Economic Fallacies All the Way Down

With friends like this, free markets have little need for enemies.

It doesn't matter how drug companies are forced by the sheer economic ignorance of their opponents, as well as probably themselves, to make absurd economic arguments that sound superficially valid. Rather, what matters is economic reality.

Why free trade won't make Atlas shrug

By Alex Singleton | 16 July 2005

In the past, I have pointed out that drug companies spend more on marketing and profits than on R&D. I am not trying to make the argument that marketing and profits are, in and of themselves, bad - both have an important social function. I state this simply in order to help people get some perspective about the cost of R&D as percentage of their turnover.

Drug company lobbyists are peddling the idea that Americans should not benefit from free trade ("parallel trading") in pharmaceuticals because R&D costs make pharma companies like Atlas, who in mythology struggled to support the sky on his shoulders. If the US allowed free trade, they suggest, Atlas would shrug. This is a myth.

The Globalization Institute appears to have missed the significance of the Marginalist Revolution of1871 completely. In the complete article, all that we see are percentages and totals and averages. This completely misses the economic incentives at the margin that the drug companies actually face and respond to.

Overall, actual free trade is a fine goal. But it is the height of folly to believe that consumers can sustainably achieve lower prices by having prescription drugs drop-shipped into Canada and then re-exported into the US. Free lunches are always scarce and often costly. What was easily predictable and has already begun is that the drug companies have started to restrict shipments into Canada. Canada has the choice of either raising its controlled prices or banning exports or doing without. The existence of a price doesn't imply a supply. The goal of lower prices through re-importation can only be achieved by forcing the drug companies to act against their own interest by shipping to Canadian pharmacies who are not compelled to obey supply contract terms that control disposition of the product received.

It was almost 40 years ago when I complained to an audio salesman that his price for an audiophile phonograph cartridge was significantly higher than the price a store across town quoted. He quickly agreed that the other store's price was also what he quoted when he didn't have any in stock.

NOTE - Comments now hopefully unjammed

To believe that the drug companies are costless targets that can be abused at will, no matter how much they may appear to deserve it, without negative effects on the future supply of new drugs, is to believe a fairy tale.

A drug company will typically have a choice of a number of drugs worthy of consideration for development. Its first step will be to rank them in terms of projected risk-adjusted rate of return on investment. Only the higher ranked candidates will be funded for development. Those candidate must have what appear to be extremely high rates of return because they must support the weight of the inevitable development failures that never reach the market. It is highly likely that that the current financial reports on drug companies tend to overstate company profitability as they don't carry over the write-offs of failed development programs in prior reporting periods. There is always a marginal development effort which would not have been funded if the company faced either lower potential rates of return or increased risk of any type, including political.

Contrary to popular belief, marketing expenses do not take away from R&D expenditures, and in fact they tend to add to them.

Assume that a given drug has a monopoly supplier, a negligible marginal cost and no marketing or advertising expenditures. In order to maximize profits the supplier will try to price to maximize the total revenue given his estimate of the level and shape of the consumer demand curve that he faces.

At this point, the question of marketing and advertising comes up. The question is no different than for any other investment. It must return something in excess of its opportunity cost in any alternative application. To be worth doing, the advertising must change the demand curve faced so that a sufficiently higher level of total revenue can be achieved. If this is likely to be achievable, then it will be accounted for when the marginal development decision is made. Thus the expectation of a positive return on future advertising will tend to increase the probability that a given marginal development program will be undertaken.

Advertising = potential higher R&D expenditures.

In addition, the change in the demand curve that results from advertising is likely to also change the revenue-maximizing price. The new price can be either higher or lower, but is likely to be lower as new low end demand may be worth accessing.

Advertising may = lower prices.

...I believe in the profit motive. But the profits being made by drug companies are monopoly profits. Because they operate in a rigged market, where imports from other countries are not permitted, they are able to act like any state-backed monopoly and screw consumers. That's great for companies like Pfizer. But the result is that 29% of prescriptions given to pensioners in the US are not converted into drugs. Senior citizens go into the pharmacy, ask the price and walk straight out. Free trade in pharmaceuticals will lower prices and increase access - without reducing R&D.

This is an irrational fear of monopoly prices and profits. Acting in its own best interest, a monopoly supplier must set a price that is at most determined by the valuation of consumers. The price set will fall until consumers no longer respond to a price decrease with a sufficient increase in unit demand. The price may be set lower still if potential new competition needs to be discouraged from entry. All consumer products of all kinds are in competition for the consumer dollar. Just because no one else manufactures green, cross-threaded widgets doesn't allow you to set prices independent of consumer demand without suffering for the action.

If 29% of pensioner prescriptions are not converted into drugs because of retail prices, that is a surprisingly small number, not a large one. If the number of prescriptions covered by health insurance prescription drug plans are included, then the 29% number is likely effectively reduced to around 15% if even half of the drugs are purchased under such plans. If we further adjust for the fact that the prescribing physicians are not spending their own money when making prescription choices, it would not be unreasonable to imagine that the appropriate effective number mght be something like 9%.

Low consumer prices are NOT an unalloyed good. Low final prices inherently require low earnings for all production factors, including labor. This is normally resolved by increases in productivity that reduce the factor requirements for a given output, and increases in output itself, but prices lower than justified by productivity and demand are overall negatives.

Complaining about 9% or even 29%, for that matter, is evidence of an economist who doesn't really understand the purpose of prices. Economic goods are by definition insufficient in supply for all the uses that people might want to make of them. The purpose of prices is to balance supply and demand. To accomplish this purpose prices MUST EXCLUDE many potential buyers who find the prices too high.

That said, retail prescription drug prices are indeed often too high, not because they are monopoly prices, but because they are well above monopoly prices. This is because the retail market is not an independent market for which the supplier can simply maximize profits. Rather, the retail price is effectively a reference price for contracted discounts for the prescription drug plans of health insurance organizations. Thus, if a large enough proportion of total sales are made to insurers, the drug suppliers are forced to raise the retail/reference prices even if it drives off most or all retail sales. Consequently, it is often the overall demand structure of the market for prescription drugs that drives retail prices to excessive heights, not the fact of a monopoly supply condition.

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All well and good, but you

All well and good, but you can't ignore the fact that the pharmaceutical companies DO lobby the federal government for protection from competition, This is certainly not a beneficial circumstance. If the domestic companies were to "shrug", should true free competition be allowed, it would be a net benefit down the road. Their production would soon be supplanted by others taking advantage of the supply lag, causing a lowering in prices. Pharma drugs are not like oil, copper or other raw commodities, more (of existing drugs) can always be produced without the necessity of waiting for newer resource pools to be found. Even with drugs currently under development this holds true, once the discovery and testing barrier has been breached.
The Globalization institute does have a point and the prices of many medical drugs are indeed largely artificial due to numerous government interventions, methinks.

Stephan, What is being

Stephan,

What is being stupidly advanced is an attempt to force drug companies with drugs under patent protection to compete with themselves. The companies are willing to supply drugs to Canada with its socialist controlled prices and even to give away drugs to Africa, neither of which actions harm US consumers in any way, but what they cannot tolerate is for those drugs to contaminate the US market. They don't necessarily need to have the import of drugs illegal, but they do need to be able to control the distribution of their own products. Since they would not allow their foreign distributers to ship back into the US, no price advantage would acrue to US consumers. This is why proposed re-importation bills in Congress include mandates for the companies to continue foreign supply, and presumably, sooner or later, to not be allowed to enforce the terms of their supply contracts, which is absurd.

Patents are truly ugly mechanisms, but I have yet to see an alternative which allows the development of products which can eventually be freely and easily produced at negligible marginal costs. No one in their right mind would invest in a company which promises to spend billions of dollars and several years in R&D and has no way to assure that any return on investment will eventually occur.

As far as I know, there is no longer any new development of drugs going on in the EU, and there may not be anywhere else in the world either. To the extent that the US increasingly adopts the European and Canadian socialist regulatory regimes, the last new drug ever will be produced in the next 20 years. If you think that government can produce drugs, look at the vaccine fiasco even when the government outsources manufacturing to private industry.

Regards, Don

Firstly, when you say

Firstly, when you say "marketing expenses do not take away from R&D expenditures, and in fact they tend to add to them", I agree with you. The point I was making is that R&D is a relatively small amount of turnover, about 7.1% when you deduct taxpayers' contributions.

Secondly, I am not arguing for a "free lunch". I'm arguing against monopoly profits.

Thirdly, you don't seem to like it when I say "29% of prescriptions given to pensioners in the US are not converted into drugs". But, as a free trader, one of the things you notice is that when countries protect their markets, people starve, and when they free them up the poor get to eat. In Britain, the Corn Laws protected farming landowners and the result was that many people starve. And what the current US protectionism does is to keep drug prices artifically high. The result is that many people can't afford drugs.

By the way, pharmaceutical

By the way, pharmaceutical companies do engage in price discrimination through programs which allow those who cannot afford prescription drugs to buy them at discounted prices. This seems like a no-brainer to me; if someone honestly can't afford to pay full price, you might as well get what you can from him, provided that your marginal costs are low enough.

I've heard radio commercials for Merck's discount program several times over the past month or two. But I wonder what's going to happen to these programs after the Medicare drug subsidy takes effect.

Digamma- I don't see how it

Digamma-

I don't see how it follows from Don's alternatives that there is a "lower prices for Americans" option. The low price in Canada is precisely because the US Pharmas have an artificial barrier separating the two drug markets, so they can afford to price lower and reap some extra cash. Absent the barrier Canada is part of the US market. The US market's effect will be to completely swamp out any possibility of price discrimination for Canada, so the only effect (if Canada allows the export barrier to fall) will be to raise Canadian drug prices significantly. Otherwise, as Don said, drug companies will restrict amounts sold to Canada or perhaps not sell to Canada at all (if it cannot raise prices nor guarantee that the discounted pills are not resold in the US, undermining its key cash market).

What was easily predictable

What was easily predictable and has already begun is that the drug companies have started to restrict shipments into Canada. Canada has the choice of either raising its controlled prices or banning exports or doing without.

Isn't that a good thing? If Canadians start paying more, either the companies make more money (which you already define as a good thing) or they offer lower prices to Americans.

Don, "...The companies are

Don,

"...The companies are willing to supply drugs to Canada with its socialist controlled prices and even to give away drugs to Africa, neither of which actions harm US consumers in any way...."

Wouldn't this cause drug prices here to rise?

Alex, Thanks for

Alex,

Thanks for commenting.

...The point I was making is that R&D is a relatively small amount of turnover, about 7.1% when you deduct taxpayers’ contributions.

My point is that there is little logical connection between current revenues and development costs. If there are 5 drugs that are considered worth development, then those will be developed largely independent of the current revenue level. More current revenue doesn't mean that an even more marginal sixth drug should be developed. If current revenue can't support all five drugs, then the company can borrow, sell equity or convertible debt, or form a joint venture.

Secondly, I am not arguing for a “free lunch". I’m arguing against monopoly profits.

I love monopoly profits, which are determined by consumer demand, and not unilaterally by the company, at least if it acts in its own best interest.

Would you deny that if a 50% tax were placed on monopoly profits that it would potentially reduce the number of drugs put into development?

Thirdly, you don’t seem to like it when I say “29% of prescriptions given to pensioners in the US are not converted into drugs". But, as a free trader, one of the things you notice is that when countries protect their markets, people starve, and when they free them up the poor get to eat. In Britain, the Corn Laws protected farming landowners and the result was that many people starve. And what the current US protectionism does is to keep drug prices artifically high. The result is that many people can’t afford drugs.

What you say is perfectly true for steel, but does not apply in the US for prescription drugs under patent protection. In this situation the only competition is a manufacturer competing with his own exports. I have no problem with removing the import ban completely, but prices will not fall as foreign distributers will be prohibited from re-exporting their supplies by contract and by limiting supply levels.

The best situation for all concerned would be isolated markets and effective price discrimination, which allows product to be delivered even to countries that have low standards of living. Nor would shipments into price-controlled foreign markets cause problems in the US market.

The primary problem in the US market is the association of health care and insurance with employment. Third-party payment means that half the people with prescription drug plans pay almost nothing for drugs and in doing so they effectively drive up the retail/reference prices for drugs, as discussed above.

Dan, I am a little confused.

Dan,

I am a little confused. Who controls the prices in Canada? This thread has people saying that it is controlled by both.

If Canada pays full price, but distributes it at a discount, that subsidy must come from taxes. For our government's plan to work, wouldn't the Canadian government have to raise their taxes in order to meet the demand of the U.S. consumer who would also be buying the drugs at the Canadian discount?

If drug companies are selling at a discount to Canada because they can still receive marginal revenue, why wouldn't the drug companies just raise their prices in order to meet U.S. demand for reimported drugs if this legislation is enacted?

If the drug companies negotiated this price with the Canadians, wouldn't Congress have to void those negotiations before implementing the legislation?

Garrett, Wouldn’t this

Garrett,

Wouldn’t this cause drug prices here to rise?

What mechanism do you have in mind?

With very low marginal costs of production, incremental profits can be earned in Canada and the give-aways would likely earn some kind of a tax advantage.

Regards, Don

digamma, The assumption is

digamma,

The assumption is that the company is already maximizing profits in the US market. You need to come up with an explanation for why a larger profit might be available after a withdrawal from Canada.

Regards, Don

I don’t see how it follows

I don’t see how it follows from Don’s alternatives that there is a “lower prices for Americans” option. The low price in Canada is precisely because the US Pharmas have an artificial barrier separating the two drug markets, so they can afford to price lower and reap some extra cash.

You don't think they charge Americans more to make up for what they lose in Canada?

Patinator, In effect, it

Patinator,

In effect, it must be something like this :

Canada sets the prices that patients pay pharmacies and determine just which drugs are eligible. Large discounts are negotiated on wholesale prices between the drug companies and either the pharmacies or some government agency.

Regards, Don