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Increasing health spending also increases profits

Megan McArdle and I have gone back and forth on pharmaceutical innovation more than enough times to know each other's positions by heart, so I'm not really trying to stir up old arguments here. But I am confused by her latest post on the subject (as opposed to her latest column, which is a good overview of the difficulty of discovering new drugs, and with which I agree almost completely). On the one hand, McArdle says that she believes she "may have seriously underestimated the risk that this thing will turn into a massive fiscal disaster that could precipitate a serious budget crisis." On the other hand, she's worried that health care reform's role in "reducing profits in pharma" will harm drug innovation.

As far as I can tell, these two positions are in direct contradiction. If health-care reform increases total health-care spending -- which is McArdle's first contention -- then it should also increase profits for pharmaceutical companies, thus juicing innovation. This is what research by MIT's Amy Finkelstein suggested happened after Medicare was formed. In that world, McArdle's concerns that lost profits will lead to less innovation are moot. Profits are going to go up because spending is going to go up. The mechanism here -- increased coverage leads to increased usage of health care by people who otherwise would be priced out of the system -- assures it.

It's also fair to ask where I come down on this given that I do believe that the Affordable Care Act will save some money and put us on the path to saving more. Put simply, I don't think the current system is very effective at encouraging drug development, and so I think more direct efforts to fund innovation (prize money, research grants) might be more effective than blocking cost-saving reforms to preserve whatever small percentage of current spending ends up in pharmaceutical R&D. If we want to maximize innovation, we should try to do that directly rather than allowing health-care spending to bankrupt us because we're concerned that changes will adversely harm pharmaceutical innovation.

By Ezra Klein  |  June 8, 2010; 3:52 PM ET
Categories:  Health Reform  
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Comments

Most basic medical and pharmacological research is conducted by large tax subsidized research universities and institutions like NIH, so Pharma is already getting a huge subsidy on the research front. I don't see the need to subsidize the multimillion dollar pay packages for pharma CEOs.

Posted by: srw3 | June 8, 2010 3:58 PM | Report abuse

"Put simply, I don't think the current system is very effective at encouraging drug development, and so I think more direct efforts to fund innovation (prize money, research grants) might be more effective than blocking cost-saving reforms to preserve whatever small percentage of current spending ends up in pharmaceutical R&D"

Really Ezra?

Cute little grants and prizes? Did you really mean to type "PRIZES" btw? They're more effective than good old fashioned American greed and profiteering? Sorry I don't think so.

Posted by: visionbrkr | June 8, 2010 4:00 PM | Report abuse

srw3,

so then. You were against the Eshoo amendment for biologics? The one that's going to cost us just billions if we're lucky?

Agreed. But wasn't it the administration that used Billy Tauzin and Pharma's money to win the PR battle?

Remember $150 million spent and untold Billions gained. Nice deal if you're PHARMA.

Feel free to shrink PHARMA's profits below 20% anytime now.

Posted by: visionbrkr | June 8, 2010 4:06 PM | Report abuse

Well, it's good everyone is now agreed that the PPACA "increases total health-care spending" and may "increase profits for pharmaceutical companies." The first step towards correcting the Obama/Pelosi health spending increase is admission that it is, in fact, a huge increase in spending.

I'd think that those who desire a higher deficit would be happy to profess the massive increase... but until now, few have admitted the increase. Onthe bright side, current numbers suggest that the PPACA will cause "only" a 1 to 2% increase in the rate of rise of health care costs compared to pre-PPACA rate-of-rise: if you know your car has no brakes and is heading for a cliff, why not hit the gas and make a good show of it!

Posted by: rmgregory | June 8, 2010 4:19 PM | Report abuse

Yeah, that's ridiculous. The drug industry expects to see a very modest increase in profits as gains in volume compensate for a haircut on prices. That's why they signed up for healthcare reform. And if anything, it incentivizes companies to develop truly innovative drugs for chronic conditions that can get good insurance coverage rather than another me-too PPI or antihistamine.

Posted by: matthewarnold | June 8, 2010 4:31 PM | Report abuse

"As far as I can tell, these two positions are in direct contradiction. If health-care reform increases total health-care spending -- which is McArdle's first contention -- then it should also increase profits for pharmaceutical companies, thus juicing innovation."

This isn't by definition a contradiction. You could be right that higher revenues for pharmaceuticals mean higher profits, but that isn't guaranteed.

Health care reform increases utilization of pharmaceuticals which increases aggregate spending. Angered that insurance companies are hiking premiums, Sebelius fires off another one or her threatening letters to insurance companies, telling them she'll wrap them up in red tape and put a bow on them if they don't keep premium increases to a minimum. Insurance companies tell pharma to either accept lower reimbursements for their drugs or nothing. Pharma accepts lower reimbursements. Total spending remains higher than baseline, but pharma still has its profits squeezed.

Visionbrkr,

The prize concept doesn't sound so bad to me. I would look at it as a way to pay firms the present value of the monopoly profits a patent would provide up front, so that the cost of each dose was much closer to the marginal cost. It would probably be tough to implement in practice (the best way would probably be to negotiate with a firm how much it would be willing to accept to forgo patent protection on its new drug, although I can see how that could get messy from a political perspective). Do you have any further thoughts here?

Posted by: justin84 | June 8, 2010 5:56 PM | Report abuse

Well, I have a rather fashionable condition (MS) that tends to happen to affluent well-insured young whites so apparently all the pharmas want to develop drugs for the condition.

Anyway, the drug I'm on (the standard drug) is very, very expensive (about $2K a month). Now the trouble is, the pharmas have very little profit incentive to develop a cheaper drug. The one I'm on is injected (syringe, needle, puncture, you get the picture) and we would all really love a pill. But what's their incentive when the current drug is so lucrative?

I just want to point out that sometimes the free market isn't as productive as you might think. In fact, in Europe, statins (very cheap) are being investigated as possible MS mitigators, but there's little interest in the US, because no one's going to make any money on statins.

Posted by: lister1 | June 9, 2010 12:07 AM | Report abuse

Friends Don't Let Friends Link McMegan.

historically, her estimations of policy costs have been terrible, and yes, many of her positions are self-inconsistent. I've been pointing out this particular pharma contradiction for a while now. (It is not new)

This post is classic McMegan on the Iraq War:
http://www.janegalt.net/blog/archives/004056.html

"But making up ridiculous numbers in order to support your predisposition isn't helpful -- and when the war doesn't cost us $2t, people are going to remember that the next time you talk about the costs of a program you don't like."

Whoops! I bet she sure is embarrassed now.....

Posted by: zosima | June 9, 2010 2:42 AM | Report abuse

Health care reform increases utilization of pharmaceuticals which increases aggregate spending. Angered that insurance companies are hiking premiums, Sebelius fires off another one or her threatening letters to insurance companies, telling them she'll wrap them up in red tape and put a bow on them if they don't keep premium increases to a minimum. Insurance companies tell pharma to either accept lower reimbursements for their drugs or nothing. Pharma accepts lower reimbursements. Total spending remains higher than baseline, but pharma still has its profits squeezed.


Posted by: justin84 | June 8, 2010 5:56 PM | Report abuse


Where your explaination goes awry is with the fact that you feel insurers can dictate to pharma. It doesn't always work that way. Just as hospitals have consolidated for market power so has Pharma. They carry a big stick with insurers and since many manufacturers also now carry the delivery chain (CVS CAREMARK for example) they carry even more power.

If you'll remember back in October pharma increased prices by about 20% if i remember correctly just before they told Obama they'd save them, well, about 20%.

I would be fine with them profiting as long as they were responsible for the drug being developed but I know many times that's not the case. I also know how devious pharma is and that the moment a profitable drug comes near patent expiration they'll go and adjust it somewhat to try to get more time.

These aren't the Boy Scouts we're talking about. I think Billy Tauzin's proven that.

Posted by: visionbrkr | June 9, 2010 8:24 AM | Report abuse

Visionbrkr,

I agree that market pressures currently don't let insurers dictate reimbursements to pharma, but consider what is happening in Massachusetts. Insurers there want to increase their rates, and the government is saying no, those hikes are too high. If the government forces premiums down by fiat, someone's going to get squeezed - insurers might just eat it for one year, but it this sort of thing happens often something will have to give. Losing money because premiums aren't covering costs is a pretty big stick too.

I'm not calling this a prediction, merely noting the possibility of total spending going up and yet profits going down - a long winded way of saying that the level of profits depend on margins as well as sales.

By the way, how do pharma companies profit from drugs they weren't responsible for developing? How do they get the patents for those?

On the prize idea, maybe it would be better to get rid of patent protection altogether and let associations fund drug research. You save money on insurance because drugs will be sold near the price of production, and then you can donate that money to the research program of your choice. I presume the federal government would continue to fund research as well.

Posted by: justin84 | June 9, 2010 9:34 AM | Report abuse

I a lot of us seem confused by the following "direct efforts to fund innovation (prize money, research grants)"

When compared to the enormous profits of pharma no prize could hope to replace that, and if it did it would be just as bad as the profit system.

Research grants are much maligned however. I would hypothesize that many scientists love the act of discovery and don't really do their job for the money (They certainly don't mind money, but most pharma profit doesn't flow to the researchers anyway).

Paying for the research at universities, and select clinics rather than only at the mega-pharma companies could actually spur a lot of good innovation.

Posted by: chrynoble | June 9, 2010 2:46 PM | Report abuse

chrynoble,

It would take a huge amount of prize money to replace lost profits, but I think a big step in the right direction would be to get rid of patent protection for new drugs. Pharmaceutical firms could produce and distribute new drugs but they wouldn't reap monopoly profits as they wouldn't have a monopoly granted via government. To induce drug discovery, the government could provide research grants, prizes to labs for high priority drugs and/or private associations could fund research into areas they care about (cancer, MS, heart disease etc).

Posted by: justin84 | June 9, 2010 4:25 PM | Report abuse

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