EpiPen Price Hikes Are a Product of Government Failure, Not Market Failure

The EpiPen price hike story is tailor-made for political outrage. It involves a large for-profit corporation, a life-saving device, triple-digit price hikes, and as usual, poor people and their children are the ones that suffer the most.

For many people, it's a textbook example of market failure that demands government intervention.

In fact, it's a perfect example of government failure, and the best solution will be found in freer markets, not increased regulation.

Background
Before we get to the economics of it, it's worth rehashing the basics of this scandal.

The EpiPen is used to treat life-threatening allergic reactions on the spot. It works by delivering a preset dose of the drug epinephrine. The tool is simple enough that even people who are panicking during an allergic reaction can self-administer the medication they need. It's a great idea, and it's been around since the 1970s. Epinephrine has also been around for some time, and is available in cheap generic forms today.

The problem is that one company, Mylan, owns the rights to the EpiPen device, and it has had a near-monopoly on the market. Thus, depending on where you read it, the price of the EpiPen has increased by 400 or 500 percent since around 2007. Given the critical nature of the device for people with serious allergies, these price hikes have not been too popular.

Economics
But this is where economics comes into play. Companies don't raise prices in a vacuum, and precious few could manage a four-fold increase and live to tell about it. If companies are raising prices dramatically and still making money, one of the following must be true:

1. Their product is perceived to be so much better than the competition that their customers are willing to pay more. (Think Apple vs. PC.)
2. Their product, and the underlying resources are in very short supply, and all companies in the industry are being forced to raise prices as a result. (For instance, this can happen for building materials after a natural disaster takes place.)
3. Or more commonly, the company has little to no competition. And the government is keeping the competition out.

This last scenario is what accounts for the EpiPen's meteoric price rise.

In particular, the Food and Drug Administration has to approve any competing product before it can be sold in the US. And getting products approved by the FDA is a notoriously time-consuming and expensive process. As Reason notes, many companies are trying to compete in the epinephrine injection market, and the FDA has blocked most of them.

Meanwhile, the one product that has been approved by the FDA, Adrenaclick, has also been subtly sabotaged as a meaningful substitute. How? The FDA made it illegal for pharmacists to substitute a different version of the epinephrine injector for the EpiPen unless explicitly called for by the prescribing physician.

In other words, there's a reason that Mylan has been able to raise the price of a life-saving technology by 400 percent over the past decade. And that reason is government, not capitalism.

The Story and the Snapshot

The EpiPen is a new story, but in some ways, it's just a new version of the same story. It goes something like this:

The government steps in to regulate the market in order to protect consumers. 

These regulations have unintended consequences, and serve to restrict the amount of competition and supply in the market. 

Prices rise as a result.

Consumers complain about the price increases, and government introduces subsidies or other programs to offset the cost. Invariably, some consumers will fall through the cracks and find themselves without any access to the product they want or need. 

Even if we assume the best, purest intentions of government at every step of the way, the above story is still the likely result. The government starts with a good intention and ends up harming the very people it aimed to help. Of course, if we assume any corruption exists, the result deteriorates further.

It is near the last stage in the process above that these stories go viral, with politicians and everyday people starting to take note. 

And at this stage, all that gets reported is a snapshot--prices are extravagant, consumers are suffering, and usually, some corporation is making a lot of profit off all of it. And in that snapshot, capitalism really does look like it's at fault. Calling for more government intervention is the default response--after all, capitalism failed right?

But when we look beyond the snapshot, we see that capitalism is just the scapegoat for failed government policies. And if government intervention got us here in the first place, it's not likely a new intervention is going to provide the cure.

Obamacare Meltdown Shows the Importance of Profits

Let me tell you a story.

Ever with good intentions, Congress passes a law to further regulate a market that was already heavily regulated beforehand.

Private businesses try to participate in this market, only to find that they continuously lose money, year after year.

Said private businesses cease participating in this market in order to stop losing money, and focus their efforts elsewhere.

How would a reasonable person describe the behavior of the businesses? Rational, prudent, obvious?

How about greedy?

On the economic left, that appears to be a winning explanation for the fact that another major health insurance company has decided to withdraw from more of the Obamacare exchanges. Specifically, Aetna has announced plans to withdraw from 11 of the 15 states they have been participating in.

Senator Bernie Sanders offered a characteristically moderate assessment of the news:

It is disappointing that Aetna has joined other large for-profit health insurance companies in pulling out of the insurance marketplace. Despite the Affordable Care Act bringing them millions more paying customers than ever before, these companies are more concerned with making huge profits then ensuring access to health care for all Americans.

A similar tone was struck by others in the progressive community, as noted in the piece cited above.

So what's Bernie talking about? Is Aetna simply walking away from profits in an effort to smite poor and sick Americans?

No.

In fact, according to Zero Hedge. Aetna is projecting that it will lose $300 million on its Obamacare exchange business in 2016 alone. In context, this would represent 12.5% of Aetna's net income from 2015. So it's not going to bankrupt Aetna, but it is still significant.

Bernie is right that the Affordable Care Act brought in more paying customers; the problem is that those customers aren't free. The average healthcare expenses that came with them, at least in the state exchanges,  were dramatically higher, on average, than the premiums and resulted in substantial losses for Aetna and others. Indeed, there has been a veritable flood of major insurance companies rushing for the exits on the Obamacare exchanges.

Bernie is also right that the health insurance companies are putting profits before ensuring access to health care for all. Of course they are. They are for-profit companies; it's kind of their thing.*

It's easy to blame for-profit companies for Obamacare's downfall, because people love to hate them. But it's not a new story that for-profit companies exist to seek profit. This was true before Obamacare was passed, it's true now, and it will be true in the future. Which leads us to a critical point:

If your healthcare policy requires companies not to pursue profits in order for it to be successful, then it is a terrible policy.

It's the economics equivalent of trying to fly by jumping off a cliff. It would have worked if gravity didn't exist, you say. Maybe so. But gravity does exist, and we know that in advance. Thus, it's a terrible idea, too.

The value of profits
More to the point, it's worth pushing back on the casual assumption that profits are evil. Profits are not evil. In fact, they are essential for a market economy to work. And the Aetna decision illustrates this point very well.

It is beyond the scope of our present discussion to give a full economic explanation of profits. But in the context of the healthcare, profits are a sign of sustainability. I don't mean sustainability in the environmental sense, but in the economic one.

If a business is making profits off providing a service, then chances are, it will continue to provide that service in the future. It's in the business's own self-interest to do so.

In a market-based healthcare system, everyone in the chain of service delivery needs to be able to make money--the doctor, the hospital, the medical supply company, and yes, even the damn health insurance company. Because if any member in this chain is failing to make money, then they are a risk to drop out.

This is precisely what happened with Aetna. It was losing money on the state exchanges, so it stopped participating. In some cases, this might be a minor inconvenience for policyholders who still have several options remaining. In other places, however, it is expected to reduce the highly touted competitive exchanges down to a single provider. So much for choice.

The core problem is that if the service-provider isn't making money, then it ceases to be about economic self-interest and starts becoming an act of charity. There's nothing wrong with charity. It's a wonderful thing. But people (and businesses, in some cases) provide charity when they have the resources and desire to do so. If they encounter financial challenges in their own life, they may have to cut back on giving and take on more profitable work. This obvious reality makes charity far less reliable and enduring than a regular market exchange that is in both parties' interest.

Based on this understanding, Aetna's decision must be viewed in a new light. Aetna's losses may have been due to the new Obamacare requirements, managerial incompetence, or a mixture thereof. In any case, something had to give. If we really want healthcare coverage for all, we probably also want that coverage to continue to exist over time. In other words, it needs to be sustainable.

And for it to be sustainable, it must be profitable--even for that widely-derided fount of evil known as the health insurance companies.

What comes next?

The Common Dreams article cited above suggests that the continued withdrawal of companies from the healthcare exchanges proves that a single-user system is necessary. And at least, that kind of system would not rest on the core structural problem in Obamacare, which all but ensures insurance companies will not be able to break even, as we wrote about previously. A single-payer system does away with the notion of profit and loss entirely, since the government clearly doesn't care if costs exceed revenues (at least for now).

That said, we must recognize that the Affordable Care Act was a substantial expansion of government intervention into the healthcare market. The result has been a very rapid collapse.

In other words, a large government intervention in a market proved to be a huge failure. Yet the proposed remedy is to give that same government even more control of that market. This should give us pause.

*Indeed, the publicly traded companies are actually required by law to attempt to maximize profits; that is, management can be sued by shareholders if they prioritize something besides profits.

Note: Another suggestion put forth to explain Aetna's behavior is that they are trying to use the bad publicity on Obamacare as leverage so that the Department of Justice will permit a major merger to go through. Senator Warren has suggested this, for instance. And the CEO of Aetna actually stated somewhat explicitly that, in the absence of a merger, Aetna might have to withdraw from its remaining states.

Certainly, this is a good negotiating tactic, but the conspiratorial angle is far from compelling. Of course, Aetna wants to pursue a merger that could save costs and further expand their insurance risk pools. That's obviously true, and it's conceivable it could help their bottom line. Fair enough.

But linking the decision to actually leave to their blackmail efforts seems to be a stretch. After all, they would have just given away 11 states worth of leverage without gaining anything in return, if this was the opening bid. So if the whole point of withdrawing was blackmail, then Aetna is awful at it.

Large Health Insurer Withdraws Further from Obamacare and the Economics of Pre-existing Conditions

Bad news for the Affordable Care Act this week as United Healthcare--the country's largest health insurance company--announced it's going to withdraw from two more state healthcare exchanges, this time in California and Illinois. This comes on the heels of announcing plans to withdraw from most of the other states as well, as Zero Hedge reports.

This is all occurring after health insurance companies discovered that the expenses of covering new enrollees on the healthcare exchanges greatly exceeded the new premiums. It was well understood that many of the people that gained coverage on these new exchanges would tend to be sicker people--the exchanges exist, in part, to increase accessibility to people who didn't have coverage before. One of the main reasons they did not have had coverage before is that they may have had an expensive pre-existing condition that meant insurance companies either wouldn't cover them, or wouldn't cover them for an agreeable fee. Obviously, taking on many new sick patients is not a good business proposition from the perspective of insurance companies. However, the hope was that there were many uninsured healthy people as well, who would flock to the exchanges as well for fear of paying the tax penalty imposed on those without coverage. This was intended to offset the losses from taking on new sick patients. And in case even this force proved insufficient to make the insurance companies whole, there was also the vaguely named risk corridor program, that was designed to cap losses of the insurance companies that participated in the exchanges (that is, subsidize them).

In practice, covering new patients on the statewide exchanges generally proved to be even more unprofitable than originally anticipated. The risk corridor program quickly ran out of resources to subsidize insurers hit hardest, and thus, health insurance companies are basically left with two options: rapidly raise premiums or withdraw from these exchanges altogether and focus resources elsewhere. They have been doing a combination of the two. And the pace of the premium hikes being planned shows just how dire the situation is. Here's a chart of some of the most incredible increases planned around the country, courtesy of the Wall Street Journal:

From a policy or economics perspective, perhaps the most important issue here is the question of pre-existing conditions. The case for disallowing insurers to discriminate on pre-existing conditions is, I'll grant, superficially persuasive--the idea of a senior with cancer getting denied care precisely because they have cancer is clearly appalling. But understanding economics often means tracing things through, recognizing how we got here, as well as the likely short-term and long-term effects of any given solution. Economic laws take effect over a period of time, so it's best to avoid making decisions based on a snapshot.

To understand the issue properly, we must first ask what is the purpose of insurance? The answer is that it is intended to protect us against unforeseen events and tragedies. Individuals occasionally have tragedies befall them, but on the whole, our society is remarkably safe, healthy, and prosperous. Thus, insurance allows us to share the risk with all these other people, most of whom will go relatively unscathed, so we all bear a small cost but no one will suffer a massive loss. The insurance company earns a profit for coordinating this risk-sharing mechanism.

When we think of pre-existing conditions, it's best to consider an analogy with less emotional baggage to see the issue clearly. Let's try homeowner's insurance.* This exists to protect against, among other things, the possibility of a fire burning down your house. It doesn't happen often, but if it does, homeowner's insurance will give you the money to rebuild. In my experience, when you go to buy homeowner's insurance, they will have you fill out a form to describe your house (square footage, bedrooms, garage, year built, closest fire station, etc.) and they may even conduct a brief inspection to see if your home appears to be a reasonable risk. And obviously, it goes without saying that, if your home was already burned down / burglarized / etc., they would not insure your house against that damage. To do so would be financial suicide.

Now suppose the government passes a law prohibiting insurers from discriminating based on existing fire damage. Obviously, everyone with a recently burned down house will apply for coverage. The insurance companies will be forced to provide coverage, promptly pay out large amounts of money, and go bankrupt. If the policy exists long enough and is thoroughly enforced, the end result is that no home insurer will be left standing.

Bringing it back to health insurance, this is essentially what we're doing with respect to pre-existing conditions. Effectively, the Affordable Care Act forces insurance companies to place bets (that is, provide coverage) that they know they will lose. The economics of this are straightforward. If it persists long enough, it will destroy all health insurance companies, unless they can find legal ways to deny coverage to sick people, which many are currently attempting to do.

Note that the above line of reasoning is making no moral judgments whatsoever. It's not saying that people with major pre-existing conditions are bad people, deserve to suffer, are mooching off the system, or anything of that sort. It's simply analyzing the predictable economic consequences of such a policy, consequences which are unfortunately beginning to show. And here's where the divergence between short-term and long-term effects is quite striking. In the short-run, requiring companies to cover pre-existing conditions is likely to be beneficial to those sick patients in reducing their immediate costs and/or increasing their care. But in the long-term (which isn't that long), it's liable to destroy health insurance for everyone, sick and healthy alike.

Now we can bring in the moral dimension properly. Supporters of the Affordable Care Act certainly try to claim the moral high-ground on this subject by pointing to the short-term benefits noted above. Meanwhile, opponents are cast predictably as heartless, insensitive, greedy, etc. But is it really morally superior to support a system that offers some short-run benefits at a cost of total collapse in a few years? The answer probably depends on where you're sitting. If you're a very sick person with only a couple years to live anyway, and won't be around for the collapse to follow, it's a good deal. For society at large, however--even counted in purely utilitarian terms--it's difficult to see how deliberately putting health insurers on a unsustainable course will make us all better off.**

Economist John Maynard Keynes once famously dismissed criticisms of the long-term consequences of his ideas by saying that "In the long-run, we're all dead." However, one wonders if he would have felt the same if he knew that the "long-run" turned out to be just a few years hence. In healthcare, that increasingly appears to be the reality.

*I apologize if you've heard this analogy before as it's far from original. But it illustrates the point well, so hopefully you'll forgive the redundancy.

**I should note here that I've heard speculation that this was actually the deliberate plan of the Obama Administration all along, to bankrupt the insurers and thus make way for a single-payer system by default. If that is the true intent, then requiring coverage of pre-existing conditions makes perfect sense strategically. The above discussion focused instead on the more official justifications offered for the policy. Also, we should note that a single-payer system is unlikely to be the panacea its supporters hope for, for many of the same reasons that other central planning activities tend to fail, but we'll leave a full discussion of that to another day.

The Greedy Stoic Capitalist Fallacy and Bernie's Healthcare Tax

The Greedy Stoic Capitalist seems to be everywhere these days. She lies at the root of nearly every economic problem that faces us. And she is also central to most of the proposed solutions. From the minimum wage debate to rising healthcare costs, the Greedy Stoic Capitalist is there. Grasping and rapacious enough to cause income inequality and exploit her workers, yet also passive and patient enough to submit to new regulations and taxes without protest or evasion.

If this seems an unlikely description, that's because it is. Common sense tells us that the Greedy Stoic Capitalist doesn't really exist. And yet, their existence is taken as a given--used to wish away basic principles of economics.

To see what I'm talking about, let us consider a recent article that discussed the likely effects of Presidential Candidate Bernie Sanders' new single-payer health plan. Note that our source for the article is US Uncut, which is a left-leaning publication that appears to openly favor Sanders over Clinton. Here, we're going to be specifically interested in the taxes Bernie has proposed to pay for the plan. The article claims that Bernie's plan will save the average American over $5,000 a year on healthcare costs relative to the status quo. But the way it reaches this conclusion is very questionable, as we'll see in a moment.

Now, if you've followed presidential politics much this year, you are probably familiar with Bernie's general worldview. On economic issues, he's about as progressive as they come, and he refers to himself as a democratic socialist. He is very concerned about income inequality, the decline of the middle class**, rising tuition costs, healthcare costs, and in general, the plight of the poor. He also rails against Wall Street and the billionaire class, which he believes wield too much political power and do not pay enough in taxes. Thus, most of his proposed reforms rely on more progressive tax hikes where tax rates go up for the highest earners. His plans for paying for the new healthcare system certainly follow this model.

Here's how US Uncut summarizes Bernie's healthcare tax plan:

First, Sanders would impose a 6.7 percent payroll tax on employers, along with a 2.2 percent healthcare tax on those making less than $250,000 per year. Sanders includes higher percentages for incomes above $250,000 in his legislation (the richest 2 percent of the U.S. population) and a 5.4 percent surcharge on the wealthiest Americans whose modified adjusted gross income is above $1,000,000 (literally less than 1 percent of Americans). Sanders’ bill also includes a 0.02 percent financial transactions tax on Wall Street trading.

Obviously, that's a lot of new taxes. But you'll notice that, true to form, the majority are directed at the rich. The rich represent a small minority of the population, and presumably have money to spare by definition. Neither Bernie nor his liberal supporters care too much about this group. Bernie is more interested in the impact on the average American. Fair enough. We'll focus our attention there as well for the sake of this discussion.

Since the average American makes around $50k per US Uncut, this means we can disregard the taxes on the $250k+ and $1M+ groups. Additionally, since people making $50k are also unlikely to be able to invest much in the stock market, we'll also assume the financial transactions tax doesn't impact them. Meanwhile, Bernie's plan is designed to eliminate all healthcare premiums and insurance and simply pay for everything. Thus, it appears to be a relatively straightforward calculation to determine the savings. Here's what the article came up with:

At first glance, this looks pretty impressive--$5,000 in expected savings would surely be a big deal to someone making $50k. It's like a 10% raise. But one reason it looks so good is because they calculated the tax wrong. Yes, the 2.2% employee healthcare tax times $50k is $1,100; you're not going crazy. But what about the employer's 6.7% tax? Where'd that go?

This is where we see the Greedy Stoic Capitalist subtly working her magic. You see, one of the underlying progressive themes in the healthcare debate is that the employers are just too greedy to pay for their employees' healthcare costs. This piece from ThinkProgress captures the sentiment well, for example. So, if employers aren't willing to voluntarily pay for it, obviously the solution is to just force them to do so with a tax. What could go wrong?

Well, the problem is that "who pays the tax" does not determine "who bears the costs". To see this, let's consider an example that isn't as convoluted as payroll tends to be.

Let's imagine Bill's Food Truck is able to make a burrito for $5, and Bill wants to make $5 on every burrito so he sells it for $10. Bill also happens to be a deeply greedy and spiteful man. So if he can't make at least $5 on a burrito, he's just going to shut down his truck and do something else. Now suppose the government has decided it needs to collect at least $0.50 per burrito to fund a new program. Most commonly, it could do this through a 5% sales tax and require the vendor to collect it. In this case, the customer pays $10.50 per burrito, Bill still gets his precious $5 profit, and he eventually sends the government $0.50 in taxes. If you saw prices before and after the tax, it would probably be obvious that the customer was bearing the brunt of the tax.

Of course, the customer might get a bit irritated by such a tax. Thus, the government might try to be a bit sneakier about it by applying the tax directly to the seller instead--this is what a value-added tax does. To keep it simple, let's assume there's a 10% tax applied to burrito-makers based on the cost of their burrito. In our example, this would mean a $0.50 tax directly on the producer, that the customer doesn't see. Now what will the price be? Of course, the answer is still $10.50. We established upfront that Bill's a greedy Scrooge of a burrito-maker who demands $5 per burrito to get out of bed in the morning. So ultimately, even though the producer literally paid the tax to the government, and the customer may not have even known it existed, they still really bore the cost of the tax.

Bill was our archetypal greedy capitalist. He wanted to make a profit before the tax was imposed, and strangely enough, he still wanted to make a profit afterward. The government's decision to tax his transaction didn't inspire a religious awakening within him or a new political ethos. He's the same guy with the same priorities. So he adjusts his behavior and his prices to account for the tax and moves on with life.

The concept of "who bears the costs" is described in economics as the incidence of taxation, and it is very well understood. In the real world, who bears the costs is rarely an all or nothing situation; buyer and seller will usually each suffer some of the burden. Without having all the facts, it's impossible to know exactly how much will be absorbed by each group. But the general rule is that the party that is more desperate for the transaction to occur will bear a higher portion of the tax, because they are more willing to tolerate price changes.

Now we return back to the payroll taxes in Bernie's plan. We can't assume that the employer will bear all 6.7% of the employer tax, and we actually can't assume the employee will bear all 2.2% of the employee tax either. Instead, the right way to look at this is as a new 8.9% tax on salaries. We don't know exactly how much will fall on each group. But if the employee is making just $50k, chances are they are not in a highly skilled position, which means they may be easily replaceable. Further, if they have any kind of family obligations at $50k per year, they probably are pretty desperate to keep that job. So if we follow the general principle that the more desperate party pays more, that means the employee will probably bear more burden than their employer. That is, the employer will reduce the employee's salary to accommodate the new taxes. The employer will still literally pay more tax, but much of the real cost actually falls on the employee. If we're starting from the premise that the employers were greedy bastards that helped create the uninsured problem in the first place, we have to also assume they'd be willing to cut salaries.

Ultimately, we can't know for sure how the burden of the payroll tax would fall between employers and employees, and, frankly, it's probably the least important part of a massive single-payer overhaul. But we can say with some confidence that Sanders' claimed savings of $5,000 for the average American is almost certainly exaggerated. Even if we grant generous assumptions about the effectiveness of a single-payer system itself, there's no way to defend excluding the employer tax from consideration. It's tough to know whether this was done out of ignorance or as a clever political ploy, but either way, it's still wrong.

Of course, the larger point is the importance of the Greedy Stoic Capitalist in modern political discussions. Bernie may be the most frequent offender, but he is far from the only one. This assumption arises in many different areas, yet it's wrong in every instance. Fortunately, like so many other topics in economics, common sense gives us the right answer. We can't assume that people are greedy jerks in general but magically become generous and compliant when we draft policies that target them. The Greedy Stoic Capitalist doesn't exist, and we need to stop pretending otherwise.

*To keep ourselves on task, we're taking for granted that a single-payer system would not dramatically increase healthcare costs, diminish healthcare quality, etc. In our view, there's good reason to assume it would not work this well in practice, but we'll leave that subject for another day.

**As a matter of statistics, it's correct to say that the middle class is smaller today than it was many years ago. However, an important piece of context is often omitted from this sound byte. More people have graduated from the middle class to the upper middle class than fallen back into poverty.