Kausian Economics
Posted by aogMonday, 30 June 2003 at 17:49 TrackBack Ping URL
Mickey Kaus, who among other problems doesn't have perma-links, wonders about the following two critiques of a partially privatized prescription drug plan, as promoted by the Bush administration. These are
  1. drug companies need to make big profits on successful drugs if they are going to finance the risky research to discover new drugs, which involves following a lot of false leads [and] if there's a drug benefit within a government-run Medicare system the government might use its massive buying power to demand low "dictated prices that don't cover" the costs of discovering those new and better drugs.
  2. new entitlements always wind up costing far, far more than initial estimates

Kaus doesn't understand how both of these can be true at the same time, arguing that if it costs a lot of money that must go to the drug companies, or alternatively if the drug companies aren't making big profits then the program can't be costing that much. I must say that Kaus should have more faith in the governments ability to get the worst of both worlds in all situations. In this case, Kaus is overlooking two factors, margins and volume.

The primary reason that government programs end up costing far more than projected is that once you give stuff away to people, they tend to treat it as if it were, well, given away. Therefore they tend to use a lot more of whatever it is. Any long as there's any net benefit to a drug, why not prescribe it? It's free! This is the real cost factor, not the amount of profits. I think it's quite reasonable to expect a surge in demand once a government subsidy is in place.

On the other side there are the "margins". This is business speak for the difference in revenue, the cash that flows from consumer to company, and profits which is the cash the company actually keeps. Push the margins low enough and even with vastly increased volume, the drug companies won't make enough to pursue risky research. I expect that profits would actually increase at first because of the additional volume. However, hitting drug company profits (which are now in effect determined by government fiat) will become a standard, yearly budget action which will erode profits in the long term. How low? Until margins just cover operating costs. In fact, you could get into a death spiral where the companies cut research to boost margins, leading to another round of government mandated price cuts leading to further research cuts to keep margins up …

Overall a prescription drug benefit will make the pharmaceutical companies far more like regulated utilities, which isn't too bad for providing an undifferentiated commodity, but perhaps not the best model for an industry that requires inovation. A partially private mechanism wouldn't be good but at least it would help some on the demand side.