The as-yet unfinished legislation establishing a prescription drug benefit as part of Medicare will set an interesting milestone. When enacted, the United States will face a situation of effective “bilateral monopoly” in the production and sale of many pharmaceuticals.
It is foolish to assume that drug prices will remain unchanged if we make substantial changes in who pays for them. The federal government may be forced to negotiate a schedule of prices for drugs, something it has avoided doing in the past. If it does not, drug prices – and Medicare drug program costs – may escalate sharply.
A quick review of terms may be helpful. There are different levels of competition in markets. The degree of competition determines how much power any producer has in setting prices.
The most competitive situation is termed “perfect competition.” For this to occur there must be many buyers and many sellers, a uniform product and everyone involved has good information. Agriculture is the classic example. In this situation prices are determined by supply and demand and no single producer, by itself, has any ability to increase prices.
The other end of the spectrum is “monopoly” when there is only one seller of a product. (If there is only one buyer we use the term “monopsony.”) Pure monopoly is rare and where it exists, prices or rates frequently are regulated by government. Utility firms that supply electricity or natural gas are the most evident monopolies.
Defense contracting may also involve monopoly. The Electric Boat Corporation, now a subsidiary of General Dynamics, has been a monopoly supplier of submarines to the U.S. Navy for a century. During World War II, subs were built in other yards, but usually through a licensing or contracting arrangement with Electric Boat.
In between these two extremes of perfect competition and pure monopoly are two other categories, “oligopoly,” when there are a few producers, and “monopolistic competition,” when there are many sellers but not enough to achieve perfect competition.
Most economists are convinced that the prices and quantities determined by market forces under perfect competition are good for society. No government action can improve the situation.
With monopoly or oligopoly, the quantities produced and the prices charged are not optimal. However, resolving the situation by government action is seldom easy. Poorly thought out measures may make society worse off rather than better off.
When the government grants a patent for products, including pharmaceuticals, it creates temporary monopolies for the patentees. If there are good substitutes for the newly patented product, such an artificial and temporary monopoly may not generate much in extra profits. But if there are no good substitutes, the monopoly created by a patent can generate a lot of income.
What does all of this have to do with the new Medicare drug measures? The answer is simple. More than half of all the prescription drugs in the U.S. are consumed by people who are eligible for Medicare. Moreover, the proportion of drugs for which there is no competing product is higher among those used primarily by seniors than in those used by the general population.
We do not have “perfect competition” in drug markets now, before the new measure is implemented, because there are only few producers for most classes of drugs. Oligopoly or monopoly are the norm.
We do have many buyers. Buyers include individuals under traditional private health insurance or Medicare together with health maintenance organizations and preferred provider organizations. HMOs, PPOs and chain hospitals have some degree of bargaining power vis-à-vis drug manufacturers. Individual consumers have virtually none. They can pay the stipulated price, look for cheaper substitutes or go without, but the action of any single consumer has no impact on drug prices.
Right now, many seniors do have some drug coverage because they have benefits through a retirement package from their former employer or because they choose to participate in an HMO that offers a plan for people on Medicare.
If a prescription drug plan under Medicare is finally passed by Congress, the federal government will effectively become the predominant, if not the only, purchaser of those drugs used primarily by retirees. There will be a situation of bilateral monopoly — one seller facing one buyer. This will resemble the market for nuclear submarines where there is only one U.S. producer, Electric Boat, and one buyer, the U.S. Navy.
It is silly to speak of any “market price” in a situation of bilateral monopoly. Any price charged depends on the relative bargaining power of the single buyer and single seller and on how well each uses it.
To the extent that any eventual Medicare drug benefit is open-ended, pharmaceutical manufacturers will have huge incentives to raise prices. Higher prices will not deter seniors from purchasing drugs except to the degree introduced by co-pay provisions.
All manufacturers need fear from boosting prices is political or regulatory fallout.
The Social Security Administration will end up where the governments of countries such as Germany and Canada are now. When government is the only buyer, it is stupid if it does not use its bargaining power with producers to arrive at some negotiated or contractual price for drugs.
Exactly how this will play out is unclear. Outcomes from bilateral monopoly situations are famously hard to predict. Perhaps drug prices will go up and perhaps they will be forced down. But it is extremely naive to assume that shifting the burden of buying drugs for seniors to the government will leave prices exactly as they were before.
© 2003 Edward Lotterman
Chanarambie Consulting, Inc.