Free Markets Mean Zero Economic Profit – or a 99% Profit Markup

By William K. Black
May 3, 2016     Bloomington, MN

Open up a conventional economics text and you will be taught that high among the glories of “free markets” is the “fact” that they lead to firms earning “zero economic profits.”  Economic profits are not the same as accounting profits.  An economic profit occurs when a firm receives greater profits than the minimum required to be able to raise capital in their industry.  A firm that receives a profit greater than that minimum requirement is receiving monopoly “rents” due to its market power.  Conventional economists used to believe that was a bad thing, but many conventional economists from the right are now openly hostile to antitrust concerns.

One of the paradoxical arguments of conventional economists is that the “free markets” are so effective and speedy in eliminating economic profits that they create powerful incentives not to engage in expensive research and development (R&D), particularly where the success of the project is highly uncertain.  The patent laws, therefore, grant a government-awarded monopoly to inventers.  That patent is limited in duration, but it has no restrictions on pricing.

The development of new “ethical” drugs, particularly novel ones, is often cited as a prime example of the benefits of the patent system.  What Wall Street has realized in recent years is that the patent-holders that develop these drugs present unique profit opportunities for those with a Wall Street mentality.  It turns out that those who develop ethical drugs commonly act less than perfectly rapaciously.  The pharmacy industry is not composed of saints, but it is composed largely of scientists and doctors who often care about the patient.  This allows Wall Street types, who often define the concept “perfectly rapacious,” and a lack of empathy for the suffering of other people the best of all worlds.

  1. They can buy the patent rights at prices that are dirt cheap (from their perspective)
  2. They face zero risks that the R&D project will fail, because it has already succeeded
  3. They face greatly reduced marketing risks because the drug is already being successfully sold and is typically authorized for reimbursement by public and private health insurance
  4. The risk of undiscovered adverse side effects is greatly reduced because they wait to buy the patent rights until after the drug has been sold for several years
  5. They can – immediately and dramatically – increase the price of the drug

This five-point strategy would seem, from a Wall Streeters’ perspective, to present the perfect opportunity for Wall Streeters to get even richer even quicker through a “sure thing.”  The paradox is that it is precisely Wall Streeters’ lack of empathy – their inability to understand how the public would respond to such a “sewer” strategy and their tone deafness in responding to the public outrage that their strategy was sure to provoke – that has been their undoing.

The thing about being a founder/CEO is that you can be a world-class asshole.  On Main Street, you would at least have to pretend to be human in interactions with the public, but Michael Lewis has made his career on the basis of the fact that on Wall Street being a world-class asshole is often viewed as an asset.  Two firms, both creatures of Wall Street, have followed the five-part strategy I described with the same results.

Martin Shkreli

The title of the New York Times’ article on Shkreli captures the point.  “Martin Shkreli All but Gloated Over Huge Drug Price Increases, Memos Show.”

Martin Shkreli, former chief of Turing Pharmaceuticals, said in an email released by a House panel that raising a pill’s price 5,000 percent would produce “a very handsome investment.”


Mr. Shkreli practically gloated about the potential profits in an email he sent last August, just after his company, Turing Pharmaceuticals, had paid $55 million to acquire the drug Daraprim, and had raised its price more than fiftyfold to $750 a pill, or $75,000 for a bottle of 100.

“So 5,000 paying bottles at the new price is $375,000,000 — almost all of it is profit and I think we will get three years of that or more,” Mr. Shkreli wrote in the email….

Shkreli had started, and has been indicted for allegedly looting, a hedge fund.  In his appearance before Congress he behaved in a manner that emphasized that his extraordinary arrogance had displaced any empathy for the patients.  In an odd way, he showed how much of what happens in economic life is due to social and ethical restraints on the part of CEOs and the public rather than “profit maximization.”  It is only when we see the behavior of someone who lacks humanity that we can see how important those normal restraints are to civilization.

Valeant’s Leadership

The same NYT column showed that Valeant followed Shkreli’s strategy.

Regarding Valeant, the Democratic staff memo says the company identified the revenue goals for Isuprel and Nitropress and raised the prices to reach those goals.

Before buying the two drugs in February 2015, the company hired a pricing consultant who concluded that there was ample room to raise the price because previous big price increases had not dampened use.

One internal presentation showed that Isuprel and Nitropress had combined “2015 plan revenue” of about $525 million, up from $153 million in 2014 under the previous owner. The explanation for the big increase was “aggressive pricing through consultant recommendation.”

One email that got attention on Wall Street was sent May 21, 2015, from Mr. Schiller, who was then the chief financial officer, to J. Michael Pearson, Valeant’s chief executive. Mr. Schiller said that price hikes accounted for 60 percent of Valeant’s growth in the first quarter of 2015, or 80 percent if the company counted the contribution from the two heart drugs it had just acquired.

The Wall Street Journal has written a similar column about Valeant’s leadership entitled “Valeant’s CEO Was Key Force on Pricing.”

In early 2015, when Valeant Pharmaceuticals International Inc.’s top brass met to set prices on a soon-to-be-acquired cardiac drug, some executives suggested slow, staggered price increases. Chief Executive Michael Pearson disagreed.

To reach Valeant’s internal profit targets, Mr. Pearson lobbied for a single, sharp increase. Hospitals could still make a profit at the higher price, he argued, which meant patients would still have access to the drug. The team deferred. The day it completed its February 2015 purchase of the drug, called Nitropress, Valeant tripled the cost.

Bet on [“sewer”] management, not on science.”

Valeant is a creature of Wall Street with its strategy championed by William Ackman and his hedge fund and other Wall Street funds.

Under Mr. Pearson, a former McKinsey & Co. consultant, Valeant earned a loyal following on Wall Street for its profitable strategy of buying existing drugs with price-increase potential rather than developing them in-house. “Bet on management, not on science,” he often said. While Valeant did have a research program, Mr. Pearson said that most of Valeant’s R&D products are reformulations of existing drugs, such as a new delivery method for a glaucoma medicine, according to the Senate documents.


Cuprimine and Syprine, are used to treat Wilson’s disease, a rare ailment involving a buildup of copper in the body, and were acquired by Valeant in 2013. Months after it raised the price of the cardiac-care drugs in 2015, Valeant sharply raised its price tags on Cuprimine and Syprine.

The price of Cuprimine has risen 5,787% to $26,189 since 2013, with most of the increase occurring in the summer of 2015, according to an analysis prepared by Senate committee staff for the hearing. The cost of Syprine jumped 2,934% to $19,783 during the same period. A doctor testified at last week’s Senate hearing that a liver transplant, an alternative treatment for Wilson’s disease, is now cheaper than a lifetime of Valeant drugs.


Upon completing its purchase of the two drugs in February, Valeant sharply raised the price of both Isuprel and Nitropress.

A month later, when a Deloitte consultant studied further price-tag spikes on the two drugs, the consultant asked a senior Valeant executive in an email: “Are you ok with the above assumptions? They are leading to high gross margins (more than 99%).”

Senior officers whose entire strategy is massive price increases, of course, thought that 99% profit margins were fabulous.

Wall Street Turns von Hayek’s “Spontaneous Order” into the Orchestrated “Sewer”

Warren Buffett and Charlie Munger excoriated the business strategy that Wall Street brought to pharmacology.  Munger said it had helped turn Valeant into a “sewer.”  Then Munger decided his description was too weak to describe Valeant’s corrupt culture.

Munger then took it a step further saying he believes “sewer” is too weak a description of Valeant’s corrupt culture.

“The main thing that Valeant did that was unbelievably clever was to pay the consumer’s part of the deductible for the drugs they were selling,” he said. “That is totally illegal—criminal under the Medicare laws. But, that doesn’t apply under the state laws. And they saw that loophole and so they did it with all the drugs that weren’t covered by Medicare… they paid the consumer share of the deductible and they tried to pretend that it was a charitable contribution, when really it was the functional equivalent of bribing the other fellow’s purchasing agent.”

Whenever Wall Street culture becomes dominant in a new field it is certain that the new field will be rigged.  Wall Street pretends to love the film Moneyball about bringing science to baseball.  Wall Street pretends that like baseball stars they are paid huge sums because their world is a “hyper-meritocracy.”  They pretend that their expertise, as with the film, is their use of statistics to identify hidden gems.  Wall Street actually runs on the opposite strategy of rigging the system to produce a “sure thing” for them at the expense of investors and customers.  Warren Buffett’s famous bet, currently shows a “fund of hedge funds” producing one-third the return of simply buying an index fund.  One of the reasons the hedge funds’ returns are so inferior is that the hedge fund owners pay themselves massive compensation.  In Moneyball terms, the Major League batting average is around .250, so hedge funds bat the equivalent of around .083.  That will get you a ticket home on the bus even from a single “A” minor league team.  Batting successfully against a Major League pitcher is one of the hardest things in sports.  Beating an index fund should be vastly easier.

When CEOs whose firms are supposed to excel in science cause Wall Street to salivate by telling them to ignore science and “bet on management” they know that they are speaking in code and signaling that they are unethical managers who will run a business like a “sewer.”  Wall Street knows that the word “bet” is a deliberate misnomer – it means to bet on CEOs who rig the system and produce a “sure thing” – not to gamble.  The only gamble Wall Street takes is whether the CEOs will be such open assholes that they will enrage the public.

Conventional economists ignore all this.  They spread propaganda about “zero economic profits” and ignore reality.  Economists, statistically, score lower in empathy than the public, which makes serving as an industry apologist not only career and wealth enhancing, but also no sweat.

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