Drug prices and the logic of collective action II

by Maria on January 20, 2004

Just by way of a quick follow up to a post from last November, today’s Guardian reports that US Pharma is still pushing hard to label and defeat as protectionist the bulk drugs buying power of the Australian government. Worryingly, it sounds as if Australian PM John Howard may blink.

Unexpected support for the Australians (and indeed Canada and Europe too) comes from Maine and Florida, where state governments are trying to lower the price they pay for drugs, and also a cracker of a letter from Rosa DeLauro (D, Connecticut) to Robert Zoellick which goes;

“We are deeply opposed to the trade office being used by the US pharmaceutical industry to achieve its strategic objective of raising worldwide drug prices to the level now paid by US consumers”.

DeLauro focuses a lot on affordable drugs for the elderly in the US, and would probably like to see more attention on keeping drugs prices down in America rather than pushing them up elsewhere.

James Glassman, however, argues that to keep markets free from government interference, the US government should use trade agreements to force other countries to pay more for US drugs. The old free-rider argument comes up again;

“U.S. policy-makers should focus attention not on the fact that Americans pay more for drugs, but on the fact that Canadians pay less because they are freeloading on Americans. U.S. consumers provide the funds necessary for pharmaceutical firms — nearly all of them now U.S.-based — to make the investment in research to develop new drugs. But the rest of the world benefits from those drugs.”

But it still seems to me that you can’t accuse the rest of the world of free-riding on US R&D until you’ve established whether a)drug prices in the US are artificially high or b)prices abroad are artificially low. (Another issue, much discussed on the thread for my November post, is how much foreign government funded R&D occurs and what role that might have in pricing) Arguably, the US prescription drugs market is at least as skewed as those attacked by free-marketeers like Glassman, but skewed in a direction that favours big pharma rather than consumers.

Secondly, I am still, and perhaps will always be, amazed at people who style themselves as free-market supporters but don’t mind any amount of market manipulation or extraction of monopoly rents as long as they’re done by large private firms, or by the government on behalf of large private firms. The free market isn’t a value in and of itself, it’s a means to an end; timely, efficient and best-priced distribution of goods and services. But market distortion happens all the time. Some might say it’s a fact of life. The only question worth asking about government intervention is when, how and for whose benefit?



Sebastian Holsclaw 01.20.04 at 7:06 pm

“Secondly, I am still, and perhaps will always be, amazed at people who style themselves as free-market supporters but don’t mind any amount of market manipulation or extraction of monopoly rents as long as they’re done by large private firms, or by the government on behalf of large private firms.”

You’ll have to give specfic examples of what you are talking about. It is drawn so broadly that even I could agree with you, and I never do. :)

As for: “But it still seems to me that you can’t accuse the rest of the world of free-riding on US R&D until you’ve established whether a)drug prices in the US are artificially high or b)prices abroad are artificially low.”

Ok that is easy. Drug prices abroad are (especially in say, Canada) priced near the unit price of physcially creating the pill. That price does not cover most of the billions of dollars of research costs for that pill, nor does it cover any of the research costs for failed pills. Therefore the price does not cover the costs and the price is too low. Any further objections?

Oh, wait I can forsee one further objection. If the prices are artifically low, why doesn’t the pharmaceutical company just pull out of the market? Answer, because if they do, the country (say Canada)threatens to break the patent and allows a competitor (with none of the research costs expended)to make money on the drug for free. The company figures that it might as well make the small per-unit profit rather than none so long as they can still make up the research costs elsewhere . This has to do with sunk costs. The research is already done and paid for, you now have to try to get that money back somehow. But don’t think for a second that investments in new research will continue if the ability to make money on it is dramatically curtailed. And dramatically curtailed is precisely what we are talking about here.

Yes the free market is a means not an ends. But unfortunately for the previous discussions on this topic here, governments are not good at designing systems to regularly produce useful pharamaceuticals.


ChrisL 01.20.04 at 9:11 pm

Any further objections?

yes. why should the US carry the entire R&D burden ?


Marcus Stanley 01.20.04 at 9:22 pm

Sebastian: leaving aside the question of your evidence (how do you know the price is at physical production cost?), your point is completely irrelevant to whether U.S. drug prices are too high. It would in fact be surprising if U.S. prices were the “right” free market prices, since firms with a grant of monopoly power often charge a substantial markup over true average costs (in this case including research costs).


Sebastian Holsclaw 01.20.04 at 9:42 pm

“yes. why should the US carry the entire R&D burden?”

In some ideal world it shouldn’t. But on the other hand what are we going to do about it? Do we want to invade these countries and force them to apply our patent laws? Should we apply sanctions to foreign drugs? (Chortle). Should we engage in a more wide spread trade war? Should we stop researching drugs so that our prices can be lower? Just because something isn’t fair doesn’t mean it can be fixed in a reasonable way. Now if reimportation becomes a big enough deal to cause drug companies to go out of business (causing less research to be done) than we will have to take some sort of steps.

But short of that it is probably just another area where so-called civilized countries get to profit off of the effort of the US while simultaneously criticizing us for not living up to their standards. (That sentence is part of my ridiculous hope that perhaps shame could cause the good result that I think we can’t persue through other means.) At this point the more socialist countries can only just afford to care for their aging population with the cut-rate drugs. They won’t be allowing the prices to rise later on when they are making other cuts. And they won’t abstain from using drugs that other people have spent hundreds of billions on researching just because they can’t afford to pay for the research. But that is why we can’t use a European model of social care. That method needs outside support. If the outside support adopts the model, the whole thing falls apart.


Jake McGuire 01.20.04 at 11:31 pm

Keep in mind that there *is* competition in the drug market. It’s just that the competition usually takes the form of competing drugs (how many statins are out there?) rather than between different companies making the same drug. No one has a monopoly on “AIDS medication,” or anything like that.

Not to mention, any drug that was available in the mid-80s is now available as a generic for a much lower price than any name-brand drug. It’s not like medical technology was in some kind of dark age then; if you don’t want to deal with the big pharma, no one is making you do so. And indeed, if other countries want to encourage their own pharmaceutical industries to develop, nothing is stopping them from doing so. New biotech companies start up in the US practically every day; it’s not like there are huge barriers to entry in the drug market.

Yet strangely, we don’t seem to see this happening. Why not?


Marcus Stanley 01.21.04 at 4:30 am

Ummm…many of the worlds largest drug companies are European companies. Astra, Glaxo SmithKline, Rhone Poulenc, etc. Last I heard they did research, and lots of it too.

The U.S. leadership in drug research has a lot to do with the amount of government money we pour into it through NIH. As for the effect of high U.S. prices on drug company research…maybe, maybe not. Glaxo Smithkline made gross pretax profits of over 30% last year (that’s a *very high* profit margin BTW, higher than competitive companies in unregulated markets tend to make). How much of the higher drug prices go into research and how much straight into stockholders pockets is an open question that you do not know the answer to. Your argument seems to assume that drug companies function as non-profit research charities of some sort.


Sebastian Holsclaw 01.21.04 at 7:35 am

So far as I know, the location of a companies incorporation has little to do with the place where it makes the profit which pays for its research.


Sebastian Holsclaw 01.21.04 at 7:40 am

I don’t confuse corporations with non-profit research charities. Non-profit research charities don’t typically discover and research as many important drugs. Patents on old drugs exist for a relatively short period of time. A drug company will not survive if it fails to do significant amounts of research. Therefore it does research. No charity impulse need be assumed.


Ali 01.21.04 at 12:37 pm

Ok that is easy. Drug prices abroad are (especially in say, Canada) priced near the unit price of physcially creating the pill. That price does not cover most of the billions of dollars of research costs for that pill, nor does it cover any of the research costs for failed pills. Therefore the price does not cover the costs and the price is too low.

Convincing if true. Can you source this claim?

A comparison of foreign prices for protected drugs vs US generic prices post-expiration for those same drugs would suffice. I’m sure such data exists somewhere.


Doug 01.21.04 at 1:34 pm

Steps boldly into the middle of the road, aware of traffic in both directions:

Sebastian, and other free marketeers, why shouldn’t large buyers use their leverage to get better prices? Wal-Mart gets good prices from P&G; Barnes & Noble gets good prices from Random House. Why shouldn’t Australia get good prices from Merck? (Maybe not great prices; it’s only got 20 million customers after all, but good prices.)

For the other side, here’s a good indicator that free-riding is more than an accusation: If you’re building a drug discovery company in, say Europe’s second largest biotech cluster in Munich, and your company is doing well enough on the scientific side, pretty soon you will have to answer the question “What are your plans for the American market?” The people usually posing this question will be your investors, and the time they will usually be posing it is when they are deciding whether or not to make an additional investment. If you don’t have plans for the American market, your chances of getting the investment you need to bring the drugs your are investigating out of the lab and onto the shelf, are very low indeed.

That is to say, even if you are based in Europe, have mostly European personnel and are drawing on European investors, the presumption remains that seven to ten years down the road, when your drug hits the market, you will need to make big money in America to justify the investment that got you there.

That’s not just some arbitrary government regulation that could be changed. That’s a deep-rooted market perception: Europe will be free-riding on American drug prices for the foreseeable future.

My questions, then: Is this desirable? At what value should we take European efforts to hinder American (public or private) moves to change this situation?

Time Magazine offers facts, figures and anecdotes on a related issue.


Robert Lyman 01.21.04 at 3:50 pm


Nothing’s wrong with volume purchasing power.

But when states do it, they have more than just the threat to walk away: they have price controls and patent laws.

The temptation on the part of legislators to uses these tools, which are not available to Wal-Mart, is rather great. After all, the taxpayers are not, for the most part, biotech investors.


Antoni Jaume 01.21.04 at 4:15 pm

Doug, what you describe is that self-called investors are free riding on other peoples works. It is not that they start from really nothing, they do not make the inversion of rising a bunch of baby to adulthood, giving them all what is needed until some of them happen to do something useful. Rather they prey on people, on other companies, that have done such an effort, hoping that they are exhausted, in order to prey on their work.

The USA market is simply another market, the fact that their laws are stacked against their people in favor of big money is their problem, do not try to pester us with such madness.



Sebastian Holsclaw 01.21.04 at 5:32 pm

Antoni Jaume, you confuse free-riding with investing. Taking a risk with money and other forms of capital in the hope of producing useful research is investing. You could put the money in a fairly sure thing like Wal-Mart or internet porn, or California rental units, but instead you take a huge risk on pharmaceuticals. You earn the money by taking the risk on something highly useful but very likely not to pan out. That is called investing. Free riding involves letting someone else do all the work and take all the risk and then swooping in and using the discovery later. (See for instance French demands that the US ‘share’ military technology with the EU.) Investors in a 7-10 year project are the precise opposite of free riders. But I’m glad you made the mistake, because it is a common confusion among leftists to mistake the productive investors they despise with the unproductive free riders that they encourage.


Sebastian Holsclaw 01.21.04 at 6:11 pm

If you want to look more deeply into the issue I would suggest perusing Derek Lowe’s website or this comprehensive overview (is that an oxymoron) by Mark A. Kleiman . I also note that Brad DeLong agrees that squeezing drug companies is a poor choice here . He isn’t at all a conservative pundit.


Doug 01.21.04 at 9:03 pm

So Robert, you’re saying that a state negotiator should get less than the best bargain possible for his/her constituents? Why exactly?

Sebastian, I’m not sure how long your view of investors would survive prolonged contact with actual VCs, to say nothing of folks in distressed asset funds. Some are, indeed, the vultures that Antoni describes. (Though it’s relevant to point out that vultures fill an important ecological niche.) Many others work very hard to take as little risk as possible. Portfolio theory is a handy tool in this endeavor; firing CEOs and closing startup companies is another. Some people with a lot of money do enjoy taking a lot of risk. They usually end with rather less money.

(Thanks, though, for the pointer to the Kleiman post, in which on of his real experts makes the observation, “Bottom line: you cannot conduct your analysis on purely theoretical grounds; you need some serious cost-benefit data.”)

Anyway, the point of the original post is that a significant chunk of pharmaceutical research is now structured around the idea that Americans (or, more accurately, American insurance companies, HMOs and government buyers) will be willing to pay much more for drugs than other developed countries for an indefinite period. Is this a desirable outcome? For whom?


Robert Lyman 01.22.04 at 2:59 pm


To begin with, I suppose you could defend price controls and patent-breaking as “getting the best deal.” But you certainly cannot call it “volume purchasing power.” When I go to Costco, I get a discout because I’m buying soy sauce 5 gallons at a time, not because I can threaten to forcibly lower their prices.

I would consider the use of force or threats thereof to be an illegitimate bargaining tactic. And threatening to change laws are very similar (although not identical) to threats of force.

If I offered to buy, say, your house, you probably would regard it as criminal if I threatened to do something to render your property interest worthless–if I had the power to zone you out of it, or if I could push through a law forbidding houses to be sold for more than 5% over purchase price, or if I could burn it down. Any such action (including legal changes) in the context of my attempted purchase would be, I think, extortionate in character, and might very well be illegal in many jurisdictions.

It would also be pretty much identical to what governments do when they impose price controls or break patents.


Doug 01.22.04 at 3:57 pm

To begin with, I suppose you could defend price controls and patent-breaking as ?getting the best deal.?

I suppose I could, too, but I didn’t. I suppose could knock down straw-men all day, if I went around attacking arguments that weren’t actually made. Care to try again?


Robert Lyman 01.22.04 at 4:51 pm


I’m at a loss. I said in my first post that there was nothing wrong with volume purchasing power.

I then went on to point out that state-run negotiations (as opposed to private insurance pools, for instance) have extortionate threats looming in the background and likely to be used, and in fact very often are used.

But if the state does not use them, and acts as a pure volume purchaser, I don’t have a problem with that.

Do we even disagree?


Doug 01.23.04 at 10:05 am

On the easy cases, I don’t think that we do, at least not in principle.

On the more difficult cases, I think that you are arguing for a priori restrictions on one type of actor – public actors – for ideological reasons, while allowing another type of actor – corporations – unlimited freedom to act, including enlisting other public actors to take up a company’s private interests. (The point of departure on this thread was the involvement of the US Trade Representative in a pricing question between various US companies and a public buyer in Australia.)

You seem to be arguing that it’s ok to use US state power to assert private interests of pharmaceutical makers, but it’s not ok to use Australian state power to protect the interests of broad swathes of the Australian population. This doesn’t add up in my books.

More broadly, I’m looking at these interactions as they actually take place. Everyone involved drives a hard bargain, and if you can succeed in placing the other side’s resources out of bounds, you’ve given yourself a big leg up. I read your arguments as attempts to place public resources out of bounds, and here we’re likely to continue to disagree.

For example, the deals that are bringing AIDS drugs to Africa would never have happened under the approach that I think you are arguing for. Drug-makers would have insisted that first-world prices should hold, and public actors in sub-Saharan Africa would have had their paths to action (set prices, rescinding patents) blocked for ideological reasons.

As Kleiman puts it in the piece that Sebastian cited: “How to pay for creating things that are, once created, very cheap to make in large numbers is a widespread problem. Given its growing importance, it probably deserves more attention than the standard intro micro text gives it. If the goods are priced way above marginal cost to allow a recapture of the initial investment, the result is that some consumers will choose to, or be forced to, forgo them. That forgone benefit represents sheer deadweight loss, or what non-economists call ‘waste.’ That’s as true of a song or a software program or a microprocessor as it is of an AIDS drug, but the problem gets more exciting when the forgone benefit is staying alive.”

We can argue empirically about what happens in iterations of the interaction, or as public interests change (India’s current policy on generics is a good example), but what we can’t do is posit corporations acting with no knowledge of the public sphere against states that always act capriciously.


Sebastian Holsclaw 01.23.04 at 5:02 pm

As for AIDS drugs in Africa, you seem to want charity. If you want charity, why not do what normal charities do? Buy the product you wish to charitably donate, and then donate it. The US, Canada, France and Germany could certainly do that. They could probably even get the companies to lower their prices somewhat as a charitable/publicity impulse. The problem is that the government want to enforce their charitable instincts by forcing the company not to get paid for their drugs. In the long run that can’t work.

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