Cap'n Arbyte's

The Solution to High Prescription Drug Costs

Everyone has something to be angry about when it comes to prescription drugs. Seniors are angry because drugs are very expensive. Pharmaceutical companies are angry at foreign price controls. Politicians are torn between the realization that allowing drug reimportation would make seniors happy, but would seriously harm innovation in the pharmaceutical industry by making it unprofitable. What to do?

There is a remarkably simple solution to the entire problem. The solution is capitalism — specifically, economic freedom and the ability to practice price discrimination. This solution would make everyone happy: Poor seniors would have access to cheaper drugs, the profitability of pharmaceutical companies would be preserved, the rate of innovation would actually increase, and politicians would be off the hook. (The issue of reimportation simply disappears; it would no longer matter.) It's a win-win-win situation.

Surely, this is a bold claim. To understand why it can work, it is necessary to review some economics.

Trade and Prices

Two people will voluntarily trade when each is able to obtain something they judge as better than what they have to give up. The usefulness of a good or service is called its utility, and varies according to each person's circumstances. For example, to a person who has been without food for several days, the utility of a unit of food is very high. To a person already has many units of food stored in the kitchen, the utility of an additional unit is very low. The utility of an additional unit of some good or service is called its marginal utility. Two people will trade when the marginal utility of the thing they gain is greater than the marginal utility of the thing they lose. The existence of unequal circumstances and therefore unequal marginal utilities is what makes trade possible.

The introduction of money — a medium of exchange — makes trade more efficient (for a variety of reasons) and also makes it possible to quantify the benefits due to trade. If I judge the marginal utility of some good to be $10, I would be willing to trade any amount up to $10 for it, and my net gain would be the difference between $10 and the price I actually pay.

With mass production, the marginal utility of the product to the seller is quite low. For example, a dairy farmer who produces 100 gallons of milk per day could not personally consume that much — the marginal utility of a gallon of milk under those circumstances is near zero. (In fact, it could be negative if storage costs are considered.) This means that theoretically a large producer should be willing to virtually give away their product. Clearly $0 prices are a rare treat, and the reason is clear when time is introduced: A business will only maintain production when it is more profitable than stopping. A business must recover its costs to remain in business, which effectively places a floor on prices at a level higher than the producer's marginal utility. Revenues must at least equal costs.

In the language of "microeconomics", businesses require that the price, or AR, is ≥ ATC. [In most browsers, you can see a definition of the acronym by placing your mouse cursor over it.] Every Econ 101 student learns that profits are maximized by producing a quantity of goods such that MR=MC, and that in a "perfectly competitive" market MR=MC=AR=ATC.

This result clearly does not happen in the pharmaceutical industry. The marginal cost of producing an extra tablet or capsule (for example) is tiny, yet the prices of these life-saving drugs are often extremely high. The disparity is so great that it becomes a political issue, and people accuse the producers of wielding monopoly power. Big Pharma, as they call it, is obviously using its power to exploit the sick and the elderly. The large corporations are morally repugnant, economically inefficient, a social cost, a market failure, evidence that health care should be nationalized and run for the common good on the basis of caring and love, not profit and greed. Right?

No. The phenomenon of pricing above marginal cost is actually normal and widespread, and is most intense in industries whose costs are dominated by fixed costs, things not very sensitive in the short run to the quantity of goods produced — as opposed to variable costs, which are. For a software company, its computer programmers represent a fixed cost, because they're all needed in order to create even a single unit to sell. Its variable costs would be things like the CDs and boxes that end up on store shelves, or perhaps the cost of bandwidth for customers who download the software instead of receiving it physically.

Consider a software company with 50,000 employees each earning $50,000/yr. The wages of these employees — a fixed cost — are $2.5 billion/yr. Let's assume that people primarily download the software, and that the marginal cost of each download is a few cents. If the price is set accordingly low, say $0.25, the company would need to sell 10 billion units simply to pay its programmers, to say nothing of its other costs. The market is too small for the company to be profitable by charging a price so near its marginal cost. The reason is that its fixed costs are very large in comparison to its variable costs. In the pharmaceutical industry the problem is even more acute: A drug that fights seizures (for example) may cost millions of dollars to develop, but will only be desired by the small market of people who suffer from seizures. Those millions of dollars of fixed costs must be recovered from a small market, which naturally means prices well above marginal cost.

Pharmaceutical Price Controls

When prices are well above marginal cost, price controls are very attractive to governments. If the controlled price is set anywhere in the large range between marginal cost and the full price, the producer is still able to offset some of its fixed costs by selling at the controlled price. This is more attractive than refusing to do business, in which case it would make no progress against its fixed costs.

It is frequently said that Americans are "subsidizing" the rest of the world's drug costs, because our markets are free but theirs have price controls. Drugs are artificially more expensive in America because they are artificially cheaper elsewhere — the fixed costs that aren't being recovered in other countries are being recovered in America.

There are actually two competing pressures involved. For those people who would have paid full price but are instead paying at the controlled price, the charge is accurate, and Americans are indeed subsidizing them. However, lower prices also increase the quantity of a good demanded, and to the extent those new customers are paying prices above marginal cost, they are making a contribution to fixed costs that offsets the people being subsidized. To understand which of these pressures is stronger in any particular country, the data must be examined.

Price controls in a relatively rich country like Canada, where many could afford the full price, probably do have the character of subsidies that increase American prices. Price controls in a poor country like Liberia probably do not.

The widespread adoption of price controls in other countries has many of the characteristics of a system of price discrimination, where different customers pay different prices for the same product.

Price Discrimination

Under the right circumstances, price discrimination can be absolutely beneficial. Consider the case of running electricity to two neighboring but remote homes. Let one homeowner be willing to spend $200 to obtain electrical service, and the other willing to spend only $100. Further, it would cost the electric company $250 to run electric lines to the area (fixed cost), and another $10 to hook up either house (variable cost). Assume these figures includes some amount of profit for the electric company.

The cost to provide service to any single house is $260, more than either is willing to spend. If the homeowners approached the electric company together and offered to split the price, they would need to pay $135 each ($270 total), which would be agreeable to one of them but not to both. They would not get electric service. However, if the electric company were able to price discriminate and offer a price of $85 to one homeowner, $185 to the other, the construction costs are met (including a profit) and both homeowners are able to obtain electric service within their respective budgets. In fact, they would each have $15 left over! This is a win-win-win situation.

This happy outcome was made possible by price discrimination. The person who paid $185 might intuitively feel ripped off compared to his neighbor, but needs to understand that he couldn't have had electric service at his neighbor's price: The electric company couldn't have recovered its costs. Furthermore, he should realize the fact that he's only paying $185, not the $260 it would have cost on his own — his neighbor's participation actually saved him money and is deserving of thanks, not jealousy.

Following this model, successful price discrimination in the pharmaceutical industry would make some projects profitable that would have been unprofitable without it. New drugs and new treatments would be invented that could not have existed without price discrimination. These advancements would benefit peoples' lives. People will live, who would have died.

Price discrimination is more difficult to analyze in a larger market. It becomes possible for "richer" people to "cheat" the system by trying to purchase at a lower price, because any one person's success at this would not endanger the entire system as it would in the simple case presented above. However, if successfully implemented, a system of price discrimination would enable the poor to purchase at near marginal cost, while simultaneously lowering the prices paid by the rich, as compared against a single-price system. There is no "subsidy" effect where one group benefits at the expense of others — all groups would benefit.

Implementation

If price discrimination is so great, why hasn't it happened already? The most important answer is that it's illegal. In 1936, Congress passed the Robinson-Patman Act (15USC13), which makes price discrimination illegal except for non-profit institutions (15USC13c) (which includes hospitals but not pharmacies). The Robinson-Patman Act must be repealed so pharmaceutical companies are able to work on creating a system of price discrimination.

By prohibiting price discrimination, the Robinson-Patman Act is, in a sense, a form of domestic price control. The explicit price controls in other countries are also an obstacle to the success of price discrimination and should be opposed.

The government need not — indeed, should not — take any special action to create a system of price discrimination. It should simply permit such a system, then get out of the way. The system would be implemented by contracts between the producers, distributors, and consumers of drugs. These contracts would need to accomplish several goals: (1) The creation of different "market segments" of customers, each segment having its own price, (2) The prohibition of reselling from a "poorer" segment into a "richer" segment at the lower price, and (3) Provide for auditing mechanisms to detect various forms of cheating. The role of government would simply be to enforce these contracts, which is not a new responsibility.

To gain access to the less expensive market segments, buyers would need to provide information to demonstrate their qualifications. No person would be forced to provide this information; by default they would be members of the highest-priced segment.

(Drug reimportation would cease to be an issue, because it would be the resale of drugs to the contractually wrong people that would be prohibited, not the mere fact of import.)

Clearly, the contracts implementing a system of price discrimination would be very complex and difficult to create. I hesitate to make detailed recommendations to an industry I have no direct experience in. The role of an economist is simply to advance this option as a possibility to be considered. I believe I have shown that if the system can be implemented in a practical way, it would have profoundly beneficial results, and therefore the implementation details are worthy of serious study.

With large incentives to cheat, price discrimination would certainly be difficult to implement, but it also clearly not impossible. First-class airline travel is a present-day example of successful price discrimination, which does not run afoul of the Robinson-Patman Act because there are obvious differences in service and comfort between first-class and economy-class travel. It is not theoretically pure price discrimination, but it is a good approximation. (The ability to create slightly different versions of drugs could aid price discrimination in drugs as it has helped in travel. Also note that the requirement to control reselling is easily implemented in the airline industry, because most tickets are non-transferable, and they check your identification before you board the plane.)

Write to your congressmen and tell them that the solution to high prescription drug prices is not through more federal programs, but through repealing the Robinson-Patman Act! (And try to get them to read this essay…)

Tiny Island