In most markets, the price system, or what Adam Smith called “the invisible hand,” drives efficient allocation of resources. The basic idea is simple: consumers make choices—votes with their dollars for the prices they are willing to pay. Consumer “willingness to pay” conveys to manufacturers the value they place on different resources, and this creates an incentive for manufacturers to align their prices with how much consumers are willing to pay. Market prices assure efficient resource allocation only if consumers are well informed, consumers face the full social costs of services (there are no externalities), and the population distribution of consumer income is appropriate or balanced. In this type of well-functioning price system there would be no need to study cost-effectiveness.

With health insurance in place, however, prices are not constrained by consumer willingness to pay. Health insurance exists for a very good reason: to protect us from financial risk that might otherwise be economically catastrophic. In this sense, it is extremely valuable. But insurance undermines patient price sensitivity and leads to “moral hazard” that drives higher volumes and prices of services. Systems of consumer co-payment and cost sharing can mitigate moral hazard, but for many services the cost shares are relatively low as a percent of total cost, and stop-loss measures are in place as an upper limit on a patient’s cost share. Therefore, these mechanisms are limited in their ability to sensitize patients to costs.

Less widely studied than moral hazard is the effect of insurance on producer pricing. On the consumer demand curve for medical care with no insurance in place, consumers use fewer services because they pay higher prices. In that situation, a manufacturer would charge a price (P1; see Figure 5-1) based on the intersection of the marginal revenue and marginal cost curves. When consumers are given insurance coverage with a 50 percent coinsurance rate, the manufacturer’s price can be twice as high, as far as the consumer is concerned, because the consumer is only paying half the total price. With this 50 percent coinsurance or co-pay, the manufacturer’s price would increase (P2), and a higher quantity (Q2 compared to Q1) can be sold because consumers pay less of the price. If this is what happens with a 50 percent coinsurance rate, imagine what happens with standard coinsurance products that require consumers to pay a fixed amount or cost percentage on the order of 20 percent or $25. In that situation, the profit-maximizing price would be even higher. To prevent this, most insurance companies include rules and constraints that try to influence this price elasticity of demand—the price sensitivity. From the standpoint of pharmaceutical manufacturers, determining the market price sensitivity can be difficult

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