July 17, 2007 Healthcare and Innovation, University of Minnesota 1 Healthcare Innovation in the US:...

July 17, 2007July 17, 2007 Healthcare and Innovation, UniversHealthcare and Innovation, University of Minnesotaity of Minnesota

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Healthcare Innovation in Healthcare Innovation in the US: A Theoretical the US: A Theoretical

Problem in Search of an Problem in Search of an Empirical SolutionEmpirical Solution

John A. NymanJohn A. Nyman

Health Policy and Health Policy and ManagementManagement

University of MinnesotaUniversity of Minnesota


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OverviewOverview Asked to discuss the economist’s perspective Asked to discuss the economist’s perspective

on healthcare innovationon healthcare innovation Economists interested in incentives Economists interested in incentives Health economists have (at least) 3 views of Health economists have (at least) 3 views of

incentives surrounding healthcare innovationincentives surrounding healthcare innovation– Innovation incentives are derived from Innovation incentives are derived from insuranceinsurance

and represent and represent dynamic moral hazarddynamic moral hazard– Innovation incentives are derived from market Innovation incentives are derived from market

competitioncompetition and represent and represent cost-reducing efficiencycost-reducing efficiency– Innovation incentives are derived from Innovation incentives are derived from governmentgovernment

granting granting monopoly power through patentsmonopoly power through patents


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Innovation as Dynamic Innovation as Dynamic Moral HazardMoral Hazard

For the last 30 years or so, most US health For the last 30 years or so, most US health economists have held that the main motivation for economists have held that the main motivation for additional health care spending in the US is health additional health care spending in the US is health insuranceinsurance

Theory suggested that when consumers become Theory suggested that when consumers become insured, they face a reduced price for health care insured, they face a reduced price for health care and consume more healthcare as a resultand consume more healthcare as a result

The additional care is called “The additional care is called “moral hazardmoral hazard” and it is ” and it is assumed to be care of relatively low value to assumed to be care of relatively low value to consumersconsumers

But the costs of producing the care remain high, so But the costs of producing the care remain high, so an an inefficiency or welfare loss inefficiency or welfare loss obtainsobtains– Mark V. Pauly “The Economics of Moral Hazard,” Mark V. Pauly “The Economics of Moral Hazard,” Am Econ Am Econ

RevRev, 1968, 1968


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Moral Hazard Welfare LossMoral Hazard Welfare Loss

M (medical care)

$/M

P = Marginal Cost

Demand for medical care

M0

P0 = WTP


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M (medical care)

$/M

P = Marginal Cost

Mu Mi

A


P = 0

BP = MC


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M (medical care)

$/M

P = the marginal costof producing a unitof medical care

Mu Mi

A


P = 0

BP = MC

Moral Hazard WelfareLoss—An Inefficiency


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Dynamic Moral HazardDynamic Moral Hazard Because insurance stands ready to pay for any Because insurance stands ready to pay for any

health care consumed, health care consumed, insurance also represents insurance also represents an incentive to develop new health care an incentive to develop new health care technologiestechnologies

According to the conventional model, innovation According to the conventional model, innovation therefore consists of new healthcare technologies therefore consists of new healthcare technologies that improve health that improve health but only marginallybut only marginally, and , and at a at a production cost that is too greatproduction cost that is too great

This is referred to as This is referred to as dynamic moral hazarddynamic moral hazard Thus, many US health economists view insurance Thus, many US health economists view insurance

as providing an incentive for as providing an incentive for inefficient innovation inefficient innovation in health carein health care


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New Theory New Theory

I have suggested that this theory is wrongI have suggested that this theory is wrong– John A. Nyman, John A. Nyman, The Theory of Demand for The Theory of Demand for

Health Insurance, Health Insurance, Stanford U Press, 2003Stanford U Press, 2003 My new theory is based on the simple idea My new theory is based on the simple idea

that the price decrease in insurance is that the price decrease in insurance is largely effective only for those who are illlargely effective only for those who are ill– For example, what For example, what healthyhealthy consumer would consumer would

purchase a coronary bypass procedure (or purchase a coronary bypass procedure (or organ transplant or course of chemotherapy) organ transplant or course of chemotherapy) just because he was insured and the price he just because he was insured and the price he faced had dropped to zerofaced had dropped to zero


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New TheoryNew Theory So, the price reduction in insurance is largely only So, the price reduction in insurance is largely only

effective for those who are ill and represents effective for those who are ill and represents the the vehicle by which income is transferred from the vehicle by which income is transferred from the healthy to the illhealthy to the ill – That is, this price reduction That is, this price reduction creates accesscreates access to health care to health care

If insurance actually paid off with this income If insurance actually paid off with this income transfer, say, by writing a check upon diagnosis to transfer, say, by writing a check upon diagnosis to the consumer for the average cost his or her care, the consumer for the average cost his or her care, the consumer would be able to show his or her the consumer would be able to show his or her increased willingness to pay for the additional increased willingness to pay for the additional health carehealth care

Therefore, a large portion of moral hazard is Therefore, a large portion of moral hazard is actually actually efficient efficient


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Moral Hazard Under New Moral Hazard Under New TheoryTheory

M (medical care)

$/M

Mu Mi

A

Du

P = 0

BP = MC

Di

New demand curve with thehigher willingness to pay fromthe additional income that is transferred by insurance

Original demand curvewith willingness to paybased on original income

C


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Moral Hazard Can Increase Moral Hazard Can Increase Consumer SurplusConsumer Surplus

M (medical care)

$/M

P = Marginal Cost

Mu Mi

A

Du

P = 0

BP = MC

Di

Consumer Surplus—An Efficiency


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Conclusion for Moral HazardConclusion for Moral Hazard Therefore, the welfare consequences of Therefore, the welfare consequences of

moral hazard (including dynamic moral moral hazard (including dynamic moral hazard) are hazard) are not known theoreticallynot known theoretically, but , but must be determined empiricallymust be determined empirically

Cost-benefit analysisCost-benefit analysis can answer that can answer that question because CBA seeks to determine question because CBA seeks to determine whether the consumer’s willingness-to-pay whether the consumer’s willingness-to-pay for medical care exceeds the cost of for medical care exceeds the cost of producing itproducing it

If WTP > cost, then the additional medical If WTP > cost, then the additional medical care is efficient, even though the medical care is efficient, even though the medical care is purchased by the consumer because care is purchased by the consumer because of insuranceof insurance


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Conclusion for Dynamic Moral Conclusion for Dynamic Moral HazardHazard

In the same way, cost-benefit analysis In the same way, cost-benefit analysis (CBA) can be used to determine whether a (CBA) can be used to determine whether a new technologynew technology is efficient is efficient

Any new technology that is generated by Any new technology that is generated by insurance incentives, but that passes the insurance incentives, but that passes the CBA test (WTP > Cost), is efficientCBA test (WTP > Cost), is efficient

So, insurance incentives for innovation are So, insurance incentives for innovation are good as long as they produce new good as long as they produce new technologies that pass a cost-benefit technologies that pass a cost-benefit standardstandard


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Innovation as Competitive Innovation as Competitive Efficiency Efficiency

More recently, health economists in the More recently, health economists in the US have begun to consider innovation as US have begun to consider innovation as a means for reducing costsa means for reducing costs

That is, rather than producing a new That is, rather than producing a new technology that technology that increases costs but increases costs but achieves better health at the same timeachieves better health at the same time,,

This argument says that innovation can This argument says that innovation can represent a new technology that represent a new technology that lowers lowers costs for the same gain in healthcosts for the same gain in health


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Innovation as Competitive Innovation as Competitive EfficiencyEfficiency

The impetus for innovation is The impetus for innovation is profit-profit-seeking firms in a competitive seeking firms in a competitive healthcare market environmenthealthcare market environment– Profit-seeking firms—health plans, Profit-seeking firms—health plans,

physician clinics, hospitals (even though physician clinics, hospitals (even though they are non-profit) desire to reduce costs they are non-profit) desire to reduce costs to increase profits (or hospital surpluses)to increase profits (or hospital surpluses)

– Competition from other firms requires that Competition from other firms requires that firms continually adopt cost-saving firms continually adopt cost-saving innovations or lose business to other firmsinnovations or lose business to other firms


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There is some confusion regarding the There is some confusion regarding the type of evidence that would support this type of evidence that would support this viewview

Some of the evidence that is cited in the Some of the evidence that is cited in the literature is actually no different than the literature is actually no different than the cost-benefit analysis (CBA) standard just cost-benefit analysis (CBA) standard just described, because the authors evaluate described, because the authors evaluate the health care results in the same way the health care results in the same way that health benefits are determined in CBAthat health benefits are determined in CBA– Cutler, McClellan, Newhouse, Remler. “Are Cutler, McClellan, Newhouse, Remler. “Are

Medical Prices Declining? Evidence from Heart Medical Prices Declining? Evidence from Heart Attacks” (Attacks” (Quart J EconQuart J Econ, 1998), 1998)

– David Cutler, David Cutler, Your Money or Your Life Your Money or Your Life (Oxford (Oxford University Press, 2004)University Press, 2004)


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The true empirical evidence to support this The true empirical evidence to support this argument, however, should simply argument, however, should simply demonstrate declining costs from an demonstrate declining costs from an innovative technology innovative technology

Thus, rather than a cost-benefit analysis Thus, rather than a cost-benefit analysis (CBA), a simple cost analysis or cost-focused (CBA), a simple cost analysis or cost-focused return on investment (ROI) analysis should be return on investment (ROI) analysis should be the empirical testthe empirical test– For example, a new treatment for diabetes patients For example, a new treatment for diabetes patients

might cost $30,000 but if it resulted in reduced might cost $30,000 but if it resulted in reduced diabetes maintenance costs by, say, $60,000, it diabetes maintenance costs by, say, $60,000, it would generate a $30,000 net cost savingswould generate a $30,000 net cost savings

Applies to only a small portion of technologiesApplies to only a small portion of technologies


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Government Granting of Patent Government Granting of Patent MonopolyMonopoly

The third major perspective of US economists The third major perspective of US economists is that innovation incentives derive from the is that innovation incentives derive from the desire of firms to desire of firms to obtain the monopoly profits obtain the monopoly profits associated with a patent monopolyassociated with a patent monopoly

The argument supporting patents is that The argument supporting patents is that research and development (R&D) is costlyresearch and development (R&D) is costly– Often because of the regulatory requirements for Often because of the regulatory requirements for

safety established by the governmentsafety established by the government In a competitive economy, innovation might In a competitive economy, innovation might

initially generate high profits, but they exist initially generate high profits, but they exist only temporarily until competitors figure out only temporarily until competitors figure out how to make and sell the new producthow to make and sell the new product


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The second firm to produce the new The second firm to produce the new technology has a cost advantage because it technology has a cost advantage because it did not incur the R&D costs associated with did not incur the R&D costs associated with innovationinnovation

Therefore, the second firm in the market (and Therefore, the second firm in the market (and subsequent producers) can profitably sell the subsequent producers) can profitably sell the innovation at a lower price than the innovatorinnovation at a lower price than the innovator

Thus, the innovator has only a limited natural Thus, the innovator has only a limited natural window for exercising monopoly pricing to window for exercising monopoly pricing to recoup the R&D expensesrecoup the R&D expenses

The The limitedness of this windowlimitedness of this window and cost and cost disadvantage vis a vis competing firms would disadvantage vis a vis competing firms would act to reduce the amount of innovationact to reduce the amount of innovation


2020


In order to encourage innovation, In order to encourage innovation, government steps in and grants a government steps in and grants a patent patent monopolymonopoly

The patent prohibits competitors from The patent prohibits competitors from producing and selling the new technology producing and selling the new technology and gives the innovator a longer period of and gives the innovator a longer period of monopoly pricing with which to recoup the monopoly pricing with which to recoup the R&D costs of the new technologyR&D costs of the new technology

Thus, patents create a larger incentive to Thus, patents create a larger incentive to innovate by enabling innovators to innovate by enabling innovators to recoup recoup R&D costs and make additional profitsR&D costs and make additional profits from from the new technologythe new technology


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But it is not clear what the optimal level of But it is not clear what the optimal level of patent life or profits should bepatent life or profits should be

For example in the pharmaceutical For example in the pharmaceutical industry, some think that patent lives and industry, some think that patent lives and drug profits are too high drug profits are too high – Marcia Angell, Marcia Angell, The Truth About Drug The Truth About Drug

CompaniesCompanies, Random House, 2004, Random House, 2004 Others think that they are too lowOthers think that they are too low There is no standard regarding what is the There is no standard regarding what is the

level of patent protection and profitabilitylevel of patent protection and profitability that would encourage the that would encourage the optimal amount optimal amount of innovationof innovation


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Philipson and Jena note that (other than Philipson and Jena note that (other than patents) the patents) the de factode facto standard that regulates standard that regulates the amount of innovation is cost-benefit the amount of innovation is cost-benefit analysisanalysis– (Philipson and Jena, “Surplus Appropriation from (Philipson and Jena, “Surplus Appropriation from

R&D and Health Care Technology Assessment R&D and Health Care Technology Assessment Procedures,” iHEA Conference, 2007)Procedures,” iHEA Conference, 2007)

But cost-benefit analysis is based on the But cost-benefit analysis is based on the consumer’s surplusconsumer’s surplus– that is, difference between the consumer’s that is, difference between the consumer’s

willingness to pay and the price of the new willingness to pay and the price of the new technologytechnology


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This might be ok for determining the value This might be ok for determining the value of new technologies of new technologies once they have been once they have been producedproduced

But, Jena and Philipson note that the firm’s But, Jena and Philipson note that the firm’s decision to innovate under a patent model is decision to innovate under a patent model is instead based on the instead based on the producer’s surplusproducer’s surplus– that is, the difference between the price the firm that is, the difference between the price the firm

receives and the cost of developing and receives and the cost of developing and producing the innovationproducing the innovation

The influence of CBA on firm behavior is not The influence of CBA on firm behavior is not related to the producer’s surplusrelated to the producer’s surplus


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Supply and Demand in the Supply and Demand in the Market for InnovationsMarket for Innovations

Supply (marginal costof new product for firms)

Demand (willingness to payof consumers for new product)

M (innovative medical care)

$/M


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Consumer Surplus v.Consumer Surplus v.Producer SurplusProducer Surplus

Supply (firm’s marginal costof producing innovation)



$/M

Pe

Market priceoccurs wheresupply= demand


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$/M

Pe

Existing CBA standard is based on consumer surplus


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$/M

Pe

Existing CBA standard is based on consumer surplus

Firm’s actualincentive to innovate isbased instead onproducer’s surplus


2828

CBA and InnovationCBA and Innovation Thus, CBA is the correct measure for Thus, CBA is the correct measure for

determining whether a new technology is determining whether a new technology is socially efficient socially efficient once it has been developedonce it has been developed

But, it is the wrong measure to use as an But, it is the wrong measure to use as an incentive to encourage firms to innovateincentive to encourage firms to innovate

Indeed, Jena and Philipson claim that a CBA Indeed, Jena and Philipson claim that a CBA standard acts to reduce innovations standard acts to reduce innovations compared to a profit-based criterioncompared to a profit-based criterion– This is because an innovation with a This is because an innovation with a lower lower

acquisition priceacquisition price is more likely to pass the CBA is more likely to pass the CBA standard, but a lower acquisition price means standard, but a lower acquisition price means that the new technology is less likely to exist in that the new technology is less likely to exist in the first placethe first place


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ConclusionsConclusions

Three perspectives of economistsThree perspectives of economists– Incentives to innovate stem from Incentives to innovate stem from

insuranceinsurance and represent and represent dynamic moral hazarddynamic moral hazard, , conventionally an incentive for conventionally an incentive for inefficientinefficient innovation but in actuality it could be innovation but in actuality it could be efficientefficient

profit-maximizing firms in competitive marketsprofit-maximizing firms in competitive markets, , and represent an incentive for and represent an incentive for efficientefficient innovationinnovation

government patent monopoliesgovernment patent monopolies that produce that produce innovation of innovation of unknown efficiencyunknown efficiency

No one has determined what the No one has determined what the optimal patent protection meansoptimal patent protection means


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ConclusionsConclusions

CBA is the standard for determining CBA is the standard for determining whether a cost-increasing technology is whether a cost-increasing technology is worth it once it has been developedworth it once it has been developed

But while CBA can correctly evaluate the But while CBA can correctly evaluate the social net value of existing new social net value of existing new technologies,technologies,

It probably does not represent the correct It probably does not represent the correct empirical test for achieving the optimal empirical test for achieving the optimal amount of innovationamount of innovation

In fact, it may result in a disincentive to In fact, it may result in a disincentive to innovate, compared to the optimuminnovate, compared to the optimum

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July 17, 2007 Healthcare and Innovation, University of Minnesota 1 Healthcare Innovation in the US:...

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