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Time, Incentives, Expectations, Marginal Costs, and Prices

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Over at EconLog David Henderson linked [2] to this essay by Dean Baker on pharmaceutical pricing [3].  David’s criticism of it overlaps the criticism that I offer here.

Consider this passage from Baker’s essay:

In the vast majority of cases, the [pharmaceutical] drugs in question are not actually expensive to manufacture. The way the drug industry justifies high prices is that they must recover their research costs. While the industry does in fact spend a considerable amount of money on research (although they likely exaggerate this figure), at the point the drug is being administered this is a sunk cost. In other words, the resources devoted to this research have already been used; the economy doesn’t somehow get back the researchers’ time and the capital expended if fewer people take a drug that is developed from their work.

Ordinarily economists treat it as an absolute article of faith that we want all goods and services to sell at their marginal cost without interference from the government, like a trade tariff or quota. However in the case of prescription drugs, economists seem content to ignore the patent monopolies granted to the industry, which allow it to charge prices that are often ten or even a hundred times the free market price.

I here wish to steer clear of the debate over the efficacy of intellectual-property law.  I say about it only that if we agree that someone has a property in his or her creative ideas, then there is no more reason to call such properties “monopolies” (or to suggest that the protection of such properties is ‘monopolistic’) than there is to call, say, a person’s property in the factory he lawfully built or acquired a “monopoly” (or to suggest that protection of that factory is “monopolistic”).  Baker’s language sneaks in as an undisputed fact the conclusion that he presumably wishes to bring readers to through a process of reasoned argumentation.

The point that I instead wish to focus on is the reality of time in market processes, and on how the reality of time in market processes makes it easy to carelessly misconstrue or misuse economic analysis, concepts, and conclusions.

Baker is correct that the ideal is for “goods and services to sell at their marginal cost” (although he’s incorrect to label economists’ discovery and explanation of this reality “an absolute article of faith”; it is nothing of the sort; it is, instead, a conclusion of scientific analysis).  But the demonstration of the optimality of (the quantity of output of X being such that) ‘the price of X equals the marginal cost of X’ implicitly encompasses an amount of time sufficiently long to ensure that X is produced in the first place.

Economists’ frequent failures to account properly in their analyses for the dimension of time has, admittedly, often led them into vagueness and carelessness about this matter.  But consider that just as the marginal cost of a new automobile is not reckoned from, say, the moment when an automobile is on a delivery truck one mile away from the auto dealership where it will be sold – that is, just as the marginal cost of a new automobile is reckoned over a span of time long enough to ensure the inclusion of all costs necessary to produce and bring that car to market (such as the costs incurred a few days earlier at the factory to employ the metal and the labor that were used to make the car) – so, too, the marginal cost of a pharmaceutical item should not be reckoned from, say, the moment after an important portion (namely, R&D) of the production process of that pharmaceutical item has been completed and, hence, “sunk.”

To see more clearly what I mean, realize that if we shorten the time horizon enough, the marginal cost of almost any good falls to near zero.  Consider, for example, all of the cooked, prepared, and wrapped hamburgers sitting at this very moment under heating elements at the thousands of fast-food restaurants around the world: what is the marginal cost of these hamburgers?  In those many restaurants that today (literally, January 18th, 2016) have slightly fewer customers than they normally have and expect, the marginal cost of each of those prepared and wrapped burgers is near zero.  After all, the meat, the buns, the pickles, the ketchup, the labor, and the fuel that were used to create these burgers are already tied up in these burgers.  The costs of these items is now sunk.  Yet nothing in economic theory carefully used suggests that restaurants should therefore give these burgers away free of charge.  This rejection of that interpretation of marginal-cost pricing occurs not because economists have a special “hamburger exception” to the marginal-cost-pricing rule but, rather, because economists understand that the appropriate time period for reckoning the marginal cost of supplying a hamburger must include the time required not only for hamburgers to be transported from warmer to consumer but, rather, also the time required to produce that hamburger from the start.

And, so, when we consider the fact that producing effective pharmaceuticals requires a great deal of up-front R&D, there is no reason why these R&D costs are not appropriately reckoned as part of the marginal cost of producing the relevant product – namely, a useful pharmaceutical product that would not otherwise exist absent the R&D that helped to created it.  Yes, of course, if we leap into the production process only after the necessary R&D expenses have been incurred and the pharmaceutical product has been successfully engineered – that is, if we look only at the costs that are subsequently necessary to produce and get this product to market – then the marginal cost of this product appears to be lower than it would appear had we instead leapt into the production process before the R&D expenses were undertaken.  But obviously, the particular point of the production process where we, as observers, choose to leap into the process to do our observations of it is not relevant for determining the costs, marginal or otherwise, of the product.  That cost exists independently of us, the theoreticians and observers.

….

One final, more basic point before closing.  I’ll make this point in the form of a question to Dean Baker: Do you, Mr. Baker, believe that efforts to investigate, hunt down, prosecute, and punish murderers are wasteful and unjustified?  If I take your comment above seriously, I might guess that your answer to my question is “yes.”  After all, once an innocent person has been murdered, the damage is done and irreversible.  No resources spent subsequent to the murder will return the victim to life; likewise, no after-the-fact price imposed on the murderer for his or her crime will return the victim to life.  So according to the logic that I infer from of your argument, because any after-the-fact efforts to address a murder will do nothing to return the victim to life, any resources expended on such efforts are wasteful: they have no justification.  Do I, Mr. Baker, read you correctly?

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