Tuesday, June 16, 2015

Price Setting with Inelastic Demand: An Ethical Approach

Introduction - Overview of a Global Business
The modern pharmaceutical industry came of age with the growth of chemistry as a science. Though healing compounds can be traced back millennia to various civilizations in Europe, the middle east, the Indus valley and China, there was no formal or systematic approach to developing new healing compounds until the rise of capitalism and the industrial revolution. The industry as we know it rose out of the german dye manufacturing companies in the late nineteenth century. With the development of compounds to treat a variety of symptoms and diseases, along with new imaging technology in the x-ray and the germ theory of disease, the science of pharmacology is a rather new science in the scope of human existence.
Though it is relatively new, it is very large. The World Health Organization explains how large it is on their website: “The global pharmaceuticals market is worth US$300 billion a year, a figure expected to rise to US$400 billion within three years. The 10 largest drugs companies control over one-third of this market, several with sales of more than US$10 billion a year and profit margins of about 30%.”  These large companies are largely American or European, and they sell many of their drugs to americans and europeans and the Japanese. In fact, the same site notes that the companies spend roughly one third of their sales revenue on sales and marketing - more than double the amount they spend on research and development.
This paper will focus on the decisions that just one of these companies has to make. Gilead science is a biotechnology drug firm located in Foster City California. In 2014, the company enjoyed revenue of almost twenty five billion dollars compared to just over eleven billion the previous year.  (financials 10-k).  What drove this increase? It was the release of a new treatment for hepatitis C, called Sovaldi. This drug is a breakthrough in treatment, and it is priced as such. Sovaldi is available as a twelve week treatment that is a daily pill. It is effective in treating 90% of Hepatitis cases. It also costs whoever is paying for the treatment a thousand dollars a pill. That means it cost the payer $84,000 in the United States. That price is the process of a deliberate set of choices in the decision making process.
Problem Statement - What Challenges in Organizational Design Exist in This Business
Though a thousand dollars a pill sounds as if it was an arbitrarily chosen price that is not true. Internally, the company should have to balance a lot of factors with their pricing decision, if they were using a rational model of decision making. A firm will look at the costs and the potential market of the drug to set pricing. In terms of Hepatitis C, the centers for disease control estimate that there are 2.7 million people living with chronic Hepatitis C in the United States. Most are unaware that they have the disease, Many of these people will develop chronic liver disease, and be in need of a new liver at some point down the line, if they can get one (CDC). This means that there is a ready market for a pill that can essentially cure Hepatitis C. With the advent of wiser health coverage under the Affordable Care act, many if not most of the people affected by the disease will have coverage that in theory should be able to pay for it. So in terms of a product, the demand side is solid The other side to look at is the supply side. The government grants patent protection to companies who make new products. This patent is a temporary monopoly on a product, meaning that there is no other company that can legally make and sell the drug. That means the price setting decision in theory is internal. Again, the company should look at the costs here. This is easier said than done, as accountants can look at costs in several different ways and they all can be correct. In one sense of the term, the cost of the drug is just the raw materials cost. How much do the constituent parts of that drug cost, and there is the cost of the drug. The problem with this view is that there may be subsumed costs. The company has to run itself and sell the drugs. This cost Gilead almost three billion dollars last year (10K). The company has to do research on new drugs, the line item for Gilead’s R&D last year was just at three billion (10K). How do you allocate these costs? Are they part of the cost of Sovaldi, or are these the costs of future drugs? A recent study by the Tufts Center for the Study of Drug Development puts the average cost of the development of a new drug that makes it to market at almost 2.6 billion dollars. Gilead is right to recoup these costs, but finding the right cost for the drugs should go through the evidence based decision making process as described in Kinicki and Fugate’s “Organizational Behavior” First, the problem is identified, then internal evidence is gathered, then external evidence is gathered, then the views of the stakeholders, then all the views and data are integrated, and then a decision is made. This model  is will inform the basic outline of the rest of this investigation.

Causes  - A look at Stakeholders
The drug pricing decision does not happen in a vacuum. The medical delivery industry in the United States is enormously complex, with many stakeholders. It is also where a lot of the GDP is funneled to. Of the large economies in the world, the United States spends the most in terms of its economy on health care. The World bank estimates that as a nation over 17% of GDP was from health spending, only bested by tiny Tuvalu (World Bank).  Overall, there are five separate players in the drug pricing scheme that all can be looked at in terms of why the pricing is so high and informs Gilead’s decision on how to price the drug.
The first stakeholder is the Gilead itself. It is the one that sets the prices, and they are the easiest to look at and say they should do things differently. There is the fact though that they did go through the research and development and clinical trials (or bought a company that did), so they should be able to reap the profits from that work. The counter argument is that they have patent protection, and we don’t know what the marginal cost is of one pill. It is most likely less than a thousand dollars.
The second stakeholder  is the government, which plays a couple of roles in the medical infrastructure of the nation. First, it helps keep prices high as a regulator, making the company have to jump through numerous hoops just to gain regulation to sell the drug from the FDA. Then if a secondary use is found for the drug, the company has to go through more trials to prove that the drug that was already proved safe and effective for one treatment is safe and effective for another. These are the so-called “off-label” uses of the drug. There are a couple of notable examples of this. The drug known as Rogaine was first used as a blood pressure medication before it was found to be a hair rejuvenator (Our History). The drug Viagra was first used as a heart medication before it was found to have its more well-known properties (The Little Blue Pill that Could). The government makes the companies show that the new use is safe, and by putting up those walls, it increases the price of bringing a drug to market (Downsides).  Governments at all levels are also one of the biggest buyers of a lot of drugs. Theoretically, they could use that market power to bargain with the drug companies to lower their prices, but unfortunately through custom and statute, they often fail to fully bargain on price where they might be able to in a sad case of regulatory capture. The government also covers a disproportionate number of patients, because many people who suffer from Hepatitis C are poor. Many are also drug users. There is a perception that some victims may have gotten the disease from tattoos or sexual intercorse. This means from a political standpoint, these patients covered by the government are not sympathetic victims. They may somehow be perceived to have deserved their disease. That lowers the government incentive to treat them, especially at such a high rate.
The third stakeholder is are the insured people, particularly the ones who have the disease. Hepatitis C, especially the chronic and acute versions of the disease do not sound like enjoyable things to have.  The current treatments are more long term, and the even then the result of managing the disease for years is liver failure and the need for a new liver. Donor livers can be found, since a live donor can give up part of their liver and there is not 100% reliance on cadaver livers. Even then, the patient will still be at risk for rejection and will have to remain under treatment for the rest of their life. So it makes sense if the patient sees Sovaldi and its success and short time frame of treatment and they decide, “I want that treatment.” and through the structure of the healthcare market, they don’t know anything about how much things cost because there is no transparency in the market about prices. This is the demand side looked at earlier.
The demand would not exist without the mediators between the drug companies and the people with the disease. These are the doctors and hospitals, who prescribe the treatment. It is their job to match the patient with the proper treatment. Is Sovaldi for every patient, or are the maintenance drugs for even chronic Hepatitis a worthwhile treatment if and until it gets worse? This is a decision for a trained medical profession to make and for the medical infrastructure to enact. By connecting patients to Sovaldi, they help mediate between the supply and demand for the drug. If no physicians prescribed the treatment, then there would be no demand, and thus the price would not matter. So that even though it is much more effective than other treatments, the ones that have been out there longer are less expensive so might be more affordable and covered by the insurance companies.
It is these insurance companies are the final stakeholder to look at. These companies do not want to pay that sort of money because Hepatitis C, as seen earlier, is relatively common. If they paid the full list price for even half of the current Hepatitis C victims out there, they would have to pay $126,000,000,000. Which is a lot of zeros. The counter to paying the cost of the treatment now is that as a long term, chronic disease, the cost for treatment over time adds up. Further, many of these patients will eventually face liver failure and the cost of a liver and transplant and after care is over half a million dollars. There are other, more expensive drugs than Sovaldi, but most of the diseases they treat have relatively few victims.  This means that there is less outcry over the price by the insurance companies and the general public. There are fewer economies of scale, so a cancer with a multisyllabic name is anticipated to cost a lot to treat. Someone with a less sympathetic disease that is actually fairly common could be seen as less of a priority, especially if there are management drugs in existence. The bottom line for the insurance companies is the bottom line. They do not want to pay for any treatment that they determine to be in excess. With the price of Sovaldi,  this has already come into play. One example in the Washington Post was a patient whose physician had prescribed the drug on three separate occasions only to be told by the insurance company that they were not sick enough yet to receive the treatment (Who gets what). The patient’s very goal was to get the available treatment and to not get sicker, but the insurance company exists to pay for needed treatment. The only catch is that they get to decide what treatments are needed.
Ethical Considerations - What What possible solutions are available for the organization?
Within the organization, with all the stakeholders just looked at, the question is what price should be priced at. This is a hard decision to make because their product is one that can greatly enhance the quality of life for people who suffer from Hepatitis C. It can also save their life. Thus it is no ordinary product. In fact, it is a special case. In terms of drugs that can cure Hepatitis C, from an economic standpoint,  they are the sole supplier. There are other similar compounds on from other companies, so the time that Gilead is the sole provider will be short. This means that Gilead comes into a special  market with a lot of power. The market is special because there is a set amount of people who want the cure. Most students of economics should be familiar with the crossing supply and demand curves. The supply curve slopes up, where companies will supply more goods when the price rises. This meets the downward sloping demand curve, where as the price rises, some customers will drop out of the market. This is a special market case. Where most demand curves are upward sloping, like water in a desert, cures for fatal diseases have an almost unchanging demand. This means that the demand curve is a nearly vertical line in a situation known as “inelastic” demand. With inelastic demand, the three million people in the United States who want a cure for their Hepatitis C will continue wanting that cure no matter how much Gilead will charge them, and they will pay as much as possible. This gives Gilead a lot of power over those other stakeholders on their pricing, and it becomes an ethical decision that they have to make through the evidence-based decision making model taking into consideration all aspects of the variou stakeholders to make an equitable pricing decision that benefits all parties.
Alternative Evaluation
Gilead can take several different tracks when it looks at its pricing. One look would be to go with the pure logic of the market. This is where the company could set the price at a point to maximize profits at the expense of the stakeholders. Looking at the data, what Sovaldi prevents at the most drastic case is a liver transplant. Seeing that the transplant and the after care cost almost half a million dollars, the company could price Sovaldi at that price and show that not only does the drug save the transplant cost, it also improves the patient’s quality of life and eliminates costly after care and lowers the chance of rejection so even at half a million dollars for a course treatment, Sovaldi is in fact a good deal. Some insurers and the the government might balk at such a pricing level. At a true market price, there would be fewer payers willing to pay even though there would be patients who wanted the treatment. It just shows the disconnect between supply and demand in our medical economy.
On the other end of the spectrum, Gilead could offer up the treatment for cost. Looking at the cost of bringing a new drug to market averaging over two and a half billion dollars seems like a lot of money. But remember that Gilead covered that average cost over four times in 2014. Based on their current pricing, everything above the materials, manufacture, and overhead for each new pill of Sovaldi is pure profit. Gilead could give away the drug as part of a lasting legacy towards the health of the planet, effectively eliminating Hepatitis C as a cause of death of the peoples of the world. There is precedent for such an action. Jonas Salk famously did not take royalties for his polio vaccine, an action that made him a much less rich man than he could have been, but cementing his legacy as a scientist and an ambassador of goodwill (How Much). Estimates for cost of manufacture of a run of Sovaldi run to about $130 (Sovaldi Tax), so the minimum price could be just that much.
The final option lies somewhere in the middle. Companies under capitalism are hard pressed not to be secular saints like Salk, but the realities of the market is that they are not the cold, hard, calculating markets of a simplified version of Econ 101. There are other issues at play and other stakeholders. Looking at the government as regulator, patents protect companies and provide a temporary monopoly so that the company can reap the benefit of its investment. The United States government has proven itself to be strong supporter of these property rights. But other countries may not be so forgiving. If Gilead takes too much license with its property, the government may expropriate it from the company and license or manufacture itself. Gilead also has to participate in the court of public opinion. This drug will soon have competitors, and there is always goodwill to be built or destroyed. Even in America, profit over and above some unspecified level is unseemly. Yes, the citizens can applaud someone for making innovative strides in medical research, but economic rent-taking is too much. The outcry over the pricing of Sovaldi proves that Gilead crossed this line. There is reaction not just from the pundits, but also the potential payees of the treatment. Though it may cost more over time, insurance companies do not want to pay the piper if they feel the benefit is not in balance with the cost.

Recommendation - what are the solutions and state the benefit of this course of action
Gilead did try the middle ground, but they aimed too high. The evidence should be reappraised and what should be examined is greater flexibility by the company. It is in drug pricing the gulf between costs to the company and price to the consumer are sometimes the most evident. Gilead has actually already shown flexibility on their pricing globally. The price for Sovaldi in some developing countries is as low as $900, such as in Egypt and India. Even in some countries that have comparable levels of development to the United States, the drug is sold at a discount to the sticker price. Gilead charges $55,000 in the UK. The difference is that there is less regulatory capture in the UK of policy makers (Unacceptable). These differences and flexibility are good in terms of being able to treat patients with a dreadful disease, but it only serves to highlight what subjectively feels like too high a price the United States. This is where Gilead should refigure all the data that they have received and make a new decision. At this point they could lower the pricing of Sovaldi even to the prices seen in the UK and they would benefit on two fronts. First, they would get credit for cutting their price almost in half - many outlets have rounded up to $100,000 for the treatment costs. Secondly, there would be greater access in terms of patients successfully treated for Hepatitis C.  The patient whose insurance company thrice rejected the treatment might be more open to paying for the treatment for patients who are only a little sick.






Working Bibliography: “Price Setting with Inelastic Demand: An Ethical Approach”

Kinicki and Fugate Organizational Behavior
World Bank http://data.worldbank.org/indicator/SH.XPD.TOTL.ZS?order=wbapi_data_value_2013+wbapi_data_value+wbapi_data_value-last&sort=desc
High prices for Drugs Criticized at Meetings; Joseph Walker June 1 2015 Wall Street Journal
Drug Shortages Plague U.S. Medical System. Peter Loftus. Wall Street Journal June 1, 2015
Speeding up Drug-Approval Process Could Have Downsides. May 29. Wall street Journal.
Appleby, J. (2014, May 2). New hepatitis C Drugs’ Price Prompts an Ethical Debate: Who
Deserves to Get Them? Washington Post. Retrieved from
Pollack, A. (2015, Feb 3). Sales of Sovaldi, New Gilead Hepatitis C Drug, Soar to $10.3 Billion.
The New York Times. Retrieved from http://www.nytimes.com/2015/02/04/business/sales-of-sovaldi-new-gilead-hepatitis-c-
Wilson, J. (2013, March 27). Viagra: The Little Blue Pill That Could. CNN. Retrieved from

Kinicki, A., & Fugate, M. (2012). Organizational Behavior: Key Concepts, Skills, and Best
         Practices (5th ed.). New York: McGraw-Hill Irwin