DRI-174 for week of 7-26-15: Oncologists’ Plea for Government Regulation of Cancer-Drug Prices is Dead Wrong

An Access Advertising EconBrief:

Oncologists’ Plea for Government Regulation of Cancer-Drug Prices is Dead Wrong

Economists learn to recognize a special-interest plea the way an ornithologist recognizes a bird call. The mellifluous sounds of special pleading were uttered last week by some 118 oncologists from leading cancer hospitals throughout the United States, who issued a statement calling for government regulations limiting prices of prescription drugs for the treatment of cancer. The statement was published in the form of an editorial in the medical journal of the prestigious Mayo Clinic in Rochester, MN. The signers hailed not only from Mayo’s but from such distinguished institutions as M.D. Anderson in Houston, TX, the Dana Farber Institute in Boston, MA and the University of Chicago.

The Attack on Drug Prices

As Jeanne Whalen of The Wall Street Journal told it (“Doctors Attack Drug Prices,” 7/23/15), “more than 100 oncologists from top cancer hospitals around the United States have issued a harsh rebuke over soaring cancer-drug prices and called for new regulations to control them.” These are the “latest in a growing roster of objectors to drug prices,” from “doctors to insurers to state Medicaid officials” to “have voiced alarm about prescription-drug prices.” Prices of prescription drugs rose an estimated 12% last year, the largest annual increase in the U.S. in over a decade.

And why does a price increase call for protest by the nation’s doctors? According to the editorial in the Mayo Clinic Proceedings, “out-of-pocket costs are bankrupting many just as they’re fighting a deadly illness. Patients have to make difficult choices between spending their incomes (and liquidating their assets) on potentially lifesaving therapies or foregoing treatment to provide family necessities.” According to the authors, some 10-20% of cancer patients do not take their prescribed treatments because they lack sufficient funds to do so.

Congress consists of people who live for the purpose of getting elected and re-elected. They are alert to every opportunity for gaining political advantage in the same way that entrepreneurs are alert to profitable market-price discrepancies. Hence we expect members of Congress to jump on the bandwagon of objections to drug prices. And sure enough, “members of Congress have demanded that pharmaceutical companies justify the pricing of hepatitis C medication, which costs tens of thousands of dollars per patient. Sen. Bernie Sanders has advised the Department of Veterans Affairs to break the patents on hepatitis C drugs so that generics companies can manufacture them more cheaply for ailing veterans.”

Trustees of the Medicare system predict that average annual increases in prescription-drug spending will rise by 9.7% through 2024, compared to the 6.5% annual increase over the previous eight years. Naturally, high prices for new medications are viewed as the culprit for these projected increases and the budgetary problems that will ensue.

The word “cancer” serves as a lightning rod to attract a disproportionate share and level of all this criticism. In the last fifteen years, prices for drugs to treat the disease have risen “five- to tenfold.” In 2012, the average cancer patient’s prescription medication cost over $100,000 per year.  Today, some new immune-system-boosting drugs cost over $150,000 per year or more. When used in “cocktail”-type combinations, they can run up a tab exceeding $300,000.

A spokesman for the oncologists, Ayalew Tefferi of Mayo Clinic, hit the keynote for true believers in government regulation of markets. “What we’re fighting is the greed. The greed and the additional maneuvering that is being exercised after you’ve already recouped what you’ve invested. There is no control, no regulation.”

To summarize the position of the objectors to high drug prices: High prescription drug prices – and increases in those prices – are ipso facto a bad thing. The motive force behind that bad thing is the greed of the price-setters; namely, the executives of pharmaceutical companies who produce the drugs in question.

The “Neutral” Press

There is another interested party in this story whose stance has not yet been made clear. In principle, the press does not participate in the news stories it reports. It is merely the messenger reporting the news. Alas, that principle is freely disregarded. Today the press is a partisan with its own agenda.

That agenda is on display here. The author, Ms. Whalen, dutifully devotes a short paragraph of summary rebuttal to the position of pharmaceutical-company executives. Its medicines “provide great value to patients and the health-care system… high prices are needed to fund future research and development.” A spokesman for a pharmaceutical trade association is quoted in a single sentence citing the falling cancer death-rates, rising survival rates and improvement in quality of life for patients.

Then she gets down to making her case against the pharmaceutical companies and in favor of government regulation. “Yet critics increasingly question whether the industry’s U.S. pricing truly reflects the value and R&D costs of medication, or simply what the largely unregulated market will bear. In most other countries, including Canada and European nations, single-payer health-payer systems bargain hard with pharmaceutical companies, sometimes refusing to pay for drugs they deem unreasonably expensive. As a result, prices are often far lower in these markets.”

“The U.S., by contrast, finds it hard to say no. ‘The U.S. has always taken a very hands-off attitude, that patients are going to have access to new medical treatments regardless of the cost,’ said David Howard [a professor of health policy]. For a big payer to refuse to cover a drug would be ‘a highly unprecedented situation,’ he said.”

The Economics of (Drug) Prices

Conspicuous by its absence in this article is any comment by or reference to an economist. As a result, there is no semblance of economic sense to any statement made by anybody, including particularly reporter Whalen. To see this, ponder the role played by prices in markets.

Prices coordinate the activities of buyers and sellers by determining the value of goods and services. The implicit assumption of the WSJ story is that prices perform the sole function of distributing – and redistributing – income between people. A high price is neither good nor bad in and of itself if the price accurately reflects the valuations expressed by individuals in the marketplace. High prices may mean that consumers are beating down the store doors trying to get their hands on the good in question. Or the high price may mean that the inputs necessary to produce the good are in short supply and have shot up in price, so that the good is now more costly to produce. Either way, the high price has sent a message to market participants. In the first case, the message to producers is “produce more of this good.” In the second case, the message to consumers is “buy less of this good because less is being produced and less is available for sale.” In neither case do we want to do anything to interfere with the transmission of the message. 

Both high prices and low prices send vital information from some people to other people. Those messages are how the economic system operates. Garble or interdict them and you make people worse off, not better off. The objectors to high prescription-drug prices are making the classic mistake of killing the messenger of bad news in the childish belief that by killing the news they can change the reality contained in the message.

A Special Case of Textbook Economic Regulation: Pure Monopoly

Inevitably, it will occur to somebody to wonder whether government regulation of price can ever be a good thing. And since even Democrats and opponents of free markets can read, one of them will pick up an economics textbook and leaf through it in hopes of picking up a few ideas. This is sound strategy because within the economics profession the political bias skews to the left; there are more left-wing economists than right-wing economists.

Most mainstream textbooks in intermediate price theory or microeconomics will include a discussion of the optimal regulatory strategy for setting the price of a pure monopolist; e.g., a single seller of a good for which there are no close substitutes. The pure monopolist will face the entire market demand for the good it sells. It will maximize its profit by producing the rate of output at which its marginal revenue is equal to its marginal cost. The price it will charge its customers for this rate of output will greatly exceed both marginal revenue and marginal cost. (Why? The market demand curve confronting the pure monopolist is always downward-sloping, which implies that the marginal or incremental revenue associated with additional sales always falls. That is, marginal revenue is always less than price at any rate of output.)

The textbooks remind their readers that, if the monopolized industry were instead comprised of a large number of sellers, each small in size relative to the whole market, no individual seller could influence the market price by varying its rate of output. In this “perfectly competitive” environment, each small seller views itself as a “price-taker.” This perception creates a mindset in which each seller views its marginal revenue and price as identical because it views market price as a given, not something the firm can influence through its own actions. Profit maximization still implies that the firm will produce the rate of output at which marginal revenue is equal to marginal cost, but since price is treated as equal to marginal revenue, it is also equal to marginal cost. Since price is equal to marginal cost for each individual competitive firm, this outcome applies to the whole industry as well. And that will result in a lower price and higher rate of output that those chosen by the pure monopolist, for whom price is greater than marginal revenue and marginal cost.

In the textbook application, the hypothetical regulator will choose to regulate a pure monopolist by locating the rate of output at which its marginal cost is equal to its price. The pure monopolist would not itself choose that rate of output at which to operate, for its marginal cost (being equal to price) is greater than its marginal revenue at that output. It could increase its profits by producing less and charging a higher price. But when confronted with the regulated price chosen by the regulator, the monopolist will produce that rate of output now because the regulator has changed the monopolist’s marginal revenue by fixing price at the competitive level. That fixity means that marginal revenue no longer falls as the monopolist increases output. Now marginal revenue, marginal cost and price are all equal at the competitive rate of output, so the monopolist is induced to operate under the same price and production conditions as would a competitive industry.

This undoubtedly strikes students as very ingenious. However, there is one tacit premise underlying this old standby textbook argument.

The argument presumes that the government regulator has the information necessary to choose the correct price.

When the student is reading this discussion in the textbook, this doesn’t appear to be a problem. The textbook’s author has made the whole problem look very easy. He (or she) has illustrated the logic behind the technique with a graph showing a market demand curve, marginal revenue curse and marginal and average cost curves. All the student has to do is follow the lines, observe the results and check the logic in his or her mind. It is seductively easy to assume that the pure monopolist must have exactly the same diagram at his disposal. And from that assumption, it is only a short way to the further assumption that a government regulator must have the same information at his or her elbow as well.

In reality, though, individual businesses do not have the kind of information that economics textbooks assume they have. Indeed, the only way businesses can acquire the sort of information shown in the diagram is by gradually piecing it together from markets, but since market data is constantly changing they don’t have the time to do it. This would be true many times over for a pure monopolist, who would have to have information about an entire market that might consist of many thousands, millions or billions of customers.

If businesses don’t have this information at their fingertips, we can bet that government regulators don’t. Businesses have the strongest possible incentives to acquire and use the information. Government incentives are much weaker and don’t run in the direction of efficiency, since the care and feeding of a government bureaucracy doesn’t depend on serving the needs of the public. Indeed, the opposite is true.

So the upshot is that the practical value of the famous textbook of government price-regulation is somewhere between slim and none. There are apparently no known cases of this technique being applied successfully. That is not surprising, since there is not much scope for its being used experimentally. Even if there were lots of pure monopolies to practice on – which there aren’t – that practice would end up getting pretty expensive to the public welfare.

The political incentive for a regulator charged with setting the price of a pure monopolist would be to set the price as low as possible. But this is very likely to produce a worse result than simply allowing the pure monopolist to maximize its profit, since it will probably equate price, marginal revenue and marginal cost at a much lower rate of output than the monopolist would choose. This is pretty obvious to anybody who studies the textbook diagram while keeping in mind that in real life, a regulator would be flying blind in deciding what price to set. Textbook writers are not anxious to undercut their carefully developed analysis and therefore do not usually point out this inconvenient fact.

Why is that bad? Well, put yourself in the position of a consumer of the monopoly good. In the case of a cancer drug, what its consumers want more than anything else is to be able to actually use the drug. To do that, it has to be produced. They can’t consume a cancer drug that isn’t produced. So any outcome that results in less output is bad from their standpoint.

What Kind of “Regulation” Are the Oncologists, Et Al, Talking About?

This brings us back to our motley band of objectors to high drug prices. According to the Mayo editorial, they want “regulation.” This is the all-purpose mantra of the day. But what can the word possibly mean?

“What we’re fighting is the greed.” The word “the” suggests we are supposed to know or intuit the meaning of “greed,” and certainly if repetition could confer meaning then further explanation would be superfluous. But Ms. Whalen’s “critics increasingly question…” implies that these people are embarked on a new crusade here. Pharmaceutical companies began in the 19th century; did they just catch the virus of greed in the last few years? Or did 118 oncologists just wake up, like so many Rip van Winkles, to the intransigent fact that investors are seeking the highest possible rate of return for a given level of risk? And while this point is up for discussion, why are the prices charged by oncologists and hospitals to their uninsured patients never tarred by this same brush?

The Mayo editorial dabbles (badly) in economics by broaching the subject of recoupment of investment, which is not the relevant economic criterion for gauging return on investment. The objectors are criticizing prices, which are the province of the managers and executives who run the pharmaceutical companies. But these people are not the greedheads. The beneficiaries of investment are the residual claimants of profits – the owners of the company, the shareholders. The shareholders are not the ones who set prices, so it’s a waste of time to link prices and greed even if it otherwise made sense to do it – which it doesn’t.

Some of the richest people in history – Bill Gates, Steve Jobs and their ilk – got that way by producing goods that were consumed by others. If we don’t begrudge them mind-blowing wealth, it stands to reason that the owners of companies producing cancer drugs are entitled to whatever wealth they get. What we really want is as many cancer drugs and as much effectiveness from those drugs as possible, not as little wealth accruing to pharmaceutical investors as possible.

Jeanne Whalen’s case for a single-payer system rests on the superior bargaining power of government vis-à-vis drug companies. In other words, the left wing that made its bones by painting “corporations” as monstrous behemoths crushing the little guy underfoot now wants us to trust our lives to a government whose efficacy depends on its relative size and coercive power against sellers unable to withstand the irresistible force of its buying power.

And will this massive power be used in a sensitive, compassionate way to tenderly protect the welfare of the consumers whose interests it places foremost? No, the government’s Food and Drug Administration has long been known for callously refusing efforts of the terminally ill to lawfully obtain promising experimental drugs. The FDA has long resisted efforts to reduce delay times to bring new drugs to market.

Ah, but perhaps those single-payer foreign governments extolled by Ms. Whalen are more solicitous of their citizens than is the U.S. government. No, if that were true, then U.S. citizens would be stampeding out of the country to receive treatment there. If anything, the reverse is true. Why, in spite of rising prices for prescription drugs and medical services of all kinds, is American health care still sought after by global consumers? Because foreign single-payer government health-care systems ration care among their citizens. They refuse to allow price to play its normal role in the marketplace, instead insisting on keeping official prices artificially low and forcing patients to suffer on waiting lists rather than allowing them to pay higher prices. (In the jargon of economics, this is called “rationing by queue.”) Oh, they bargain hard with doctors and drug companies, all right. They do so because all welfare states ultimately run out of other people’s money and go broke – and the health-care component is the first part of the system to break down, even before the pay-as-you-go old-age-and-survivor component that is following closely behind it. The single-payer systems bargain as follows: They hold a gun to the heads of patients, saying “Reduce prices or I’ll shoot.” This leaves doctors, hospitals and drug companies with the unenviable choice of cutting their own throats now or being forced to do it later after being publicly demonized as the villains by the government.

Even welfare states cannot afford to flatly deny medical care to their citizens. So those governments are forced to take over the medical sector completely. Pharmaceutical companies become wards of the state, consigned to the competitive limbo of companies that have been castrated but kept alive by government subsidies. Doctors become menial time-servers rather than true physicians. Hospitals become – well, take a look at our own state mental hospitals to get a general idea. Meanwhile, consumers are trapped in a downward spiral of deteriorating quantity and quality of medical care. Only those who can afford to travel abroad can escape. The rest can only hope to keep their health as long as possible; otherwise, they die on waiting lists cursing the system while the healthy young get free checkups and sing the praises of “free health care.” And nobody feels the sharp end of this system more keenly than cancer victims, whose care is the most expensive and who suffer the ultimate penalty from rationed care.

The irony is that Ms. Whalen began her article complaining that cancer victims have to make “difficult choices” and may well end up foregoing some care because prices are too high. She ends it criticizing the U.S. health care system because it “can’t say no!” Isn’t that exactly what the cancer victims she herself reports on are doing? The cancer victims she describes are making the tough choices and running their own lives, but she implies that they and the rest of us would be better off surrendering all our choices to a single-payer system. Ms. Whalen begins by subtly suggesting that in a single-payer system, cancer-drug prices will be lower and cancer victims magically will be able to buy all the drugs they want at those lower prices. Of course, that isn’t what actually happens. The truth is that a single-payer system achieves its artificial lower prices only at the cost of a lower supply of cancer drugs, which the government rations among the desperate consumers.  Apparently she expects us to believe that if cancer victims have no say in their own care, they won’t feel as bad as they do now when they have to forego treatment. Today, though, they have the hope of buying the drugs they need if they can get the money. Under the single-payer system, they have no hope unless they are among the lucky few who win the rationing lottery, because there aren’t enough drugs produced to accommodate the patients who need them. The laws of economics override any bureaucratic laws man can devise.

The Role of Monopoly

The recourse to regulation has become the knee-jerk reflex solution to every public-policy problem, despite its conspicuous lack of success in solving any of them. The concept of regulation is poorly defined and its actual workings are poorly understood. In the world of politics, this makes it the perfect solution – it is an empty vessel into which each citizen can pour his or her own personal dreams, ideals and vision.

The production-structure of pharmacology makes it a tempting target for this kind of hazy thinking. Patents are customarily granted on the formulas for complex new medicines. A patent is defined as a government grant of monopoly on the ownership rights to a product or process, which include the right to produce it and license its production and use. The general public is used to associating the notion of monopoly with regulation. It became accustomed to that from decades of exposure to public-utility regulation, in which privately owned utilities received a grant of monopoly in exchange for submission to rate-of-return regulation by state-government commissions.

The two situations have nothing in common. Public utilities are (or, more accurately, were) natural monopolies owing to the peculiar characteristics of their production functions. Pharmaceuticals have no natural-monopoly characteristics, so there is no inherent rationale to subject them to the same kind of regulation applied to electric, gas and phone companies – not that public-utility regulation compiled such a sterling record of success in any case. The purpose of the patent is to encourage innovation. The existence of drugs that patients want to take is evidence of success. This is not an argument for regulation – just the reverse, in fact.

The Role of the Private Sector

The prospect of death at the hands of a life-threatening, complex illness like cancer is by definition a catastrophic illness. We expect that catastrophic illnesses will impose severe and sudden financial burdens on patients even in a perfect, well-functioning health-care system. This is a classic case where insurance can and should function to protect both the patient and the public at large from the direct and indirect (spillover) effects of catastrophe.

Unfortunately, health-care insurance in America and elsewhere has gotten sidetracked from its proper function. Beginning in World War II, employers began offering more comprehensive health-care insurance as a means of evading wage and price controls and offering employees an effective increase in real income that, unlike wage increases, was not subject to taxation. The health-care insurance lost its focus on catastrophic illness and became more and more “first-dollar coverage” that paid for routine health-care procedures. In turn, this caused insurance companies to avoid paying the large claims that should and normally would have constituted their proper insurance province. Today, health insurance is upside down. Subsidization of most garden-variety health-care services has driven prices through the roof while the uninsured face sky-high prices.

The Mayo oncologists should be devoting themselves to the only problems worth solving. First, they should be reforming the system by returning it to its roots – fee-for-service medicine supplemented by catastrophic insurance policies with low premiums and inter-state competition between insurance companies. That is a reform program well worth the time of busy professionals like the Mayo 118.

Second, the oncologists should busy themselves in finding ways to get money to cancer patients who need it. This is the classic function of private charity. As it stands now, the oncologists support a program of reverse-reform that will succeed only in killing more of their patients.

Should any readers – or the oncologists themselves – indignantly insist that they know better than economists how the market works, let them prove it.

Since they claim that pharmaceutical companies are greedy and can subsist perfectly well by charging lower prices, let the oncologists start a pharmaceutical company or buy an existing company and make it thrive by putting their principles into practice. Rather than force existing companies to do it their way, they can prove their point the old-fashioned way by competing in the marketplace and winning out.

Judging by the popularity of politicians who demonize corporations and profit, they would have many people cheering them on.

What Could the Mayo Oncologists Have Been Thinking? 

Readers may be wondering what the Mayo oncologists could possibly have been thinking when they signed on to the editorial referred to above. The old adage “Never ascribe to venality that which can be explained by mere stupidity” may well apply here. On the other hand, it may also be true that the doctors hope to secure for themselves and their patients a favorable place in line in the future rationing regime of a single-payer health-care system that evolves as the natural heir to ObamaCare.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s