Corporate executives, the management consultants who advise them, and the financial industry executives who help corporations finance their capital investments tend to believe that whenever their joint work enhances the wealth of a firm's shareholders, they ipso facto enhance also the nation's wealth. It is a soothing narrative, one routinely trotted out to college students in their textbooks of economics, which often slouch vaguely toward propaganda.
Very often this narrative is, of course, valid. It is especially so for venture capitalism, which acts as the midwife, so to speak, of newly-born companies creating valuable products hitherto unknown. It is valid also when established companies introduce new products or even when they merely expand existing product lines. Hereafter in this post, this version of capitalism will be labeled "value creation."
But, as the pharmaceutical industry has been busily teaching us in recent times, alongside this value-creating facet, modern capitalism can also play a more dubious role by merely redistributing wealth from some members of society (for example, sick people) to the shareholders of particular enterprises, without making any net contribution to overall social value. Hereafter we refer to this process as "value shifting," meaning that value is taken away from some members of society and channeled to the owners of capital.
Exhibit 1 serves to illustrate this distinction.
Source: Author's analysis
In this exhibit, we assume that Acme Inc., possibly a pharmaceutical company, has developed a new product that is highly valued by the rest of society. Let us call that value "social value." Measuring it is a methodological challenge. At the conceptual level, however, we may think of it as follows: Acme, Inc. can sell the new product to each individual, prospective customer at that individual's maximum bid price — the monetary expression of the value that individual puts upon a unit of the product. That bid price naturally varies among individuals, because their income and wealth varies and also because their desire for the product—economists call it "taste" for the product—varies.
If we added up these maximum bid prices across all individuals potentially interested in the new product, we might call that sum the product's "social value." In the exhibit, it is shown as the value-flow in pipe A. In many instances, the true social value might even be higher, if there are spill-over effects from the individual user of the new product to other members of society. That would be the case, for example, if the products cured an infectious disease.
Usually, in the real world, firms cannot extract from society all of the social value their products create. Even drug companies with government-granted monopolies usually capture only a fraction of total social value in the form of the firms' sales revenue. That captured value is shown in pipe B of the chart. The firm distributes that captured value to its employees (pipe C), to its suppliers of other productive inputs and of credit (pipe D), and to government in the form of taxes (pipe E). The residual that is left over accrues to the firm's shareholders (pipe F). It is the source of the wealth the firm bestows on them.
A major point to take away from the preceding discussion and the accompanying exhibit is that a firm adds net social value to society as a whole only through pipe A. If a firm's policies do not add net social value, but its shareholders nevertheless are enriched by the firm's decisions, the firm merely has redistributed already existing value from some members of society (for examples, customers or employees) to its shareholders.
Normally, neither politicians, nor the media, nor the general public pay much attention to the fraction of total social value (pipe A) that firms can capture as revenue (pipe B). In health care, however, that fraction can be quite controversial, as was seen in the public's reaction to the pricing of high-value specialty drugs such as Gilead Sciences Inc.'s new drugs Solvadi and Harvoni.
It is widely thought that the proper fraction of total social value to be garnered by health care product manufacturers as sales revenue is one that just covers research and development (R&D) and production costs, with a profit margin designed to encourage further innovation — hence the demand that drug manufacturers make their costs transparent to the public. Health care product manufacturers, on the other hand, argue that the proper base for their pricing policies is not the cost of developing and producing their products, but the total social value they create for society. This pricing policy is called "value pricing." At its extreme, it can extract enormous prices from seriously stricken patients or their insurers, because better health and longer life are so precious.
There is growing evidence that, save perhaps for some economists, American society is not comfortable with the idea of value pricing in health care, as can be inferred from the uproar over the pricing policy adopted by Turing Pharmaceuticals, which raised the price of one long-established product by 5,000 percent, and of Valeant Pharmaceuticals International. Valeant's business model has been to acquire already existing pharmaceutical companies with long-established products, substantially increase the prices of these products and further enhance short-run cash flow to shareholders, reducing outlays on R&D by the acquired firms. These strategies are purely value shifting. In fact, it can be argued that by reducing R&D spending, Valeant destroyed social value.
Although Turing Pharmaceuticals' and Valeant Pharmaceuticals' business models are extreme versions of value shifting, the entire drug industry has for some time now leaned more and more toward that model by repeated price increases for long-existing products. Substantial price hikes have been observed even for off-patent generic products.
Spokespeople for the industry argue that the cash from these price increases flows directly to higher spending on R&D. Some of it probably does. But these firms spend considerably more on SG&A, which stands for "sales [marketing] and general and administrative expenses." Spending on R&D by these companies tend to be well below 20 percent of revenue, while spending on SG&A is well above 20 percent. From the endless series of advertisements for prescription drugs on cable and network news and entertainment, patients (sick people) can infer that with the prices they pay for drugs, directly out of pocket or through health-insurance premiums, they now have become the main source of financing for the television industry — a truly bizarre circumstance.
Another part of the added cash flow generated by price hikes on existing pharmaceutical products often flows to shareholders through buy-backs of these firms' stocks in the open market, to boost the earnings per share of the remaining stock outstanding. As Obi Ezekoye, Tim Koller, and Ankit Mittal of McKinsey and Co. argued in a recent article, these stock buy-backs usually do not create value even for the remaining shareholders, let alone add social value (enhance the value flow in pipe A).
In short, it is far from clear to what end the industry's repeated price increases under value shifting are used by the industry. There is no reason to believe that they will all, or even predominantly, flow into R&D.
Consolidation in both the R&D-based and the generics industry through mergers appear to have contributed to value shifting. When large pharmaceutical firms acquire smaller entrepreneurial companies, the objective usually is to expand the R&D pipeline of the large companies whose own R&D shops may have failed to produce enough new breakthroughs. But when large pharmaceutical companies or other health care companies merge, the objective is likely to be mainly to reduce price competition. Usually these deals are sold to regulators and the public as means to enhance the efficiency of pharmaceutical production, which should result in lower prices. But as The New York Times Leslie Picker observes in her "Health Care Companies See Scale as the Only Way to Compete" (April 28, 2016):
The whole industry seems to be reading from the same playbook: Pair up with a company that makes the same product to become a leading provider, and thus gain more clout to negotiate business with hospitals and health insurers.
There is ample empirical research in health economics showing that consolidation on the supply side of the health care sector has served to drive up prices. It is another way of saying that it supports value shifting, rather than value creation.
There has been harrumphing in the business media at millennials who, in a recent survey, revealed that they reject capitalism as a social order. Perhaps these millennials sense that capitalism as practiced these days is not quite like the creative capitalism introduced to them in economics courses. There is similar sneering at, and handwringing over, the supporters of extreme political views in the current presidential campaign season—the supporters of Bernie Sanders on the left and of Donald Trump on the right—who sense that their economic position in society has been eroded through manipulation by "the establishment" and who look to a political messiah promising to lead them out of their misery. Value shifting of the sort described in this post is part of that manipulation.
My gratuitous advice to the drug industry, and to the health care industry in general, is to be very mindful of the distinction between value creation and value shifting in their pricing policies, lest they eventually invoke the wrath of the losers in that game, with dire consequences.
A healthy addition to corporate board meetings at these companies, for example, might be a presentation on the distribution of family income in the United States, whose median now is around $52,000 (meaning 50 percent of American families have a lower family income). Similarly, the boards should know more about the health insurance status of the American people, including the ever-increasing deductibles and coinsurance families are made to bear. These data might give boards some feel for how much money can reasonably and humanely be extracted from their fellow Americans, especially those in the bottom half of the income distribution, with whom the boards and business executives have lost touch.
But should not businesses in a free-enterprise economy be free to charge for their products what the market will bear? Here, the leaders of the R&D-based pharmaceutical industry should keep in mind that their industry is not really a free-enterprise model, selling products in perfectly competitive markets. In a very real sense, their industry is partly a creature of government, which protects the industry's economic turf through patents, market exclusivity, data exclusivity, prohibition of resale of drugs among customers and of parallel imports, and so on. These many protections are provided for defensible reasons. But they inevitably and legitimately invite political considerations into the protected firms' drug pricing policies.
from Health Affairs BlogHealth Affairs Blog http://ift.tt/1TK8IvL
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