NBER Working Paper 22353: Insurance and the High Prices of Pharmaceuticals

By David Besanko, David Dranove, Craig Garthwaite
National Bureau of Economic Research, June 2016

Abstract

We present a model in which prospective patients are liquidity constrained, and thus health insurance allows patients access to treatments and services that they otherwise would have been unable to afford. Consistent with large expansions of insurance in the U.S. (e.g., the Affordable Care Act), we assume that policies expand the set of services that must be covered by insurance. We show that the profit-maximizing price for an innovative treatment is greater in the presence of health insurance than it would be for an uninsured population. We also show that consumer surplus is less than it would be if the innovation was not covered. These results show that even in the absence of moral hazard, there are channels through which insurance can negatively affect consumer welfare. Our model also provides an economic rationale for the claim that pharmaceutical firms set prices that exceed the value their products create. We empirically examine our model’s predictions by studying the pricing of oncology drugs following the 2003 passage of Medicare Part D. Prior to 2003, drugs covered under Medicare Part B had higher prices than those that would eventually be covered under Part D. In general, the trends in pricing across these categories were similar. However, after 2003 there was a far greater increase in prices for products covered under Part D, and as result, products covered by both programs were sold at similar prices. In addition, these prices were quite high compared to the value created by the products – suggesting that the forced bundle of Part D might have allowed firms to capture more value than their products created.

From the Introduction

While our model is too stylized to offer precise numerical predictions, a canonical example that broadly fits real world data confirms some of the model’s surprising implications. First, we show that the profit- maximizing price for products is far greater in the presence of health insurance than it would be for an uninsured population, and consumer surplus is lower. The decrease in consumer surplus is quite large and exceeds the consumption smoothing benefits of health insurance for these products. We further show that this negative effect on consumer welfare grows as the number of innovative products increases. In fact, as the number of innovative products covered by insurance increases, the high prices they charge for their products eventually cause some consumers to not purchase insurance, resulting in a decrease in total surplus. We note that these results do not rely on moral hazard in that it exists even when customers never buy a product at a price that exceeds its value. Therefore, these results show that even in a situation where insurers could eliminate moral hazard (either through well designed cost sharing or effective managed care organizations) there are still other channels through which insurance can reduce welfare.

We note that the ability of firms to capture more value than they create solely results from regulations requiring an insurance bundle and that without these regulations, even in the presence of moral hazard, a monopolist selling an innovative product would be constrained by the effect that its price would have on insurance premiums.

From the Conclusions

While health insurance bears many similarities to more traditional financial insurance products, it also conveys the important benefit of breaking the liquidity constraint that many consumers face when attempting to purchase costly but valuable medical goods and services, including high priced pharmaceutical treatments. Previous work has asserted that this increase in access represents a benefit for consumers. However, our results, which endogenize the prices charged by the monopoly manufacturers of high value products, demonstrate that consumers may actually enjoy less consumer surplus, even in the absence of moral hazard. This occurs because insurance allows firms to more fully price out the expected benefits that their drugs generate for consumers, charging prices that may be far higher than what they would select if patients had to pay the entire price of their drugs out of pocket. This not only reduces consumer surplus, it may also reduce total surplus if some consumers are liquidity constrained from purchasing insurance. Thus, regulations requiring insurers to provide coverage for all new high-value products, such as the minimum insurance definition of the ACA, can decrease consumer surplus and, potentially, decrease total surplus.

While there may be worries that attempts at price controls in pharmaceuticals will be welfare reducing through reduced innovation, our results suggest that some existing regulations may provide incentives for innovation that are themselves not welfare maximizing because they are based on prices that exceed value.

http://www.nber.org/papers/w22353

***

Comment:

By Don McCanne, M.D.

Although this paper is quite technical, the conclusions are straightforward. Health insurance makes expensive products and services affordable for patients and thus they will use them – a desirable policy outcome since patients will then receive the care they should have. But beyond that, by bundling services and products into the same insurance package, it allows monopoly manufacturers of high value products, such as expensive pharmaceuticals, to charge prices that exceed the value their products – an undesirable policy outcome.

The authors indicate that the mandate to include certain benefits in insurance products, such as the essential health benefits required by the Affordable Care Act, allows the firms to capture more value than their products created (i.e., charge prices greater than the value of the product).

Those preferring market solutions might suggest that specific mandated insurance benefits be eliminated thus creating a greater sensitivity to high prices. But since far too many patients do not have enough liquid assets to pay these high prices (they are “liquidity constrained”), they would have to do without beneficial health care services and products that are truly unaffordable in the absence of insurance. This is yet one more example of why the tradeoffs in depending on a market of insurance plans can lead to excessive prices and financial barriers to care.

A single payer system does not depend on markets to set prices and make determinations on coverage. Rather they include all essential services and products and use government-administered negotiated pricing to be sure that prices do not exceed value. Patients get the care they need without an excess drain on our collective funds.

NBER Working Paper 22353: Insurance and the High Prices of Pharmaceuticals

By David Besanko, David Dranove, Craig Garthwaite
National Bureau of Economic Research, June 2016

Abstract

We present a model in which prospective patients are liquidity constrained, and thus health insurance allows patients access to treatments and services that they otherwise would have been unable to afford. Consistent with large expansions of insurance in the U.S. (e.g., the Affordable Care Act), we assume that policies expand the set of services that must be covered by insurance. We show that the profit-maximizing price for an innovative treatment is greater in the presence of health insurance than it would be for an uninsured population. We also show that consumer surplus is less than it would be if the innovation was not covered. These results show that even in the absence of moral hazard, there are channels through which insurance can negatively affect consumer welfare. Our model also provides an economic rationale for the claim that pharmaceutical firms set prices that exceed the value their products create. We empirically examine our model’s predictions by studying the pricing of oncology drugs following the 2003 passage of Medicare Part D. Prior to 2003, drugs covered under Medicare Part B had higher prices than those that would eventually be covered under Part D. In general, the trends in pricing across these categories were similar. However, after 2003 there was a far greater increase in prices for products covered under Part D, and as result, products covered by both programs were sold at similar prices. In addition, these prices were quite high compared to the value created by the products – suggesting that the forced bundle of Part D might have allowed firms to capture more value than their products created.

From the Introduction

While our model is too stylized to offer precise numerical predictions, a canonical example that broadly fits real world data confirms some of the model’s surprising implications. First, we show that the profit- maximizing price for products is far greater in the presence of health insurance than it would be for an uninsured population, and consumer surplus is lower. The decrease in consumer surplus is quite large and exceeds the consumption smoothing benefits of health insurance for these products. We further show that this negative effect on consumer welfare grows as the number of innovative products increases. In fact, as the number of innovative products covered by insurance increases, the high prices they charge for their products eventually cause some consumers to not purchase insurance, resulting in a decrease in total surplus. We note that these results do not rely on moral hazard in that it exists even when customers never buy a product at a price that exceeds its value. Therefore, these results show that even in a situation where insurers could eliminate moral hazard (either through well designed cost sharing or effective managed care organizations) there are still other channels through which insurance can reduce welfare.

We note that the ability of firms to capture more value than they create solely results from regulations requiring an insurance bundle and that without these regulations, even in the presence of moral hazard, a monopolist selling an innovative product would be constrained by the effect that its price would have on insurance premiums.

From the Conclusions

While health insurance bears many similarities to more traditional financial insurance products, it also conveys the important benefit of breaking the liquidity constraint that many consumers face when attempting to purchase costly but valuable medical goods and services, including high priced pharmaceutical treatments. Previous work has asserted that this increase in access represents a benefit for consumers. However, our results, which endogenize the prices charged by the monopoly manufacturers of high value products, demonstrate that consumers may actually enjoy less consumer surplus, even in the absence of moral hazard. This occurs because insurance allows firms to more fully price out the expected benefits that their drugs generate for consumers, charging prices that may be far higher than what they would select if patients had to pay the entire price of their drugs out of pocket. This not only reduces consumer surplus, it may also reduce total surplus if some consumers are liquidity constrained from purchasing insurance. Thus, regulations requiring insurers to provide coverage for all new high-value products, such as the minimum insurance definition of the ACA, can decrease consumer surplus and, potentially, decrease total surplus.

While there may be worries that attempts at price controls in pharmaceuticals will be welfare reducing through reduced innovation, our results suggest that some existing regulations may provide incentives for innovation that are themselves not welfare maximizing because they are based on prices that exceed value.

http://www.nber.org/papers/w22353

Although this paper is quite technical, the conclusions are straightforward. Health insurance makes expensive products and services affordable for patients and thus they will use them – a desirable policy outcome since patients will then receive the care they should have. But beyond that, by bundling services and products into the same insurance package, it allows monopoly manufacturers of high value products, such as expensive pharmaceuticals, to charge prices that exceed the value their products – an undesirable policy outcome.

The authors indicate that the mandate to include certain benefits in insurance products, such as the essential health benefits required by the Affordable Care Act, allows the firms to capture more value than their products created (i.e., charge prices greater than the value of the product).

Those preferring market solutions might suggest that specific mandated insurance benefits be eliminated thus creating a greater sensitivity to high prices. But since far too many patients do not have enough liquid assets to pay these high prices (they are “liquidity constrained”), they would have to do without beneficial health care services and products that are truly unaffordable in the absence of insurance. This is yet one more example of why the tradeoffs in depending on a market of insurance plans can lead to excessive prices and financial barriers to care.

A single payer system does not depend on markets to set prices and make determinations on coverage. Rather they include all essential services and products and use government-administered negotiated pricing to be sure that prices do not exceed value. Patients get the care they need without an excess drain on our collective funds.