What Sets Prices?

Dean BakerDean Baker wrote a very short blog post the other day that gets at an important economic point that most people seem to miss, If Drug Companies Could Charge Higher Prices, Why Aren’t They? It refers to a Katie Thomas and Robert Pear New York Times article that claims that the government plans to pay drug companies less for medications as part of Medicare. “Some have speculated that other consumers could end up paying for the cost savings if drug makers raise their prices to account for the lost revenue.”

What journalists just flunked Econ 101?

Yet, this is an incredibly common fallacy. The idea is that the price of a product is some function of how much it costs to make it. Wrong! In fact, this is what drug patents are all about. They create an artificial monopoly so that drug companies can charge far more than they would cost in a free market (much less what they would cost based only on production expenses).

Think of it in terms of a new piece of electronics. The cost of producing flat screen televisions have gone down over the last ten years, but that isn’t the main reason the prices have gone down. When a product is new, its profit margin is high. Because it’s new. Because people will pay more to be the first. Because they’re idiots. (I think so, anyway; I am most definitely not an “early adopter.”)

So here’s the ultimate rule of business: products are priced so as to maximize profits. As Dean Baker’s headline indicates: drug companies would charge more if they could. The very fact that the government is able to pay less for the drugs proves the point. Why don’t the drug companies just refusing the sell the drugs at that price? Because they are still making money! That reminds me of a joke.

Two haberdashers are talking. The first one says, “I lose a dollar on every hat I sell!” The second one says, “How do you stay in business?” The first one replies, “It’s the volume!”

So the drug companies are not going to sell at a loss to the government, regardless of how big a customer it is. A high volume of losses is a big loss, just as for the haberdasher in the joke. So don’t fall for this fallacy. It pops up a lot. You especially see it used to argue against corporate taxes. People say, “If you raise the corporate tax, the corporations will just pass it on to the customer!” No, not really. In fact, with corporate taxes, it makes even less sense, because corporate taxes are only paid on profits.

Don’t be like Katie Thomas and Robert Pear. In fact, unless it’s Paul Krugman, be skeptical of any economic information you get from the New York Times. And note: the Sunday New York Times does not cost $5 because that’s what it costs to produce. In fact, the Sunday Times has been $5 for over a decade. You’d think Thomas and Pear would have noticed that.

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About Frank Moraes

Frank Moraes is a freelance writer and editor online and in print. He is educated as a scientist with a PhD in Atmospheric Physics. He has worked in climate science, remote sensing, throughout the computer industry, and as a college physics instructor. Find out more at About Frank Moraes.

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