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Myths of Drug Price Controls

Via Steve Burnap (incidentally, the author of the excellent RoboDJ weighted shuffler plugin for Winamp and a coworker of my cousin training for the triathlon), I see that Kevin Drum is talking about the drug price controls issue (yeah, I typically read Kevin for myself, but I’ve fallen far behind):

Foreign methods for lowering drug prices are apparently too Stalinistic for Republicans to consider, but it’s OK to let other countries use these methods and then import the drugs from them. That’s nuts.

He’s right, it is nuts. That’s politics for you. However, he goes astray in the next paragraph:

Other countries use both legal measures and massive buying power to negotiate lower drug prices. Pharmaceutical companies go along with it because presumably the business is still profitable for them even at these lower prices.

Common misunderstandings like this is probably a big reason why politicians do strange things. Doing the right thing is often a harder political sell (and I’ll return to this theme in several future posts). This doesn’t excuse it, I’m just pointing out that Kevin’s contributing to the problem.

In the pharmaceutical industry, there’s a lot of upfront research and development (R&D) costs. But once you’ve developed one working sample of the product, the cost to create additional samples (the marginal cost) is very low. It’s a lot like the software industry in that respect. Currently, pharmaceutical companies charge American consumers a high price for these drugs to recoup the R&D costs.

However, they sell the same product at different prices, depending on the circumstances. Some developing nations can’t afford to pay these costs, and some countries (like Canada) choose to legislate a maximum allowable price. The drug companies will still be willing to sell at these lower prices as long as it’s still above the marginal cost. That is, every item sold still gives them a positive profit margin, so they’re still better off selling at this lower price than not at all. This is known in economics as discriminatory pricing. Indeed, these extra profits mean they can recoup their R&D costs more quickly and can eventually lower the price they charge to American consumers to increase volume.

Discriminatory pricing, despite it’s unfortunate name, is actually a net good for the economy. Recall in in my discussion of Microsoft I mentioned the other examples of it, bundling and buy-one-get-one-free deals, that Tyler Cowen and Alex Tabarrok explained. Developing nations get cheaper access to drugs, the American consumers’ burden of the R&D costs are lessened, and the drug company gets higher profits.

Note that the countries that get the lower prices are known in economics as “free riders.” Namely, they are benefiting from money paid by somebody else (American consumers, in this case). Of course, if the companies were forced to sell the drug at that low price to everybody (either by implementing price controls ourselves or allowing reimportation of the drugs from countries with price controls, like Canada), then this money disappears. After all, there ain’t no such thing as a free lunch. Also note that the companies would develop fewer drugs, since the likelihood of recouping the R&D costs would be much lower.

For more on the issue, you can check out this old piece from Alex Tabarrok and this old op-ed from Bruce Bartlett.

Update 4/28/04

My wife remarks that drug prices have outpaced inflation. I don’t mean to imply that drug prices aren’t too high, and that there isn’t anything we can do. I’m sure the pharmaceutical companies have lobbied the government to get favorable treatment. However, I’m just saying that price controls aren’t the answer, just like rent control didn’t work in New York City (or anywhere else), Nixon’s use of price controls to fight inflation failed, and oil price controls made the 70’s energy crisis much worse. I’ll blog further on the whys of this later.

As for why drug prices are so high, my guess is it’s because the pharmaceutical companies are spending a lot more money on television advertising, which increases costs (keep that in mind when deciding to buy something because you saw it on TV). Of course, they wouldn’t be doing it unless it was working, which means people are asking for and buying drugs they don’t need. I know Galbraith isn’t popular among Libertarians, but I know he was on to something. Demand isn’t determined solely by price and utility. People are more complicated than that, and marketing does play a role, or else companies wouldn’t be spending so much money on it and getting no return.

Should we have laws banning marketing of prescription drugs? I don’t know.