Man Without Qualities

Thursday, July 24, 2003

A Lesson In The Economics Of Marginal Cost

A basic discovery of micro economics is that a seller will sell product as long as sales proceeds of one additional unit (marginal proceeds) exceeds the total cost to the seller of selling that additional unit (marginal costs). In the case of a unitary, freely competitive market, there is an additional constraint on the seller: the seller can only charge one price for all of the seller's goods.

So what?

Well, national boundaries - the one between Canada and the United States being one example - disrupt the "unitary, freely competitive market," especially where the goods in question are subject to import restraints imposed at the discretion of the seller. Patented drugs are the example now much in the news as Congress considers a law governing drug reimportation, a law that would allow American drugs that sell for less in foreign countries (especially Canada) to be reimported and sold here at a price based on the foreign sale price which is lower than the domestic price.

Some people have argued that such a drug reimportation law would cause private drug research funds to dry up, since the law would impair earnings from the drugs produced by the research. That's possible - but if this law has meaningful effect, it is likely to do far more harm to Canada and other foreign countries than the United States - while raising United States drug prices by some measures.

Patented drugs sold in Canada represent marginal sales for the drug companies - similar to a gas station's sale of, say, model cars or soft drinks. [For purposes of this post, I will use "Canada" as synonymous with "non-US," although that is not strictly correct.] American drug companies do not depend on Canadian sales for most of their profits. Drug companies sell to Canada at lower prices because those sales do not now affect United States profits, so the marginal return to the drug companies is positive even at the lower foreign price. If Congress mandates that open drug reimportation be permitted, and drug companies can stop selling in Canada altogether, they will likely do that rather than gut their core profitability in the United States market by exporting to those marginal, foreign markets. (Actual Canadians - that is, not just non-Americans - amount to 2 to 3 percent of the prescription drug market; Americans, 65 percent. Actual Canadians get a substantial free ride on the research and development for the American market.) So Canada will suffer unless drug companies are allowed to raise their Canadian prices - which will gut the effects of the proposed reimportation law, since there will be no "cheap foreign drugs." At the moment Canadian drug prices are determined through a heavy dose of government intervention and a deal involving the prices of generic and patented drugs - so a drug reimportation law will require some heavy political decisions on the part of Canada.

The United States will also likely be harmed by the reimportation law. The positive side of a drug company's decision as to whether to go forward with research for a particular drug depends on expected aggregate revenue from sales. Canadian sales may now be marginal, but they are still profitable - and therefore factor into a drug company's decision as to whether to go forward with a particular drug. If the drug reimportation law causes drug companies to cease sales to Canada, then expected aggregate revenue from sales will equal expected aggregate revenue from sales in the United States but not Canada. Some drugs that would have been sufficiently profitable if Canadian sales were possible will (with open drug importation mandated) not be profitable - and will therefore not be pursued. Only drugs likely to be profitable from United States sales alone will be privately researched. That will put upward pressure on average drug prices for new drugs. So it is even possible that the reimportation law could have positive effects - if the result is that Canadian drug prices are forced to go up. In that case, the expected aggregate return to research will increase because Canadian sales will result in more profit to the companies, and therefore more drugs will be researched by the companies.

So, unless Congress is willing to mandate cheap Canadian sales of drugs, or Canada is able to force drug companies to sell a full line of their drugs in Canada cheaply, both Canada and the United States will likely suffer badly from this proposed Congressional action. Of course, if either Congress or Canada take such actions, private drug research funds will dry up, since the law will impair earnings in the United States from the drugs produced by the research.

[One can only shudder to imagine the results of the incentives created by such regulatory efforts for a company to evade them, efforts which would probably soon surpass in complexity and economic distortion the efforts made to avoid the corporate income tax. Will companies holding a patent for a new drug sell it - or spin it off - to a single-purpose company set up solely to make and sell that drug - thereby avoiding regulatory pressure which might be brought on a company selling a broad line of patented and generic drugs? That would only be a simple beginning.]

In any event, the negative consequences will all happen after the next election - so it's probably okey-dokey with Congress. Besides, if the majority of the most immediate negative results of the law fall on Canada, through the loss of American drugs or a rise in Canadian drug prices or whatever, Congress cares less. That United States citizens and the rest of the world suffer from a fall off in drug research and a focus on more expensive drugs is a more subtle long-term effect that can be denied by fudging the statistics in the usual academic/beltway fashion - in the same way such fudging allows some academic economists to pretend they doubt that raising the minimum wage increases unemployment.

Too bad one can't get a job - or make a malignant tumor or an HIV infection go away - with fudged statistics.


UPDATE: The House has approved the reimportation bill.

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