The confusopoly' of pricing drugs

THOMAS K.THOMAS
The pricing of medical products can be extremely complex and confusing because there the rules of economics stop
working.
For several years after Viagra was introduced in the US market in 1997, there was no other drug approved for
treatment of erectile dysfunction. But even though the drug was a unique product, its demand curve sloped
downwards in the normal way where quantity demanded increases with reductions in price. Even a monopolist
there had good reason to lower the price.
On the other hand, the decline in price of biosimilar drugs generic versions of medicines derived from living
organisms is less rapid despite there being perfect competition with many manufacturers. That's because unlike
chemically synthesised molecules, protein-based biologics are complex with greater manufacturing cost.
The above two examples show that pricing of medical products can be extremely complex and confusing.
There are many factors that affect drug pricing, including upfront cost for research and regulatory approval to
market the drug, manufacturing cost, branding cost and uniqueness of the product. (The Health Ministry has
appointed a high-powered committee to understand drug pricing in the country, which will lead to a policy decision
on whether or not to increase control over drug prices through regulations).
An NBER paper by Ernst R Brendt, Thomas G. McGuire and Joseph P Newhouse unravels the economics of
prescription pharmaceutical pricing in health insurance markets. (NBER Working paper16879
www.nber.org/papers/w16879.pdf)
Insurance impact
To begin with, they confirm that some aspects of demand-side pricing for prescription drugs are difficult to
understand.
One root cause of the complexity in the US is the intermediation of insurance and other third party payers. Supply
prices those paid to manufacturers are set in market or by negotiation.
Demand prices those paid by patients at the time they buy medical devices are specified as part of the insurance
contract for a great majority of the American population.
They show how the market structure on the supply side, characterised alternatively by monopoly (unique brands),
differentiated product market and competition (generics), influences the insurer's choices about demand prices in
countries such as the US where 79 per cent of spending on prescription drugs was made by patients with health
insurance in 2009.
For example, in a monopolistic situation suppose the insurer declared that it would cover only $x for each
prescription purchased by the consumer.
No matter the price the seller set, the consumer would need to pay the balance when purchasing the drug.
As long as the insurer's payment is fixed at some amount, the monopolist will recognise that supply prices above
that amount will simply move consumers along their demand curves, thereby reducing the quantity demanded, says
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Policy-makers could look at ways to expand health insurance coverage as a means to check
drug pricing.
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the NBER paper.
Differentiated market
A different and prevalent insurance contract arises when several drugs that are partial but not perfect substitutes
compete with one another within a therapeutic class. An example of such competition would be statin (cholesterol-
lowering) drugs.
The paper casts this situation as a Bertrand model of differentiated products. Suppose that firm 1 manufactures
drug 1 and firm 2 manufactures drug 2. The Bertrand model explains why an insurer may not offer both products,
even though by excluding a product, some consumers will not get their best match in terms of therapeutic option
or, more precisely, will have to pay the full market price to obtain it.
Manufacturers offering maximum discounts would be picked by the insurer. In a number of countries, when there
are several competing differentiated drugs within the same therapeutic class, the insurer will designate one
particular drug as the reference drug, and will offer to pay no more than the supply price of that drug, regardless of
which drug in that class is prescribed.
The NBER paper says that with the consumer being responsible for the entire gap between the supply price and the
insurer's fixed amount, reference pricing can become a powerful tool, reducing manufacturers' market power in
differentiated product markets.
These models may not yet be relevant for most in India because nearly 75 per cent of the expense on healthcare is
from one's pocket. But maybe it is time policy-makers looked at ways to bring more people into the health insurance
ambit as a means to check drug pricing.
Scott Adams, the caricaturist of the comic strip Dilbert's, coined the word confusopoly' a situation in which
companies make the pricing mechanism so confusing that no one can do comparison with rival products. Telecom
companies are best examples of this, but the NBER paper suggests that pharmaceuticals are not far away.
But as Brendt, McGuire and Newhouse write While our inability to rely on conventional consumer demand theory
limits our ability to make unambiguous welfare statements about how well health care markets are working, we do
know that market demand functions exist, whatever their sources.
Using those functions along with the familiar frameworks of competition, monopoly and Bertrand differentiated
product price competition, we can still productively employ microeconomic tools, as well as theories of firms and
markets, to help us better understand the confusopoly of pricing in biopharmaceutical markets.
(This article was published on March 28, 2011)
Keywords: pricing of medical products, drug pricing, confusopoly, rendt, McGuire and Newhouse, Scott
Adams, prescription drugs
Printable version | Aug 24, 2012 1:43:30 PM | http://www.thehindubusinessline.com/opinion/article1576592.ece The Hindu Business Line
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