Economists may disagree about many things, but absent among
them is the role of incentives in the determination of choice
behavior. Whether shaping the choices made by individuals
in isolation or in groups acting collectively, the nature
and power of the relevant incentives can be used to predict
decisions and outcomes, at least directionally, in both
the private and public sectors. With respect to the latter,
the incentives confronting policymakers and agency administrators
making decisions under a given set of rules, constraints,
and opportunities will yield particular kinds of choices,
while a different set of incentives or institutional arrangements
will engender different outcomes.
These initial observations are trivial, but seemingly few
people apply them to emerging public policy issues as those
specific legislative and regulatory choices come to the
fore. Such policy choices can significantly affect individuals,
firms, industries, and the economy, so the importance of
analyzing the incentives of policymakers as a tool with
which to predict the implications of policy choices ought
not to be ignored.
As discussed in Section II, the incentives of federal policymakers
are inherently biased in favor of current budget savings
at the expense of greater, rather than lesser, inclusiveness
of federal drug formularies, relative to the case for private
profit-seeking intermediaries balancing the demand of customers
pursuing both price savings and formulary inclusiveness.
This has the short-term effect of reducing the number of
drugs included in the formularies; because of this relatively
weaker incentive to include given drugs in formularies,
prices can be predicted to be lower than in the alternative
case.[a1]
The narrow long-term effect of these lower prices must
be a reduction in the flow of research and development investments
in pharmaceuticals, in turn yielding fewer medicines and
higher medical costs (and greater suffering) over time.[a2]
The pharmaceutical producers — which are entities with
infinite lives — have incentives to preserve the flow
of efficient research and development investments; those
incentives are consistent with the partial incentives of
private purchasers to make formularies more, rather than
less, inclusive.[a3]
In this sense, the profit motive leads the pharmaceutical
producers implicitly to represent the interests of future
patients, while the large profit-seeking retail buyers implicitly
represent the interests of current patients.[a4]
It is reasonable to predict that the bargaining process
between pharmaceutical producers and the firms serving retail
customers will yield current prices and investment flows
that are roughly efficient.
A different long-term dynamic emerges in a world in which
the incentives of federal policymakers transform pharmaceutical
pricing into an implicit tax/transfer mechanism. As noted
above, the stream of relatively large price discounts negotiated
by the federal government is analogous to a flow of tax
revenues distributed to drug consumers (or to the beneficiaries
of other budget programs) in the form of ongoing price savings.
For any given drug, there is a negotiated price (or price
discount), P*, that maximizes the present value of the flow
of price savings.[a5]
Prices higher than P* (i.e., smaller discounts) would yield
a smaller flow of price savings but a higher stream of research
and development investment.[a6]
Prices lower than P* would yield a smaller flow of price
savings because of more stringent formulary exclusions imposed
by the drug producers[a7]
and clearly engender a lower stream of research and development
investment. A price lower than P* may make both consumers
and producers worse off and therefore cannot be the optimal
price or price discount. The observation to be made here
is that the incentives of federal policymakers lead them
systematically to demand prices lower than P*.
Consider the decision-making environment confronting a
policymaker driven to use tax and expenditure policies to
maximize political support.[a8]
Additional tax revenues (in this context, price savings
on drugs) always serve the interests of policymakers as
long as the price discounts in the short run do not create
economic effects that over time offset the price-discount
stream more than fully during the policymakers’ terms
in office.[a9] In other
words, as long as industry adjustments to adverse policies
take longer than the terms of current policymakers, their
net political incentive is to transfer as much wealth as
possible from the producers to their constituencies.[a10]
In the absence of constraints on the choices made by current
policymakers--the extreme case--the federal government would
pay only the marginal production cost for drugs, thus maximizing
the current flow of price savings while ignoring the obvious
adverse effects for future investment in research and development
and production capacity.
Such constraints do exist, of course. The longer-term adverse
effects of current policy choices should be resisted in
some measure by the political parties, which to a degree
have longer time horizons than given policymakers, who in
turn might have incentives to take such effects into account
to the extent that they receive funding and other kinds
of support from the parties. Some patient groups and others
will oppose actions yielding important expected declines
in the future delivery of medical and pharmaceutical services.
The pharmaceutical sector is an interest group of nontrivial
influence. In addition, to the extent that policymakers
can hide their behavior from voters, they might choose to
demand smaller drug price discounts than otherwise would
be the case.[a11]
Even in the presence of such constraints, policymakers
can be predicted to negotiate a price lower (price discounts
that are greater) than the price P* that maximizes the present
value of the flow of price savings as long as their political
time horizons are shorter than the period over which the
industry would adjust fully to the implicit tax inherent
in the actual negotiated price. Moreover, the short time
horizon of the policymakers leads them to favor preservation
of the negotiated price below P*, because a lower price
yields a larger stream of price savings (implicit tax revenues)
immediately, while the longer-term benefits of the larger
research and development investments yielded by P* will
accrue politically to their successors. In short, negotiation
of prices lower than P* yields a political equilibrium (or
trap) in which no current policymaker has an incentive to
choose policies avoiding or reducing the adverse research
and development effects of the negotiated prices.[a12]
Appendix
B: Data Tables
Table B1. Historical
and Projected Data on Pharmaceutical Research and Development:
NSF Data and Investment Growth of 7.967 Percent (millions
of year 2005 dollars)
Table B2. Historical and Projected Data on Pharmaceutical Research and Development:
NSF Data and Investment Growth of 4 Percent (millions of year 2005 dollars)
Table B3. Historical and Projected Data on Pharmaceutical Research and Development:
PhRMA Data and Investment Growth of 4 Percent (millions of year 2005 dollars)
Appendix
C: Charts
Chart 1. Base Case
R & D Investment
Chart 2. Base Case R
& D Capital
Stocks
Chart 3. First
Sensitivity Case R & D
Investment
Chart 4. First
Sensitivity Case R & D
Capital Stocks
Chart 5. Second
Sensitivity Case R & D
Investment
Chart 6. Second
Sensitivity Case R & D
Capital Stocks
Appendix
D: Brief Observations on the Congressional Research Service
Report on Federal Price Negotiations for Drugs
The Congressional Research Service (CRS) has prepared a
brief analysis of the arguments for and against federal
negotiation of drug prices for Medicare beneficiaries.[d1]
Summary observations on that paper are as follows.
The paper argues that differential pricing (“price
discriminate”) of drugs flows from the monopoly power
of the producers attendant upon the issue of patents, as
well as the presence of “numerous channels of distribution
from manufacturer to consumer.” This argument is poor
at best: Differential pricing is fully consistent with competitive
conditions[d2] and even
in the absence of patent restrictions on entry and the like
can yield improved economic efficiency. This is particularly
the case with such goods as drugs with low marginal production
costs; differential pricing can enable producers to cover
large fixed costs while still producing aggregate levels
of output that equate marginal cost and marginal value.
The discussion of the VA pricing system is incorrect, in
that it fails to distinguish between the mandated minimum
24 percent discount from the AMP (the FCP) and the FSS requirement
that the pharmaceutical producers sell drugs to the VA at
the “best price” offered to private-sector buyers.
These are not “negotiated” prices, particularly
given that FSS “best prices” must be offered as
well to many health-care programs receiving federal funding;
thus does the FSS “best price” requirement allow
the federal government and many others to receive the benefits
of private-sector negotiations without undertaking any negotiations
themselves. The VA is entitled under the law to receive
the lower of the FCP and FSS prices.
The discussion of third-party (middlemen) markups is poor:
Wholesalers and the like reduce various types of transaction
costs. Why else would profit-seeking firms utilize them?
The elimination of such layers of market participants by
a large government program does not by simple virtue of
that fact improve “efficiency.” Instead, it shifts
the various transaction costs onto someone else: the taxpayers,
the drug producers, the consumers, and so on. While it may
be the case that federal involvement would reduce various
kinds of transaction costs, that ought not to be assumed;
and the experience with other federal procurement programs
is not encouraging.
The paper argues that the “plethora of choices”
under Medicare Part D “is not universally viewed as
a positive outcome.” Even in principle, consumers cannot
be made better off with fewer options; cost reductions might
be one effect of fewer options, which is why no market has
an infinite number of competitors, but a federal takeover
of such market functions as price negotiations is not obviously
consistent with that goal.
The paper in its discussion of the arguments against federal
price negotiations fails to consider the differing incentives
of federal policymakers and large private buyers in terms
of the tradeoffs between low prices and more inclusive formularies.
Finally, the paper argues that “there is very little
evidence that quantifies the degree to which reductions
in retail prices would lead to fewer new products being
introduced.” That is simply incorrect: Various works
by Santerre, Vernon, Lichtenberg, and others referenced
above are examples.
