South-Western College Publishing - Economics  
Just Say No To Drugs
Subject Profit Maximization
Topic Production and Costs
Key Words Incentives, spending, budget, fee
News Story

In the face of rising drug prices, insurance companies are increasingly giving doctor groups incentives to reduce their spending on drugs. Typically, doctors are given a fixed budget - calculated by multiplying a per capita fee of anything from $9 to $15 per person by the number of patients - and they have to fund all prescriptions out of that money. If they succeed, they can keep the money that remains. If they do not, then they have to incur the loss. The companies believe that doctors will behave as stakeholders in the process, reducing unnecessary tests, prescribing generic drugs, and keeping patients healthy. The incentive works in a similar manner to the capitation fee that doctors receive for each patient on their roster, regardless of the number of visits.

Some doctors' groups have spent more than their drug budgets because their patients have severe chronic illnesses such as cancer, diabetes, hypertension and depression, which require medications. The alternative is to behave unethically and deprive patients of necessary medical care. Some states like Texas have passed laws that prevent insurance companies from using financial incentives to limit medically necessary services.

(Updated December 1, 1999)

Questions
1. Draw the marginal cost and average total cost curves for a doctors' practice. Draw the price line assuming that the insurance company pays a fixed fee.
  a) If the practice wants to maximize profits, show the number of patients it would choose to serve. Which patients would it choose to exclude?
  b) If the practice cannot affect the roster of patients, it may not be in equilibrium. Show such a point on your diagram. How might the practice try and reach an equilibrium point? How would the curves be affected?
2. Draw a second diagram of the practice's costs and the price received.
  a) Drug prices are rising quickly. Show how the cost curves are affected.
  b) What happens to the profit of the practice, other things being equal?
  c) How might the doctors in the practice respond?
Source Julie Appleby, "Prescription for problems," USA Today, September 23, 1999.

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