Friday, January 12, 2007

Drug Wars

About the Medicare drug prices for the elderly (via NoCapital):

President Bush vowed Thursday to veto Democratic-drafted legislation requiring the government to negotiate with drug companies for lower prices under Medicare.

The House is to debate and vote Friday on the legislation, which is one of a handful of priority items for Democrats who gained control of Congress in last fall's elections.

"Government interference impedes competition, limits access to lifesaving drugs, reduces convenience for beneficiaries and ultimately increases costs to taxpayers, beneficiaries and all American citizens alike," the administration said in a written statement.

It said that competition already "is reducing prices to seniors, providing a wide range of choices and leading to a more productive environment for the development of new drugs."

Democrats shot back quickly.

"Evidently, the president is more concerned with protecting pharmaceutical company profits than American seniors," said Rep. Rahm Emanuel (news, bio, voting record), D-Ill., a member of the House Democratic leadership.

It is very hard to take a step back from all this emotional stuff to actually look at the underlying ideas, but I'm going to do just that. Don't fall asleep quite yet.

The conservatives have a religious idea of "the markets" and of "competition". These gods can do no wrong and always work to help the consumers. Where did they get this religion?

It comes from a particular kind of marketplace, the one economists call a perfectly competitive market. Alfred Marshall, an old white dead guy in economics, compared the actions of such markets to the two blades of scissors, both cutting at the same time. So consumers and producers both affect prices in such a market. But at the same time consumers and producers are so many and so tiny, atomistic, indeed, that no one person or firm has any ultimate say in what the price might turn out to be.

The perfectly competitive market is fairly rare in reality, because it requires a market where people can come and go almost costlessly so that new firms can be set up in a moment without a great outlay (this is called free entry and exit) and because it requires a market where the product is so obviously constant in quality and so easy to check out that the only thing the sellers can compete in is the price which all can observe (homogeneous product requirement with perfect information thrown in). And this market must have many potential buyers and sellers.

Most markets in reality are not perfectly competitive. The further away we get from the basic requirements, the fewer economists there are who would swear that competition helps the consumers. At the other extreme of the perfectly competitive market is the case where we have one firm providing everything, a monopoly (or, theoretically, we could have one firm buying everything, a monopsony). Such a firm will not act like the blades of scissors in determining the price, and believe me, it is this firm which will determine the price. It will be set as high as the consumers can possibly endure, assuming no government regulation or potential entrant firms waiting in the wings.

Where does the pharmaceutical industry fall along this range of possible markets? Much closer to the monopoly end than the perfectly competitive end. For instance, the total number of pharmaceutical firms in the world markets for pharmaceuticals is a small one. In theory, these firms could get together and collude on the prices, the way the OPEC does in oil markets. Note also that you can't just set up a pharmaceutical firm without lots of money, so entry to the market is not free. The products are not homogeneous and consumers have great difficulty in judging their quality. Uncertainty abounds. It is fairly silly then to say that competition in this market would cause prices to automatically drop. The market might compete more in quality and in innovations, say.

Now add to such markets a large buyer, the Medicare program of the U.S. government. It's pretty obvious that this large buyer is not a small atomistic speck in a competitive market, powerless to affect prices. Instead, it would have great negotiating powers because of its large orders. It might expect quantity discounts if there are economies to scale in producing the drugs it orders. But the previous Congress ruled all this out. Medicare must act as if it has no market power at all.

This can't avoid helping the industry.

But does it help the consumers, the elderly, who rely on Medicare for their drugs? I am pretty sure that they pay more for their medications because of the ban on price negotiations. - Isn't it fascinating, by the way, that the pro-market forces in the Congress banned the very thing that would drive prices down in most markets? - What the effects of the ban are on all the other goodies mentioned in the above quote isn't quite as clear, but the list of goodies looks to me like something dug up from textbooks on government regulation of markets. Not all the points apply to this particular case at all.

Note that in reality the pharmaceutical firms trade globally to a large extent with governments of all types, and this makes the market analogy even less useful when looking at what the U.S. government should do. As an example, if all other governments bargain and negotiate over the prices they are willing to allow but the U.S. government does not, who do you think will get to pay the highest prices in the world?