Friday, November 6, 2009

Costs Surge for Medical Devices, but Benefits Are Opaque

New York Times article "Costs Surge for Medical Devices, but Benefits Are Opaque" (November 4th, 2009), offers a subtle but fundamental misunderstanding of the manner in which profit maximization will take place. Speaking on defibrillators, the Times quotes a doctor who argues that companies may produce deliberately short-lived products as a ploy to make higher profits:

The federal government could also play a more aggressive role in making sure it is getting better value for its money, he added. A case in point — requiring that makers of heart devices use batteries that last longer than five years, the period of time when patients must now undergo an additional, potentially dangerous operation to have a costly device replaced.

Dr. Maisel said, “Why would you build a better light bulb that lasts longer if it is going to reduce your profits?

This thinking is wrong. Planned obsolescence should not take place. Given two technologies, firms will produce using the technology that is cheapest per unit of quality good.

Take Dr. Maisel's lightbulb. If I am offered a choice between a "good" lightbulb and a "bad" lightbulb at two different prices, which will I pick? To be specific, but with no loss of generality, let's say I'm offered two lightbulbs that last for year each rather than one lightbulb that lasts two years. I will purchase the cheaper lightbulb, as defined as the cheapest lightbulb per unit time. If the two-year lightbulb is priced more than twice as expensive as the one-year lightbulb, then I will only purchase the one-year lightbulb. The "worse" lightbulb. If the two-year lightbulb is priced less than twice the one-year lightbulb, then I will only purchase the two-year lightbulb. This is because I am not purchasing a lightbulb when I go into the store, I am buying light for a specific period of time. The price I am willing to pay is not a function of number of lightbulbs, but of dollars per unit time.

In economics, we will often see scenarios in which monopolists deliberately reduce quantity produced to raise price and lower profits. Dr. Maisel and the Times are in error in extending to the conclusion that a monopolist will deliberately reduce quality.

This is because a monopolist knows that the price they can charge is determined only by the price they charge per unit time provided by the good they are selling. A consumer doesn't care about how much a good took to produce, only what they get out of it and the price charged. Therefore, a profit-maximizing monopolist will choose the cheapest means of producing per unit time, as that choice has no impact on consumer behavior (purchasing more or less), just on profits. That is to say, only prices (price per unit time) and quantities (total light per unit time) come into the consumer's decision, not cost to make. A monopoly will doubtlessly reduce quantity of lightbulbs, but the choice of quality is a concern of cost minimization, and they will always arrive at the efficient technology.

It is precisely for this reason that even monopolists will produce the best, cheapest technology they can--they will charge the same price for it, but will get greater profit from producing a better product.

The Times is wrong on the economics of lightbulbs and defibrillators.

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