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August 31, 2004

Combined vs. Separated Bargaining; Government Drug Purchases

We had a good discussion last week in the law-and-econ lunch on bilateral vs. multilateral bargaining vs price-taking. Here's the story.

Suppose Eli Lilly has a patent monopoly on Zyprexa. Compare four systems:

1. Lilly sets one price and consumers or insurance companies are price takers.

2. Lilly negotiates with each of 5000 insurance companies.

3. Lilly negotiates with each of 50 state governments.

4. Lilly negotiates with just the federal government.

Which would Lilly prefer? ....

The answer is not as simple as it might seem. If Lilly just charges one,
monopoly price that is very inefficient. If Lilly negotiates with one buyer, the
federal government, they will choose the efficient quantity, and some lump-sum
price which splits the surplus (and then the federal government will sell
Zyprexa to consumers at marginal cost). The efficiency gain might be so great
that both Lilly and consumers gain.

Cases (2) and (3) really are no different from each other-- tehy are both
negotiation instead of price taking, but negotiation with lots of buyers instead
of just one. The idea in my price discrimination notes is that if we continue to
split the surplus 50-50, Lilly won't be any better off negotiating with 5000
than it was negotiating with 1. Each of the 5000 insurance companies has (we
woudl assume) irreplaceable consumers-- if company 4322 decides not to buy from Lilly, Lilly has lost the 43,000 customers of company 4322 and can't replace

Our discussion at lunch focussed on psychological things such as the envy of
New York if Mississippi got a cheaper price, on info (how would New York know?)
and on corruption (is it cheaper to bribe 1 big buying agent, or 50 small
ones?). All those things are interesting but separate from the perfect price
discrimination idea. Yet another thing which is separate but practically
important is that there are economies of scale in bargaining. It is not that
having 1 US governmetn negotiate for all 50 states really gives it more
bargaining power, but that the 1 buyer finds it worthwhile to hire a super duper
bargaining team, spending 49 times as much on it as each of the 50 states. Thus, if the Federal-Lilly surplus split was 50-50, the state-LIlly split might be
more like 20-80 for each state because of Lilly's superior bargaining skill.

Posted by erasmuse at August 31, 2004 09:44 PM

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