Health Affairs Blog
June 1, 2016
'Value Creation' And 'Value Shifting' In Health Care
By Uwe E. Reinhardt
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.
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.
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.
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.
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.
Comment by Don McCanne
Uwe Reinhardt once again helps us to understand another aspect of the inequitable economics in our health care system by explaining the difference between value creation and value shifting.
Bringing us new beneficial health care services and products creates value, whereas extracting more revenues from the ill without providing any further health benefit shifts value, creating more wealth for the owners of capital (rent-seekers). Value shifting is pervasive throughout our health care system and has been detrimental to the health and finances of middle- and low-income individuals and families.
Reinhardt concludes, "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."
Dire consequences for the health care rent-seekers, anyone? It's about time.