The Scientific Activist (Archives)


Mar 13, 2006

Free Market Frenzy

If sellers are allowed to compete freely without any regulations, market forces will inevitably drive down prices and improve the quality of services so that everyone wins, even the consumer—or so the dogma goes. Life is rarely so simple, and markets don’t always behave so predictably. In the case of energy, in fact, deregulation has had the opposite effect, catalyzing massive price increases.

Although this is not a new phenomenon, Sunday’s Washington Post details some of the more recent problems consumers have faced after buying into deregulation programs that promised to drive down energy costs:
Maryland and District consumers angry at the record electric bills they will receive this summer might want to recall the promises made by proponents of deregulation seven years ago. If they do, they'll be even angrier.

At the time, in 1999, evangelists for deregulation described a competitive, efficient and lower-priced system of energy delivery that, for the most part, remains a fantasy in the Mid-Atlantic region and other parts of the country today, according to industry experts.

The District, Maryland and Virginia, along with much of the nation, are wrestling with the ramifications of deregulation at the same time that the cost of producing electricity is skyrocketing. But as energy prices have soared, electricity rates have gone up more in deregulated states than in regulated ones….

…Residential customers -- especially those in Maryland facing an average $743 yearly increase in their BGE bills -- are left wondering what deregulation was for, if not to reduce prices.

The basis of the argument for deregulation depended on price competition between power suppliers, but due to a lack of real competition in most areas, prices have only gone up. In fact, deregulation was sold as a silver bullet that would address a variety of issues beyond just lowering prices, including encouraging infrastructure updates and modernization. However, in real life…
Another promise was that suppliers, freed from state regulation, would sell their power to the highest bidder, creating market incentives for increased efficiency and investment in new technologies. But since 1999, older, less-efficient plants have remained profitable, discouraging investment in new plants. The Mid-Atlantic region still has a shortage of capacity, and during much of the year must import energy from outside the area, often at high prices.

Deregulation was also supposed to encourage development of a national grid system. Utilities and their would-be competitors could buy from the lowest-cost producer, no matter where the producer resided. Pepco could, in theory, buy power from a plant in Oklahoma using cheap natural gas. But the national grid hasn't been improved because power producers -- the most logical source of capital to improve the system -- don't want the competition a robust national grid would allow. Today it is nearly impossible to move large amounts of electricity over long distances.

So, energy deregulation was based more on fantasy than fact, and hopefully state legislatures will have learned their lessons after this fiasco and find a more reasonable solution that won’t subject their constituents to such wild price increases. Putting that aside, though, there was something else about the Washington Post article that really caught my eye:
Under the old system, the price of electricity was strictly based on what it cost the power company to produce it. Now, prices are based on what several hundred highly sophisticated power suppliers and traders believe the market will bear, prices that can have only nominal relation to cost.

This sounds surprisingly similar to what’s happening in the pharmaceutical industry right now. Although drug companies have traditionally argued that high prices were justified based on the large investment in research, development, and testing required to bring a drug to the market, many examples are coming to light where the price of a drug has little to do with these costs. An article in Sunday’s New York Times discusses a few examples of this disturbing recent trend:
The medicine, also known as Mustargen, was developed more than 60 years ago and is among the oldest chemotherapy drugs. For decades, it has been blended into an ointment by pharmacists and used as a topical treatment for a cancer called cutaneous T-cell lymphoma, a form of cancer that mainly affects the skin.

Last August, Merck, which makes Mustargen, sold the rights to manufacture and market it and Cosmegen, another cancer drug, to Ovation Pharmaceuticals, a six-year-old company in Deerfield, Ill., that buys slow-selling medicines from big pharmaceutical companies.

The two drugs are used by fewer than 5,000 patients a year and had combined sales of about $1 million in 2004.

Now Ovation has raised the wholesale price of Mustargen roughly tenfold and that of Cosmegen even more, according to several pharmacists and patients.

Sean Nolan, vice president of commercial development for Ovation, said that the price increases were needed to invest in manufacturing facilities for the drugs. He said the company was petitioning insurers to obtain coverage for patients.

The increase has stunned doctors, who say it starkly illustrates two trends in the pharmaceutical industry: the soaring price of cancer medicines and the tendency for those prices to have little relation to the cost of developing or making the drugs.

Genentech, for example, has indicated it will effectively double the price of its colon cancer drug Avastin, to about $100,000, when Avastin's use is expanded to breast and lung cancer patients. As with Avastin, nothing about nitrogen mustard is changing but the price….

… And once a company sets a price, government agencies, private insurers and patients have little choice but to pay it. The Food & Drug Administration does not regulate prices, and Medicare is banned from considering price in deciding whether to cover treatments.

I have written previously about Avastin and its producer Genentech, which openly acknowledges that its pricing of Avastin had little to do with the cost of producing the drug. The current Times article gives another example of this from Pfizer:
But people who analyze drug pricing say they see the Mustargen situation as emblematic of an industry trend of basing drug prices on something other than the underlying costs. After years of defending high prices as necessary to cover the cost of research or production, industry executives increasingly point to the intrinsic value of their medicines as justification for prices.

Last year, in his book "A Call to Action," Henry A. McKinnell, the chairman of Pfizer, the world's largest drug company, wrote that drug prices were not driven by research spending or production costs.

"A number of factors go into the mix" of pricing, he wrote. "Those factors consider cost of business, competition, patent status, anticipated volume, and, most important, our estimation of the income generated by sales of the product."

The idea that the income generated from a drug is the most important factor at play here seems surprisingly cynical coming from an industry purported to have the humanitarian goal of alleviating human suffering from disease. Although I have already written at length about this, I should reiterate that the drug industry is indirectly, but heavily, subsidized through federal funding of biomedical research. I’m pretty sure that voters support this funding for the promise of medical breakthroughs and new medications, not to give big pharmaceutical companies new vehicles for making bundles of money.

Although there are plenty of differences between the energy and pharmaceutical industries, the drug companies’ previous use of research and development costs as justification for high prices isn’t that different from energy companies preaching the benefits of deregulation. As the logic of both of these arguments begins to break down, it appears that the lessons learned in one may have some relevance to the other. Regardless, based on how things have gone in these industries, the idea of paying a price for a good or service based on what it actually costs to deliver doesn’t sound all that unreasonable anymore.


  • As every free-market proponent will reminds us, the purpose of a corporation is to increase value for the shareholders. The basic premise is that by providing goods and services to individuals, those individuals will trade value for value. The amount an ill person will pay for a pharmaceutical is supposed to reflect the amount of value that individual purchaser believes they will receive by using the product.

    In a world where insurance industry formularies are the only real determinants for pharmaceutical purchasing decisions, and employers desire to cut the cost of employee benefits are the major determinants of insurance purchasing decisions, it is not surprising that our 'free markets' do not function quite as the economics textbooks predict it will.

    There is another type of good or product, a 'public good', one in which it is impossible to determine the individual value returned to each person. How much is it worth to one person to know that if they contract a disease that the research has been done to develop a treatment? That, of course, depends on how you approach the numbers. Is it of no value to those who have not yet contracted the disease?

    Government funding of basic research is premised on the idea that there is value to all of us who are susceptible to diseases to research cause, mechanisms and interventions of what we might contract as individuals. When we or a loved one are ill we want the diagnostic and care expertise available on the shelf, ready and waiting for use.

    The method by which large companies, pharmaceutical and otherwise, make use of publicly funded government research to drive profits is very analogous to the way natural resource companies use minerals from the earth. For many years the only cost of iron, coal, oil, copper and other minerals was the cost of digging them up and delivering them to a customer. When we realized that the supply of these critical minerals was not inexhaustible, State governments began levying resource depletion taxes. This was a way to make the real costs to 'producers' match the real loss of irreplaceable resources.

    We don't have any similar way of billing back the very real costs of basic research to manufacturers. Perhaps we could devise a research recovery tax which would fund basic research, rather than simply spreading this burden through general funds. That would seem to make some sense, since taxing the revenue from a pharmaceutical would seem to track the profit benefit from the research which led to it. But how do you calculate the balance between the publicly funded knowledge and the privately developed expertise which turns research into treatments? And how do you marshal the distributed will of individual patients against the concentrated lobbying power of a deeply entrenched industry?

    By Blogger gardoglee, at Mon Mar 13, 06:18:00 PM  

  • Fascinating post. Despite the evidence that free market economics don't always succeed in benefiting society, consumers by and large, believe the opposite is true. I can't decide what depresses me more.
    I'm linked to you at threadingwater dot wordpress dot com

    By Blogger threadingwater, at Tue Mar 14, 05:49:00 PM  

  • Since there's no chance of anything in the market changing in the near future, perhaps universities making a greater effort to launch spin-off companies will help? At least that way some of the revenue can go back into research. Alternatively, what about a reduction in the length of patents (eg. 5 years)?

    By Blogger sas, at Wed Mar 15, 05:39:00 PM  

  • You won't be surprised to see that I have a dissenting view.

    By Anonymous Jim Hu, at Thu Mar 16, 07:05:00 PM  

  • The best explanation I found to answer the claims in favor of energy deregulation was this article from "Engineering & Science", the Caltech magazine:

    In it, Wilkie makes the point that electricity and health care provision (he uses the example of HMOs) are fundamentally different from a manufactured good because they rely on networks. Because of the infrastructure required to deliver electricy or health care, theories about how these markets operate require a different set of assumptions than those for commodities. Unfortunately for the residents of the West Coast, the California market was gameable and was gamed by Enron. I always say that there was a reason we ended up with regulated utilities in the first place, and just because it's 80 years later, the reason still apply.

    By Anonymous Halli, at Sat Mar 18, 05:12:00 PM  

  • Halli,

    That's a great point, and thanks posting the interesting link.

    Just as I would obviously be wrong to say that all industries should be nationalized, those who point to the "free market" as the best way to deliver all types of services are not any more correct. Many industries are fundamentally different from others, and some operate much better and much more efficiently under one system than another. It seems like that would be common sense, but that doesn't really come across in the debate on these issues.

    By Blogger Nick Anthis, at Mon Mar 20, 10:55:00 PM  

  • Hold on a second - I hold a Bachelor's in economics, and I've never ever heard this contention:

    If sellers are allowed to compete freely without any regulations, market forces will inevitably drive down prices and improve the quality of services so that everyone wins, even the consumer....

    What economists and market proponents do say about this issue is that a market equilibrium, in the absence of market failure, optimizes social welfare (this has been proven by a Nobel-winning economist by the name of Kenneth Arrow). Now obviously these idealized conditions don't exist in the real world, but most mainstream economists agree that markets work for the vast majority of all goods and services produced today. In fact, none other than Joseph Stiglitz, hardly a member of the right, says that free markets are a good thing. There's no reason why prices would automatically go down.

    In fact, why is it so ridiculous that energy prices should rise right now? The price of energy production has soared due to supply shocks and booming demand from third world countries, so why shouldn't the price of energy consumption increase? This is how goods are efficiently allocated without resorting to rationing.

    Furthermore, environmentally speaking, why wouldn't you want energy prices to increase? In fact, the economist would speculate that energy prices should, in fact, be much higher, in the first part due to the fact that energy is highly subsidized already, and secondly because of the externalities associated with energy consumption.

    As for the issue of pharmaceutical companies, whether you like it or not, it is a capital-intensive industry, with billions of dollars being invested every single year. Investors have to get a decent return on this investment or else the industry dries up. Price controls clearly aren't the answer, and I think you'd have a difficult time finding a mainstream economist who doesn't agree with me on that.

    The simple fact is that while markets are not perfect, they are, broadly speaking, the most efficient means of allocating goods and services of which we know.

    By Blogger Jackson, at Tue Mar 21, 05:47:00 PM  

  • Thanks for your post, Jackson.

    As far as the quote from my blog that you mentioned above, I agree that good economists would not make that simplification, but I have often heard that rhetoric from ideologues trying to push a certain agenda. The important point here, which you noted, is that these idealized conditions do not translate to real life, which I believe brings about the necessity for a third party, the government, to look out for everyone's best interest in these situations. I think the best example of pure free market economics not being appropriate is the health care industry. If you compare the market based American system to most others, it becomes clear that the markets create a very inefficient system that does not work in the interest of providing this basic need to most people.

    I think your point about the high cost of energy not necessarily being a bad thing is a good point, and it deserves further consideration. Clearly a reduction in energy consumption is a desirable goal in helping protect our environment.

    The main point of the Washington Post article, though—that energy deregulation has not led to decreases in energy prices—still stands and is a fact that is hard to argue with.

    By Blogger Nick Anthis, at Wed Mar 22, 01:42:00 AM  

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