare costs. And the reasoning behind your individual decision to do so is sound: if you have insurance, seeing the doctor is cheaper than being sick, just as if you have a car, driving a mile to the store is cheaper than walking. Conservation is simply not a rational option for the insured consumer of health care goods.

An interesting thing about economics: one can neither create nor destroy money. A dollar is a share of the total dollar-demand of the world economy, and its value is forever proportional to that demand. One can transfer this value, but one can't create it from nothing. If I burn a one-hundred dollar bill, every other dollar becomes more valuable, and if I counterfeit my own money, every other dollar loses value to compensate. In the same way, one cannot change the value of health care by minting ones own insurance. One can only create insurance inflation. That is, it will take more and more insurance in order to maintain the same level of coverage.

Kerry's rationale would seem to be that he is simply expanding access to what the wealthy already have: inexpensive (relative to income) health insurance. Would his plan have this effect? If insurance companies were no longer responsible for the profit-killing cost of health catastrophes, they might indeed have incentive to lower their prices. But only for those who agreed to use the Kerry health plan in such an instance. In other words, Kerry's plan would provide incentive for the health insurance companies to drive individuals toward cheaper (and more profitable) plans that encouraged dependence on government coverage. These costs would be passed on, and the consumer would end up paying twice: once for taxes covering this government service, and again for the insurance the government doesn't cover.

Assuming that insurance companies acted fairly and the government was as efficient a broker as the original health insurance providers, these amounts would precisely offset one another. However, we all know that insurance providers have little incentive for fairness, when unfairness adds to profitability, and the federal government has no talent for efficiency, when inefficiency adds to bureacratic power.

So what would Kerry's plan accomplish? It would certainly increase demand for health care, thus increasing wholesale prices. It would increase costs, through the inefficiency of government action and the opportunity for insurance companies to lower prices while padding profits. It would raise taxes and increase the deficit, though both these problems would primarily effect the wealthy (at least initially). And finally, it would do nothing at all to address the true problem of health insurance: lack of supply in the face of ever-increasing demand.

But does Bush's plan address the root cause of excessive health insurance costs? That will be examined in my next post.

Saturday, October 09, 2004

The Afghan Election

Let the maligning of democracy begin. It should be no surprise to anyone that the Global Media (proctors of the Global Test) are focusing on the accusations of fraud among the 15 candidates for Afghan President who are not Hamid Karzai. It should be equally unsurprising that such allegations are being tendered by these candidates, whose chances of achieving victory over a popular incumbent, whose approval rating among his countrymen has been reported as anywhere from 62 to 85%. What is somewhat amazing, however, is the long term trend in media toward raising and lowering the bar without comment.

Few now remember and note when Afghanistan was first invaded, its opponents, led by International ANSWER (the remnants of an international Communist party left castrated by the collapse of its benefactor, the Soviet Union), organized mass rallies against what they claimed would be a humanitarian disaster, and another Vietnam. Yet today, the issue is whether Democracy was served in light of potential voter fraud enabled by a poor voter verification system. Let me reiterate: in Afghanistan's historic first election, which, as recently as last week, everyone believed would be marred by violence, the top story is not a massive car bomb destroying a polling station and killing hundreds of voters, nor polling irregularities related to Taliban pressure upon voters to eschew the polls, nor even a story of observable fraud by the ruling parties. Instead, the top story, the indictment against this election and the Bush Administration, whose leadership made it possible, is potential voter fraud that would not appear out of place in Cleveland.

Friday, October 08, 2004

Senator John Kerry-McClellan

There is a striking historical parallel between this election and the election of 1864. In both instances, the United States fought in a deeply divisive war that appeared the depths of folly to some, and to others the summit of necessity. Both elections were contested between plain-spoken incumbents of simple appearance and bearing, whose rhetoric tended to the spiritual, and whose themes were liberty and resolve, and challengers who ran on anti-war platforms under the protection of checkered histories as military officers.

In 1864, it was Abraham Lincoln, probably the most reviled leader in American history, certainly the most divisive, leading the country into a war that some believed far too costly to be fought. His position as President was challenged in light of his slim electoral majority, the plurality of his election, and the deep and abiding hatred felt for him by his opponents, who felt cheated by his victory, propelled as it was by a anti-Lincoln-vote split between Stephen Douglas, John Breckinridge, and John Bell.

His opponent in 1864, General George McClellan, ran as a war hero, despite having been among those most responsible for the Union's inability to emerge victorious early in the war. Under McClellan's leadership, the Union army proved unwilling to engage fully, to bring its superior forces to bear against the rebel armies. It was this attitude that led to McClellan's removal after more than a year of fighting to a stalemate in battle after battle, sacrificing countless men to indecision rather than facing the casualties necessary to win the war decisively. McClellan ran as a peace candidate in a Democratic Party deeply divided over the Civil War, but whose hatred of Lincoln ran deep enough to paper over their divide, and neglect the deficiencies of the feckless McClellan.

But why would the Democrats choose a leader like McClellan, a soldier with no victories to his name? For that, I turn to Frederick Francis Cook in his 1910 book Bygone Days in Chicago,

So far as the leaders are concerned, they probably argued like this: "one of our own sort would stand no chance with the masses. We must have a soldier; but a successful one would not serve our purpose, nor is there any likelihood that we could get him to stand on the kind of platform we are determined to adopt." So it was McClellan or a civilian.

McClellan spent the campaign vacillating between his desire, as a soldier, to win the war, and his need as a Democrat to justify the removal of Lincoln in terms of the Politics of Failure.

The [Democrats'] platform not only declared the war a failure, but demanded that "immediate efforts be made for a cessation of hostilities." But this part the candidate disavowed in his letter of acceptance. [ibid]

Kerry spoke in tonight's debate of the need for better armored Humvees, and more bulletproof vests before war could be undertaken. Leaving aside his vote against funding the war in Iraq, which would have denied funding for the very supplies he recommended, this statement provides a clear example of Kerry's McClellan-esque viewpoint on war. It would seem that having the best equipped, best trained military in the world is not sufficient to go into battle. Kerry, like McClellan, demands that we must approach the theoretical limits of preparedness before action is taken.

Ultimately, Lincoln won a decisive victory over McClellan for one reason: Sherman's march to the sea. Does this mean we'll see a major offensive, with tangible reports of victory coming out of Iraq over the course of the next few weeks? Hmmmm....