I’m trying to figure out a model to make the following make sense to me regarding the US negotiating or not negotiating drug prices through the purchasing power of Medicare. I’m picking on Enplaned from comments just because this is a fairly common argument structure:
Health authorities of other countries routinely get lower prices for their citizens on drugs than are charged in the US. What this means is that US consumers effectively subsidize those of Europe, for instance. This makes sense for drug companies because selling it for less in Italy or Germany or whatever is still additional profit, assuming it’s greater than the cost of production.
What’s the model that produces this statement?
My best bet at figuring out a model is one that assumes drug distributors are actually profit satisficing entities and not profit maximization entities.
By this I mean the implied model assumes that the C-level of a major multi-national drug company will decide that they want a set annual return on equity for the next fiscal year. They can sell in three markets. The United States, the rest of the OECD (middle class and higher industrial countries) and the rest of the world. Rest of the world is broke so most of the sales of expensive drugs there are marketing loss leaders and charity care. The primary decision point then is how to allocate profits from the disjointed US market where almost no one with market power can say no and the rest of the OECD where locally concentrated buyer power can effectively say no. So it is an allocation decision that the US will supply 75% of the net profit and the rest of the OECD will supply 25% of the profit. Now under this profit satisficing model if Medicare is authorized to say no and exclude certain drugs from coverage, the US, all else being equal would now only supply 60% of the profit and without any other changes the OECD would supply 25% of the profit and then there would be a 15% decrease in net profits. However in this story, the drug companies now will raise rates in the rest of the OECD so they supply 40% of the profits so total profits under either scenario are the same.
I have a hard time buying this and reconciling this implicit model with the left/liberal critique that drug companies are soulless bastards who are trying to make money above all else.
What if we follow the logic of profit maximization through the entire drug pricing decision chain?
Here I’ll be ripping off a lot of the logic in the argument against cost shifting when payer mix changes for hospitals as I think these are functionally isomorphs.
The first decision a drug maker has to make when selling to either the US or the rest of the OECD is what is the minimum price that is not a guaranteed incremental money loser to sell at. A drug maker won’t sell a dose at less than the marginal cost of production. It will attempt to sell as many doses at a price level as high above the marginal cost as possible. In time period 1, Medicare can not negotiate so the American drug buying market is extremely fragmented and weak while the rest of the OECD buyers are fairly strong for their respective national markets. A negotiation between the drug maker and the rest of the OECD has a plausible agreement zone if the per dose price is above the marginal price of production for the drug maker and below the maximum willingness to pay for a buyer. If there is space between these two points and maximum willingness to pay is above the marginal price, then an agreement will be reached. Where that agreement is reached will be a function of negotiating skill and the existence of next best alternatives as near substitutes for the buyers. The same set of negotiations occur between the drug maker and a dozen American pharmacy benefit managers who all have far less power to say no and thus their aggregate maximum willingness to pay is higher. The higher paying customers will have priority to get the last incremental dose available but the agreements are not linked to each other.
Now let’s say Medicare is given the power to negotiate and say no much like the Veterans Administration can say no. The drug maker will still sell if the Medicare maximum willingness to pay is above marginal cost. The difference in this time period is that the single negotiator now has a credible threat to leave and its maximum willingness to pay is less. The shared plausible agreement zone shrinks. So US drugs will cost less as Medicare can credibly threaten to divert billions of dollars of business from Company A to Company B if Company A is asking for an arm, a leg and a kidney while Company B is just holding out for an appendix.
The same negotiation is happening with the rest of the OECD. Deals will be reached as long as the maximum willingness to pay is more than marginal, incremental cost of production. Nothing has changed here. It is the same discussion in Year 2 as it was in Year 1 when the Americans were fragmented. If anything there could be an minor decrease in the rest of the OECD willingness to pay as they now know that the Americans won’t set as high of a price for the last incremental dose available.
Under a profit maximization model where the US now has a single point of negotiation for a significant portion of US drug expenses and it has the ability to issue a strong NO, the rest of the world will either see no change in their plausible agreement zone or a slight improvement in terms.
I think it is important to have a decent functional model that is overly simplistic but tractable in order to make our predictions and our policy preferences clear. I can’ figure out the model where lower US prices automatically lead to higher rest of OECD prices without making a profit satisficing assumption which is inconsistent with both evidence and other concurrent ideological priors. Let’s think clearly, so what am I missing here?
What have the Romans Ever done for us raises the great new research vs. hookers and blow question