In the continuing debate over the prices of prescription drugs, Ellen Goodman, a Pulitzer Prize-winning columnist, believes she has found the real answer to why many drugs are so expensive. The culprit, she says, is advertising, and lots of it. She writes: "Pharmaceutical companies tell us that the cost [of drugs] is connected to research and development. No cost, no cure. But major drug companies, as a Families USA report shows, spend more on marketing, advertising, and administering than on R&D. Indeed, some of what they call research-Let's color that pill purple!-is what we call marketing."1
Goodman is hardly alone in her views. Indeed, people on all sides of the debate often say the same thing. Drug companies do cite R&D costs as a major contributor to prescription drug prices, just as oil companies cite the high cost of crude oil for high gasoline prices. In other words, according to most who participate in such debates, costs drive prices. To be more specific, these folks hold that the costs of the factors of production (or what economists call inputs) directly determine the prices of the final products that individuals consume.
Government regulators usually base pricing policies on this "cost-plus" notion of prices. For example, when the U.S. government regulated gasoline prices during the 1970s, regulators tied increases in pump prices to price increases in crude oil. Of course, those regulators also forbade gasoline retailers to raise pump prices immediately after crude prices increased, since it would take four to six weeks before the higher priced crude actually became usable gasoline. Therefore, retailers had to wait before being permitted to raise prices.
(It does not take an economic expert to know what chaos this system created. Consumers, correctly anticipating future price increases, quickly increased their demand for gasoline purchases in the present. Because retailers were not able to raise prices in the presence of demand increases, it did not take long for anxious buyers to strip current supplies, leading to the infamous "Sorry! Out of Gas" signs that began to appear at gas stations across the country.)
The notion of cost-plus pricing is hardly new. Many ancient scholars, in search of the "just price," assumed that such a price had to be based on production costs. However, as Murray Rothbard noted, by the Middle Ages many of the Scholastic writers had jettisoned that view for a utility-based interpretation of value.2 In fact, it wasn't until the rise of the English classical economists of the eighteenth and nineteenth centuries, including Adam Smith and David Ricardo, that cost of production once again took center stage.3
Had the classical view been correct, folks like Ellen Goodman and the government regulators would have been justified in believing the cost of production ought to determine prices. However, the cost-of-production theory of value has a number of inherent problems, the chief one being that it explains nothing.
If one were to employ the cost-ofproduction theory to explain the price of my computer, the causality might go as follows: the price comes from the cost of the factors of production that went into making the computer, including labor, raw materials, components, and the machinery (capital goods) that assembled them.
Fine enough, one might say, but from where did those costs come? A classical economist might answer that those costs came from the costs of the factors that produced the capital goods and raw materials. The costs of raw materials would come from the land and labor. Karl Marx reduced all production to labor in his variation of the labor theory of value. (Marx developed his theory of value from the "cost of production" theories of Adam Smith and David Ricardo. He took those theories to their logical conclusion in developing his own interpretation of value.)
The problem is that we are stuck in an endless regression. …