Markets, like people, can be either healthy or sick. Healthy markets need no assistance from the government to provide adequate quantities at reasonable prices; however, sick markets do.
For a market to be healthy, its price must equal the marginal cost of production. In equation form this is P = MC. Marginal cost (MC) is the incremental cost of producing one more unit of a good and price (P) is the amount of money a consumer must pay for that unit. This equation is as fundamental for economics as “energy equals mass times the speed of light squared (E = MC2)” is for physics.
Sovaldi, a treatment for Hepatitis C, is just a combination of common chemicals. Consequently, the marginal cost of producing one additional pill of it is approximately the same as that for aspirin. You can buy the latter for a few cents, but one pill of Sovaldi will set you back around $1,000.
It is safe to say that the price of Sovaldi is no where near its marginal cost. This situation is quite common in the US and has led to the consensus that the pharmaceutical drug market is sick. There are several proposals for reducing drug prices that range from government production to partial regulation. Which is the best treatment for this illness?
The Lone Economist has argued that healthcare policy proposals often seek to dictate a result without considering the root cause of the problem. They treat the symptom rather than the disease itself. So, it is important to understand why the pharmaceutical drug market is sick.
Research and Development are Sunk Costs
Unlike that of most goods, almost all the cost of producing a pharmaceutical drug is incurred before the first pill is even sold. Economists call them “sunk”. It may cost only a few cents to produce one additional pill of a new drug, but the research and development costs can be billions of dollars. Charging a price equal to the marginal cost would result in huge losses for the manufacturer.
How then can a pharmaceutical company earn a normal profit from its enormous investment? The answer is to grant them a monopoly — in the form of a patent — and allow them to earn monopoly profits to compensate them for their investment costs.
But aren’t monopolies bad? Don’t monopolies charge prices above the marginal cost of production and sell quantities below the optimal level?
The answer to these two questions is yes, in general. But if pharmaceutical companies could really maximize their profits, they would sell the optimal quantities of their drugs and, oddly enough, poor people would be able to buy the drug just as easily as rich people.
The Power of Price Discrimination
Price discrimination is the practice of charging a higher price to customers who are willing and able to pay a higher price and a lower price to the rest. The Lone Economist has explained that the U.S. healthcare system relies on price discrimination to shift much of the cost of healthcare for the poor and chronically sick to the healthy working-age population. Private insurers pay much more than public insurers for the same services.
The lone exception to this rule is the provision of pharmaceutical drugs. Private and public insurers pay approximately the same prices for the same drugs. The reason is that price discrimination is not as easy to enforce in the drug market as it is in the healthcare services market. This is unfortunate because taken to its logical conclusion, perfect price discrimination in the pharmaceutical market would result in poor people paying only a few cents for a pill and the rich paying thousands of dollars. Pharmaceutical companies might earn enormous excess profits, but the distributional problems that currently exist would not happen if perfect price discrimination was possible in the drug market.
Arbitrage in the International Drug Trade
Monopoly power is not the only condition needed for price discrimination to occur. The other one is the power to prevent arbitrage, the reselling of a good. For example, if I wanted to sell you pills for $1,000 each and the same type of pills to somebody else for $100 each, then that person would have a large incentive to resell you their pills for $200 each. Unless I can stop them from doing that, I will not be able to price discriminate.
It is impossible to conduct arbitrage for a geographically fixed service like a hospital stay, but not so for a pill. As a result, there is very little price discrimination in the international pharmaceutical industry. The reason why is that these companies know that if they sell the same pill to the UK at a much lower price than they do in the US, then their US sales will be undercut from arbitrage. What usually happens is the UK either purchases a very small amount of the drug at the US price or refuses to buy it at all.
Economic Policy Myopia
Many of the proposals for fixing the pharmaceutical industry assume the U.S. government has the same amount of market power in that market as it does in the healthcare services market. The fact is that the government’s power to dictate pharmaceutical prices is much more limited than it is for services, like surgery. Pharmaceutical companies operate in a global market. The U.S. government is just one large payer out of several.
This policy myopia reminds me of the wealth tax proposals. A wealth tax is a tax on capital. Unlike the labor market, the capital market is global. This makes taxes on capital much less lucrative and much more expensive than taxes on labor. Capital can just as easily flow out of a country as it can flow into it. This is why we rely so heavily on taxes on labor.
The primary motivation for a wealth tax is that it is considered by many to be fair. Tax fairness is good, but like most other good things, it comes at a high price. We shouldn’t pay too much for it.
The most likely outcome of the current proposals for fixing the price of pharmaceutical drugs is a drastic decrease in investment into developing new drugs. In the long-run, this harms everybody.
The optimal policy must take into account the international nature of the pharmaceutical industry. There are huge opportunities for improving the performance of the international pharmaceutical market, if only we would exploit them.
More on that in future posts.