Robert's Stochastic thoughts

Thursday, June 28, 2007

I disagree with Kevin Drum and Mark Kleiman about an economic issue.

How odd. Drum wrote

Andrew Sullivan returns to the Big Pharma debate today, stepping back a bit from yesterday's claim that European pharma companies have been "decimated" by Europe's widespread adoption of universal healthcare. And a good thing too. After all, the market for pharmaceuticals is global. Every pharmaceutical company, no matter where it's based or where it conducts R&D, sells into the exact same market. If European national healthcare had really decimated European pharma companies, it would have decimated American companies too.

But it hasn't. So today Andrew moves on to a different, and more common, conservative claim. With some coaching from Mark Kleiman, he argues that the real issue is drug innovation, which he thinks is driven largely by profits from U.S. sales. If we introduce national healthcare in American and start bargaining down the price of drugs, Big Pharma will no longer have an incentive to invest lots of money in R&D. Result: no new drugs.

On its face this sounds reasonable. Pharma companies are like anyone else: they invest in R&D to the extent that they can earn a return from the drugs they develop. If drug company profits are driven mostly by high-priced U.S. sales, then the rest of the world is getting a free R&D ride on our backs.

But I don't think that's quite what's happening. There's a free ride happening, but it's not a free ride on innovation. It's a free ride on pricing.

As Mark points out, pharma companies have to raise capital in the same markets as everyone else, and that means their overall pricing has to be high enough to provide them with the risk-adjusted returns on equity that the market demands. So what happens if prices in America are gradually pushed down? Answer: prices everywhere else will be gradually pushed up. Americans will pay a bit less and Europeans will pay a bit more — which suits me just fine — and both profit levels and risk-adjusted returns will remain constant, just as basic economics demands. The only difference is that Europeans will be forced to pay their fair share of pharma R&D budgets. No more free ride on pricing.

This reassoning seems to me to be very very odd. A standard simple model of pharmaceutical company managers would have them sell for the highest price they can get. This would suggest that they are squeazing all of the money out of Europe that they can already. It is not clear how a decline in profits earned in the US would change the game played by the pharmaceutical companies and European states. Now I don't believe in standard simple models of firms (or anything) especially since I mean models which have been proven false decades ago. However, I don't see how a more sophisticated model would imply that prices in Europe go up as prices in the USA go down.

Before going on, I have to distinguish two kinds of risk adjusted returns. One would be risk adjusted returns to investments in the shares of pharmaceutical companies. It is very easy for these to remain the same (after a period of adjustment) even if the USA begins bargaining seriously about drug prices. A surprising discovery of a federal spine (plus a federal pair and other anatomical metaphors) would cause a drop in share prices. That would imply higher returns for a given path of dividends or, in a simple model, equal returns given lower dividends due to lower drug prices and profits. No problem there. In particular appropriate risk adjusted returns on shares can be achieved via changes in share prices no matter what firms' R&D (or any other) policy is.

On the other hand, it might be that MK and KD think shareholders will demand a given risk adjusted return on investments included investments in R&D.

Now if the required return on an investment stays the same, the pharmaceutical companies can manage that by investing only in projects which currently pay higher than the required return. That is by investing in fewer projects. In other words via a reduction in R&D as argued by Sullivan.

But how do investors demand such returns ? The return on investment in the pharmaceutical industry is very high compared to other sectors (also adjusting for risk that is their Q even including R&D investment in the denominator is very high). How and why do investors manage to make managers earn such high returns. In the simple model (which I don't believe) managers act in shareholders' interests. Ha. Back to seriousness. Investors can demand a high return on investments by only buying new shares issued by firms if the firms have high enough returns. Pharmaceutical companies are not issuing new shares, so this is not a factor.

Basically the way that investors can force managers to act in their interests is via the threat of takeovers, that is, if the current management doesn't maximize shareholder value, someone can make a lot of money buy quietly buying 5% minus one of the shares then taking over the firm. In other words managers are forced to make the highest return possible. There is nothing that implies that this return must be constant.

My guess is that if the US got tough on drug prices, the price of pharmaceutical companies shares would fall as would the value of those companies to predators. Managers' incentives would not change. I would guess R&D would remain about the same.

The reason pharmaceutical companies must earn huge returns on capital is that they can and if current management won't someone else will. If the environment changes so that they can't make such returns, they won't be forced to make such returns.

8 comments:

Anonymous said...: Nice, nice, nice. Remember Marcia Angell, who is wonderful.

I could not open this site from Mark Thoma's blog, which is what I always have done to ease access. I will let Mark know.

anne; 11:39 PM
Anonymous said...: Yes; I like this a lot, and on a glum glum day given the horrid Supreme Court rulings. I knew who Robert and Alito were, but who could listen? At least the New York Times opposed the confirmations.

anne; 11:41 PM
Anonymous said...: Thank goodness, for Michael Moore!; 12:32 AM
Anonymous said...: I am just heartsick about the Supreme Court ruling on segregation.

anne; 12:33 AM
Anonymous said...: http://www.nytimes.com/2007/06/29/opinion/29fri1.html

June 29, 2007

Resegregation Now

The Supreme Court ruled 53 years ago in Brown v. Board of Education that segregated education is inherently unequal, and it ordered the nation’s schools to integrate. Today, the court switched sides and told two cities that they cannot take modest steps to bring public school students of different races together. It was a sad day for the court and for the ideal of racial equality.

Since 1954, the Supreme Court has been the nation’s driving force for integration. Its orders required segregated buses and public buildings, parks and playgrounds to open up to all Americans. It wasn’t always easy: governors, senators and angry mobs talked of massive resistance. But the court never wavered, and in many of the most important cases it spoke unanimously.

Today, the court’s radical new majority turned its back on that proud tradition in a 5-4 ruling, written by Chief Justice John Roberts. It has been some time since the court, which has grown more conservative by the year, did much to compel local governments to promote racial integration. But now it is moving in reverse, broadly ordering the public schools to become more segregated.

Justice Anthony Kennedy, who provided the majority’s fifth vote, reined in the ruling somewhat by signing only part of the majority opinion and writing separately to underscore that some limited programs that take race into account are still acceptable. But it is unclear how much room his analysis will leave, in practice, for school districts to promote integration. His unwillingness to uphold Seattle’s and Louisville’s relatively modest plans is certainly a discouraging sign.

In an eloquent dissent, Justice Stephen Breyer explained just how sharp a break the decision is with history. The Supreme Court has often ordered schools to use race-conscious remedies, and it has unanimously held that deciding to make assignments based on race “to prepare students to live in a pluralistic society” is “within the broad discretionary powers of school authorities.”

Chief Justice Roberts, who assured the Senate at his confirmation hearings that he respected precedent, and Brown in particular, eagerly set these precedents aside. The right wing of the court also tossed aside two other principles they claim to hold dear. Their campaign for “federalism,” or scaling back federal power so states and localities have more authority, argued for upholding the Seattle and Louisville programs. So did their supposed opposition to “judicial activism.” This decision is the height of activism: federal judges relying on the Constitution to tell elected local officials what to do.

The nation is getting more diverse, but by many measures public schools are becoming more segregated. More than one in six black children now attend schools that are 99 to 100 percent minority. This resegregation is likely to get appreciably worse as a result of the court’s ruling.

There should be no mistaking just how radical this decision is. In dissent, Justice John Paul Stevens said it was his “firm conviction that no Member of the Court that I joined in 1975 would have agreed with today’s decision.” He also noted the “cruel irony” of the court relying on Brown v. Board of Education while robbing that landmark ruling of much of its force and spirit. The citizens of Louisville and Seattle, and the rest of the nation, can ponder the majority’s kind words about Brown as they get to work today making their schools, and their cities, more segregated.

anne; 12:51 AM
Anonymous said...: http://select.nytimes.com/search/restricted/article?res=F30B13FC3F5B0C748DDDAC0894DC404482

May 17, 2004

50 Years After Brown
By STEPHEN G. BREYER

Fifty years ago today the Supreme Court of the United States decided Brown v. Board of Education of Topeka. Here is the question that case presented: ''Does segregation of children in public schools solely on the basis of race, even though the physical facilities and other 'tangible' factors may be equal, deprive the children of the minority group of equal educational opportunities?'' The court answered this question unanimously: ''We believe that it does.''

As a member of the Supreme Court, I am going to Topeka today to represent that court; not nine individual justices, but the institution itself -- an institution as old as the Republic, charged with the responsibility of interpreting the Constitution of the United States.

May 17, 1954, was a great day in the history of that institution. Before May 17, the court read the 14th Amendment's words ''equal protection of the laws,'' as if they protected only the members of the majority race. After May 17, it read those words as the framers who wrote them immediately after the Civil War meant them to be read, as offering the same protection to citizens of every race. Thurgood Marshall, who later became a member of the court, represented the schoolchildren in Brown. He argued that separating children by race violated the Constitution's promise of equal protection. The court agreed, embracing Marshall's argument with a simple affirmation: ''We believe that it does.'' And what great effect those few words have had.

The court told the nation that segregation based on race is wrong and that the law cannot tolerate that wrong. It said to parents in Topeka and across the country that ''education is perhaps the most important function of state and local governments,'' thereby setting the United States on a still-unfulfilled path toward a goal of quality education for all children.

Those words also forced Americans to ask themselves whether they believed in a rule of law -- a rule of law that President Dwight D. Eisenhower enforced in 1957 when he sent federal paratroopers to Arkansas to take black schoolchildren by the hand and walk them safely through that schoolhouse door. We now accept that rule of law as part of our heritage, thanks to Brown and to its aftermath. But too often we take it for granted, without recollecting the conditions of 50 years ago and without adequate appreciation for those whose struggles made it possible.

Above all, Brown's simple affirmation helped us to understand that our Constitution was meant to create a democracy that worked not just on paper but in practice -- one that can work only if every citizen understands that the Constitution belongs not to the majority, or to the lawyers, or to the judges, but to us all. Brown helped us to understand that the Constitution is ''ours,'' whoever we may be....

anne; 1:34 AM
Anonymous said...: http://www.bartleby.com/114/2.html

April 25, 1903

The Souls of Black Folk
By W.E.B. Du Bois

Of the Dawn of Freedom

THE PROBLEM of the twentieth century is the problem of the color-line,—the relation of the darker to the lighter races of men in Asia and Africa, in America and the islands of the sea. It was a phase of this problem that caused the Civil War; and however much they who marched South and North in 1861 may have fixed on the technical points of union and local autonomy as a shibboleth, all nevertheless knew, as we know, that the question of Negro slavery was the real cause of the conflict. Curious it was, too, how this deeper question ever forced itself to the surface despite effort and disclaimer. No sooner had Northern armies touched Southern soil than this old question, newly guised, sprang from the earth,—What shall be done with Negroes? Peremptory military commands, this way and that, could not answer the query; the Emancipation Proclamation seemed but to broaden and intensify the difficulties; and the War Amendments made the Negro problems of to-day.

It is the aim of this essay to study the period of history from 1861 to 1872 so far as it relates to the American Negro. In effect, this tale of the dawn of Freedom is an account of that government of men called the Freedmen's Bureau,—one of the most singular and interesting of the attempts made by a great nation to grapple with vast problems of race and social condition.

The war has naught to do with slaves, cried Congress, the President, and the Nation; and yet no sooner had the armies, East and West, penetrated Virginia and Tennessee than fugitive slaves appeared within their lines. They came at night, when the flickering camp-fires shone like vast unsteady stars along the black horizon: old men and thin, with gray and tufted hair; women, with frightened eyes, dragging whimpering hungry children; men and girls, stalwart and gaunt,—a horde of starving vagabonds, homeless, helpless, and pitiable, in their dark distress. Two methods of treating these newcomers seemed equally logical to opposite sorts of minds. Ben Butler, in Virginia, quickly declared slave property contraband of war, and put the fugitives to work; while Fremont, in Missouri, declared the slaves free under martial law. Butler's action was approved, but Fremont's was hastily countermanded, and his successor, Halleck, saw things differently. "Hereafter," he commanded, "no slaves should be allowed to come into your lines at all; if any come without your knowledge, when owners call for them deliver them." Such a policy was difficult to enforce; some of the black refugees declared themselves freemen, others showed that their masters had deserted them, and still others were captured with forts and plantations. Evidently, too, slaves were a source of strength to the Confederacy, and were being used as laborers and producers. "They constitute a military resource," wrote Secretary Cameron, late in 1861; "and being such, that they should not be turned over to the enemy is too plain to discuss." So gradually the tone of the army chiefs changed; Congress forbade the rendition of fugitives, and Butler's "contrabands" were welcomed as military laborers. This complicated rather than solved the problem, for now the scattering fugitives became a steady stream, which flowed faster as the armies marched.

Then the long-headed man with care-chiselled face who sat in the White House saw the inevitable, and emancipated the slaves of rebels on New Year's, 1863. A month later Congress called earnestly for the Negro soldiers whom the act of July, 1862, had half grudgingly allowed to enlist. Thus the barriers were levelled and the deed was done. The stream of fugitives swelled to a flood, and anxious army officers kept inquiring: "What must be done with slaves, arriving almost daily? Are we to find food and shelter for women and children?"

* * *

I have seen a land right merry with the sun, where children sing, and rolling hills lie like passioned women wanton with harvest. And there in the King's Highway sat and sits a figure veiled and bowed, by which the traveller's footsteps hasten as they go. On the tainted air broods fear. Three centuries' thought has been the raising and unveiling of that bowed human heart, and now behold a century new for the duty and the deed. The problem of the Twentieth Century is the problem of the color-line.

anne; 2:06 AM
Anonymous said...: Fortunately, I have done so decent things for I am already hearing from former students on this disgraceful Supreme Court decision.

anne; 2:08 AM