Pharmaceutical Companies Price Discriminate Too

Price discrimination is a very common type of pricing strategy engaged in by those businesses who have any control over their pricing, which includes most of them. "Price discrimination is a policy where a seller sets different incremental margings on various units of the same or similar prudcut. " (Managerial Economics, 3rd Edition, 2007. Png & Lehman. Pg 231.)

Pharmaceutical companies are no different in that the firm's profits are generally the main motivating factor behind pricing decisions. If pharmaceutical companies were not able to engage in price discrimination, who knows what potential life-saving medicines may never actually make it to market. Pharmaceutical companies, by the very nature of their business, have much higher R&D expenses, and as such, have price structures set well before a medicine makes its way to the pharmacy or store shelves.

The article, Pharmaceutical Price Discrimination and Social Welfare, http://www.bepress.com/cas/vol5/iss1/art2/, authored by Frank Lichtenberg, pointed out that people in the lowest income bracket pay 25% less than high income people. However, people in the middle income bracket pay 6% more than those same high income people. This should be an area of concern for regulators, or someone, in my opinion, as the middle income bracket appears to be bearing the higher burden. I will admit though, that I am very biased on this matter as I have a young daughter with major health issues. The most recent medicine the neurologist started her on comes with a jaw-dropping invoice each month. The pharmaceutical companies charge it because they can. Plain and simple. That does not make it right or fair, obviously, but how often in life is everything fair? I would pay whatever I was invoiced, as I have placed the opportunity costs of not having my daughter in my life as much, MUCH higher than the money that may or may not be residing in my pocket book.

The ability of these firms to price discriminate increases the chances that more medicines have a chance to make it to market, which will hopefully save or improve more lives, including my daughters. If these firms were regulated as to what "had" to be charged, the R&D process might be halted too soon for any benefit to ever be realized.


Kevin said...

It makes logical sense that in any market where competition exists, there should be price discrimination. Pharmaceutical products tend to be very unfavorable as far as affordability for the average consumer, so I am with you on that one. I also agree that R&D eats a large portion of the costs, but where would we be without such costs? Yes price discrimination is present in the pharmaceutical world, but I want to play devil's advocate here. How much profit is disguised in the price? In other words, are the prices of most pharmaceuticals inflated in such a way that the companies can look like the good guys by offering discounts and such while still being the benefactors of large profit margins? Just an objective thought.

Dr. Tufte said...

I like both the post and comment.

I'd add that price discrimination is also what's going on when U.S. pharmaceutical companies sell their drugs at different prices in different locations. Those cheap drugs are in Tijuana because they're thinking you won't make the effort to go get them, and for the most part, they're right.

To counter Kevin's objective point, we should look at ROE (return on equity) for pharmaceutical firms. It's OK, but not great (and there's a lot of risk).

This makes me think that our issues with drug companies are framing effects.

Gunny said...

These companies can charge high prices because what they provide is needed and at least in the first few years there are no substitutes to the product. The thing I wanted to add is that price discrimination continues in the later years of the project when companies provide the original product as well as a generic. These products are usually offered at different prices and would therefore constitute as price discrimination.

Dr. Tufte said...

The phrase "what they provide is needed" means their demand is inelastic, and the phrase "there are no substitutes" means they can exercise monopoly power. The latter means their markup will be non-zero, and the former means it will be big.

Xavier said...

If a pharmaceutical company can exercise monopoly power, and the demand for the good is inelastic, this brings up a very interesting question -- how much can the company charge before deadweight loss occurs? As Windwalker mentioned in his original post, even though the medicine cost may be obscenely high, it still isn't high enough for Windwalker to say, "no thanks, I'm better off going without the medicine instead of paying that price."

I hadn't thought of this before now, but from the way I understand it, if the demand is a vertical straight line (completely inelastic), then there really isn't any deadweight loss. I came to this conclusion because the deadweight loss is represented by a triangle, but with the vertical demand curve, that triangle is not created.

Dr. Tufte said...

That's actually a very good point; and, like a lot of things in economics, there are two effects that you have to net out.

First, a monopoly is a more useful thing to have, and will exploit customers worse, if demand is more inelastic.

Second, the extent of the deadweight loss - that society should actually worry about - is smaller when demand is more inelastic.

The end result is that monopoly can be bad for buyers, or bad for society, but it isn't likely to be bad for both.