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Event Transcript
October 21, 2003

Drug Prices and the Rising Cost of Health Care

MR. ROBERT GOLDBERG: Good afternoon. I am Robert Goldberg, the Director of the Center for Medical Progress at the Manhattan Institute. This is the first in an ongoing series of briefings that we will be holding on the future of medical progress and the role that medical progress will play in reshaping our health and our world. The aim of this series is to show that, contrary to the critics who claim that we can’t afford state-of-the-art medical innovation, America can’t afford to live without the next generation of medical breakthroughs.

While no technological advance is without risk or cost, our speakers will show that medical progress reduces the cost of treating disease by developing new drugs and medical devices that can be used to prevent and control expensive and life threatening illnesses. The mission of the Center for Medical Progress is to remind the public that the use of new medicines is an excellent investment that saves and prolongs lives, and improves the quality of life by increasing productivity, keeping families together, and allowing children to live without being chained to respirators or dialysis machines.

Where will these innovations come from? The same place the rest of America’s great innovations come from: the private sector. Our series will show how universal benefits flow from investments made largely by private companies. These benefits are a direct result the existing system of intellectual property protection and market competition—a system that is under assault from anti-capitalist ideologues.

The next revolution in medicine is on the way: a genomic-based platform for discovering and developing 21st century medicines and vaccines. The challenge to the future of medical progress—and developments like genomic medicine—is a political challenge from people who despise the idea of market-based medical innovation.

For over a decade rival health care interests and politicians have sought to convince the public that rising drug prices add nothing of value to public health, and are the principal forces driving increased health care spending and huge jumps in health insurance premiums.

This argument, I believe, is a red herring, but it has led to various proposals to contain drug expenditures, ranging from price controls, to limits on patent protection, to drug re-importation and restrictive drug formularies. The goals of such initiatives are to contain drug costs in order to expand health care entitlements and government control of the healthcare market.

Our first speaker will expose the fallacy of this argument and the danger of following its flawed thinking to its illogical conclusion. J.D. Kleinke is one of America’s leading thinkers about the future of medical innovation. His two books on the future of health care, Bleeding Edge and Oxymorons, are extremely well regarded in the field of health-care economics.

As a former operator of a managed care company, he understands the economics and ethos of the medical market place. He is a contributing writer and member of the editorial board of Health Affairs, the leading health care policy journal, and his articles on the role of medical innovation have appeared in The Wall Street Journal and Barrons. He is a keen observer of the forces shaping the healthcare community and has influenced the national debate on medical progress.

MR. J.D. KLEINKE: Thank you Bob. First off, consider this. (Mr. Kleinke holds up the November 2003 issue of Reader’s Digest) The cover story of the current issue of Reader’s Digest is “The New Pill That Can End Aging”. I’d like to point out that we already have a pill that can end aging. It’s called cyanide. It is available as a generic. And it beats the heck out of the placebo.

 All joking aside, consider what tthe title of this article really represents.”The New Pill That Can End Aging”encapsulates our a deeply held cultural attitude regarding medicine in this country. We expect miracles. We take it for granted that there will some day be a better pill for everything, including the very fact of aging. As Americans, we take tremendous amount pride in our health care technology and we have come to expect everincreasing types and amounts of innovation as a result.

Here is another anecdote that illustrates the same phenomenon. Several months ago I was at a meeting at the National Institutes of Health. We were discussing research priorities for the coming year in breast cancer. As is usually the case at these meetings, there were some breast cancer survivors in attendance and they were very vocal about their concerns.

One woman in particular advocated greater research into sentinel node biopsies. She practically pounded the table advocating the need for sentinel node biopsies, arguing that it’s a less invasive surgery after chemotherapy. It works just as well as the standard biopsy, and yet nobody is researching it because there is no money involved in promoting it.

During a lull in our meeting I spoke to her. I said, well, obviously you had the traditional biopsy where many nodes are taken out of your armpit after your chemotherapy. Has this affected your life? She said yes, it’s completely screwed up my tennis swing.

I’m very grateful to be living in a world where breast cancer patients are worrying about the impact of cancer biopsies on their tennis swings. Twenty years ago it wouldn’t have occurred to anyone to worry about this - because breast cancer was a fatal disease. We now take medical miracles for granted so much so that we now have the luxury to complain about them.

I am proud that we’ve made this incredible progress. But we need to retain a sense of perspective once we get into policy debates about whether or not the latest cholesterol or anti-depressant drug is worth its price. The system has done incredible things, but we can’t expect the system to produce miracles for free.

That expectation is our real problem. Medical miracles are not free. They are incredibly expensive. We all know that the price tag to develop new drugs and new medical devices is mind-boggling, and companies have to be able to recoup their costs.

Expecting miracles for free is a form of cultural self—deception that some people in the media and in Washington have an interest in promoting. Who gets to be the whipping boy for consumer outrage when they have to pay for miracles? The drug companies that developed them.

Take, for instance, drug advertising. Everywhere you look these days there are ads for drugs that weren’t there ten years ago. Most of the popular media harps on this as a horrible development. The conventional wisdom is that direct to consumer advertising is why drugs cost so much. It’s also incredibly wrong-headed.

The actual data on direct to consumer advertising shows that advertising costs account for about 1.92% of total pharmaceutical revenue. Let me repeat that: advertising costs account for less than 2% of our spending on pharmaceuticals —compared to much more substantial sums for fast food and cars. It’s a pittance and yet the visibility of pharmaceutical advertising has drawn the ire of consumer advocates and the media.

This advertising has become a lightning rod for the industry. But the industry is doing exactly what it’s supposed to do, which is to sell its products. But because people expect those products to be free, they get mad at the industry and blame the ads when, in fact, what the ads are trying to do is get people better and more appropriately medicated. Advertising helps to link the right medicine to the right patient.

In short, we have this enormous cultural dissonance between what we want medicine to do for us—cure everything—and the reality that cutting-edge medicine is very expensive to develop. The discussion of drug development in the U.S. has to start with this cultural ambivalence, because that ambivalence is driving the public policy debate in very perverse ways.

The reality behind the debate is very different. I have studied the economics of health care my whole career and what’s really going on now is that we are spending more money on drugs than ever before on a real dollar basis, adjusted for inflation.

Four years ago, we spent 7% of our health care dollar on pharmaceuticals, while just last year we spent 10%. Pharmaceuticals have had a relative increase in their share of the health care dollar by 3%. That angers people because health care spending is largely a zero sum game. Money spent on drugs to treat illness diverts money that might’ve been spent on more hospital care or other kinds of treatment. Year to year, there is a fixed dollar amount of health care spending and everybody fights over it. When the pharmaceutical industry’s share increases—as it should, because drugs offer more and better cures—people move away from hospitals and into the pharmacy, which is the natural evolution of medicine. Nonetheless, this creates a lot of resentment and angers quite a few entrenched economic interests.

So competitors and entrenched interests attack pharmaceutical advertising. They point at the ads and they say, that’s “the real problem”. But lets look at the real numbers for a moment. Pharmaceutical costs for the average health care plan went up 14% last year. . Drug prices went up about 5% and utilization increased by 9%. Again, increased drug utilization is a good thing. It should be the goal of a well-functioning health care system to get people out of the hospital and onto medications.

Those are the real numbers. But the health insurance industry has been claiming that this 14% increase in pharmaceutical costs forces them to raise their premiums at the same rate. Reporters, of course, are in a big hurry to get the best sound bites possible. So the media takes the health insurers claim at face value, not realizing that there isn’t a 1-to-1 correlation between a percentage point increase in drug costs and a percentage increase in insurance premiums. In fact, when you stop and think about it, the insurers’ math is completely untenable. If pharmaceutical costs account for 10% of health care spending, a 14% increase in that 10% is 1.4%. So if pharmaceutical costs are driving up health care premiums, there should be only a 1.4% increase. It’s miniscule. And it shouldn’t even show up in the premium increase to consumers and employers, because that 1.4% increase is offset by savings elsewhere, as better drugs keep people out of the ER, out of the hospital, and off the operating room table.

Health insurers have been incredibly sophisticated at making this non-issue an issue. What the plans have actually been doing is raising their premiums because those premiums have been artificially low for a long time. It is a little known fact that not just health insurance but the entire insurance industry goes through something called the underwriting cycle. For big companies with access to capital, health insurance has relatively low barriers to entry. It’s a very easy business to get into and out of, and when it’s a profitable business, a lot of people get in, make terrific profits, and then exit the market when it gets too competitive and a price war begins. Once the price war starts, profits crash, and the weak firms get weeded out. Then prices stabilize and start rising again.

Health insurance prices fluctuate in a sine-wave that repeats itself in about a seven-year cycle. The same cycle occurs in a much shortened form in auto insurance and a much longer cycle in medical malpractice insurance. The reason for the different lengths of the industry cycles is based on how easy it is for consumers or businesses to jump in and out of different types of insurance coverage.

People turn over their auto insurance very easily. You can switch auto insurers with a single phone call. You can change your health plan only once a year, if at all, and in medical malpractice markets, doctors are tied to long-term contracts. This cyclicality is what’s really driving the recent increases in health-insurance premiums.

Pharmaceutical costs are not really the problem for insurers at all. Better drugs are actually part of the solution to rising health care costs. What any drug does – especially a newer and better one - is to keep someone off the operating table or out of the hospital. Drug substitution for these other forms of health care pays for itself many times over.

We had theorized this for years in the health economics community and finally Frank Lichtenberg, an industrial economist over at Columbia, came along and proved it. He showed that for every dollar that we spend on better, newer, more effective drugs, we save almost $4 elsewhere in the health care equation—almost always from reduced hospital costs.

This is a natural technological evolution and it’s happening everywhere in our society. We replace labor with technology. We replace services with capital, as has happened through computers. It’s what’s happened across the board in manufacturing and it’s what’s happening in health care. When we talk about pharmaceutical costs we are really talking about the industrialization of health care.

So why have drug costs become the villain du jour? I think it’s because drugs are so visible in our society in a way they have not been in the past. Also, part of the psychology of being a patient makes the market for health care unique. People are willing consumers of fast food and automobiles. They are not often willing consumers of medicine. Regina Herzlinger, a professor at Harvard Business School, authored a piece in the Wall Street Journal not too long ago where she talked about why we needed rational consumer markets in health care. We should, she argued, think of health care options like a menu in restaurants.

The problem with that analogy is that victims of disease don’t think of themselves as consumers. Most people would disagree with the premise that victims are rational consumers of anything. Whether or not this is really true, the media portrays patients as victims, and political rhetoric reinforces that perception, and so people act as if they had no rational control over their condition – and therefore no real responsibility to pay for treating it, something reinforced for decades by the expansion of health insurance to cover not just major illness, but all of our ills and misfortunes. People don’t believe they have to pay for their health care because they didn’t ask for cancer, or heart disease, even though in many cases their behavior contributed to the illness.

The final problem I’d like to talk about is how we have structured the health care system. Recently, in one of these policy debates, someone showed mea very interesting document - a hospital bill from 1951. It was for a normal delivery of a normal newborn infant, and a five-day hospital stay. The bill was for $191. Do you know what the deductible was in 1951 for health insurance? It was $200, the same as it is today.

In short, in 1951 you could not deliver a baby and exhaust your deductible. What that meant was, back then, health insurance was insurance. God forbid you needed it. It was like fire, or homeowners, or auto insurance. You really didn’t rely on it for anything routine, not even delivering a baby. The vast majority of health care costs were paid out of pocket, and health insurance was there in case of a true disaster.

That changed very slowly over time because of the tax advantage of all health insurance spending, by employers, on behalf of consumers. Managed care accelerated the change because it made all routine medical services exponentially more accessible. In many cases, we went from having a $200 deductible to a zero deductible, while our costs and our technology were increasing all the while. As a result, the whole idea of health insurance as pure insurance doesn’t even exist anymore. Instead, we have big group buying plans that generate 25% transaction costs for every medical procedure under the sun.

As a result, these plans buy a plethora of services, including physicals and routine care, and some policymakers are even talking about expanding HMO coverage for over the counter medications and vitamins. Health care is an enterprise that has enormous inflationary pressures built into the system because third parties have been paying for more and more of what used to be routine things. This creates a tremendous amount of dysfunction and inefficiency in health care markets because consumers have no incentive to choose between wants and needs.

This idea of health insurance paying for everything explains, I think, all this conflict among providers and health plans, and all the recent resentment from consumers as this conflict has found its way to their own doors. Every time a rule gets created, or there is bickering over a transaction between the patient and the insurer, the providers themselves have to add administrative help to cope with all the new red tape. So by the time you add up all the administrative costs, nearly half of everything Americans spend on health care is spent managing the other half—an incredibly bizarre situation.

Yes, the health insurance system ought to cover breast cancer. Those people are victims. It’s a horrible, expensive disease. But toenail fungus, or impotence, or hair transplants are not necessities. A couple of decades ago, we had all of these chronic conditions that people just lived with. Or they paid for whatever remedies were available out of their own pockets.

Culturally, that has changed. We have come to expect that health insurance should pay not just for disease, but also for impairment, discomfort, and vanity. Why shouldn’t it? Everyone wants something for nothing. It’s human nature. That’s the real problem. The problem isn’t how much better we are getting at finding new medications as a society. The problems is the fact that the health insurance enterprise is gargantuan and ever expanding, along with being inefficient and generating incredibly archaic and bizarre rules.

What’s the solution for this? It’s the simplest thing in the world. Reform the tax code. If people are going to insist on buying everything, down to the $200 deductible with their employer’s money, which is really their money, they should simply continue to do so - but direct that spending personally. It should fall outside of the health insurance premium. Deductibles should be raised to something resembling what we had decades ago, when insurance was involved only when someone got really sick. The premiums for this type of coverage are much lower. And the difference can be set aside, pre-tax, for all that routine spending. This way, for a great deal of the health care entereprise generally, we get consumers far more involved and bureaucrats far less involved.

Medical savings accounts, or MSA’s, are one example of how to do this. Right now, a typical person spends – through his employer - about $5,000 on health insurance. If we moved the deductible to where it ought to be, i.e. consistent with historic trends and inflation, the deductible would be about $2,500. Under this sort of plan, we would basically be giving people a $2,500 debit card that they could use for discretionary healthcare spending: for the vitamins, toenail fungus drugs, etc. It would be their money and we would have a very simple and elegant solution to our health care mess.

If, as statistics show, 70% of the average health insurance premium is spent on medicine and 30% on administrative costs, most of the administrative costs occur in the first $2,500 (out of $5,000). That in and of itself is incredibly inefficient. The health insurance industry counters that they get good discounts that come along with their bureaucracies. It is also true that, with MSA’s, the “retail” health care customer, with a $2,500 debit card, is out there fending for himself or herself. I don’t deny that. But in that world, health insurance plans would adapt, and would be able to function more explicitly as what they really are - buying clubs for consumers.

Health insurers wouldn’t get involved in health care transactions other than to give a customer a discounted price on something. The advantage in this new system would be that people would be at risk for that first $2,500 every year, and would be motivated to spend it wisely and well, not chew through it. Any amount left over at the end of the year would roll over.

The pharmaceutical industry would thrive in this world. The drug companies would thrive because they are very good at marketing and they are very good at advertising, and they often have very good consumer product businesses.

If we could start from scratch, I think that the best change in American health care would involve consumers actually managing all their own truly non-catastrophic and routine care for themselves. If people were allowed to manage all of that, the pharmaceutical industry would adapt. People would stop blaming the industry for a lot of problems that it didn’t create. That would be better for both industry and consumers alike, because right now the pharmaceutical industry is being punished for making products that really do improve lives.


Center for Medical Progress.




In this forum, noted medical economist J.D. Kleinke presented research showing that drug usage accounts for only a fraction of health insurance costs, and substitutes for more expensive health expenditures, such as hospital care. Ultimately, he argues, increased drug utilization leads to lower total health care costs for insurers and society alike. Current health insurance premium increases—in some cases by as much as 25 percent—are actually due to cyclical market forces, not rising expenditures on prescription drugs. Kleinke concludes by suggesting that America’s reliance on a system where consumers of health care are completely isolated from the cost of medicine is flawed.  Instead, he recommends creating individual savings accounts so that people spend their own money on routine or preventative care, and reserving insurance for catastrophic events and illnesses.


Robert Goldberg, Ph.D., Senior Fellow, Manhattan Institute; Director, Center for Medical Progress


J.D. Kleinke, Founding Executive, HCIA Inc., Member, Editorial Board, Health Affairs

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