Fixed Costs, Marginal Cost, and Ronald Coase

On January 18, Dean Baker published a blog post on the subject of Medicare. In it he discusses the cost of medicine and the standard economic theory of sunk costs and marginal cost pricing. He writes:

In the vast majority of cases, the drugs in question are not actually expensive to manufacture. The way the drug industry justifies high prices is that they must recover their research costs. While the industry does in fact spend a considerable amount of money on research (although they likely exaggerate this figure), at the point the drug is being administered this is a sunk cost. In other words, the resources devoted to this research have already been used; the economy doesn’t somehow get back the researchers’ time and the capital expended if fewer people take a drug that is developed from their work.

Ordinarily economists treat it as an absolute article of faith that we want all goods and services to sell at their marginal cost without interference from the government, like a trade tariff or quota. However in the case of prescription drugs, economists seem content to ignore the patent monopolies granted to the industry, which allow it to charge prices that are often ten or even a hundred times the free market price. (The hepatitis C drug Sovaldi has a list price in the United States of $84,000. High quality generic versions are available in India for a few hundred dollars per treatment.) In this case, we are effectively looking at a tariff that is not the 10-20 percent that we might see in trade policy, but rather 1,000 percent or even 10,000 percent.

The high fixed costs associated with research and development (R&D) in medicine are "sunk" in the sense that they can't be recovered after they are incurred. Leaving aside the effect of patents on the price of medicine, it is really the case that the price of a pill of Medicine X should be equal to the incremental cost of producing the marginal pill? In other words, should these firms follow marginal cost pricing?

If you've read previous posts on monopoly and competition, you might have an idea where I'm going. Though perfect competition theory suggests that marginal cost pricing is efficient, Ronald Coase and other new institutional economists have pointed out problems with this standard.

Coase's 1946 article "The Marginal Cost Controversy" provides some insights on this specific issue. Don Boudreaux's summary of the article back in 2005 is pretty good. I reproduce the bulk of it below.

Economists: loose your devotion to marginal-cost pricing. The best prices are not necessarily those that equal marginal cost. Prices above marginal cost help convey important information – namely, information about the value of the capital invested that makes provision of the good or service possible in the first place. This information, in turn, is important to entrepreneurs searching for profitable places to invest their money and energies. [italics in original]

For example, consider a bridge spanning the Mississippi River. Jones builds the bridge and charges tolls to pay for it. When the bridge is not congested, the marginal cost of allowing each driver access to the bridge is zero. Is the optimal toll zero? According to textbook theory: yes. According to the much-wiser Coase: no. If Jones were forced, by whatever means, to charge a price equal to his marginal cost of zero, clearly he would not recover his cost of building the bridge. Equally importantly, other investors would have no way of knowing if, and how much, additional investment is appropriate in building bridges to span the Mississippi.

By charging tolls that maximize his profits – even if these prices are above marginal costs – Jones helps to send informative signals to other potential bridge builders on the value of building additional spans across this river.

Coase’s point seems obvious. But it remains shockingly unheeded by economists who, hypnotized from the first with the sterile, static beauty of the (woefully misnamed) "model of perfect competition," are in awe of prices that equal marginal cost.

Don's point is well-made. Prices communicate information that is crucial for improving everyone's standard of living. The idea that a price above marginal cost is an indication of inefficiency in markets misses this important insight.

Is it possible to question the fixed cost concept on a more fundamental level? At the end of Don's post, he mentions another article by Armen Alchian written in 1958. Though the article was accepted for publication in the American Economic Review, Alchian had the article pulled so that it could be published in a short book in honor of his graduate school advisor.

In the article, Alchian proposes an alternative to the traditional short-run vs long-run fixity of inputs:

Statements to the effect that certain inputs are fixed in the short run are frequent and characteristic. In fact, there is no such fixed factor in any interval other than the immediate moment when all are fixed. Such statements may represent a confusion between revealed choice and technological constraints. There are no technological or legal restraints preventing one from varying any of his inputs.

...

At any calendar moment, T, the producer will choose which input to vary according to economic costs and not because of technical or legal fixities that prevent the changing of some inputs. [emphases in original]

Alchian continues later in the article:

The implication of our proposition is worth emphasizing here. It is that we define a "short run" and a "long run" not as differing in the fixity of some inputs. Instead, we use T [which is the "moment at which the first unit of output is to be completed"] as the length of the run, and then from proposition 8 derive the implications that were sought by the fixity assumption.

Most important, however, proposition 8 makes it clear that there is not both a "long-run" and "short-run" cost for any given output program. For any given output program there is only one pertinent cost, not two. Unambiguous specification of the output or action to be costed makes the cost definition unambiguous and destroys the illusion that there are two costs to consider, a short- and a long-run cost for any given output. There is only one, and that is the cheapest cost of doing whatever the operation is specified to be. To produce a house in three months is one thing, to produce it in a year is something else. By uniquely identifying the operation to be charged there results one cost, not a range of costs from immediate to short to longer run costs. There is a range of operations to be considered, but to each there is only one cost. The question is not, "What are the long-run or short-run costs of some operation?" but instead, "How do total, average and marginal costs vary as the T of the operation is changed?" Answer: "They decrease as T increases, according to propositions 7 and 8."

The significance of this should be evident in the debate about marginal cost pricing policies for "optimal" output. Also the use of short-run and long-run costs as alternatives in public utility pricing appears to be a ripe area for clarification of concepts. [emphases in original]

If Alchian is correct that current theory misses important real-world aspects of asset fixity, then Baker's concern about the price of medicine is not well-founded. Alchian's argument, in conjunction with Coase's points about the information prices communicate and the need to cover "fixed costs," helps us understand why real world price/cost relationships deviate from the standard of perfect competition.