What Is The Right Price To Pay For Drugs? Part II

In response to Donald Trump’s invitation to a national discussion on how much we should pay for drugs, I proposed in Part I to take the same approach economists take toward most public policies. That is, we begin by asking what would happen in a completely free market. Then, we ask whether government intervention of some sort would improve social welfare.

In Part I, I surveyed the seller side of the market. Let’s now turn to the buyer side.

Buyer behavior

How would people make decisions about whether to purchase drugs and which drugs to purchase in a free market? For low-cost drugs (which includes most generics), they would likely pay directly—probably from a Health Savings Account. Their decisions would be based on a physician’s advice and personal experience.

Individuals have different biological makeups. A drug that works for one person may not work for another. How long a drug is needed is also likely to be personal. So, people would purchase drugs the way they purchase any other product. They would rely on experience and engage in personal cost-benefit analysis, occasionally aided by professional advice.

For expensive drugs, people would almost certainly turn to third-party health insurance. In doing so, they would have to rely on the insurer to make collective decisions about which drugs to cover and how much to pay for them. In doing that, the insurer would be doing cost-benefit analysis for the enrollees as a group.

How is that possible?

From the medical research, the insurers would have estimates of the health value of a drug—how many additional years of life it promises, for example. From the economics literature, they would have estimates of the value people place on additional years of life—based on decisions they make in everyday life.

Some readers may object that life is priceless. It may be, but we don’t act like it is. In driving a car, crossing a street, playing sports and in many other activities, all of us take small risks in return for small rewards. Economists have measured these tradeoffs—mainly by looking at behavior in the job market. For example, jobs that have higher death and injury rates pay higher wages. By measuring how much more people have to be paid to take additional risks, economists are able to estimate what is called the “value of a statistical life year,” or VSLY.

Space does not permit a full discussion of all the issues involved (including adjustments for the “quality” of life), but a common estimate is in the range of $150,000 to $200,000 per year of life saved. If a drug promises to save a year of life and its annual cost is less than $150,000 it is said to be cost- effective, or worth what it costs. If it costs more than $200,000, it is said to be not cost-effective.

Note: this is not the same thing as saying that a person’s life is worth no more than $200,000. Instead, it is saying that when everyone is healthy and we all know that we face low probabilities of many different future risks, how much money are we willing to commit today to avoid (or reduce) those risks? Based on decisions people make with respect to other risks in life, it looks like the cutoff point is around $200,000.

This exercise isn’t theoretical. It is already being done by our federal regulatory agencies, including the Department of Transportation (DOT), the Environmental Protection Agency (EPA) and the Food and Drug Administration (FDA). Each of these agencies must make many decisions involving tradeoffs between money and improvements in the health and safety of the public. They can’t make consistent decisions without a standard.

Right now, no health insurer in the US (public or private) uses the VSLY for decision-making. But the British National Health Service does—for drugs and other interventions. The cut-off point for the British is between $25,000 and $37,500 per quality adjusted life-year—a much lower value than American agencies are making for regulatory decisions. Critics argue that these limits are too low. Yet it is interesting that the British government has a standard and that it is very public about it.

Public policy implications

From this brief overview of the buyer’s side of a free market for prescription drugs, we can note five important things.

First, private insurers should be able to adopt the same cost-benefit standard the federal government uses.

Because of perverse regulations, private insurers can’t be counted on to adopt the socially optimal cost-benefit tests. (I’ll address this in Part III.) But there is no reason why they shouldn’t be able to use the same cut-off criteria the federal government uses. Drug manufacturers would know that if the price they are asking can’t meet this criterion, private insurance probably won’t cover their drug.

Second, if private insurers were allowed to use the federal cost-benefit criteria, many state and federal health insurance mandates would have to be repealed.

It is not just drugs that might fail the cost-benefit standard. State governments for years have mandated heath insurance benefits that are not cost-effective. The Affordable Care Act (Obamacare) did the same thing under federal law. An annual cervical cancer screening in low-risk populations, for example, costs more than $1 million per year of life saved. Yet Obamcare requires that it be covered. It is doubtful that Obamacare’s mandated annual wellness exam has saved any lives.

Third, individuals should be able to make private provision for items not covered by their health plan.

Women at low risk should be able to pay out-of-pocket for an annual cervical screening— even if their health plan doesn’t pay for it. But people may also want to buy a separate insurance policy for expensive uncovered services.

This, for example, would be a possible solution for the problems faced by British cancer patients. According to one study, as many as 25,000 British cancer patients die every year because (1) they don’t have access to drugs that are available in other countries and (2) they don’t have access to other complementary care.

Of course, in many cases we may be talking about only a few months of additional life. But different people have different preferences. So why not let them buy “top up” insurance, which would pay for the drugs and also for private care, should the occasion arise? Because the likelihood that it would be used is very small, this type of insurance would probably be very inexpensive.

Fourth, if the private insurance plan is large enough, insurers would be able to negotiate prices.

In a free insurance market, a garden-variety health plan would be a price taker in the market for prescription drugs. That is, manufacturers would quote a price, and the plan would take it or leave it. However, if the plan were large enough, it might be able to achieve bargaining power. For example, if a drug company faced the possibility of losing every one of the people insured by UnitedHealthcare, it almost certainly would be willing to discuss a lower price at the bargaining table.

Fifth, if we allow monopoly on the seller side, we should be open to allowing monopsony on the buyer side.

If a group of businesses got together and as a group tried to force sellers to lower their selling price this would ordinarily be a violation of the antitrust law. However, in the market for drugs, we have explicitly created monopoly. It seems reasonable, therefore, to let buyers be free to combine and form a countervailing force.

In Part III, I will explain why private negotiations will almost always be better than government price negotiations.