ECONOMIC SCENE

Examining Differences in Drug Prices

PRESCRIPTION drugs have become politicized. Al Gore recently criticized the
manufacturer of the arthritis drug Lodine for selling it for $108 a month
when prescribed for humans and $38 when prescribed for dogs.

It's not just the doggy divide that has politicians upset; international
price differences for drugs are another flash point.

The House and Senate recently approved a measure allowing pharmacists to
import prescription drugs from countries where they sell for substantially
less than in the United States.

Charging different prices for humans and animals, or different prices to
consumers in different countries, is what economists call "third-degree
price discrimination." It is a common practice for pharmaceutical companies.

A month's supply of the antidepressant Zoloft sells for $29.74 in Austria,
$32.91 in Luxembourg, $40.97 in Mexico and $64.67 in the United States.

This kind of differential pricing is motivated in part by drug companies'
cost structure and in part by differences in bargaining power.

It can cost millions of dollars to research, develop, test and market a new
drug. Once these fixed costs are incurred, however, actually producing the
drug may cost very little.

Since the market price is often far greater than the marginal cost of
production, there is always a temptation to cut prices to generate
incremental sales and profit.

The problem is that cutting prices across the board tends to reduce revenue.

The natural strategy is to selectively cut prices and set different prices
for different markets. Drugs sold for humans generally sell for more than
drugs sold for animals.

Drugs in rich countries tend to cost more than drugs in poor countries. A
daily dose of the AIDS drug PLC sells for $18 in the United States and $9
in Uganda, while a generic equivalent sells for $1.50 a day in Brazil.

Even at $9 a dose, the drug company makes a profit on incremental sales.
But if the drug were sold at $9 to everyone, profits would be substantially
lower than they would be under differential pricing.

The United States ends up paying more for drugs since it is much richer
than the rest of the world and tends to spend a large fraction of that
wealth on health care.

Furthermore, in most countries, a single governmental health care provider
bargains over drug prices. America's health care system is much more
fragmented, which tends to reduce the bargaining power of health care
providers in negotiating drug prices.

Price discrimination is not popular with consumers, especially those paying
the higher price.

What does economics say about whether this kind of differential pricing is
good or bad? To answer this question, we have to ask what price would
prevail if only one price could be charged.

Imagine that there are only two countries involved, the United States and
Uganda, and PLC sells for $18 here and $9 in Uganda. If the drug company
had to charge the same price in each country, what would it be?

In this case, it is likely that the price would be closer to $18 than to $9.

True, sales would drop significantly in Uganda, but that loss in revenue
would be very small compared with the revenue loss in the United States
from setting a price close to $9 because it is a significantly larger market.
In this case, mandating a fixed price makes the Ugandans a lot worse off
and does little for American consumers.

But it could work out differently. Imagine an antimalarial drug that lots
of people in Uganda might buy at $2 a dose and a few people in America
might buy at $10 a dose.

If the Ugandan market is more than five times the American market, the drug
company, if it could set only one price, would make more revenue by setting
that price at $2.

If the manufacturing cost of the drug is small enough, this would also be
the more profitable price.

The critical question, from the viewpoint of economics, is whether
differential pricing or a flat price leads to more people getting the drug.

In the case of the AIDS drug, differential pricing leads to more total
consumption; in the case of the antimalarial drug, it is the other way around.

When two different prices are charged, people paying the higher one are
convinced that if the company were forced to charge one price, it would be
the low one.

Alas, it's not always so. Sometimes forcing one price results in just
cutting off the small market, rather than lowering the price to the large
market.

In fact, public health advocates have argued for a long time that
pharmaceutical companies have little incentive to invest in developing
drugs for tropical diseases, since they tend to be a problem only in poor
countries, where people can't afford to pay for drugs anyway.

All the money is in the rich countries, and drug research focuses on health
problems of interest to those markets, like obesity, heart disease and
cancer, virtually ignoring diseases that strike the residents of poor
countries.

From the economic viewpoint, this behavior is entirely understandable: that
is the way the incentives are set up. If you want to change the drug
companies' behavior, you have to change their incentives.

The World Health Organization has advocated offering monetary prizes for
companies that develop effective drugs for tropical diseases, as long as
they subsequently sell the manufactured drug at marginal cost.

There is no easy answer as to whether price discrimination, in general, is
a good thing or a bad thing.

It tends to raise additional revenue that can be plowed back into research
and development, which creates better incentives to invest in drug
development.

When it allows markets to be served that would otherwise be ignored, price
discrimination will tend to be socially useful.

But if differential pricing is just an excuse to raise prices that would
otherwise be low, it doesn't have much to recommend it.


By HAL R. VARIAN
Copyright 2000 The New York Times Company
http://www.nytimes.com/2000/09/21/business/21SCEN.html

janet paterson
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