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Lotterman: It may not be a bad idea to let government negotiate drug prices

When Congress passed the Medicare Prescription Drug Improvement and Modernization Act in 2003, it specifically banned the Social Security Administration from negotiating preferential prices with drug companies. The new Democratic majority in Congress wants to change that. Indeed, removing that ban was a key campaign plank for many Democratic candidates in the most recent election. Is this a good idea?

Deciding whether such a change is wise depends on some assumptions about the forces both in markets and in politics. On the surface, the ban is a classic example of "rent seeking." This occurs when a special interest group seeks favorable government action that brings a financial benefit it could not otherwise obtain.

Gordon Tullock, long a professor of law and economics at George Mason University, coined "rent seeking" in a 1967 paper. Together with 1986 Nobel laureate James Buchanan, Tullock explored the economics of how special interest groups secure favorable treatment by government.

Both scholars are politically conservative Libertarians. I think that both probably look askance not only at the Part D drug benefit, but also at Medicare and Social Security in general. Nevertheless, I think they would see the ban on Social Security price negotiation as a classic case of rent seeking.

Before the drug benefit's enactment, drug companies lobbied Congress and showered millions of dollars in campaign contributions on lawmakers. There certainly was no popular demand for such a ban, and no member of Congress offered an articulate exposition of the principles behind it.

Defenders of the ban did argue generally that allowing Social Security to bargain over drug prices for Medicare recipients would violate free-market principles. But the Veterans Affairs Department, the federal government's largest direct provider of medical care, long has practiced just such negotiations with little evidence of adverse effects.

Others argued that the competing private drug plans that are the centerpiece of the program could and would do just that kind of negotiating. The Congressional Budget Office reported that this was the case. Still, it is not obvious that allowing bargaining by Medicare administrators would somehow negate parallel efforts of private plans.

More recently, some argue that allowing government negotiation of drug prices effectively would establish government price controls on drugs and would stifle research and innovation in pharmaceuticals. Alberto Mingardi, from an Italian free-market think tank, made that argument in a recent op-ed piece written for the Washington Post.

Mingardi cites the experience of Italy. The Italian government purchases some 60 percent of all the drugs in Italy. It negotiates prices, and prices are lower in Italy than in most of Europe, and much lower than in the United States. On the surface, he acknowledges, the system seems to work well.

On closer examination, there are many problems. Low drug prices may encourage overuse of drugs. Overall health spending by the Italian government continues to grow apace. Fiscal constraints mean that newer, more sophisticated drugs are not reimbursable and effectively not available.

This is a useful cautionary tale. The question is whether allowing Medicare administrators to bargain necessarily would lead to the same outcomes as in Italy.

The core problem is that markets break down in many ways in health care. Consumers have very imperfect information. Many are insulated from the true cost of health insurance because it is provided through employers or government. Few know the relative effectiveness of alternative treatments or medications. Patents are necessary to foster research but grant monopoly power. Effective collusion between drug firms or other health providers may be commonplace.

It is never clear whether government initiatives in health care will achieve the stated objectives. However, that should not motivate inertia.

We may gain much from repealing the ban on bargaining with drug firms and any costs need not be serious or irreversible. It is an experiment that is worth trying.

Economist Edward Lotterman teaches and writes in St. Paul, Minnesota. Write him at ed@edlotterman.com.

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