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Government Negotiated Prices Creates Drug Shortage

Opinion Editorial
January 10, 2007

By Linda Gorman

The latest fairy tale floating out of Washington claims that the federal government will do a better job than the private sector in negotiating low prices for Medicare drugs. Backers rely on the Costco Fallacy to support their case. It asserts that big buyers always get the best prices.

If the Costco Fallacy were true, it would follow that big buyer government would be the best possible purchaser of everything. Therefore the Soviet Union, a country in which government bought everything for everyone, should have been a consumer paradise. In reality, of course, it was a consumer hell that featured low, low prices, execrable quality, lousy distribution systems, appalling waste, a complete lack of innovation, and unending shortages.

Believers in the Costco Fallacy forget that the U.S. government is not Costco. The government has dependents, not customers. It does not care about profits, which show whether customers like what a firm is doing and how well it is minimizing costs, it doesn’t care about value, and it certainly doesn’t care about individual patients. What government does care about is avoiding responsibility for poor outcomes, and increasing both its power and its ability to take money from productive people and give it to politically favored groups.

To see how the American government creates a consumer hell via price negotiation, one need only look at the federal government’s attempt to purchase children’s vaccines. In 1993, Hillary Clinton’s Vaccines for Children (VFC) program was set up to buy children’s vaccines from manufacturers and provide them to Medicaid clients and the uninsured free of charge. To ensure low prices, the program legislation capped the price of the three vaccines then in use.

The price controls did what price controls always do, they created a shortage. As a 2005 Department of Health and Human Services (HHS) budget brief pointed out, “the price caps [were] so low, however, that the tetanus vaccine was removed from the VFC program in 1998 when no vender would bid on the contract.”

The fact that no bids were submitted should have given the government a clue that its price offers were below production costs. But the government doesn’t have to answer to consumers, so for seven years tetanus boosters were not available to children dependent on the VFC program. As is so often the case when people depend on government for health care, the children mattered only when the cameras were rolling. Once the program was enacted they were out of sight, out of mind, and out of luck.

The problem is that bureaucrats see budgets, not patients. Large swathes of the political and health policy establishment both loathe private business and have little understanding of what it takes to make real products. By 2002, the VFC program was purchasing slightly more than 40 percent of U.S. pediatric vaccines. Its focus on low prices likely helped destabilize long term vaccine supplies by eroding profit margins. When profit margins are low, firms move scarce capital to other, more highly valued, uses. Production facilities do not get repaired, replaced, or upgraded. When current plant and equipment wear out, producers simply exit the market.

A 2003 report from the Institute of Medicine on vaccine finance reported that the number of vaccine producers licensed for the U.S. market fell from 26 in 1967 to 4 in 2002. Factors cited for the decline included more stringent regulation, concerns about tort liability, and “poor returns on investment.” In short, the government’s myopic focus on low, low prices likely destroyed the U.S. vaccine industry.

Government focus on price also harms patients by denying them drugs. Research by Columbia University professor Frank Lichtenberg shows that after the imposition of the Veteran’s Administration National Formulary in 1997, VA patients were less likely to be prescribed new drugs than patients in the rest of the U.S. health care system. Professor Lichtenberg notes that veterans’ life expectancy “increased substantially before the National Formulary was introduced (during 1991-1997) but did not increase, and may even have declined, after it was introduced (1997-2002). The life expectancy at birth of all U.S. males increased after as well as before 1997.”

People advocating direct government negotiation for Medicare drugs apparently think low prices are more important than anything else. Medicare beneficiaries, who know how important a wide choice of medications is to their health, might beg to disagree. If allowed to, they would likely prefer to stick with the successful private system, possibly paying a little more now to ensure that they drugs they need will be available in the future.

Department of Health and Human Services, FY 2005 Budget in Brief, p. 25 as numbered by Adobe Acrobat software. Original document lacks page numbers.

Board on Health Care Service, Institute of Medicine. 2003. Financing Vaccines in the 21st Century: Assuring Access and Availability. Washington, DC: National Academies Press, page 122 of online edition. Full report. The quote is available here.

Frank R. Lichtenberg. October 2005. Older Drugs, Shorter Lives? An Examination of the Health Effects of the Veterans Health Administration Formulary. Medical Progress Report No. 2, The Manhattan Institute, New York, New York. Available Here.