Drugs and the Cost of Medicare

The Medicare Challenge--Posner's Comment

Becker makes the ingenious suggestion that the effect of adding drug coverage to the Medicare program is to prevent spending on drugs from growing as rapidly as the number of persons covered by Medicare. The reason is that because the marginal cost of drugs tends to be very low; most of the costs of drugs are fixed costs of research and development. Hence the larger the number of persons eligible for Medicare drug benefits, the lower the average cost of drugs.

Nevertheless the net effect of the addition to drug coverage on total Medicare spending is likely to be a substantial expansion in the total cost of Medicare. As of January of this year, 25 million persons had enrolled in Medicare Part D (the drug part), and the total annual expense to Medicare is estimated to reach $36 billion this year. As the program is only two years old, further increases in enrollment and usage can be expected, irrespective of increases in the eligible population, since more than 40 million persons receive Medicare benefits.

The net addition to Medicare costs will be less than the cost of Medicare drug coverage if drugs are a net substitute for other covered treatments. But they may not be, because there is also a complementary relation between drugs and other forms of treatment, such as surgery; to the extent that drugs reduce the pain, discomfort, or disability of surgery, they may increase the demand for surgery by reducing its nonpecuniary costs, a cost reduction that though real will not be reflected in the Medicare cost figures.

In addition, by increasing the demand for drugs, Part D will increase the net expected profits from new drugs, and thus increase the incentive to create such drugs, with the heavy fixed costs that, as Becker points out, are entailed by the development of new drugs.

Still another problem with Medicare drug coverage is that people have less aversion to popping a pill than to being operated on or otherwise confined in a hospital. The cost of surgery, as it appears to most people, includes a significant nonpecuniary element that of course is not reimbursed by public or private health insurance. Taking drugs does not impose such costs unless a drug has serious side effects. Hence the Medicare drug subsidy should cause a greater percentage increase in demand than the traditional Medicare subsidies did.

Drugs also provide an attractive but costly substitute for life-style changes designed to improve one's health. If the choice is between giving up rich food and taking a pill paid for by Medicare, the latter may be preferred though the social cost may be higher; the subsidy confronts the consumer with false alternatives from an overall social perspective, just like monopoly pricing.

The addition of drug coverage to Medicare entrenches the worst feature of the Medicare program, which is the lack of a means test. There is no reason why people who can afford to purchase health insurance that will cover their medical expenses in their old age should be subsidized by the taxpayer. There is, however, no political will to require a means test. More broadly, there is no political will to reduce public expenditures on health care. The focus of politicians is not on containing costs but rather on what has the opposite effect: expanding coverage. Congress is moving to require health insurance companies to cover mental illnesses, despite uncertainties about the efficacy of treatments for mental illness and the "cosmetic" element in the treatment of such illness because of the lack of a clear distinction between being mentally ill and simply being less happy, focused, energetic, outgoing, and, in short, successful than one would like to be. Especially because of the optional character of treatment for borderline mental "illness," demand for such treatments will be highly responsive to a subsidy, assuming the insured person who demands such treatments can shift some of the cost to the other members of his insurance pool. Notice too how the movement to require insurance coverage for mental illness will interact with Medicare drug coverage to further expand drug usage by the elderly.

In addition of course the politicians want to extend health-insurance coverage to the 40 million plus uninsured Americans, and this will increase the demand for medical services. What politicians say in a presidential-campaign year is not, however, a reliable guide to their intentions. I suspect that when the new Administration takes office in January of next year it will find that fiscal constraints preclude any significant expansion in the gargantuan federal subsidies for health care (including such indirect subsidies as imposing mandates on private insurance companies); but neither can we expect meaningful measures of cost containment.

Medicare is the federal system that covers hospitalization, physician care, drugs, and a limited amount of nursing home care for men and women over age 65. President Lyndon Johnson started it in 1965 in a modest financial way when the elderly were a small fraction of the adult population, and when drugs and surgeries to treat diseases of old age were far fewer and less complex. This program has grown in the 42 years since then into a major entitlement, with spending of almost $400 billion, which is more than 3 percent of American GDP. Of even greater concern is the projected growth in this program during the next several decades.

If past growth in Medicare is a reasonable guide to future growth, and assuming that real GDP grows at an annual rate of two and one half percent, Medicare spending as a share of GDP will double by 2020, and increase some 3-4 times by 2050 to 10 percent or more of GDP. Dollar spending on Medicare patients would increase to over a trillion dollars by 2020. Less than half of the projected increase would be due to the further aging of the population, while the majority is the result of the expected continuing growth in spending on hospitalizations, surgeries, and drugs for the elderly of given ages.

Much of the increased spending would occur even with the most efficient health delivery system since senior citizens along with younger adults put a high value on living longer in reasonably good health. The value placed on longer life and good health generally rises as incomes grow; indeed, economic analysis and past experience indicates that the willingness to pay for better health will increase in the future at least as rapidly as incomes do.

Still, there is no doubt that while the American health care delivery system has many strengths, including an encouragement to medical innovation, medical costs for the elderly could be significantly reduced with no reduction in quantity and quality if various inefficiencies in the system were corrected. Numerous proposals have been advanced to make the Medicare delivery system more efficient. Former Secretary of State and of the Treasury George Shultz, along with Professor John Shoven, in an important forthcoming book, Putting our House in Order, review several of these proposed reforms and advance their own thoughtful reforms for social security as well as Medicare and Medicaid. We discussed various reforms of American spending on medical care in our blog posts on January 13 of this year, and I will not repeat them now.

Instead, I discuss why drugs should have an important role in inefficient as well as efficient medical delivery systems. Medicare only started to cover spending on drugs in 2003, and the coverage had various defects. These include a deductible that is much too low, and a "doughnut" where there is no coverage at all for additional spending in the middle ranges of drug spending (see my discussion on Feb. 13, 2005 of these and other defects of drug coverage, with suggestions for how to make that coverage more effective). It is no surprise that spending on drugs by the elderly were not part of Medicare at the beginning since drugs were a minor part of their total medical spending in 1965. However, discoveries since then have led to various blockbuster drugs, and many less revolutionary advances in medications. These include drugs to lower blood pressure and cholesterol, to treat Parkinson's disease and other disorders of the nervous system, to help thin the blood, to overcome erectile dysfunction, to fight Aids, and to reduce testosterone to combat the spread of prostate cancer. The share of their total medical care that seniors spend on drugs has moved steadily upwards during the past 40 years, and now is more than 12 percent, and before long might approach 20 percent.

Drugs should be part of an effective health delivery system not only because of the continual introduction of new drugs, including a growing importance of genetic based drugs, but also because drugs have a very attractive cost structure, especially for the growing elderly population. As the number of persons over age 65 increases during the next several decades, it would be useful to have a health delivery system in which costs do not rise as rapidly as the number of persons treated. Surgeries do not have this property since their cost tends to increase in proportion to the number of surgeries performed since each one takes a more or less fixed number of surgeons and supporting personnel. Hospitals also have few economies of scale with respect to the number of in-patients treated once a relatively small efficient bed size is reached.

Drugs have a totally different cost structure. They typically have very high fixed costs of research and development and low marginal costs of adding additional users. To develop a new drug to treat depression, or Alzheimer's, or another serious medical problem, usually requires hundreds of millions of dollars in the form of spending on research and various stages of clinical trial development, including many failures before a successful treatment is developed. Once a valuable drug is developed, however, the cost of producing each pill is usually small, certainly a tiny fraction of its fixed costs of development. This means that additional users can be added with relatively little increase in total costs, and a decline in average cost per user.

This property of the cost of producing drugs has two extremely important implications for Medicare costs. The first is that drugs are an efficient way to treat diseases and disorders that hit a large number of men and women since then the fixed costs can be spread over a larger number of users. This makes them particularly valuable to the elderly who are a growing share of the population in the United States and all other developed countries, and in many developing countries as well, including China. Moreover, the U.S. and world populations are also increasing, which increases the demand for all drugs, including those that help treat older persons.

Drugs are also valuable in inefficient delivery systems that have trouble choking off medical treatments that would not pass a benefit-cost calculation. This would characterize systems with highly subsidized medical care, with excessively low deductibles, or with rules that cannot deny treatments to the very elderly and those close to dying who would benefit only a little from receiving treatment. Surgery, hospitalization, and close physician supervision are expensive ways to treat seniors who do not benefit much from this care since the cost of these procedures tend to rise in proportion to the number treated. On the other hand, while treating seniors with drugs sometimes also may not add much in the way of benefits, the additional cost per user would be much smaller than the average cost per user. This property of the cost of using drugs makes them particularly useful in the American medical system since that system errs on the side of generosity toward the elderly and others compared to the health care systems in most developed countries.

This advantage of drugs in inefficient health delivery systems does not argue against the need for major reforms of Medicare to make it more efficient. It recognizes, however, the value of second-best solutions in a political environment where reforms of health care are likely to come slowly because they run up against many powerful vested interests.