Opinion: What’s Good for Pharma Isn’t Good for America (Wonkish)

May 14, 2018 by

Image CreditcAudra Melton for The New York Times

So Donald Trump broke another promise: he did not, after all, empower Medicare to negotiate lower drug prices. Instead he (and Michael Cohen, who definitely isn’t his bagman) took money from drug lobbyists, appointed them to key positions, and announced a plan that sent drug stocks soaring. I’m sure you’re shocked.

But promise-breaking aside, would introducing a policy of bargaining drug prices down have been good for America? Actually, yes.

Oddly, I never got around to doing my homework on the economics of drug-price bargaining – partly because I was realistic enough about the political economy to realize that it wasn’t going to happen in America any time soon. Still, the fact that Trump promised to do something makes it somewhat relevant, even if he did predictably break that promise. And it turns out that the economic case for doing what Trump just didn’t do, for putting caps on drug prices, is remarkably strong.

[Personal note: why am I doing this on a Saturday night? Because I just finished two days of meeting with men in gray suits talking about money and banking, I have to leave for the airport at 4:45 AM tomorrow, and I’m about to order in room service and go to bed. Life of the party, me.]

Let’s start with where things are right now. After a drug company gets a patent, it has a temporary monopoly on sales of its drug. So its situation looks like that of a standard monopolist, as shown in Figure 1:

It charges a price that is above the marginal cost of producing the drug – usually well above marginal cost. Nonetheless, consumers gain from the drug’s availability: the marginal consumer is willing to pay the drug’s price, and all the inframarginal consumers gain consumer surplus. Meanwhile, the drug company makes a profit, which is also a gain to the economy (although we haven’t deducted the cost of developing the drug; more about that in a minute.)

So overall, society gains from the drug’s existence. However, as Figure 2 shows, society would gain more if someone – regulators, purchasing managers at government agencies, whatever – forced the drug company to charge less than the monopoly price:

Image

Consumer surplus would rise; the drug company would earn less profit per unit sold, but this would be partially offset by the profits earned on increased sales. Overall welfare would rise by the green-shaded area.

But wait: wouldn’t bargaining drug prices down reduce the incentive to develop new drugs? And wouldn’t this mean in some cases forgoing the welfare gains that come about, even with unregulated monopoly, from the mere fact that a drug becomes available?

Yes, it would. But despite this effect, the United States would almost certainly be better off with a moderate level of bargaining/price control than it is under the current hands-off regime. Why? I count at least four distinct reasons.

First, a point made by Lackdawalla and Sood is that the profit effects of constraining a monopolist’s price are second-order. That is, if you look at a drug company’s profits as a function of the price it charges, they look like Figure 3, with the company at the top of the curve. Pushing the company slightly to the left has approximately zero impact on profits, precisely because it starts at the maximum, where the curve is flat. What’s going on here is that the profits lost on existing sales are almost fully offset by the profits on additional sales.

What this means in turn is that the negative effect on innovation is small if prices aren’t pushed down a lot, while the consumer gains are first-order. Some price bargaining is always welfare-improving.

Second, the standard picture in Figure 1 in effect assumes that a drug is completely de novo, not a perhaps somewhat better substitute for an already existing drug. This is clearly a bad assumption in many cases; if a drug is introduced to snatch away rents from an existing, similar drug – people used to call this a “me too” drug, although we’re going to need a new name — the gains from its creation will be smaller. Indeed, it’s often argued that pharma companies basically develop too many drugs, wasting resources on what amounts to unnecessary duplication. To the extent that this is true, discouraging some innovation isn’t a bad thing.

Third, the consumer surplus calculation assumes that consumers actually pay for the drug. In fact, many drugs are paid for by insurers – which is necessary, because like much of modern medicine the cost if you need it is far beyond most people’s ability to pay out of pocket. But this means that the price someone is willing to pay may greatly exceed the value to the patient. In general, the interaction of drug insurance with monopoly pricing creates potentially huge distortions in both drug development and drug use, reinforcing the case for bargaining.

Finally, it’s a global market – which means that much of the consumer surplus from drug development accrues to foreigners, not U.S. citizens. Maybe there should be more drug development from the point of view of global welfare. But given the unique unwillingness of the U.S. to bargain over prices, we end up paying a much larger share of the costs of that development than we receive of the benefits. Funny how Trump is America first on everything, except when a nationalist position might be bad for Big Pharma.

Yes, Trump says he wants to force other countries to raise drug prices. Good luck on that.

What this comes down to is that there is a very strong case for doing what Trump promised to do but didn’t. I’m aware that simply saying “let’s bargain over drug prices” isn’t effective unless coupled with a willingness to say no – to tell a drug company that an overpriced drug will be excluded from the formulary. So it wouldn’t be politically easy. But it would be good economics.

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