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Commentary By Peter W. Huber

Gouging The Drug Companies

Public Safety Policing, Crime Control

Drugs should be priced in much the same way as seats on a jumbo jet. The guy in the business suit pays $1,000, the kid with the backpack sitting right next to him $200. The suit pays for most of the fuel, the pilot and the $200 million jet. The kid gets to fly for just a few dollars more than the cost of the extra fuel needed to haul his body and backpack. The 300 tons of fuselage and engine, and the fuel it takes to move them, are all free. For the kid.

This makes perfect economic sense. Any other pricing scheme would be less efficient. The economist, mathematician and philosopher Frank Ramsey proved this in 1927. The efficiency of “Ramsey pricing” has since emerged as one of the most profoundly important principles of our information-centered economic lives.

It is also routinely assailed by people in positions of economic authority. When airlines were still regulated, anti-Ramsey regulators sharply raised the average price of flying. We pay, on average, far more than we should for electricity because utility commissions generally ignore Ramsey, or stand him on his head. And if current trends continue, the flat-pricers will kill our pharmaceutical industry.

Almost all the cost of a drug is in the development and the complex hardware required to concoct the chemicals that become the medicine. These costs are fixed, and they are sunk. Like the jet’s fuselage, you pay for them once, up front, regardless. Once a drug is in production, churning out one more little pill costs next to nothing. You can almost give it away to the desperately poor in sub-Saharan Africa. Provided, of course, that somewhere else the suits pay billions. What Ramsey proved is that the most economically efficient way to set prices when producers have high fixed costs and low marginal costs is (roughly) to soak the rich. Set prices on a sliding scale. Charge the suits more, the jeans less. Ideally, you slice it a lot more finely than that. The best scheme all around, for sellers and buyers together, is to charge a wide range of wealth-adjusted prices covering the poorest to the richest consumers.

And that, pretty much, is exactly what smart vendors try to do. United Airlines finds ways to really squeeze the suit and collect just a few extra dollars from the backpacker, too. Microsoft has a business price, home price, student price and Third World price for Windows. GlaxoSmithkline does much the same with its AIDS drugs. You pay a lot more in Kansas than you do in Kenya.

But then there are Canada, much of Europe, our very own Department of Veterans Affairs and our HMOs. All of them are determined to make collective yes/no calls about which drugs will be bought, at what price, by very large groups of people. And these flat-price collectives are now contriving to act in concert. The U.S. HMO tells the U.S. drug company it just won’t let its patients pay a dime more than a Canadian pays. If you live in Detroit, you can have U.S. freedom of choice at Canada’s choice-free prices by hopping on a Greyhound bus. If you’re willing to shop online and skirt the law, you can shop Canadian anywhere.

Drug-buying collectives and cartels have an unconditionally negative impact on economic welfare. As they coalesce, they transform drug manufacturers into price-regulated utilities. Sure, you can go ahead and invest a billion to develop a new vaccine or AIDS drug. But just like your electric power company, you can sell your product only at a price acceptable to Canada’s minister of health. Or maybe Kenya’s. Yes, Merck or Pfizer has honestly earned the government-issue, fixed-term monopoly that we call a patent. But when it tries to cash in at the store, it meets a government-established buyers’ cartel on the other side of the counter.

Patent a miracle drug, choreograph the pricing just right and you recover your sunk costs efficiently, earn a good profit and move on to your next miracle. You can survive the arrival of me-too generic competitors: They put an end to your sunk-cost recovery only after the patent expires. Collectivized buying, however, imposes generic pricing from the get-go.

With so much of global health care spending now collectivized, drug companies have, perhaps inevitably, been sucked--or was it “suckered”?--into joining the system. They lobbied hard to get prescription drugs covered by Medicare, and if they can’t get Ramsey’s price, they quickly settle for Canada’s. In the short term no other strategy makes sense. In the long term it’s ruinous.

When a rich American drug company voluntarily decides to charge impoverished Third World patients much less than it charges comparatively rich Americans, this is good all around. It can generate some marginal gross profit, thus making the medicine slightly cheaper for all, and it makes the world healthier all around, too. When rich people form buying cartels to put a price squeeze on properly patented drugs, the few win in the short term and everyone loses down the line.