Sowell Applied Economics Thinking Beyond Stage One (revised and enlarged ed)

necessarily the most important costs. One-stage thinking has much to do with these costs.

The threat of lawsuits can impose costs on obstetricians which raise their insurance premiums high enough to cause many of these doctors to stop delivering babies, or to stop delivering them in places where high jury awards on dubious evidence make it uneconomic to continue practicing obstetrics. The net result of this can be that pregnant women in those places are at more risk than before because now there may be no doctor available in the vicinity to deliver their baby when the time comes. Nor are obstetricians the only doctors who flee from places where it is easy to file lawsuits and win large damage awards. Pennsylvania, for example, lost onethird of its surgeons between 1995 and 2002.

Ideally, juries would award malpractice damages only when the probability that malpractice had actually taken place was sufficiently clear, and the award only at a level sufficient to compensate real damages and deter such malpractice in the future. In reality, an injured, deformed, or brain-damaged baby and an eloquent lawyer can lead to jury awards in the millions of dollars, even when it is by no means clear that the doctor who delivered that baby was in any way at fault. A large study conducted jointly by the American College of Obstetricians and Gynecologists and the American Academy of Pediatrics— released in 2003 and reviewed and approved by leading medical authorities in and out of government, as well as from as far away as Australia and New Zealand— concluded that “the vast majority of brain damage and cerebral palsy among these infants originates in factors largely or completely outside the control of deliveryroom personnel.”

According to The Economist, “few clinicians think that babies get cerebral palsy because the obstetrician failed to deliver them by caesarean section.” Yet “fear of being sued prompts doctors to perform unnecessary C- sections— a risky and invasive procedure.” Nevertheless, “a five-fold increase in C-sections in rich countries in the past three decades has brought no decrease in the incidence of cerebral palsy.” Seventy-six percent of American obstetricians have been sued at least once. The rationale for medical malpractice lawsuits is to force doctors to be more careful and

thereby reduce risks to patients. The actual consequences, however, include unnecessary medical procedures, such as delivering babies by Caesarean section, as well as ordering medically unnecessary tests that doctors feel are financially necessary to protect themselves against lawsuits.

There may also be additional risks to patients when substantial numbers of doctors leave an area where malpractice lawsuits are easy to file and win. Doctors usually win lawsuits that go to trial but the pressure to settle out of court is substantial, since the average damage award in jury trials is $4.7 million. Given the size of the damage awards and the resulting escalating costs of malpractice insurance, it is hardly surprising that defensive medicine has become widespread among obstetricians. A study of obstetricians in Pennsylvania found that “54% frequently called for tests, like sonograms, they felt were unnecessary and 38% often admitted to invasive procedures, like biopsies, that were not called for.” Such “defensive medicine” may not make patients any safer and in some cases, such as Caesarean sections and biopsies, can create additional risks. It is not merely the damages awarded in medical malpractice cases that add to the costs of medical care but also the greatly increased costs of defensive medical procedures.

It costs a jury nothing to “send a message” warning doctors to be more careful, and the particular doctor in the case at hand probably has insurance from a company that can pay a few million dollars easily out of its billions of dollars in assets. Only if the jurors think beyond stage one will they take into account the increased cost of medical treatment brought on by their awards and the future non-financial costs to pregnant women unable to find obstetricians in their area at the time of delivery and the lifelong costs to babies who may incur more or worse injuries or disabilities as a result. This is especially likely to be the end result in states where juries hand out multimillion-dollar awards readily, such as Nevada:

Kimberly Maugaotega of Las Vegas is 13 weeks pregnant and hasn’t seen an obstetrician. When she learned she was expecting, the 33-year-old mother of two called the doctor who delivered her second child but was told he wasn’t taking any new pregnant patients. Dr. Shelby Wilbourn plans to leave Nevada because of soaring medical-malpractice insurance rates there. Ms. Maugaotega says she called 28 obstetricians but couldn’t find one who would take her.

the United States— about ten percent, according to data from the Centers for Medicare and Medicaid Services. The costs behind these prices are not only high, but unusual, in the predominance of research costs over the cost of actually manufacturing the medications themselves.

While the process of creating a new pharmaceutical drug involves science, it also involves trial and error, often taking years. In the pharmaceutical drug industry, creating a new medicine to cure a particular disease can involve many failures before finally developing a drug that is simultaneously effective, affordable, and without major adverse side-effects for most people. In 2003, an official of the drug producer Pfizer said: “Last year we made over 5,000 compounds. Only half a dozen of them will make it to clinical trials.” How many of those half dozen would prove to be successful in the clinical trials and then make it through the approval process of the Food and Drug Administration (FDA) only the future would tell.

If the pharmaceutical company has spent years working on many different chemical compounds before finally coming up with one that meets all the criteria— and gets the approval of the Food and Drug Administration as well— then its profits on that successful drug have to cover all its costs on the many unsuccessful ones. Otherwise there will not be sufficient earnings to repay all the individuals, pension funds, and other investors whose money they use to finance the creation of new drugs.

Since the creation of a single new drug typically costs hundreds of millions of dollars,2 keeping enough investors willing to continue supplying such huge sums of money is essential to keeping the discovery of new drugs going.

Those who do not think beyond stage one see the situation in wholly different terms. Rather than examine what happens before and after a new drug is created, they essentially treat existing drugs as having been created

2 “It can take fifteen years and hundreds of millions of dollars to go from finding a bacterial target to putting a drug into production.” James Surowiecki, “No Profit, No Cure,” The New Yorker, November 5, 2001, p. 46. “Estimates range from around $250 million per drug to more than $800 million.” “Drug Prices: A Much-Needed Primer,” Wall Street Journal, July 22, 2002, p. A15.

somehow and focus on how these drugs are priced, what profits they earn, and how those prices can be brought down. Since the cost of manufacturing a pharmaceutical drug is often a small fraction of its total costs, or of the price paid by the consumer, there are ample opportunities for politicians, journalists, and others to decry the “unconscionable,” “outrageous” or “obscene” profits made by charging two dollars a pill when the ingredients in the pill may cost only a quarter.

By ingredients they mean physical ingredients, which are usually inexpensive, rather than the knowledge ingredient which is usually astronomically expensive because of years of research, with much trial and error, including many costly and failed attempts to create effective new medicines.

The same misconception of costs can appear in another form when politicians, journalists, etc., contrast the high price charged for a pharmaceutical drug by the company that created it versus the much lower price of a “generic equivalent” produced by another company, which simply uses the same formula, free of charge, after the patent has expired. The second company’s costs are just the low costs of manufacturing the drug, so that they may be able to make a profit selling a generic equivalent for a fraction of what the company that created the drug charged. In the case of a pill whose ingredients cost a quarter, the generic manufacturer may be able to make a profit charging thirty-five cents for the same pill, causing the brand-name manufacturer who created the drug to be accused of unconscionably exploiting people who are ill and desperate by charging a much higher price before the patent expired.

The combination of very high fixed costs for developing a new drug and very low incremental costs of producing it leads to other economic consequences that are easy to misunderstand or misrepresent by those who do not think beyond stage one. For example, Canadians pay much lower prices for American pharmaceutical drugs than Americans do. When a government agency in Canada buys vast quantities of medicines for its comprehensive, government-run medical care system, and offers an American pharmaceutical company a price which covers the incremental costs of manufacturing a particular drug, but not the vast costs of developing

identical brand-name drugs can often reduce the cost to hospitals or healthinsurance systems. Some demand that all drugs be generic, ending the high prices and presumably unconscionable profits of the brand-name drug producers. But here we must beware of the fallacy of composition. What is true for some is not necessarily something that can be made true for all. The overlooked factor is that generic drug producers are essentially getting a free ride on the costs and experience built up at great expense by producers of brand-name drugs.

Since it usually takes a decade or more to develop a new pharmaceutical drug, this situation is virtually ideal for political demagoguery. A politician can gain instant popularity by advocating any of a number of ways of forcing down the price of medications immediately, and it could be at least ten years later before people begin noticing a decline or disappearance of new pharmaceutical drugs to deal with deadly diseases that still ravage millions of people. But, by this time, our popular politician could be elected president, serve two terms in the White House, and be living in retirement as a revered figure. As noted in Chapter 1, killing the goose that lays the golden egg can be a viable political strategy.

It should also be noted that “generic equivalents” may not all be equivalent for all people. Some patients report adverse side effects from generic equivalents that they did not have from the original brand of the medicine. Generic equivalents do not have to be chemically identical, as a health reporter noted:

By law, generics must have the same active ingredient and the same action as the brand-name version, which allows them to piggyback on the original safety and efficacy trials. But generics do have different inactive ingredients, which can affect how they are absorbed into the body. Generics can produce blood levels as much as 20% below or 25% above that of the original drug and still be considered “bioequivalent,” according to Food and Drug Administration guidelines.

Leaving aside the question whether an ingredient is truly inactive if it affects the rate at which the active ingredient is absorbed by the body, there is also a question whether a lesser known firm— perhaps in a Third World country— copying a medication developed by an internationally known

pharmaceutical company, has the same incentives to maintain production quality standards as the original producer of the drug, for whom billions of dollars’ worth of international brand name reputation is at stake, not just for this particular drug but for all its many other drugs, present and future.

Price Controls

While past costs are irrelevant to present decision-making— they are history but they are not economics— those past costs do matter when pharmaceutical companies decide whether, or to what extent, to invest in developing more new drugs. If those past costs have not been covered, future costs may not be as readily incurred to create future drugs to cure or prevent such scourges as Alzheimer’s, AIDS, or cancer. Despite such weighty economic considerations— for the society, as well as for the company— in political terms the pharmaceutical drug industry is virtually ideal for imposing price controls. As noted in Chapter 1, price controls can be very popular in the short run, with their bad effects usually coming some time after the next election.

Since pharmaceutical drugs can easily take a decade or more to be created, even if price controls caused all research and development of new drugs to come to a halt immediately, it would be long after the next election before people began to notice that no new medications were being created to deal with the ravages of still deadly diseases. These are virtually ideal political conditions for killing the goose that lays the golden egg. The shortrun result would be visibly lower drug prices, making millions of voters happier, and the long-run consequences would be postponed until several elections later, by which time even those suffering needlessly from illnesses that new medications could have cured or prevented may see no connection between their own suffering and political decisions made years earlier.

The effects of such political incentives can be seen in many countries around the world. The United States is the only major industrial nation without price controls on pharmaceutical drugs. In other words, politicians in other countries have already sacrificed the long-run medical benefits of pharmaceutical drug research and reaped the immediate political benefits,

leaving their countries to depend on the American pharmaceutical industry to supply a wholly disproportionate share of the new medications in the world. If a similar policy is followed by the United States, the resulting drying up of American pharmaceutical research would affect not only the American population, but also the populations of other countries that have been able to rely on the creation of new drugs in the United States and being able to buy these drugs by paying prices that cover only the manufacturing costs, while Americans pay prices that cover the far larger costs of developing such drugs.

As was pointed out by a Commissioner of the Food and Drug Administration, “the U.S. is paying the lion’s share of the cost of developing drugs.” Americans pay in two different ways. As BusinessWeek magazine pointed out, “it’s not just that the higher prices Americans pay for drugs fund half of the industry’s research efforts. U.S. taxpayers also support most of the world’s government-funded basic biomedical research— as much as 80%, by some estimates.”

One of the irrelevant distractions in many discussions of the costs of creating new medications is that much of the drug companies’ research is a continuation of more fundamental scientific research done in academic institutions and government agencies such as the National Institutes of Health. However, in every aspect of our lives, we all stand on the shoulders of giants, and all those giants were not in the past. The costs incurred in turning scientific discoveries into new medications are no less real and no less important because other individuals and organizations incurred other costs earlier. Nor does the fact that the taxpayers’ money was used mean that the best way to make decisions about pharmaceutical drugs is to take those decisions out of the marketplace and have them made by politicians. Yet this non sequitur is what seems to be implied by those who think that the prior costs of scientific discoveries change the economic requirements for producing new medicines.

While advocates of price controls on pharmaceutical drugs refer to this as “bringing down the cost” of these drugs, it is in fact simply refusing to pay those costs— and ignoring the consequences of that refusal, especially when

those consequences occur after stage one. Europe has already gone that route:

Already, Europeans are fretting that their relatively low prices are killing their pharmaceutical industry. In 1990, European and U.S. companies each held about a one-third share of the world drug market. Now, Europe’s share is down to 21%, while the U.S.’s has jumped to 50%. European companies have increasingly moved their R&D operations to the U.S., and they make 60% of their profits in the American market, analysts estimate.

In short, European policies that Americans are being urged to emulate are what drove much European research and development out of Europe to the United States. If the United States does now follow the European policies, this can shut down much of the world’s research and development of new pharmaceutical drugs. It could mean killing off the biggest goose that is laying most of the world’s golden eggs when it comes to producing new medications to fight painful, debilitating and fatal diseases.

Advertising

However easy it may be for outside observers to dismiss advertising as an expense that accomplishes nothing for society and only increases the advertiser’s profits, that is in fact not the case. The most wonderful drug ever created will help no one’s medical condition unless it becomes known. Advertising does that. Nor is making the drug known something that can be done once and for all, and advertising discontinued thereafter, without consequences.

After the patent for the drug Ceclor expired and its producer, Eli Lilly & Co., cut back on the promotion of it when generic substitutes began to be marketed by other companies, prescriptions for this drug fell to one-fifth of the former level. The generic producers had little or no incentive to advertise, since no one of them would have a large enough share of the increased sales to recover the advertising expenditures. As far as the