TCS Daily


The High Cost of Low Price

By Fred L. Smith - January 16, 2007 12:00 AM

Should free market advocates oppose a plan aimed at lowering prescription drug costs? Generally, no. But, when such a plan involves the flexing of federal government muscle and threatens future health care, the answer changes. Those are the stakes in the current debate over whether Medicare should have authority to directly negotiate prices for its prescription drug program.

Under the current system, prices for drugs covered by Medicare's Part D program are negotiated by insurance companies and pharmacy benefit managers (PBMs) that operate Part D plans. Advocates of direct negotiation argue that the current system doesn't produce the lowest possible prices. Medicare's vast enrollment, they argue, would grant government negotiators sufficient clout to get a "better deal." To no one's surprise, the House of Representatives has voted to grant Medicare this authority. However, before the Senate rushes to agree, everyone should reflect on whether coercively-produced lower prices are really a "better deal" for ailing Americans.

There is little doubt that coercive government power could lower drug prices, creating some short-term accounting savings. The question is whether those "savings" today might not worsen health care tomorrow. Driving down drug costs might push pharmaceutical sector revenues below the rates of return needed to justify continued investment. And reducing investments in a world where medical progress is both important and costly means a slower rate of medical progress. Are lower prices of this sort really a good thing?

It is true, as many point out, that the Veterans Administration (VA) already negotiates its prices and enjoys substantial price discounts. However, these discounts in part reflect the fact that the VA buys in bulk which does lower marketing costs. In contrast, Medicare merely pays the bills while the individual enrollee makes the purchase. Medicare's involvement doesn't reduce marketing costs by much. Moreover, the VA's savings stem less from its effective bargaining than from its political power. The VA drove down prices in part by threatening to deny firms access to the Medicaid and Medicare programs.

But, in the real world, any industry wishing to continue operations must find some way of covering its total costs. If the VA is to pay less, someone must pay more. That problem is not very serious as long as these coercive powers are granted only to the VA, a rather small component of the total drug market. In contrast, Medicare covers a much larger fraction of the US population which would make it much harder to cover costs elsewhere. And while it remains true that the House legislation does not grant Medicare the power to coerce pharmaceutical firms as does the VA, taking this first step increases the likelihood that such additional powers would be granted in due course.

Thus, the basic question remains: Are lower prices obtained in this way (rather than via efficiency gains or regulatory relief) really in the public interest? Pharmaceutical firms like many other sectors of our modern economy are characterized by what economists call "declining costs" (the costs of production fall as total production levels increase). Consider that a drug company may spend several hundred million dollars producing the first pill but incur minimal costs in producing subsequent units. The high introductory prices for the product reflect the huge investment needed for research and development, not only for that drug but for the many other drugs that fail to make it out of the lab

For industries of this sort, setting price equal to production costs is crazy. The firm would cover none of its overhead costs, none of the costs of research, development or testing. Thus, while a firm may well charge such marginal costs to some customers, it will charge others much more. In practice, firms often vary the prices widely to match the diversity of their customer base. Unfortunately, such diversity pricing is often attacked as "discriminatory" - how dare a firm sell a life-enhancing pill for a dollar when it costs pennies to produce? Of course, this challenge confronts every industry characterized by declining per unit costs. Firms in this situation can always sell a few items at the lower prices (everyone can handle a few VA situations) but they can remain in business only if they are also able to sell a reasonable fraction of their output at much higher prices. In such industries, it is not easy for everyone to fly tourist class!

The pharmaceutical industry has long operated as other declining cost industries, seeking creative ways of marketing its products so as to serve the widest population, while still raising enough revenues to ensure a healthy rate of return. PBM purchasers may pay somewhat lower prices on one drug, somewhat higher on others. The pricing and marketing of such products is highly complex and not readily understood by outside observers. But it should be clear that any attempt to simply thwart current pricing and marketing practices would be a disaster.

Moreover, it is far from clear that granting Medicare direct negotiation powers would produce significantly lower costs. Yes, Medicare is a massive program and would presumably have major purchasing power. However, the three largest PBMs that now dominate much of the drug purchasing world already handle the needs of some 200 million Americans. True, the 42 million Medicare beneficiaries spend somewhat more than do most Americans on medical care, but certainly these PBMs possess considerable market clout. Why should anyone assume that Medicare bureaucrats would do better?

The one asset that Medicare might uniquely exercise would be the political power already exercised by the VA. As noted, the current legislation soft-pedals this feature but the threat remains. Does anyone really believe that a Congress eager to promise a champagne health care system at beer budget prices would long allow any drug maker to defy Medicare's demands for lower prices? Does anyone believe that Congress would be passive if Medicare beneficiaries lost access to drugs that might represent their best treatment option? The more likely option would be for Medicare to make an offer they couldn't refuse: Sell to Medicare at bargain basement prices or sell to no one at all!

This push, therefore, for granting Medicare negotiation powers is really a push for imposing pricing controls on the drug sector. In time - possibly a very brief time - the result would be to transform today's innovative pharmaceutical sector into another regulated utility. And the last century has amply demonstrated that regulated utilities are far less innovative than the economy as a whole. And America - faced with the growing significance of the diseases of aging, the emergence of new diseases around the world, and the fact that many important ailments still lack any effective intervention - needs more not less medical innovation. Yet, if the Senate follows the House down this road, we can anticipate a drastic reduction in the rate of medical innovation.

Lower prices are often a good thing - but paying a reasonable price for a quality health care future is a much better idea.

Mr. Smith is president of the Competitive Enterprise Institute.


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144 Comments

Any excuse will do to avoid the market
The worst that the current bill can achieve is the status quo. It contains no coercive powers of the kind fretted about: no price controls, etc. If the drug companies don't want to sell at a given price, all they have to do is say no, as they can now say no to the VA. Is there some reason why we need to protect drug companies from competition and the market?

Didn't you read the article?
The worst the proposed bill can achieve is the first step down the road of price controls enforced by the power of the Govt. Price controls set by the Govt is NOT the market at work, it is the State interfering in the marketplace. If the drug companies say no to the VA, then they might not be able to sell to Medicare patients.

Look at the vaccine "market", with its price controls. How many companies are innovating in this area?

only eric could think that govt is the market
The coercive power does not have to be explicitly stated.
Everyone knows that when you don't do what the Don asks, bad things happen to you.

Except that's not what the bill says
It just gives the government the same power it has in making any other purchase, the same power any buyer has in any transaction. The government bargains for all kinds of stuff, often successfully. The handwaving about compulsion and price controls is just that.

But of course, we should instead just trust in the drug companies -- who, incidentally, are among the largest contributors to Republcan candidates.

Sure, just look at Halliburton to see how coercive government can be
That poor company, whipsawed and exploited by vicious, price-controlling, mean-spirited bureaucrats who just don't understand the power of the free market.

pathetic attempt to change the subject, duly ignored.
...

Of course it was a govt program that gave Halliburton control of these things
but of course, to eric, it's not the govt program that the problem, it's that the wrong people are in charge of the govt program.

I should add, that it was also Clinton who approved awarding the program to Halliburton.
...

pathetic attempt to avoid the basic issue, typical
The problem with the Halliburton contract was not that the government didn't have power to negotiate: It had that power. It failed to use it.

Duh and double duh
The government signed a bad contract, and then failed to enforce even its lax requirements. Yes, the problem is that the wrong people are in charge.

You should also add that Clinton didn't block investigations of problems in the contracts
... and have government auditors who found problems taken off the job.

The greediest generation
Brokaw was close, only off by a few letters.

Behold the future and enjoy!

The government "negotiates" lower prices for the drugs that taxpayers buy for those in Medicare/Medicaid

The drug companies raise prices for those not enrolled in Medicare/Medicaid to maintain a static bottom line

The "suckers" are greatly annoyed by the shifting of costs from the greediest generation to them and they complain loudly to Congress.

Congress answers the call! The price gouging by Big Pharmaceutical must be stopped! Everyone must be included in the negotiated price but how to do it? The agreement only covers the government administered Medicare and Medicaid... what can be done? Of course! Cue the trumpets! We must have national health care! Congress saves the day!

10 years later on every street corner you hear "willow bark, get your willow bark, good for what ails ya".

Gee. Wonder what this doesn't happen in Canada
But sure, blame it all on those vicous oldsters.

That's because Canada was never a major developer of new drugs
What little they did have, moved to the US.

So they get lower prices and we pay for them. Great system!!!
We are so lucky!!

It is a great system, for us anyway
We get most of the drug R&D $'s and we get unlimited access to new drugs. Other countries may get some lower prices but they don't get the new drugs as quickly and, more importantly, they don't get an unlimited supply of the new drugs.

But, not to worry, we'll soon quit subsidizing the enlightened nations of the world that engage in pharmaceutical price fixing.

Congress hereby proclaims:

All drugs, henceforth, will be generics.

All new drugs will be circa 1984. Big Brother may be watching but he won't be watching any drug R&D.

Of course there is a way to get new and cheaper drugs... it's called competition

So: market forces are good to motivate drug companies
But having the government bargain with drug companies on prices -- not price fixing, bargaining - is anti-market and bad.

Maybe you can explain this for all of us. Try to do it without making up imaginary laws that nobody is proposing.

here's the point . and here's you 0+
the point isn't that the government made the wrong decision because the wrong people are in power the point is that the government will always make decisions based on politics and not what is actually best for the market i.e. there are no 'right' people.

if only
if only there was some kind of within us market derivative of this problem of one group fronting costs for expensive health care and another group getting it essentially for free...

wait...

thank you government
i'm clearly to stupid to make educated health care consumption choices on my own or hunt for my own prices. thank god the government is here to pay someone else to do that for me. i can't imagine how this system might be open to corruption or increase overhead or be manipulated for politcal gain. it's not like drug development has ever been manipulated that way before, right?

Enlightened Negotiating
When governments negotiate in good faith then markets work. But, I'm afraid you don't understand how enlightened governments negotiate.

It may come as a shock to you but governments carry a very big stick, they have a lot of power. The enlightened governments stipulate a price and the drug companies can either comply or have their patent stolen. Of course the patent isn't really stolen, it's just appropriated for the good of the people.

"Imaginary laws"? Sorry bud, voiding drug patents is a long established practice around the world and has been proposed by the brain trust in Congress on prior occasions. Besides, I never said they were proposing National Heath Care now, I just suggested a view of the future.

Not price fixing? Take a look at the "negotiated" vaccine prices and the impact they had on the vaccine manufacturers. Forget about the flu vaccine shortages, just focus on the low price.

ain't it though. That's what always happens when politicians try to outwit the market.
...

govt bargaining, is govt price fixing
there's no way around it.

You're welcome, citizen
you're welcome to buy your own insurance. In fact, right now you have little choice. Except if you have a pre-existing condition. Then you have no choice.

> i can't imagine how this system might be open to corruption or increase overhead or be manipulated for politcal gain. it's not like drug development has ever been manipulated that way before, right?

Drug development? Are you talking about drugs being rushed to market before tests are complete,or about drug companies hushing up negative results to keep their stock prices up? If not, what are you talking about?

Poor, poor defenseless drug companies
Yup, they sure take a shellacking from government all right. Barely hanging on. Raised a mere $134 million in campaign contributions since 1990, 2/3 of the total going to Republicans.

>"Imaginary laws"? Sorry bud, voiding drug patents is a long established practice around the world and has been proposed by the brain trust in Congress on prior occasions. Besides, I never said they were proposing National Heath Care now, I just suggested a view of the future.

Suggest all you like but that's not what the law passed by Congress (and threatened with a veto) established.

Mark posting is Mark making things up or repeating slogans
That's all he's capable of .

That's called corruption
And, sure, it's a danger. So is people dying because they have to choose between filling their Rx and eating. But here's a clue: if you elect people who believe government can't work, it won't: that's a classic self-fulfilling prophecy.

inherent != self-fulfilling
it doesn't matter who you elect, as long as people are elected they will make decisions that make it easier to get re-elected. this rarely results in making decisions that are best for the market and it is also not necessarily corruption.

wrong comment
you quoted the wrong comment, that one was in your favor. many times drug companies have gotten out of being held responsible by the market by contributing towards the right campaigns and i was implying that the same thing could happen here.

why?
"So is people dying because they have to choose between filling their Rx and eating."

why should any individual have to pay someone else money just so they can avoid death?

the only possible reason, and correct me if i'm wrong on this, is because it's the 'right thing to do.'

but isn't that just legislating morality? where do you draw the line on what acts are the 'right thing to do,' and are therefor compulsory? more importantly, who draws thoes lines?

look down, the slope you're sliding down is quick slick.

Don't see why
>this rarely results in making decisions that are best for the market

sometimes it does, sometimes it doesn't. Nor is 'the market" the only or final arbiter of what's a good decision. And in this case, the idea of having the government using its bargaining power hardly seems 'anti-market."

Maybe you should live somewhere you don't have to worry about this
Lots of places in Africa have no effective government at all. You don't pay taxes, and won't have to support anyone living or dying. Check itout.

>but isn't that just legislating morality?

As opposed to legislating morally? We're not talking charity. People contribute to Medicaid while they're working; they collect when they're too old to work. Why is this so threatening and wrong?

> look down, the slope you're sliding down is quick slick.

Again, many places in Africa can show you the benefits of doing away with leglslating morality. Try a visit.

So you're expecting perfection? That's not likely to happen.
Government, like the market, is a human institution, and can fail or lead to counterproductive results. That doesn't discredit the idea, any more than a lemon car discredits the idea of automobiles.

that's funny,
coming from the guy who decrees that lack of perfection in the market is the reason we must rely on govt for everything.

this from the guy who yells Halliburton, everytime someone suggests that govt is not perfect.
...

That's hilarious
I'm the one who says that nether the government nor the market is the solution, but that each case must be evaluated individually, on its merits. Yoo're the one who say sthat the market is always right. You're also the one who keeps misrepresenting what other people say no matter how many times they make the same correctin.

This is from the guy who actually looks at the real world instead spraying slogans
I have never said in any way that government is perfect. All I have said is that it can be effective in solving certain problems where markets fail.

Monopoly Bad!!!! Unless its your friendly federal gvernment
For a variety of services, Halliburton is the only enterprise capable of delivering the services specified in the RFQ.

The only power you have, is the power of an alternative.

You don't like it when a market is so limited and specialized that only one firm can prosper..

Somehow having an individual surrender all alternatives to the government is ok.

Eric probably thinks "Hi, I'm from the IRS and I'm here to help you" is free tax help provided by a dedicated group of public-minded, helpful sincere, loving accountants and lawyers

Except the Market Didn't Fail.
Healthcare is among the top three most regulated industries there are- and the entire apparatus is dedicated to providing the illusion that one and should can get unlimited "access" to healthcare while "somebody else" pays for it.

This is not a market and not a market failure.



le sigh
you seem to have a problem with word definitions.

asking not to be forced to do something against your will is not the same thing as having 'no effective government at all.'

asking not to be forced to pay for state sponsored charity IS NOT the same thing as not paying taxes at all.

charity IS, in fact, when people give money to others. medicaid does this because money contributed by an individual does not exactly equal the money they recieve in return.

good?
who decides what 'good' is? what gives anyone the right to choose that for someone else?

in terms of this debate, why is the government using bargaining power to negotiate prices on items instead of the consumer making those choices themselves?

that's right, i almost forgot, people are too damn stupid to be trust to make their own consumption choices.

having the government use its bargaining power doesn't seem anti-market to you because you have accepted the premise on which the statement is based, namely that the government bargaining is a market action. which, in point of fact, it isn't.

Those comments have nothing to do with anything in the article or the real world
This is really unclear on a whole bunch of concepts.

>For a variety of services, Halliburton is the only enterprise capable of delivering the services specified in the RFQ.

And because of intellectual property rights, only one manufacturer can supply many drugs. That doesn't mean government (or anyone else can't negotiate with them -- and enforce contracts made.

>The only power you have, is the power of an alternative.

You have the power of being the company's only cllient (for some of the Halliburton services), or the largest client. You don't know how much leverage this gives you until you negotiate. Why not try?

>You don't like it when a market is so limited and specialized that only one firm can prosper..

With Halliburton, I don't like it when they do bad work.

>Somehow having an individual surrender all alternatives to the government is ok.

Surrender akk alternatives???? Individuals are still free to buy drugs individually, or in Canada, or not at all. Your generalized I-hate-the-state slogan doesn't fit here.

>Eric probably thinks "Hi, I'm from the IRS and I'm here to help you" is free tax help provided by a dedicated group of public-minded, helpful sincere, loving accountants and lawyers

It's not the IRS that's authorized to negotiate with the drug companies.But don't let that interfere with your sloganizing.


Sure: we pay much more for health services and get worse results.
But it's not a government failure: places where the government is more involved, with a single payer plan, spend much less and have better public health numbers. (statistics on request, but this is known)

If you have a pre-existing condition - diabetes, for example, try buying health insurance in the market. Is this because of something the government did?

> the entire apparatus is dedicated to providing the illusion that one and should can get unlimited "access" to healthcare while "somebody else" pays for it.

That's the idea of insurance: everyone pays, so that risks (and that's what we're talking about) are distributed. Are you against insurance too?

not really, no
the market is not a human institution and is therefore not corruptable. the market is a force created by scarcity.

the governemnt IS a human institution and since it is run by humans. humans are curruptable and by extension the government is too. markets can fail or lead to productive results and i would much rather deal with those effects without having to deal with the add problems of government that makes it in some people's best interests not to do anything about it.

there is nothing wrong with striving for perfection even if it is not attainable. thank you for admiting that my ideal and perfection are, in fact, one and the same.

I see: you want to obey some laws but not others
but your general principle seems a little strange.

>medicaid does this because money contributed by an individual does not exactly equal the money they recieve in return.

Ok, I live in a town and pay taxes to support a fire department. If the FD has to respond to fire, this will cost much more than my tax payment.

You might also look up the idea of insurance. You'd be amazed, but the amount you recover if you have a loss isn't equal to your payments.

Good!
You don't seem to be used to the idea of having a government.

>who decides what 'good' is? what gives anyone the right to choose that for someone else?

Right. I want to drive 120 miles per hour on the roads. Hell, I pay for them. Why should I care about silly rules made by other people?

>n terms of this debate, why is the government using bargaining power to negotiate prices on items instead of the consumer making those choices themselves?

You mean making choices about what drugs they need to treat their diseases? Choice is pretty limited, wouldn't you say? You mean choice about how to pay? They can still pay out of their own pocket. Where'sthe hangup.

>hat's right, i almost forgot, people are too damn stupid to be trust to make their own consumption choices.

You're right!!! and the sooner they stop listening to so-called "doctors" and "pharmacists," the better. Imagine thinking that they need someone else to tell them about their own bodies.

>having the government use its bargaining power doesn't seem anti-market to you because you have accepted the premise on which the statement is based, namely that the government bargaining is a market action. which, in point of fact, it isn't.

Because you say so??? You'll have to do better than that. Note that government bargains all the time for everything it buys (competitive bidding,etc). Shlould it stop, and simply accept the first bid that comes in, no matter what the price, because it isn't in the market??

everyone pays?
exactly which part of a socalist health care system where some of the popluation doesn't even pay at all is the same as 'everyone pays.' if everyone was paying based on their risk as they do in open insurance markets the health care system would not be in the mess it currently is.

lastly, produce said statistics on more involved government with lower cost and better public health numbers in countries that make the same per captia contributions to R&D that the U.S. does.

Yes really, yes
>the market is not a human institution and is therefore not corruptable. the market is a force created by scarcity.

That's simply ridiculous. Go to the New York stock exchange, with its elaborate rules, and say that it's not a human institution. Yes, economists can describe various forms of market, but that doesn't make them any less artificial or human.

>is too. markets can fail or lead to productive results and i would much rather deal with those effects without having to deal with the add problems of government that makes it in some people's best interests not to do anything about it.

So would everyone. That's why people avoid bringing in government as long as the market is working.

>there is nothing wrong with striving for perfection even if it is not attainable. thank you for admiting that my ideal and perfection are, in fact, one and the same.

Of course not. I do not accept corruption in government and I back every attempt to get rid of it, including the repeal of the silly and special-interest inspired regulation forbidding the medicaid program from negotiating with drug companies.

Everyone pays
Some pay more, but everyone pays. Why not look at the systems that existin the real world.

> if everyone was paying based on their risk as they do in open insurance markets the health care system would not be in the mess it currently is.

If everyone was paying based on their risks, many people would not be able to get insurance at any price, as many cannot now. No, institutions shop for insurance and can get employees covered even with pre-existing conditins. Individuals have no leverage and cannot buy it. This is the market at work. For drivers, it works oK; For health - don'tyou see the problem.

Statistics: sure.
http://www.kff.org/insurance/snapshot/chcm010307oth.cfm
look at all the charts, especially exhibit 4

insurance
you should look up the idea of insurance. you'd be amazed but in a free market the amount you recover is EXACTLY THE COST OF YOUR PAYMENTS if you assume that risk is a cost.

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