TCS Daily

Quack Economic Prescription

By Arnold Kling - June 25, 2003 12:00 AM

In a recent opinion piece for the Washington Post, physician Marc Siegel made a proposal for containing health care costs. The proposal was approximately as follows:

Physicians are ripping off the public with excess profits and overhead. The cost to the consumer of seeing a physician should be cut sharply, using at least one of two approaches. The first approach would be to enact price controls on all physician visits. The second approach would be to allow any patients who receive discounts (either because the physician chose to give the consumer a break or because the physician was required to give a discount by Medicare or another payer) to pass those discounts along to other patients. That is, if Fred gets a discount from Dr. X, then Fred can bring Ethel in to Dr. X for the same discount.

Physicians argue that they already are squeezed, and that the rates that they charge reflect the need to earn a return on the cost of going to medical school. Siegel's rejoinder is that physicians spend money on unnecessary overhead, such as nurses and assistants in the office. They could cut back on those expenses.

Just Kidding

As I said, this is approximately what Dr. Siegel wrote. Below is a comparison of this approximation to what he actually wrote.

Feature Approximate Proposal Actual Proposal
Price to be Reduced Price of a physician visit Prices of prescription drugs
Alternative to Price Controls Allow patients with discounts to share discounts with other patients Allow prescription drugs to be imported from countries with price controls
Fixed cost that prices would no longer recover The cost of going to medical school The cost of research and development of new drugs
Alleged excess overhead nurses and assistants drug company advertising
Economic impact not addressed fewer people choosing to go to medical school fewer new medications developed

I am sure that Dr. Siegel is well qualified to dispense medical advice. However, as far as economics is concerned, he is pushing harmful remedies.

Do the prices of prescription drugs exceed the marginal cost of manufacture? Definitely. But marginal cost pricing will not recover fixed costs. The marginal cost to a doctor of seeing a patient might be $10, but if that were the price hardly anyone would go to medical school. Similarly, the marginal cost of manufacturing a pill might be a few cents, but if that were the price then hardly any effort would be expended on research and testing of new drugs.

Do drug companies charge lower prices in other countries? Yes. Perhaps this is because the market will not bear higher prices in those countries. If so, then as long as overseas prices are greater than marginal cost the drug companies are recovering some overhead in other countries and this allows them to keep prices lower here than they otherwise would be.

There is, however, a less benign explanation for lower drug prices overseas. As 'Jane Galt' pointed out, foreign governments have tremendous negotiating leverage with U.S. pharmaceutical companies. The foreign government has the option of telling local manufacturers that they do not have to honor U.S. drug patents. Because the chemical formulas of drugs are published, the drug companies are helpless unless they have legal protection for their intellectual property. Foreign governments could choose to take away this legal protection, and 'Jane Galt' believes that this potential threat is the reason that U.S. companies comply with foreign price controls. She believes that this allows foreign citizens to act as "free riders" on U.S. drug research -- obtaining drugs at a cost below what is needed to support research and development and forcing American consumers to bear a disproportionate share of that cost.

Regardless of the reason for the success of foreign price controls, allowing importation of drugs for resale in the United States would drive prices down to the levels seen in other countries. While this indeed would serve as a short-term transfer from drug companies to consumers, it would have a chilling effect on pharmaceutical research and development.

Changing the Subject

When reminded of the issue of research and development, price-control advocates like Dr. Siegel respond by changing the subject. He writes:
"When asked why pharmaceuticals cost so much, the drug companies often point to the high cost of that R&D. What they don't say is that they also spend an inordinate amount plying physicians with free lunches and over-packaged sample products. Or that they overspend on expensive advertising aimed at patients. (In fact, the industry's advertising costs exceed its R&D costs!)"
Dr. Siegel's factual allegations are open to question. For example, I have seen references to data that in 2001 the drug industry's direct advertising costs were $2.7 billion, compared with over $30 billion in research and development.

However, in terms of economics, those facts are not the issue. Economically, it would not matter if advertising were a hundred times research and development expenditures. What matters is whether or not the advertising is successful at increasing demand. If advertising is successful, then its economic effect is to increase the return on investment in new drugs. This either causes an increase in research and development spending, a reduction in drug prices (because with more demand firms can recover costs at lower prices), or both.

If drug company advertising is not successful at increasing the return on investment in drugs, then drug company advertising should be banned -- by drug company shareholders.

If drug prices were forced down, then drug companies might reduce advertising, because they would have less incentive to stimulate demand. However, in that case, the effect would be to compound the adverse impact on the rate of return on pharmaceutical research.

If physician payments were reduced sharply, many doctors would exit the business. If you told them to reduce the number of nurses and assistants, then the doctors' productivity would suffer, and they would have to exit the business even faster. Changing the subject to nurses and assistants does nothing about the physician's need to earn a return on investment for going to medical school.

Changing the subject to advertising does not solve the fundamental economic problem that the cost of up-front investment in drug research has to be recovered. Cutting spending elsewhere does not make money available for drug company research. Expected returns on investment are what make money available for research. That is basic, first-year economics.

It is not my purpose to defend the status quo in the pharmaceutical industry. It is not my field of expertise. But constructive reforms to improve the drug market should be guided by sound reasoning. It requires a combination of economic sophistication and industry expertise. It is disturbing that Dr. Siegel and others, who lack a basic understanding of the way markets work, can pass themselves off as authorities in economic policy. This is no field for quacks.

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