For most goods – like cars or shoes or groceries – the market does a good job of determining how much producers should supply and at what price to sell it. It does this by matching the quantity that consumers are willing to buy at a given price to the quantity that suppliers are willing to sell at that price. The market – through the interaction of supply and demand – then arrives at a price at which the quantities consumers are willing to buy is equal to the quantity suppliers are willing to provide. The figure below illustrates this. In this example, producers will supply 45 units and consumers are willing to buy 45 units at a price of $45. At a higher price, say $50, producers would supply 50 units, but consumers would only be willing to buy 40. At a lower price, say $30, consumers would be willing to buy 60 units, but producers would only 30 units.
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But the market may not do such a great job at determining optimal prices and quantities for pharmaceuticals. There are at least two reasons for this: the effect of insurance and prescribers’ awareness of drug prices.
The insurance effect
Insurance impairs the ability of the market to match the quantity that producers will supply at a given price to the quantity that consumers would buy at that price. This occurs because insurance pays part of the price. As a result, the price the consumer actually pays, and the price on which she makes her decision, is less than the price the supplier receives (the insurer makes up the difference). The figure below illustrates this. The solid line is a demand curve. It shows the quantity that consumers would be willing to purchase across a range of prices. Let’s say a drug is priced at $74. The demand curve indicates that consumers would be willing to buy 38 units of the drug at this price. Let’s also assume that consumers have insurance for prescription drugs and that their copay for this drug is $25. At the price consumers have to pay – $25 – they would be willing to buy 82 units of the drug. This is far more than they would purchase if they had to pay full price.
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The physician effect
In most markets, the consumer has the primary, if not the sole, role in deciding whether she will buy a product. This is not true in the pharma market. Here, consumers, insurers, and prescribers share this role. Insurers decide whether or not they will pay for a particular product and how much they will require the patient to pay. Prescribers decide whether a product will be prescribed and which particular product is prescribed. Only after the prescriber has decided to prescribe a product and the insurer has decided to pay for it does the consumer’s choice matter. (This assumes consumers will not purchase drugs the insurer will not pay for.) Without a prescription, a consumer cannot get a prescription drug. Unfortunately, prescribers do not know much about drug prices. A review of the subject indicates “Doctors consistently overestimated the cost of inexpensive products and underestimated the cost of expensive ones.” Price is a lot less effective in determining the optimal quantity of drugs sold when the primary decision makers don’t know what the prices are.
So should government set prices?
In the pharmaceutical market, insurance and prescribers’ lack of awareness of drug prices distorts the normal relationship between price and quantity. A reasonable conclusion might be that because the market does not do a particularly good job at setting prices and levels of use (quantities consumed), it might make sense for the government to regulate or negotiate prices. This is what actually occurs in many countries.
However, there are a couple of additional factors to consider. First, prices set the quantities consumed and produced based on what consumers are willing to pay. These are not necessarily the quantities that are best for their health. Consumers are not always willing to pay for things that are good for them. Consumers never considered seat belts to be important enough to pay for even though they were proven to save lives. And consumers are willing to pay for things that aren’t good for them – like cigarettes and lottery tickets. So the fact that insurance results in consumers using more prescription medicines than they would be willing to pay for is probably healthy.
Second, there is the price elasticity of demand. This is a measure of how sensitive consumers are to the price of a product. If consumers are very sensitive to prices then changes in price will lead to proportionately larger changes in the quantities consumers buy. Price elasticity is higher for products that are luxuries (rather than necessities), for products that have many good substitutes, and when consumers’ incomes decrease. Price elasticity is lower for products that are necessities, those that have few or no good substitutes, and when incomes increase. Prescription drugs fall into the latter category. Research estimates that a 10% increase in the price of prescription drugs will result in a decrease in use of between 0.2 and 5.6%. This suggests that the extent to which insurance increases drug use is small.
Effects differ across pharma markets
The effects of insurance and physician unawareness of drug prices vary by prescription market. In the last blog, I suggested that there were three pharmaceutical markets: one for generics, one for brand-name drugs with therapeutic substitutes, and one for brand-name drugs with no substitutes.
Insurance probably has little effect on the quantity of generic drugs consumers use. These drugs are, for the most part, inexpensive. Quintiles IMS reports that the prices of 29% of generic prescriptions are less than the consumer’s copay and the prices for another 70% are less than $50.
Insurance probably has a stronger effect in the market for brand-name drugs with therapeutic substitutes. However, even this effect is blunted by PBMs’ use of formularies to switch consumers to therapeutic substitutes on which they receive large rebates. I would expect the largest insurance effect in the market for brand-name drugs without substitutes. Here the insurance effect is large because insurance brings down the cost of drugs to consumers from astronomical levels (e.g., $750,000 per year for the new therapy for Spinraza) to levels that are much more affordable. The problem here is that insurance also allows pharma to charge prices that consumers could otherwise not afford.
This analysis suggests that there’s little need for government regulation or negotiation of prices for generics or brand-name drugs with therapeutic substitutes. The analysis also suggests that there might be a need for government regulation or negotiation for very expensive brand-name drugs with no substitutes. But there’s more to the story.