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Profits and Pharmaceuticals

  • Timothy D. Terrell,
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Many arguments by socialists have a basic premise: each person has a right to a good "X," even if he does not have ownership of X and does not have enough money to induce an owner to give X up voluntarily. If the owner will not provide X voluntarily, there are three options:

    1. Convince the owner that he is selfish and encourage him to give X up for free, swallowing any of the costs of acquiring or producing X.
    2. Take X from the owner without compensation and provide it to everyone who cannot afford it.
    3. If the owner is resistant to the first option and politically powerful enough to prevent exercising the second option, coerce others into giving up the funds to buy X from the owner and transfer X to those who cannot afford it.

There is certainly such a thing as selfishness, and a place for charitable giving. Yet the vast majority of goods and services produced in this world are produced in this hope of exchanging those things for something the producer desires more — in a voluntary transaction. Egalitarians hate the system of voluntary transactions because they do not approve of the resulting distribution of goods and services. In their view, in a market system, the owner (who is perhaps the original producer) and the right-holder are not usually the same person. Thus, the owner must be persuaded or coerced into giving the good to the right-holder.

An article in a recent issue of the British Medical Journal, by Donald Berwick of the Institute for Healthcare Improvement, argues that pharmaceuticals producers should provide AIDS drugs to people in poor nations for free. "People living in poverty being denied access to modern health care is a form of violent, systematic social deprivation that we, as a civilized global community, ought not to accept," he writes. At a "bare minimum," Berwick contends, the companies should provide the drugs at "exactly their marginal costs of manufacture, not loaded at all with indirect costs or amortized costs of development."

Perhaps the drug companies could do this, though it would certainly not be as light a burden for them as Berwick suggests. As he says, "one year of triple drug therapy for an HIV-positive person costs $15,000." In a world with between 35 and 40 million AIDS sufferers, most of those in developing nations, the drug companies might easily be eating half a trillion dollars per year. Some lost revenues would be in industrialized nations, because the enormous price differential would surely result in massive smuggling of AIDS drugs from poor nations to wealthy ones.

Berwick's proposal is permeated by bad economics. He believes it is simply a matter of the drug companies "choosing" to cut their prices for those in poor nations, and sacrificing profit. Yet market prices are not determined by the whim of an executive, but by the constraints of supply costs and the willingness of customers to pay. An executive acting on whim would quickly be rendered unemployed. In a competitive industry, the costs of production are the primary influence on price. These costs include the payments to entrepreneurs (e.g., stockholders or venture capitalists) who have the rare and valuable skill of discovering ways resources could be better used, and who risk their own capital to reorganize resources into those uses. Those payments, commonly referred to as "profits," are not as disposable as many socialists would have us believe. Without them, entrepreneurs would not bring their skills to the market, and resources would be misallocated. Massive loss of wealth would result — in fact, the human race would cease to exist without profit in some form. It is profit that has brought the right resources together to produce the drugs to treat AIDS.

Those with a socialistic mindset tend to believe that profits are limited only by the extent of capitalistic greed. However, competition tends to constrain entrepreneurial profits in the same way that it limits the prices of consumer goods. In a competitive market, the amount of profit is driven toward a level barely enough to cover the cost to the investor-entrepreneurs of foregoing other investment opportunities — which are basically opportunities to use their skills at reallocating resources. Because of competition, unusually high profits tend to be temporary. In a dynamic market, more profit in the pharmaceutical industry attracts more resources from entrepreneurs, resulting in increased production. The price of drugs is driven down. If the price goes low enough to induce losses, entrepreneurs redirect resources into other industries, so that drug production declines and drug prices rise. Profits therefore tend to move toward a "normal" level, which economists refer to as "zero economic profit."

Of course, Berwick does not completely disregard profits — he just misunderstands their purpose. One respondent to Berwick's argument protested, "Where does the R&D money come from? Current profits. If you take away the profits, then the companies will have no incentive to do …research." Berwick's response was that "drug companies today get no profits, anyway, from countries that cannot afford their products, and that the international goodwill …could put the companies in a much better position to make the case for support for their research agendas." So, because the drug companies receive zero profits from these nations, losses should be equally acceptable? Drug companies are not selling AIDS drugs in poorer nations because people there are not willing and able to pay a price sufficient to produce even "zero economic profit." Selling below cost, much less giving away the drugs, would result in below-normal profits (or even losses) so that investors are cued to direct their capital elsewhere. Investment in drug research and development would indeed fall, and the availability of lifesaving drugs would decline further.

It is true that goodwill is valuable for any firm, and firms may take what seems like a loss, when they are actually replacing dollar revenues with goodwill or positive media attention. Yet a firm must have funds to operate, and as long as employees, entrepreneurs, and suppliers require something other than warm fuzzies in compensation for their time, effort, and materials, goodwill and media attention must at some point translate into dollars. Berwick's statement that goodwill could aid a firm in acquiring research dollars is revealing. Investment in a firm generally increases when the firm's expected profits are high. Goodwill and positive media attention come in particularly handy when a firm wants to accomplish political goals. It may wish to avoid crushing regulation or push for government subsidies for its research. I suspect Berwick has the latter goal in view.

In the socialistic view, profits are at best a necessary evil, an unfortunate concession to greed that will be gradually eliminated as people are converted to a truly selfless humanitarianism. Berwick might wish (hypocritically1) that entrepreneurs would forego even normal profit and work for free, but even if this were achievable, there would still be major problems. First, entrepreneurs still incur risk of loss whenever they reorganize resources. If losses remain possible while all profits are being foregone, entrepreneurs would soon be bankrupted and unable to function at all. Second, unusually high profits in a certain industry serve as a signal that resources need to be reallocated toward that industry, and away from industries where the profits are unusually low. Without the signals that profit differences provide, even completely selfless entrepreneurs would not have enough information to know how to reallocate resources. We might have too much capital devoted to improving water and sewer service, and too little devoted to education, for example. Or, too much devoted to cancer drug research and not enough to AIDS drug research. As the great Austrian economist Ludwig von Mises pointed out repeatedly, the socialist system fails because it has no way to calculate the costs and benefits of alternative uses of resources.

Berwick's article is an attempt at the first option under a socialistic wealth-transfer agenda: convince the owner of a resource (the drug companies) of his selfishness and encourage him to give up wealth voluntarily. Note that this is distinct from an appeal to charity. The socialist's appeal is based not on a moral requirement of generosity, but on an alleged right that the poor have to the goods of the wealthy. The socialist's appeal is a confirmation of covetousness and a legitimization of theft.

When Berwick's appeal fails, as it almost certainly will, an attempt will be made to exercise the second or third option. Some form of "market failure" will be alleged, and the civil government will probably step in. Unless citizens change their usual response to such socialistic proposals, pharmaceutical companies will be nationalized to some extent, in practice if not in law. If this occurs, the stultifying influence of government management will produce fewer, not more, innovative drugs. People like Berwick will decide that their own individual judgments are superior to the judgment of countless millions of individuals expressed in their bidding up or down of market prices. To borrow Berwick's own words (and reinterpret them for my own purposes), this "is a form of violent, systematic social deprivation that we, as a civilized global community, ought not to accept."


1. Did Berwick pursue an education in the expectation that future income would be enough to more than cover the costs of obtaining that education?

  • Timothy D. Terrell

Timothy Terrell is associate professor of economics at Wofford College in Spartanburg, South Carolina. He is assistant editor of the Quarterly Journal of Austrian Economics and is an Associated Scholar with the Mises Institute.

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