2009 November 16 Monday
The Mysteries Of Drug Price Economics

The Gray Lady misses the elephant in the hospital operating room. An article in the New York Times looks at how the drug makers are hiking prices right before the US Congress passes legislation to subsidize health insurance for more people.

Even as drug makers promise to support Washington’s health care overhaul by shaving $8 billion a year off the nation’s drug costs after the legislation takes effect, the industry has been raising its prices at the fastest rate in years.

The article suggests drug companies are doing this in order to negotiate from higher existing price positions. But they entirely miss an obvious really unpolitical explanation for the higher prices.

In the last year, the industry has raised the wholesale prices of brand-name prescription drugs by about 9 percent, according to industry analysts. That will add more than $10 billion to the nation’s drug bill, which is on track to exceed $300 billion this year. By at least one analysis, it is the highest annual rate of inflation for drug prices since 1992.

The article reports that a Harvard economist observed the same pattern of bigger price increases when Congress passed a bill to fund a Medicare drug benefit for old folks. Well, of course. If you increase demand you'll increase prices. But the article fails to mention this obvious lesson from basic economics.

The article continues in this oblivious vein. Look how they mention that the new health care legislation in Congress will increase demand. But they do not say "increase demand". In fact, "demand" doesn't show up in the whole article. How about some economic literacy?

The industry stands to gain about 30 million customers with drug insurance from the legislation pending in Congress. But the industry also faces the prospect of tougher negotiations from both public and private buyers as the government tries to squeeze savings out of the health system.

An aging, growing population combined with more subsidies for drug purchases will drive up prices. Higher demand raises prices.

Share |      By Randall Parker at 2009 November 16 11:37 PM  Economics Health

Joe said at November 17, 2009 2:42 AM:

That doesn't seem right. These drugs aren't some rare, limited commodity. If there's more demand, they can just pump out more pills. If anything, I'd expect prices to go down slightly because of economies of scale. There may be a short transition period however.

not anon or anonymous said at November 17, 2009 8:01 AM:

Joe, you're right for generic drugs. Recently developed drugs are limited by patent rights, however.

AMac said at November 17, 2009 7:57 PM:


I think you're likely largely mistaken on this point. Ethical drugs are a funny product, from a supply-and-demand perspective.

1. They are, to varying extents, monopoly products (the point of patent protection, and a side effect of regulation).

2. Their cost is largely in R&D, secondarily in sales, with Cost of Goods often about 15% to 20%. "The first pill out of the factory cost the pharma company ten billion dollars to make, every subsequent one cost them ten cents."

3. Pharmas manufacture, advertise, and sell, doctors decide and prescribe, patients consume, and third-party payers pay. For most medical services and products, consumers don't know the cost, and have no compelling reason to care.

A question as interesting as "Why did Pharma X raise the price of drug Y? Why now, and why Z percent?" is the converse. In some other year, "Why didn't Pharma X raise the price of drug Y?"

It doesn't seem to be a question of supply-and-demand. The constraints seem to be things like "we already hiked prices last year," "we want to avoid the spotlight of bad publicity," "we don't want to engender a backlash among consumers/voters."

True, there are also issues such as "we're getting pushback from contracting organizations (PBMs, etc.)" "higher copays will drive patients towards generics," and "we can maintain a favored position on PBM formularies by forgoing a price hike." Those fit the classical economics perspective, at least to an extent.

Bob Badour said at November 17, 2009 9:39 PM:
"we can maintain a favored position on PBM formularies by forgoing a price hike."

That only matters when one cannot sell one's entire production without a favored position on PBM formularies. As Randall pointed out, rising demand raises prices.

Tom West said at November 20, 2009 6:00 AM:

If you increase demand you'll increase prices.

Which is why as demand for computers has gone up, prices have gone through the roof.

Oh wait...

Randall, prices automatically increase as demand increases *only* if supply doesn't change. Supply is going to change.

There's a point to be made about the effect of government interference in the market, but this isn't it.

Bob Badour said at November 20, 2009 7:26 AM:


Your example is flawed because the supply curve for computers changed as technology progressed--not necessarily the demand curve. Introducing or increasing the role of a government 3rd party payer to the drug market shifts the demand curve not the supply curve.

Randall's point is spot on.

Randall Parker said at November 20, 2009 11:18 AM:


Drug companies that sell patented products that give them monopolies on those products. There's no competitor present to increase supply.

Now, with patented statins there are competing statins. But if, say, you tried one statin and got side effects and tried another and it works you are probably reluctant to try a third one for a lower price. But not all patented drugs have plausible substitutes.

Government intervention that decreases elasticity of demand while increasing total demand will cause drug prices to rise.

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