Supply, meet demand. Demand, meet supply. I just knew you two are going to hit it off!

By Megan McArdle

There's an argument about pharmaceutical prices on parts of the center-left through right in America that goes roughly like this: It is true that high pharmaceutical prices provide both the capital and the incentive for innovation. However, Europe is free-riding on our pharmaceutical spending. Therefore (it usually continues), we must get tough with the pharmaceutical companies in order to force them to force Europe to pay their full share.

This is rife with economic error. It imagines that there is some basket of drug money that the pharmaceutical companies need to recoup--if we pay more, that allows them to charge Europe less.

I, however, assume that there is a demand side as well as a supply side to the equation. That is, the pharmaceutical companies are charging Europe about as much as they are able to for drugs; they are also charging about as much as they can charge us. If Europe raised the price that they were willing to pay for drugs, this would not lower the price they charged us--any more than Citibank lowers your interest rate here because they just had record profits in Canada. What we are losing through Europe's refusal to pay higher prices for drugs is not help covering the cost of the drugs that our buying funds; it is the never discovered drugs that a larger and more lucrative market would have supported.

The main constraint on prices in Europe is that the buyers have monopsony power. Changing what America pays will not alter the demand side of the equation. European governments might realizing that they have been free riding on our drug payments, and decide to raise the prices that they pay in order to support more R&D. But the political incentives all run the other way, and I see no evidence that the EU governments are excited about spurring private sector innovation by offering high profits on life-saving drugs. So the most probable outcome of introducing monopsony power here is that the market for drugs shrinks to the point where it will support few-to-no new drugs. This result will be sufficiently removed in time from the decision to monopsonize purchasing that the politicians will escape most of the responsibility. And even if the public realizes that it has forgone future discoveries for the sake of a few dollars now, and wants to undo this, the fact that everyone is monopsonizing will make it difficult to enact such a change: no one wants to be the patsy, even if they themselves are made better off by paying higher prices and getting new drugs in return. Witness the insistence on multilateral trade deals, even though all the evidence suggests that unilaterally lowering your trade barriers makes your nation unambiguously better off.

Derek Lowe, a toiler in the bowels of Big Pharma, has more thoughts on this.

This article available online at:

http://www.theatlantic.com/business/archive/2008/01/supply-meet-demand-demand-meet-supply-i-just-knew-you-two-are-going-to-hit-it-off/2630/