Pharmaceutical prices and innovation

In new research, Alan Garber, Chad Jones and Paul Romer show how the system of co-payments for health insurance may encourage socially desirable use of pharmaceutical drugs. Drugs that are under patent are priced in a monopolistic way. This usually means that their use will be much lower than would be socially desirable: put simply, there may be consumers out there who are willing to pay for drugs more than the marginal cost of producing them but monopoly pricing is rationing them out of the system.

Garber, Jones and Romer point out that when patients are covered by health insurance, they do not pay the full price for drugs. They share the cost with their insurers through a co-payment. This means that a consumer is more likely to purchase a drug than if they had to bear the full price. This over-purchase tendency will counteract the under-purchase tendency that is coming from monopoly pricing of drugs. The end result could be socially optimal drug consumption.

In Australia, the government enacts this system but in a way that makes it more likely that the social optimum can be reached. Drugs that are covered by Australia’s Pharmaceutical Benefits Scheme (a scheme that has been operating since the 1950s) are sold to patients at a price equivalent to marginal cost (taking into account the costs of manufacturing and distributing the drugs). Thus, Australian consumers face (near) socially optimal incentives to use medicines.

The difference between the government scheme and private co-payments is critical. Under the US system, the pharmaceutical company is still able to set their own price and with the co-payment demand is even greater than they would have under monopoly. The end result is much higher profits from drugs. Indeed, as Garber et.al. show this can mean that drug companies have socially excessive incentives to innovate. They recommend capping drug prices to improve the situation.

In Australia, that already happens. Moreover, the cap is set with reference to the profits of pharmaceutical companies who can always opt out of the system if they want. As such, they will always receive at least their monopoly profits. In this way, innovation incentives are not diminished by the Australian scheme and, moreover, do not generate excessive incentives either.