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James Boyle: Deadweight loss and dead people

Thomas Hazlett: Static arguments don’t apply to dynamic markets

In all the years that I have consulted for firms in the pharmaceutical industry, one of the most fiendish and frustrating problems has been the issue of drug pricing. The source of the difficulty lies in the fact that many valuable pharmaceutical products are under patent, so that the patent holder has some discretion in the price that it charges to various segments of the market.

Where the ordinary profit-making norms hold sway, the key questions facing the patent holder are technical. To what extent is it able to discriminate among various segments of the market in order to maximise its profits? In general the discrimination in question will increase the profits of the firm in two ways. It will first allow the firm to extract more from those demanders who can pay it; and second it will let the patent product reach those parties with lower effective demand. The social gain to consumers as a class comes from the fact that the higher rate of profits will induce more research and development, allowing life-saving drugs to hit the market sooner. Remember where there are no drugs, there are neither firm profits nor consumer benefits.

Yet the one point that the current political situation has made clear, world-wide, is that these cold-blooded economic calculations are often subject to endless buffeting in the political process. To folks who are impatient with their own situation, there are only two pricing imperatives - which turn out to be flatly inconsistent with one another.

The first imperative proclaims that it is unfair to charge differential rates. This claim is made most vociferously in the United States by consumers who chafe at the lower rates that are charged in Canada and elsewhere, and demand that they receive the same lower prices. In part this price differential is the result of higher effective demand in the United States with its greater wealth. In part it is because the prices in other countries are kept artificially low when the state acts as a single buyer. The widespread demand price controls offers some evidence of the strength of this conviction.

Yet at the same time that these calls are made, there are impassioned pleas for lower prices for life-saving drugs, such as AIDS-related drugs that are in desperately short supply in Africa. The argument is a combination of hard-headed economics and international compassion. It is hard-hearted because why charge more than the market can bear. It is compassionate because the demand is that the drugs be sold for little or no money. But either way, the upshot is that lower prices have to be charged in places that cannot bear full freight.

The two positions are in a sense in sharp tension with each other, for it is not possible to have uniform world prices for rich and lower prices for poor ones. The hard question is where one should yield on this question. The answer is probably keep the price differentials, with higher prices in the more developed countries.

But real difficulties stand in the path of benevolence, for it is much more difficult to supply low-price drugs than it appears at first instance. The physical delivery of drugs is no easy task. Chains of custody are long, and unscrupulous individuals stand ready at every step of the way to subvert the system in underdeveloped countries that do not have a well-established transportation and storage system.

First, drugs can be resold in the markets of developed countries where they undercut the manufacturer’s ability to maintain the higher prices needed to cover the front end costs of develop.

Second, drugs are easily spoiled in transit, or administered in dangerous or ineffective ways. Drug companies can guard against these risks only by assuming the end-to-end control over the system, which is hard to do in countries where they operate under a presumption of distrust.

Third, there are serious issues of tort liability, which arise in suits that seek compensation from the adverse consequences that sometimes flow from the use of powerful drugs needed to treat life-threatening diseases. For US companies, in particular, there is the constant risk that these cases could be decided in American courts under rules that carry the risk of serious financial burdens.

Having to guard against these contingencies raises prices overseas. At some point, therefore, the demand for lower prices often translates into a demand for sales below cost. To some extent, drug companies should be prepared to lose money when human life is at stake. But it is a mistake to assume that they should be the sole source of this subsidy. Money is perfectly fungible, and some portion of the shortfall could be covered by foreign governments or charitable organisations that work overseas.

The overall complexity of this situation should caution against yet another proposed remedy. It has been suggested that whenever a foreign drug company does not supply products at the prices deemed acceptable by one government or another, then that country should break the patents and allow generic suppliers to enter the market at a lower cost. This short-sighted manoeuvre, when repeated, could sap the validity of the patent system world-wide, as it is relatively easy to transship generic products across national borders. Nor does going generic do anything to deal with the serious structural obstacles that surround the prompt and sensible distribution of pharmaceuticals in the places they are needed most. The drug pricing issue is, alas, part of a much larger structural social problem.

Richard A. Epstein is the James Parker Hall Distinguished Service Professor of Law at the University of Chicago, and the Peter and Kirsten Senior Fellow at the Hoover Institution


James Boyle: Deadweight loss and dead people

Jamie Love, an influential activist on access to medicines, sometimes begins his talks with an uncharacteristically dry slide: the graph illustrating monopoly pricing found in every economics textbook.

His listeners assume the glazed expression of people about to relive an unpleasant moment from their undergraduate economics course. Love points to the shaded grey triangle representing those who would pay more than marginal cost for the good, but who will be unable to purchase it because of monopoly pricing. “In economics,” he says, “we call this deadweight social loss.” Pause. “In healthcare, we call it dead people.”

Love is right. Worldwide, millions of people die of preventable diseases because they cannot afford the medicines needed to cure them, medicines that the rich world takes for granted. Millions more die because there is no research on their ailments – there is a “market need” for impotence drugs, but not one for tropical diseases such as malaria and leishmaniasis.

Richard Epstein is also right. Solving these problems is complicated. Trying to solve the problem of access to medicines in the developed world at the same time makes it even more complicated. Blaming drug companies for the deaths of the global poor, while buying the global rich’s drugs in Canada is not the solution – though it sometimes appears to represent the limits of the political imagination in Washington.

But Epstein’s column mixes undoubted truths with some misconceptions. First, the entire developing world makes up about 4-6 per cent of the market for pharmaceuticals. The threat of compulsory licenses in the case of health care emergencies in the developing world is not the apocalypse the drug companies have suggested.

Second, drug companies are right to worry about drugs sold at lower prices “leaking” into developed markets, but the fear is overblown. In the case of antiretrovirals used to treat AIDS for example, the formulations used in the developing world are often not the frontline therapies used in the developed world. Leakage can also be prevented by legal barriers to reimportation, regional markings and colourations for medicines and a host of other techniques. The attack on the quality of generic drugs is also largely a canard. There are extremely high quality generic manufacturers worldwide. The drug companies admit as much.

There is a larger question here. The point of a patent is to allow a drug company to charge monopoly prices – that is the way we have chosen to fund the final stages of pharmaceutical innovation. This method has its problems: we pay a high social cost relative to the amount of money going to R&D, for example.

But it actually produces drugs that save lives. One cannot simply demand access to medicines without solving the problem of how those medicines are developed. Innovation has to be paid for. Yet drug patents are not the only method of doing so. Considerable attention has been generated by a proposal for a Medical Research and Development Treaty, which would require countries to devote a minimum percentage of their GDP to R&D but allow them flexibility in how they supported pharmaceutical innovation – using anything from prize funds to the current patent system.

In effect, this would establish a worldwide market for methods of encouraging innovation. We could compare the efficacy of different techniques, something our current system does not allow. The Treaty also has mechanisms for encouraging research on neglected diseases. Like our current system, the proposal has problems. But it is better than concentrating on blaming drug companies and importing drugs from Canada.

This writer is William Neal Reynolds Professor of Law at Duke Law School, founder of the Center for the Study of the Public Domain and a board member of Creative Commons and Science Commons.


Thomas Hazlet: Static arguments don’t apply to dynamic markets

The dead body that specifically comes to mind from the monopoly pricing graphic is that of the late, great Joseph A. Schumpeter, Jr. Surely the Harvard economist suffers gravely from the use of static arguments to describe dynamic markets, an error he endeavoured so eloquently to correct.

The reality is that “dead weight losses” only appear given the existence of the product in question. When medical innovations are sought, that given is gone. It is then a question of how to compensate investors for the costly risk-taking required to invent our way around deathly ailments. To squeeze prices to costs would eliminate “dead weight losses.” But it would strew corpses all about – those poor souls denied the miracle of “monopoly priced” drugs.

The tension between how to create what is not yet available, yet making fully available what is, is deadly serious. Schumpeter, confronting the trade-offs in his 1942 treatise, Capitalism, Socialism, and Democracy, argued compellingly that the process of “creative destruction” - unregulated rivalry for temporary positions of monopoly - was far friendlier to consumers than the zero-profit equilibrium of textbook fame. The life-saving drugs popped out by investment markets capitalising patent-protected revenues suggest that the old professor had his meds just about right.

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