August 24, 2010

The Upside of the Sliding Scale

Rich and poor alike — even those who pay the highest prices — can be better off when pharmaceutical firms serve different markets at different rates.

Topics: Healthcare

About a decade ago, Brian Schweitzer, then a candidate for one of Montana’s congressional senate seats, chartered several buses to transport would-be constituents across the US-Canadian border to embark on a bargain-basement prescription-drug shopping spree. Images of Americans — mostly senior citizens — boarding buses for Canada were splashed across the headlines of newspapers and cable TV. Schweitzer’s campaign-stunt-cum-policy-critique brought attention to disparate drug-pricing policies, and consumer advocates and their allies questioned the fundamental fairness of the price differences, arguing that US consumers were subsidizing low drug prices in Canada and other countries.

One reason drug prices vary so widely from country to country is because pharmaceutical firms practice price discrimination, charging higher prices in some markets and lower prices in others. Price discrimination is the rule in most industries, rather than the exception: companies employ price discrimination because market-sensitive pricing is more profitable than uniform pricing.

Under uniform pricing, a drug might cost all consumers $100 per month. Under price discrimination, that same drug might sell for $25 in one market and $150 in another. Typically, the lower the income in a market, the lower the price of a drug; the higher the income, the higher the price. (Canada is hardly a poor country, but it does have a lower mean income than the United States, and its national healthcare system also figures in the relatively low price of drugs there.)

“To many people it seems fair that consumers in rich countries pay more because they have a higher ability to pay,” says Professor Frank Lichtenberg. He was interested in determining whether or not consumers throughout the world — in rich and poor countries alike — are better off when pharmaceutical firms employ price discrimination.

In the 1920s, some economists made the argument that price discrimination is always bad for consumers. But subsequent theorists showed that if firms produced larger quantities of products under price discrimination, consumers as a whole could be better off. “Clearly the people who pay less are better off, since otherwise they would pay a higher price or not have access to the drug at all,” Lichtenberg says. “But do the gains to those who pay lower prices under price discrimination outweigh the losses to those who pay higher prices?”

To answer this question, Lichtenberg compared price differentials for thousands of drugs and across 50 countries, measuring the average price of drugs in each. He found that, with a few exceptions, prices are indeed higher in richer countries — the United States pays the fifth highest drug prices among the countries he studied — and lower in poor countries.

Lichtenberg then looked at the rate of growth of production of a drug, and whether it was related to the growth in price dispersion, or the variation between prices in different countries. He found that the greater the increase in international price variation, the greater the increase in total consumption of the drug. “This is consistent with the view that greater price discrimination is associated with more consumption,” Lichtenberg says. “If firms are able to charge different prices in different markets, they will produce more of the drug.” The positive relationship between the total quantity of drugs produced and the degree of price discrimination means that price discrimination is likely to benefit society as a whole (including consumers in many countries).

Lichtenberg suggests that not only does price discrimination make greater quantities of drugs available, it may also improve overall social welfare by making newer, better drugs available. A new AIDS drug that must be sold at the same low price in the United States as it is in Malawi, where drug prices are quite low, is not going to look very profitable. The higher profitability conferred by price discrimination encourages firms to invest in more research and development for new drugs.

“I see good theoretical reason to believe that the ability to price discriminate does in fact increase the number of new drugs,” Lichtenberg says. “Love them or hate them, pharmaceutical firms are profit-seeking, and the probability that they will develop a new drug depends on that drug’s expected profitability.” While there are some exceptions, in general, new drugs are more effective than old drugs, or they treat previously untreatable conditions. So, in effect, when people in rich countries pay more for drugs, they support investment in the development of new, better drugs.

One potential impediment to price discrimination is the possibility that third-party arbitrageurs will scoop up drugs from low-priced markets and resell them in higher-priced (richer) markets. Too much of this parallel trade could prevent firms from engaging in price discrimination. Interfering with price discrimination, whether the interference comes via third parties or regulation, reduces the expected profitability of a drug and thereby reduces the willingness of firms to risk investing in research and development.

“In the short run, the United States and other rich countries might benefit from the ability to buy drugs more cheaply,” Lichtenberg says. “But in the long run, that would undermine incentives for the pharmaceutical industry. There is good evidence that the industry would respond by curtailing research and development. Ten or 20 years down the road, we would expect fewer drugs to be launched.”

Frank R. Lichtenberg is the Courtney C. Brown Professor of Business in the Finance and Economics Division and in the Healthcare Pharmaceutical Management Program at Columbia Business School.

Read the Research

Frank Lichtenberg

"Pharmaceutical Price Discrimination and Social Welfare"

View abstract/citation  Download PDF  

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