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als use medical care. Despite a tendency to regard medical care as a
more or less fixed "need," the amount that is demanded can vary
greatly according to who is paying. For example, the use of tax-free
medical savings accounts in the United States has tended to in-
The Economics of Medical Care 77

crease greatly in December, since unexpended money in those ac-
counts is not carried over to the next year. One chain of eyeglass
stores reports that its sales are 25 percent higher in December
than in any other month "as people scoop up a second or third pair
of fashionable frames." As one such customer, who already had
eight or nine pairs of glasses, put it, "They go out of style after a
while."
Even if it is medically necessary for a given person to wear
glasses, is keeping up with fashions also medically necessary?
More to the point, would this same customer have bought eight or
nine pairs of glasses with her own money? If not, then medical
savings accounts have led to a misallocation of resources to buy
things that are not worth what they cost, but which are purchased
anyway because the government is helping to pay for them by ex-
empting from taxes the income that goes into medical savings ac-
counts. Eye glasses are not the only goods or services that can be
charged to these accounts. Condoms, birth control pills, and mas-
sages have also been paid out of medical savings accounts. So long
as a physician signs off on the expenditure, it is legal”and the
physician has no strong incentives to hold back on the spending of
someone else's money.
Free market prices, paid by the customer, do not simply convey
more or less inevitable costs. They restrain costs by providing in-
centives for the individual to use a given good or service only to
the extent that its incremental value to that individual is greater
than its incremental costs. But, when third parties cover all or
part of these costs, then additional increments continue to be
used beyond that point. Often a given medical problem can be
treated in more than one way. For example, an arthritic knee may
be treated by taking medication, having therapeutic exercises, or
undergoing surgery. Eyesight problems can be treated not only
with glasses of varying degrees of fashion, but also with the use
78 APPLIED ECONOMICS

of contact lenses, eye exercises, or laser surgery. Choices among
these and other treatments depend not only on how serious the
medical problem is, but also on how much each of these treat-
ments costs”and who pays those costs. When third parties pay,
the more expensive treatments become more likely than when
the individual pays.
Because health care is so often discussed in politics and in media
as if there is a more or less fixed amount of "need" and the only
question is how to pay for it, much attention has been focused on
those who do not have any form of health insurance. But these fi-
nancial arrangements are not ends in themselves. The real question
is: How much medical care is available, whether or not particular
individuals have health insurance?
The most poverty-stricken person living on the streets will be
treated in an emergency room, with or without health insurance.
Abandoned babies are likewise treated without regard to their
ability to pay. No doubt those with insurance, and still more so
those with wealth of their own, can get more comfortable accom-
modations in a hospital and can afford more elective or even cos-
metic, medical procedures. But to discuss people without health
insurance as if they were also without access to medical care is very
misleading.
Some uninsured people have low incomes but others with in-
comes sufficient to purchase health insurance simply choose to
use their money for other things, especially when they are young
and feel less at risk of medical problems. Forty percent of unin-
sured Americans are under the age of 25 and more than 60 per-
cent are under the age of 35. Fewer than 10 percent of people
over 55 are uninsured, despite the widespread political use of an
image of old people who have to choose between food and med-
ical care. That may be the image of the uninsured, but it is hardly
the reality.
The Economics of Medical Care 79


MEDICAL MALPRACTICE

One of the major costs of American medical care is malpractice
insurance for doctors and hospitals. The average cost of this insur-
ance for individual doctors ranges from about $14,000 a year in
California to nearly $40,000 a year in West Virginia. In particular
specialties, such as obstetrics, the cost of malpractice insurance can
exceed $100,000 a year. These costs of course get passed on to pa-
tients, the government, or whoever is paying for medical treat-
ments. One-stage thinking has much to do with these costs and
with the consequences that follow.
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 un-
economic to continue practicing obstetrics. The net result of this
can be that pregnant women in those places are at more risk than
before because there may be no doctor available in the vicinity to
deliver their baby when the time comes.
Ideally, juries would award malpractice damages only when the
probability that malpractice had taken place was sufficiently cer-
tain, and the award only at a level sufficient to compensate real
damages and deter such malpractice in the future. In reality, an in-
jured, 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 certain that the doctor who delivered that baby was
in any way at fault. A large study conducted jointly by the Ameri-
can College of Obstetricians and Gynecologists and the American
Academy of Pediatrics”released in 2003 and reviewed and ap-
proved by leading medical authorities in and out of government,
as well from as far away as Australia and New Zealand”con-
cluded that "the vast majority of brain damage and cerebral palsy
So APPLIED ECONOMICS

originates in factors largely or completely outside the control of de-
livery-room personnel."
Whether that will stop multimillion dollar jury awards in such
cases is another question. After all, it costs the jury nothing to
"send a message" warning doctors to be more careful, and the par-
ticular 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 future 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 that she was expecting, the
33-year-old mother of two called the doctor who delivered her sec-
ond child but was told he wasn't taking any new pregnant patients.
Dr. Shelby Wilbourn plans to leave Nevada because of soaring med-
ical malpractice insurance rates there. Ms. Maugaotega says she
called 28 obstetricians but couldn't find one who would take her.

This is just one of the ways that huge jury awards and the huge
malpractice insurance premiums that result from them increase the
costs of medical care. Another cost is the cost of "defensive
medicine"”medically unnecessary treatments which protect the
doctor from lawsuits, even if they do not protect the patient from
any real danger. For example, because some lawsuits have alleged
that cerebral palsy in newborn babies might have been avoided if
the physician had delivered the baby by Caesarean-section, the
number of Caesarean-section births has been rising to become
one-fourth of all births. This has not reduced the incidence of
The Economics of Medical Care 81

cerebral palsy in newborn babies, though it may have reduced the
ease of suing doctors. The median award for negligence in child-
birth exceeds two million dollars.
As in so many cases, political "solutions" to the malpractice prob-
lem can create new problems. One popular political solution has
been to put upper limits on the amount of awards for "pain and
suffering." But if the carelessness or incompetence of some physi-
cian or surgeon has in fact caused someone to be in pain for the rest
of his or her life, a quarter of a million dollar cap, as in California, is
completely inadequate compensation. The fundamental problem is
not with the huge amounts of money awarded, as such, but with
the fact that there may be no adequate basis for any award at all.
Doctors and hospitals win a majority of the malpractice cases that
go to trial but the risk of damage awards in the tens of millions of
dollars cause them to settle many cases out of court.


PHARMACEUTICAL DRUGS

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 devel-
oping 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 clin-
ical trials." How many of those half dozen would prove to be suc-
cessful in the clinical trials and then make it through the approval
process of the Food and Drug Administration 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
82 APPLIED ECONOMICS


Food and Drug Administration as well”then its profits on the
successful drug has 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 million dollars,1 keeping enough investors willing to supply 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 somehow and focus on how these drugs are
priced, what profits they earn, and how those prices can be
brought down. Since the costs 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 cost only a quarter.
By ingredients they mean physical ingredients, which are usu-
ally inexpensive, rather than the knowledge ingredient which is
usually astronomically expensive because of years of research, in-
cluding much trial and error. The same misconception of costs
can appear in another form when politicians, journalists, etc., con-
trast 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

'"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, No-
vember 11, 2001. "Estimates range from around $250 per drug to more than $800 Million." "Drug
Prices: A Much-Needed Primer," Wall StreetJournal, July 22,2002, p. A15.
The Economics of Medical Care #3


same formula free of charge after the patent has expired. The sec-
ond 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 quar-
ter, the generic manufacturer may be able to make a profit charg-
ing thirty-five cents for the same pill, causing the brand-name
manufacturer who created the drug to be accused of uncon-
scionably exploiting people who are ill and desperate.
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 misrep-
resent by those who do not think beyond stage one. For example,
Canadians pay much lower prices for American pharmaceutical
drugs than Americans do. When the Canadian government,
which buys vast quantities of medicines for its comprehensive, na-
tional government-run health care system, offers an American
pharmaceutical company a price which covers the incremental
costs of manufacturing a particular drug, but not the vast costs of
developing that drug in the first place, the pharmaceutical com-
pany's alternatives are (1) to lose millions of dollars in sales by not
accepting the offer or (2) earn whatever money it can by accepting
the offer, since the past costs have already been paid and are irrele-
vant to current decision-making. As economists say, "sunk costs
are sunk."
While past costs are irrelevant to present decision-making”
they are history but they are not economics”those past costs do
matter for future decision-making, when pharmaceutical compa-
nies 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.
84 APPLIED ECONOMICS


One of the irrelevant distractions in many discussions of the
costs of creating new medications is that much of the drug compa-
nies' research is a continuation of more fundamental scientific re-
search done in academic institutions and government agencies
such as the National Institutes of Health. Critics who say "the
pharmaceutical industry has so far devoted most of its R & D re-
sources not to scientific discovery but to the practical application
of discoveries generated at taxpayer expense" are saying much less
than meets the eye. In every aspect of our lives, we all stand on the
shoulders of giants, and all those giants were not in the past.
The principles of aerodynamics were not discovered by the
Wright brothers. They were simply the first people to get a plane
off the ground. If no one had ever gotten a plane off the ground,
then the principles of aerodynamics would be just an irrelevant cu-
riosity. Similarly, the scientific bases of the numerous inventions by
Thomas Edison were not discovered by Edison himself. But we
rightly celebrate the work of those who turned known facts and
principles into something that could actually be used to make life

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