Towards A Good Samaritan World

Monday, November 27, 2006

MEDICARE DRUGS: SUBISIDIZING KNOWLEDGE CREATION

Of all government activities above the basics of providing national security, law and order, and protection of property, subsidizing knowledge creation is one of the most defensible. Economists call knowledge a "non-rival" good, meaning that if one person knows something that doesn't exclude others from knowing it. Once knowledge has been created, it can be spread and used at a low marginal cost. And because it is "non-rival," protecting knowledge is difficult and inefficient. The most widely used solution to the problem of incentivizing knowledge creation in our society is intellectual property: the knowledge creator secures certain rights over the commercial use of the knowledge created, through patents, copyrights, trademarks, etc. But this is both difficult to enforce and inefficient, since many people are prevented from using knowledge that they could benefit from, if the benefits are less than sufficient to justify their paying royalties to the patent-holder.

If one million more people burn copies of a Billy Joel CD, this benefits them and harms no one, if these people would not otherwise have bought a Billy Joel CD. But if some people would have bought the CD, and don't because they can burn it, that does hurt Billy Joel and his record company. If the government could just provide Billy Joel a hefty state salary, and then make his music available for free to everyone, this would, in theory, be more efficient. But of course the government is no good at figuring out which artists are really creating value.

Medicinal drugs can improve quality of life, especially for the elderly who suffer from more health problems than the rest of the population. Seniors in America and other industrialized countries are actually doing something unprecedented, exploring new frontiers of longevity. Medical research that opens these new frontiers to mankind generates huge social benefits. But how is it to be financed? There would be no difficulty in financing it if the firms that did the research could recover all or most of the value created. But because knowledge is a non-rival good, once they've done the research, generic drugmakers can produce copies of the drug and prevent the researching firm from profiting from its discovery, unless the government prevents this. And since preventing this means depriving needy people of life-saving drugs, it's difficult for the government to make a credible commitment to enforce the brand-name drug company's monopoly. Direct public financing of medical research would in theory be more socially efficient, if the government could "pick winners" effectively, but it's highly unlikely that it would do so.

The Medicare drug benefit may be a clever compromise. Profit-motivate private-sector agents will still decide what investments to make, and private consumers will make the choices about what drugs to buy and consume. But the government will pick up much of the bill, at least in the case of prescription drugs for senior. Not all of it, though; seniors still have to pay 75 percent of costs under $2,250, and all costs in a "doughnut hole" between $2,250 and $5,100. These charges should help to (a) cover the marginal costs of drug production, and (b) encourage consumers to economize and only use drugs that are actually significantly helpful. Because the government is not allowed to negotiate prices, i.e., to exploit the market power it derives from its monopsony position to reduce its costs at the expense of drug-company profits, the program has so far been helpful to pharmaceutical companies, as the Washington Post reports:

Consumer advocates contend that if Medicare were permitted to negotiate prices, its purchasing power would produce drug discounts similar to those obtained by the Veterans Affairs Department, which covers 4.4 million people. As it is, Medicare prices are significantly higher than VA prices, according to Families USA, a nonprofit association of health-care consumers that analyzed 20 drugs commonly prescribed to seniors.

Even Medicaid, the federal health program for the poor, appears to employ better negotiators than the private Medicare plans. On Jan. 1, 6 million elderly and disabled people were switched from Medicaid pharmacy plans to the new Medicare program. Overnight, many drugmakers began selling the same drugs at higher prices. Pfizer, for example, reported saving $325 million in Medicaid discounts during the first six months of this year "due primarily to the impact of" the Medicare drug benefit, according to a company report to the Securities and Exchange Commission. (my emphasis)


I'm not necessarily completely sold. Given America's long-run fiscal problems, I am worried, though the news that "Medicare Benefit's Costs Beat Estimates" (i.e., it's cheaper than expected) is good. But affordability issues aside, the Medicare prescription drug benefit seems like an unusually smart concept for a government program.

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