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Optimal payment contracts for pharmaceuticals Back

Wednesday, 3/22/2023   
Odd Rune Straume
The development of new and effective pharmaceutical treatments requires large investments in drug discovery and clinical trials. In order to incentivize such investments, pharmaceutical firms are granted patent protection, which in most cases gives the patent holder a considerable market power to charge high prices during the patent period. However, inducing innovation by allowing firms to charge high prices for new drugs runs the risk of reducing access to new treatments in spite of relatively low variable costs of production. In order to alleviate this problem, a recently proposed new drug pricing mechanism, often referred to as the “Netflix model”, has been implemented by public health plans for a selected class of drugs in a few countries. The proposed payment contract is a two-part tariff where, instead of paying a fixed price per package of the drug, the health plan negotiates a fixed amount (similar to a “subscription fee”) in exchange for unlimited prescription volume at unit prices equal to marginal production costs. Proponents of this payment mechanism argue that it will allow pharmaceutical firms to recover their development costs (through the fixed fee) while simultaneously ensure efficient access to new drugs (through the low unit price).
In a recently published article, Odd Rune Straume (Professor at the Department of Economics at EEG) and two co-authors, Kurt R. Brekke (Professor at the Norwegian School of Economics) and Dag Morten Dalen (Professor at the Norwegian School of Management), provide a theoretical analysis where they compare the relative performance of pharmaceutical payment contracts based on two-part tariffs (the “Netflix model”) versus a standard payment contract based on uniform pricing. The authors find that the relative merits of these two payment contracts crucially depend on whether or not a patented drug faces therapeutic competition from other (substitutable) drugs. In the absence of such competition, a two-part tariff allows the pharmaceutical monopolist to extract a larger share of the surplus, leading to higher total drug expenditures. Thus, although two-part tariffs ensure efficient access to the drug, the health plan prefers uniform pricing if therapeutic competition is out of reach. However, the health plan’s preferences for different types of payment contracts change dramatically in the presence of therapeutic competition. In this case, the use of two-part tariffs not only leads to more efficient access to drugs of different quality, but it also intensifies competition between therapeutically substitutable drugs for inclusion in the health plan, thus leading to lower overall drug expenditures. The authors also identify a dynamic efficiency gain of two-part tariffs, since this type of payment contract yields socially optimal innovation incentives, while payment contracts based on uniform pricing yield too strong incentives for so-called “me-too” innovations relative to drastic innovations.

The article was awarded the 2023 EEG Research Prize in Economics.

Brekke, K.R., Dalen, D.M., Straume, O.R., 2022. Paying for pharmaceuticals: uniform pricing versus two-part tariffs. Journal of Health Economics, 83, 102613. https://doi.org/10.1016/j.jhealeco.2022.102613
Gabinete de Comunicação
Escola de Economia e Gestão
Universidade do Minho
Telefone: 253 604541
Email: gci@eeg.uminho.pt
Odd Rune Straume