02 February 2008

Drugs and the Free Market

Jon sent me this link yesterday.
People who think that there will be continuing R&D in the pharmaceutical industry are basically thinking of it as a budgeting problem. They think of the pharmaceutical industry's gross income as a budget to be allocated between various functions, such as marketing and R&D. They may concede that by changing the size of the budget, you may shrink the amount of money to fund R&D, because there will be less money in the kitty. (Though many or most hope that shrinking the size of the pie will force pharmaceutical companies to transfer money from the advertising budget to R&D1). But, their reasoning goes, there will still be money in the kitty; if you allow pharmaceutical companies 1/3 as much gross income, you will get 1/3 as much R&D. Or perhaps they will cut their advertising budgets to zero, and then you will get 2/3 as much R&D. But still, you will get something.

I don't think of R&D as a budgeting problem; I think of it as an investment problem. After all, even if the pharmaceutical industry has no profits right now, they can borrow the money in the financial markets at fairly attractive rates.

The main obstacle to R&D, then, is not the current state of pharmaceutical industry profits; it is the potential return on the investment in R&D. After all, Merck doesn't have to make drugs; it could generate a nice, safe return of 5% a year in government bonds. Or it could get into some other business, such as making soap. If you drive down the profits on new drugs too far, it stops making sense to invest in new drugs, even if there is a small profit to be made on current production.

Now, let me be fair. I'm actually reasonably sympathetic to the argument that drug companies aren't quite as profitable as you might think, and that it's an intrinsically risky business. All basic research is risky, and it's fair to let drug companies make a fair profit on their investments. But.

There's a central misunderstanding of reality here that I see quite regularly from hard-core free-market types, and I think it's worth remarking on. That fallacy is this: that no one ever does anything except for the remunerative incentives for doing so. That is, that the only reason anything ever gets done is so that someone can make money off of it.

Now, it may be the case that in the instance of drug companies, it makes sense to have a system of a free market that creates profit-making opportunities. But the plans under proposal here are very moderate, and involve allowing for those buying drugs to collectively bargain down the price they pay. A radical solution to the drug-cost solution, one that could rightly be called communist or socialist, would be to nationalize all drug companies and to have the factories work for government agencies instead of being held in private hands. This, I agree, would be a mistake -- must we consider any kind of public action to be a necessarily evil, communist plot?

Let's step back a moment. Corporations exist to make money for their shareholders -- that's the very purpose they have, the cause for their existence in the first place. In a properly-running economy, companies make profits by selling goods and services to either individuals or to other corporations or to governmet agencies or whatnot. Merck, for instance, makes its money by developing, making, and selling drugs, and in the hypothetical that the company stopped making enough money on drugs, it might just make a move to making soap or just by investing in the market.

My question? So what? If Merck finds the competition under a lower profit-making scheme too tough, another company willing to take that risk can easily step in. If Merck wants to start making soap, maybe Ivory will start making drugs. Or maybe Pfizer will step in where Merck stepped away. Either way, this is a purely market-based outcome, and libertarians should cheer at the wonderful workings of the invisible hand.

The more specific argument that McArdle is making in her segment quoted above, of course, is that without the incentive created by giant profits, there will simply be no one who will take the effort to make new drugs. But this is simply false, because of the failure of the principle I outlined above: people don't always do things just for money.

Consider, for instance, medical researchers. Generally, a person conducting actual clinical trials as the primary researcher in an organization is an MD-PHD. That means that after four years of college, this person spends two years in medical school, followed by two or three years of grad school in pursuit of a PhD, followed by the last year of med school, then a combination residency/dissertation period that may last several years. This takes a bare minimum of seven years, and in many cases can stretch to twice that, and that's not counting the four years of college to even get to the point of being able to begin the course of study.

In any realistic sense, this is economically foolhardy, because the actual people doing the research in any medical field (for that matter, people doing research at all) isn't really financiall lucrative. Oh, sure, at the end of it you'll generally be able to make a good upper-middle-class living in your field, with the possibility if you're good of moving into lower-upper-class, but the people actually doing the PCR analyses and slicing up organisms aren't the ones making giant profits. The people making those giant profits are the people who pay their salaries, who own the building and the factories and who control advertising budgets and everything else. In other words, the suits make the money off of the backs of scientists who are after something else, generally the joy of discovery or the feeling of doing something genuinely for the betterment of mankind.

Let's say the worst happens and every drug company in America has to close up shop due to the increased competition due to lower drug profitability. People (that is, you and I) are still going to want new drugs, new research -- it'd be a snap to fund the production of these drugs directly, either through the creation of nonprofit companies that make drugs, or through the funding of scientists at the university level.

(Indeed, it's one of the dirty little secrets of the drug industry that much of the basic research that goes into making a new drug isn't done at the R&D labs at pharma companies at all, but is done at the University level by scientists making a comparative pittance and funded by grants from either the NSF, the NIH, or the CDC. Indeed, in many cases scientists working for drug companies will apply for these grants to fund their research -- this is a case in which drug companies actually make huge profits off of research funded by taxpayers.)

To repeat, it may be the case that the best way to go about providing drugs to people is through a market-based system without collective bargaining. But somehow I doubt it, as there are plenty of medical and drug companies in countries with some sort of universal health care (flu vaccine, for instance, is made by a French company), and these companies seem to be able to turn a nice profit nonetheless. The best way to foster medical innovation is an empirical question, not an ideological one, and endless bleatings about the free market while pounding the chest don't really accomplish anything. The next time I see this argument, I'm going to ask the person making it is our drug companies weaker and more pathetic than those in France? And if not, why are they so scared of a little competition?

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