9/21/00 4:05 p.m.
Don't Bark at Drug Prices
The flaws in fixing drug prices.

By Gene Callahan, who is working on a book, Economics for Real People,
for the Ludwig von Mises Institute

rug prices have been a political hot potato lately. In a recent NRO article, Robert A. George mentioned a justification for the (alleged) fact that drug prices for humans run higher than those for animals for the same drug. As the American Veterinary Medical Association's Governmental Relations Division put it in a letter to Rep. Henry Waxman (D-CA):

All drugs are developed for human use first as this is the biggest market. If in the course of development, substantial animal benefits are discovered, then the drug may be further developed for animal use, piggy-backing on the work already done for the human drug. This significantly reduces the sunken costs in the development of a veterinary drug and therefore allows it to be sold for less.

However, sunk costs are irrelevant to both how prices are formed and what public policy toward prices should be. This argument opens the door for calls to justify other prices in the same way, and is a severely flawed strategy for those who wish to defend economic liberty.

First of all, the argument is based on the long-discredited idea that the price of consumer goods is set by the cost of the producer goods needed to create them. The classical economists resorted to such theories because they had not developed a coherent theory of value.

The marginalist revolution of the 1870s did develop one, and, in the process, explained the connection between the price of consumer goods and producer goods. Consumer goods are valued because they satisfy some perceived need. Producer goods are valued based on the (entrepreneur's estimated future) price for the consumer goods. Ludwig von Mises illustrated this by pointing out that burgundy wine is not more expensive than chianti because it is produced on more costly land, but the reverse: The land is more costly because producers, spurred on by the higher price of burgundy, have bid up its price. Consumers are not willing to pay more for a good than its perceived value simply because the cost of producing it was high. Imagine a builder coming to bid on some new construction you wish to undertake. Yes, he says, his price is much higher than his competitors — but this high price is justified, because his carpenters have very little experience, and therefore they waste a lot of wood.

Those who wish to contend that cost objectively determines price might say that they are not talking about sunk costs, but opportunity costs. These are what an entrepreneur could have made with the next-best use of his resources. If he thinks he can make $20,000 selling hot dogs, then this is his "cost" of selling hamburgers instead. This would be fine, except that there is no objective way to measure such costs. Consider Michael Jordan's former NBA salary. Did it "cost" him $19.99 million a year to produce his basketball output, justifying his salary of $20 million?

Those arguing that costs set prices might say: "Yes. It is because the Lakers would have paid him almost as much as the Bulls that the Bulls had to pay him as much as they did. That's his opportunity cost of playing with the Bulls — the money he could have gotten from the Lakers."

But unless we can arrive at an objective statement on opportunity costs, we cannot use them to justify a price to a critic who feels it is "too high." If we try to do so, we encounter the following difficulties:

1) Jordan may never have received any offers from any other team (a quite realistic scenario) before signing the contract. In this case, no one has any idea what the Lakers would pay him.

2) Jordan may love living in a cold, windy city, in the proximity of meatpacking plants, near a large Polish population. While each of these could come into play in his decision — raising his opportunity cost for moving — even Jordan himself could not quantify them. He prefers certain scenarios to other ones, but since these are subjective judgments, "how much" he prefers them cannot be measured. As Mises says: "Profit and loss in this original sense are psychic phenomena and as such not open to measurement and a mode of expression which could convey to other people precise information regarding their intensity."

3) Jordan might also be considering an acting career, in which he thinks he might be able to make $40 million a year, without sweating as much. Then again, he might fail miserably. This is the real situation of entrepreneurs considering a speculative venture, for instance, of a pharmaceutical company contemplating the development of a new drug. How do the profits from this drug compare to those the company might make on a different drug, or from a new advertising campaign on an existing drug? At best, the company has an educated guess as to the answer. Far from being amenable to objective calculation, real business estimates of opportunity costs are often based on vaguely sensed premonitions of future market states (e.g., "Joe, I think we're gonna sell a lot of these.").

4) The notion of opportunity cost does not account for the possibility of "true" profit. By anticipating consumers' future desires better than others can, the entrepreneur hopes to make more than any costs he incurs — in fact he hopes to make a lot more. If we (correctly) include the interest that simply lending the capital would have yielded as a cost, true profit only emerges when an entrepreneur can collect more than he lays out. It is the possibility of true profit that lends urgency to the entrepreneurial adventure, and leads entrepreneurs to devote time and energy to anticipating consumers' needs.

Quantitative economic models that attempt to find "correct" prices are sterile. They are similar to predicting the future batting average of major league ballplayers with a model that abstracts out the batter himself, then formulates equations involving just the bat and the ball.

For someone who doesn't believe that markets work, it is impossible to back into the correct market price from any notion of cost. If it were possible to calculate costs in an objective fashion, then the government could set "correct" drug prices — it would just calculate the production costs, then set prices so as to allow only a "reasonable profit."

But to try and justify a market price on the basis of costs only leads to endless wrangling over what these costs "really" are. The defenders of liberty would do better to understand Mises when he points out:

It is no less vain to ponder on what prices ought to be. Everybody is pleased if the prices of things he wants to buy drop and the prices of the things he wants to sell rise. . . . But one deludes oneself or practices deception if one calls such wishes and arbitrary value judgments the voice of objective truth. In human action nothing counts but the various individuals' desires for the attainment of ends. With regard to the choice of these ends there is no question of truth; all that matters is value. . . . Any price determined on a market is the necessary outgrowth of the interplay of the forces operating, that is, demand and supply. Whatever the market situation which generated this price may be, with regard to it the price is always adequate, genuine, and real.