ne of the most often stated arguments in favor of government intervention in American healthcare are the enormous costs paid by consumers in the United States in comparison to the rest of the Western world. Sadly what is left out of this analysis is a mathematical and economic understanding of the difference in drug prices between nations. With the recent nomination of an avowed socialist in New York, now is as good a time as any to discuss conservative policy proposals to counter the inevitable siren-song of socialized medicine. This essay will attempt to provide a basic introduction to the concept that a comparison between national healthcare expenditures is flawed and should result in altering the goals (and policies for achieving those goals) of government intervention.
American spending on healthcare is the topic of constant hand wringing by political do-gooders in Washington and their allies around the country. Americans, we are told, are being screwed out of their hard earned money by greedy CEOs and insurance companies. Leftists say we need to regulate prices and subsidize the sick with the healthy in order to do reduce spending the way Europeans and Canadians do. While I cannot prove that American costs would lower to those of our Western counterparts (or that theirs would rise to be the same as ours), I can show that Western social democracies leverage American spending to their benefit (in much the same way they do with NATO). In effect Americans subsidize the cost of European and Canadian healthcare in such a way that comparing international prices results in, at best, misleading information and, at worst, a misguided path that ends in the total elimination of private medical research.
Medical innovations do not happen accidentally. Research and development of new drugs is an enormous cost ranging from, on average, roughly $800 million to $1.2 billion.The only method by which pharmaceutical companies can bear such enormous costs is by passing the expense of R&D on to the consumer. This should be patently obvious to anyone who has ever purchased cutting edge technology–the cost of a mobile phone in 1982 was $3995 (the price would be more than double that if you calculate for inflation).Paying enormous prices while the technology was in its infancy has allowed us to live in a world where we have more computing power in our pockets than the computers that landed astronauts on the moon while costing less than 10% of 1982 mobile phone prices, inflation adjusted.
The process of funding medical advancement is no different. A pharmaceutical company that invests a billion dollars into research relies on market prices that make such investments a reasonable financial decision in order to finance further innovation. Opportunity cost of investing in R&D must be taken into consideration. For those unfamiliar, opportunity cost is the cost incurred by placing finite resources (time, money, etc.) in one venture rather than another. When I spend $500 on cigars in a year I forgo the returns I could have made by investing that money in my retirement account. The rational decision maker must enjoy the cigars more than the cost of the cigars multiplied by the growth rate compounded annually. So if you assume a 10% per annum growth rate, I need to value the cigars more than $550 a year from now, and $605 two years from now. Clearly I’m not spending my money wisely, but I digress. A company investing in R&D must, in order to justify the costs, expect long term return on investment (ROI) to be greater than the alternative uses for their capital.
This is all to say that when a new drug is developed the cost of the drug is passed along to consumers. In order to turn a profit the average price of the new drug must be greater than the average total cost (ATC) as defined by the following equation where C represents cost and Q represents quantity:
It should be noted that this is different from marginal cost (MC) in that MC is the change in cost relative to the change in quantity without regard to fixed costs (MC being a differential equation and the constant disappears following differentiation). Often the cost of producing additional units of any good rise due to situations such as the necessity of purchasing additional equipment in order to meet increased production requirements. For the sake of simplicity we will assume that our hypothetical pharmaceutical company can purchase additional factories a zero cost. This actually can be useful in our understanding as long term outcomes can treat additional infrastructure expenses as fixed costs. Finally, from a practical actuarial perspective, ATC is a far more useful business metric than that of MC (although both obviously have different uses).
How does this all relate to the difference between American healthcare prices and those of Western social democracies? American consumers of healthcare pay market prices, although they primarily deal with pharmaceutical oligopolies rather than the ideal market situation of multiple buyers and multiple sellers. As such, the companies producing the goods can sell at the highest price that the market is willing to bear; the price at which the average consumer values the good is equal to the price of the good. Conversely, Western social democracies utilizing a single payer system can demand prices of producers far lower than what the market would otherwise predict. Pharmaceutical companies, as they have the American market to recoup their R&D costs, evaluate the minimum price they are willing to sell at to single payer systems through the following equation:
The result is that, in the long run, the minimum price that a producer will accept is the cost of producing another unit of the drug rather than the ATC.This is the leverage that single payer systems utilize to reduce the prices they pay. But given that the average price worldwide of the good sold must remain higher than the ATC, the consumers in the United States end up being required by pharmaceutical companies to pay higher prices to offset the worldwide prices which may be lower than the ATC. This is American subsidization of research, plain and simple. It’s not just me saying this–everysingleoneofthesearticlesrefersto it as subsidization (and that’s just the front page of Google).
This difference in drug prices has a large impact on the overall price of healthcare in the United States. A 2003 study found that the difference in price of healthcare is primarily due to the higher price of health goods and services.With this information it should be plainly obvious that comparing American healthcare costs to those of Western social democracies with the intention of attempting to mimic the cost-saving measure of other countries is folly without the ability to predict where prices would be without American subsidies.
There is one thing that is undeniably true: if American healthcare consumers suddenly started paying the same prices as their European and Canadian counterparts the world’s private medical research would come to a screeching halt. This should give pause to any American single payer advocate (I’m looking at you, hippies).
So what policy suggestions can be made to rectify the situation? There is no magic pill (pun totally intended) to solve all our problems regarding medical spending but we can start by getting accurate numbers. Any bill aimed at improving healthcare costs must include the requirement for pharmaceutical companies, both foreign and domestic, to treat American consumers with “Most Favored Nation” status. This means that companies who wish to do business within the United States may not charge more than their lowest price abroad. That forces companies who do not wish to lose access to the wealthiest nation in the world’s consumer base to raise their prices abroad, lower their prices within the United States, or a combination of both.
Again, this does not necessarily solve the problem but we cannot solve something for which we have inaccurate information.
Matt Wiltshire is a Republican campaign veteran. He was Rick Walker’s campaign manager during the CD2 primary and Jeff Williams’ during the runoff for JP5, Place 2.
I should admit that it has been many years since I took formal economics or calculus classes–so while my equations might be slightly off, the principle should be apparent enough.
One obvious flaw in the equation is that no producer plans on producing infinite units of a good. The actuarial calculations vary from company to company and will take into account the expected lifespan of a product which is a variable I am not qualified to make any guess at.