Naked Economics (11 page)

So why do we allow Pfizer to fleece Viagra users? Because if Viagra did not get patent protection, then Pfizer never would have made the large investments that were necessary to invent the drug in the first place. The real cost of breakthrough drugs is the research and development—scouring the world’s rain forests for exotic tree barks with medicinal properties—not making the pills once the formula is discovered. The same is true with drugs for any other illness, no matter how serious or even life-threatening.
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The average cost of bringing a new drug to market is somewhere in the area of $600 million. And for every successful drug, there are many expensive research forays that end in failure. Is there a way to provide affordable drugs to low-income Americans—or poor individuals elsewhere in the world—without destroying the incentive to invent those drugs? Yes; the government could buy out the patent when a new drug is invented. The government would pay a firm up front a sum equal to what the firm would have earned over the course of its twenty-year patent. After that, the government would own the property right and could charge whatever price for the drugs it deemed appropriate. It’s an expensive solution that comes with some problems of its own. For example, which drug patents would the government buy? Is arthritis serious enough to justify using public funds to make a new drug more affordable? How about asthma? Still, this kind of plan is at least consistent with the economic reality: Individuals and firms will make investments only when they are guaranteed to reap what they sow, literally or figuratively.

I once stumbled on a curious example of how ambiguous property rights can stifle economic development. I was working on a long story on American Indians for
The Economist.
Having spent time on a handful of reservations, I noticed that there was very little private housing stock. Tribal members lived either in houses that had been financed by the federal government or in trailers. Why? One principal reason is that it is difficult, if not impossible, to get a conventional home mortgage on an Indian reservation because the land is owned communally. A tribal member may be given a piece of land to use, but he or she does not own it; the Indian Nation does. What that means to a commercial bank is that a mortgage that has fallen delinquent cannot be foreclosed. If a bank is denied that unpleasant but necessary option, then the lender is left without any effective collateral on its loan. A trailer, on the other hand, is different. If you fall delinquent on your payments, the company can show up one day and haul it off the reservation. But trailers, unlike conventional housing, do not support local building trades. They are assembled thousands of miles away in a factory and then transported to the reservation. That process does not provide jobs for roofers, and masons, and drywallers, and electricians—and jobs are what America’s Indian reservations need more than anything else.

Government lowers the cost of doing business in the private sector in all kinds of ways: by providing uniform rules and regulations, such as contract law; by rooting out fraud; by circulating a sound currency. Government builds and maintains infrastructure—roads, bridges, ports, and dams—that makes private commerce less costly. E-commerce may be a modern wonder, but let’s not lose sight of the fact that after you order khakis from Gap.com, they are dispatched from a distribution center in a truck barreling along an interstate. In the 1950s and 1960s, new roads, including the interstate highway system, accounted for a significant fraction of new capital created in the United States. And that investment in infrastructure is associated with large increases in productivity in industries that are vehicle-intensive.
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Effective regulation and oversight make markets more credible. Because of the diligence of the Securities and Exchange Commission (SEC), one can buy shares in a new company listed on the NASDAQ with a reasonable degree of certainty that neither the company nor the traders on the stock exchange are engaging in fraud. In short, government is responsible for the rule of law. (Failure of the rule of law is one reason why nepotism, clans, and other family-centered behavior are so common in developing countries; in the absence of binding contractual agreements, business deals can be guaranteed only by some kind of personal relationship.) Jerry Jordan, former president of the Federal Reserve Bank of Cleveland, once mused on something that is obvious but too often taken for granted: Our sophisticated institutions, both public and private, make it possible to undertake complex transactions with total strangers. He noted:

Shakespeare may have advised us to get rid of all the lawyers, but he was a playwright, not an economist. The reality is that we all complain about lawyers until we have been wronged, at which point we run out and hire the best one we can find. Government enforces the rules in a reasonably fair and efficient manner. Is it perfect? No. But rather than singing the praises of the American justice system, let me simply provide a counterexample from India. Abdul Waheed filed a lawsuit against his neighbor, a milk merchant named Mohammad Nanhe, who had built several drains at the edge of his property that emptied into Mr. Waheed’s front yard. Mr. Waheed did not like the water draining onto his property, in part because he had hoped to add a third room to his cement house and he was worried that the drains would create a seepage problem. So he sued. The case came to trial in June 2000 in Moradabad, a city near New Delhi.
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There is one major complication with this civil dispute: The case had been filed thirty-nine years earlier; Mr. Waheed was dead and so was Mr. Nanhe. (Their relatives inherited the case.) By one calculation, if no new cases were filed in India, it would still take 324 years to clear all the existing cases from the docket. These are not just civil cases. In late 1999, a seventy-five-year-old man was released from a Calcutta jail after waiting thirty-seven years to be tried on murder charges. He was released because the witnesses and investigating officer were all dead. (A judge had declared him mentally incompetent to stand trial in 1963 but the action was somehow lost.)
Bear in mind that by developing world standards, India has relatively good government institutions.
In Somalia, these kinds of disputes are not resolved in the courts.

All the while, government enforces antitrust laws that forbid companies from conspiring together in ways that erase the benefits of competition. Having three airlines that secretly collude when setting fares is no better than having one slovenly monopoly. The bottom line is that all these institutions form the tracks on which capitalism runs. Thomas Friedman, foreign affairs columnist for the
New York Times,
once made this point in a column. “Do you know how much your average Russian would give for a week of [the U.S. Department of Justice] busting Russia’s oligarchs and monopolists?” he queried.
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He pointed out that with many of the world’s economies plagued by endemic corruption, particularly in the developing world, he has found that foreigners often envy us for…hold on to your latte here…our Washington bureaucrats; “that is, our institutions, our courts, our bureaucracy, our military, and our regulatory agencies—the SEC, the Federal Reserve, the FAA, the FDA, the FBI, the EPA, the IRS, the INS, the U.S. Patent Office and the Federal Emergency Management Agency.”

The government has another crucial role: It provides a wide array of goods, so-called “public goods,” that make us better off but would not otherwise be provided by the private sector. Suppose I decide to buy an antimissile system to protect myself from missiles lobbed by rogue nations. (It would be similar to the DirecTV satellite dish, only a lot more expensive.) I ask my neighbor Etienne if he would like to share the cost of this system; he says no, knowing full well that my missile defense will shield his house from any missiles that North Korea may send our way. Etienne, and most of my other neighbors, have a powerful incentive to be “free riders” on my system. At the same time, I do not want to pay the full cost of the system myself. In the end, we get no missile defense system even though it might have made us all better off.

Public goods have two salient characteristics. First, the cost of offering the good to additional users—even thousands or millions of people—is very low or even zero. Think of that missile defense system; if I pay to knock terrorist missiles out of the sky, the millions of people who live relatively close to me in the Chicago metropolitan area get that benefit free. The same is true of a radio signal or a lighthouse or a large park; once it is operational for one person, it can serve thousands more at no extra cost. Second, it is very hard, if not impossible, to exclude persons who have not paid for the good from using it. How exactly do you tell a ship’s captain that he can’t use a lighthouse? Do you make him close his eyes as he sails by? (“Attention USS
Britannica:
You are peeking!”) I once had a professor at Princeton who began his lecture on public goods by saying, “Okay, who are the suckers who actually contribute to public radio?”

Free riders can cripple enterprises. Author Stephen King once attempted an experiment in which he offered his new novel directly to readers via the Internet. The plan was that he would offer monthly installments for readers to download in exchange for a $1 payment based on the honor system. He warned that the story would fold if fewer than 75 percent of readers made the voluntary payment. “If you pay, the story rolls. If you don’t, it folds,” he wrote on the website. The outcome was sadly predictable to economists who have studied these kinds of problems. The story folded. At the time “The Plant” went into hibernation, only 46 percent of readers had paid to download the last chapter offered.

That is the basic problem if public goods are left to private enterprise. Firms cannot force consumers to pay for these kinds of goods, no matter how much utility they may derive from them or how often they use them. (Remember the lighthouse.) And any system of voluntary payments falls prey to the free riders. Think about the following:

Basic research. We have already discussed the powerful incentives that profits create for pharmaceutical companies and the like. But not all important scientific discoveries have immediate commercial applications. Exploring the universe or understanding how human cells divide or seeking subatomic particles may be many steps removed from launching a communications satellite or developing a drug that shrinks tumors or finding a cleaner source of energy. As important, this kind of research must be shared freely with other scientists in order to maximize its value. In other words, you won’t get rich—or even cover your costs in most cases—by generating knowledge that may someday significantly advance the human condition. Most of America’s basic research is done either directly by the government at places like NASA and the National Institutes for Health or at research universities, which are nonprofit institutions that receive federal funding.


Law enforcement. There is no shortage of private security firms—“rent-a-cops” as we used to call them in college as they aggressively sought out twenty-year-old beer drinkers. But there is a limit to what they can or will do. They will only defend your property against some kind of trespass. They will not proactively seek out criminals who might someday break into your house; they will not track Mexican drug kingpins or stop felons from entering the country or solve other crimes so that the perpetrator does not eventually attack you. All of these things would make you and your property safer in the long run, but they have inherent free rider problems. If I pay for this kind of security, everyone else in the country benefits at no cost. Everywhere in the world, most kinds of law enforcement are undertaken by government.


Parks and open space. Chicago’s lakefront is the city’s greatest asset. For some thirty miles along Lake Michigan, there are parks and beaches owned by the city and protected from private development. If this is the best use of the land, which I firmly believe it is, then why wouldn’t a private landowner use it for the same purposes? After all, we’ve just stipulated that private ownership of an asset ensures that it will be put to its most productive use. If I owned thirty miles of lakefront, why couldn’t I charge bicyclists and roller bladers and picnickers in order to make a healthy profit on my investment? Two reasons: First, it would be a logistical nightmare to patrol such a large area and charge admission. More important, many of the people who value an open lakefront don’t actually use it. They may enjoy the view from the window of a high-rise apartment or as they drive along Lake Shore Drive. A private developer would never collect anything from these people and would therefore undervalue the open space. This is true for many of America’s natural resources. You have probably never been to Prince William Sound in Alaska and may never go there. Yet you almost certainly cared when the huge oil tanker
Exxon Valdez
ran aground and despoiled the area. Government can make us collectively better off by protecting these kinds of resources.