One of the controversies swirling around the movement for health-care reform concerns the use of “buying power” by the federal government to reduce drug prices; the government is a huge indirect purchaser of drugs since it finances the Medicare and (with the states) Medicaid programs, in addition to providing medical care to military personnel and veterans and medical insurnance to the government’s civilian employees. A related issue (which I do not discuss) is whether the government should finance the importation of drugs from countries in which drug prices are lower.
The technical issue is the use of monopsony power. Monopoly power in economics refers to restricting output in order to push price above the competitive level, which is the level at which a further increase in output would cause price to fall below the cost of producing that additional output. A price above that level will deflect some buyers to substitute products that cost more to produce but are cheaper because they are sold at a competitive price. For example, if the marginal cost of product A is 5 and its price is equal to marginal cost, most buyers will prefer it to B, a similar product that costs 6 and is sold at 6. If now A is monopolized and its price rises to say, 7, some buyers of A will switch to B, and therefore will be buying a product that actually costs society more to produce. This deflection is a social cost of monopoly, as is also any costs that sellers incur to obtain monopoly power, such as costs of collusion or of obtaining government protection from competition. In addition of course there is a transfer of wealth from consumers to producers if products are sold at monopoly prices, though this does not reduce economic welfare unless consumers derive greater utility from a marginal dollar than producers (their shareholders, etc.) do.
Monopsony power is parallel. It refers to a situation in which a buyer reduces its purchases of an input in order to reduce its costs. Most products have an upward-sloping supply curve, meaning that the larger the quantity that is produced, the higher the unit cost of production, because the producer or producers have to bid more resources away from other producers. So one way a company can increase its profits is by buying less of an input, though this will work only if the company buys a large fraction of the quantity of the input that is produced, as otherwise its reduction in quantity purchased will not have a substantial effect on the quantity of the input that is produced and therefore on its price.
Monopsony is inefficient, like monopoly, because it reduces the output of the monopsonized product below the competitive level; the monopsonist produces below that level in order to reduce his input costs. In the drug setting, the government, purchasing or (more commonly) controlling (acting in effect as an intermediate buyer) the purchase of such a large fraction of total drug sales could reduce by some arbitrary amount the drug prices that it is willing to reimburse or permit the reimbursement of doctors, pharmacies, and hospitals for.
The drug companies in turn would reduce their output, though not immediately. The reason is the structure of drug costs. The cost of developing and obtaining FDA approval of a new drug, all of which cost is incurred before the drug is sold, is a large percentage of total costs. Once the drug is on the market, the cost of actual production is very low. The sale price of the drug is dominated by the presale development costs. The effect of the government’s pushing down the sale price would therefore be to reduce the development of new drugs rather than the production of existing drugs. (As Becker points out in his comment, this analysis does not apply to generic—unpatented—drugs, which generally are sold at a price close to marginal cost. To those drugs, the normal monopsony analysis would apply: the government would pay a price that forced the producer to move down his supply curve, reducing output.)
Slowing the development of new drugs would be politically attractive because the reduction of government-financed drug costs would be experienced immediately but the cost in slower development of new drugs (because they would be less profitable) would be deferred, and indeed would be invisible because no one would know how much faster the development of new drugs would have been had it not been for the government’s exercise of its monopsony power. In addition, the cost savings to the government from reducing the price of drugs could be used to reduce the deficit that the health-care reform program soon to be adopted by Congress will create.
Complicating analysis is the fact that expenditures on medical care are not well aligned with social benefits. Because beneficiaries of government health-care subsidies do not pay the full cost of health care, including the full cost of drugs, health care is overproduced from the standpoint of economic efficiency. This overproduction is exacerbated by the immense marketing expenses of the drug industry, which appear to exploit the ignorance and desperation of the sick. Particularly objectionable in my opinion is television advertising of prescription drugs, which is designed to bypass physicians’ exercise of professional judgment by appealing over the heads of the physicians to the patients, who pester their physicians to prescribe drugs that the patients have seen advertised on television.
There is no doubt that many people derive great subjective utility even from new drugs that do not do much for them—that are not significantly superior to old drugs and produce only slight extensions of life. But if they are misinformed or, more likely, do not bear the cost of the new drugs, there is no presumption that the provision of these drugs is utility-maximizing in an economic sense. If I am correct that government subsidies and patients’ information costs have resulted in an overproduction of drugs from an efficiency standpoint, there is an argument for the government’s using its monopsony power to reduce the price of drugs. If drug production is above its optimal level, the economic objection to monopsony—that it reduces output below the optimal level—withers.
An objection likely to block any such measure is that it amounts to government’s rationing medical care. It does. But if government is to be the (indirect) provider of care, it has to ration it; otherwise the costs of medical care will strangle the economy.