NBER WORKING PAPER SERIES

INTERNATIONAL HEALTH ECONOMICS

Mark EganTomas J. Philipson

Working Paper 19280http://www.nber.org/papers/w19280

NATIONAL BUREAU OF ECONOMIC RESEARCH1050 Massachusetts Avenue

Cambridge, MA 02138August 2013

We are thankful to Gary Becker, Anupam Jena, Dana Goldman, Darius Lakdawalla, Jonathan Adams,and Casey Mulligan for comments as well as seminar participants at The University of Chicago, TED-MED, Yale University, Peking University, The Milken Institute Global Conference, University ofSouthern California, and The Scientific American Super Session at BIO. The views expressed hereinare those of the authors and do not necessarily reflect the views of the National Bureau of EconomicResearch.

NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies officialNBER publications.

© 2013 by Mark Egan and Tomas J. Philipson. All rights reserved. Short sections of text, not to exceedtwo paragraphs, may be quoted without explicit permission provided that full credit, including © notice,is given to the source.

International Health EconomicsMark Egan and Tomas J. PhilipsonNBER Working Paper No. 19280August 2013JEL No. F0,F42,I1,I11,I18

ABSTRACTPerhaps because health care is a local service sector, health economists have paid little attention tointernational linkages between domestic health care economies. However, the growth in domestichealth care sectors is often attributed to medical innovations whose returns are earned worldwide.Because world returns drive innovation and innovation is central to spending growth, spending growthin a given country is thereby highly affected by health care economies and policies of other countries.This paper analyzes the unique positive and normative implications of these innovation-induced linkagesacross countries when governments centrally price health care. Providing world returns to medicalinnovation under such central pricing involves a public-goods problem; the taxation to fund reimbursementsinvolves a private domestic cost with an international benefit of medical innovation. This has the directnormative implication that medical innovations have inefficiently low world returns. It also has thepositive implication that reimbursements in one country depend negatively on those of others; reimbursementsare “strategic substitutes” through free riding. Because reimbursements are strategic substitutes, worldconcentration of health care is a significant issue. A small European country has no access-innovationtrade-off in its pricing; it will have low reimbursements because it does not affect world returns andsees the same innovations regardless of its reimbursement policy. The public-goods problem of innovationthereby implies that the United States, despite being the world’s largest buyer, will pay the highestreimbursements. This problem also implies that free riding counteracts the standard positive impactof larger world markets on innovation when health care concentration falls. Indeed, currently, healthcare is highly concentrated; about half of world health care spending occurs in the United States, despitethat fact that it makes up only about one-fifth of the world economy. We assess the effect that emergingmarkets will have on this concentration and thus world returns. We use pharmaceutical reimbursementdata from 1996–2010 to provide IV estimates of the degree to which domestic reimbursements arestrategic substitutes. We find that these estimates imply that world returns from innovation may actuallyfall from a growth in “market size” of BRICS countries as a result of increased free riding in non-BRICScountries. The overall analysis has important positive implications for spending patterns across countriesas well as normative implications for evaluating domestic or regional health care reforms.

Mark EganUniversity of ChicagoDepartment of Economics1126 East 59th StreetChicago, IL 60637egan@uchicago.edu

Tomas J. PhilipsonIrving B. Harris Graduate Schoolof Public Policy StudiesUniversity of Chicago1155 E. 60th StreetChicago, IL 60637and NBERt-philipson@uchicago.edu

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Section1:Introduction

Perhapsbecausehealthcareisprimarilyalocalserviceindustry,healtheconomists

havepaidrelativelylittleattentiontointernationaltradeissues.Nevertheless,thehealth

economicsresearchcommunityholdsthewidespreadbeliefthatmedicalinnovationisa

centralforcebehindtheworldwidegrowthofspending(Newhouse,1992).Today,most

countriesarespendingontechnologies,orphysician‐andhospitalservicesconnectedto

thosetechnologies,unavailablejustafewyearsago.Reimbursements,eitherdirector

indirect,createtheincentivetoinnovate.Paymentsforpharmaceuticalswouldbean

exampleofadirectreimbursement,whilepaymentstohospitalsordoctorsfordevices

usedinpatientcarewouldbeanexampleofanindirectreimbursement.

However,itiswellunderstoodthatresearchanddevelopment(R&D)ingeneraland

medicalinnovationinparticulararedrivenbyworldreturnsratherthanreturnsofagiven

domesticmarket.Forexample,Swedishmedicalproductfirmsinnovatetosellworldwide

notjusttotheirownsmallpopulation.Becauseworldreturnsdriveinnovationandare

centraltohealthcarespendinggrowth,itfollowsthatagivencountry’sspendinggrowthis

drivenbyhealthcareeconomiesandpoliciesofothercountries.Assuch,spendinggrowth

inasmallEuropeancountrycurrentlydependsonhowUSpoliciesaffectworldreturns,

justasfutureMedicarespendingwilldependonhowemergingmarketswillaffectthose

returns.However,healtheconomistshaveconductedlittleexplicitanalysisonhowhealth

carepoliciesinonecountryaffectorshouldaffectthoseofanother.Thispaperanalyzesthe

positiveandnormativeimplicationsoftheseinnovation‐inducedlinkagesbetween

domestichealthcareeconomiesandcentrallysetreimbursementpolicies.

Wearguethatdomesticgovernments’centralizedpricingofmuchofhealthcarehas

someuniqueimplicationsfordeterminingworldreturnsandtheinnovation‐induced

spendinggrowththosereturnsimply.Inparticular,theactofsettingreimbursement

policiesforprovidersandmanufacturers,whetherbyallowingprivatepricingorpublic

reimbursements,createsapublic‐goodsproblemingeneratingworldreturnstomedical

innovation.Taxationtofundthereimbursementstothehealthcareindustryinvolvesa

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privatecostwithaworldwidebenefitthroughinnovation.Itfollowsdirectlythatifmedical

innovationbenefitsallcountries,agivencountryunder‐reimbursesprovidersand

manufacturersasaresultofitspositiveexternaleffectonothers.Thus,therewillbetoo

littlemedicalinnovationasitwillnotbesufficientlyrewardedbyworldreturns.

Akeypositiveimplicationofthispublic‐goodsproblemisthatprofit‐provision

throughreimbursementsinagivencountryisnegativelycorrelatedwiththeprofit

provisionofothercountries;thatis,reimbursementswillbe“strategicsubstitutes.”Asmall

EuropeancountrymayreimburselessgenerouslybecausetheUnitedStatesreimburses

moregenerously.Moreprecisely,wearguethatthesmallertheshareofworlddemandand

supplyacountrymakesup,thelessthatgovernmentswillmarkuppricesabovecostto

promoteinnovation.Putdifferently,asmallcountryhasnothingtogainfromraisingits

reimbursements,asitwillseethesameflowofnewinnovationsregardlessofwhatitdoes.

WethereforepredictthatEuropeancountrieswillhavelowerpaymentsand

reimbursementsthantheUnitedStates,despitethelatterbeingthelargerbuyer.Thismay

bereflectedinrelativelylowerEuropeanreimbursementsfordoctorandhospitalservices

thatcoverinnovationssuchasdevicesordrugsorformedicalproductsdirectlythrough

referencepricingorcost‐effectivenessthresholdpolicies.2

Weanalyzehowchangesinbothworldwidedemandandsupplydriveworldreturns

whenreimbursementsarestrategicsubstitutes.Wepredictthattheconcentrationof

aggregatedemandandsupplyacrosstheworldhasimplicationsformedicalinnovation.

Theseconcentrationeffectshavenonstandardconsequencesforthefutureofmedical

innovationandworldspendinggrowth.Forexample,futuregrowthinworlddemandfrom

theemergingmarketsofBrazil,Russia,India,China,andSouthAfrica(orBRICS),despite

recentslowdowns,willlowerworldconcentrationofaggregatedemandandsupplyby

makingtheUnitedStateslessdominant.WepredictthatthiswillleadtolowerUS

reimbursementswhenitlosesitdominantroleinworldreturns.Ingeneral,growthin

                                                            2PhilipsonandJena(2008)discussestheimplicitpricecontrolsthatreimbursementbasedoncost‐effectivenessstandardsimplies.

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worldmarketsmayhavetwooffsettingeffectsoninnovation:thestandardpositiveeffect

fromanincreaseinworldmarketsize,andtheoffsettingnegativeeffectduetoincreased

freeridingwhenworldconcentrationinhealthcarefalls.

Weprovideempiricalevidenceoftheseeffectsbyanalyzingtheimpactofthe

growthofBRICSonfutureworldreturnsand.Indoingso,weprovidesomebasicfactson

worldconcentrationinhealthcare,includingthedegreetowhichtheshareoftheworld

supplyofmedicalproductsfromBRICShasrisenrelativetotheirshareofworlddemand.

Wethenusepharmaceuticalreimbursementdatafrom26developedcountriesoverthe

past15yearstoprovideinstrumentalvariable(IV)estimatesofthedegreetowhich

reimbursementsarestrategicsubstitutestodemandandsupplyconditionsofother

countries.

WeusetheseIVestimatestoassesstheimpactonworldreturnsofadiminishing

concentrationcreatedbythegrowthofBRICS.Aback‐of‐the‐envelopecalculation

illustratesthatthemarkupreductionsintheUnitedStatesandothercountriesdonothave

tobelargetooffsetpredictedgrowthratesindemandfromBRICS.Currently,theBRICS

contributeapproximately7%toworldspendinginhealthcare.Ifbycurrentindustry

estimates,suchasthatofIMSHealth3,theirspendinggrew20%inthenextthreeyears,

theywouldstillmakeuponlyabout8.28%ofworldspending.Thisimpliesthatadecrease

inmarkupsofonly1.5%innon‐BRICScountrieswouldbeenoughtooffsetthis20%

growthfromBRICS.Thesmallreductioninmarkupsneededtooffsetthesubstantial

spendinggrowthfromtheBRICSisduetothesubstantialconcentrationinworldhealth

carespending.Ourestimatesofthesizeofthestrategicsubstitutabilityinreimbursements

suggestthatunderreasonableconditions,whenworldconcentrationofhealthcaresupply

anddemandfalls,thegrowthinBRICSmarketsizemaylowermedicalinnovationreturns

asaresultofdeclinesinreimbursementsintheUnitedStatesandotherrichcountries.

                                                            3 Thisisthesuggestedgrowthrateinindustrypublications,seee.g.IMSInstitute’s“TheGlobalUseofMedicinesOutlookThrough2016” 

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Ouranalysisrelatestoseveralotherstrandsofwork.Beckeretal.(2005)

documentedthatmedicalinnovationinrichcountriesgreatlyaffectedhealthoutcomesin

poorcountriesandreducedworldinequality.HultandPhilipson(2012)consideredthe

impactofdomestic,ratherthaninternational,reimbursementpoliciesoninnovation

incentives.Lakdawallaetal.(2009)simulatedtheimpactofUSpharmaceuticalpricing

policiesonbothUSandEuropeanhealthoutcomes.Danzon(1997)discussedhowto

efficientlyraiseagivenamountofpharmaceuticalR&DacrossregionsthroughRamsey

pricing.Thisresearchdiffersfromourstrategicanalysis,whereinpositiveandnormative

implicationsstemfrominefficienciesinthepublic‐goodsprovisionofworldreturns.4Our

analysisalsorelatestoalargeliteraturecomparingdomestichealthcareeconomies(see,

e.g.,GerdthamandJönsson,2000),whichdoesnotconsidertheinnovation‐induced

linkagesacrosscountrieswediscusshere.

Theoverallpointofouranalysisistoanalyzehowinternationallinkagesaffectboth

positiveandnormativeanalysesofdomestichealthcarepolicies.Onapositivelevel,these

linkagesseemtobeimportantforexplainingdifferencesinEuropeanandUS

reimbursementpoliciesandhencespendingdifferences;onanormativelevel,theyare

importantforevaluatingtheeffectsanddesirabilityofdomestichealthcarereformsaimed

atcurbingdomesticspendinggrowthresultingfromworldreturns.

Thepaperisstructuredasfollows:Section2providesatheoreticalexaminationof

theimplicationsoftheinnovation‐inducedlinkagesamongdomesticreimbursement

policies.Section3providesourempiricalanalysisofstrategicsubstitutabilityandthe

impactoftheBRICSonfutureworldreturns.Section4concludesanddiscussesfuture

research,includingthelimitedvalueofregional‐orstate‐levelreimbursementexperiments

inexaminingspendinggrowthinducedbyworldreturns.

                                                            4Inadditiontheiranalysisimpliesthecentralimportanceoftheprice‐elasticityofmedicalproductdemandinefficientlyraisingagivenamountofR&D,whichislessrelevantwhenreimbursementsarecentrallysetandpubliclyfinancedinwhichcasetheexcessburdenoftaxationisthedeadweightlossofinterest.

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Section2:ThePublicGoodsProblemofProvidingWorldReturnstoInnovation

Wefirstlayouttheframeworkconsideredforthepublicgoodsproblemof

providingworldreturnsformedicalinnovation.Thekeyissueisthatprotectinginnovator

profitsthroughhigherpublicreimbursementsinvolvesprivatecostforacountry,butthis

provisionhaspositiveexternaleffectstoothercountriesbypromotinginnovation.

Therefore,publicreimbursementswillbeunder‐providedbycountriesactingintheirown

interestcomparedtoefficientworldreturnsandreimbursementswillbestrategic

substitutes.

ConsiderwhentheamountofR&Daffectstheprobabilityofdiscoveryofamedical

innovationaccordingto where isincreasingandconcave.If arethe

worldprofitsaggregatedupoverKcountriesthentheR&Dthatmaximizesexpectedprofits

canbewrittenas .Thisimpliesthattheinducedprobabilityof

discovery isincreasinginworldprofits .

Eachcountryprovidesprofits andhasitsownwelfare whichisdecreasing

inprofitprovisiongiventheexcessburdenofthetaxesfinancingreimbursements.The

worldexpectedsocialwelfareacrossallcountriesis

Withinagivencountry,providingprofitsisaprivatebadthatenablesthepublicgoodof

worldreturnstoinnovation.Thesociallyefficientprofitprovisionofeachcountry

thereforesatisfiesaclassicpublicgoodconditionthattheprivatecostofraising

reimbursementisequatedtothevaluetotheworldofraisinginnovativereturns

(1)

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Thisefficientprovisionofprofitsdiffersfromtheprivatelyoptimal(Nashequilibrium)

provisionwhichonlytakesintoaccounthowthecountry’scostlyprofitprovisionaffectsits

ownwelfare

(2)

Thus,theprivateinnovationbenefittoagivencountryissmallerthanthesocialbenefitto

allcountriessothatworldreturnstomedicalinnovationareunder‐providedbycountries

whenactingintheirowninterest.Inotherwords,theNashequilibriumofprofitprovision

hasworldreturnstoinnovationbelowtheefficientlevel5.

Thispublicgoodsproblemofprovidingworldreturnsaltersstandardarguments

abouttheclassiceffectsofmarketsizeoninnovation.Inparticular,thepublicgoods

problemmaycounteractthecanonicalpositiveeffectthatagrowthofworldmarketshas

oninnovativereturns.Toseethisinitssimplestform,considerwhenthereareK

homogeneouscountrieswiththesamedomesticprofits .Anincreaseinthenumberof

countriesmaybeinterpretedastherisein“profitable”countriesforwhichdemandis

abovevariablecosts,suche.g.thegrowthofworlddemandthroughtheBRICS.TheFOCfor

privatelyoptimalprofitprovisioninthiscaseimplies

   

Underregularityconditions6thisimpliesfree‐ridinginthesensethatthatdomesticprofits

fallwiththenumberofcountriesthatcontributetoworldprofits; .Worldreturns

are andthustherearetwoeffectsofagrowthinworldmarketsizeonworld

returns

                                                            5Moreprecisely,foranyprofitlevel themarginalcostofprofitprovision( )isthesameundersociallyoptimalandprivatelyoptimalsetting;However,foranyprofitlevel ,themarginalbenefitofprofit provisionisgreaterunderthesociallyoptimalframeworkthantheprivatelyoptimalframework

.Consequently,profitsareunderprovidedintheprivatelyoptimalsetting.

6Sufficientbutnotnecessaryconditionsfor arethat isincreasingandconcaveintotalprofits

and isdecreasingandconcaveindomesticprofits.

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Thissaysthatthefirststandardpositiveeffectofmarketsizeoninnovativereturnsis

mitigatedbythesecondnegativeeffectinducedbyincreasedfree‐ridingwhenalarger

groupofcountriesprovidesthepublicgoodofmedicalinnovation.Intheextremecase

whenUSorasinglecountryistheonlychampionofmedicalinnovativereturns,K=1,world

returnsareefficient.AsincomegrowthintheBRICSmakesthemprofitableforthe

innovation,Krisesandtheoverallimpactonworldreturnsisahorseracebetweenlarger

worldmarketsandsmallerUSmarkups.

Toillustrate,considerwhendomesticwelfareisgivenbythefirst‐orderTaylor

approximation andworldreturnsaffectsinnovationaccordingto

where 7.Here, representsthe“size”ofacountry(saypopulationor

incomelevel)and representstheexcessburdenofprovidingagivenlevelofprofits.

DirectalgebrathenimpliesthatefficientworldprofitsthenexceedNashprofitsaccording

to

   

where   . Ifthereisonlyonecountry,thesociallyefficientandNash

equilibriumprofitlevelscoincide.Whenmorethanonecountrycontributestoworld

profits, ,worldreturnsaretoolowinthesensethattheefficientlevelofprofitsare

greaterthantheNashequilibriumlevel.BoththesociallyefficientandNashequilibrium

levelsofprofitsareincreasinginthenumberofcountriesKcontributingtoworldreturns

andtheriseinthe“benefits”ofworldinnovation(countrysize )butaredecreasingwith

the“costs”ofinnovation(theexcessburdenoftaxationinfundingthereimbursements ).

Theextentofunderprovisionofworldreturns, ,risesinthenumberof

countriesduetofree‐riding.Under‐provisionalsorisesinthesizeofeachcountry

benefittingfrommedicalinnovation, ,butfallsintheexcessburdenoftaxation, .The                                                            7Therangeof isnotlimitedto buttheformisanapproximationchosenforillustrativeease. 

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under‐provisionoccursbecauseeachcountryfailstoconsidertheexternalbenefitofprofit

provisionwhendeterminingitspricesettingpolicies.Consequently,whenthebenefitofthe

innovationinothercountriesfalls(fromeitheradecreasein oranincreasein )orthe

numberofcountriesdecreases,thefreeridingproblemshrinks.

Wecanallowheterogeneouscountriesbywritingthewelfaregeneratedbythe

innovationinaparticularcountryasafunctionofdomesticdemandfactors, ,andthe

country’sownershipshareofglobalprofits, asin

   

Here reflectsthedecreasingconsumerwelfaretothecountry’spopulationasa

functionofprofitprovision.Generalizingtheexamplefromabove,thevector includes

bothdomesticfactorsthatincreasethedomesticvalueoftheinnovationsuchas

population,percapitaincome,ordiseaseprevalencerelatedtotheinnovationaswellas

thecostofraisingtaxestoreimbursefortheinnovation.Thesecondcomponentofwelfare

representsthebenefittodomesticownersoftheinnovation.

Sincethereimbursementpolicysetbyeachcountrydependsontotalworldprofits,

eachcountry’sreimbursementpolicyisafunctionofothercountriesreimbursement

policies.Thisisthekeyinternationallinkageinreimbursementlevels.Moreprecisely,

totallydifferentiatingtheFOCfortheprivatelyoptimalprofitprovisionwithrespectto

anothercountry’sprofits yields

Itcanbeshownthatunderthemaintainedregularityconditionsprofitprovisionsare

“strategicsubstitutes”inthesensethat8

                                                            8Sufficientbutnotnecessaryconditionsforprofitsprovisionsbeingstrategicsubstitutesarethat isincreasingandconcaveintotalprofits, isdecreasingandconcaveinprofits,and .Thelastassumptionholdstriviallyprovidednocountriesprofitshareexceeds0.50asthemarginalcostofprofitprovision,intermsofprofits,isgreaterthan1.

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Ifonecountry’sreimbursementpolicyraisesitscontributiontoworldreturns,other

countriesrespondbyreducingtheirprofitlevels.However,anincreaseinCountryj’s

profitsleadstolessthanoneforonedecreaseinCountryk’sprofitssuchtotalworldprofits

increaseoverall.

Figure1illustratesthebestresponsefunctionsinaheterogeneoustworegioncase

as,say,theUSandtheBRICS.TheNashequilibriumprofitlevelsarecharacterizedatthe

pointatwhichthetwobestresponsefunctionsintersect.Thenegativeslopeofthebest

responsefunctionsintheFigurecorrespondstothatstrategicsubstitutabilityofprofits;

onecountrypreferstocontributelesstoworldreturnsthemoreothercountries

contribute.TheNashequilibriumprovisionofprofitsislessthanthesociallyefficient

provisionofprofitstothenortheastoftheNashprofits.

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FIGURE1:BESTRESPONSEFUNCTIONSANDEQUILIBRIUM

Thegeneralresultthatcentrallydeterminedreimbursementsarestrategic

substitutesdiffersfromotherpredictionswithoutworldreturnsbeingapublicgood.First,

standardtheoriesofoptimalprivatelydeterminedmonopolypricingacrossregionsimply

thatthedemandelasticityofagivencountrygovernitsownprice,andthusdoesnot

dependonfactorsofothercountries.Second,explanationsofnationalpricesbasedon

governmentmonopsonypoweryielddifferentimplicationsthanoursbecausesuch

explanationsimplylargereconomieshavelower,nothigher,prices.Toillustrate,thefact

thattheUSgovernmenthasgreatercentralizedbargainingpowerthansmallerEuropean

countriesbuthavelargermarkupsinitsreimbursementsisconsistentwiththepublic

goodsinterpretationdiscussedhere.

Asecondgeneralresultisthattheconcentrationofownershipdoesnotaffectthe

efficientlevelofprofitsbutwillaffecttheNashequilibriumprofits.Thisfollows

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immediatelyfromthataggregatewelfaredoesnotdependontheconcentrationof

ownership

   

Therefore,theefficientlevelsofprofitsareindependentofwhatcountryownsthem.

Toillustratetheheterogeneouscase,consideragaintheparametricP‐functionand

theTaylorapproximationsofwelfare where .It

canthenbeshownthatthebestresponsefunctionsofthetwocountriesarelinear

functionsaccordingto

   

Theparameters and arefunctionsof , and while and aresimilarly

functionsof , , and 9Thestrategicsubstitutabilityofprofitsoccurswhenthe

signof and arenegativewhichholdsundermoregeneralregularityconditions10.The

Nashandefficientlevelsofprofitsintheparametricexampleare11

     

Asbefore,itiseasilyshownthatprofitsareunderprovided; .Theparametric

exampleillustratesthemoregeneralresultthattheequilibriumandefficientlevelof

profitsareincreasinginthewelfarebenefitoftheinnovation.Consequently,the

equilibriumandefficientlevelsofprofitsareincreasinginthedemandsizeparameters                                                            

9Directderivationsimply and

10Asufficientbutnotnecessaryconditionforprofitsbeingstrategicsubstitutesincountrykis .Since and ,thisconditionislikelybenigninpractice,especiallywhenthenumberofcountriesisexpanded.

11Thesociallyefficientlevelofprofitsarecalculated,withoutlossingenerality,undertheassumption

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and .Similarly,theequilibriumandefficientprofitlevelsareweaklydecreasinginthe

excessprofitburdenparameters and .Notethat,asdiscussed,unliketheprivately

optimalequilibriumlevel,theefficientlevelofprofitsdoesnotdependonthedistribution

ofownership.

2.1TheEffectofDomesticDemandGrowth

Toassesstheimpactofgrowthinworlddemandforaninnovation,considertheFOC

forprivatelyoptimalprofitprovision

(3)

Undertheconditionsthat isdecreasingandconcaveinprofitsandtheadditional

conditionthat ,itcaneasilybeshownthatthebestresponsefunctionisofprofit

provisionisstrictlyincreasinginthedemandparameter , 12.Thecondition,

statesthatthesocialcostoftransferringsurplustoproducersisnotincreasingin

populationsize;it’scheaperforalargerpopulationtoprovidethesamelevelofprofitsto

theinnovatorasper‐capitataxesarelower.

AsillustratedinFigure2,considerthescenariowheredemandgrowthinCountry1

(saytheBRICS)increasesfrom to .ForanygivenlevelofprofitsallocatedbyCountry

2,Country1willfinditoptimaltonowsetahigherprofitlevelduetoitsincreasein

demand.Consequently,Country1’sbestresponsefunction, ,willshift

outwardsto .TheunilateralresponsearrowintheFigureindicatesthechange

intotalprofitsresultingfromthedemandgrowthkeepingCountry2’sprofitlevelfixed.

However,sincepricesarestrategicsubstitutesacrosscountries,bothCountry2and

Country1strategicallyrespondaccordingtotheirbestresponsefunctionssuchthatthe

equilibriumlevelofprofitsshiftstotheintersectionofthebestresponsecurves

                                                            12Totaldifferentiatingfirstordercondition(3)withrespectto and yields

   

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and .Althoughprofitsincreaseoverallfrom to ,the

equilibriumresponsearrowintheFigureindicateshowtotalprofitsdecreaserelativeto

thatindicatedbytheinitialunilateralresponseofCountry1duetostrategicresponsesof

thetwocountries.Themainpointisthatsincepricesarestrategicsubstitutes,Country2

(saytheUS)“free‐rides”offthelargerprofitsprovidedbyCountry1byloweringitsown

profitlevel.Althoughtotalprofitsincreaseoverall,Country2setsalowerdomesticprofit

levelinthenewequilibrium.ThestrategicprofitresponsebyCountry2willpartiallybut

notfullyoffsettheincreaseintheprofitssetbyCountry1suchthattotalworldprofits

increaseoverall.

FIGURE2:THEEFFECTOFADOMESTICDEMANDINCREASE

ThisFigureillustratestwomoregeneralimplications.First,anincreaseindomestic

demandgrowthleadstohigherdomesticprofits; .Second,thestrategicprofit

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responseofothercountrieswillatleastpartiallyandcouldpotentiallyfullyoffsetthe

entireincreaseinprofitsstemmingfromthedomesticdemandgrowth13.

   

AnillustrativecaseofthisoffsetisthatwhendemandgrowthintheBRICSoccurs,US

reimbursementsmayfallasUSbecomesoneofmanyprovidingworldreturnsto

innovation.

2.2TheEffectsofChangesinOwnershipofInnovativeReturns

Nowconsidertheimpactonworldreturnswhenchangesinownershipofthose

returnsshiftacrosscountries.Justasdomesticdemandgrowthincreasesthebenefitofthe

innovationandconsequentlythecountry’soptimallevelofprofitprovision,the

reimbursementlevelofacountrywillbeapositivefunctionofhowmuchofworldprofitsis

ownedbythatcountry.ImplicitlydifferentiatingtheFOCforprivatelyoptimalprofit

provisionasbefore,itcaneasilybeshownthatacountry’soptimalprofitlevelwillbea

positivefunctionofhowmuchofglobalprofitsitowns; 14.However,anincreasein

onecountry’sprofitshareimpliesadeclineinanothercountry’sshare.Consequently,any

changeinownershipshares( )arezerosumandresultsinthatprofitsare

protectedmoreincountriesthatgaininownershipandlessincountriesthatdonot.The

impliedchangeintotalworldreturnsis

   

                                                            13Foreachcountry ,theimpactofanincreaseindemandincountrykresultsinlowerprofitsincountry

j, .Consequently, .

14Totallydifferentiatingthefirstordercondition(3)withrespectto and yields

   

Thesignof followsfromtheresultthat andtheconcavityof and

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where  .  

Figure3illustratestheeffectofchangesinownershiponworldreturnsforthetwo

countrycasewithshares .Ifworldreturns isaU‐shaped

curvein thenconcentrationinownershipraisesworldreturnsbutifitisaninvertedU‐

shapedfunctionconcentrationlowersworldreturns.IftheshareofCountry1risesfrom

to thebestresponsefunctionshiftsoutsuchthat .Sincethe

secondcountryownlessoftheworldreturns,itsbestresponsefunctionshiftsinward.The

neteffectonaggregateprofitsofashiftinprofitsisambiguousanddependsonthe

curvatureofthewelfare‐andprobabilityofdiscoveryfunction.

FIGURE3:THEEFFECTOFACHANGEINOWNERSHIP

Thegeneralpointillustratedbythetwocountryexampleisthatchangesin

ownershipshareshasindeterminateeffectsonworldreturns; maybepositiveor

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negative(TheAppendixderiveshowwelfare, ,andtheprobabilityofinnovation, ,

affecttheimpactofchangesinownershiponworldreturns).

Section3:EmpiricalAnalysis

Ourempiricalanalysisdocumentstheconcentrationinworldhealthcarespending,

providesIV‐estimatesofthestrategicsubstitutabilityinreimbursementandusesthose

estimatestoassessthedegreetowhichdemandgrowthfromtheBRICSwillimpactworld

innovativereturns.Thedescriptivestatisticsdiscussedincludesoverallhealthcare

spendingbuttheestimationisdoneforreimbursementsforpharmaceuticals.

3.1WorldTrendsinConcentrationofHealthCare

3.1.1TrendsinConcentrationofHealthcareandPharmaceuticalExpenditures.

Tables1and2summarizeworldhealthcareandpharmaceuticalexpendituresfor

thelargestcountriesbyhealthcareandpharmaceuticalexpenditureshares.Thehealth

careexpenditure,GDPandpopulationdatacomefromtheWorldBankDataBank.

PharmaceuticalexpendituredataforOECDandBRICScountriesiscompiledfromtheOECD

iLibraryandtheNationalHealthAccountsdatabaseattheWorldHealthOrganization15

(WHO)respectively16.GDPandexpendituredataforallofthecountriesaremeasuredin

constantUSDollars(baseyear=2000).

EventhoughhealtheconomistsoftendebatenumberssuchastheshareofGDPofa

countryspentonhealthcare,ortotalspendinggivenpercapitabyincomelevels,what

mattersforinnovationincentivesaremoretiedtoaggregateworldmarketshares.Ourdata

                                                            15WewouldliketothankRichardLiangattheWHOforgivingustheBRICSpharmaceuticalexpendituretimeseriesdata.

16NotethatweusetheNationalHealthAccountsandOECDdatatocomputepharmaceuticalexpendituresharesratherthanthemorecommonlyquotedIMSdata.TheIMSpharmaceuticaldataconsistsof“manufacturerssalestowholesalersandhospitalsaswellasretailsalesofprescriptionmedicine”(WorldHealthOrganization2004).TheNHAandOECDdatausesabroaderdefinitionofhealthcareexpendituresthanIMS;forexampleIMSdatadoesnotincludeoverthecountermedicinesales.Consequently,theNHAdataindicateshigherpharmaceuticalexpendituresharesindevelopingcountriesthantheIMSdata.

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indicatesthatcurrentlytheUSremainsthechampionofbothoverallhealthcareand

pharmaceuticalexpenditures,accountingforabout50%oftheworldmarketsharefor

healthcareand40%ofworldpharmaceuticalshare.However,despiterecentslowdowns,

theprojectedsurgeinhealthcareexpendituresinBRICSandothercountriesmaydiminish

thisconcentrationinspendingintheglobalhealthcareeconomy.

AlthoughthehealthcarespendingintheUSandotherdevelopedcountries

dominatesthecurrentlevelofspendingintheBRICScountries,overtheperiod1995‐2010

BRICSoverallhealthcareexpendituresgrewattwicetherateoftheworldhealthcare

expenditures.Intermsofitsshareoftotalworldhealthexpenditures,theBRICScountries

growthhascomenotattheexpenseoftheUSbutattheexpenseoftheotherlarge

countries(i.e.Japan,FranceandGermany).AstheBRICScountrywithboththelargest

overallhealthcaresectoraswellaspharmaceuticalsector,Chinaisthedrivingforce

behindBRICShealthcarespendinggrowthintermsofbothgrowthratesandlevels.

Despitesimilarpopulationsizes,ChinaspendsfourtimesasmuchonhealthcarethanIndia

andChina’sspendinggrowthcontinuestooutpaceIndia’sby4.60%17.

                                                            17Overtheperiod2005through2006,healthcareexpendituresgrewatanaverageannualrateof12.88%and8.28%inChinaandIndiarespectively. 

19 

 

TABLE1:WORLDHEALTHCAREEXPENDITURES

TABLE2:WORLDPHARMACEUTICALEXPENDITURES

NotesonTables1and2:

(*)Measuredin2000constantUSDollars. (**)WorldtotalscalculatedusingallavailabledatawhichislimitedtoBRICSandOECDcountries. GDPandpopulationdatacomefromtheWorldBankDataBank. PharmaceuticalexpendituredataforOECDandBRICScountriesiscompiledfromtheOECDiLibrary

andWHONationalHealthAccountsrespectively.

Country 2010 1995 2010 1995 2010 1995 2010 1995 2010 1995 2010 1995UnitedStates 309 266 37,330 30,051 17.9% 13.6% 2,066 1,085 48.0% 45.0% 1 1Japan 127 125 39,972 36,177 9.5% 6.9% 483 312 11.2% 13.0% 2 2Germany 82 82 25,306 21,061 11.6% 10.1% 241 174 5.6% 7.2% 3 3France 65 60 22,758 19,478 11.9% 10.4% 176 120 4.1% 5.0% 4 4UnitedKingdom 62 58 28,034 20,724 9.6% 6.8% 168 82 3.9% 3.4% 5 5China 1,338 1,205 2,426 658 5.1% 3.5% 165 28 3.8% 1.2% 6 10Italy 60 57 18,943 17,671 9.5% 7.3% 109 73 2.5% 3.0% 7 6Canada 34 29 25,575 20,170 11.3% 9.0% 99 54 2.3% 2.2% 8 7Brazil 195 162 4,717 3,606 9.0% 6.7% 83 39 1.9% 1.6% 9 8Spain 46 39 15,458 12,049 9.5% 7.4% 68 35 1.6% 1.5% 10 9Korea,Rep. 49 45 16,219 9,548 6.9% 3.9% 56 17 1.3% 0.7% 11 17Netherlands 17 15 26,553 20,429 11.9% 8.3% 53 26 1.2% 1.1% 12 11Australia 22 18 25,249 18,627 8.7% 7.2% 49 24 1.1% 1.0% 13 12Mexico 113 92 6,105 4,832 6.3% 5.1% 44 23 1.0% 1.0% 14 13India 1,225 964 795 367 4.1% 4.3% 39 15 0.9% 0.6% 15 20Russia 142 148 2,927 1,618 5.1% 5.3% 21 13 0.5% 0.5% 22 22SouthAfrica 50 39 3,753 2,960 8.9% 7.5% 17 9 0.4% 0.4% 27 25World 6,894 5,715 6,006 4,788 10.4% 8.8% 4,301 2,410 100.0% 100.0%

Population(millions)

GDPPerCapita*IncomeShareSpentonHealth

Care

TotalAmtSpentonHealthCare*

(billions)

ExpenditureShare

(%WorldExp.)

WorldRank(Expenditure

Share)

Country 2008 1995 2008 1995 2008 1995 2008 1995 2008 1995 2008 1995UnitedStates 304 266 38,209 30,051 16.5% 13.6% 12.1% 8.4% 232 91 38.6% 30.1%Japan 128 125 40,433 36,177 8.5% 6.9% 19.4% 22.2% 85 69 14.2% 22.9%China 1,325 1,205 2,033 658 4.6% 3.5% 42.7% 54.2% 53 15 8.9% 5.0%Germany 82 82 25,620 21,061 10.7% 10.1% 15.0% 12.8% 34 22 5.6% 7.3%France 64 60 23,366 19,478 11.2% 10.4% 16.4% 15.0% 28 18 4.6% 6.0%Italy 60 57 19,903 17,671 9.0% 7.3% 18.1% 20.7% 19 15 3.2% 5.0%UnitedKingdom 61 58 29,107 20,724 8.9% 6.8% 11.8% 15.3% 19 13 3.1% 4.2%Brazil 192 162 4,479 3,606 8.3% 6.7% 24.6% 16.7% 17 6 2.9% 2.1%Canada 33 29 26,102 20,170 10.3% 9.0% 17.0% 13.9% 15 7 2.5% 2.5%India 1,191 964 689 367 4.0% 4.3% 44.2% 55.4% 15 8 2.4% 2.8%Spain 46 39 16,251 12,049 9.0% 7.4% 18.7% 19.2% 12 7 2.1% 2.2%Mexico 111 92 6,327 4,832 5.9% 5.1% 28.3% #N/A 12 0 1.9% 0.0%Korea,Rep. 49 45 15,350 9,548 6.5% 3.9% 23.2% 23.6% 11 4 1.9% 1.3%Australia 21 18 25,246 18,627 8.7% 7.2% 14.6% 12.2% 7 3 1.2% 1.0%Belgium 11 10 25,100 19,940 10.0% 8.5% 16.4% 18.1% 4 3 0.7% 1.0%SouthAfrica 49 39 3,796 2,960 8.6% 7.5% 25.1% 28.3% 4 2 0.7% 0.8%Russia 142 148 3,044 1,618 4.8% 5.3% 18.8% 18.9% 4 2 0.7% 0.8%World 6,737 5,715 6,026 4,788 9.8% 8.8% #N/A #N/A 601 302 100.0% 100.0%

ExpenditureShare**

(%WorldExp.)

Population(millions)

GDPPerCapita*IncomeShareSpentonHealth

Care

ShareofHealthCareExp.SpentonPharm.

TotalAmtSpentonPharm.*(billions)

20 

 

ContrastingTable1relativetoTable2suggeststhatemergingeconomiesdevotea

higherportionoftotalhealthexpenditurestopharmaceuticalsthandevelopedcountries.

BRICShealthcarespendingisconcentratedinpharmaceuticalswithover40%oftotal

healthexpendituresspentondrugsinIndiaandChinarelativeto12%intheUS.Asaresult,

theBRICScountriesaccountforlessthan8%oftotalworldhealthexpendituresbutmore

than15%oftotalworldpharmaceuticalexpenditures.Thus,duetotherelativesizetheir

pharmaceuticalmarkets,theBRICScountriesmayplayalargerroleinspurringthe

innovationofpharmaceuticalsversusnon‐pharmaceuticalmedicalproductsandthe

physicianandhospitalservicestiedtothoseproducts.However,thenon‐pharmaceutical

relatedhealthcaremarketintheBRICScountriesisgrowingfasterrelativetothesizeof

theirpharmaceuticalmarkets.

3.1.2SupplyTrends

Ouranalysisimpliedthatownershipsharesacrosscountriesdrivesactual,although

notefficient,reimbursementpolicy.Ascountry‐specificownershipsharesof

pharmaceutical‐andotherhealthcarecompaniesarenotavailablegivenexistingdata

sources,weusepharmaceuticalproductiondata18.Inparticular,weusepharmaceutical

productiondatatoproxyforacountry’sattentiontosupplysideissuesofsupporting

innovativereturns.Figure4displaysthevalue19ofpharmaceuticalproductionintheUS,

Japan,China,IndiaandRussiaoverthepastthirtyyearsasreportedinthe2006and2010

onlineeditionsoftheUNIndustrialStatisticsDatabase20

                                                            18Dataonfirmownershipacrosscountriesistoourknowledgeunavailable.IdeallywewouldliketoknowthepercentageofcompanyXYZthatownedbyUScitizens,Chinesecitizens,etc.foreachfirmandcountry.

19Productionisvaluedeitherintermsoffactorcost,whichexcludesallindirectproductiontaxesbutincludesproductionsubsidies,orintermsofproducerprices,whichincludesindirectproductiontaxesbutexcludesproductionsubsides.

20TheDatabasedoesnotcontainproductiondataforthecountriesinBRICSnotrepresentedingraph. 

21 

 

FIGURE4:PHARMACEUTICALPRODUCTION

NotesonFigure4: Thedataisfromthe2006,2010andonlineeditionsoftheUNIndustrialStatisticsDatabase.Datafrom

theonlineand2010editionreflectsISICcode2423“Pharmaceuticals,medicinalchemicals,etc.” Datafromthe2006editionreflectsISIC352“Otherchemicals”andisscaledby1/2toreflectthatISIC

352includesnon‐pharmaceuticalchemicalproduction.ThescalingfactorwasdeterminedbytheaverageratioofISIC2423toISIC352fortheyears/countriesinwhichdataoverlappedbetweenthe2006and2010datasets.

Fortheonlinedata,outputwasconvertedintoUSDusingannualforexdatafromhttp://www.oanda.com/.

Missingdatapointswerelinearlyinterpolated.

Overtheperiod1990to2008,pharmaceuticalproductioninChinaandIndia

increasedbyamultiplesof15and6respectively.Duringthesameperiodpharmaceutical

productionintheUSincreasedbyamultipleof3whileproductioninJapanandRussia

remainedrelativelyflat.OuranalysispredictsacontinuedgrowthintheChineseand

Indianproductionshouldputupwardreimbursementpressureinthosecountries,while

puttingdownwardpressureonreimbursementsinothercountries.

22 

 

3.2EmpiricalAnalysisofStrategicSubstitutability

3.2.1Specification

Weconsideranempiricalspecificationthatallowsustotestforthestrategic

substitutabilityofreimbursementsaswellastheimportanceofsupplyanddemand

changesonreimbursementpolicy.Duetotheavailabilityofdata,ourmodelfocusesonthe

reimbursementsforpharmaceuticalproductsratherthanthemoregeneralproblemof

profitprovisionforothermedicalproductsandservices.Thespecializedversionofthe

previousanalysisconsideredconcernswheneachcountryfacestheoptimalpricesetting

decision:

    (4) 

wheretheprofitscontributedbyagivencountry isanincreasingfunctionofits

ownprice.

Thispricesettingproblemandtheprofitprovisionproblemdiscussedearlierare

directanalogs.Thefirstorderconditioncorrespondingtothecountry’soptimalpricing

problemisthedirectanalogofthefirstordercorrespondingtotheoptimalprofitprovision

policy.Justaswithprofitprovision,acountry’soptimalpricewillbeafunctionofits

demandfactors,profitshareandaggregateprofits.Theprecedingcomparativestaticresult

thatprofitsarestrategicsubstitutesacrosscountriesappliestopricessuchthatacountry’s

optimalpricelevelisdecreasingintotalworldreturns.Similarly,acountry’soptimalprice

levelisincreasinginitsprofitshare.However,eventhoughacountry’soptimalprofitlevel

isincreasingindemandfactors ,itscorrespondingoptimalpricemaynotbeincreasing

indemandfactors.Thekeyintuitionbehindtheresultisthatsinceprofitisfunctionof

bothpriceandquantity,anincreaseinacountry’ssizeorincomecouldleadtoahigher

domesticprofitlevelevenifthecountrychoosestolowersitsownpricelevel.Thisoccurs

23 

 

whenthequantityincreasefromthelarger“size”ofthecountrymorethanoffsetsany

possiblereductioninmarkups21.

Thispricesettingcaselendsitselftoestimationofthefollowinglinearized

specificationofstrategicinteraction

    (5) 

where isthepriceofpharmaceuticalssetbycountrykattimet, ispharmaceutical

productionincountrykattimet(proxyingforownershipshares), arecountryfixed

effects(anelementofthex‐vectoraffectingcountryspecificwelfare), arequantity

weights,and isavectorofthedemandfactorsthatdrivedomesticpricingbutnot

foreignpricingofcountrykattimet.Theterm correspondstothepharmaceutical

revenuesincountryjattimet.Ifthemarginalproductioncostsarenegligible,theempirical

model(eq.5)isanalogoustothemodel

    (6) 

Equations(5)and(6)arethusthelinearizedbestresponsefunctioncorrespondingtothe

country’soptimalprofitprovisiondiscussedearlier.Weestimateacountry’sbestresponse

asperequation(5)ratherthanequation(6)duetothedataavailabilityissuesregarding

accuraterevenueandprofitdata.

Ouranalysisimpliesthatpricesarestrategicsubstitutes,whichcorrespondstothe

parameterrestriction .Theanalysisalsopredictsthatcountriesearningagreater

                                                            21Inparticular,thekeysufficientconditionweusedtoshowthatprofitsareincreasingdomesticindemandfactorsinsection2.1is .Thenecessaryconditiontoshowthatpricesareincreasingindomesticdemandfactorsismuchstrongerandlesstenableandintuitiveconditionthat

Theconditionimpliesthatanincreaseindemandfactorsincreasesthemarginalbenefitofincreasingpricebyalargeramountthanitincreasesthemarginalcostofincreasingprice.

24 

 

producersurplusfromthepharmaceuticalindustrywillsethigherprices.Althoughwedo

notobservetheglobaldistributionofpharmaceuticalprofits,weusepharmaceutical

productionasaproxyforpharmaceuticalprofits.Also,countriesmayvaluedomestic

pharmaceuticalproductionforotherreasons,suchaslabordemand.Inthatvein,the

analysispredictsthatcountrieswithgreaterpharmaceuticalproductionwillsethigher

prices; .Further,weexpectthetwodemandfactorspopulationandGDPpercapitato

berelevantpricesettingfactors.Althoughourtheorysuggeststhatprofitswillbe

increasinginthetwodemandfactorspopulationandGDPpercapita,pricescouldbe

decreasingineitherpopulationand/orGDPpercapitaasquantitymayrisemorethan

markupsfall.

Twoprimaryeconometricissuesarisewhenestimatingequation(5):the

simultaneityofpricesandtheendogeneityofproduction.Theoptimalpricesetbycountry

kisafunctionoftheweightedsumofallothercountriesprices .Similarly,the

optimalpricesetbyeachothercountry ,includedtheweightedsum, ,is

alsoafunctionof .Consequently,equation(5)suffersfromtheclassicsimultaneity

problem.Anysimpleregressionof on wouldresultinbiasedestimatesdue

totheendogeneityoftheterm .Weimplementaninstrumentalvariables

strategytocircumventtheendogeneityproblemandrecovercountryk’sbestresponse

function.FollowingourtheoreticaldiscussioninSection2ontheeffectsofdomestic

demandshifts22weuse,asinstruments,thecovariatesofothercountries, ,weighted

bythesameweightsasspecifiedinequation(5)laggedbyoneyear 23.Weusethe

quantityweightsfromthepreviousasopposedtothecurrentperiodtoavoidfurther

endogeneityproblems.Theinstrumentalvariablesstrategyreliesonusingexogenous

variationinthecovariatesofothercountries, ,totraceoutcountryk’sbestresponse

function.ThetwocountrydiscussionofdomesticdemandshiftspresentedinFigure2of

                                                            22 SeealsosomerelatedworkinurbanendenvironmentaleconomicsFiglioetal.1999;FredrikssonandMillimet2002. 

23SeeBrueckner(2003)foranoverviewofempiricalstudiesonstrategicinteractionamonggovernments.

25 

 

Section2.1illustratesthemainconceptbehindourIVstrategy.Holdingallelseequal,we

usetheexogenousvariationinCountry1’sdemandcovariates, ,totraceoutthebest

responsefunctionofCountry2(andviceversa).

ThevalidityofourIVestimatehingesonourinstrumentsatisfyingsocalled

relevancyandexogeneityconditions.Therelevancyconditionofinstrumentalvariables

requiresthattheinstrument,theweighteddemandcharacteristicsofothercountries(

),iscorrelatedwiththeendogenousvariable, ,conditionalon , and

.WetestforrelevancyinastandardmannerbycomputingandanalyzingtheF‐statistics

fromthefirststageregressionsandShea’spartial measure(1997).Eachmeasure

providesevidencesuggestingthattherelevancyconditionholds.

Theexogeneityconditionrequiresthatourinstrumentisuncorrelatedwith

unobservederrorterm.Specifically,thisrequiresthattheunobserveddeterminantsof

pharmaceuticalprices(suchassaypreferencesorcosts)areuncorrelatedwithweighted

demandcharacteristicsofothercountries.Sincethenumberofinstrumentsexceedsthe

numberofendogenousvariables,weempiricallytesttheexogeneityconditionasper

Sargan(1958)andfailtorejectthenullhypothesisofexogeneityinourfullyspecified

model.

Relatingtotheexogeneitycondition,theIVmethodshouldalsoabateconcerns

aboutpotentiallyomittedvariablesinequation(5).Itisreasonabletoassumethat

equation(5)doesnotcontaintheentirerelevantpricesettingfactors.Forexampleone

mightthinkthatequation(5)omitspotentiallyimportantdemandandsupplycontrol

variablessuchas,mostobviously,productioncosts.Ifpharmaceuticalcostsand/or

preferencesarepositivelycorrelatedacrosscountries,onemightexpecttheweightedsum

ofothercountriesprices, ,conditionalon , and tobepositively

correlatedwiththeerrorterm, ,whichwouldresultinourOLSestimatesof being

asymptoticallybiasedupwardsuchthat .Hence,thepotentialomitted

variablesandendogeneityproblemcouldresultinOLSestimatesof suggestingthat

pricesarestrategiccomplementsacrosscountrieswhentheyareinfactstrategically

26 

 

substitutes.Providedthattheomittedvariablesareuncorrelatedwithoursetof

instruments,theobserveddemandcharacteristicsofothercountries,ourIVestimateswill

correctforthisasymptoticbias.

Thefinalempiricalissueinvolvestheendogeneityofpharmaceuticalproduction.

Unobserveddomesticdemandfactorscouldpotentiallybepositivelycorrelatedwith

quantityofpharmaceuticalsproducedwhichwouldresultsinbiasedestimatesof .We

correctfortheendogeneityproblemagainusinginstrumentalvariablesusinglagged

productionasaninstrumentforcurrentproductionsimilartothestrategyemployedby

Villas‐BoasandWiner(1999).Theinstrumentisvalidprovidedthatdomesticproductionis

correlatedovertimebutpreviouspharmaceuticalproductionisuncorrelatedwithcurrent

demandshocks.Asdiscussedpreviously,weagainempiricallyassessthevalidityofthe

instrumentandfindevidencesuggestingthattheexogeneityandrelevancyconditionshold.

3.2.2Data

Weestimateequation(5)usingpharmaceuticaldatafromabalancedpanelof21

OECDcountriesovertheperiod1999to200824.The21countriesaccountedforroughly

over80%ofpharmaceuticalspendingin1999.Thepharmaceuticalpriceindexis

constructedfromseveralsources.WeuseCPIdatafromtheBLS,Eurostat,Japanand

StatisticsCanadatomeasurewithincountrypharmaceuticalpricemovementsacrosstime

byusingtheratioofpharmaceuticalpriceindexrelativetoconsumerpriceindex(all

goods)assuggestedbyGolecandVernon(2006).Next,wearethenabletoscalethe

relativepharmaceuticalpricelevelsacrosscountriesintheyear2005usingOECDrelative

pharmaceuticalpricedata25.Figure5belowindicatesthepricemovementsoftheUS,Japan,

France,GermanyandtheUKovertheperiod1996to2010.Theremainingdatausedin

estimationaresummarizedinTable3.

                                                            24 Although the full data set spans 26 countries over 1996‐2010, we trim the data set to allow for a balanced panel.  

As a robustness check we use the full unbalanced data set. 

25TherelativepharmaceuticalpricedataisfromOECDHealthPolicyStudies(2008).

27 

 

Duetodataconstraints,ourpharmaceuticalpriceindexmaybeanoisymeasureof

pharmaceuticalprices.Weusecountryspecificpharmaceuticalandconsumerpriceindices

tocapturethewithincountrypharmaceuticalpricemovementsacrosstimebylookingat

changesintheratioofpharmaceuticalpricesrelativetoallconsumerprices.The

methodologyusedbytheBLS,Eurostat,JapanandStatisticsCanadatocalculate

pharmaceuticalandconsumerpricelevelsvariesacrossthefoursourceswhichcould

createinconsistenciesinourpriceindices.Thepharmaceuticalpricelevelsarefirstscaled

acrosscountriesusingOECDrelativepharmaceuticalpricedataandthenre‐scaledusing

theDanzonandFurukawa(2003)datasetasarobustnesscheck26.TheOECD

pharmaceuticalpricedataisintermsofrealpurchasingpowerparitywhichmaynotbethe

applicablemeasureforourcontext.However,aslongasthemeasurementerrorinour

pharmaceuticalpricevariableisorthogonaltoourinstrument,thedemandcharacteristics

ofothercountries,ourestimateswillnotsufferfromanymeasurementerrorrelatedbias.

                                                            26TheOECDrelativepharmaceuticalpriceindexreflectsfinalretailprices,orinotherwordsthetotalsocialcostofpharmaceuticals,whichincludeswholesalerandpharmacymarkupsandVATrates.DanzonandFurukawa’sindex(DiscountedAllMolecule‐Indication)reflectsmanufacturepricelevelsandwhichexcludesbothwholesalerandpharmacymarkups.

28 

 

FIGURE5:REALPHARMACEUTICALPRICES

TABLE3:SUMMARYSTATISTICS

Variable Obs Mean Std.Dev. Min Max

RealPharm.PriceIndex( )

210 1.08 0.21 0.57 1.60

PharmaceuticalProduction( )(10billion,USD2005)

144 1.96 3.39 0.02 18.65

GDPPerCapita(10thousands,USD2005)

210 2.60 1.06 0.53 5.63

Population(100million)

210 0.40 0.65 0.003 3.04

NotesonFigure5andTable3:

TheRealPharmaceuticalPriceindexisscaledacrosscountriesusingOECDrelativepricesasdiscussedinSection3.2.2.

29 

 

Thehealthcareexpenditure,GDPandpopulationdatacomesfromtheWorldBank

DatabankwhilethepharmaceuticalexpendituredataiscompiledfromtheOECDiLibrary.

Pharmaceuticalexpendituresarecomputedastheproductof:pharmaceuticalexpenditures

asapercentageoftotalhealthexpenditures;totalhealthexpendituresasapercentageof

GDP;andrealGDP(measuredinconstantUSD)27.

TheproductiondatacomesfromcomesfromtheUNIndustrialStatisticsDatabase

(INDSTAT42010ISICRev.3).Productiondataisavailableforonly19outofthe21

countriesdiscussedpreviouslyovertheperiod1999‐200628.Onepotentialissueisthat

howproductionisvaluedacrosscountriespotentiallydiffersintermsofwhetheritis

valuedatproducer’spricesorfactorprices.Thismeasurementerrorcouldresultin

potentialbias.Further,itislikelythatthemeasurementerroriscorrelatedacrosstime;

consequentlyourinstrumentalvariablesstrategydoeslittletomitigatethisissue.Provided

thatthemeasurementerrorisclassical,ourestimateof maysufferfromanattenuation

bias.

3.2.3EstimationResults

Table4indicatesourestimationresultscorrespondingtoequation(5).Columns(1)‐

(3)reporttheresultsoftheregressionofpharmaceuticalpricesontheweightedsumof

otherprices, ,,GDPpercapita,andpopulation.Pharmaceuticaloutputis

includedasanadditionalregressorinthespecificationsreportedincolumns(4)‐(6).We

reportspecificationswithandwithoutpharmaceuticaloutputasincludingpharmaceutical

outputlimitsthesizeandtimespanofourdataset.Incolumns(4)and(6),weinstrument

fortheweightedsumofprices, ,usingtheweightedsumofothercountry

                                                            27DataonpharmaceuticalexpendituresasapercentageoftotalhealthexpendituresislinearlyinterpolatedforPortugalandtheUnitedKingdomintheyear1999,theNetherlandsinyears2003‐2006,andBelgiuminyears1999‐2002.

28ProductiondataisunavailableforJapanandtheUnitedKingdomintheyear2006,SlovakiaandBelgiumintheyear2002,Irelandintheyear2004,andCanadainyears2004‐2006.Thesedatapointsaretreatedasmissingobservationsinspecifications(4)‐(6),butarestillincludedintheterms when

productiondataisunavailable. 

30 

 

populationandGDPpercapitacovariates.Wealsoinstrumentforpharmaceuticaloutput

usinglaggedpharmaceuticaloutputincolumn(6).

Theresultsofallsixspecificationsindicatethatpharmaceuticalpricesacross

countriesarestrategicsubstitutes.Thecoefficient, ,fortheweightedsumofother

countriesprices,isnegativeandstatisticallysignificantattheeither5%or1%levelineach

regression.Theresultsfromcolumn(1)canbeinterpretedasfollows:foraparticular

country,anexogenous$100billiondollarincreaseinglobalpharmaceuticalexpenditures,

,iscorrelatedwitha0.081unitdecreaseinthecountry’sabsolutepriceindex.

Sincethescaleofthepriceindexissomewhatarbitrary,itisusefultonotethata0.081unit

decreaseinthepriceindexcorrespondstoaroughly7.9%29decrease.Giventhe

aforementionedendogeneityconcerns,if and 30we

wouldexpectourOLSestimatesof tobebiasedupwards.WhencomparingtheIV

regression(3)totheOLSregression(2)andtheIVregression(6)totheOLSregression(5),

isindeedhigherintheOLSspecifications.

ThemodeldevelopedinSection2suggeststhatpharmaceuticalpricesanddomestic

pharmaceuticalproductionshouldbepositivelyrelated.Whencontrollingforcountryfixed

effects,ourestimateofproductioneffects, ,ispositiveandsignificantatthe1%levelin

bothspecifications.Theestimateof incolumn(6)canberoughlyinterpretedasa$10

billionexogenousincreaseinacountry’spharmaceuticalproductioniscorrelatedwitha

0.08unitincreaseinacountry’spriceindexlevelwhichcorrespondstoa7.8%decreasein

prices.Theinclusionofdomesticpharmaceuticalproductionismotivatedfromour

theoreticalresultsregardingdomesticprofitsharesandisusedasaproxyvariable.If

domesticproductionisapoorproxyfordomesticprofitshares(andpotentiallycountries

maynototherwisevaluedomesticproduction),ourestimatescouldsufferfroma

measurementerrorbias.Providedthatthemeasurementerrorisclassical,ourestimatesof

                                                            29Thepercentagechangeestimateandallprecedingpercentagechangecalculationsarecalculatedatthemeanpricelevelinthesample,1.02.

30 representstheresidualfromtheregressionof on and .

31 

 

couldsufferfromattenuationbias.Consequently,wemaybeunderestimatingthe

domesticsupplyeffectonpharmaceuticalprices.

Ourtheoreticalmodelsuggeststhatthedemand,populationandGDPpercapitaare

relevantfactorsinacountry’spricesettingdecision.However,ourtheoryonlyindicates

thatprofits,notnecessarilypriceswillbepositivelycorrelatedwithGDPpercapitaand

population.TheempiricalestimatessuggestboththatGDPpercapitaandpopulationare

relevantpricesettingfactorsandthattheoptimalprofitlevelisincreasinginGDPper

capitaandpopulationsize.TheGDPpercapitacoefficientestimateispositiveand

significantinfourofthesixspecifications.Further,themagnitudesoftheGDPpercapita

coefficientestimatesseemintuitivelyplausible.Theresultsfromcolumn(1)suggestthata

1,000increaseinGDPpercapitaiscorrelatedwitharoughly0.01unit(1.0%change)in

pharmaceuticalprices.

Therelationshipbetweenpopulationsizeandpharmaceuticalpricesislessclear

thantherelationshipbetweenGDPpercapitaandprices.Thepopulationcoefficientis

positiveintwoofthespecificationswhilenegativeandstatisticallysignificantintwoofthe

otherspecifications.Theresultsfromcolumn(5)canbeinterpretedasa10million

increaseincountry’spopulationsizeisassociatedwitha0.24unit(23.5%)decreaseinthe

pricelevel.Eventhoughthepricecoefficientisnegative,thatdoesnotimplythatan

increaseinpopulationsizeleadstoadecreaseinprofits.Forexample,supposeacountry’s

populationexogenouslyincreasesfrom$29millionto$30millionpeople.Ourestimates

implythepricelevelwilldecreaseby2.35%asaresultoftheshiftinpopulation.

Concurrently,thequantityofpharmaceuticalsconsumedwillincreaseduetotheshiftin

population.Providedthatthequantityofpharmaceuticalsconsumedpercapitadoesnot

changeasaresultoftheshiftinpopulation,profitswillincreaseoverallby1%.

32 

 

TABLE4:ESTIMATIONRESULTS

VARIABLES (1) (2) (3) (4) (5) (6)

‐0.81*** ‐0.50*** ‐0.58** ‐0.63** ‐0.83*** ‐0.89***

(0.23) (0.18) (0.24) (0.28) (0.18) (0.22)

‐0.02 0.06*** 0.08***

(0.01) (0.01) (0.02)

GDPPerCapita 0.01*** ‐0.00 ‐0.00 0.02*** 0.02** 0.01** (0.00) (0.01) (0.01) (0.00) (0.01) (0.01)

Population ‐0.03 0.10 0.01 0.05 ‐2.37*** ‐3.27*** (0.02) (0.25) (0.30) (0.07) (0.63) (0.74)

Constant 1.11*** 1.26*** 1.31*** 0.94*** 1.17*** 1.29*** (0.11) (0.08) (0.10) (0.12) (0.12) (0.15)

IV X XFixedEffects X X X XObservations 210 210 189 144 144 122R‐squared 0.369 0.913 0.918 0.534 0.949 0.949

NotesonTable4 One,twoandthreestarsindicatesignificanceat10,5and1percentlevels. TheRealPharmaceuticalPriceindexisscaledacrosscountriesusingOECDrelativepricesas

discussedinSection3.2.2.

Inspecification(3)and(6)weinstrumentfor usingtheweighted(weightslaggedby

oneyear)sumofothercountrycovariates(populationandGDPpercapita).Specification(6)alsouseslaggedpharmaceuticaloutputasaninstrumentforpharmaceuticaloutput.

Populationismeasuredin100millionpeople,GDPPerCapitaismeasuredin10thousands(2005USD),andpharmaceuticaloutputismeasuredin10billions(2005USD)

Theweights correspondtothequantityofpharmaceuticalsconsumedincountryjattimetin

termsoftrillionsdollars(2005USD).Wealsoconstructweightsusingpopulationandincomesharesandfindquantitativelysimilarresults.

Specifications(3)and(6)wereestimatedusingtwostageleastsquares.ThecorrespondingF‐statisticsforeachfirststageregressionexceed100.FollowingSargantestofoveridentifyingrestrictions(1958),wefailtorejectthenullhypothesisofexogeneityatthe1%levelinspecification(3),andfailtorejectthenullhypothesisofexogeneityatthe10%levelinspecification(6).

Asarobustnesscheckwere‐estimatethemodelusingalternativepharmaceuticalpricingdatafromDanzonand Furukawa’s(2003).Further,weestimatealternativespecifications(suchasincludingatimetrend)andalsore‐estimatethemodelusinganunbalancedpanelcovering26OECDcountriesovertheperiod1996‐2010.Ultimately,wefindquantitativelysimilarresultsineachrobustnesscheck.

33 

 

Asdiscussed,theIVestimatesdisplayedincolumns(3)and(6)relyonour

instrumentssatisfyingtherelevanceandexogeneitycriteria.TheF‐statisticscorresponding

tothefirststageregressionsexceed100ineachofthethreefirststageregressions.As

therearetwoendogenousvariablesinspecification(6),examiningtheF‐statisticfromthe

firststageregressionsispotentiallymisleadingintermsofassessingtheinstrument

relevancycondition.Asafurthercheck,wefindthattheSheapartial exceeds0.55for

eachendogenousvariableinspecification(6).Sincethenumberofinstrumentsexceedsthe

numberofendogenousvariablesinbothspecification(3)and(6)wetestthe

overidentifyingrestriction.FollowingtheSargan(1958)test,wefailtorejectthenull

hypothesisofexogeneityatthe10%levelinthefullspecificationincolumn(6)31.

Combinedwiththeprecedingtheoreticaljustification,wefindextensiveevidence

suggestingthatboththeexogeneityandrelevancyconditionshold.

WerunseveralrobustnesscheckstoassessthevalidityofourestimatesinTable4.

Giventheaforementionedconcernsregardingthepharmaceuticalpricedata,were‐

estimatethemodelafterfirstre‐scalingourrelativepharmaceuticalpriceindexacross

countriesusingDanzonandFurukawa’s(2003)cross‐countryrelativepriceindex.Wefind

quantitativelysimilarresultsintermsoflevelsandsignificance,especiallywithregardsto

theparametersofinterest and .There‐scaledestimatesofourpreferredspecification

(Column6ofTable4)arestatisticallyindistinguishablefromouroriginalestimates.We

alsofindquantitativelysimilarresultswhentryalternativespecifications(suchas

includingtimetrends,takinglogs,etc.)andwhenusinganexpandedunbalancedpaneldata

setcovering26countriesovertheperiod1996‐2010.

Theempiricalfindingsarein‐linewiththosefromthetheoreticalmodel.Wefind

thatpricesarestrategicsubstitutesamongstcountriesandsomelimitedevidence

suggestingthatpricesarehigherincountrieswithhigherdemandforpharmaceuticals.It

shouldbenotedthatitwouldbeamistaketointerprettheestimatedcoefficientstoo

                                                            31Wealsofailtorejectthenullhypothesisofexogeneityatthe1%levelinspecification(3).

34 

 

literally.Thefirstordercondition(3)indicatesthattherelationshipbetweencountrykand

countryj‘spricesquitepossiblynon‐linearandheterogeneous;however,weestimatea

linearreactionfunctionassimpletestforstrategicsubstitutability.Althoughtheexact

reactionfunctionremainstobedetermined,understandingthedirectioninwhichcountry

krespondstopricereformincountryjhasimportantpolicyimplications.

3.3BRICSandtheFutureofWorldReturns

Thissectiondiscusseshowtousetheestimatedeffectsofstrategicsubstitutability

inreimbursement,whetherinpharmaceuticalsashereorinothermarkets,toestimatethe

impactofgrowingworlddemandonworldreturns.Usingourestimates,weprojecthow

thehealthcareandpharmaceuticalexpendituregrowthinBRICSwillimpactworld

returnstomedicalinnovation.

ConsiderthetworegioncasewithCountry1(BRICS)andCountry2(US).TotalNash

equilibriumworldreturnsare

   

OurearlieranalysisindicatedthatfutureBRICSincomegrowthshouldleadtoanincrease

indemandforhealthcareandanincreaseinBRICSreturnsaswellastotalworldreturns.

   

Fromourpreviousanalysisweshowedthatpricesarestrategicsubstitutes.Thus,total

returnswillincreaseduetothedirectdemandgrowthfromtheBRICScountriesbutwill

increasebylessthanthatdirectresponseduetothedecreaseinprofitprovisionfromthe

US

SupposetheincreaseindemandfromtheBRICScountriesisassociatedwithashift

inproductionandprofitsharesfromtheUStoBRICSsuch .Thechangeinprofit

sharesofBRICSresultsinanincreaseinprofitprovisionofBRICSbutadecreaseinUS

profitprovision.

35 

 

   

Thenetimpactofashiftinprofitsharesonaggregateprofitsisthusambiguous.Putting

thesetworesultstogethertheanticipatedshiftinBRICSdemandandprofitsharesleadsto

anetincreaseordecreaseinworldinnovation.

Somesimplebackoftheenvelopecalculationsareusefulinillustratingthe

magnitudesofthetradeoffsinvolved.Inyear2010,totalworldhealthcarespendingwas

$4.3trillion,ofwhich7%percentwasfromBRICScountries.Nowconsideraprojected

two‐foldincreaseinrevenuesforBRICScountriesby201632.Bothourtheoreticaland

empiricalanalysisindicatesthatnon‐BRICScountrieswillrespondtothegrowthinBRICS

byloweringtheirdomesticreimbursements.Ifnon‐BRICScountriesweretorespondtothe

100%increaseinBRICSrevenuesbyloweringreimbursementsbyamere7.5%,world

revenueswoulddeclineoverall.ThefactthatUSandothercountriescurrentlydominate

worldreturnsmeansthatmarkupsreductionsneedtobefairlysmalltooffsetasubstantial

demandgrowthintheBRICS.

Ourempiricalanalysisestimatedacounty’sstrategicpriceresponsetoachangein

totalpharmaceuticalrevenuesaswellasitsowndemandfactors.Considertheprojected

two‐foldincreaseinpharmaceuticalrevenuesstemmingfromBRICScountriesbytheyear

2016.Theprojectedincreaseamountstoaroughly$100billionincreaseinpharmaceutical

expendituresfromBRICScountries.Ourmodelsuggeststhataportionandpotentiallyallof

theincreaseinpharmaceuticalexpenditurescouldbeoffsetbythestrategicpricing

responsesofrichercountriescurrentlydominatingthecontributiontoworldreturns.

Eachcountry’sstrategicresponsetoanoutsideincreaseworldrevenues,

,isgivenby intheempiricalspecificationestimated(eq.5).Anexogenous

increaseinpharmaceuticalrevenuesisequivalenttotheterm, ,increasingby

                                                            32Thisisthesuggestedgrowthrateinindustrypublications,seee.g.IMSInstitute’s“TheGlobalUseofMedicinesOutlookThrough2016”

36 

 

$100billoninourempiricalmodel.Themodelestimatesindicatethata$100billion

increaseinpharmaceuticalrevenuesiscorrelatedwitharoughly0.089unitdecreaseina

country’spriceindexlevel,holdingallelseequal.Byaggregatingthepriceresponseacross

allcountriesandholdingquantitiesconstant,weareabletoestimatethehowmuchofthe

exogenousincreaseinpharmaceuticalrevenuesfromBRICScountrieswillpotentiallybe

offsetbystrategicpriceresponses.Letting denotethesetofBRICScountries,the

aggregateimpact,intermsofpharmaceuticalrevenues,ofthenon‐BRICScountries

strategicresponsetotheexogenousincreaseinBRICSrevenuesisgivenby:

   

where representstheexogenouschangeinglobalrevenuesfromtheBRICS

countrieswhichinthiscaseis$100billon.Sincequantitiesareassumedtoremain

constant,thechangeinprofitscorrespondsoneforonewithachangeinrevenues.Using

theestimate ,theabovecalculationimpliesthattheaggregatestrategicresponse

willberoughly‐$37billon.Inotherwords,a$100billionexogenousincreasein

pharmaceuticalrevenueswillbepartiallyoffsetbya$37billondecreaseinpharmaceutical

revenuesascountriesstrategicallyrespondbyloweringtheirpharmaceuticalprices.

The$37billionstrategicresponseshouldbethoughtofasanupperbound(interms

ofthemagnitudeoftheresponse)forseveralreasons.First,byfixingquantitiesweare

overstatingtheimpactdecreasingpharmaceuticalpriceswillhaveonpharmaceutical

revenues.Aspricesfall,thedeclineinrevenueswillbelessinpercentagetermsthanaone

forone.Thequantityofpharmaceuticalsdemandedwillincreaseaspricesfallwhichoffset

someofthecorrespondingdeclineinrevenues.Secondly,theaboveanalysisignores

secondarypriceresponses.Forexample,iftheUSknowsthatthestrategicresponseof

othercountrieswillpartiallyoffsettheexogenousincreaseworldpharmaceuticalrevenues,

theUSwillloweritspricesbyasmalleramountthanitwouldhaveotherwise.Regardless

oftheexactmagnitude,ourmodelindicatesthatasizeableamountofthepharmaceutical

37 

 

expendituregrowthstemmingfromtheBRICScountrieswillbeoffsetbythestrategic

responsesofothercountries.

Asdiscussedpreviously,theincreaseinBRICSmayalsobeassociatedwithashift

concentrationintheownershipofprofitswhichinadditiontodemandgrowthaffects

reimbursementpolicies.Considerwhen10%ofUSprofits(asrepresentedbyproductionin

ourempiricalanalysis)shiftstotheBRICScountriesoverthenextfewyears.The

theoreticalandempiricalresultspredictthatthisshiftwillresultinadecreaseinUSprices

andanincreaseinBRICSprices.Figures6and7illustratetheestimatedimpactBRICS

growthwillhaveonfuturepharmaceuticalandtotalhealthcarerevenueswhenproduction

shiftsfromtheUStotheBRICScountries.Usingdatafromthepharmaceuticalsector,in

section3.2weestimatethatforevery$1increaseinBRICSpharmaceuticalspendingleads

toonlyanincreaseof$0.63inintotalpharmaceuticalrevenues.InFigures6and7we

analyzetheimplicationsofthisoffsetassumingitextendedtooverallhealthcare

reimbursementsaswellasforpharmaceuticalsalone.Theseparateimpactofthe

productionshiftonworldreturnsiscalculatedwiththeestimate fromthe

precedinganalysisofpharmaceuticalpricing.AsBRICScountriesrepresent15%ofthe

pharmaceuticalmarketandonly7%ofthetotalhealthcaremarket,anincreasetheBRICS

growth(inpercentageterms)hasamuchlargerimpactonthepharmaceuticalmarketthan

thetotalhealthcaremarket.Giventhe10%shiftinproduction,BRICShealthcare

(pharmaceutical)revenuegrowthwouldhavetoincreasebyover270%(126%)forworld

revenuestoincreaseoverall.Themainpointthesequantitativeeffectsimplyisthatwhen

bothdemandandsupplygrowthoccursthroughtheBRICS,reasonableparameterlevels

suggeststhatafall(asopposedtoarise)inworldreturnsmayresult.

38 

 

FIGURE6:FUTUREWORLDRETURNS(TOTALHEALTHCARE)

FIGURE7:FUTUREWORLDRETURNS(PHARMACEUTICALS)

39 

 

ThesequantitativeeffectssuggestthatdemandgrowthinBRICScountrieshasthe

potentialtoexpandpharmaceuticalreturnsandconsequentlystimulatefurthermedical

innovations.However,thestrategicresponsesofexistingdevelopedcountriescouldlargely

offsetandevendecreaseworldreturnstoinnovationandthelargerspendinggrowthit

mayentail.Thisisespeciallytrueiftheexpectedincreaseindemandisaccompaniedbya

shiftinownershiptotheBRICS.

4.ConclusionsandFurtherResearch

Becauseworldreturnsdriveinnovationandbecauseinnovationiscentraltohealth

carespendinggrowth,healthcareeconomiesandpoliciesofothercountriesthereby

drasticallyaffectdomesticspendinggrowth.Thispaperanalyzedtheuniquepositiveand

normativeimplicationsoftheseinnovation‐inducedlinkagesacrosscountrieswhen

governmentscentrallypricehealthcare.Westressedtheimplicationsoftheinherent

public‐goodsprobleminprovidingworldreturnswhentaxationtofundreimbursements

involvesadomesticcostwithaninternationalbenefit.Becauseofthispublic‐goods

problem,medicalinnovationshaveinefficientlylowworldreturns,andreimbursements

werepredictedtobe“strategicsubstitutes.”Wearguedthatthepublic‐goodsaspectof

medicalinnovationcreatesasignificantconcernintheconcentrationofworlddemandand

supply.Weprovidedanempiricalanalysisoftheeffectsofthefuturedeclineinthis

concentrationonworldreturnsbyconsideringtheplausibleconditionsunderwhichfuture

growthoftheBRICSmaylowerworldreturns.

Weconcludebydiscussingsomeoftheimplicationsofouranalysisaswellasfuture

areasofresearch.

4.1DomesticandRegionalHealthCareReforms

Ouranalysisimpliesthathealthcarereformsthataimtocurbspendinggrowthwill

havedifferenteffects,dependingonacountry’simportanceforworldreturns.Put

differently,reformsinsmallcountrieswillnotaffectspendinggrowthratesinducedby

40 

 

innovation,althoughUSreformswill.Forthesamereason,usingUSstatesas“laboratories

forreform”doesnotcaptureinnovationorgrowtheffectsbecauseindividualstatesdonot

affectworldreturns.Forexample,eventhoughreformsinMassachusettsweresimilarto

thefederalAffordableCareAct(ACA)reforms,thelessonslearnedabouttheimpacton

growthofspendingareminimalifthatstatedoesnotaffectworldreturns.Likewise,the

manyregionalpaymentdemonstrationexperimentsthatACAisfinancingdonotaddress

spendinggrowthinducedbyworldreturnstoinnovation.Rather,differencesintechnology

adoptionproceduresappeartobeakeyfactoraffectingregionalspendinggrowthinthe

faceofworldreturnsdrivingcommoninnovationsacrosscountries.Indeed,ouranalysis

impliesthatsubnationalorregionalreimbursementlevelswillbelowerthannationalones.

Forexample,stateMedicaidprogramsarepredicted,asobserved,topricebelowthe

federalMedicareprogramintheUnitedStates,eventhoughMedicareclearlyisabigger

buyerwithlargerbargainingpower.Futureresearchshouldinvestigatetheimpactof

regionalversusnationalpublicreimbursementpolicies.

4.2InternationalSpendingLevelsandGrowthRates

Ouranalysiscanbedevelopedfurthertoexamineinternationalspendingpatterns

acrosscountries,particularlyasthosespendingpatternsareoftenattributableto

differencesinpricingratherthanuse.Ifinnovationisapublicgoodthatdrivesspending

growthandisusedbyeveryone,itsuggestslessvarianceingrowthratesacrosscountries

thanthatinlevelsduetothedifferentialmarkupincentivesdiscussed.Moregenerally,a

betterunderstandingoftheincentivesthatdeterminethegrowthinreimbursementsover

timeimpliedbyouranalysis,ratherthanthelevelsanalyzedhere,seemsausefulavenueof

research.

4.3AnEvaluationofDomesticUnderpricingthroughExistingPricingRegimes

Sinceefficientworldpricingcanbeviewedasaclassicpublic‐goodsproblem,

standardremediestoavoidfreeridinginprovidingpublicgoodsseemrelevant.Asis

commonunderpositiveexternaleffects,thebehaviorofinterestisunderprovided,and

efficiencygainscanbeachievedwithPigouviansubsidiesthataimtoequatethedomestic

41 

 

costsofmarkupprovisionprovidingtheworld’sbenefitintermsofgeneratingnew

innovations.Evaluatingtheefficiencyeffectsofinternationalreimbursementreformsin

thiscontextseemstobeworthwhile.Inparticular,morecentralizedEuropeanUnion(EU)

pricingmayraiseinnovativereturnsratherthantheseparatedomesticpricingby

individualcountries.Thiswouldbethereimbursementanalogtothemoreadvanced

EuropeanMedicinesAgency(EMA)harmonizationforapprovalprocessesintheEU.If

countriesunifiedtheirreimbursementdecisions,itmightraisepricestomoreefficient

levels.Theobviouscounterargumentisthatalargerbuyerforcesdownpricesmore,butas

wehaveshown,thatisnotalwaysthecase.Smallercountriesarefreeridingmore,inan

individuallyoptimalmanner,bykeepingreimbursementslow.

4.4PersonalizedMedicine

Manyanalystshavearguedthatpersonalizedmedicinesandorphandrugsarelikely

toreducemarketsizefortherapies.Clearly,thegrowthofworldmarkets,inparticular,the

BRICS,maywellsubstantiallyincreasetheuseofdomesticorphandrugsinaworldmarket,

thusaggregatingtheorphanstatuswithineachcountryacrossnew,largeeconomiessuch

astheBRICS.However,thefree‐ridingincentivesdiscussedheremitigatethepositive

impactonworldreturns.Avaluablecourseofresearchmaylieininvestigatingthedegree

towhichemergingmarketsaffecttheincentivesforinnovationofrarediseasesor

personalizedmedicines,oftenarguedtobeplaguedbylowinnovationincentivesdueto

smallmarketsize.

Overall,morequantitativeanalysisisneededconcerningtheimpactofinnovation‐

inducedlinkagesacrosshealthcareeconomies,bothforpositiveanalysistoexplain

differencesinreimbursementsandspendingandfornormativeanalysisofwhatpolicies

functioninagivencountry’sself‐interest.

42 

 

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Appendix:ImpactofaChangeinOwnershiponTotalProfits

Considerthetwocountryexamplewithcountries1and2wheretheownership

shareofCountry1increasesby andtheownershipshareofCountry2correspondingly

decreasesby .Werewritefirstordercondition(3)asfollows(wherethe

demandargumentsofconsumersurplusareomittedforconvenience):

   

Totallydifferentiatingtheaboveequationyields

     

Forconveniencewedefinetheterms and suchthattheabovetotaldifferentialcan

berewrittenas

    

Rearrangingtheaboveequation,wehavethat

      

Bysymmetry,andnotingthat ,wecansubstituteinfor intheaboveequation

andsolvefor .

   

Where and correspondtotheterms and definedforCountry2ratherthan

Country1.

Thechangeintotalequilibriumprofits,resultingfromachangeinprofitsisequalto

45 

 

    

Thesignthusdependsonthelevelsandcurvaturesofthesocialcostandprobabilityof

innovationfunctions.InthesimpleparametricexamplediscussedinSection2,itis

straightforwardtogeneratecasesinwhichachangeinprofitsharesincreasestotalprofits,

decreasestotalprofits,anddoesnotchangetotalprofits.