Tuesday, 10 May 2016

Creating and capturing value in pharmaceutical markets

In managerial economics, we recognise that business profitability is all about creating and capturing value. Creating value for customers attracts them to buy the product from your firm, and capturing some of that value for your firm is what leads to business profits. The better at creating and capturing value your firm is, the more profitable it will be.

This is essentially what we will be covering in ECON100 this week. Which made this New Zealand Herald article from last week particularly timely. The article talks about pricing in the market for pharmaceuticals, and tells the story of Mick Kolassa:
The Kolassa theory seems straightforward enough. Basically, it holds that drug companies should charge handsomely for products that will benefit not only the patient but the economy, by keeping people out of hospitals or allowing them to live productive lives. The price should factor in a profit that can finance more crucial discoveries.
A case study displayed on MME's website sheds light on what the firm calls its "value-based strategies." A client wondered whether it should cut a price to reverse slowing sales. After discovering some doctors really liked the drug, MME recommended "a set of aggressive price increases immediately." The client obliged, and "revenue has increased substantially."...
In his book "The Strategic Pricing of Pharmaceuticals," Kolassa wrote about drug-price elasticity. "It is theoretically possible to set a price that is too high," he said. "We have yet to identify such a situation in the U.S. market."
Pharmaceuticals create a lot of value for patients (the difference in value between life and death is pretty stark!). Pharmaceutical companies therefore seek to capture much of that value for themselves, by charging high prices (I've written on the economics of drug development and pricing before). They can get away with the high prices because they have market power, and this market power arises because there are barriers to entry into the market - the drugs can be patented, and patents keep competitors out of the market. Even after a drug is off-patent though, there are still barriers to entry because it is costly and takes time for firms to divert resources to drug development, testing, and accreditation, even if it only involves creating a generic version of an existing drug. This is one of the reasons that Turing Pharmaceuticals was able to radically increase the price of Daraprim last year.

So, even though a full course of the hepatitis C drug Sovaldi sells for US$84,000, because it requires a shorter treatment period and has fewer side effects than alternative treatments, it generates a lot of value for patients. Patients (and by extension, health insurers and providers) are willing to pay the high price because of the value it generates for them in terms of improvements in health and wellbeing. All of this makes Sovaldi enormously profitable for Gilead.

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