We’re told that Amazon has plans to move into the prescription drug market. We’re also told that this will be very difficult for the reasons that Warren Buffett gives about economic moats. The first claim may be true, and the second definitely is, but that’s not the end of the story. As with the higher the castle walls, the greater the treasure therein; so the wider and deeper the moat, the more profit to be made by conquering it.
Warren Buffett has, for many years, pointed out that he likes businesses that have an economic moat around them. The thought being that if there is something (a brand name, a monopoly of some sort) that makes it difficult for competitors to arise, then profits are going to be nice and safe and predictable. That moat could be something like the Coke or See’s Candy brands, or it could be the fact that we’re just not building railways any more with Burlington Northern.
There’s an interesting manner in which Buffett’s investing strategy is exactly the opposite of all that stuff we see in the textbooks about the joys of competition in free markets. Indeed, much of being in business itself is the consideration of how to beat those market strictures, how do we fend off all that potential competition? To a very large extent those guys getting the big bucks in the corner offices are getting them for trying to work that out.
Which brings us to Amazon and their potential move into the prescription drug market. It’s entirely true, as the CVS CEO Larry Merlo says, that the pharmacy business has “many barriers to entry.” It’s also true that it’s highly concentrated — the top three drug benefit managers have 70 percent of that market — along with thickets of laws, permissions, and licenses required to compete in it. That does indeed mean that some start-up out of left field is unlikely to upend the business structure, as many of those standalone Internet pharmacies found out when various people started to properly enforce the current laws.
However, note what also happens within such a moat. The economic profits being made by those inside it are rather juicy. No, don’t think just of the corporate profits, the employees inside such barriers get a share of the pie too. Sure, being a pharmacist is a skilled job requiring real qualifications, but the average salary is around $108,000 a year. An insurgent disruptor would be slicing away at those incomes as well as the profit margins. Perhaps not even by paying people less — in fact, they’re likely to pay individuals more, though by employing many fewer of them with an online model.
So, breaching that moat is going to be difficult. But does anyone really think that Amazon doesn’t have the resources to make the needed investment if they decide they want to?
They almost certainly would, which is why having an economic moat isn’t the unmitigated boon you might think it is. Sure, it’s just great as long as no one has the resources to overcome it. But when someone does you’ve just painted a large target on your back precisely because of the profits being made within those restrictions to market entry.
I’ve no idea personally whether Amazon is going to compete in this space. But it’s entirely obvious that they could if they wished to and that would make me very nervous indeed if I were one of the incumbents. Not because I don’t have an economic moat against disruptors, but because no defense is successful against overwhelming force, something we’d agree Amazon has if they do decide they want to go after some protected pool of profits in the retail economy.
We’d all like Amazon to go after it of course, for shaking out those protected profits is exactly why we like the free market system: it makes us consumers better off over time by killing off the producer surplus. That’s the very point economics textbooks make about the undesirability of regulations, which make it so difficult at times for competition to arise to conquer those economic moats.
Tim Worstall (@worstall) is a contributor to the Washington Examiner’s Beltway Confidential blog. He is a senior fellow at the Adam Smith Institute.
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