Economics of Biotechnology Home Page
THE ECONOMICS OF BIOTECHNOLOGY
4.0 Performance
© Harry Hillman Chartrand
Compiler Press, 2008
Index
4.1
Allocative & Technical Efficiency
4.1.1 Side Bar: Trade Lessons from Biology
In the Industrial Organization Model:
Basic Conditions lead to Structure;
Structure leads to Conduct; and,
Conduct leads to Performance.
Some, however, including Joe Bain himself, argue that the logic can be reduced to: Structure leads to Performance. In either case the question remains: How well does an industry perform – internally and externally?
Internal Performance is reflected by, among other things, how efficiently an industry utilizes its resources, accounts for its opportunity costs and benefits and the profit that it earns (respectively: 4.1 & 4.4). External Performance is reflected by, among other things, the external costs and benefits an industry generates in the natural environment or biosphere and in society (respectively: 4.2, 4.3 & 4.5). This last point is critical. Performance accounts not just for costs and benefits internal but also external to the industry such as environmental impact and economic equity Put another way: the economy is a means to satisfy human ends; it is not an end in and of itself.
Assessing Performance of the biotechnology industry, however, raises some additional complicating questions. First, the industry is arguably about 30 years old, i.e., it is an ‘infant industry’ born with the first genetic patent, i.e., Diamond v Chakrabarty 1980. Does one judge its Performance relative to mature industries like automobiles or adolescent ones like software or infants like nanotechnology? Second, should one measure current Performance or promise and potential? Third, does one judge at the sub-sector level or overall? Fourth, is biotechnology a ‘progressive’ industry fostering attainment of higher social objectives? Thus one Performance measure of U.S. industries, for example, is ‘racial integration’.
4.1/ Allocative & Technical Efficiency
How ‘efficient’ is the biotech industry? In economics, efficiency has a number of dimensions. First, efficiency refers to the ratio of outputs to inputs. To measure it one must therefore be able to calculate, i.e., quantify, both inputs and outputs. This is most easily done in manufacturing, e.g. cars produced per worker per day, rather than services or intangibles. When one cannot directly measure inputs and outputs then surrogates must be used and the relevant measure becomes ‘effectiveness’ rather than efficiency.
Second, there is a difference between technical and economic efficiency. Technical efficiency is achieved when it is not possible to increase output without increasing inputs. Economic efficiency, on the other hand, is achieved when the cost of a given output is as low as possible. Thus all economically efficient solutions are technically efficient but not all technically efficient solutions are economically efficient. The final determining factor is, of course, 'price' or the marginal revenue received. Thus some goods and services may be technically possible but uneconomic. They cannot pay their own way, e.g., the Arts, education, space exploration, ‘pure’ scientific research, the military, etc.
Third, there is allocative efficiency which occurs under conditions of perfect competition. As such it implies all factors of production and all commodities demanded by consumers are in their best use and receive their opportunity cost. Further, it is assumed that there are no external costs or benefits, i.e. all costs and benefits are ‘internalized’ in market price. For allocative efficiency to exist three conditions must be satisfied:
(i) Consumer Efficiency: when consumers cannot increase utility by reallocating budgets;
(ii) Producer Efficiency: when firms cannot reduce cost by changing the input mix; and,
(iii) Exchange Efficiency: when all gains from trade have been exhausted. Gains from trade include ‘consumer surplus’ which is the difference between what consumers are willing to pay and what they actually pay for a given quantity. Gains from trade to producers are ‘producer surplus’ which is the difference between what producers are willing to accept and the price they actually receive for given quantity of output.
Allocative efficiency of an industry is measured relative to the quantity/price established under perfect competition. Perfect competition requires that no player – consumer or producer - exercises market power, i.e., the ability to manipulate the final quantity/price outcome. In turn, this requires that:
(i) goods produced by different firms are considered homogenous by consumers (final or intermediate); and,
(ii) there is free entry to and free exit from the industry with no barriers to entry.
Beyond barriers to entry created by economies of scale and scope available to producers in bio-agriculture and bio-medicine, the central pillar of biotechnology, as a knowledge-based industry, is IPRs. These are temporary grants of monopoly privilege made by the State. As such they create barriers to entry. In turn such rights can only be granted for ‘original’ works meaning that each new product or process is not seen as homogenous by consumers.
Accordingly, one can conclude that the biotechnology industry is not allocatively efficient. Entry is generally achieved through an IPR. As previously noted, many entrants are created simply to be sold off to large established firms enjoying economies of scale and scope in manufacturing, distribution and/or satisfying regulatory requirements of the State.
The question becomes whether allocative inefficiency is worth the price paid through the market power of firms to set the quantity/price outcome? The answer hinges on the benefits of new knowledge generated by IPRs. The rapid growth and development of biotechnology since the first genetic patent in 1980 suggests the price is right as does continuing capital venture investment. As the industry matures, however, it is an open question whether growth will continue. Given the widening 'scope' of biotech patents (Barton 1995) and the increasing frequency and intensity of patent wars, innovation may now be inhibited by the existing IPR regime. The future is also clouded because IPRs themselves continue to evolve with each new legal precedent, national statute and multilateral convention. Uncertainty is the enemy of good business.
4.1.1 Side Bar: Trade Lessons from Biology
For Kauffman, and biology in general, gains from trade are old news:
Economics has its roots in agency and the emergence of advantages of trade among autonomous agents. The advantages of trade predate the human economy by essentially the entire history of life on this planet. Advantages of trade are found in the metabolic exchange of legume root nodule and fungi, sugar for fixed nitrogen carried in amino acids. Advantages of trade were found among the mixed microbial and algal communities along the littoral of the earth’s oceans four billion years ago. The trading of the econosphere is an outgrowth of the trading of the biosphere. (Kauffman 2000, 211)
To demonstrate the gains from trade, Kauffman uses a biological example that, to my mind at least, is intuitive:
Consider two bacterial species, red and blue. Suppose the red species secretes a red metabolite, at metabolic cost to itself, that aids the replication rate of the blue species. Conversely, suppose the blue species secretes a different blue metabolite, at metabolic cost to itself, that increases the replication rate of the red species. Then the conditions for a mutualism are possible. Roughly stated, if blue helps red more than it costs itself, and vice versa, a mixed community of blue and red bacteria may grow. How will it happen? And is there an optimal “exchange rate” of blue-secreted metabolite to red-secreted metabolite, where that exchange rate is the analogue of price? (Kauffman 2000 2000, 216-17)
The first edition of Bain’s Industrial Organization was published in 1959 three years before the modern environmental movement was born with publication of Silent Spring by Rachel Carson in 1962. The 1960s & 1970s were a pre-revolutionary period characterized by radical new ideas on campus and a general stirring up of society’s status quo. A materially satisfied and educated middle class, specifically its younger generation, awoke to a new spectrum of needs.
It appeared to some that material success was paid for with environmental degradation plus international, racial and gender inequity. Cities burned; riots and protests plagued campus; presidents fell; civil, environmental and gender rights became slogans of mass movements. And into the headlines were propelled pacifism, a.k.a., hippies, Woodstock and the anti-war/anti-draft movement, as well as extremist groups, e.g., the Yippies, Weathermen, Black Panthers, et al.
It was in this context that economics met ecology with publication in 1967 and 1968 (the year of the Democratic Convention in Chicago and the down fall of President Johnson together with his dream of a ‘Great Society’) of three very different yet related texts with continuing significance for the economics of biotechnology.
In December 1968, Garrett Hardin, a biologist, published “The Tragedy of the Commons”. The article was based on his presidential address to the Pacific Division of the American Association for the Advancement of Science in June 1968. Hardin demonstrated that unfettered competition for natural resources within and between countries was destroying the natural commons, a.k.a., the environment or biosphere including the air, water, land and biodiversity living therein. Given such resources belong to everyone yet to no one, i.e., they are ‘public goods’, competitive self-interest dictates getting for oneself as much as possible as quickly as possible with no consideration for others – past, present or future. This is “The Tragedy of the Commons”. Unfortunately, a variation on this theme also plagued Second World or communist command economies resulting in even greater environmental damage, debilitation and destruction.
In 1968 the second edition of Bain’s Industrial Organization was published. Responding to growing evidence of the external costs of industry Bain added a section on Conservation Performance, of which more below.
A year before Hardin and Bain published, Harold Demsetz (1967) offered an alternative solution to the tragedy of the commons – property rights. If a public good belongs to everyone but to no one then one way to solve the problem is to assign ownership to someone. That someone will then have a vested interest to ‘conserve’ the resource. This is the approach taken in the Conventions on the Law of the Seas and on Biodiversity (CBD) and the Kyoto Accord. In the case of the Law of the Seas and CBD ownership is vested in the Nation-State. In the case of Kyoto it is similarly vested in the Nation-State but some have transferred ownership to private agents – both natural and legal persons, e.g., using carbon auctions and credits.
As to Bain’s section on Conservation Performance, I reproduce the full two pages below for a number of reasons. First, it affirms Hardin’s argument demonstrating what Robert Merton in the history of science calls ‘multiple discovery' in this case in economics and ecology. The word 'economy' derives from the ancient Greek oikos meaning 'house' and nemo meaning 'manage', i.e. managing the house. In this sense, economics shares its root with 'ecology' which derives from oikogie meaning modes of life and relations within the house. Another connection is Ekistics - the science of human settlement. This term also derives form oikos but in the sense of founding an ancient Greek colony like Syracuse in Sicily or the numerous city states established by Alexander the Great in India. These three terms – economics, ecology and ekistics - are increasingly linked through growing awareness of the unintended effects of human activity or 'externalities' on the house of humanity - Planet Earth.
Second, Bain’s text clearly distinguishes between ‘preservation’, i.e., no use, and ‘conservation’ meaning appropriate use. The human species like other organisms does not just adapt to its environment it also adapts its environment to its own wants, needs and desires. This is called ‘technology’ (Heidegger 1955). With biotechnology the totality of the biosphere is now toolable to human purpose. In this sense, if ‘Nature’, in a pre-human sense, is to survive it will be as a theme park or, the worst case scenario, as a movie providing re-ligio to before the time of human dominion.
Third, it is a period piece benchmarking how far our thinking has come. That human impact on the environment was, at one point in recent history, absent from our collective consciousness should serve as a wakeup call to our ignorance. In our ignorance, i.e., the absence of knowledge, should we be arrogant or humbled by cost-benefit analysis, the precautionary principle or other inhibiting practices?
Fourth, its language is classic economics highlighting all costs are opportunity costs – the next best alternative foregone. Preservation of the existing biosphere entails a cost measured in restriction or reduction of the human population forecast to grow from about 6 billion in 2000 to 9 billion in 2050. Quite simply, who is to die; who is not to be born between now and then? Who is to decide that the panda not people will survive? In the words of Milton Friedman: ‘There is no free lunch’.
I will resume my narrative after Bain speaks. Enjoy.
From Chapter 10
MARKET PERFORMANCE IN AMEICAN INDUSTRIES
MARKET PERFORMANCE IN OTHER DIMENSIONS
Conservation Performance
For any of a group of industries whose operations involve extraction of natural resources (mining, petroleum production, agricultural cultivation, lumbering, commercial fisheries) a significant dimension of the market performance of the firms engaged involves how well they do in the matter of “conservation” of resources. To paraphrase the popular literature on this matter, conservation in an economic sense of course does not mean non-use or simple deferment of use, but “wise use” of the resources being exploited. In technical terms, good conservation requires a choice of technique of exploitation, time pattern of production, and time pattern of investments and other costs, which together yield an optimal net social benefit relative to costs over all future time periods in which society is interested. In determining this optimum, distant future benefits and costs should be appropriately discounted by whatever rate of “time preference” society wishes to assign in assessing the relative importance of current as opposed to future benefits and sacrifices. And conservation performance is poor to the extent that enterprises deviate from this abstract ideal.
An adequate operational definition of ideal conservation performance is extremely complex and next to impossible to apply fully in the evaluation of actual performance. Using the definition just given as a guide, however, it is possible to identify certain types of gross departure from good conservation which would have to be censured under any acceptable criterion. These include:
1. Exploitation of resources by a technique that raises both present and future costs above the obtainable minimum while reducing or not increasing the amount of resources ultimately recovered, or the amount of use obtained from resources over time.
2. Unduly rapid or intensive current use of resources which has the result of impairing (or eliminating) future use of the resources to a degree not compensated by current additions to output.
3. Pinching on current costs or investments in the use and development of resources in a way that curtails future use or raises future costs of use to a disproportionate degree.
What of the actual performance of industries in regard to conservation? Of course, only a minor proportion of all industries are sufficiently involved in extraction to make conservation an issue, and for these we do not have highly organized, systematic information on which to base an overall appraisal. However, a broad scattering of evidence on individual cases suggests that, among extractive industries, conservation performance is or has very frequently been poor.
Thus we observe in petroleum production in the United States a history of gross elevation of recovery costs coupled with a substantial reduction of ultimate recovery of available petroleum, attributable largely to the selection of techniques in the context of competitive exploitation of individual oil pools by antagonistic interests. In both lumbering and commercial fisheries, and in some agriculture, we find that a serious long-run depletion of resource productivity has resulted from overintensive immediate rates of extraction or exploitation of the available resources. In much of agriculture, a history of pinching on current costs for or investments in the preservation of the land (against erosion or reduction in fertility) has resulted in long-run losses in soil productivity.
These deviations from reasonably good conservation performance seem in large part attributable to four things: (1) antagonistic exploitation of resource deposits by competing interests, in which a competitive race to capture the resource or its output before others do results in a disregard of long-run yield considerations; (2) an inherent “short-sightedness” of firms engaged in exploiting resources - firms that attach much less importance to distant future production than society would, or than they do to immediate profits; (3) competitive conditions which bring about such low returns to firms in some extractive industries that they cannot afford to invest in the long-run maintenance of resource yields; and (4) stupidity. Whatever the cause, poor market performance in the matter of conservation has evidently been chargeable against firms in many extractive industries. It is encouraging, in the light of this, that in the past twenty or thirty years there has been a rapidly increasing body of governmental regulations designed to encourage or require better conservation performance on the part of these industries.
Bain 1968, 425-427
The key to Bain’s analysis is ‘time preference’, i.e., preferring present vs. future benefits and costs. Such resources will ultimately be used to serve human purpose. The question is when the time preference of industry and society correspond? But then who legitimately speaks for society’s time preference? Is it industry itself with its supply satisfying human wants, needs and desires? Is it government or non-governmental – secular or religious - organizations (NGOs) or popular plebiscites? And, of course, on what evidence is the decision to be made?
Any preferred Future is one which we – the present generation - may not live to ‘enjoy’. A preferred Future nonetheless requires Present sacrifice. How much are we willing to pay for an uncertain Future we will not live to see? And if successful will our descendents bless or curse us? How much current sacrifice is the Future worth compared to the pleasures of the Present?
In the 1960s, however, Demsetz, Hardin and Bain could not have anticipated the biotechnology industry and the new questions it raises including whether or not the biosphere is a commons unlike any other.
Bain’s ‘extractive industries’ are just that – extractive. They engage in a zero-sum game with current use reducing the finite supply of a natural resource. At worst, in mining, oil exploration and traditional fishing, we are left literally with a whole in the ground (or water). At best, in pre-biotech agriculture and forestry, we delay the process of soil degradation by using artificial fertilizers mainly derived from mining and oil exploration and application of various re-planting techniques. In this sense the extractive industries belong more to the geosphere than the biosphere. All tend to gross overuse unless private property rights are established by the State.
As we have seen, the public domain of knowledge too is a commons but one which grows and expands with use – We all stand on the shoulders of giants! To accelerate its growth the State grants limited private property rights. The public domain, however, belongs to the noösphere of human thought not to the geosphere of inanimate matter/energy or the biosphere of living things.
At least with respect to biotechnology the biosphere appears to share characteristics of the other two commons. On the one hand, biotechnology can add to the biosphere by creating new organisms and organic compounds. It thereby enframes and enables the biosphere to better serve human purpose. On the other hand, biotechnology can eliminate or otherwise alter what humanity considers unwanted inhabitants of the biosphere like Aids, malaria, tuberculosis, etc. Again, the biosphere is enframed and enabled to serve human purpose. In both cases, however, there can be unintended consequences.
How is conservation performance of the biotechnology industry to be assessed? With respect to the extractive industries Bain concluded that:
An adequate operational definition of ideal conservation performance is extremely complex and next to impossible to apply fully in the evaluation of actual performance. (Bain 1968, 245)
He fell back on general principles. In the case of the biotechnology industry such general principles can arguably be found in the 1992 Rio Declaration and the Cartagena Protocol on Biosafety of 2000. While not accepted by all Nation-States, especially the United States of America, these multilateral instruments articulate the highest level of global value consensus yet achieved on the matter.
Principle 1of the Rio Declaration reads:
Human beings are at the centre of concerns for sustainable development. They are entitled to a healthy and productive life in harmony with nature.
The Preamble to the Convention on Biological Diversity (the Cartagena Protocol) calls for the “conservation and sustainable use of biological diversity”. It is important to note that the Cartagena Protocol re-affirms application of the precautionary approach enunciated in Principle 15 of the Rio Declaration. This is the primary reason for the refusal of the United States to adhere to these two instruments.
Leaving aside the cost/benefit vs. precautionary principle controversy as well as interpretation of words like ‘harmony’, from these two statements one can conclude that conservation performance of the biotechnology industry can be assessed by answering the following questions:
Does the industry foster a healthy and productive human life in harmony with nature?
Does the industry promote conservation and sustainable use of biodiversity?
For the moment, however, these must remain unanswered questions.
The economic concept of equity arguably derives from English Common Law. With the Norman Conquest of 1066 all rights and privileges of the previous regime were abrogated by right of conquest. In effect William the Conqueror had carte blanche to shape a kingdom without accounting for pre-existing feudal rights and privileges. Unlike other European kingdoms, it was his exclusive unqualified domain. Nonetheless, what he conquered was a patchwork of Angle, Saxon, Jute, Danish, Viking and Celtic settlements, regions, laws and languages.
The new King assigned the regions, after accepting oaths of fealty, to a new Anglo-Norman aristocracy. The new local rulers, while subject to the King, also inherited rights and privileges acceded to traditional rulers under local ‘legal systems’. These are the root of ‘Common Law’, i.e., traditional English law based on precedent.
His new subjects soon brought to his attention (and that of his successors) inequities in a supposedly unified kingdom. At the extreme, in one jurisdiction theft of a loaf of bread cost a hand; in another it cost two days in the stocks being hit by rotten vegetable and insults thrown by one’s neighbours. It was not a question of guilt or innocence they cried but fairness or equity of punishment before the King.
Over time responsibility for hearing such calls for mercy was transferred to the King’s chancellor and a court of his own. Thus the English justice system evolved two distinct strands – law and equity. Two issues of equity played an important role in the monarch’s continuing ability to control his vassals. These were trusts and tenant-landlord rent disputes. Originally trusts (from which modern charities and much later financial trusts evolved) generally concerned widows and orphans left at the mercy of a local lord. The most famous example is Lady Marion of the Robin Hood legend who was an orphan and ward of the King. With respect to tenant-landlord rent disputes, the court of equity served to balance the power of local lords by connecting the King to his subjects. This relationship was called the ‘rent bargain’ by J.R. Commons (1924) and served to stabilize the social system of Norman and then Plantagenet England.
Equity in economics also refers to ‘fairness’. While generally used with reference to taxation, it is a general economic concept. With respect to taxation equity has three dimensions: horizontal, vertical and overall equity or tax burden.
Horizontal equity refers to ‘like treatment of like’. Vertical equity refers to ‘unlike treatment of unlike’. Overall tax equity refers to the accumulated impact of all taxes on citizens. In effect, it reflects the difference between earned and disposable income after all taxes are paid.
While not part of Bain’s original model, equity has become one measure of IO Performance. A classic U.S. example is affirmative action in employment of racial and other minorities. Does the industry promote or inhibit integration? With respect to the biotech industry there are several questions of equity that must be answered to assess its Performance.
Does the industry favour large over small intermediate consumers, e.g., large agribusiness versus small famers? Does it favour rich over poor final consumers of medical services? Does it favour Nation-States over aboriginal or First Nations peoples? These are questions of vertical equity.
Does the industry favour men over women as final consumers of medical services? Does it favour developed over developing Nation-States – all equal in the United Nations General Assembly? These are arguably questions of horizontal equity.
Does the industry through its many sub-sectors contribute to a more or less equitable society? This is a question of overall equity.
For the moment, however, these remain unanswered questions.
Financial profitability is a basic measure of Performance. Those who believe that Structure leads to Performance argue high or excess profits reflect imperfect competition – monopoly, oligopoly and short-run monopolistic competition. Profits at normal or average levels reflect perfect competition. Industries experiencing excess profits should, under perfect competition, see the entry of new firms; if losses, the exit of existing firms from the industry.
With respect to the biotechnology industry, it not possible, at present, to estimate overall profit levels. Available information suggests, however that while there are some winners overall inflow of venture capital and losses are the norm. The fact that venture capital continues to flow into an industry with no current profits arguably reflects two things: (i) expectations about the long-run profitability and growth of the industry; and, (ii) the role of IPRs in attaining a short-run monopoly position and the excessive profits it permits.
In addition to adding Conservation Performance in his second edition, Bain also explored Performance as ‘progressiveness’ defined as continuing reduction in the cost of production due to technological advance (Bain 1968, 419-421). Gross measures of progressiveness such as “a simple enumeration of and comparison of the number and importance of inventions and innovations over a certain time period… or … of a gross count of ‘research and development’ expenditures…” (Bain 1968, 419) is faulty and inadequate.
What is needed is a measure of an industry’s actual progressiveness “relative to its opportunities” (Bain 1968, 419). The difficulty is that the “fantastically complex body of information required… is either unavailable or protected by secrecy” (Bain 1968, 421). Bain concludes that because:
we are unable to distinguish good from bad performance in the dimension of technological progress, we are unable to establish empirically the conditions of market structure which might favor good progress… We therefore drop the matter of technological progressiveness and turn to other matters. (Bain 1968, 421)
