Why study economics? Part 3

The big picture.

In 1946, Henry Hazlitt wrote one of the most succinct and insightful descriptions of economics.

“The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

In this one sentence, Hazlitt brings art into data science. When companies expend resources to collect and analyze vast quantities of data, they intend to answer a particular business question. Consider the challenge of determining a drug’s price in the pharmaceutical industry. If a company possesses a marketing license or patent to be the sole manufacturer of a drug, both market demand and the costs of production play a role in selecting the profit-maximizing price. Estimates of market demand can be calculated using historical data and data science techniques, but what happens when the drug’s patent expires and generic competition enters the market?

Fortunately, economists like Bertrand and Cournot developed and refined economic theories of production and pricing competition since the 1800s. These theories have been used by the Congressional Budget Office to estimate the effect of additional drug manufacturers on market price. Studying game theory in economics teaches critical thinking skills to understand how market prices could change under competition. With only a few drug manufacturers in the market, the drug’s price will not collapse to the marginal cost of production; rather, a profit can be sustained when every firm deploys a strategy that considers every competitor’s production and pricing options.

Particularly astute drug manufacturers can even employ strategies of limit pricing in which the drug’s price is sufficiently low to deter entry from potential competitors, but high enough above marginal costs to maintain profits. None of these pricing strategies and market behaviors will be revealed by simply looking at historical data and applying data science algorithms.

Henry Hazlitt’s quote demonstrates how economists are particularly well-versed in understanding two effects of any business decision. First, what is the indirect effect on other groups not targeted by the decision? And second, what is the effect over a period of time, in addition to the immediate effects of the decision? Let’s continue to use the pharmaceutical industry as an example of answering these questions.

Because of the high price of brand-name pharmaceutical drugs, drug manufacturers will sometimes offer consumers a coupon if they purchase the brand-name version of the drug instead of the generic version of the drug. Most consumers under an insurance plan pay a copay when they purchase a drug. The insurance company often creates an incentive for consumers to choose the lower priced, but equally effective generic drug, by offering a lower copay. For example, a generic drug may have a copay of $10 while the brand-name drug has a copay of $25. If a brand-name manufacturer offers a coupon of $20, the consumer will instead choose the brand-name drug. When a coupon is offered to consumers though, the insurance company continues to pay the full price of each drug.

Imagine that the insurance company is billed $100 for the generic drug and $200 for the brand-name drug. The drug manufacturer can generate goodwill in the press by appearing to benefit consumers with a $20 coupon, but at the same time, actually making more profit. When patients switch to the brand-name drug, consumers under the same insurance plan will see higher prices since the insurance company passes on the increased costs through higher insurance premiums. By analyzing 23 cases of drug coupons, researchers found that an extra $700 million to $2.7 billion was spent on drugs over a five year period. A good economist would foresee the impact of a drug’s pricing on not just the people who consume a particular drug, but on those who may have never even heard of the drug.

In 2015, a company called Turing Pharmaceuticals announced a price hike of over 5,000 percent on its recently acquired drug — Daraprim. When asked why he raised the price by such a large amount, the CEO at the time, Martin Shkreli, replied

“My shareholders expect me to make the most profit”

But once again, a good economist would use data not only to estimate profits in the short-run, but in the long-run. Presumably, Martin Shkreli used historical data to determine the profit maximizing price for Daraprim in the immediate future. The CEO failed to consider the negative political and media attention that was generated as a result of his actions. Congressional investigations were launched, the press publicly criticized his company, and as a result, the drug’s sales plummeted. A decision that may have optimized profits immediately, may have led to future declines in profitability.

The pharmaceutical industry provides several good examples of how economic thinking can address a business decision. A good economist considers not only the effects of a decision across all markets, suppliers, and consumers, but also considers the immediate and long-run effects.

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