What Price Innovation? | EDITORIAL |
BY JOHN MCCORMICK, MARCH 21, 2005
I was struck by economist Paul Krugman's article "America's Senior Moment" in the most recent New York Review of Books. In the article Krugman assails the Bush Administration's push for social security "privatization" with the fervor of a campus radical, but he saves his formidable lucidity for Medicare, Medicaid and the overall healthcare challenge.
Krugman points out that the increasing share of healthcare spending as a percentage of GDP is actually no cause for alarm. The trend neither reflects runaway government spending nor the ravages of medical cost inflation. Not even well known industry blemishes such as price gouging [in big pharma] or waste are noteworthy independent variables. In fact, Krugman asserts that private healthcare expenditures are a significant driver of these apparent costs to society. He relies on some provocative data to back this up. According to the article, in 1980 private healthcare spending was 5% of GDP and government health spending was 3.8% of GDP, but in 2003 these numbers were 8.3% and 7.0% respectively.
Krugman is not alone in supporting these arguments. In fact he found an interesting tidbit in a recent Congressional Budget Office report that forecasts increases in healthcare spending as a percentage of GDP for years to come. The report states:
"Although the rise in health care costs is a serious concern for many policymakers, it largely reflects private choices... As income rises, consumers may prefer to allocate a larger share of their resources to healthcare and a smaller share to other goods and services." www.cbo.gov
His ultimate thesis as to why private expenditures are the driver of healthcare costs rising as a percent of GDP is nothing short of stunning and is potentially encouraging news for our industry. Krugman states that "the main reason health care is continuing to absorb a larger share of the economy is innovation: that the range of things that medicine can do keeps increasing." He goes on to make the case that if healthcare spending is being driven by technology opportunities then dedicating a larger share of the economy to healthcare may not necessarily be a bad thing.
Mulling over these points helped me extend my understanding as to how the orthopedic medical device industry can deliver such substantial gross margins year after year. Patent protection has never been the answer in my book. Although patents theoretically award a company monopoly status and outsized margins, I find this explanation falls flat on its face in areas of the industry such as hip and knee replacements where companies compete head to head with similar products and still have substantial margins. Certainly one aspect of the industry's attractive gross margins is the requirement to support a sophisticated distribution mechanism. The industry can't just pull teenagers out of McDonald's and tell them to go train surgeons on percutaneous vertebral compression fracture repairs. Supporting premium sales and training infrastructure does not fully explain the industry's gross margins, however. The real answer is, in fact, the very innovation Krugman is alluding to.
The orthopedic medical device industry requires substantial gross margins to support innovation and meet the private sector demands and preferences that are the real drivers of the healthcare economy. If government spending was the principal driver of healthcare spending it is doubtful that it would demand the kind of innovations patients really need. If government has trouble hiring a decent architect when it needs a stately building, how is government going to drive innovation in alleviating a complex phenomenon like back pain? Looking at the Rubik's Cube from another angle, if government was overpaying for orthopedic implants the industry would have no incentive to innovate. We seriously doubt that innovations like arthroscopic surgery, kyphoplasty and coblation came to life due to excessive government payouts. In fact, such new innovations have historically had to fight (and are still fighting!) for reasonable reimbursement status.
Gross margins in the industry are, in fact, indicative of a well functioning market where patient demand is driving innovation. Witness the recent direct to consumer artificial hip advertising by Johnson & Johnson (DePuy). Patients are now actively looking for ceramic hips and are even willing to pay up for an artificial lumbar disc despite the lack of CMS support. Why? For the price of a used car, a patient can get their lives back with an implant that lasts decades. This kind of patient demand and private sector support endorses meaningful gross margins which are critical to allowing research and development teams to innovate which, in turn, supports better patient outcomes in the long run.
In fact, industry gross margins support innovation through two additional subtle, but very important mechanisms: (i) the "Innovators Dilemma" and (ii) attracting venture capital. Nearly a decade ago, Harvard Business School professor Clayton Christensen produced a critically acclaimed book called "The Innovators Dilemma" which noted that disruptive technologies breed their own demise because they attract followers. Even if you are king of the hill and own an earth shattering orthopedic device technology, you should sleep with one eye open because someone is going to find a way to develop a similar (even non-infringing) device with related or even superlative properties. Substantial gross margins on device revenues are essential for keeping this ecosystem of innovation well nourished.
Finally, high gross margins support industry innovation by attracting venture capital to the industry. Greed is good for patients. Imagine if Medicare implemented artificially low gross profit margins in the industry. Fresh capital would not come to the industry, companies would have no incentive to innovate and VCs would not earnestly seek out docs with extraordinary inventions and patients would ultimately suffer.
In conclusion, Krugman's comments lend perspective to why the orthopedic medical device industry should be rewarded for its innovations. In simple terms, the private sector is willing to pay for it because patients know best. No one should therefore be alarmed if healthcare costs continue to rise. After all, it's the market - the collective will of our society - that is ultimately paying for it and receiving the benefits.
