Chapter 12: Hospitals

Chapter 13: The Pharmaceutical Industry

Essentials of Health Economics

Hospitals• Hospital care tends to be the most expensive

aspect of healthcare delivery • Dominated by the private not-for-profit hospital, the

industry is responsible for more than one-third of all healthcare spending

• The changes that began in the 1980s pushed hospitals to become competitive and profit oriented– This corporate mentality has led to extensive

local marketing, leveraging debt, multihospital chains, and administrators earning salaries rivaling corporate executives

The role of the Not-For-Profit Organization in the Hospital Industry

• The Not-For-Profit Organizational Form– A not-for-profit hospital does not have

shareholders in the typical sense of the term• Equity capital does not come from the sale of

stock, but from donations • Nature of Competition in the Not-For-Profit

Sector– The popularity of the not-for-profit organizational

form in the hospital industry may seem a bit odd given the dominance of the for-profit firm in the rest of the United States economy

The role of the Not-For-Profit Organization in the Hospital Industry

– A second argument is based on the notion that profit-maximizing hospitals will not undertake any activity where the marginal revenue is less than the marginal costs

• Many argue that even with the preponderance of not-for-profits in the industry, the profit-maximizing objective is a reasonable operating assumption – Decision making in a not-for-profit hospital

resembles decision making in a for-profit hospital

Alternative Models of Hospital Behavior

• Utility-Maximizing Models– Decision makers in a not-for-profit hospital

maximize utility subject to a break-even constraint

– The utility-maximizing approach assumes that the hospital decision maker’s objective is to be in charge of the largest or the highest quality hospital possible given the resources available

– In practice, the assumption of quality maximization is merely a variant of profit maximization (and cost minimization) to support other objectives

Alternative Models of Hospital Behavior

• Physician-Control Models– If physicians are the relevant decision makers, they have a

stake in what combination of inputs is used – Physician control leads to technical efficiency in

production, where the physician faces a zero price for other inputs, and too many other inputs are used relative to physician inputs

– The physician wants the hospital to price complementary services in order to increase demand for physician services

– Payment for hospital services is separated from payment for physician services, making the physician neither financially responsible to the hospital nor accountable to the patient for the cost of the hospital portion of care

The Trend Toward Multihospital Systems

• The Theory of Consolidation– Mergers, acquisitions, and other forms of

consolidation occur in the hospital industry for the same reasons that they occur in any other industry

– Firms are said to experience economies of scale when the long run average costs fall as the size of the operation expands• If economies of scale are to result in

improved efficiency, a number of technical advantages must be realized.

The Trend Toward Multihospital Systems

• The Empirical Evidence on Consolidation– Most of the empirical research on the growth of

hospital systems and efficiency is based on data from a time period when cost-plus reimbursements were the standard practice

– As hospital reimbursement shifted from retrospective to prospective payment beginning in the mid 1980s, the efficiencies of the multihospital system have become more evident

The Trend Toward Multihospital Systems

• Marketing strategies, similar to the one used by international franchises in the fast food industry, have a goal to create a perception of standardized quality in the minds of potential customers

• Consolidation activity presents a challenge to antitrust policy– If consolidation leads to efficiency gains, then patients

could benefit from higher quality care at lower prices

Drug Costs • Chapter 13 will help you to understand why drugs

are priced as they are and to evaluate the pros and cons of government regulation of the pharmaceutical industry

• An understanding of the biopharmaceutical industry requires us to study its market structure, pricing policies, the effects of government regulation, the effects of cost-containment strategies of third party payers, and the role of international competition

• Also considered are the effects of new drugs, insurance coverage, and advertising on the demand for prescription drugs

The Biopharmaceutical Industry

• Biotechnology, which involves research into the nature of fundamental genetic material, is the new entrant in the biomedical field

• Products developed by the pharmaceutical industry have historically been based on chemistry rather than biology, and new pharmaceutical products are often called new chemical entities (NCEs)

• The distinction is becoming blurred and both industries are now producing therapeutic drugs

The Importance of Pharmaceuticals

• Even though pharmaceuticals still make up only a small fraction of total healthcare expenditures, the proportion devoted to these products has been increasing rapidly in recent years

• Increases in expenditures are partly the result of price increases and partly a result of increases in quantity utilized – The increase in quantity is a mixture of higher

utilization of existing drugs and the purchase of new pharmaceuticals

Market Structure• Industry Concentration

– The biopharmaceutical industry is far less concentrated than is commonly believed and is better described as monopolistically competitive

• Competition at the Product Level

– Although patent protection confers monopoly power in the production of a drug over the life of a patent, most brand name drugs experience some competition from other drugs used to treat the same illness during their period of patent protection

• Most new brand name drugs have at least one fairly close substitute at the time of their introduction into the market

Market Structure

• Effects of Firm Size on Research & Development Productivity– Larger firms, which conduct more

research projects, tended to also have more productive research programs • Larger firms were also found to be

more likely to undertake research that integrates process improvements and product development

Government Regulation of the Pharmaceutical Industry in the United

States • Regulation by the Food and Drug Administration

– Federal regulation of the quality of drugs marketed in the United States began with the enactment of the Pure Food and Drug Act in 1906 that created the FDA

– The passage of the Kefauver-Harris Act  in 1962 greatly strengthened the FDA

• The Kefauver-Harris Act required a more stringent regime of clinical testing to launch both NCEs and generic versions of drugs already on the market. The number of new drugs launched per year declined after 1962

• Smaller firms suffered a decline in both their research productivity and market share

Government Regulation of the Pharmaceutical Industry in the

United States• In 1971, the government added a proof of efficacy to the

requirements for the introduction of new drugs– Overall requirements became more stringent, and by

the 1990s the average time from first application to the FDA approval of a drug had risen to over nine years

• The following schedule shows the average time required for the development of an NCE in the late 1980s:– Discovery of an NCE– Preclinical animal testing– File application for authorization for human testing

(approximate time for discovery, preclinical and application approval: 3.5 years)

Government Regulation of the Pharmaceutical Industry in the

United States– Phase I clinical testing: test the effects on a limited

number of healthy volunteers—test absorption rate, metabolic effects, etc. (average time: 15 months)

– Phase II clinical testing: administer drug to larger sample of humans—those with conditions the NCE is intended to treat (average time: 2 years)

– Long-term animal studies (usually concurrent with human testing)

– Phase III clinical testing: large scale testing to determine efficacy and side effects (average time: 3 years)

– New drug approval process (average time 2.5 years)

Drug Patents

• In the U.S., drug patents protect the manufacturer for 20 years. However, it should be remembered that patents are applied for before clinical trials begin, so the actual life of a drug patent is 7-12 years.

Liberalization of the FDA Process

• Generic Drugs– When patents expire on brand name drugs,

chemically equivalent copies of the drug can be produced

– In 1984, the Waxman-Hatch Act was passed, which allowed generic drugs to be introduced with much less burdensome testing requirements

• Orphan Drugs– The Orphan Drug Act was passed in 1983 and

defined orphan drugs as those used to treat rare diseases (i.e., those with fewer than 200,000 cases)

– From 1998 to 2003, orphan drug prices rose by 40 percent per year compared with an increase of 15 percent per year in nonorphan drug prices

Liberalization of the FDA Process

– In 2003, the Centers for Medicare and Medicaid Services (CMS) reduced rates of reimbursement to hospitals and doctors for most orphan drugs

• Compassionate Use of Experimental Drugs– Criticism of the FDA’s conservative stance led to the

adoption of a new drug approval procedure in the 1980s, whereby experimental drugs awaiting approval may be made available to physicians for limited use in treatments for patients in advanced stages of disease

• The Prescription Drug User Fee Act of 1992– Caused some acceleration of the approval process by

granting the FDA authority to collect fees from firms when applications are filed and when they are accepted

Requirement for Prescriptions (Rx)

• A second type of regulation intended to promote the safety of the general public is the requirement that a wide range of drugs be available to consumers only when prescribed by a licensed physician

• The argument that the requirement of prescriptions from physicians is not in the public interest is made more plausible when one observes the many near-equivalents to newer prescription drugs that are available without prescription in the over-the-counter (OTC) market

Liberalization of the Rx Requirement

• Beginning in the 1970s, the FDA began to allow the conversion from prescription (Rx) status to OTC status for a limited number of drugs when pharmaceutical companies could prove that even misuse of the drug would not have harmful effects– Note: It is in the insurance companies’ (and the patients’)

best interests to promote OTC status for drugs because the OTC drugs are not usually covered by insurance

• Effects of Regulation on Pharmaceutical Firms’ Success– Firms with home countries that impose higher safety

standards in the introduction of new drugs into the domestic market have been shown to benefit in their command over market share in foreign markets

– In countries where approval of drugs has an efficacy requirement, firms seem to direct more research toward developing products that improve existing drugs

Demand for Pharmceuticals

• Effect of Increased Insurance Coverage for Prescription Drugs– Third party payment now routinely reimburses

a higher proportion of generic drug costs, as opposed to brand name drugs, in an attempt to make consumers and physicians more cost-conscious

– Medicaid also reimburses only the price of the generic drug when a generic is available• In this way, insurance companies can affect

the balance of generic and brand name drugs utilized by altering relative prices to consumers

Demand for Pharmceuticals

• Effect of Direct Marketing to Consumers– Since 1997, direct marketing of drugs to

consumers has been legal in the United States• This makes it possible for drug companies

to create a consumer demand for products that physicians might not otherwise recommend

– Direct marketing to consumers also provides a greater incentive to develop lifestyle products, such as treatment for hair loss or sexual dysfunction

Pricing Issues

• Price Differentials between Brand Names and Generic Drugs– It is widely believed that generic drugs are sold for lower

prices than equivalent brand name drugs, even when produced by the same company

• Discounting of Drugs to Third Party Payers– Discounts to insurers below the retail price is a form of

price discrimination and one that has become increasingly important in the United States in the age of managed care.

• Pharmacy Benefit Management Firms– Insurance companies also employ other firms to

negotiate for them. Pharmacy Benefit Management firms (PBMs) have emerged as service institutions for large insurance companies

Profitability of the U.S. Pharmaceutical Industry

• Profits are often thought to be higher in the pharmaceutical industry than in most other industries in the United States

• Because the proportion of cost devoted to R&D and the rate of technological change are substantially higher in the pharmaceutical industry than in most other industries, the return on equity tends to exaggerate the profitability of pharmaceutical firms, given the way R&D expenditures are treated on corporate balance sheets

• Even in the case of drugs that receive FDA approval, only a small proportion provide enough revenue through sales to cover the R&D costs incurred in their development

Summary

• At the end of the twentieth century, the United States still led the world in the development of new pharmaceuticals. This is in spite of the fact that costs of developing new drugs had risen dramatically at the same time that managed care imposed downward pressure on the domestic prices of new drugs.

• The flow of new products continues to stimulate demand for pharmaceuticals, as does the increase in third party prescription drug coverage