Incentives Matter

 

399px-Elizabeth_Warren_Nov_2_2012One of the virtues of free-market capitalism—perhaps the greatest—is how well it aligns incentives with desired outcomes. If you produce a good or provide a service that other people want, they will pay you for it. If demand for that good or service increases, it’s price will climb, which further incentivizes producers and providers.

Sadly, it doesn’t always work that out that way. Free markets can make tremendous errors and bad players can often get away with deceit and fraud for much longer than we’d like. This is why we have regulations: to impose a level of top-down authority in those areas where bottom-up incentives don’t work.

Of course, designing smart regulations is easier said than done. Simple regulations have the enormous benefit of being predictable and easily-comprehended, but are extremely blunt instruments. Complicated regulations can have the virtue of precision, but are much harder to design and can be difficult to follow if you take their intent seriously and easy to avoid if you don’t. Moreover, poorly-designed regulations often overcompensate for their intended/purported purpose, causing far more harm than they could ever hope to prevent.

If you ever needed a good example of the latter phenomenom, look no further than the latest proposal from Senator Elizabeth Warren (I really should save that sentence as a macro; it’d save me so much time). Warren wants to add an extra level of fines on big pharmaceutical companies who settle with the government, specifically mandating that a percentage of their future profits be used to fund research at the National Institutes For Health.

Megan McArdle offers five excellent reasons why this is a terrible idea, but the one below really takes the prize for explaining just how badly this would work out:

If fines should be higher on pharma violations — and maybe they should be — then we already have two very good ways of achieving that: Congress can mandate them, or regulators can impose them. A percentage-of-profits surcharge is not a good alternative. For one thing, you’re going to end up fining companies based on how profitable they are, not how serious a violation was — you could easily have a situation in which an unprofitable company that committed grave violations ends up paying nothing, while a profitable one that’s guilty of less serious offenses contributes a great deal to the NIH coffers. This is neither just nor efficient.

As Juvenal might have said, Who incentivizes the incentivizers?

By Twp (Own work) [CC BY-SA 3.0], via Wikimedia Commons

There are 20 comments.

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  1. user_138562 Moderator
    user_138562
    @RandyWeivoda

    But Tom, don’t you get it?  Making profit itself IS part of the crime.  If your company is totally reckless but never made much money, that’s more forgivable than a highly profitable company making an honest error.

    • #1
  2. Matede Inactive
    Matede
    @MateDe

    Don’t we already fine pharmaceutical companies already through the FDA approval process?

    • #2
  3. Ricochet Inactive
    Ricochet
    @PleatedPantsForever

    I would love to try free market capitalism for awhile. Unfortunately, after removing banking and finance (too big to fail), education (gov backed student loans), healthcare (ACA, Medicare, and Medicaid), housing (Fannie Mae and Freddie Mac), and automobiles (bailouts), we don’t have too much these days.

    Allowing the government to better pick winners and losers in pharmaceuticals seems a perfect way to further bring yet another industry under their fold

    • #3
  4. Mendel Inactive
    Mendel
    @Mendel

    I obviously don’t support this idea (not least because those big, fat, juicy pharmaceutical profits write my monthly paycheck).

    But a dirty secret of drug development is that none of those pharmaceutical products – or profits – would exist without NIH-funded research. Looking back on all the drugs developed over the last 2 decades, every project has started by taking knowledge produced by public research and then building on it.

    So in a sense, pharmaceutical companies have been receiving government subsidies since time immemorial.

    • #4
  5. Mendel Inactive
    Mendel
    @Mendel

    On a broader note, I don’t approve of the moral hazard which arises when we use the penalties for “bad behavior” to fund “good behavior.”

    It doesn’t matter whether it’s punitive fines extracted from a company, a cigarette or alcohol tax, or civil forfeiture. When the government profits from individuals’ bad behavior, it gives the government a perverse dependence on that bad behavior.

    I’m not against fining companies to cover the costs of rectifying their mistakes, as we do after chemical spills and the like. But when it comes to “punitive” measures, sometimes I think it would be better for the government to simply burn the money it collects rather than to pocket it.

    • #5
  6. DocJay Inactive
    DocJay
    @DocJay

    Not a fan of Big Pharma but this proposal is a joke.

    • #6
  7. user_1008534 Member
    user_1008534
    @Ekosj

    Hi Randy W. Re: “…..Making profit itself IS part of the crime”. Spot on!

    Hi Mendel. Re: “…pharmaceutical companies have been receiving government subsidies since time immemorial.” They have been paying taxes since time immemorial as well. (a few notable years excepted) So, in a sense, the pharmaceutical industry has been underwriting the NIH research.

    • #7
  8. user_3467 Thatcher
    user_3467
    @DavidCarroll

    Sadly, it doesn’t always work out that way. Free markets can make tremendous errors and bad players can often get away with deceit and fraud for much longer than we like. This is why we have regulations: to impose a level of top-down authority in those areas where bottom-up incentives don’t work.

    Bad players may not get caught as quickly as one might like, but that does not justify the regulatory state.

    However, essentially I agree with the post about the evils in regulatory incentives, except that I go further. I do not believe that regulations are ever a good idea. Regulations are efficient at only one thing: stifling innovation.

    Regulations inevitably lead to unintended consequences.  The market will eventually straighten everything out with the correct incentives, but sometimes private actions to combat fraud and deceit are slower than anyone would like. By the way, I do not consider criminal penalties against fraud and deceit to be part of the regulatory state.

    • #8
  9. Arahant Member
    Arahant
    @Arahant

    How does one incite people to use real words instead of longer neologisms coined by people with limited vocabularies?

    • #9
  10. DocJay Inactive
    DocJay
    @DocJay

    BTW, you didn’t write this article yourself ;-).  Someone else did with government help.

    • #10
  11. Pilli Inactive
    Pilli
    @Pilli

    I don’t like the idea of fining companies at all.  Companies do not commit crimes.  People do.  Companies are run by boards of directors  and CEOs / Presidents.  THEY should be held responsible / culpable.  They should be fined/jailed.  If that happened more often, there would be a LOT less incentive to commit corporate crime.  I’m thinking specifically of the guys who were in charge of the banks and finance houses during 2008 & 2009 that got off Scott free even though their companies paid fines.

    • #11
  12. user_3467 Thatcher
    user_3467
    @DavidCarroll

    I was thinking about he comment that pharmaceuticals research benefits from government funded NIH research.  I wonder if the pharmaceutical might internally fund more research if the government regulations did not eat up so much funding to get through the regulatory process to get new drugs to market.

    • #12
  13. Mendel Inactive
    Mendel
    @Mendel

    Ekosj: Re: “…pharmaceutical companies have been receiving government subsidies since time immemorial.” They have been paying taxes since time immemorial as well. (a few notable years excepted) So, in a sense, the pharmaceutical industry has been underwriting the NIH research.

    Sort of. While the pharmaceutical companies of course pay taxes, they still aren’t paying the market rate (whatever that would be) for the value they have received from NIH-sponsored research. In fact, the taxes they have paid are likely much lower than the free-market cost of the same research due to the even higher degree of risk surrounding basic research compared to applied research.

    I also think the argument “I paid for X through my taxes” is generally a poor one, because taxes and government distribution are such poor mechanisms for transmitting the important signals of value and cost. The rider of an underused light rail system can also claim that he helped pay for it to be built through his taxes, but in the end he is still disproportionately benefiting from others’ subsidies.

    • #13
  14. Arahant Member
    Arahant
    @Arahant

    Pilli:I don’t like the idea of fining companies at all. Companies do not commit crimes. People do.

    Amen, brother! But why is it that way? People don’t have much money; businesses do. It’s not about the crime; it’s about the money.

    • #14
  15. Mendel Inactive
    Mendel
    @Mendel

    David Carroll: I wonder if the pharmaceutical might internally fund more research if the government regulations did not eat up so much funding to get through the regulatory process to get new drugs to market.

    I’m sure they would, but I’m not sure that the extra funding would cover the gap.

    Having worked in both the basic and applied sides of the research house, I can attest that they are two very different beasts. The “risk profile” of very basic research tends to be off the charts compared to the applied research taking place in the pharmaceutical industry.

    There is also the aspect that many of the fundamental techniques used in all facets of research today are based on findings from the 40s and 50s at places like Cold Spring Harbor – research would have never been funded by the private pharmaceutical industry (which itself was much smaller at the time) back then. At some point such research might have indeed been performed by the private sector, but likely several decades later (and with much slower dissemination for IP reasons), correspondingly delaying our current biotechnological revolution.

    Of course this is also based on counterfactuals, but I have yet to meet anyone in the field who disagrees. Also, now that the basis of public biomedical knowledge has become so broad, we probably could stop publicly funding research now without severely crippling private development.

    • #15
  16. Misthiocracy Member
    Misthiocracy
    @Misthiocracy

    Tom Meyer, Ed.: Sadly, it doesn’t always work that out that way. Free markets can make tremendous errors and bad players can often get away with deceit and fraud for much longer than we’d like.

    Almost always, always, with the help of connections in government.

    It’s a vicious cycle.

    • #16
  17. user_129539 Member
    user_129539
    @BrianClendinen

    Mendel:

    David Carroll: I wonder if the pharmaceutical might internally fund more research if the government regulations did not eat up so much funding to get through the regulatory process to get new drugs to market.

    research would have never been funded by the private pharmaceutical industry (which itself was much smaller at the time) back then. At some point such research might have indeed been performed by the private sector, but likely several decades later (and with much slower dissemination for IP reasons), correspondingly delaying our current biotechnological revolution.

    Either that or really rich people could fund it to leave a legacy, or because that have to do something with all that money and think basic research is cool. In reality college students are also funding a lot of this basic research also because money if fungible. If a college professor is getting any money from a colleges general fund (including free or subsidized office &  lab space or Admin support like IT services) then their research is in part being paid for by student debt. What % becomes hard to calculate because of how the accounting works. But if research and teaching were completely separate from an organizational and accounting prospective nation wide, I think we would all be shocked how much tuition and Alumni donations are funding basic research and silly and pointless research (that 8000th book of supposedly original research analyzing Shakespeare).

    • #17
  18. user_1008534 Member
    user_1008534
    @Ekosj

    Hi Mendel. That’s the thing witth basic research. It is essentially valueless until suddenly, unpredictably, it isn’t. Which is why it makes sense to fund those kinds of activities publicly. There’s just no way to predict which tidbits of today’s esoterica will be tomorrow’s gott’a have building blocks.

    Classic example is the math that forms the basis of stealth technology. Back in the ’60’s, when they hardly allowed anybody to publish anything, Soviet mathematician Petr Ufimtsev was allowed to publish some papers in the West. The stuff was so esoteric that the Soviet censors couldn’t imagine it ever having anything beyond arcane theoretical value. And they were right. Until someone at Lockheed’s skunk works read it in the early ’70’s … at which point it became almost priceless!

    • #18
  19. user_966256 Member
    user_966256
    @BobThompson

    Mendel:I obviously don’t support this idea (not least because those big, fat, juicy pharmaceutical profits write my monthly paycheck).

    But a dirty secret of drug development is that none of those pharmaceutical products – or profits – would exist without NIH-funded research. Looking back on all the drugs developed over the last 2 decades, every project has started by taking knowledge produced by public research and then building on it.

    So in a sense, pharmaceutical companies have been receiving government subsidies since time immemorial.

    How is this accomplished – the acquisition of the results of publicly funded research that private corporations then use for profitable enterprise?  Is the research freely available to anyone interested in further development? If not, what are the requirements to be met, generally speaking?

    • #19
  20. user_966256 Member
    user_966256
    @BobThompson

    It seems to me that the pure research performed by NIH is much more closely aligned with the idea behind the ‘general welfare’ clause of the Constitution than, for example, the notion of ‘single payer’ (federal government) health care coverage which seemed or seems to be the actual objective of recent legislation. The prohibitively high investment risks puts this in a category similar to research for national defense and all Americans benefit.

    • #20

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