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Dean Baker
Boston Review, May/June 2009

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When it comes to health care, economists ignore their own rules.

Fundamental economic principles tell us that goods should be sold at their marginal cost of production—the cost of producing one more unit of the good. If a company needs to pay twenty dollars for the material and labor used to produce one more shirt, then shirts should sell for twenty dollars plus a small profit-earning markup. The price-equals-marginal-cost principle maximizes economic efficiency and limits opportunities for fraud and corruption. Building on this principle, economists also strongly advocate globalization: the elimination of trade barriers allows consumers to buy goods and services from where they are cheapest, thus maximizing global efficiency and output.

Unfortunately, when it comes to health care, these principles are routinely violated. Prescription drugs that could be manufactured and sold profitably for a few dollars per prescription may instead sell for thousands. Performing one more high-tech scan or other medical test may require just a few cents of electricity and a couple of hundred dollars worth of a technician’s or a doctor’s time. But diagnostic procedures can be billed at several thousand dollars a shot. Prices are often well above marginal costs, yet economists involved in health care reform rarely recognize this as a problem.

Nor do they show their usual zeal for trade. Health care may have features that make it place-specific, but globalization offers clear opportunities for gains. Specifically, the health care system can take greater advantage of foreign doctors and highly skilled medical professionals, who can be trained at far lower cost in the developing world than the United States. And it is simple to design mechanisms that increase the number of trained personnel by an amount sufficient to supply both the United States and developing countries with more doctors and health care professionals. We should also consider that globalization offers people ways to get health care where it is cheaper, which is already happening to some extent with the growth of medical tourism.

Too-often ignored, the basic economic principles of marginal-cost pricing and gains from trade have much to offer in the area of health care. They need to be brought into the discussion.

Suppose a family member is diagnosed with a rare and typically fatal form of cancer. She is 80 years old and in otherwise good health. A new drug with no major side effects but an uncertain success rate costs $200,000 for a year’s dosage (the actual price for some newly developed cancer drugs). Should the family struggle to come up with money for the treatment, or alternatively, should an insurance company or the government be forced to pick up the tab? Should treatment be withheld?

This question has no good answers. The decision to allow a family member to die when a possible cure exists would haunt the family for years to come. However, as individuals and as a society, we know that what we can spend on health care has limits. Suppose we spend the $200,000 and the patient dies anyway in 6 months. Is that a good use of money—ours or anyone’s—in a world where poor children are going without decent housing, childcare, or even food everyday?

Now change the story slightly. A year’s dosage costs $200, and the calculation becomes suddenly far less difficult. With a reasonable hope of benefit, we would, of course, expect an insurance company or the government to pick up the tab, if it is not paid out-of-pocket.

Reducing the price to $200 is neither slight of hand, nor wishful thinking; it is marginal-cost pricing. Brand drugs, selling at hundreds or thousands of dollars per prescription, are not chemically distinct from the ones on Wal-Mart’s shelves for four dollars. Few drugs are expensive to manufacture and distribute. A year’s dosage of a cancer drug sells for $200,000 because the government grants the drug’s developer a patent monopoly as an incentive to develop new drugs. Without that monopoly, the latest drug could be one of thousands of low-priced generics.

Economics textbooks are filled with graphs showing how trade barriers that raise the price of shirts or shoes by 10-20 percent above marginal cost lead to economic inefficiency and make the economy as a whole less productive. The same graphs would show large losses when government patent protections drive drug and medical-equipment prices above marginal costs—on the order of 1,000 percent, 10,000 percent, and in some cases 100,000 percent.

Even in Econ 101, the direct inefficiency associated with setting prices above marginal cost is only part of the story. When government interference sets the price of any product above its marginal cost, it also creates the opportunity for monopoly rents—extra profits due to artificial scarcity. The rents cause producers to engage in wasteful activities that will maximize the value of their share of excess profits. These activities include lobbying politicians, pursuing expensive legal actions, advertising and marketing, and in the case of prescription drugs and medical equipment and supplies, possibly withholding relevant data on effectiveness and safety. As economic theory predicts, all of these forms of rent-seeking thrive in abundance in the pharmaceutical and medical supply industries.

The pharmaceutical industry always invests heavily in political campaigns: no surprise, since governmental actions directly affect its profitability. For example, the Medicare Modernization Act, which created the Medicare prescription drug benefit, was largely crafted to meet the needs of the pharmaceutical industry. Almost immediately after the passage of the bill, Representative Billy Tauzin, who was Chair of the House Energy and Commerce Committee, became president of the Pharmaceutical Research and Manufacturers of America, the industry lobbying group, a reward for his work in getting the bill to the House floor.

The industry also regularly fights about the length and depth of its patents. Extending the length or increasing the strength of patent protection can mean large increases in profits. And companies work to ensure easy (and ideally costless) access to research funded by taxpayers through the National Institutes of Health (NIH) or other public institutions. In addition, the industry counts on the U.S. government to represent it in dealing with foreign countries. Measures that strengthen foreign commitments to protect drug patents feature prominently in almost every trade pact negotiated over the last two decades.

The pharmaceutical industry can expect substantial returns on its investments in political influence at the state level, where decisions are made about which drugs will be covered by Medicaid and other state programs. In addition to the direct demand generated by extending state Medicaid coverage to a new drug, the practices of state Medicaid programs in covering drugs help to build pressure on private insurers, so that they will also cover the drug for their patients.

The industry can expect returns from legal actions to enforce or extend patent protection as well. Brand-name drug companies commonly initiate suits against producers of generics even when those producers enter a market after a patent has expired. The brand producer generally has a basis for getting into court since there will often be at least some colorable claim to patent infringement. (There are typically many patents that apply to a particular drug.) But there is enormous asymmetry in potential gains for both parties. The brand manufacturer is protecting its right to sell its product at a patent-protected price, and the generic producer is trying to gain the right to sell drugs in a competitive market. As a result, a producer of generics will often make concessions simply to be left alone. In some cases, it may surrender the right to compete altogether, deciding that potential profits will not offset the cost of the legal proceedings. The brand manufacturers typically have very deep pockets.

And the rent-seeking does not end with lobbying and legal bullying. It is hardly a secret that pharmaceutical companies find extensive advertising and marketing campaigns profitable. The industry spends almost as much on advertising and marketing as it does on research. Its ads dominate commercial breaks on news shows, encouraging viewers to ask their doctors about drugs for arthritis, heart disease, and many other common ailments. Patients cannot assess the merits of a particular drug based on a commercial pitch, but the industry hopes that doctors will prescribe the drug if patients ask for it. This route is not likely to lead to the best medical outcomes.

The other part of the industry’s marketing effort is the work of the detailers, the tens of thousands of ground workers who go from doctor’s office to doctor’s office pitching the latest drugs. Ostensibly, they provide doctors important information about new drugs. In reality, they often have little knowledge of the drugs; they are hired for being very effective salespeople. In fact, the industry has made a strategy of seeking out former cheerleaders because they are generally attractive and can be enthusiastic promoters.

Perhaps the most pernicious form of drug-industry rent-seeking occurs when companies conceal research findings that reflect poorly on their drugs. The industry maintains control of its research and only shares results that it considers appropriate to make public. (The Food and Drug Administration is prohibited from revealing the results of any studies the industry makes available to it, but evidence is occasionally leaked by researchers concerned about the public’s health.) A regular flow of news stories report concealed research findings suggesting that certain drugs could be harmful, or not as effective as claimed. The Washington Post, for example, recently reported that the schizophrenia drug Seroquel may be less effective than claimed. Studies revealing the potentially harmful effects of the arthritis drug Vioxx were famously suppressed. Given the enormous profits at stake, the withholding of relevant evidence from drug research is entirely predictable.

While few economists would dispute that patent monopolies in pharmaceuticals and medical technology provide incentives for wasteful activities, they defend patents as the price we must pay for financing drug research and development. But patents are simply one option for financing research, not essential at all. We could expand the public funding going to NIH or other public institutions and extend their charge beyond basic research to include developing and testing drugs and medical equipment. Or the government could contract out the research and development process to private firms and pay for the work up front so that all patentable results fall in the public domain. Or the government could construct a prize mechanism under which it buys up patents after the fact for a premium keyed to the patent’s usefulness.

The government will need to provide funding to cover research costs through whatever mechanism of public financing is chosen, but this expense is likely to be dwarfed by the savings from marginal-cost pricing for prescription drugs. The amount of patent-supported research that must be replaced would be in the neighborhood of $30 billion a year, while the savings from marginal-cost pricing would almost certainly be more than $200 billion a year. The difference now goes to marketing costs and profits. While generic makers would still make normal profits on their sales, brand company profits would be far lower if research were funded by the government.

Public funding obviously involves the government in the research process, but demand for medical care is already determined in large part through the political process. The vast majority of health care costs are paid by third parties, either insurance companies or the government; costs are not distributed according to individuals’ willingness to pay. If the government and insurance companies cannot be forced to pay for a drug, the industry will not develop it. Since politics inevitably decide which drugs are developed, government and insurance companies should determine whether they will pay for a drug before it is developed. This way there is no painful question about whether to spend $200,000 on a year’s dose for our 80-year-old loved-one. Though the ethical calculus is similar, it is much easier to forgo hundreds of millions of dollars researching a drug that may benefit relatively few, hypothetical people than to refuse $200,000 for a drug that may benefit a real dying person.

The logic of paying for research upfront rather than tying medical costs to the individual patient makes sense. The same logic applies in other areas of health care. Most tests and scans are expensive because of patent protection, not because the resources actually used in the process are costly. Once the equipment or testing method has been developed, the value of the resources (labor and materials) used in the test is relatively small. Society must pay for the research and development costs, but these costs have already been paid at the point where an insurer must decide whether it will pay for a test for a particular patient.

Some aspects of medical care may always be expensive. Open-heart surgery, involving many hours of the time of highly skilled heart surgeons, will inevitably carry a substantial price tag. However, once developed, MRI, sophisticated tests for various diseases, or more effective drugs for treating cancer should be available at their marginal cost. The hard decision should be which areas of research to pursue, not whether to withhold potentially life-saving care that in reality costs society very little.

Economists overlook their price-equals-marginal-cost mantra when it comes to the health care sector. They also forget their commitment to globalization and the removal of trade barriers.

This is surprising since one of the most obvious indictments of the U.S. health care system is that its costs are so hugely out of line with costs in the rest of the world—with no corresponding benefits in outcomes. Canada, Germany, France, and the United Kingdom all pay roughly half as much per person for their health care as the United States, yet all these countries, and many more, enjoy longer life expectancies. International comparisons of quality are difficult, but the gap in life expectancies makes it hard to believe that the health care system in the United States is qualitatively better than its peers. Since other countries operate their health care systems far more efficiently, there are enormous potential gains to the U.S. economy in opening this sector to increased international trade.

The health care sector can be opened to global competition in three obvious ways: increasing opportunities for foreign-born medical personnel to work in the United States; facilitating “medical tourism,“ so that Americans can more easily have major medical procedures performed in other countries; and allowing Medicare beneficiaries to buy into the lower-cost health care systems of other wealthy countries.

Each of these offers enormous opportunities for savings in the health care sector and benefits for the economy. And we can structure any new arrangements to ensure that our trading partners also reap the rewards. This is especially important in the case of developing countries: we cannot let health care savings for the United States came at the expense of reduced access to care for people in the developing world.

Increasing the openness of the United States to highly trained medical personnel should be on every trade economist’s mind. Doctors in the United States, especially highly trained specialists, earn far more than their counterparts in Western Europe or Canada, at least in part because it is very difficult for doctors—even those who meet our high standards—to train in other countries and then work in the United States. Licensing procedure acts as a trade barrier.

What if, however, the government sought to remove the barriers for foreign physicians in the same way that it sought in NAFTA to remove barriers for imported goods manufactured in Mexico? Low tariffs were only a small part of the story; for most goods, they were already low. NAFTA’s innovation was to promote the transfer of manufacturing facilities to Mexico for the purpose of exporting the output back to the United States. U.S. trade negotiators sat down with manufacturing company executives and asked them about the obstacles to setting up factories in Mexico. They then negotiated a treaty that removed the obstacles.

Similarly, U.S. trade officials can sit down with major hospitals and ask what prevents them from hiring doctors from Mexico, India, and other developing countries at much lower wages than U.S.-born doctors receive. Some obstacles are obvious. A hospital cannot legally hire a foreign doctor at a wage that is far below the market rate without first attempting to hire a U.S. citizen or green-card holder at the current market rate. Such protectionist barriers could be easily eliminated. (The economic argument for hiring foreign doctors who are willing to work for lower wages than their U.S. counterparts is the same as the argument for buying foreign-made clothing that is cheaper than U.S.-made clothing: the benefits to consumers are clear in both cases.)

Drafting international training and licensing standards would be the next step. Doctors could be tested by U.S.-certified testers in their home countries to determine whether they meet the standards. Those who do would have the same opportunities to work in the United States as a U.S. citizen. A kid growing up in Mexico City or Beijing would have as much opportunity to work as a neurosurgeon in the United States as a kid growing up on Long Island.

Compensation in the most highly paid medical specialties averages far above $250,000 a year, even after physicians have paid for their malpractice insurance. Many doctors trained outside the United States would find these positions attractive even if they paid $100,000 a year. Opening medical practice to foreign competition would allow for the same sorts of gains from trade that we have seen with opening trade in apparel and textiles— except that we spend far more on doctors each year than we do on clothes.

In addition, we could impose a fee structure on foreign-trained physicians working in the United States. The money would go toward compensating their home countries for the cost of their education. This would be comparable to the sort of income-based student loan repayment system that the United Kingdom has put in place. For example, a 10 percent tax would almost certainly support the training of two or more doctors in most developing countries and could ensure that developing countries sending doctors to the United States would also see an improvement in the quality of care at home.

Increased openness in the provision of medical services can lead to other win-win situations. One already exists but lacks government oversight: medical tourism. Facilities in developing countries such as Thailand and India can perform many major medical procedures at costs far lower than prevail in the United States, and for some of these medical procedures the savings of foreign care can easily cover the cost of airfare and hotel bills for the patient and several family members. These facilities are designed to meet Western standards of care; in many cases they are equipped with the most modern medical equipment.

Medical tourism is growing rapidly, and nothing short of a massive overhaul of the U.S. health care system will stop it. U.S. policy-makers should embrace rather than ignore it. They could allow for a huge expansion of medical tourism by certifying facilities in other countries to ensure the quality of care and establishing guidelines for liability in the case of medical malpractice or other issues. Insurance companies could contract with facilities in the developing world and offer large discounts to patients who opt to have major procedures performed in these facilities. Some insurance companies have already offered such options, but the process will advance far more quickly if appropriate institutional and legal structures are put in place.

The U.S. government can also insist that developing countries impose taxes on medical tourism; the proceeds would support improvements in their own health care systems. It will, of course, be difficult to enforce a government’s commitment to improving the quality of the health care for its citizens if it does not face domestic pressure as well. But, with formal agreements, some revenue from medical tourism will more likely be put to this use.

Finally, why not allow Medicare beneficiaries to buy into the health care system of other countries? Tens of millions of current or future Medicare beneficiaries have close family or emotional ties to countries with more efficient health care systems. At present, however, Medicare beneficiaries moving to these countries cannot apply their Medicare to the provision of health care. They would be left to make health care arrangements for themselves. Retirees have already largely paid for their Medicare benefits through the Medicare payroll tax that they paid when they were working. It seems reasonable that retirees should be allowed to apply the value of this benefit in whatever country they choose to live.

As an incentive for other countries, the U.S. government could offer a premium to countries that allow Medicare beneficiaries to be covered under their health care systems—say, 10 percent above per-person-health-care costs there. Medicare beneficiaries and the U.S. government could split the savings, which would be substantial. For example, a beneficiary moving to the Netherlands or the United Kingdom in 2010 could expect to pocket close to $2,000 a year from their share of the savings. The amount will grow over time, especially if the explosive projected increases in U.S. health care costs prove accurate. By 2040 beneficiaries may be pocketing more than $8,000 a year (in 2009 dollars) by buying into the health care systems in one of the Western European countries. By 2080 annual savings could reach $30,000 (also in 2009 dollars).

Making this option available could allow Medicare beneficiaries to enjoy much more comfortable retirements and generate enormous savings for the U.S. government. To establish quality control and to give developing countries such as Mexico incentives to improve their health care systems, the program could require that eligible countries have longer life expectancies than the United States. Every country in Western Europe and a few in Eastern Europe would already qualify, as would Jordan.

The goal of course is not to have globetrotting Americans in search of health care; we should fix the U.S. health care system to provide quality health care at a reasonable price. In the meantime, good policy would take advantage of the potential benefits of using efficient foreign health care systems. Moreover, the competition may well increase the pressure for reform by making the inefficiencies of the U.S. system more apparent. And the global market in medical services might put downward pressure on prices in the United States. If the gap between the cost of major medical procedures performed in the United States and other countries continues to grow, relatively few people might have those procedures performed in the United States. Highly paid medical specialists will either accept lower fees or go with much less work. The same logic will apply to other high-cost areas of the U.S. health care system.

Economists, often painfully dogmatic in pushing economic principles in contexts where they are not appropriate, behave the opposite way in the health care debate: they fail to raise their most basic principles in an arena where they offer enormous potential gains. Economists should act like economists in assessing health care, where the benefits of marginal-cost pricing are even greater than in apparel or cars. And the gains are not only economic. Many of the tough choices created by the current system disappear if patients and their families face only the marginal cost—the actual cost to society—for medical procedures and treatments.

Similarly, economists’ commitment to free trade should not end at the hospital door. Globalization offers enormous opportunities: it allows Americans to escape a broken health care system and generates new pressures to fix it. We can structure arrangements that ensure our trading partners benefit as well.

Economists have not done a great job lately in managing financial markets. But sound, mainstream economics is still safe and effective. Health care policy could use a dose.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy. He also has a blog on the American Prospect, "Beat the Press," where he discusses the media's coverage of economic issues.