Differential Pricing Of Pharmaceuticals

Case Differential pricing of pharmaceuticals: the HIV / AIDS Crisis

1) Is the monopoly on patented pharmaceuticals warranted? What barrier to entry prevents the re-
importation into the United States of pharmaceuticals sold at lower prices abroad (say, in Canada)?

The monopoly on patented pharmaceuticals is an improper term, and represents only a limited warranty.

* First, it is limited in time. The company needs to recover its R&D investment and make a fair profit
during the period of exclusivity.

* Second, it is limited geographically – as some countries will not respect intellectual property and allow
their own pharmaceutical companies to copy innovations, making generic drugs even before the original
patent expires.

* Third, it lacks the most important element of a monopoly: price control. In most countries, the prices of
drugs are set by a governmental agency. The manufacturers are merely consulted; their influence is very
limited. In the end, once the price is set, they can only decide if they are willing to sell at that price or not.
Take it or leave it.

* The combinations of the factors above will put pressure on the pharmaceutical companies to expand
geographically as quickly as possible, in order to maximize their chances of recovering their R&D costs
and making a fair profit within the time period covered by patent protection. In order to do that, they will
accept in some countries prices that are far from ideal – prices they would never accept in a true
monopoly situation. In doing so, they open the gates for grey trade – re-importation and parallel imports.

* The barrier to grey trade is formed by the combination of several factors:

* Price difference

* Trade Tariffs (where applicable)

* Cost of transport

* Regulatory considerations

* Reimbursement procedures

For example, if a HIV drug is sold in the US at an annual treatment cost of 10,000 USD, and the same
drug is sold in Canada at a price 10% lower, then re-importation is likely to occur. In the absence of trade
tariffs and with a transportation cost of maximum 2%, a grey trader has an 8% trading margin to cover
selling & operational costs and retain a profit. The product is likely to have been kept in Canada in the
same conditions as required by US laws (e.g. temperature controlled and recorded the entire time, etc).
Therefore a US pharmacy can safely buy it and sell it forward to its patients.

* There may be a further limitation regarding reimbursement – e.g. if the US government only reimburses
to the pharmacy drugs purchased from manufacturers in the US, or if the reimbursement is paid directly to
the manufacturers. In that case, the potential for re-import would be very limited, i.e. only for patients who
pay for their medicines from their own pocket (usually a very small percentage of the patient base).

* The regulatory considerations can play a big role in protecting against grey trade. For example, a drug
sold in Botswana at 1/5 of the price in US, is still unlikely to get re-imported. The distance is irrelevant, as
the transportation costs are very small. Trade Tariffs could be well covered by the 80% total potential
margin (400% mark-up). But often, procedural barriers such as the need to have the temperature history
in a certain format, or distributor quality control certificates, can make a product unfit for sale back in the
US.

2) The contribution margin percentage on pharmaceuticals exceeds the 55 percent to 70 percent margins
on ready-to-eat cereals. Identify three reasons why pharmaceutical margins are higher

* First, the higher margin reflects the proportion of indirect vs. direct costs. Like in the case of software,
the development process is lengthy and costly. The vast majority of R&D projects fail to finalize in a
product being placed on the market. The few products that pass all the stages of the development
process successfully, need to provide sufficient margin to cover for the high R&D costs, and sufficient
cash to finance future R&D projects. The direct cost of the goods sold is insignificant. In fact, very often
the cost of the packaging and transportation is higher than the direct production cost of the pills
themselves. But of course, such comparison is misleading – it’s like judging the value of Leonardo da
Vinci’s “Mona Lisa” compared to the cost of the oil paint that went into making it.

* Second, the higher margin reflects the higher risk that the pharmaceutical company takes. During the
development stage, the outcome is very uncertain – it is impossible to judge if a viable drug will emerge,
and it is always possible that another company will discover a better product in the meantime. After the
launch, the time between regulatory submission and regulatory approval in each market (often 2-3 years)
can take away valuable years from the drug’s patent protection. And finally, once the product is launched
and available in several markets, the company can often find its profit margins in high-price markets being
eroded by grey trade.

3) Suggest an approach to the big pharmaceutical company problem of differential pricing in the United
States, Western Europe, and Japan versus the less-developed world.
* The dilemma is similar to that of a manager vs. sales team. Like the manager, the manufacturer wants
to maximize profit. Like the sales force, the distributor and pharmacy want to maximize sales (because
they get a more or less fixed return on the sales). In a country with low prices, the distributor and
pharmacy will be interested in exporting the drug towards higher-price markets. Some of them will even
form their own “ghost” export companies, and get not only additional sales, but additional profit as well.
The manufacturer on the other hand will be only interested in making that product available to all patients
in that particular country, and nothing more.

* The problem appears mostly on expensive drugs, usually the ones used in treating very serious
conditions like AIDS or cancer. The number of patients in each country is relatively small, and the vast
majority of them get their treatment reimbursed. So getting more control over this part of the consumption
would be a very good first step. The problem lies in the reimbursement process. Manufacturers sell the
drug to distributors, who sell it further to pharmacies. Pharmacies give it to patients at zero cost and get a
validated reimbursed prescription signed by the doctor. They submit this to the governmental agency; wait
several months to get the money, then they pay the distributor and so on. The process is very
bureaucratic and paper-intensive, and controls are very difficult. This means fraud is relatively easy,
especially if done on small quantities every month (as one large bulk order is likely to trigger a control).
The solution would be a radically different reimbursement system, where each patient would get a unique
Healthcare Credit Card. All purchases would only be allowed through this HCC, making them directly
traceable to each patient.

* The Healthcare Credit Card would bring significant other advantages:

a. Bureaucracy would be greatly reduced, as the doctors would authorize reimbursements directly in the
electronic system for each patient.

b. Relevant medical history for each patient would be directly available to any doctor or pharmacy by
simply swiping the card, greatly simplifying both the consult and the medicine recommendation (e.g.
allergies to certain substances, etc).

* In developed countries, the same system could easily be deployed, further limiting the risk of re-import /
parallel import.

* Also, the system could be further simplified if the card payments went directly into the manufacturer’s
bank account, while the manufacturer would simply be paying distribution fees towards the wholesalers /
pharmacies.