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Smothering Medical Innovation

If we want to maintain our innovative mojo, the one thing we cannot do is continue down the road we are on of socializing the whole system.

James V. DeLong


April 2, 2011 - 12:06 am
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Increased efficiency in regulation. A major source of innovation is the extension of existing drugs and devices to new uses, a process that depends heavily on the “wisdom of the crowds” of the medical profession. Calfee said:

Even for devices that, like drugs, go through the pre-marketing approval process, what really counts, again, is what we learn after approval. Most cardiac stents, for example, are used in ways not strictly in accordance with the FDA label, while new applications of MRI (magnetic resonance imaging) machines are a staple of the medical literature.

As the government gets more efficient at extending its control down to the working level of the health industry, an inevitable by-product of the digital revolution, the freedom of the profession to act on such opportunities declines. The rapacity of the liability bar reinforces this trend, of course.

Reimbursement levels and cost controls. The R&D necessary for innovation constitutes the capital investment of the pharmaceutical and device industries, just as a generator constitutes the capital of a utility provider. The old story is that the second pill of a particular drug costs only 10 cents – but the first pill costs about a billion dollars.

This creates difficult pricing problems, because in the abstract world of the economics texts the assumption is that the price “ought to” equal the marginal cost, the 10 cents.  The assumption has no validity in the real world, because it does not allow for the recapture of capital or compensation for risk, but the idea has seeped into public debate, where it puts the pharmaceutical and device companies on the continuous defensive.

In systems in which costs are paid by third parties, such as insurers or the government, the gap between marginal cost and fully allocated cost presents a temptation. The payer cares about today’s drugs, not the long-term system of innovation. If the price can be driven down to marginal cost, a lot of money can be saved.

The specific drug under review would still be produced, because the seller would still make a profit on immediate production, even if it had to write off its capital investment. Screwing down the price discourages new investment, naturally, and dams the flow of innovation for the next possible drug, but that is tomorrow’s problem, and in any case the public will not blame the payers, who can talk loudly about the greedy drug and device companies that failed to innovate.

This issue is not at all hypothetical. Efforts to impose marginal cost price controls are a continuing theme of the regulatory state. The issue is also at the heart of the continuing controversies over reimportation of drugs (basically, U.S. prices provide the cushion needed for R&D, and other nations pay something nearer marginal cost), and over allowing Medicare and Medicaid to negotiate drug prices instead of using the benchmark of prices in the private sector (the government has such clout that it could push its costs toward marginal cost, and devil take investment in innovation).

Relentless federal budget problems dictate no let up in the pressures in this area.

Moral hazard. The third-party payment system creates another hazard for innovation.  New treatments are expensive, and often the cost-benefit calculation is far from clear. End-of-life issues present particularly difficult dilemmas.

In a fine post on PJM last week, Beth Haynes explained the unpleasant truth that once health care expenses are collectivized, rationing is inevitable. No individual can be given a blank check to draw on the communal resources for as much as they want in a desperate effort to stave off the inevitable hour for an extra minute or so.

From the point of view of a third party payer, this situation is awful. Treatments must be denied. There will be some mistakes, and there will always be rage. Anyone making the decisions would rather that the controversial treatments not exist. Then he/she could not be blamed for refusing to pay for them, the company or the government could keep costs and premiums down, the patient and his/her family could blame fate and not some malevolent organization, and everyone would be less unhappy.

In this calculus, a lack of innovation is not a bug but a feature.

Reimbursement Rates and Industry Structure. Christensen devotes considerable space to the problems of reimbursement rates and their reinforcement of inefficient industry structure – see Chapter 7, in particular. He notes:

Today’s methods of health assistance . . . create three major distortions to the efficacy and efficiency of health care. First, they preserve costly providers rather than enabling disruptive ones to emerge. Second, they dictate the price of services, and as a result create artificial bubbles of profitability and unprofitability in different sectors of the industry — thereby misdirecting the flow of investment in new products and services. And third, their contracting practices actually drive hospital costs up, not down.

Existing institutions complain, but buy into the system, especially when they have invested in reaction to its incentives, and they then join the government agencies in resisting any serious innovation.

Intellectual Property. Because medical innovation requires heavy up-front investment, and because innovative products and drugs are easily replicated once proven out, the industry has always relied on intellectual property protection to protect its wellsprings of creativity.

This is a complex area, and there are many tough issues of how far to extend intellectual property so as to optimize the balance between supporting investment and allowing broad use of new discoveries. Reasonable people have substantial differences. But on the Left, there has arisen a generalized hostility to the basic institution of intellectual property and patent rights, and pressure to replace the system with government funding and regulation.

Investments in medical devices and drugs are very long term, and, while this movement may not be dominant at the moment, it adds to the long-term incalculability of the possible pay-off from investment. It becomes yet another barrier.

Corporate “Reform.” Both Sarbanes-Oxley and Dodd-Frank have added to the expense and uncertainty of venture investment. Since medical technologies are already in the high-risk category, the impact of these laws has an impact.

One can argue that these pressures, while real enough, need not hinder innovation unduly. Some innovations will surely save money as well as lives or health, and will replace less efficient existing therapies, to the advantage of the system’s finances. Further, the restless energy of medical professionals will create pressure for improvement, as will the forces-in-being of the research community and the drug and device makers.

These points are valid, thank heavens, and they will exert counterpressures against the forces of stasis. Nonetheless, over time, the constant problems will have a strong impact, especially as the government’s fiscal situation becomes more desperate and the imperative grows to cut anywhere that weakness, especially political weakness, can be found.

Under the current structure of our health care system, especially as it will be changed if ObamaCare survives, there is no effective response to these drags against innovation. People can hold all the conferences and write all the strategy papers they want about the need for innovation; the incentives at work will still grind down the innovators.

Innovators will also find that other nations appreciate them more, and there will be a steady shift out of the U.S., to nations willing to be more flexible and long-term oriented, nations which eye our medical innovation industries covetously, and would love to give them a good home if we send them to the dog pound.

Oddly, from the standpoint of our health system, the effect of off-shore migration might be muted. If other nations took over innovation leadership, then the U.S. could piggyback on them, paying manufacturing costs but not development, just as they have piggybacked on the U.S. in the past. Indeed, federal budgeteers and political demagogues might well congratulate themselves on their perspicacity in encouraging such a shift.

This development would be a disaster for the nation’s overall financial well-being, since medical innovation is an important source of good jobs, potential exports, and high-tech synergies, but since when did budgeteers or demagogues take such a big view?

The question, of course, is “given these pressures, what can be done?”

The exact answer is uncertain, but the first part of it is clear : no half-way measures will suffice. Beth Haynes has it right; once the system turns into a commons, bad things follow inevitably, including rationing and pressures for stasis:

The only way to escape the need for centralized rationing is to recognize that health care expenditures are not a national phenomenon, but an individual one. We have to stop thinking of medical care in collectivist terms, such as a “national resource” available for dispersal through political wrangling. Medical care is of, for, and by private individuals.

The proper alternative to the increasingly top-down, coercive central planning integral to our current system is restoring to each of us the right and responsibility for making our own rationing decisions.

So the first part of the answer is more innovation, but focused not on devices and pharmaceuticals, but on incentives and institutional structures. Get those right, and the detailed innovations will follow.

The Heartland Institute has an interesting idea in its Free to Choose initiative, also written up in PJM last week.

Clayton Christensen’s work is important, because of its broad focus on organizational and institutional structures and how they might and must change to improve quality, provide incentives for innovation, bring the organization of the industry into the 21st century, and cut costs. (I am a big fan of Christensen and his theories of disruptive innovation.)

The American Enterprise Institute has just issued a new book that “proposes five specific reforms to improve the ability of markets to create a lower-cost, higher-quality health care system that is responsive to the needs of individuals, including increasing individual involvement, deregulating insurance markets and redesigning Medicare and Medicaid, improving availability and quality of information, enhancing competition, and reforming the malpractice system.”

We don’t lack for understanding. Nor do we lack for ideas. There are many good proposals to push for.

The one thing we cannot do if we want to maintain our innovative mojo is continue down the road we are on of socializing the whole system, which leads only to more conferences on innovation, strategy papers, committees that promise to identify the very best innovations no matter how long it takes, new government institutions to compensate for the destruction of the old private ones, and ultimate paralysis, probably while China and other Asian tigers zip by us by adopting market-oriented systems.

The one thing we cannot do if we want to maintain our innovative mojo, is continue down the road we are on of socializing the whole system, which leads only to more conferences on innovation, strategy papers, committees that promise to identify the very best innovations no matter how long it takes, new government institutions to compensate for the destruction of the old private ones, and ultimate paralysis, probably while China and other Asian tigers zip by us by adopting market-oriented systems.

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James V. DeLong lives in Arlington, VA.
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