In 2018, the Kaiser Family Foundation reported near-unanimous support for giving the Department of Health and Human Services power to negotiate drug prices for Medicare beneficiaries — currently prohibited by law. The poll showed 96 percent support from Democrats and 92 percent from Republicans and independents. Pundits enthusiastically endorsed the idea.
Unfortunately, HHS-as-negotiator wouldn’t yield the cost savings enthusiasts imagine and would likely stifle innovation. To understand the weakness of HHS-as-negotiator, some basic drug economics might help.
Consider a hypothetical pharmaceutical company investing in research on various potential drugs. It abandons some. Others begin the trek through clinical trials and regulatory oversight. Ultimately, the Food and Drug Administration approves one drug. The company probably spent more than a billion dollars over 15 years to win approval — along with vast sums on failed drugs.
Now, manufacturing the drug is relatively inexpensive. The pills may cost pennies apiece. But, depending on the size of the market, the company may have to charge hundreds, thousands, or even tens of thousands per pill to recoup the development costs.
Let’s say the pill costs $1 to manufacture and sells on average for $2,000 in the United States and $500 in, say, Europe. “Mammoth markup” and “obscene profit” headlines hit the news, festooned with the low European prices that journalists attribute to hard-nosed, high-minded government negotiators. Democrats, Republicans and independents join hands, allowing HHS to negotiate directly.
At least four big problems spoil the pre-hatch chicken counting:
First, lower European prices don’t necessarily reflect government bargaining skills. Since cross-border drug trade is severely limited by American law, drug companies can charge different prices in different countries (“price discrimination” in economics-speak). For maximum profits in such circumstances, sellers will charge high prices to wealthy, profligate, insistent buyers and low prices to poorer, frugal, take-it-or-leave-it buyers. Compared with Europeans, Americans are considerably wealthier, less frugal, and more insistent on having the latest and best treatments.
Second, if pharmaceutical companies fail to recoup the high costs of developing drugs, their stocks will underperform, and investors will take their capital elsewhere. The government may have sufficient power to force a company into losses today, but the secondary effect will be to discourage investors from capitalizing pharmaceutical companies going forward. Hence, we’ll see fewer new drugs and miracle cures.
Third, there’s an incentives problem (“public choice” in econ-speak). When an HHS negotiator sits down with a drug company, he’s bargaining with a prospective future employer. Only a saintly HHS negotiator could avoid at least a passing thought that, “If I authorize Medicare to pay an extra five dollars per pill, this company will earn an extra $20 million. And when I apply to this company a year from now for a job that pays five times what I earn today, my name will ring out fondly.” This process is all too familiar in Defense Department procurement. Hence, $6,700 monkey wrenches (in 2018 dollars).
Fourth, while this same incentive problem might exist today with large private purchasers of drugs (pharmacy benefit managers — PBMs), their negotiators’ self-interests are restrained in ways that wouldn’t be true of HHS negotiators. The PBM negotiator might similarly ponder a job with the company on the other side of the table, but his performance is gauged against peers at competing PBMs. Today’s performance trumps tomorrow’s resume. If HHS were the only purchaser, no such comparison (read: similar competitor) would be available for assessing whether the government negotiator has been overly generous.
Incidentally, another oft-heard big idea for bringing prices down is legalizing drug reimportation — letting Americans buy the pills for $500 from Europeans rather than for $2,000 from Americans. But price discrimination only works if cross-border trade is banned. Allow such trade, and arbitrage will hurl European prices upward toward the American price. The primary result may be Europeans losing access to the drug when their governments balk at paying the American price.
The surest way to lower drug prices is to make drugs less expensive to develop. Above all, that means the hard work of radically overhauling the FDA’s approval process. It’s more tempting, though, to pray for a strong, talented, saintly government negotiator — riding a unicorn, perhaps.
