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At the heart of the political debate on health care reform lies an economic assumption: The health care industry makes too damn much money. Resentment of what President Obama himself calls “windfall profits” underlies much of the support for the public option, for example, which proponents see as the only way to check runaway profiteering by insurers. And while the plan introduced last week by Senate Finance Committee chairman Max Baucus (D-Mont.) dumps the controversial option, Baucus too seems to believe that new taxes and fees might be needed just to keep health care companies honest.
And who can blame him? Health care costs have been rising far faster than inflation for years. You just have to believe these companies are minting money at patients’ expense.
Well, maybe you shouldn’t believe it. Take health care insurers, whom everyone loves to hate. As the middlemen who deliver the bad news about health care costs, they’re easy to blame — like retail gas stations whenever oil prices spike. But insurers are not exactly raking it in. Their average net profit margin is just 3.9 percent. Health care plans, including giants like WellPoint, Aetna, and Humana, earn an estimated margin of 3.3 percent. Dozens of other industries beat that.
One of them is pharmaceuticals, where net margins run more than 16 percent. However satisfactory that sounds, it still ranks below margins earned by beer makers and magazine publishers. Yet few people complain about the greed of Anheuser-Busch or Condé Nast. Why is it okay to pay a high margin for a cold beer but not for treatments that extend your life?
Besides, the 16 percent is misleading, a product of what statisticians call “survivor bias.” Profits look rich, in part, because they’re skewed by the winners — the small number of start-ups that take risks, succeed in getting drugs through initial FDA testing, and then list their company on a stock exchange to secure more funding. Most losing drug companies, by contrast, vanish without a trace. By counting the returns of only the winners, you skew the results upward.
To be sure, survivor bias occurs in many industries, but it’s especially marked in risky ones like drug making. For example, imagine you’re a start-up launching a product that could return either $25 per share or $75 per share with equal probabilities. Now compare that gamble to launching a product that is equally likely to generate a per share loss of $50 or a per share gain of $150. Both products yield an identical expected return of $50 per share. But companies in the riskier industry will look like they produce a larger rate of return because start-ups that made failed bets won’t go public.
No other industry takes bets as large as pharmaceuticals. On average it takes more than seven years and $800 million to take a drug from the beginning of human trials through FDA approval. And the vast majority of drugs never make it.
In other words, once you factor in risk and survivor bias, even the drug makers aren’t making unreasonable profits. This is exactly what economists would predict — absent a monopoly, competition keeps profits in check. True, drug makers do get patents, which are temporary monopolies designed to reward innovation. But a patent’s life begins in the early stages of a drug’s discovery, not when it comes to market years later — which is why $10 billion in drugs lose their patent protection each year.
For my money, reformers should drop the idea that the root of the system’s problems is profiteering by the health care industry. Doing so would clear the way to work on things that could really start to control costs: eliminate the tax subsidy for employer-sponsored health care and encourage more cost-sharing by patients. Many minor, yet very expensive, medical advancements would fail to pass the cost-benefit sniff test if people had to shell out more of their own dough.
And then this column can move on to other great economic conundrums of our time. Like, exactly why do we pay so much for beer?
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About the Author
Kent Smetters is an associate professor of insurance and risk management at the University of Pennsylvania’s Wharton School and a visiting scholar at the American Enterprise Institute. This column was written with Andrew Biggs, a resident scholar at AEI.
