Elasticity of demand

Even in an ideal situation in which the doctor is a perfect agent for the patient, the need to regulate prices in the pharmaceutical market may arise from insufficient or very weak competition owing to the temporary market power of the manufacturers, the oligopolistic nature of many therapeutic submarkets, low elasticity of demand and imperfect prescriber information.1... 

A similar model is provided by what is called Ramsey pricing, after the economist Frank Ramsey.1213 This author showed that if the above conditions for market segmentation are fulfilled, social welfare is maximized in a particular market when the profit margin that is added to the marginal cost of production in order to determine the ex-factory price is inversely proportional to the price elasticity of demand. In other words, the price is always fixed above the marginal cost in order to recover the sunk costs, but this margin is inversely proportional to the sensitivity of demand in that market. Formally, this can be expressed as follows ... 

In the third section we analyse expected effects from a microeconomic perspective, and we discuss to what extent the neoclassical microeconomic theoiy of demand is applicable to the case of pharmaceuticals. We explore the effects of co-payment on consumption and expenditure, and how it is shared between user and insurer, but also the possible effects on the health of individuals and populations. Equity considerations are inevitably raised in this analysis. The elements on which the analysis hinges in this section are price and income elasticities of demand for pharmaceuticals the role of the doctor as an inducer of demand consumer sovereignty discontinuities in demand functions and other notable exceptions to the classical ma.rgina.1ist. theoiy of demand. These exceptions require special microeconometric models and methods. 

Voluntary insurance would be the market solution to uncertainty for risk-averse individuals. In this context, the user chooses the optimum co-insurance rate. Theory offers some analytical results on optimal health insurance contract designs.1 The consumer decides the extent of the coverage and the optimum co-insurance rate, and ultimately the price to be paid for the premium. In competitive markets, with actuarially fair premiums, the optimum co-insurance rate varies between individuals and depends on the risk of falling sick and the price elasticity of demand. 

The phenomenon of moral hazard, and the consequent welfare loss, occurs when the demand of the insured party shows price elasticity, and the greater the elasticity the greater the moral hazard. Recall that the price elasticity of demand is defined as follows ... 

If we say, for example, that it stands at -0.2, we mean that if the price rises by 1 per cent, the quantity demanded will decrease by 0.2 per cent. In fact, the price elasticity of demand measures the potential for moral hazard.9 In Figure 7.1, the slope of the demand function for 100 per cent copayment is what ultimately determines the shaded area, which as we already know, corresponds to the welfare loss of total coverage pharmaceutical insurance. 

In addition to this, however, as the reader can see from Figures 7.1 and 7.2, the price elasticity of demand increases as the co-payment rate increases. 

Clearly, if the co-payment rate (c) is proportional to the price CP), the elasticity of demand with respect to the price paid (P = c P) coincides with the elasticity with respect to the co-payment rate c ... 

Furthermore, the price elasticities of demand for pharmaceuticals are likely to differ depending on individuals income. If low-income households have a more price-elastic demand, an increase in co-payment will cause them to make a proportionally larger reduction in their pharmaceutical consumption than high-income households. The same thing could happen if we make the comparison in terms of levels of health. We are faced with equity problems, to which we will return below. 

In order to evaluate the practical effects of co-payment it is essential to have access to quantifications of elasticities. The fourth section of this chapter deals with this. It is far from straightforward to obtain reliable estimates of the elasticities of demand for pharmaceuticals with respect to co-payment and price. Distinctions must be made between active ingredients, brands and generics, and between essential and non-essential drags, and substitution elasticities must be taken into account. 

How the pharmaceutical expenditure is shared between the two parties (the patient and the insurer) depends on the initial co-payment rate (c), the size of the increase (Xc) and the drop in the quantity (XQ). which in turn depends on the elasticity of demand. Before the rise, the patient bore expenditure equal to cPQ. This is shown in Figure 7.3 as the rectangle 0AGQW. After the rise in the co-payment, the patient spends (c + Xc) P (Q + XQ). In the figure, this is represented by the rectangle OBEQ40. 

The first addend is positive, and measures the direct effect of the rise of the co-payment rate. It expresses the effect of the normative change in the distribution of the financial burden between the two parties, before the user s reaction of restraint in the use of the pharmaceutical is taken into consideration. The other two addends are negative, and quantify the decrease in expenditure caused by the drop in consumption as a reaction to the rise in the price paid. The balance can have either sign, depending on the elasticity of demand and the size of the increase in the co-payment. In the example shown in Figure 7.3, despite a considerable decrease in the quantity consumed, the patient will end up paying more for the drag than before. 

There are a considerable number of empirical estimates of the elasticity of demand for pharmaceuticals. Unfortunately, most of them deal with the USA, and their results cannot be completely extrapolated to the health systems of Europe. 

These considerations highlight the methodological difficulties in estimating elasticities of demand for pharmaceuticals and partly account for the extremely high variability of the results. 

In Spain the price elasticity of demand for pharmaceuticals is low, according to available estimates. Puig-Junoy26 has estimated that the figure stands... 

One of the classical topics of pharmaceutical economics, the price elasticity of demand when there is co-payment or shared financing between the insurer and the user, is addressed by Cruz-Roche20 with some calculations on this elasticity. The same topic is developed by Puig-Junoy,21 applied to the Spanish case. This study includes a review of the international literature with empirical content, a detailed description of co-payment in Spain, its regulation since 1978, the main data and estimates of the effect of the switching of prescriptions from the employed to pensioners, and the price elasticity of demand (which is found to be small). 

Table 6.7 Own and cross price elasticities of demand for organic and conventionally produced dairy products in Denmark...

Table 6.8 provides a more comprehensive set of estimates of own-price elasticities of demand for organic products, compared to the conventional equivalent, this time for the UK. In all cases the response of consumption of organic products to change in price is about double that for conventional produce. 

One key assumption is that total sales of the molecule remain Constantin terms of units in the face of generic competition (zero elasticity of demand). This can lead to an overstatement of savings, but studies of the effect of generic competition... 

These studies must make assumptions about changes in, for example, future input and output prices, yields, subsidy and premium levels, the way consumers and producers will react to changes in prices (price elasticities of demand and supply), population increase or decrease and level of adoption. The possible outcomes are too numerous to summarise here, so only a few results are presented as examples. 

Fuels that are hard to substitute with each other may have elastic demand with respect to changes in own price or income, but will have low (close to zero) cross-elasticities of demand. Such fuels will not be in the same market and would not compete with each other within their respective markets, however, there may still be strong same-fuel competition. To illustrate, let quantity demanded of gas Qg be determined by its own price Pg, prices of oil P , power Pp, coal Pc and income Y ... 

Once the proportion of cost increase that is passed on to customers is known, the impact on profits from a decrease in margins can be established relatively easily. The magnitude of this effect is given by the sensitivity of demand to price, the own-price elasticity of demand . Estimates of this elasticity are available in the economic literature. 

The data required to run the model were substantial. They included financial data of individual companies, fuel use and C02 emissions per product, in addition to the price of an average product. Other data inputs included the own-price elasticity of demand, the total volume of product consumed, the number of firms manufacturing the product, and the proportion of total consumption supplied by imports. 

Sales of these products also demonstrate what a complete fiction is the story that the average physician pays no attention to prices in writing prescriptions. Product 11 among the anti-infectives languished at 0.1% of the market for 5 years until it had cut its price by 47%. At that point, its market share rose to 0.7%, a sixfold increase. Another 14% price cut raised its market share another 170%. Still further cuts over the next three years amounting to 12% raised its market share by still another 68%. This would seem to demonstrate a remarkably high price elasticity of demand for a branded patented product particularly in view of the price cuts of competitive products. 

Nuclear Power Issues and Choices, a study prepared by the Ford Foundation and MITRE Corporation, a strategy study center, claims that the income elasticity of demand for energy was between 0.8 and 0.9 for the United States in 1975. 

---