Tuesday, December 6, 2011

Patented Drugs versus Generic Drugs, an Example of Knowledge versus Capacity Value

The Concepts of Value
In the first chapter of my book, Organizational Economics: The Formation of Wealth, I describe three types of value, knowledge, capacity, and political (I also discuss these in three posts: Knowledge, Capacity, Political).  Essentially, knowledge value is "I have researched something and know what you don't know, so, pay me and I will share"; capacity value is "more of the same", but political value is of two types, "I can mediate between you and her reducing the cost of your interaction, so pay me", and "I have a bigger stick or a truer religion, so do homage to me and pay me and I will let you live".

Examples of Knowledge Value versus Capacity Value
The categories of value types, above, are based on observation, not theory.  This post will demonstrate this for the interaction between knowledge and capacity value.

The example I used in my book is of the doctor and the painter.  I hire a doctor because he or she has knowledge that I don't have about the body that I need; so the doctor provides knowledge value to me.  However, I hire a painter even though I know how to paint a room. The reason is that I'm a slow painter and I don't have all of the tools to speed up the job; the painter is faster and has all of the tools.  The painter provides capacity value to me.

Additionally, I discussed in my book the fact that, from the perspective of the supplier, it is better to provide knowledge value than capacity value.  However, I did not provide an example.  The best example I have found is that of patented drugs versus generic drugs.

As is well known, when a patent comes off a drug, its price plummets immediately.  Why?  And why is the price high to start with.  Both of these are affects of the change from knowledge value to capacity value caused by the patent.  A patent for any product, system, service, or process is the right to gain knowledge value from the invention or innovation on a unique concept or idea.

Creating knowledge value is a two part process; invention and innovation, or research and development.  Both require resources (effort over time).  Additionally, it requires the organization (or person) to "take on risk (unknowns)".  Investing resources in an unknown should be rewarded, or there is much less incentive to invent or innovate--though some people have those urges built into their DNA.  One of the rewards is a patent; the right to product the product, system, or service, or use the process for a period of time.  If anyone else wants to use the concept or idea, the patent owner must grant the right and garner royalties.

However, a patent requires full disclosure of the concept or idea including internal details and formulas; meaning anyone can copy it.  Therefore, a the end of the period of the patent, anyone can copy it. Consequently, during the the period while the patent is in force the inventor/innovator of record can reap the rewards of knowledge value, while at the end of the patent, the product immediately produces only capacity value.  The is the reason for the drop in price and the difference between the value produced by knowledge and the value produced by capacity.

Wall St., Growth and Value Stocks
Actually, the financial engineers of Wall St. have long intuitively understood that once initially produced and patented, an economic organization will immediately start producing knowledge value (which economists misconstrue as "monopolistic value").  Consequently, they call the stock in these organizations "growth" stocks because their value grows--while these stocks should probably be called "knowledge stocks" instead.  The reason Wall Streeters call stocks built on knowledge "growth" stocks is that their price increases, sometimes rather rapidly, that is, they grow in value.  However, they may not produce a dividend.

On the other hand, "value" stocks create capacity value--more of the same.  I have heard that of the Total Cost of Ownership (TCO) or the Total Lifecycle Cost (TLC) of an aircraft, only 10 percent is in the initial cost; the rest is maintenance, upgrades, and disposal.  And there is a saying, "You can tell a homeowner by the many visits to Home Depot or Lowe's and returning with an empty wallet".

As any product matures the value it creates for its manufacturer turns from knowledge to capacity.  Part of the reason for this transformation is that competitors see the "extra" value created from the application of knowledge and attempt to exploit a portion of it for themselves.  This competition drives out the knowledge from the knowledge value leaving only the capacity value, and the product, system, or service at a much lower price.  Adam Smith called this change from production of knowledge value to capacity value "the invisible hand".  Others call this process commoditization, that is, conversion from a differentiated product to a commodity (price driven).  So under many guises, this concept has been around for a long time.

All Sorts of Monopolies
Within this framework of value types, monopolies (and oligopolies) are defined as an organization (or organizations in the case of an oligopoly) that prevent the natural conversion of knowledge value into capacity value.  For the purposes of this post, both monolopies and oligopolies will be considered as monopolies.  To prevent a product, system, or service from becoming a commodity, supplier have created a variety of methods, which turn out to be artificial and natural monopolies.  Monopolies have many guises. 

Government Monopolies
One method is to hold the knowledge, thereby creating a monopoly.  In exploitive political organizations this includes state owned businesses.  In this case, The State dictates that no one other than the state agency or organization may produce the product.  Authority-based exploitive organizations, like religious authorities, can also create this type of monopoly (i.e., power corrupts and fanatical religions destroy value faster than any other force short of nature).

Manipulation of Policies and Standards
Another method to maintain and exploit knowledge value is to manipulate or game the laws and regulations of the country (policies and standards for most organizations) to favor the organization with the knowledge.  One way is to keep the knowledge secret; frequently, this is known as a "trade secret".  For many companies this is their product differentiation.  For example, Coca Cola keeps their formula for Coke secret.  This is a good example because the company advertised a new formula and their customer's rebelled.  The company had to bring out "Coca Cola Classic" to avoid a major  ROI disaster.  Consequently, brands and branding of products and services can maintain some knowledge value, and that is the reason for branding (especially when coupled with the concept of brand loyality from the consumers).

[sidebar] Sometimes there is real reasons for brand loyality.  For example, I've found that "the fillers" or inert ingredients in "off brand" or generic drugs like vitamins have undesirable side effects that the brand I use does not have.  At least that is my assumption, since the formulation of the active ingredients looks the same from the labeling.

Politicians, especially members of Congress game the laws and regulations to the advantage of their constituents (those that pay for their re-election).  Many times this is good.  For example, a tax reduction (loophole) for charity (if the charity spends the money wisely) might be considered good; a tax reduction (loophole) for investing in a "green technology" startup company might be considered good, and so on.  Still, these loopholes end up like the temporary "for the duration of WWI only" 1918 buildings on the Mall in Washington DC that were torn down in 1975, more or less permanent.  Each has a constituency that would be hurt if the loophole was removed.  There is still a deduction for gambling losses, and there would be a hue and cry if the mortgage deduction was removed--and not only from homeowners, but the whole real estate industry (as if there would be no more sales of houses if the loophole was removed).  What is happening is that there is exploitive value being extracted by each of these constituency.  And each constituency looks at that exploitive value as "their just entitlement".  But, each is a manipulation of laws and regulations causing knowledge value to be transformed into exploitive value instead of capacity value.

One of the best known examples of this (maybe most blatant) is the way J.P. Morgan set up railroad tariffs on all railroads so that only steel mills in Pittsburgh could really make money; most of these mills were owned by Morgan (US Steel).  This is a prime example of regulations creating an uneven economic field of opportunity, but it is far from unusual even today. ([Sidebar] This is a key valid concern of the "Occupy Wall St. Movement.)  But there are natural barriers.

Natural Barriers to Converting Knowledge Value to Capacity Value
There are three "natural" barriers to converting knowledge value to capacity value.  The first barrier to entry is the well known "economies of scale".  Starting with the Industrial Revolution of the late 1700s and early 1800s, and continuing with "Mass Production" until the maturing of computers and networks in the late 1970s to 2000, economies of scale ruled and were the highest and widest barrier to competition that converts knowledge value into capacity value.  Prior to the industrial revolution, nearly all tools were hand tools that a person could make with materials at hand or that cost a modest amount.  As companies adopted assembly line processes based on Adam Smith's division of labor, and adopted and adapted new technologies of the time, the cost of tooling (equipment) when up, while the price per unit of product dropped dramatically.  This cost of tooling turned into a natural economic barrier to entry because someone wanting to go into competition needed the funds to by the tooling to compete.

A second natural barrier to entry is size.  During the industrial revolution, organizations realized that size matters; especially for capacity value-based products.  The this happens is as much do to physics and technology as any other reason.  Suppose a plant that stamps out parts has one stamping press of a certain size.  The press can only make a certain maximum number of parts in a given duration--e.g., if it takes a minute to stamp out a part then the maximum is 60 per hour.  If the plant has a customer that demands 60 parts per hour, then the tool is operating at its maximum cost efficiency.  However, if the customer increases the demand 70 parts per hour, the plant with the press has three choices; loose the customer, buy another stamping machine of the same size or replace the current machine with a new higher production capability machine.  I suspect the first choice would not be the choice of most managers, unless there were extenuating circumstances.  If there is an opportunity to sell a good deal more of the stampings to other customers, then the second choice, increasing the company's production capability through a second tool, would have a lower risk and potentially higher reward (it presents the greatest VOI and potentially ROI).  However, if there is little opportunity to sell more product, then the third choice may be best, that is, replace the existing stamping tool with one that produces more per period.  There are synergies in this last choice.  Two machines normally requires twice the labor.  For example, in today's regulator environment that may make the cost for stamping the parts higher than with the single machine; or the waste from the new tool may be much less, and so on.  [Sidebar: Of course, there is a fourth choice of sub-contracting out for the additional stampings, which has it own risks and rewards; but it can be done when the organization is producing capacity value where there is competition, but natural economic barriers to entry.]  With either the second or third choice alternative, there may be additional cost efficiency benefits.  For example, they may be able to ship a complete container, box car or truck load of components, rather than just a partial, which reduces "handling costs".  Or they may be able to order a supply of metal the same way, with a cost reduction. Walmart has made a core competence of this type of supply chain management.

A third, and perhaps the most natural barrier is the location and quantity of raw materials.  Minerals and elements concentrations are unevenly dispersed throughout the world.  When a particular mineral is in high concentration, it becomes much more cost efficient to mine. This was a key reason for European Colonialism, together with cultural arrogance.  However, this too is based on knowledge; that is the Europeans had the knowledge of what and how to mine the materials, how to use them, and how to use technology developed from the knowledge to impose their will. 

Knowledge Value and Money
Knowledge, not money, plays the key role.  Until the late 1800s, crude oil and gas were treated as noxious poisons.  The fungus (or blue mould) that creates penicillin was considered simply that a fungus until enough knowledge was created to show how it works as an antibacterial agent.  Using that knowledge, kick started the antibiotic industry of today.  The knowledge created the value.  As the knowledge became widespread, it was converted into capacity value that is, there are no branded drugs for penicillin today, they are all generic.  Still, no one wants to do without the knowledge and capacity value of antibiotics.  

1 comment:

  1. Good stuff. Thank you so so much for sharing your knowledge with world through the Internet. Wonderful blog and post you got here