1. July 17, 2007 Healthcare and Innovation, University of Minnesota 1 Healthcare Innovation in the US: A Theoretical Problem in Search of an Empirical Solution John A. Nyman Health Policy and Management University of Minnesota

2. July 17, 2007 Healthcare and Innovation, University of Minnesota2 Overview Asked to discuss the economist’s perspective on healthcare innovation Asked to discuss the economist’s perspective on healthcare innovation Economists interested in incentives Economists interested in incentives Health economists have (at least) 3 views of incentives surrounding healthcare innovation Health economists have (at least) 3 views of incentives surrounding healthcare innovation –Innovation incentives are derived from insurance and represent dynamic moral hazard –Innovation incentives are derived from market competition and represent cost-reducing efficiency –Innovation incentives are derived from government granting monopoly power through patents

3. July 17, 2007 Healthcare and Innovation, University of Minnesota3 Innovation as Dynamic Moral Hazard For the last 30 years or so, most US health economists have held that the main motivation for additional health care spending in the US is health insurance For the last 30 years or so, most US health economists have held that the main motivation for additional health care spending in the US is health insurance Theory suggested that when consumers become insured, they face a reduced price for health care and consume more healthcare as a result Theory suggested that when consumers become insured, they face a reduced price for health care and consume more healthcare as a result The additional care is called “moral hazard” and it is assumed to be care of relatively low value to consumers The additional care is called “moral hazard” and it is assumed to be care of relatively low value to consumers But the costs of producing the care remain high, so an inefficiency or welfare loss obtains But the costs of producing the care remain high, so an inefficiency or welfare loss obtains –Mark V. Pauly “The Economics of Moral Hazard,” Am Econ Rev, 1968

4. July 17, 2007 Healthcare and Innovation, University of Minnesota4 Moral Hazard Welfare Loss M (medical care) $/M P = Marginal Cost Demand for medical care M0M0 P 0 = WTP

5. July 17, 2007 Healthcare and Innovation, University of Minnesota5 Moral Hazard Welfare Loss M (medical care) $/M P = Marginal Cost MuMu MiMi A Demand for medical care P = 0 B P = MC

6. July 17, 2007 Healthcare and Innovation, University of Minnesota6 Moral Hazard Welfare Loss M (medical care) $/M P = the marginal cost of producing a unit of medical care MuMu MiMi A Demand for medical care P = 0 B P = MC Moral Hazard Welfare Loss—An Inefficiency

7. July 17, 2007 Healthcare and Innovation, University of Minnesota7 Dynamic Moral Hazard Because insurance stands ready to pay for any health care consumed, insurance also represents an incentive to develop new health care technologies Because insurance stands ready to pay for any health care consumed, insurance also represents an incentive to develop new health care technologies According to the conventional model, innovation therefore consists of new healthcare technologies that improve health but only marginally, and at a production cost that is too great According to the conventional model, innovation therefore consists of new healthcare technologies that improve health but only marginally, and at a production cost that is too great This is referred to as dynamic moral hazard This is referred to as dynamic moral hazard Thus, many US health economists view insurance as providing an incentive for inefficient innovation in health care Thus, many US health economists view insurance as providing an incentive for inefficient innovation in health care

8. July 17, 2007 Healthcare and Innovation, University of Minnesota8 New Theory I have suggested that this theory is wrong I have suggested that this theory is wrong –John A. Nyman, The Theory of Demand for Health Insurance, Stanford U Press, 2003 My new theory is based on the simple idea that the price decrease in insurance is largely effective only for those who are ill My new theory is based on the simple idea that the price decrease in insurance is largely effective only for those who are ill –For example, what healthy consumer would purchase a coronary bypass procedure (or organ transplant or course of chemotherapy) just because he was insured and the price he faced had dropped to zero

9. July 17, 2007 Healthcare and Innovation, University of Minnesota9 New Theory So, the price reduction in insurance is largely only effective for those who are ill and represents the vehicle by which income is transferred from the healthy to the ill So, the price reduction in insurance is largely only effective for those who are ill and represents the vehicle by which income is transferred from the healthy to the ill –That is, this price reduction creates access to health care If insurance actually paid off with this income transfer, say, by writing a check upon diagnosis to the consumer for the average cost his or her care, the consumer would be able to show his or her increased willingness to pay for the additional health care If insurance actually paid off with this income transfer, say, by writing a check upon diagnosis to the consumer for the average cost his or her care, the consumer would be able to show his or her increased willingness to pay for the additional health care Therefore, a large portion of moral hazard is actually efficient Therefore, a large portion of moral hazard is actually efficient

10. July 17, 2007 Healthcare and Innovation, University of Minnesota10 Moral Hazard Under New Theory M (medical care) $/M MuMu MiMi A DuDu P = 0 B P = MC DiDi New demand curve with the higher willingness to pay from the additional income that is transferred by insurance Original demand curve with willingness to pay based on original income C

11. July 17, 2007 Healthcare and Innovation, University of Minnesota11 Moral Hazard Can Increase Consumer Surplus M (medical care) $/M P = Marginal Cost MuMu MiMi A DuDu P = 0 B P = MC DiDi Consumer Surplus— An Efficiency

12. July 17, 2007 Healthcare and Innovation, University of Minnesota12 Conclusion for Moral Hazard Therefore, the welfare consequences of moral hazard (including dynamic moral hazard) are not known theoretically, but must be determined empirically Therefore, the welfare consequences of moral hazard (including dynamic moral hazard) are not known theoretically, but must be determined empirically Cost-benefit analysis can answer that question because CBA seeks to determine whether the consumer’s willingness-to-pay for medical care exceeds the cost of producing it Cost-benefit analysis can answer that question because CBA seeks to determine whether the consumer’s willingness-to-pay for medical care exceeds the cost of producing it If WTP > cost, then the additional medical care is efficient, even though the medical care is purchased by the consumer because of insurance If WTP > cost, then the additional medical care is efficient, even though the medical care is purchased by the consumer because of insurance

13. July 17, 2007 Healthcare and Innovation, University of Minnesota13 Conclusion for Dynamic Moral Hazard In the same way, cost-benefit analysis (CBA) can be used to determine whether a new technology is efficient In the same way, cost-benefit analysis (CBA) can be used to determine whether a new technology is efficient Any new technology that is generated by insurance incentives, but that passes the CBA test (WTP > Cost), is efficient Any new technology that is generated by insurance incentives, but that passes the CBA test (WTP > Cost), is efficient So, insurance incentives for innovation are good as long as they produce new technologies that pass a cost-benefit standard So, insurance incentives for innovation are good as long as they produce new technologies that pass a cost-benefit standard

14. July 17, 2007 Healthcare and Innovation, University of Minnesota14 Innovation as Competitive Efficiency More recently, health economists in the US have begun to consider innovation as a means for reducing costs More recently, health economists in the US have begun to consider innovation as a means for reducing costs That is, rather than producing a new technology that increases costs but achieves better health at the same time, That is, rather than producing a new technology that increases costs but achieves better health at the same time, This argument says that innovation can represent a new technology that lowers costs for the same gain in health This argument says that innovation can represent a new technology that lowers costs for the same gain in health

15. July 17, 2007 Healthcare and Innovation, University of Minnesota15 Innovation as Competitive Efficiency The impetus for innovation is profit- seeking firms in a competitive healthcare market environment The impetus for innovation is profit- seeking firms in a competitive healthcare market environment –Profit-seeking firms—health plans, physician clinics, hospitals (even though they are non- profit) desire to reduce costs to increase profits (or hospital surpluses) –Competition from other firms requires that firms continually adopt cost-saving innovations or lose business to other firms

16. July 17, 2007 Healthcare and Innovation, University of Minnesota16 Innovation as Competitive Efficiency There is some confusion regarding the type of evidence that would support this view There is some confusion regarding the type of evidence that would support this view Some of the evidence that is cited in the literature is actually no different than the cost- benefit analysis (CBA) standard just described, because the authors evaluate the health care results in the same way that health benefits are determined in CBA Some of the evidence that is cited in the literature is actually no different than the cost- benefit analysis (CBA) standard just described, because the authors evaluate the health care results in the same way that health benefits are determined in CBA –Cutler, McClellan, Newhouse, Remler. “Are Medical Prices Declining? Evidence from Heart Attacks” (Quart J Econ, 1998) –David Cutler, Your Money or Your Life (Oxford University Press, 2004)

17. July 17, 2007 Healthcare and Innovation, University of Minnesota17 Innovation as Competitive Efficiency The true empirical evidence to support this argument, however, should simply demonstrate declining costs from an innovative technology The true empirical evidence to support this argument, however, should simply demonstrate declining costs from an innovative technology Thus, rather than a cost-benefit analysis (CBA), a simple cost analysis or cost-focused return on investment (ROI) analysis should be the empirical test Thus, rather than a cost-benefit analysis (CBA), a simple cost analysis or cost-focused return on investment (ROI) analysis should be the empirical test –For example, a new treatment for diabetes patients might cost $30,000 but if it resulted in reduced diabetes maintenance costs by, say, $60,000, it would generate a $30,000 net cost savings Applies to only a small portion of technologies Applies to only a small portion of technologies

18. July 17, 2007 Healthcare and Innovation, University of Minnesota18 Government Granting of Patent Monopoly The third major perspective of US economists is that innovation incentives derive from the desire of firms to obtain the monopoly profits associated with a patent monopoly The third major perspective of US economists is that innovation incentives derive from the desire of firms to obtain the monopoly profits associated with a patent monopoly The argument supporting patents is that research and development (R&D) is costly The argument supporting patents is that research and development (R&D) is costly –Often because of the regulatory requirements for safety established by the government In a competitive economy, innovation might initially generate high profits, but they exist only temporarily until competitors figure out how to make and sell the new product In a competitive economy, innovation might initially generate high profits, but they exist only temporarily until competitors figure out how to make and sell the new product

19. July 17, 2007 Healthcare and Innovation, University of Minnesota19 Government Granting of Patent Monopoly The second firm to produce the new technology has a cost advantage because it did not incur the R&D costs associated with innovation The second firm to produce the new technology has a cost advantage because it did not incur the R&D costs associated with innovation Therefore, the second firm in the market (and subsequent producers) can profitably sell the innovation at a lower price than the innovator Therefore, the second firm in the market (and subsequent producers) can profitably sell the innovation at a lower price than the innovator Thus, the innovator has only a limited natural window for exercising monopoly pricing to recoup the R&D expenses Thus, the innovator has only a limited natural window for exercising monopoly pricing to recoup the R&D expenses The limitedness of this window and cost disadvantage vis a vis competing firms would act to reduce the amount of innovation The limitedness of this window and cost disadvantage vis a vis competing firms would act to reduce the amount of innovation

20. July 17, 2007 Healthcare and Innovation, University of Minnesota20 Government Granting of Patent Monopoly In order to encourage innovation, government steps in and grants a patent monopoly In order to encourage innovation, government steps in and grants a patent monopoly The patent prohibits competitors from producing and selling the new technology and gives the innovator a longer period of monopoly pricing with which to recoup the R&D costs of the new technology The patent prohibits competitors from producing and selling the new technology and gives the innovator a longer period of monopoly pricing with which to recoup the R&D costs of the new technology Thus, patents create a larger incentive to innovate by enabling innovators to recoup R&D costs and make additional profits from the new technology Thus, patents create a larger incentive to innovate by enabling innovators to recoup R&D costs and make additional profits from the new technology

21. July 17, 2007 Healthcare and Innovation, University of Minnesota21 Government Granting of Patent Monopoly But it is not clear what the optimal level of patent life or profits should be But it is not clear what the optimal level of patent life or profits should be For example in the pharmaceutical industry, some think that patent lives and drug profits are too high For example in the pharmaceutical industry, some think that patent lives and drug profits are too high –Marcia Angell, The Truth About Drug Companies, Random House, 2004 Others think that they are too low Others think that they are too low There is no standard regarding what is the level of patent protection and profitability that would encourage the optimal amount of innovation There is no standard regarding what is the level of patent protection and profitability that would encourage the optimal amount of innovation

22. July 17, 2007 Healthcare and Innovation, University of Minnesota22 Government Granting of Patent Monopoly Philipson and Jena note that (other than patents) the de facto standard that regulates the amount of innovation is cost-benefit analysis Philipson and Jena note that (other than patents) the de facto standard that regulates the amount of innovation is cost-benefit analysis –(Philipson and Jena, “Surplus Appropriation from R&D and Health Care Technology Assessment Procedures,” iHEA Conference, 2007) But cost-benefit analysis is based on the consumer’s surplus But cost-benefit analysis is based on the consumer’s surplus –that is, difference between the consumer’s willingness to pay and the price of the new technology

23. July 17, 2007 Healthcare and Innovation, University of Minnesota23 Government Granting of Patent Monopoly This might be ok for determining the value of new technologies once they have been produced This might be ok for determining the value of new technologies once they have been produced But, Jena and Philipson note that the firm’s decision to innovate under a patent model is instead based on the producer’s surplus But, Jena and Philipson note that the firm’s decision to innovate under a patent model is instead based on the producer’s surplus –that is, the difference between the price the firm receives and the cost of developing and producing the innovation The influence of CBA on firm behavior is not related to the producer’s surplus The influence of CBA on firm behavior is not related to the producer’s surplus

24. July 17, 2007 Healthcare and Innovation, University of Minnesota24 Supply and Demand in the Market for Innovations Supply (marginal cost of new product for firms) Demand (willingness to pay of consumers for new product) M (innovative medical care) $/M

25. July 17, 2007 Healthcare and Innovation, University of Minnesota25 Consumer Surplus v. Producer Surplus Supply (firm’s marginal cost of producing innovation) Demand (willingness to pay of consumers for new product) M (innovative medical care) $/M PePe Market price occurs where supply= demand

26. July 17, 2007 Healthcare and Innovation, University of Minnesota26 Consumer Surplus v. Producer Surplus Supply (firm’s marginal cost of producing innovation) Demand (willingness to pay of consumers for new product) M (innovative medical care) $/M PePe Existing CBA standard is based on consumer surplus

27. July 17, 2007 Healthcare and Innovation, University of Minnesota27 Consumer Surplus v. Producer Surplus Supply (firm’s marginal cost of producing innovation) Demand (willingness to pay of consumers for new product) M (innovative medical care) $/M PePe Existing CBA standard is based on consumer surplus Firm’s actual incentive to innovate is based instead on producer’s surplus

28. July 17, 2007 Healthcare and Innovation, University of Minnesota28 CBA and Innovation Thus, CBA is the correct measure for determining whether a new technology is socially efficient once it has been developed Thus, CBA is the correct measure for determining whether a new technology is socially efficient once it has been developed But, it is the wrong measure to use as an incentive to encourage firms to innovate But, it is the wrong measure to use as an incentive to encourage firms to innovate Indeed, Jena and Philipson claim that a CBA standard acts to reduce innovations compared to a profit-based criterion Indeed, Jena and Philipson claim that a CBA standard acts to reduce innovations compared to a profit-based criterion –This is because an innovation with a lower acquisition price is more likely to pass the CBA standard, but a lower acquisition price means that the new technology is less likely to exist in the first place

29. July 17, 2007 Healthcare and Innovation, University of Minnesota29 Conclusions Three perspectives of economists Three perspectives of economists –Incentives to innovate stem from  insurance and represent dynamic moral hazard, conventionally an incentive for inefficient innovation but in actuality it could be efficient  profit-maximizing firms in competitive markets, and represent an incentive for efficient innovation  government patent monopolies that produce innovation of unknown efficiency No one has determined what the optimal patent protection means No one has determined what the optimal patent protection means

30. July 17, 2007 Healthcare and Innovation, University of Minnesota30 Conclusions CBA is the standard for determining whether a cost-increasing technology is worth it once it has been developed CBA is the standard for determining whether a cost-increasing technology is worth it once it has been developed But while CBA can correctly evaluate the social net value of existing new technologies, But while CBA can correctly evaluate the social net value of existing new technologies, It probably does not represent the correct empirical test for achieving the optimal amount of innovation It probably does not represent the correct empirical test for achieving the optimal amount of innovation In fact, it may result in a disincentive to innovate, compared to the optimum In fact, it may result in a disincentive to innovate, compared to the optimum