November 2, 2004

The economics of the health industry have begun to fail America

The discourse in America right now over drug re-importation schemes involving Canada and Europe is largely misguided. The issues raised concerning safety are barely worth mentioning and easily mended with factory inspections. What is needed is a serious discussion of the economics of the health industry and how the market has begun to fail America.Laura Hamilton's assertion ("Stop blaming the big pharmaceuticals," 10/29/04) that the American medical system was founded on principles of competitive markets is inaccurate. It was not until recent decades, most significantly the 1990s, that for-profit hospitals became a powerful force in American health care. Before the advent of for-profit hospitals, such as the infamous Columbia hospital chain and despised HMOs, hospitals were research centers or non-profit organizations run by a board whose primary interest was the health of its patients, not its own pocketbook. Now, however, the rate of profits and consumer costs in the health care industry has sky-rocketed thanks to corporations which exploit patients' inelasticity of demand in the name of capitalism. As we all know, this has not led to a decrease in the number of people without access to health care. Indeed, quite the opposite is true. It is thus obvious that the market is not providing a socially optimal level of health care. With respect to pharmaceutical companies in particular, the Canadians are indeed "having their cake and eating it too" with access to cheap medicine and a fast pace of innovation. The original point of the patent system was to deal with the following problem: if I invent something, how does society structure the market such that I am rewarded? If I did not reap benefits, then I would have no incentive to continue to invent, and innovation would quickly stagnate. The patent system is only one in a range of options for solving this problem. Pharmaceutical companies spend twice as much on marketing as they do funding research and development. What may come as more of a shock is that the federal government subsidizes health care research at over twice the level that the pharmaceutical companies fund it. All told, of the approximately $92 billion spent on health care research in the U.S. each year, only $29.4 billion is paid for by pharmaceutical companies. Thus it can be seen that the patent is just the icing on the cake for the pharmaceutical industry, as their research costs are already subsidized. Patents are not designed to create monopoly markets, yet this is exactly what they do in the drug market. The patent is designed to create a trade-off between newer, more efficient goods and older, less efficient (but cheaper) goods. Take an example: patenting an entire engine is impossible. There are a number of different mechanisms you'd have to patent, and many of the other parts would be in the public domain. When it comes to a drug, there is usually only a single chemical entity that is patented; thus that patent creates an entire product that is off-limits to production. Further, the impact of a drug on a market is significantly different than most products that we are familiar with. Drugs are patented because they do things other drugs were unable to accomplish. For example, a drug that cures cancer doesn't compete with Advil for market-share. It has a specific purpose, and therefore the patent on that drug does not create a trade-off between two sets of drugs, but rather creates a monopoly, where the trade-off is between death (or illness) and health. Analyses of price differentials upon patent expiration in the drug industry compared to other industries bears this out. We might be able to shrug off the fact that we subsidize research on patented goods if the patent system wasn't abused. Dozens of lawsuits are decided each year in anti-trust litigation showing that the patents received by the companies were in fact illegal or abused. The pharmaceuticals are rarely hurt because being sued under these conditions still leads to vast profits, garnered illegally, over the amount they will have to pay due to their behavior. Without getting into details, I will note that now we can patent things like mathematical formulas and organic material, which used to be explicitly illegal. This has led many economists as well as the Federal Trade Commission to say that the patent system is seriously broken. Economists Andrew Horowitz and Edwin Lai have shown that in markets where products are patented, the level of trade-off between dispersion to consumers and the rate of innovation that is optimal for consumers is sub-optimal for producers, and vice-versa. Thus we have to make a choice: Do we want to benefit people more or corporations? I tend to agree with Peter Rost, vice president of marketing for Pfizer, the world's largest drug manufacturer. We need to fix the system in America and in the meantime find cheaper drugs.