Volume 3, Number 88
17 November 2003

Dear Friends,

For the present letter, I choose two separate, short topics: drugs from Canada, and safe cars, plus a postscript on the World Trade Organization.

Drugs From Canada?

Because drugs in Canada are much cheaper than those in the United States, many Americans cross the border to buy them, despite the illegality of these imports. Now, the governors of Minnesota, Iowa, Illinois and Wisconsin would like to import cheaper drugs in order to finance their health-care programs, which threaten their budgets. Those who oppose such imports argue that Canadian drugs have not been examined by the U.S. Food and Drug Administration, and it is possible that some may be dangerous. But that is not the real reason to oppose them.

The real story is generally not told, possibly because Americans are considered not able to understand it. It is the old question of fixed versus direct costs. It costs billions to develop drugs, many of them don't make it to market, and for those that do, the cost to manufacture is a pittance. The development costs are called fixed costs, the manufacturing and selling costs direct costs. Fixed plus direct costs are total costs. As they determine prices, the pharmaceutical companies must somehow allocate the fixed costs into the prices of all drugs sold. If they think consumers will pay more for anti-cancer drugs than for aspirin, they will allocate more of the fixed costs to anti-cancer drugs than to aspirin. That is why certain drugs cost so much, though the direct cost is little.

The government of Canada controls the price of drugs at a low level, just high enough to cover direct costs, possibly plus a small portion of fixed costs, but too low for total costs. The pharmaceutical companies can afford to sell to Canada because the direct costs are covered. Therefore, the Americans pay most of the fixed, or development, costs. Now, if more and more Americans buy Canadian drugs, the fixed costs will be inflicted on the remaining Americans, who will be squeezed. Drug prices for them will go higher and higher.

William Safire summarizes this situation as follows (NYTimes 10/27/03):

"The price of most new prescription drugs is high in the U.S. mainly because it includes the producers' huge investment in scientific research. In Canada, the government strips out the cost of such research and imposes a low price ceiling. Shortsightedly, our pharmaceutical companies have meekly or greedily gone along with this foreign rip-off, picking up extra sales on a research investment already made."

It is the same for any producer with heavy fixed costs and low direct costs. Textbook publishers sell at lower price in Europe than in the United States. Presumably Americans can afford to pay the fixed costs of publication, whereas Europeans might not. Airlines segregate the market all the time. They do not want seats to travel empty, so they offer them to tourists at lower prices than to businesspeople. Other than these examples, however, market segregation is not popular in the United States, and producers try to sell at the same price everywhere (or at least, pretend they do).

If all students could buy their textbooks in Europe, no one would be left to pay the fixed cost of publication. If tourists didn't fill the extra seats, business travelers would pay more. If all Americans could go to Canada to buy cheaper drugs, no one would be left over to pay the fixed costs of developing new drugs.

Normally, market segregation helps even those who have to pay higher prices. Businesspeople will pay less for airplane seats if otherwise empty seats go to tourists who will pay some (even if very little) of the fixed costs.

I first heard about market segregation while studying economics in college sixty years ago. Here's the example I was told: Suppose a railroad has more shipments from New York to California than from California to New York. Once the cars reach the West coast, they must return to New York for the next load. Should some return empty? No, say the railroads, the rates should be lowered for West-to-East traffic (W-E), at least low enough to fill the cars that would otherwise travel back to the East empty. Indeed, by giving a discount to W-E traffic (charging it only "some" of its share of fixed costs), that "some" enables them to charge less for E-W traffic as well, and so to compete better with trucks and other forms of transport.

An example: Suppose a railroad has to pay $100 million anyway, even if no traffic passes over its tracks. This amount is necessary to keep the tracks in good condition, pay taxes, cover depreciation and renewals, and other fixed costs. Let us suppose that to carry a given load, East to West (E-W), it also pays the direct cost of handling the load, of $50 million. If there is no other traffic on the RR, the total cost to carry this load is $150 million ($100 fixed plus $50 direct).

Suppose another load, of equal weight, would travel, W-E, for $35 million but cannot be shipped for $50 million because Easterners (the "poor market") will not buy it at a price high enough to cover all that transportation. Either the RR returns the car empty, or it makes a concession to the W-E load. In determining rates, it might charge $75 million of its fixed costs to the E-W load, and so charge that load only $125 million (instead of $150 million). Then it could charge only $25 million fixed cost to the W-E load, for a total of $40 million, which (we suppose) its eastern purchasers are willing to pay.  My apologies to easterners for calling them the "poor " market; it could just as easily have been the other way.  (When I was in college, I was an easterner.)

Why does it charge only $125 million instead of $150 million for the E-W load? Because of competition. If it did not do so, we presume the load would go by truck and the RR would earn zero. So, the concession to the W-E load actually decreases the cost of the E-W load. RRs do this all the time.

By the same token, whatever small amount the Canadians pay toward the fixed costs of pharmaceuticals reduces the costs that the remnant of Americans have to pay, provided they are not so squeezed that only a tiny remnant pays all the fixed costs.

Suppose it costs pharmaceutical companies $100 million (fixed costs) to develop a drug but only $10 million (direct costs) to put it on the market in either Canada or the United States. If there were no Canadian buyers, the American buyers would have to pay $110 million. However, if Canadian buyers are willing to pay (say) $40 million (or $10 million direct plus a concessionary $30 million share of fixed), then the fixed costs for Americans would be reduced, so they could buy the drug for $80 million ($70 fixed plus $10 direct) instead of $110 million. But if there are so few Americans remaining to cover the fixed costs, they will pay more instead of less.

So, high-fixed-cost companies try to segregate markets, selling for less in the poor-people's market, causing them to pay some of the fixed costs, so that inhabitants of the rich-people's market will pay less than they would if they had to cover all the fixed costs. However, if inhabitants of the rich-person's market go over, en masse, to the poor-people's market, as is the case of Americans buying drugs in Canada, then those remaining in the rich-people's market pay more, and ultimately they will be completely squeezed.

Forgive me, Canadians, for calling you the poor-people's market. But, by the grace of your government, that's where you are.

Let us now turn to a completely different topic:

Safe Cars

"I hate the capitalist system," one Friend said to me, "with its constant attention to the bottom line. When Ford Motor Company makes a car, they figure that if there is one fatal accident in a thousand, they may have to pay a lawsuit of a hundred million dollars. So they just factor that cost into their total, and they do not make the car safe enough so the lawsuit would be avoided. It's the bottom line that counts, not human life." What would an economist say to this?

Well, here's what:

Start with the safest car conceivable, with close to zero probability of accident caused by the manufacture. It looks like a tank, with armored sides, goes no faster than 30 miles an hour, and costs $500,000 to manufacture. No one except a few eccentrics would buy it. So the Motor Company starts changing it, first by altering the design, then increasing the speed slightly, and comes up with a less safe version — but still safe enough — costing about $300,000, maximum speed 50 miles an hour, and thinly armored sides. Still, not marketable. So the Company fiddles with the design, speed, and other variables, and finally comes up with a marketable car at $20,000, with bodily comforts, and which will go up to 120 miles per hour. Yes, that car will sell. In fact, it's the one we have now.

In the book Simple Rules for a Complex World, Richard Epstein quotes a product liability specialist named Babcock at General Motors who described a vehicle (the Babcockmobile) based on all the multiple features various juries had said should be absolutely put in a car. It was incredibly expensive and unable to move, precisely because it did not make any design trade-offs. (This information was provided by Geoffrey Williams, a member of the TQE board.)

Looked at this way, the car is designed to suit the consumer. Of course, the company has to guess what the consumer wants, how much he or she will pay. Often they do market studies: Would you pay $75,000 for a car that would reduce the risk of fatal accident (on account of the manufacture) by 50%, compared to the car you now have?

So, the manufacturer decides what the consumer wants, but it is really the consumer who chooses which risks to take. However, when the accident occurs, the consumer sues the company. The process then becomes one for the courts, who decide whether the manufacturer is "responsible." So they prescribe a car (Babcockmobile) that most consumers would never have been willing to pay for.

Of course, auto makers have sufficient information about consumer tastes, costs and affordability that they do not go through this entire analysis for every new model. They spend much time, effort and money on making design choices and trade-offs, which occupy many engineers, economists, finance people and others. My example above suggests how economists are always comparing alternatives and figuring risks, attempting to model or simplify real world activities in order to test basic assumptions. But in either case — the economist at the blackboard or computer, or the Motor Company design team testing thousands of hypotheses — the consumer is the one who actually decides. Isn’t this the way it should be?

We all make trade-offs about risks all the time. Every time you go for a walk you risk being killed by a car, and the fault may lie more in the road design than with the driver, or with yourself for being careless. But the costs to pay for absolutely safe roads (with over- or underpasses at every corner) would be more than taxpayers would be willing to pay.

Economists have noted that most people actually place a somewhat low imputed value on their own lives when you ask them what they would be willing to pay for a slightly safer car, or what raise they would want to compensate them for accepting a slightly riskier job. (Risk of loss of life x probability of that risk = imputed value of life). Most people suggest an imputed value of their own life of under $1 million, given the risk and its probability. But if you were to ask them directly to value their lives I'm sure most would think of a much higher number.

And by the way: the bottom line for auto makers is not much different from that of other producers with similar risks. 

Sincerely your friend,

Jack Powelson

Post Script: Last Monday (November 10) the World Trade Organization determined that American tariffs on steel are illegal under the trade treaty, opening the way for European sanctions against the United States. The Europeans are thinking of levying tariffs on Florida citrus fruits, since Florida is a key state in the next election. In January 2002, the W.T.O. ruled against U.S. Extra-Territorial Income exemptions, a ruling that will potentially cost millions to many multinationals. Anyone who still thinks the W.T.O. is "run" by multinational corporations had better think again.

Readers' Comments

Several readers have written about the enormous profits accruing to pharmaceutical companies. They do not indicate the origin of their data. Three of my board members have done the necessary research, and they report the following:

The S&P Health Care Index, the benchmark for pharmaceutical sector funds, has an average annual total return of 16.1%. Given that stock prices over long periods of time are correlated to the underlying earnings, I would assume that the profits of these pharmaceutical companies are reflected in these total returns.

— Ann Dixon, Boulder (CO) Friends Meeting.

Pfizer is to pharmaceuticals what GM used to be for autos.  It virtually is the index of the industry.  The last 12 months results show a 9% return on equity. It actually lost money in the 2nd quarter.  They are under increasing pressure from generics and foreign distribution. Many smaller competitors, such as Merck and Schering Plough, are in deep trouble and their stocks are at 52 week lows.

— Asa Janney, Herndon (VA) Friends Meeting.

The investment management firm that I am a part owner of holds about 7.8 million shares of Pfizer on behalf of the firm's clients. Pfizer is an extremely profitable business: using the 9/30/03 1Q that Pfizer files with the SEC, I calculated that the company has about $9.2 billion of accounts receivable and inventory net of accounts payables and other current liabilities, and about $24 billion in property, plant and equipment and other long term tangible assets. The real capital tied up in the business is the sum of these 2 figures, or $33.2 billion. Soooo, on the $33.2 billion tied up in the business, Pfizer is expected to earn $13.2 billion after taxes (or $1.73 per share) in 2003, about a 40% return on the real capital tied up in the business. A return on capital of 10–12% is sort of average in business — OK but not great. A 20% return on capital is "very good."

— John Spears, Princeton (NJ) Friends Meeting.

Summary: In fact, drug companies have had extraordinary profits over the last 30 years and investors in the pharmaceutical industry have had good returns from owning drug stocks. But there are risks:  there is competition; patents run out and then the price of the patented drug (and the related profits from that drug) collapses due to low- priced copycat generic drug competition. Several previously very-profitable drug companies have had their patents run out on highly profitable drugs and have experienced large declines in income (and the price of their shares).  Being in the drug business is not a sure thing at all: they all have to scramble to keep inventing good stuff that they can patent and charge very high prices per pill for a few years. As consumers, we all benefit from this scrambling to make more money by finding new ways to keep us healthier.

It is a “fact of life” (which we can do nothing to change) that it is necessary to hold out the possibility of extraordinary profits to persuade people to come forth with investment funds they may lose completely.

I personally am thankful for the pharmaceutical industry, without which I would probably not be alive today, and you (if still alive) would not be receiving TQE.

— Jack

It is interesting that the pharmaceutical companies cry foul and talk about black market re-importation when told to sell to sub-Saharan and other third world countries at or slightly over direct costs, and yet let the Canadian government do the same thing with barely a whimper. The real problem is obviously the price controls set by the Canadian government. Canadians are not poor, and they should be made to pay their fair share of the fixed costs. To that end, the U.S. government should legalize and encourage re-importation. When the pharmaceutical companies withhold their drugs in Canada until they can get better prices, the ball will be squarely in the Canadian government's court to abolish the price lids or deny drugs to their citizens (as presumably U.S. citizens will still have access at U.S. prices).

— Larry Powelson, Seattle (WA).

We seem to be hard on Canadians, even through they reduce the costs of medicines to Americans. However, our friends to the north are actually greedy free riders when it comes to drugs. Why should users of drugs, especially from a very wealthy country dedicated to Peace, Order and Good Government (that is, fairness), not pay their share of the development costs of drugs they use?

— J.D. von Pischke, a Friend from Reston (VA).

US prescription prices are the highest in the world. The profit margins of the major drug companies that sell these drugs is very high, consistently so, and growing. I believe this phenomenon is not merely a matter of dividing up the "fixed" and the "direct" costs thereof, as was suggested in TQE #88. The term I would apply is one which may not be an economists' term of art but should be recognizable to most readers, namely price-gouging.

In addition, the behavior of the Canadian government, in my view, is not merely a matter of one large customer irresponsibly avoiding the "fixed" costs and taking a free ride on the "direct" costs. Rather, I believe what is going on is better described as capitalism in action, of the form described repeatedly in the works of Jack Powelson, where groups with differing interests bargain for the best deal they can get, and social change results.

— Chuck Fager, Director, Quaker House, Fayetteville NC.

Canada doesn’t have drug advertising — with all the side-effects and small print — like that which permeates your airwaves. With single payer health care, manufacturers here market to a few thousand professionals, not to millions of twitchy consumers. Thus it might be more accurate to say Canadian drug prices cover the fixed costs of development but have little need to cover direct costs of marketing — which often amount to more.

On another subject: I feel I have been getting a better education about economics as it relates to present problems from you, over the past couple of years, than I got from university.

— Paul Connor, Toronto, Ontario.

I think your car design logic ignores two basic facts. First, consumers buy (mostly) what they are taught to buy. Advertising works. Talk of consumer choice rings patriotic but ignores the basic impact of Madison Avenue. Second, a given car is "safe" primarily in relation to other objects — many of which are other cars. Increase CAFE standards, design safety into less massive cars, and the car will not cost $750k; rather, it will cost far less than a Suburban.

— Bob Earnest, Chebeague Island, ME.

Note: Ford Motor Company's Edsel, Microsoft Bob, and IBM's OS/2, are all heavily advertised products that fell flat on their faces. — Jack

One of the major quandaries of our time indeed is setting a value on a human life that can realistically be used in the many trade-offs that have to be made in a modern economy. Trial lawyers (and juries) try to do so, of course, but it seems to me that the numbers they come up with place a tremendous burden on economic progress. What do other countries do, and how do you think the value should be determined? Do trial lawyers represent a valid "marketplace"?

— Tom Selldorff, Weston (MA).

Thanks Jack for what you do. I understand the need for higher prices in different markets, but why is the pharmaceutical industry reportedly one of the highest profit margin industries?

— Jim Booth, Red Cedar Meeting, Lansing (MI).

OK, Jack, I'll be brief. I think you really started something very valuable with TQE, which I read avidly even though I am no longer on the board. Bravo, and thanks.

— Roger Conant, Mount Toby Meeting, Leverett (MA)

As a physician of many years, I have difficulty fully accepting the high cost of present day medicines based on the economic theory that you cite. I am constantly plied with remunerative offers to get me to prescribe the drug company's medicine when most of them are "me too" drugs. Also, even when a unique drug comes along and becomes very popular and widely prescribed (i.e. Neurontin), the price is still exorbitant.

— Ken Woerthwein, Harrisburg (PA) Meeting.

An ethical company charges all customers in a class the same price. Volume discounts must be justified on cost differences.

— Lee B. Thomas, Jr., Friends Meeting of Louisville (KY).

Thanks so much for all of the wisdom and insight you continue to share with us. Your example is a shining one, that I hope I will have the energy to follow when I am 83! No need to reply to this. I just wanted to send you my best wishes and my appreciation.

— Brian Holt Hawthorne, a friend of the Friends, Plainfield (MA).

Jack, I had no idea you were 83! Wow. You're amazing. When I'm 83, I'm sure I'll aspire to no more than just keeping healthy. More power to you.

— Sally Ann Garner, Lake Forest Meeting (IL).

What happens when a car part designed to the reliability indicated acceptable by the car companies' market research fails in testing to live up to expectations?  The temptation to cover up rather than redesign would be great. Yes, the market and the legal system would eventually correct the aberration, but not before lives are lost.

— Rick Brooks, Green Country Friends Meeting, Tulsa, OK

If the Europeans decide to levy tariffs against Florida citrus, I would happily volunteer to give them the fruit from our two orange trees. Or would you recommend instead I send ours to the captains of the steel industry, who, like Florida citrus farmers, appear to rely on the government's assistance to succeed in the grand style to which they have become accustomed.

I do not appreciate, however — nor do I admire — nature's insistence that you slow down to take naps or grow old. People who levy tariffs should grow old, and do.

— Roger Williams IV, Fort Meyer, FL.

Trade theory shows that a monopolist selling a transportable product to two countries will maximize profits by selling at a lower price to the country with the higher elasticity of demand but at not so low a price that the product can be sold by buyers back to the country with the lower elasticity after paying transportation costs. If these are zero, the prices will be equalized, rising in the low-priced country, and falling in the high-priced country. In the case of U.S./Canada drugs, U.S. prohibition of re-importation keeps prices in Canada lower, and higher in the U.S., than otherwise.

— Herb Fraser, Clear Creek Meeting, Richmond (IN).

Note: Herb, a retired economics professor, is using economics jargon. "High elasticity" means that as price rises (falls), much more (less) is bought. "Low elasticity" means only a little more (less) is bought. — Jack

Research and marketing are mixed in, so that to get a drug with a slight, perhaps imperceptible difference from a current  product, huge expenditures are labeled research and then are the justification for the higher prices, which are part of marketing and also overhead costs. Then the retail price is set to cover all these, plus a reasonable profit. If there were to be real competition the generic drug selling price would determine the market, and the real innovations would sell for whatever the market would bear — but note that 80–90% of the new drugs are not new at all.

— Dick Wolf, Coral Gables (FL).

A reliable informant has told me that research expenditures in Great Britain are proportionately equal to research expenditures in the U.S., but that the single payer system is quite able to bargain for much lower prices of prescription drugs there.

— Marjorie Ramphal, Sandy Spring (MD) Meeting.

Stated as a fact is the following: "Textbook publishers sell at a lower price in Europe than in the United States." Absolutely not so in Britain. A price of say 15 dollars in the USA becomes 15 pounds here, which is a 50% increase. The opposite of what TQE says. I hope that other statements of fact are more accurate than this.

— Eric Walker,  Friends Meeting, Ipswich England.

Those decision makers now spend much more for advertising than for product development. And by inducing the viewer/listener/reader to "talk to your doctor" about their branded prescription drugs (where the profit margin is the greatest), the potential customers  intrude, rather ignorantly, on the professional judgment of the doctor. If, on the other hand, they also "bribe" the doctor to push their particular brand, along with extending the patent protection of the brand as long as possible, are they not distorting the "rational market" rather severely, to benefit their profits well beyond what product development and production costs would justify.

— Wil Bernthal, Boulder CO.

The lesson of drug price management omitted the longstanding Friends' principal of charging the "right price," and way of honest business practice well earned and respected through three centuries. Double standards of pricing are like double standards of honesty that lead to loss of integrity.

— Gary Nisley, Little Egg Harbor (NJ) Meeting

What of the billion dollars and ten years to get a new drug thru the FDA? Professor Peltzman's chart seems to indicate that we've been losing 60% of our new drugs, ever since 1962. And getting very little in return.

Why not give every Iraqi citizen shares in the Iraqi oil? They could have a big election for the oil company board well before they start electing politicians. If they were getting checks every 3 months, they might be less likely to see us as folks who want to grab their oil.

— Dave Meleney, Unitarian, Littleton, CO.

Note: When the oil proceeds in Chad were divided among residents, they had all spent them within two months. One took a bath in beer, another checked in to a five-star hotel for four days. In Russia, the "mafia" very quickly bamboozled the unknowing, poorer people out of the shares of stock that had been distributed to them. — Jack


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Publisher and Editorial Board

Publisher: Russ Nelson, St. Lawrence Valley (NY) Friends Meeting

Editorial Board:

  • Chuck Fager, Director, Quaker House, Fayetteville, NC
  • Virginia Flagg, San Diego (CA) Friends Meeting
  • Valerie Ireland, Boulder (CO) Friends Meeting.
  • Asa Janney, Herndon (VA) Meeting.
  • Jack Powelson, Boulder (CO) Meeting of Friends, Principal Editor
  • Norval Reece, Newtown (PA) Friends Meeting.
  • J.D. von Pischke, a Friend from Reston, VA.
  • John Spears, Princeton (NJ) Friends Meeting
  • Geoffrey Williams, Attender at New York Fifteenth Street Meeting.

Members of the Editorial Board receive Letters a week in advance for their criticisms, but they do not necessarily endorse the contents of any of them.

Copyright © 2003 by John P. Powelson. All rights reserved. Permission is hereby granted for non-commercial reproduction.

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