The ‘confusopoly' of pricing drugs

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 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.”

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