There's an interesting discussion going on over at David Glasner's excellent Uneasy Money blog, dealing with what Keynes had to say in the General Theory about saving and investment and how that fed into his theory of the rate of interest. This is an area which we tend to take very much for granted, and it's one of several points of theory with regards to which you could argue that we have discarded the economics of the General Theory and simply slapped the label "Keynesian" onto what is really AC Pigou's macro model.
Keynes is quite clear about S and I in the General Theory: each is the gap between income and consumption, and since each equals Y-C, they must be equal. They are, however, behaviourally different: Investment is a choice variable in an intertemporal optimization problem, but saving is not - it is consumption which is the choice variable in the household's intertemporal utility maximization problem. Keynes had not forgotten Frank Ramsey's work on saving, he did see the individual household as solving an intertemporal optimization problem - see the chapters in the General Theory on the propensity to consume - , it was just that he took the view that, especially in the short run, income was the predominant determinant of saving. Further, whatever decisions the individual household might be making, in the aggregate saving had to be equal to investment by definition, and the equality was not driven by saving.
The important thing, to Keynes, was what this meant for the determination of interest rate. Since S was always identically equal to I by definition, the interest rate could not be a price which equated S and I, so it must be determined somewhere else in the economy. This tied into his criticism of the way standard texts of his time treated interest rate policy - if the rate of interest, r, was determined by the S(r) and I(r) schedules, how was it that the central bank could influence r? What did monetary policy affect, S or I, and note that in the classical model this effect would have to involve a shift of whichever of the curves it was operating on, not a movement along it (or them).
Keynes' answer to this was that the rate of interest was determined by portfolio choices; not the level of saving but the way individuals allocated their savings across financial assets. The default choice of holding savings was in the form of money (in the General Theory, money pretty broadly defined) and here Keynes agreed with Irving Fisher that the fact that money is, by definition, something which confers complete liquidity on its holder means that there is a liquidity return for holding cash (including certain types of bank money) and this liquidity return creates a certain preference for liquidity. The rate of interest, then, depends on how strong this preference for liquidity is and what kind of return it takes to get people to put part of their savings (the level of which in the aggregate is determined by income) into non-monetary, interest bearing assets.
Keynes knew, by the way, that there was more than one interest rate - in the General Theory he simply assumed for simplicity that the spectrum of rates across duration and risk of assets was stable, so that a change in the short term rate would serve as an index of the shift in the whole spectrum of rates. He also assumed that what mattered for economic purposes was the long term rate of interest - that was what drove Investment spending - but he held that the bank rate could influence the long term rate in a stable manner. Hawtrey argued that it was the short term rate itself which mattered and further that, if you looked at data over a Century of Bank Rate, you'd find that the relation between long and short rates wasn't so stable after all.
When we consider what Keynes had to say about S=I it's important to remember that he was trying to counter three theoretical arguments. There was the classical one which we're familiar with, to the effect that S equalled I because the interest rate made it so. But in addition to that, there was Hawtrey's argument that I equalled S plus any new bank credit which the banks created to finance investment that period. And, ironically, there was Keynes' own model from the Treatise on Money, according to which (using what he later admitted was a non-intuitive definition of income) investment could differ from saving. In the Treatise, the central bank could influence the market rate of interest (exactly how was rather taken for granted) and Keynes defined a natural rate of interest as the rate which would make S = I (using to the definitions of the Treatise). So he had to convince people that his own earlier writings had been wrong. Thus what he needed to do if he wanted to convince people of what was really important, i.e. his monetary theory of the rate of interest, was to convince them that S had to equal I by definition.
There's much more in the Uneasy Money post, in particular about Keynes' comments on Irving Fisher's concept of the real rate of interest, but commenting on that'll wait for another post.
Sunday, October 25, 2015
Valeant and Health Economics (1)
The guys at Valeant must really hate the guys at Turing. It was Turing's decision to jack up the price of Daraprim which brought the whole pricing strategy thing out into the open, prompting blog posts like this one from Derek Lowe, and news articles like this one from the Financial Post and this one from the Globe and Mail, along with claims from a short seller that Valeant had a somewhat unhealthy (for the payer) relation with a specialty pharmacy. Valeant is apparently denying that there's anything improper in their business relations with Philidor, and they may well be able to make their case, although the whole thing's going to leave a bad odour for a long time.
This post is not about the legalities or the accounting rules involved - plenty of other people are posting about those. I'm interested in how I could use the Valeant example to teach health economics (and my view on that has changed over recent days - I see a wider gap between Valeant and Turing than others do).
It comes down to two well known pieces of economic analysis of the US (and to lesser but increasing extent Canadian) market for pharmaceuticals.
The one I'll deal with in this post is the well known fact that most people don't pay the full cost of their prescriptions. Their insurance pays most of it (unless they're uninsured, which is a matter for yet a different post). The cost of the prescription to the insurer depends on the price set by the pharmaceutical company. When a drug is under patent, with no on-patent competitors (and if you don't think that on-patent competition matters, see this paper by Lichtenberg and Philipson) the insurer basically just pays the price set by the supplier. When the drug goes off patent, generic competitors can come on the market.
We used to speak as if a generic was automatically a lot cheaper than an on-patent drug: Turing has punctured that illusion. the price set by a generic company will depend on the degree of competition it faces. No competition means monopoly, which means monopoly price. But for the moment let's assume that the old assumption holds and that generics are cheaper than their brand-name counterparts. Insurers want to shift as many of their insured across to the generic as possible, for obvious reasons.
Sometimes they do it through mandatory generic substitution. When one of my meds went off patent, my pharmacist shifted me across to the generic with my next refill (I was relieved, by the way, to see that he gets his generics from Teva and not from one of those generic manufacturers whose quality control has been shown to be, shall we say, less than sterling recently - seems brand name matters even in the case of generic drugs). Alternatively, if the insurance plan operates using co-payment (a flat patient charge per refill, as distinct from co-insurance under which the patient pays a percentage of the price of the drug) the insurer will put the brand name drug in a high co-pay tier and the generics in a low co-pay tier, and count on the patient's elasticity of demand with regards to out-of-pocket payment to induce him to shift from the brand name to the generic drug.
What's been happening recently (and Valeant is by no means the only firm doing this, so too are a number of brand name companies - take a look at what happened when Lipitor went off patent) is that manufacturers have been offering to cover the co-pay for any patient who has his or her doctor specify no substitution - i.e. has their doctor insist that the patient get the brand name drug. The patient pays next to nothing out of pocket, the brand name company makes the sale and the insurer has to pay the price which the brand name company set (unless the insurer chooses to refuse to cover the brand name drug at all, which some insurers decided to do in the case of Lipitor).
So it looks as if part of what Valeant might be doing is using a specialty pharmacy to cut the price to the person in the prescription chain who has a big say in the buying decision and who is likely to be pretty sensitive to price - i.e. the patient. If so, they're doing it differently, if they are indeed using a specialty pharmacy to do it rather than sending out co-pay credit cards, but it may well be exactly the same pricing strategy as a number of brand name drug companies have engaged in in recent times. Basically, they are making it very convenient for patients to order their prescriptions through one distributor, who can pay the co-pay on behalf of the patient, and so keep those patients loyal to Valeant's products.
As I say, the legalities and accounting rules re Valeant's relation with its specialty pharmacy are way outside my competence, but from the perspective of teaching health economics, it's not impossible that Valeant is actually engaging in a variant of a now pretty well established pricing policy.
There's more health economics theory to be invoked here, but that'll wait for another post.
This post is not about the legalities or the accounting rules involved - plenty of other people are posting about those. I'm interested in how I could use the Valeant example to teach health economics (and my view on that has changed over recent days - I see a wider gap between Valeant and Turing than others do).
It comes down to two well known pieces of economic analysis of the US (and to lesser but increasing extent Canadian) market for pharmaceuticals.
The one I'll deal with in this post is the well known fact that most people don't pay the full cost of their prescriptions. Their insurance pays most of it (unless they're uninsured, which is a matter for yet a different post). The cost of the prescription to the insurer depends on the price set by the pharmaceutical company. When a drug is under patent, with no on-patent competitors (and if you don't think that on-patent competition matters, see this paper by Lichtenberg and Philipson) the insurer basically just pays the price set by the supplier. When the drug goes off patent, generic competitors can come on the market.
We used to speak as if a generic was automatically a lot cheaper than an on-patent drug: Turing has punctured that illusion. the price set by a generic company will depend on the degree of competition it faces. No competition means monopoly, which means monopoly price. But for the moment let's assume that the old assumption holds and that generics are cheaper than their brand-name counterparts. Insurers want to shift as many of their insured across to the generic as possible, for obvious reasons.
Sometimes they do it through mandatory generic substitution. When one of my meds went off patent, my pharmacist shifted me across to the generic with my next refill (I was relieved, by the way, to see that he gets his generics from Teva and not from one of those generic manufacturers whose quality control has been shown to be, shall we say, less than sterling recently - seems brand name matters even in the case of generic drugs). Alternatively, if the insurance plan operates using co-payment (a flat patient charge per refill, as distinct from co-insurance under which the patient pays a percentage of the price of the drug) the insurer will put the brand name drug in a high co-pay tier and the generics in a low co-pay tier, and count on the patient's elasticity of demand with regards to out-of-pocket payment to induce him to shift from the brand name to the generic drug.
What's been happening recently (and Valeant is by no means the only firm doing this, so too are a number of brand name companies - take a look at what happened when Lipitor went off patent) is that manufacturers have been offering to cover the co-pay for any patient who has his or her doctor specify no substitution - i.e. has their doctor insist that the patient get the brand name drug. The patient pays next to nothing out of pocket, the brand name company makes the sale and the insurer has to pay the price which the brand name company set (unless the insurer chooses to refuse to cover the brand name drug at all, which some insurers decided to do in the case of Lipitor).
So it looks as if part of what Valeant might be doing is using a specialty pharmacy to cut the price to the person in the prescription chain who has a big say in the buying decision and who is likely to be pretty sensitive to price - i.e. the patient. If so, they're doing it differently, if they are indeed using a specialty pharmacy to do it rather than sending out co-pay credit cards, but it may well be exactly the same pricing strategy as a number of brand name drug companies have engaged in in recent times. Basically, they are making it very convenient for patients to order their prescriptions through one distributor, who can pay the co-pay on behalf of the patient, and so keep those patients loyal to Valeant's products.
As I say, the legalities and accounting rules re Valeant's relation with its specialty pharmacy are way outside my competence, but from the perspective of teaching health economics, it's not impossible that Valeant is actually engaging in a variant of a now pretty well established pricing policy.
There's more health economics theory to be invoked here, but that'll wait for another post.
The Pharmaceutical Sector is a Godsend if you Want to Teach Old Fashioned IO (1)
The recent kerfuffle about Turing Pharmaceuticals having jacked up (and then maybe jacked down) the price of the anti-parasitic drug Daraprim should provide an opportunity to do some serious old-fashioned industrial organization (i.e. pre-game theory) teaching, if only because of the way it highlights just how complex the IO of the pharmaceutical sector is.
First, you've got the division between on-patent (or brand name) drugs and off-patent generics. The usual notion is that generics should be cheaper than brand name drugs because the generic companies don't have to put their products through clinical trials, they just have to demonstrate bioequivalence with a brand name drug whose patent has expired. The Daraprim incident shows that the only thing which will keep prices down is competition. Alex Tabarrok had a post on Marginal Revolution a little while ago dealing with the competition issue in this case - the FDA's regulations set the bar for entry into the US market by foreign (or for that matter any new) producers so high that once a number of existing producers drop out, it's not uncommon for the remaining producers to find themselves in a monopoly/duopoly position. Daraprim isn't the only recent example, it's just the most dramatic.
The basic IO story here's pretty simple. The actual physical manufacture of drugs is pretty close to being a constant marginal cost industry. For brand name drugs the research costs are fixed costs; generics don't have those. For a while, the generic drug sector was very profitable, but nobody noticed because of the halo effect of the notion of generics. New producers entered and the price was continually driven down, at least in the US. In Canada, provincial drug plans regulated generic prices by tying them to the prices of brand name drugs and, as so often happens, what was supposed to be a price ceiling turned into a price floor and we would up paying considerably more than the Americans did for generics. More on that in a later post.
Anyway, in the US the profitability of the generics sector attracted entry, and prices and profits were competed down, causing some producers to leave the market. Getting back in's a lot harder than getting out (the reverse lobster trap effect) so the ones which stayed found themselves with market power, which they started to take advantage of by raising their prices significantly, but not catastrophically from the payer's point of view. (Is that like raising the temperature in a pot of water containing a frog?)
Bottom line on generics: standard economic theory works. Price regulation will hold prices down for a little while but only competition will keep them down long run. For a while it looked as if Indian generic manufacturers were going to fill the competitive niche, but quality control problems knocked some of the biggest of them out of the American market. If the Trans Pacific Trade Partnership negotiators want to do something useful, they should agree on a new reciprocal production quality regime and encourage free trade in generics among TPP members. Canada's got an exporting generic industry - bets that that could be significantly expanded under the right trade rules?
First, you've got the division between on-patent (or brand name) drugs and off-patent generics. The usual notion is that generics should be cheaper than brand name drugs because the generic companies don't have to put their products through clinical trials, they just have to demonstrate bioequivalence with a brand name drug whose patent has expired. The Daraprim incident shows that the only thing which will keep prices down is competition. Alex Tabarrok had a post on Marginal Revolution a little while ago dealing with the competition issue in this case - the FDA's regulations set the bar for entry into the US market by foreign (or for that matter any new) producers so high that once a number of existing producers drop out, it's not uncommon for the remaining producers to find themselves in a monopoly/duopoly position. Daraprim isn't the only recent example, it's just the most dramatic.
The basic IO story here's pretty simple. The actual physical manufacture of drugs is pretty close to being a constant marginal cost industry. For brand name drugs the research costs are fixed costs; generics don't have those. For a while, the generic drug sector was very profitable, but nobody noticed because of the halo effect of the notion of generics. New producers entered and the price was continually driven down, at least in the US. In Canada, provincial drug plans regulated generic prices by tying them to the prices of brand name drugs and, as so often happens, what was supposed to be a price ceiling turned into a price floor and we would up paying considerably more than the Americans did for generics. More on that in a later post.
Anyway, in the US the profitability of the generics sector attracted entry, and prices and profits were competed down, causing some producers to leave the market. Getting back in's a lot harder than getting out (the reverse lobster trap effect) so the ones which stayed found themselves with market power, which they started to take advantage of by raising their prices significantly, but not catastrophically from the payer's point of view. (Is that like raising the temperature in a pot of water containing a frog?)
Bottom line on generics: standard economic theory works. Price regulation will hold prices down for a little while but only competition will keep them down long run. For a while it looked as if Indian generic manufacturers were going to fill the competitive niche, but quality control problems knocked some of the biggest of them out of the American market. If the Trans Pacific Trade Partnership negotiators want to do something useful, they should agree on a new reciprocal production quality regime and encourage free trade in generics among TPP members. Canada's got an exporting generic industry - bets that that could be significantly expanded under the right trade rules?
Pharmaceutical IO (2)
So what about the IO of the brand name sector? There's a New York Times piece on it here which suggests that you could use it to teach Coase's question on the nature of the firm. To paraphrase, since economic theory teaches that production and exchange can be coordinated through the price mechanism, why do firms, especially big, vertically-integrated firms exist at all?
The usual answer is transactions costs. There is something intrinsic to a sector which prevents the price mechanism from working its magic (I'd say something about preventing the Invisible Hand from working, but I don't want to wind up on one of Gavin Kennedy's Looney Tunes lists) and which requires direct, command-and-control assignment of resources to tasks.
So the structure of a particular sector, whether it be made up of a few large vertically integrated firms (as the auto industry is now) or of a lot of smaller firms which sell parts to each other and to final assemblers (as the auto industry was before Henry Ford created the modern auto firm) is going to vary across sectors according to the nature of the transactions cost in each sector.
But the research-based pharmaceutical sector has both extremes. You've got the traditional Big Pharma integrated firms which do everything from basic research through production and marketing, and you've got small specialist companies, some of them doing basic research, others buying the products of the first firms and bringing them to market, and you've got CROs, Contract Research Organizations, which specialize in running clinical trials for firms which are hoping to bring drugs to market. And the structure isn't static - it's a wheel which is always turning; sometimes being small and nimble is the way of the future ans sometimes being large and having a portfolio of drugs and drug candidates which can see you through bad times is the only way to survive (according to that year's favoured theory).
So the research based pharmaceutical sector is one in which Coase's firm structures are in a constant state of churn. Which has got to mean something really cool as far as the industry's Coasean transactions costs are concerned.
The usual answer is transactions costs. There is something intrinsic to a sector which prevents the price mechanism from working its magic (I'd say something about preventing the Invisible Hand from working, but I don't want to wind up on one of Gavin Kennedy's Looney Tunes lists) and which requires direct, command-and-control assignment of resources to tasks.
So the structure of a particular sector, whether it be made up of a few large vertically integrated firms (as the auto industry is now) or of a lot of smaller firms which sell parts to each other and to final assemblers (as the auto industry was before Henry Ford created the modern auto firm) is going to vary across sectors according to the nature of the transactions cost in each sector.
But the research-based pharmaceutical sector has both extremes. You've got the traditional Big Pharma integrated firms which do everything from basic research through production and marketing, and you've got small specialist companies, some of them doing basic research, others buying the products of the first firms and bringing them to market, and you've got CROs, Contract Research Organizations, which specialize in running clinical trials for firms which are hoping to bring drugs to market. And the structure isn't static - it's a wheel which is always turning; sometimes being small and nimble is the way of the future ans sometimes being large and having a portfolio of drugs and drug candidates which can see you through bad times is the only way to survive (according to that year's favoured theory).
So the research based pharmaceutical sector is one in which Coase's firm structures are in a constant state of churn. Which has got to mean something really cool as far as the industry's Coasean transactions costs are concerned.
Friday, October 2, 2015
Prizes as Incentives
There's a strand of the literature on the economics of intellectual property that argues, harking back to the Longitude Prize, which holds that prizes are better than patents as devices for stimulating invention and innovation. Some argue, for example, that they have a lot of promise in drug development. I am sceptical on that front - among other things I'd argue that the prize proposals underestimate the true cost of the development of a successful drug, since that cost includes the cost of all the blind alleys which research-based drug companies go down. I'm also inclined to suspect that supporters of prizes in pharmaceutical development haven't considered how that approach would affect the development of competitors for the winning drug, or, more likely, that they don't believe that having a number of drugs targeting the same problem is a good thing.
There are, however, areas where I'd argue that prizes make a lot of sense, and that this is one of those areas. I'd argue that it would have made a lot more sense had, say, the government of Ontario offered a prize for the development of a climate-friendly energy technology rather than pushing existing technologies with assorted subsidies. Just because a technology exists doesn't mean that it's the best long run solution, but the more governments support existing technologies, the harder it is for new ones to gain a foothold, even if they're superior. So if you think we need to reduce carbon emissions, impose a carbon tax and create a green-energy prize.
There are, however, areas where I'd argue that prizes make a lot of sense, and that this is one of those areas. I'd argue that it would have made a lot more sense had, say, the government of Ontario offered a prize for the development of a climate-friendly energy technology rather than pushing existing technologies with assorted subsidies. Just because a technology exists doesn't mean that it's the best long run solution, but the more governments support existing technologies, the harder it is for new ones to gain a foothold, even if they're superior. So if you think we need to reduce carbon emissions, impose a carbon tax and create a green-energy prize.
I'm From the Government and I'm Here to Manipulate You
The White House has apparently discovered behavioral economics. When Tyler Cowen linked to this a few days ago, I did wonder if it was really a link to The Onion, but it seems not. Consider, for example, Binyamin Appelbaum's piece in a recent New York Times. There are some interesting bits in the NYT article: note for example the observation that having companies make enrolment in retirement savings plan the default option increased the number of workers who enrolled but might have reduced the amounts some people saves. However, there's no indication in the NYT article as to whether this takes account of how much people were, and continued to be, saving in other forms.
In a lot of ways the most interesting part of the article is the paragraph dealing with an experiment which tested out eight different versions of an e-mail encouraging members of the military to enrol in a retirement savings plan. Seems the most effective version combined step-by-step instructions on how to do it with an example showing how regular small monthly payments could add up over time.
Is that anything other than saying that it'd be a good thing if government forms were written in Plain English?
In a lot of ways the most interesting part of the article is the paragraph dealing with an experiment which tested out eight different versions of an e-mail encouraging members of the military to enrol in a retirement savings plan. Seems the most effective version combined step-by-step instructions on how to do it with an example showing how regular small monthly payments could add up over time.
Is that anything other than saying that it'd be a good thing if government forms were written in Plain English?
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