Innovation and the Welfare Effects of Public Drug Insurance

Published in: Journal of Public Economics, v. 93, no. 3-4, Apr. 2009, p. 541-548

Posted on RAND.org on December 31, 2008

by Darius N. Lakdawalla, Neeraj Sood

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Rewarding inventors with inefficient monopoly power has long been regarded as the price of encouraging innovation. Prescription drug insurance escapes that trade-off and achieves an elusive goal: lowering static deadweight loss, without reducing incentives for innovation. As a result of this feature, the public provision of drug insurance can be welfare-improving, even for risk-neutral and purely self-interested consumers. The design of insurers' cost-sharing schedules can either reinforce or mitigate this result. Schedules that impose higher consumer cost-sharing requirements on more expensive drugs help ensure that insurance subsidies translate into higher utilization, rather than pure increases in manufacturer profits. Moreover, some degree of price-negotiation with manufacturers is likely to be welfare-improving, but the optimal degree depends on the size of such transactions costs, as well as the social cost of weakening innovation incentives by lowering innovator profits. These results have practical implications for the evaluation of public drug insurance programs like the US Medicaid and Medicare Part D programs, along with European insurance schemes.

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