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January 2007

What everyone needs to know about drug marketing. Part 2: Prices

This is the second part of a 3 part article. The first part focused on pharmaceutical products. This part will be easier to understand if you have read the first part first. If you have any comments or suggestions for improvement please contact .(JavaScript must be enabled to view this email address)


Price and promotion
Drug promotion can persuade people to pay higher prices for drugs than they would otherwise by increasing the perceived benefit, ie the benefit that the buyer expects to get from the drug. [1]  Higher drug prices give drug companies an incentive to do more promotion because they will get more return on investment in promotion. Under conditions described below a high price can also increase the income that companies receive so that they have more money to invest in drug promotion. Consequently, understanding the basic economics of drug pricing is useful for understanding drug promotion and what can be done about it.

Price and quantity
The buyers of drugs range from individuals who buy small quantities to third party payers including insurance companies and government subsidy schemes that may cover the entire population and thus buy or subsidise very large quantities. The best outcome for buyers is to gain the best ratio of benefits (eg quality adjusted life years gained) to costs. Sometimes a drug that has a high price but provides great benefit but will be better value for money than a drug that costs a little less but provides much less benefit.

Buyers often have a limited budget and so cannot afford all of the drugs that they could benefit from. In that case, the best outcome for the buyer is to give priority to buying drugs that provide the most benefit per dollar until the budget limit is reached. Consequently, if drug prices are lowered then more will be bought. Any beneficial drug can be made better value for money by reducing the price.

Drug companies usually aim for a price that will maximise their income. Income equals sales turnover minus the cost of sales. (NB Drug companies may also derive income from activities other than drug sales but that is what we are focusing on here.) Turnover (known as revenue in the US) equals price multiplied by quantity sold. The cost of sales equals production and administration expenses and is discussed further below.

Market power

Sellers have more market power when there are more buyers than sellers so that there is less competition from other sellers. Market power enables sellers to set higher prices than they would otherwise because buyers have less places to go to get lower prices. In many developing countries, and some developed countries especially the USA, many individual consumers face alone the market power of companies that sometimes have near or full monopoly market power to demand higher prices. Drug companies gain market power from an anticompetitive government intervention in the market: patent monopoly protection.

Third party payers rarely have as much market power as large drug companies but they do have more market power than individuals. Third party payers have the potential to use their market power to negotiate lower prices for the benefit of consumers but many third party payers do not use their full potential.

Price elasticity of demand
In some situations small price decreases cause large increases in the quantity bought because the lower price makes the drug better value for money and affordable for a much larger number of people. Economists describe such situations as having a high price elasticity of demand. When the price elasticity of demand is very high, drug companies will get more income from low prices than high prices because the increase in quantity sold will more than compensate for the decrease in price. 

The opposite situation is low price elasticity of demand. In this situation large price increases cause only small decreases in the quantity bought. When the price elasticity of demand is low, drug companies will tend to get more income if they increase prices because the percentage decrease in quantity sold will be less than the percentage increase in price.

The market for most drugs should have high price elasticity of demand for the following reasons. As mentioned above in the product section, for most drugs there is a spectrum of benefit with some people gaining major net benefit and larger numbers of people gaining less benefit. If a drug is only available at a high price then it is only worth the price for the small group who get major benefit. If the price is lowered then the drug becomes worth the price for a larger number of people. Regrettably, income inequality is an overlapping second factor. At high prices only the wealthy can afford the drug. As the price is lowered more people can afford it.

To the extent that promotion provides information, it can increase price elasticity of demand by providing information about availability, price and net benefits that buyers need to decide whether the drug is the best buy for them or not. To the extent that promotion is persuasion, it can decrease price elasticity by persuading people to buy more expensive products that are not such good value for money.

Perfect competitive markets
Markets are never prefect but it is useful to use the theoretical concept of a perfect competitive market [2] as a comparison point to help understand the consequences of distortions away from that ideal. In this report the term “high price” refers to prices that are high compared to the price that would occur in a perfect competitive market.

A perfect competitive market has the following features:

Atomicity: There are a large number of small buyers and sellers. There are no big buyers or sellers. Consequently no buyer or seller has market power.
Homogeneity: There are competing products that are perfect substitutes for each other.
Perfect and complete information: All buyers and sellers have full access to accurate information about all the products and prices.
Equal access: All sellers have access to production technologies, and resources (including information) and are perfectly mobile.
Free entry: There are no barriers against new sellers entering the market. 

Perfect competitive markets have high price elasticity of demand. The opposite of a perfect competitive market is a monopoly where there is no other product that is an acceptable substitute. 

Price concepts
There are 5 price concepts that are useful for understanding price negotiations:

the offer price
the real ceiling price
the perceived ceiling price
the floor price
the final price
The offer price
The offer price is the price that the seller asks for. In situations where sellers benefit from higher prices it is common for them to commence negotiations by asking for a higher price than they expect the buyer to be willing to pay. This is a negotiating tactic known as an ambit claim: an extravagant initial demand made in expectation of a counter-offer and then a compromise. This tactic takes advantage of the fact that in situations where people have difficulty estimating the value of a product it is common for them to use the price as a clue indicating the value. [3] The ambit price claim tactic also takes advantage of anchoring and adjustment bias. This is the normal tendency for people to not be able to adjust as much as is justified once they have been anchored by being told an extreme number. [4]

The real ceiling price
The ceiling price is the threshold at which the product provides no more benefit for the buyer than the benefit that would be gained from spending the money on the best alternative ie the opportunity cost for the buyer. (The opportunity cost is the benefit forgone that could have been gained by choosing the best alternative option.) Consequently paying more than the ceiling price does the buyer more harm than good by wasting money that would have provided a greater benefit for the buyer if they had spent it on a better alternative. The real ceiling price for an individual or group depends on how much benefit they are likely to get from the drug. As explained above in the first part of this article, the benefit gained from a drug is difficult to predict and varies depending on many factors including disease severity. Consequently it is difficult for buyers to calculate their real ceiling price. Currently drug companies control most of the research on their products and may not disclose all of the findings so buyers may not have all the information they need for estimating real ceiling prices reliably.

The perceived ceiling price
The perceived ceiling price is the highest price that the buyer is willing to pay based on the buyer’s estimate of the benefit to be expected from the product. Because it is difficult to calculate the real ceiling price, the perceived ceiling price may be higher or lower. Drug promotion increases the perceived benefit of drugs and thus increases the perceived ceiling price. Drug promotion can increase the perceived ceiling price above the real ceiling price. A high offer price can contribute to increasing the perceived ceiling price. When vulnerability to promotional techniques leads buyers to pay more than the ceiling price, they suffer more harm from the waste of money than good from the product.

The floor price
The floor price is the threshold below which it is not worthwhile for sellers to produce and sell products. The floor price depends on the following two costs:

The marginal cost of sales which is the cost of producing one extra unit. This includes manufacturing and administration costs. Because a pharmaceutical is a drug plus information this includes the cost of providing information about the drug. It also includes the cost of informing potential buyers that the product is available for sale without the additional costs of persuasive promotion. Once a company has developed the capacity to produce a pharmaceutical the marginal costs are low compared to the setup costs. Consequently as the quantity sold increases the cost of sales per unit falls.
A normal level of profit. This is equal to the rate of return that the company’s shareholders would have received on average if they had invested anywhere else that had a similar level of risk.

If prices are below the floor price then sellers would be better off to invest elsewhere. In a perfect competitive market the final price is the floor price so there is no extra profit above the normal level of profit. When there is price competition between sellers as sometimes occurs for generic drugs then final prices approximate the floor price.

Perfect markets achieve perfect allocative efficiency which occurs when prices drop to the floor price and the drug is sold to everyone for whom it is worthwhile at that price.

Sellers have access to all the information they need to calculate the floor prices for their products. To my knowledge no commercial drug company has ever disclosed to any buyer the information required to enable the buyer to know the company’s floor price. However floor prices can be estimated for generic drugs by observing prices in relatively competitive markets. Information for estimating floor prices is also sometimes available from government owned factories.

The final price
The final price is the price that the buyer pays the seller after negotiation. This price will be higher if the seller has more market power and lower otherwise. Final prices below the floor price are not sustainable. Buyers will not buy above the perceived ceiling price. Clearly, the scope for negotiation ranges from the floor price to the perceived ceiling price.

Higher final prices increase opportunity costs for buyers. Because it is difficult to calculate the real ceiling price it is possible for drug companies using promotion and market power to achieve prices that are above the real ceiling price.

Lower final prices have two types of benefits for consumers:
1. The drug becomes affordable and worth the price for more consumers so many who would not have bought the drug at a higher price can now buy and benefit from it.
2. Consumers who would have bought the drug at a higher price now have more money to spend on other things.

Many economists believe that all final prices should be equal to the floor price. They call this marginal cost pricing.

Consumer surplus and Producer surplus.
The consumer surplus is the difference between the ceiling price and the final price. The larger that gap the greater the benefit for consumers who are predominantly the sicker and poorer members of society. The producer surplus is the difference between the floor price and the final price. Larger producer surpluses provide greater benefits for shareholders and staff of drug companies via dividends, higher wages and bonuses. These people tend to be wealthier members of society. Consequently negotiations over drug prices are really negotiations about who gets most of the benefit from drugs. When the seller is based in a developed country and the buyer is in a developing country consumer surpluses can contribute to reducing inequality between countries.

Deadweight losses
If the price of a drug is higher than the floor price then it is unaffordable, or not worth the money, for some people for whom it would have been affordable and worthwhile at the floor price. This loss of benefit because a lower quantity is produced and sold is called a deadweight loss. Economist Dean Baker of the points out that:

“Economists typically place an enormous value on promoting marginal cost pricing. This is a basic condition of economic efficiency. When prices exceed marginal cost, for example due to trade barriers or government regulations, it imposes a deadweight loss on the economy. Consumers are willing to buy goods or services at a price that is more than the cost of production, but are denied the opportunity. In such situations, it is easy to show how all parties can gain (in principle) by reducing the price to the marginal cost and redistributing some of the resulting gains from consumers to producers.

This is exactly the argument that has motivated the quest to reduce trade barriers and government regulation over the last quarter century. Of course the gaps between price and marginal cost that result from most trade barriers or regulations are trivial compared to the gaps that are created by patent protection in the pharmaceutical industry. For example, the steel tariffs that President Bush imposed in 2002 hit their peak at 30 percent for a narrow category of steel products. By contrast, the average increase in price for pharmaceuticals due to patent protection is probably close to 400 percent, with the gap in many cases exceeding 1000 percent of the marginal cost.” [5]

Interim conclusions

When the seller uses market power to achieve higher prices than would occur in a perfect competitive market the consequences include lower or negative consumer surpluses and deadweight losses. When third party payers use their market power to reduce prices they reduce all those adverse consequences but they don’t treat the cause of the adverse effects which is patent monopoly protection.

Pricing strategies
Drug companies can choose from anywhere between two extreme pricing strategies:

Lowest possible price
Highest possible price  

Because people want drugs to be value for money and all drugs are better value for money if the price is lower, the lowest possible price strategy is consistent with Kotler and Armstrong’s “marketing concept” discussed above whereas the highest possible price strategy requires the “selling concept”.

Lowest possible price strategy
The lowest possible price strategy is to sell the product at the floor price. This involves the seller accepting only normal profits per unit sold but can produce higher absolute profits if the market rewards low prices with high sales volumes. This is sometimes called market penetration pricing. It is the most profitable strategy if the market approximates a perfect competitive market with high price elasticity of demand. These ideals are approximated in some countries for some generic drugs. 

In an ideal market, competition forces prices down towards the floor price. If consumers make perfect purchasing decisions influenced only and appropriately by price and accurate calculations of product quality and net benefits, then the company will do better by spending only enough on promotion to inform customers of the existence, specifications and price of their product. Spending extra money on persuasion would be counterproductive. More customers would be lost because of the price increase required to pay for the persuasion than gained via persuasion. Under these ideal conditions the only way for sellers to get more than an average return on investment will be by becoming more efficient at production, administration and information provision before competitors catch up. If all players in the market are trustworthy, well informed and equally wealthy then this ideal market is hard to beat for delivering maximum social benefit. However real markets are often very far from the ideal market conditions described in this paragraph, especially in developing countries. Consequently, social welfare can be increased by developing interventions (including government and non-government interventions) that improve trustworthiness, access to information and equality. [6]

The highest possible price strategy
The highest possible price strategy is to aim to sell the product at the perceived ceiling price and to use promotion to make the perceived ceiling price as high as possible. The high price strategy involves the seller accepting lower sales as a trade off for higher profits per unit sold. This strategy is called: “skimming the market”. It is more profitable than a low price strategy only when there is little competition and there is low price elasticity of demand.

Patent monopoly protection
High price strategies are made profitable for drug companies selling original drugs by a government intervention in the market: patent monopoly protection. Patents reduce competition by making it illegal for other companies to sell the same drug for many years. Patent monopoly protection breaks all of the five requirements for a perfect competitive market:

Atomicity: Under patent monopoly protection there is only one seller allowed.
Homogeneity: Under patent monopoly protection no competing products are allowed.
Perfect and complete information: Under patent monopoly protection companies are allowed to keep information secret from potential competitors.
Equal access: Under patent monopoly protection potential competitors have no access.
Free entry: Under patent monopoly protection competition is forbidden from entering the market. 

The reduction in competition caused by patents makes persuasive promotion more profitable. In competitive markets promotion may increase use of all similar drugs with the company who paid for the promotion only getting a small share of the increased sales. Without competition the company promoting a drug gets all the sales increase that results from persuasive promotion.

The high price strategy aims to maximise economic rent for the seller. The higher the price, the lower the social surplus. For many people the difference between high and low prices can be the difference between a happy and productive life versus a painful short life.

High R&D spending is a consequence rather than a cause of high prices
It is often claimed that drug companies selling new drugs must charge high prices to recoup their research and development (R&D) expenses. If that was the only cause of high prices then companies would lower the price for every drug as soon as their income from that drug was enough to cover the R&D costs for that drug. However, to our knowledge, no drug company has ever lowered its price for that reason. On the contrary it is common for drug companies to increase prices after they have many people taking the drug regularly despite the fact that economies of scale will have reduced the cost of production per unit. Some drugs cover their R&D costs within a few months after launch onto the market. Lipitor is the current top selling drug in the world and is an extreme example to make the point. Pfizer may have spent around US$ 500 million to develop the “me too” drug Lipitor [7] but sales in 2004 alone were over US$ 10.86 billion. [8] Many other drugs bring in more than US $ 1 billion per year. However it is also true that many drugs are less commercially successful including many that cost millions of dollars for research but never make it to the market.

Rather than saying that large R&D expenditures causes high prices it is more correct to say that high prices causes large R&D expenditures. Drug companies really charge high prices for new drugs because they are more profitable than low prices. They are willing to invest more money in R&D because they get high prices. Higher prices also reward and provide the funding for more spending on promotion which in turn can persuade people to accept even higher prices. Drug companies usually spend more on promotion than they do on R&D because promotion provides higher return on investment. 

Patents are a governmental intervention in the market with adverse effects that arise from distorting the market away from perfect competition. The justification for patents is to accelerate the development of better treatments by encouraging companies to invest more on R&D than they would otherwise. Patents give companies a period of monopoly protection from competition so they can profit from a high price strategy. This enables companies to take economic rents that it is hoped they will invest in R&D. In fact, companies invest only a small part of these economic rents in R&D. Compared to most other industries research based drug companies spend more on promotion, on staff and on returns for shareholders. Furthermore, much of the companies’ R&D investment is on “me too” drugs which have little or no advantage over other drugs already on the market. In countries where governments are third party payers they could achieve more R&D and greater social benefit by paying lower drug prices and investing some of the savings into R&D directly via competitive tender. [9]

Third party payers
Many third party payers are now using economic evaluations to estimate ceiling prices so as to avoid the error of paying above the ceiling price. Many of them then pay the estimated ceiling price. Even when the drug is as good as estimated there is no consumer surplus because the benefit is cancelled out by the cost of the drug. If the drug is not as beneficial as expected then there will be a consumer deficit - the benefit from the drug will be less than the opportunity cost so purchasing the drug will do more harm than good. Third party payers could achieve more consumer surplus, and funds available for other more cost effective forms of health care, by using their market power to negotiate lower prices to as close to the floor price as possible.

Treat the cause: Abolish patent monopoly protection: What is the best replacement?
Patent monopoly protection should be abolished because it is the root cause of the problems discussed above. [10, 11]

What needs to be debated is what system(s) should be used to replace patents by providing incentives for research. This is discussed elsewhere. [12]


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