Drug Re-importation, a Fallacy

One of the many fallacies that accompanies the question of drug re-importation is the idea that low drug prices in foreign markets harm American consumers.

I will attempt to briefly demonstrate that this is not the case.

For simplicity, assume a monopoly supplier of a patented prescription drug selling into a free American market with a zero marginal cost of production. Also assume that the supplier sells directly to consumers. These assumptions are not true, especially that of a free American market, but the conclusions should not be fundamentally affected.

In the American market, the monopoly supplier will attempt to price so as to maximize his profits or minimize his losses. Since we are assuming a negligible marginal cost of production, the price that maximizes profits is also the price that maximizes revenues. For a sufficiently high price, say PHIGH, there will be no demand and, therefore, no revenue. For a price of zero, there will be lots of demand, but again, no revenue. Somewhere in between a price of zero and a price of PHIGH there must exist at least one price, call it PMAX, which produces a maximum amount of revenue. This is exactly the same argument that results in the Laffer curve for tax rates and tax revenue.

The drug supplier will attempt to set his price at PMAX, to maximize both revenues and profits. Just to be clear, we are not talking here about accounting profits, which would have to take into account all sorts of non-marginal costs and sunk costs, which are not relevant for current pricing. What does determine pricing is the supplier's estimation of how consumers would modulate their demand as price is changed. The point of maximum revenue is also the point at which the price elasticity of demand is unity. Above this point a given percentage increase in price will result in a larger percentage reduction in unit demand, producing a lower level of total revenue.

At this point we have said nothing about foreign markets, and the price is entirely determined by a supplier's estimation of what the shape and level of the consumer price/demand curve is that he faces. He is guaranteed to be wrong in his estimation, but whether he is too high or too low in his estimation of PMAX, in either case he will leave money on the table.

Now assume that other markets exist in Liberia and Canada. IF,and this is a big IF, the supplier is allowed to write legally and effectively enforceable sales contracts that prohibit the re-export of drugs, then the supplier is able to enforce price discrimination in the three isolated markets. In this case, the same pricing mechanism as detailed above will be applied separately in each of the three markets, again assuming that all three markets are free.

We can expect that the revenue-maximizing price in LIberia will be very low, due to a low standard of living, possibly so low that the supplier will refrain from participating in the market at all. In Canada, [edited] the revenue-maximizing price may be somewhat higher or lower than that in the US. [edited] In any case, no mechanism has appeared that will obviously affect the price/demand curve in the isolated US market.

If the requirement for free markets in Liberia and Canada is taken away, nothing is really changed. The Liberian government is likely to pay what would be a higher than a Liberian market price for the drugs and distribute them free to its population. The Canadian government, on the other hand, will likely negotiate a lower than Canadian market price for drugs and pass on the savings to its client-citizens. In neither case are the US market or US consumers negatively impacted.

What needs to be clear is that the decade-long development costs of drugs have nothing to do with their current market prices. These are sunk costs, best recovered in whole or in part by maximizing current profits and revenues, independent as to whether a full historical accounting shows a profit or a loss.

Far from harming US consumers, the isolated foreign markets make at least incremental additions to the recovery of development costs. It is the possible promise of those revenue additions that help bias future development decisions towards proceeding, resulting in a higher probability of valuable drugs.

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I imagine that if enough

I imagine that if enough senior citizens get on buses and smuggle the drugs back to America the supplier might re-think the values of PMAX in America and in Canada. Enough smuggling could cause a scarcity in Canada.

Don, The problem with your

Don,

The problem with your argument is that you are assuming away the very thing you are arguing against! I don't think anyone would argue that in a case of a completely effective ban on re-importation, low drug prices in other countries do not harm American consumers. Of course they don't! The markets are entirely separate from each other.

Of course, without this assumption, there is a strong case that can be made against low drug prices in other countries. The American consumer would in effect be subsidizing other markets, and consumers in these other markets could commit arbitrage by reselling the product back to American consumers.

One other factor that should be noted here: pharmaceutical companies benefit greatly from re-importation restrictions. This restrictions are enforced, and therefore subsidized by the government, and vicariously, the taxpayers. Without this subsidy, it is unlikely that pharmaceutical companies would be able to price discriminate to the extent they do now.

Drug research and production is perhaps the most difficult area of intellectual property to challenge. Most of us agree that there is considerable benefit flowing from drug research (witness our much longer life-spans relative to people living a century ago. But as you said, the marginal cost of drug production, once it is discovered, is close to zero. Therefore, the socially optimal price to charge is also zero, because all costs are sunk. Of course, if this was the actually the case, no one would have spent any money on drug research in the first place. This makes it very difficult for economists to calculate the costs and benefits associated with pharmaceuticals.

Also, Jonathan told me that you are at least partly an Austrian. Don't Austrians reject the existence of demand curves insofar as individual's demand curves cannot be calculated or aggregated?

Bill, I don't think that

Bill,

I don't think that re-importation by individual consumers is a problem, or at least not a long lasting one. If someone is willing to go to all that trouble and expense, then it is unlikely that they would have been a significant part of the US market in the first place. This means that they are part of the Canadian market, adding incremental revenues. The Canadians might eventually complain about Americans free-riding on their health system without paying the taxes, as well as stealing their supply of drugs.

Regards, Don

The problem with your

The problem with your argument is that you are assuming away the very thing you are arguing against! I don't think anyone would argue that in a case of a completely effective ban on re-importation, low drug prices in other countries do not harm American consumers. Of course they don't! The markets are entirely separate from each other.

It seems to me that that is exactly what people are arguing - that even with completely separate markets, people of other countries are 'free-riding' off American consumers. The very push for re-importation comes from this argument.

I hope I'm not misstating Don's argument, but he is saying that even with completely separate markets due to enforcable contracts banning re-importation, the American consumer gains. The marginal cost of production is essentially zero, and thus any extra revenues from additional markets help recoup sunk costs, which result in a greater incentive for future investment in drug research.

Don't Austrians reject the existence of demand curves insofar as individual's demand curves cannot be calculated or aggregated?

Austrians reject the ability to add one person's utility to another's. But demand curves surely exist (at least as a rough approximation of the market process). At a given price, a certain number of individuals are willing to give up their cash for the good. This is true for every price from zero to infinity.

Micha, What you missed is

Micha,

What you missed is that my argument has nothing to do with a legal ban on drug imports, but instead focuses on the ability of manufacturers to control the flow of their own product by contractual means. I see no way that the manufacturers will not be allowed to employ their WMD, the supply cutoff, as well as rcovering damages from breech of contract. A legal ban is needed rather to prevent counterfeiting, not only of drugs, but of goods in general. As far as individual consumers is concerned, I think that I have an almost full bottle of the generic Lisinopril, and can give you a good price as I decided to stay with the branded Zestril. Low level arbitrage is not likely to be of economic significance.

Price discrimination is difficult to undertake, and especially hard to come out ahead financially at. However, there is nothing inherently wrong with it. Everyday price discrimination includes supermarket coupons, discount loyalty cards and rotating supermarket sale prices.

As you yourself seem to realize, the idea of a social optimum being marginal cost pricing is nonsense. Wages can only be paid out of revenue and the lower prices are, the lower the marginal value product of workers, which limits their wages. To the extent that profits are outlawed, there will be no production. All of the benefits of competition result from potential competition from new entrants. The system has failed when actual competition arises, locks up resources in a profitless war and consolidation is prohibited.

It is not the function of economists to calculate costs and benefits, that is the function of entrepreneurs to embrace the difficulty and risk their own time and money.

The issue of Austrians and demand curves is with the unrealism of the infinite divisibility of goods and the idea of precise equality of supply and demand. There is no problem with counting up and aggregrating demand at a given price, but no continuous curves can result. There is no problem with demand curves being used as a visual tool of understanding, but they are not real.

Regards, Don

Don, I have no objection to

Don,

I have no objection to price discrimination.

I'm still not clear on the disagreement over demand curves between neoclassical economists and Austrians. Most neoclassical economists I have spoken with would agree that all demand curves are are a visual tool of understanding.

And I also disagree with the notion that it is not the proper role of economists to calculate costs and benefits. Economists are well trained at this task; for example, one of my econ professors serves on multiple boards of directors for large corporations, and she is often asked to advise the firms based upon the costs and benefits of certain opportunities, as well as the current market climate, with a roughly estimated demand curve necessary for this task.

Micha, Good. No one has a

Micha,

Good.

No one has a problem with the visual tool.It is the further mathematical uses that are invalid unless the curves are continuous and an actual intersection exists. For example, anything that involves a derivative cannot be applied to a non-continuous curve.

I will concede at least to the degree of admitting that economists do have some market value as consultants. Whether they earn their pay in results is another question. -g-

Regards, Don

One of my textbooks from

One of my textbooks from last semester specifically addressed the issue of taking derivatives from non-continuous demand curves. Unfortunately, it was one of my least interesting textbooks, so I returned it. I cannot recall the justification the author gave for doing so.

However, what is wrong with assuming that the demand curve in continuous, even when in "reality" it isn't? When economists do ordinary least-squares in order to estimate a demand curve from a series of empirical data points, a smooth curve may not exist in reality, but it seems to serve the necessary purposes and is a useful approximation for economic analysis.

Micha, From one of your

Micha,

From one of your references :

This is the basic idea of the equimarginal principle. Maximization occurs when the return on the last dollar spent is the same in all areas.

This is the kind of thing that results when imprecision is allowed to remain unchallenged. The equimarginal principle would only be true if goods and the size of the marginal quantities of goods demanded were infinitely divisible and infinitesimal respectively. This error is often compounded by claiming that the last purchase made is of no more than a marginal benefit, which is the result of misunderstanding the future-oriented character of money.

Regards, Don

Don, Again, I really don't

Don,

Again, I really don't understand the objection. True, in order for marginalism to work perfectly, goods must be infinitely divisible. But so what? The principle is still easy enough to understand, tremendously important, and useful.

I'm no physicist, but from the little knowledge of physics I have, it seems to me that physicists do the same thing. They make assumptions in order to make problems easier to solve. The assumptions may not ever hold perfectly true in the real world, but they are close enough to be useful.

This is the part of Austrianism I've never understood. Why critize neoclassical economics for imperfections when nearly everyone else does not accept the axioms upon which Austrian economics depends?

Micha, A flat earth theory

Micha,

A flat earth theory is adequate for a lot of day to day living, but it likely precludes satellite television.

Truth is not a matter for concensus, or majority vote. Austrian theory will survive or fail based on the degree to which it reflects economic reality, but this is an intellectual test, not the result of a vote or the result of the accuracy of predictions about precise numerical outcomes.

Defective economic theories are an ultimate cause of poverty and war. Defective economic theories held in the majority of the 20th century have produced serious shortfalls in the standards of living of even the best countries, and utter catastrophes in many of the others.

If economic theories were merely academic discussions, then the contents of those theories would be of little real import. Since, instead, those theories are often used to justify the exercise of enormous political power, even minor elements of theory can have substantial consequences.

Regards, Don

A flat earth theory is

A flat earth theory is adequate for a lot of day to day living, but it likely precludes satellite television.

True enough, but flat earth theory can be rejected because it has been empirically falsified and replaced with a better theory. The faults that you mention regarding neoclassical economics have not been replaced, precisely because those faults stem from a lack of empirical knowledge: one cannot contruct a perfect demand curve without extensive (and perhaps unobtainable) data. But Austrian economics doesn't solve this problem; it merely throws the baby out with the bathwater. Instead of proposing a better theory to take the place of the supposedly deficient one, it presents a theory which cannot be empirically falsified.

Defective economic theories are an ultimate cause of poverty and war. Defective economic theories held in the majority of the 20th century have produced serious shortfalls in the standards of living of even the best countries, and utter catastrophes in many of the others.

No doubt this is true. But one can just as easily blame this on missapplied neoclassical theories and/or overzealous economists who believed they had access to more information than was even theoretically possible. Anarchist economists like David Friedman and Brian Caplan make this argument all the time: In order for the state to achieve a better outcome than the market, those running the state would need perfect economic knowledge, and even then, the market would equal or outperform these god-like economists in many cases.

Micha, The requirement for a

Micha,

The requirement for a science to be falsifiable is as untenable as a requirement that a science must involve controlled experiments. I am hoping that Cosmology does not soon become an experimental science.

Austrian economics is a study of the logical structure of man's actions in employing scarce means to pursue subjectively desired ends. It is neither comprehensively falsifiable nor substantively subject to controlled experiments.

This implies nothing about its validity.

Regards, Don

I agree, partly. I've been

I agree, partly. I've been studying the philosophy of science, and while it is true that many philosophers reject Karl Popper's criterion for separating science from pseudo-science, I think most would agree that falsifiability is at the very least a praiseworthy and useful attribute.

My point is not that Austrian economics is necessarily flawed (I have not studied enough of it to know for sure either way); merely that I don't see how Austrian economics solves any of the problems that neoclassical economics exhibits. Why is this important? Because almost everyone agrees that a scientific theory which is Pareto efficient relative to another theory should replace that theory; that is, if theory A can do everything theory B can do and more, than theory A is superior and should replace theory B. I don't see Austrian economics doing this to neoclassical economics. It does not seem to solve any of the stated problems.

Regardless, I'm still not sure what criterion you are using to determine when it is okay to use demand curves and when it is forboden.

Canada was able to

Canada was able to "negotiate" lower drug prices by threatening to stop recognizing the IP rights of drug developers to their product.

Allowing reimportaion will effectively void such IP rights and the result of that will not be good for the American consumer.

Which is not to say that I favor government involvement in this.

Micha, ...Because almost

Micha,

...Because almost everyone agrees that a scientific theory which is Pareto efficient relative to another theory should replace that theory; that is, if theory A can do everything theory B can do and more, than theory A is superior and should replace theory B. I don't see Austrian economics doing this to neoclassical economics. It does not seem to solve any of the stated problems....

I would not necessarily agree that, when it comes to theories, more is better. If neoclassical economics claimed that all money is green, it could be falsified by a sample of non-green money. But if all money happened to in fact be green, it couldn't be falsified. However, a theory that tried to explain less, saying that economics can have nothing valid to say about the color of money, is, to my mind, a more correct theory.

Thus part of the problems of incorrect theories is that they may try to explain too much.

Regards, Don

John T, My perception is

John T,

My perception is that a Canadian threat to violate IP rights isn't significant as long as the company is willing to write off the Canadian market, if necessary. Neither Canadian or other counterfeit drugs should be able to fill an American prescription.

Taking the opportunity to make a correction from my original post --

In Canada, it is likely that the revenue-maximizing price will be somewhat lower than that in the US, due to a lower population unable to as fully respond with demand to lower prices.

This no longer makes any sense, and the Canadian revenue-maximizing price may be higher or lower than the US price, but without any impact on the argument. The original post has now been edited.

Regards, Don