Problem 1: Firms that discover a new drug (or purchase rights to someone else’s discovery) typically apply for and receive a patent on that drug from the government in each country in which the drug might be sold, before going through the expensive and time-consuming development and testing process to bring it to market. These R&D costs can be very large, sometimes in the tens or even hundreds of millions. (Drug companies overstate them, but they are large.) The patent makes it illegal for any other firm to sell that drug without the patent-holder’s permission-granting a monopoly on the sales of patented drug. Would-be competitors must either purchase the right to sell the same drug- if the patent-holder is willing to sell- or go through the process of discovering the and developing a slightly different drug with a more or less similar effect.
a. The conditions of “allocative efficicency” require that the price at which a commodity sells on the market be equal to its marginal cost of production. This equaility is supposed to be ensured for commodities produced by profit-maximizing firms under conditions of perfect competition and free entry. Yet patents represent a deliberate policy to block entry and create a monopoly. Under these conditions, what considerations will determine the price of a patented drug and what relation, if any, will the price bear to the marginal cost of manufacturing and distributing that drug? Show graphically the allocative distortion, the “welfare burden” in terms of Question 1, created by the patent.
b. So why do governments issue patents at all? Explain, showing the contrast between the average and marginal cost curves for a firm with very high fixed costs and low marginal costs, and those assumed for the “standard” textbook firm. What might one predict would happen to the rate of innovation if there were no patent protection? Why? Can you interpret your prediction in terms of trade-ff between short-run and long-run allocative distortions, or “short-run pain for long-run gain”? Be as specific as you can about exactly what society as a whole is giving up, and getting, within the terms of this trade-off.
c. Consider the elasticity of demand for drugs. How does it affect the terms of this trade-off? Can you explain why, if the elasticity of demand is low, the short-run allocative distortion associated with patent protection—the “welfare burden” may be relatively small—and the incentive to innovate relatively large (compared with a greater elasticity), but the distributional effects within the population will be correspondingly larger. (This one takes a bit of price theory. If your answer is no, just say “no.”)
d. But the “allocative distortions” of textbook price theory are not the only consequences of patent protection. If patents permit firms to set P>MC (P might be ten times MC or in extreme cases even 100xMC), this implies very large “gross margins”- in accounting terms the spread between sales revenues and the cost of goods sold, before allowances for contributions to fixed costs and other costs not directly related to production. What incentives and capabilities (consider both) does this large gross margin create of advertising? Is it then surprising that drug that drug companies—strictly for profit firms—spend about twice as much for advertising (primarily to physicians) as they do for research? (They do not advertise this fact.) Thus consider the link between patent protection and the scale of advertising budgets. How might one think about the private and social costs, the opportunity costs of resources used in advertising, relative to their benefits? Could patent protect provide resources and incentives to support the transfer of information to prescribers about new therapeutic possibilities (a social benefit)? Or might it be a way of buying “inappropriate prescribing” to the benefit of drug marketers (a private benefit, and social cost)? How might one tell?
e. Patents operate powerfully to encourage innovation. But can there be too much innovation? Explain, again considering the difference between the private and the social benefits from innovation. What considerations would guide a profit-maximizing firm in deciding how to allocate its research budget? )Go a little deeper than “Where it thinks it can get the largest profit”!) What considerations might the general public, you or I, want to have determining research priorities? Considering your answer to pars d. and e., how might you re-formulate the trade-off between the benefits and the costs of patents identified in part b.?
f. A purely unregulated free market would almost certainly result in signification “under-innovation,” at least in drugs, but the present patent system also has significant costs. What regulatory modifications or alternatives to the present patent system might one want to consider, to improve the policy trade-ff between social benefits and costly “side-effects”?
g. The question to this point has implicitly assumed a closed economy. The real world pharmaceutical market consists of many national markets dominated by a few very large multi-national firms that have great influence over government within and beyond their “home” countries- another consequence of large gross margins. Consider a hypothetical situation of two differently placed countries, one a large country with a large drug industry and high expenditures on R&D, and another a small country with little or no drug R&D. Keeping in mind that discoveries travel across borders, and drugs discovered in one country can be produced and marketed in others, how might the optimal patent policies for these two countries be different? If for example the small country allows firms to patent their drugs in its market, on the same terms as in the large country, will the balance of benefits and costs for its citizens be the same? Explain. But if the government of the small country designs its patent policy, or other aspect of drug regulation, strictly in its own interests, what tactics might the large country or its drug marketers employ? Does this suggest yet another important dimension of trade-off faced by governments in the formulating their patent policies? Hint: what is going on right now with respect to cross-border sales by Canadian pharmacies?
Problem 2: “The basic function of health insurance is the reduction of uncertainty; other things being equal, individuals prefer and are willing to pay for a reduction in their financial risks.” (Arrow, 1976 p.3). Arrow envisions individuals voluntarily purchasing insurance policies, like any other commodity, from private firms selling in competitive markets. Most of the academic economics literature makes similar assumptions. Yet for health insurance, the free markets of the economics textbooks are virtually non-existent. World-wide, private pre-paid health insurance reimburses about 16.6% of total expenditure on health care, but this figure is dominated by the United States. If one reclassifies the tax expenditure subsidy, just in the U.S., as public expenditure and removes it from the contribution of private insurance, the figure drops to 11.0% and it one removes the U.S. entirely, private coverage in the rest of the world accounts for 5.6% (World Health Report, 2004). In U.S. and Canada, private insurance is not only heavily subsidized by governments but most is provided as a condition of employment-individual employees have no choice about participating. (If as group they opt out, they lose the public tax-expenditure subsidy.) This question asks you to explore why truly competitive, unsubsidized private health insurance, voluntarily purchases by individual buyers is restricted to little niche markets like (perhaps) travel insurance.
a. Lay out graphically the elementary model of insurance purchases by a hypothetical risk averse individual contemplating a risky future in which a specific adverse event with a well0defined and known money cost may or may not occur, and the probability of occurrence is know with certainty by everyone. “Actuarially fair” insurance can be purchased by this individual. Explain why the rational individual in this situation will always purchase full insurance coverage against the costs of the adverse event, and how the premium will be determined. What does it mean, that the individual is risk-averse and the insurance coverage is “actuarially fair”, how are these shown on your graph, and why are they critical to the outcome described?
b. “Actuarially fair” insurance is an abstraction, like a frictionless surface. In reality, if insurance is purchased in a private market from competitive, for-profit firms. The premium charged must always be larger than the actuarially fair one, by some “load factor”. Explain, and show graphically how this must reduce the individual’s utility gain from insurance coverage. Show how the “gain” might be negative, so that the rational individual would not buy insurance, and interpret his choice in terms of efficient resource allocation. Some analysts have argued, on the basis of this very simplified model, that optimal public insurance would include some (relatively low) level of user charges for care, rather than providing full first dollar coverage as Canada’s Medicare does. Explain this argument.
c. This model describes the behavior of a “representative agent”, implicitly suggesting, as Arrow explicitly assumed, that the world is made up for a large numbers of identical individuals. (Why must there be a large number of such individuals?) It directs your attention away from the reality that people differ greatly in their risk status (size of potential loss and/ or probability of occurrence). If people do all differ in their risk status (heterogeneous individuals), but both they and potential insurers know that status, what will this imply for the pattern of premiums charged? How will an individual’s premium relate to her state of health? To her income? Will everyone still buy coverage, and if not, who will be left uninsured (by the private market)? Would this represent a form of “market failure”? Why or why not? If coverage is incomplete, how will the proportion of the population buying private coverage relate other proportion of total population losses (expenditures) covered? What choices would this leave for governments?
d. Now assume that individuals do know their own risk status precisely, but insurers have no idea- they cannot distinguish among individual purchasers (asymmetric information). Explain the resulting process of “community rating”, why this leads to “adverse selection”, and how under these hypothetical conditions the private insurance market could conceivably vanish in a “death spiral”. Historically, of course, this did not happen- or did it? Private insurers in North America had largely ceased selling, health insurance policies to individual buyers by the early 1850s; instead they sold to employee or other groups on condition that coverage was compulsory within groups. Explain. Arrow’s free market for individual purchase never really existed. In what sense might this result represent “market failure”, or a failure of private markets to yield an allocatively efficient outcome?
e. Private insurers remained highly competitive. But the competition took the form of classical underwriting- identifying as precisely as possible the average risk status of different groups and setting differential premiums accordingly. Risk information is not free, but I can be a profitable investment if it permits a company to expand its market share while avoiding selling policies to high-risk individuals. This competitive dynamic leads to increasing fragmentation of the risk pool, premium differentiation, and increasing administrative overheads for the costs of underwriting. Insofar as past experience is the best guide to current risk status, it also leads to “experience rating”- this year’s claims come back as next year’s premium increase. Both rends reduce the effective level of insurance coverage per premium dollar. Explain these effects, and then explain how the tax expenditure subsidy for employer-paid health insurance works and how it tends support private coverage despise these trends.
f. Private health insurers tend to be quite passive in the face of health care cost escalation – simply passing increased costs forward as increased premiums or back as reduced coverage and larger requirements for patient payment. (Think of Canadian drug insurers.) How would one interpret cost escalation in the framework of part a. above? Is there any reason for insurers to worry about cost escalation, or might it in fact be good for their business? Over twenty years ago, however, large employers in the U.S. became sufficiently troubled by cost escalation that some began to “self-insure,” bearing the risks of their employees’ health expenditures themselves and contracting with insurers only to administer the premium collection and claims payment process (for a fee). They began t look for firms that could offer various forms of cost control services (“managed care”). Traditional insurers also moved into this market, initially with apparent success as suggested by American cost trends between 1992 and 2000. (These activites, however, generated significant additional administrative costs, both for cost controllers and for providers revisiting their control.) Since 2000 these private market initiatives seem totally to have lost their grip (in market contrast to the experience of other industrialized countries.) Employers are beginning to roll back coverage, passing more of the costs onto employees. What does this experience suggest about the determinates of health care costs, and the long-run scope for private health insurance even with subsidy and compulsion?
g. In class, we described Arrow’s statement quoted above as either positive and false, or normative and pretty much irrelevant (because based on personal values not widely shared.) Explain, identifying the two very significant additional functions, beyond reduction of individual risk, that public insurance systems perform everywhere (to varying degrees) and explain why private commercial coverage cannot do. So why does private insurance persist, where it does (including its no-trivial role in Canada)? And why do governments continue to prop it up with subsidy and regulation? Might its persistence and continuing support be explained in terms of the triad? Who pays?, who gets? And who gets paid? Consider the distribution of benefits and costs in private, as compared with public, insurance systems. Does this cast any light recent claims of “fiscal unsustainability” of the Canadian health care system, and the alleged need to reintroduce private insurance funding?
DO NOT ANSWER !!!! PROVIDED AS REFERENCE, it’s mentioned in one of the questions above!!!
1. Economist Smith, Physician Jones and Health Services Researchers Brown are debating how the Canadian health care system should be financed. Smith argues that full, first-dollar insurance coverage for heatlh care costs (like Canada's Medicare) is "allocatively inefficient", causing overuse of health care services and imposing a "welfare burden" on the Canadian population. Jones argues, by contrast, that the Canadian health care system is "underfunded." Unmet needs for care result in a burden of ill-health that could be alleviated with more resources. Brown is more agnostic, recognizing the evidence of unmet needs, but unconvinced that these arise from global underfunding. He considers Smith's criterion of allocatively efficiency irrelevant, and suspects that Smith’s real objective is an increase in social inequality.
a. Sketch Smith’s argument. Make clear what he means by “allocative inefficiency” and his corresponding criterion for “overuse” of health care. Show graphically his derivation, from standard supply and demand analysis, of the corresponding “welfare burden” or the amount of welfare loss to society as a whole from this overuse. (For simplicity, assume a horizontal supply curve.) In what sense are people (who?) made worse off from the production and use of “too much health care?”
b. Jones’ argument can also be represented graphically, as a presumed relationship between (some aggregate index of) the quantity of resources devoted to providing health care, and a corresponding index of population health status achieved. What is her criterion for defining the under provision of health care, and how does it compare with Smith’s
c. Brown considers Smith’s criterion to be irrelevant, focused on the wrong social objective. He rejects it on normative grounds. He argues on positive grounds that Jones’ criterion is incomplete because it identifies every level of financing as insufficient. This is unhelpful. Explain, making clear the distinction between normative and positive propositions, Is Brown’s rejection of Smith’s criterion simply a disagreement about normative principles, or can Brown claim some positive, empirical, basis for his position?
d. Smith and Jones both seem to accept the positive proposition that charging patients some part, at least, of the cost of the services they use would lead to a reduction in total use. Smith cites studies showing that when individuals must pay out of pocket charges for care they tend to use less. Brown accepts this evidence, but argues that it is a “fallacy of composition” to generalize these observations to a whole system. Rather he claims that the total output of health care services is primarily determined by the human and physical capacity of that system, so that user charges simply re-allocate services from the more to the less price-sensitive patients. Furthermore he notes that Smith’s policies would transfer the burden of payment from taxpayers to the users themselves. Both effects benefit the healthy and wealthy at the expense of the unhealthy and unwealthy. Brown is certainly right on the burden transfer, pretty much by definition, since tax liability is strongly positively correlated with income and illness and use of care are (in a system without price barriers) strongly negatively correlated. But what sorts of evidence and argument might he use in support of the claim that the aggregate level of use of health care is determined by system capacity, not by adding up the individual decisions of price-sensitive patients? (Make clear the meaning and significance, in his argument, of the concepts of “asymmetry of information” and “imperfect agency”. How might Smith respond to Brown’s claims? What do you see as the crucial disagreements between them?
e. The logic of Jones’ position would seem to lead her to oppose user fees. She is concerned about unmet needs, so should hardly support further barriers to access. She might however be willing to accept user fees if they were applied to services or to people with minimal or zero elasticity of demand- no barriers to access—and if the revenues so raised were uses to expand the total flow of resources into health care production—meeting more needs. What might Smith and Jones say about either the possibility or the desirability of such a policy? (They are not likely to say the same thing!)
f. While Smith and Jones focus, respectively, on the allocative inefficicency resulting from “free” care and the need to mobilize more resources and fianicing to meet currently unmet needs, neither gives any explicit consideration to questions of the technical efficiency of health care production, or the effectiveness of health care in improving health. But the analysis of each does, in fact, rest on assumptions about these, based in turn on further assumptions about patient and provided behavior, and market structure. Smith’s implicit assumptions, embodied in the supply and demand curves, permit him to assume that the conversion of resources into health care commodities always takes place efficiently, at least cost, and to ignore the question of effectiveness. Jones’ implicit assumptions permit her to assume (more or less) perfect effectiveness, but she ignores (without obvious justification) the question of technical efficiency. Explain these implication assumptions.
g. Brown, on the other hand, challenges these assumptions of Smith and Jones on both theoretical and empirical grounds. He argues that improving the relative efficiency of health care production, and its effectivness in improving health – doing the right thing and doing things right—are central to the management and evaluation of all health care systems, and in particular to the choice of financing and governance mechanisms. The conceptual frameworks of both Smith and Jones divert attention from these central issues. (He gets quite heated about this.) What sorts of theoretical argument and particularly empirical evidence might he rely on in focusing attention on the efficiency and effectiveness, the relative value for money, of health care systems in general and or Canada in particular?