The pharmaceutical industry in the USA is not influenced by strict regulations and pricing policies. The Food and Drug administration controls pharmaceutical products thus it does not influence pricing and costs. In the pharmaceutical industry, the most significant supply-related factor influencing the prices charged for an item is the economic structure of an industry.
In this context, the structure is defined in terms of the number of competing firms within the industry, the power of individual firms to influence market prices, the barriers to market entry, and the extent of product differentiation. The two most prevalent forms of industry structure are oligopoly and monopolistic competition. In addition, because of the tremendous amount of change occurring in today’s business environment, some new hybrid structures are emerging.
The market structure in the US pharmaceutical industry is characterized as a monopoly. It represents an industry in which relatively few competitors hold a disproportionate share of the market. Fewness is the dominant characteristic; four or five companies may account for 80 to 90 percent of a given market (Petersen 81). Each has some influence on overall market prices, the barriers to entry are high, and products can be standardized or differentiated. The oil and airline industries in the United States are examples of fairly undifferentiated oligopolies, while automobiles and computers represent fairly differentiated oligopolies (Petersen 82). Differentiation is in the mind of the customer.
The economic concentration found in these industries has a major impact on the pricing practices of firms (Greider 44). Where markets are oligopolistic, the strategies pursued by companies are heavily interdependent. That is, whatever one firm does with its prices is dependent upon what the other firms do, and its pricing actions also affect the decisions of those firms. Further, since a relatively small number of competitors controls most of the market, competitors focus much effort toward capturing market share. The main pharmaceutical companies in the USA are Jonson and Jonson, Pfizer, Merck and Co., Abbott Laboratories, Amgen, etc.
The uniqueness of the pharmaceutical industry in the USA is that the country has no regulations on drug pricing. The pharmaceutical industry has differentiated market structures which means that those companies in which the customer base is fairly homogeneous but several sellers with specialized technologies are present (Petersen 89). Each offers fairly proprietary and unique products or services to this common market using very similar marketing programs.
In the US pharmaceutical industry, each competitor offers unique and proprietary drugs to the general hospital and physician market using very similar marketing programs. Deregulation is the topic of the day. Although economists and many members of Congress are quick to point out the huge costs and distortions resulting from existing regulations and their agencies, few actually mean, by deregulation, the outright abolition of the agencies in question. Except for the Airline Deregulation Act of 1978, not one of the proposed deregulation bills of the Ninety-sixth or Ninety-seventh Congress proposed the complete elimination of a part of the federal regulatory apparatus (Greider 49).
The category of price-related actions that raise legal or regulatory concerns falls under the heading of deceptive practices. A mainstay in the area of product advertising is the use of price promotions. Under the regulations of the Fair Packaging and Labeling Act (1982), sellers must be careful to truthfully represent the various aspects of their price promotions. For example, price surveys that favorably compare a seller’s prices to those of competitors must accurately detail the actual product prices compared.
The seller may not use such surveys to create the inference that the survey applies to his entire, storewide range of products. When using cents-off price labeling (to imply the product is “on-sale”), the Federal Trade Commission has specified that
- the product must have been sold at the regular price recently,
- the price reduction must be genuine,
- the regular price must be prominently displayed on the shelf or on the package,
- the frequency of the promotion must not exceed three months in a twelve-month period, and
- sales must not exceed more than fifty percent of the year’s volume (Greider 84).
Further, “introductory offers” must involve products that are in fact new to the market. Such offers cannot exceed six months in duration, and the seller must intend to price the product at a more customary price for an ongoing period after the introduction. Also, if a product is advertised under an economy package label, the product must be available in at least one other size, the savings must be confined to that package size, and they must represent a real savings of at least 5 percent relative to other same-brand packages. In general, price savings must be real. They must involve a savings relative to the standard price or, if already discounted, the most recent price at which the product has been sold.
Under such circumstances, the prices charged by the monopolistic competitor are likely to change as conditions change. For instance, when the company first develops its unique product offering, it is in virtually a monopoly position. As a result, higher margins can be charged. When competitors enter and claim their own shares of the profit opportunity, prices are typically driven down. Special price deals, promotions, or rebates may be offered, and the general level of price is reduced.
Unlike oligopoly, however, there is little opportunity for cooperative pricing behavior. A large number of current and potential competitors make this unrealistic. The effective competitor will recognize the very dynamic nature of monopolistic competition. Pricing decisions will be made with an eye toward the long term. The goal should be to set a price that takes advantage of the significant demand for the firm’s innovative product offering but that also helps to build a loyal customer following before the competition makes inroads. Once customer loyalties are well established, competitors have a much more difficult time achieving successful differentiation (Greider 67).
Company-specific factors include an image, technological prowess, cost structure, product differentiation, and established loyalties. Companies find their competitive position is enhanced when they have a well-established and clearly defined corporate image, are an industry leader in terms of developing and applying technology, or have a cost advantage over competitors. Similarly, competitive positions are weakened where different firms are unable to differentiate their respective products from one another, and where they have failed to establish and maintain loyal relationships with key suppliers, distributors, and buyers (Petersen 86).
Like prescription (or “ethical”) drugs, pharmaceutical products reach the end-user in several different ways. The pharmaceutical manufacturer typically has an employee sales force (but may also use contract salespeople who are not employees) that calls on physicians, hospitals, distributors, and insurance companies (Schweitzer 33). Most health insurance companies have formularies, lists of approved drugs that may be prescribed for particular conditions, and sales effort is used to convince them to put a company’s new drugs on the list (or keep existing ones on it). The ethical drugs themselves may pass through the hands of independent distributors on their way to a retail pharmacy or a hospital pharmacy.
Even the physician plays a role, in actually prescribing the pharmaceutical that the patient will use. In cases where the patient’s health care coverage includes prescription drug coverage, payment may flow not from the patient directly to the pharmacy, but from the insurance company to the pharmacy. Thus, the main problem is that: “groundbreaking advances in technology have led to unprecedented pharmaceutical discoveries. Yet a major concern is that regulations by the FDA will generate low returns to investments in R&D” (Ramrattan and Stenberg 65).
The pricing behavior pursued by anyone firm is constrained by its relative industry and market position. Competitive position is defined by a variety of factors, some of which are external to the firm and some of which are company-specific. These factors were identified, with an emphasis on how companies can enhance their competitive position and, correspondingly, their pricing leverage (Schweitzer 87). Pricing decisions must also consider the positions of competitors and their likely response to pricing initiatives (Greider 49). The competitive environment will only intensify in the years to come. The competition will come from completely unanticipated sources.
At the same time, product differentiation will become increasingly difficult unless firms can produce a continuous flow of innovations. As a result, the price variable will receive renewed emphasis as a competitive weapon. New, creative approaches to setting and changing prices will prevail (Schweitzer 60). Pricing managers will be forced to do more than react to the pricing actions of other firms. They must develop the insight necessary to anticipate and preempt the moves of competitors. Following Ramrattan and Szenberg: “pricing strategies are complicated by the fact that a firm can transfer or license encoded experience to other firms (Levitt and March 1990, 24).
The tendency has been for firms in developed countries to press their government for strengthened patents regulation in foreign, particularly less developed, countries. Domestic manufactures claim that they can sell abroad at higher price” (68).
The most important tool for achieving such coordination is the price variable. Prices delineate where products are positioned with respect to one another. They reinforce the relationships among products that management wishes to communicate to customers. If improperly designed, the product line pricing structure can send mixed messages to customers, items can receive an inappropriate amount of emphasis, and profits can be lost (Schweitzer 83).
Price levels may require frequent modification in response to changes in production costs, competitor tactics, and evolving market conditions. For instance, costs of a key raw material may increase, a leading competitor may unexpectedly lower prices on a selective basis, supply conditions may change because a competitor has overproduced, or demand sensitivity (elasticity) may change within the current price range (Greider 00).
Beyond objectives, the pricing strategy of other firms is a source of insight. A competitor pursuing a premium price strategy is not in a strong position to match price cuts and needs to compensate for any price increases so as to maintain a premium differential (Schweitzer 33). Related to strategy is the question of target markets. If competitors are emphasizing target markets different from those of the firm, then they will be less concerned with attacking or retaliating to the firm’s pricing moves.
The second area of focus concerns the operating characteristics of competitors. Four of the most important characteristics are costs, product lines, production capacity, and financial resources. The extent to which a competitor is operating at an advantage or disadvantage either in production costs or in the amount of overhead that must be covered is directly related to its price responsiveness. Firms operating on a full-costing basis may be especially vulnerable in this regard (Kraus 527).
Product line considerations have to do with the depth and breadth of a competitor’s offerings. Given that the price of anyone product must complement the other items in that product line, competitors may be less able to respond to pricing actions directed at that one product. Otherwise, the competitor would be creating inconsistencies and undermining product line strategy. Pricing behavior is also driven by a competitor’s available production capacity. The closer a firm is to 100 percent capacity utilization, the less concerned it will be with meeting any price reductions. However, the incentive to initiate or match price increases is strong among such firms (Kraus 527).
Similar to production capacity is the question of financial capacity. Competitors that are strapped in terms of financial resources are more apt to price for short-run profitability. They will be hesitant to risk revenues on price cuts, fearing lost margins will not be compensated by increased volume. Yet, they may tend to hold the line when other firms raise prices, in an attempt to capture sales from competitors.
In spite of high R&D costs and huge investments, many critics claim that the pharmaceutical industry sets too high prices and limits some categories of citizens to access (buy) drugs. Ethical concerns involve the following question: Should a pharmaceutical company charge an elderly person a higher price for a particular drug than is charged all other age groups, assuming the elderly person has a greater need for the drug? (Schweitzer 132).
Many people would find such a practice distasteful, if not unconscionable. And yet free enterprise economies operate most efficiently when customers compete amongst themselves for goods and pay prices that reflect their willingness and ability to buy. Prices ultimately determine how the resources of society will be allocated (Kraus 528). As a result, pricing practices that are perfectly legal often raise complex ethical questions for the concerned manager. Unethical actions are those that appear to be inconsistent with what one feels to be right. Unfortunately, there tends to be little agreement among those in the business community as to just what is and what is not beyond the pale when determining pricing policy.
What agreement exists seems to be confined to below-cost predatory pricing practices, price-fixing, and exploiting buyers who are in a particularly vulnerable position. There are a large number of competitors for a particular product category, but firms are able to successfully differentiate their products from one another. Each firm establishes price relatively independently of the others without concern for retaliatory action from competitors. Specifically, each establishes a price to reflect its own differentiated product offering. monopolistically competitive industries have fairly low barriers to entry (Greider 44).
The major area of pricing in the pharmaceutical industry involves competitor flexibility in the pricing area. A major issue in this regard concerns how quickly competitors can react to the firm’s pricing moves. Competitors with more bureaucratic structures and those in which pricing authority is either not clearly assigned or is maintained at the senior levels of the organizations tend to be slow to respond. Flexibility may also be hindered if price changes were made possible by changes in production techniques that will take competing firms time to adopt. An additional limitation on competitor price flexibility is the existing commitments to customer groups, suppliers, and production schedules for various products (Schweitzer 12).
Such commitments constrain firms in terms of what they are producing, how much, when, and for what price. Price changes can undermine the ability to fulfill those commitments. The final set of competitor considerations include the situational factors that cause firms to engage in specific pricing actions, usually on a short-term basis. Some of these are predictable (e.g., seasonal sales patterns) while others are not (e.g., obsolete inventory) (Kraus 529).
Predictable situational factors tend to produce consistent competitor behaviors over time, which can sometimes be capitalized upon. Alternatively, nontypical situational factors can be much more threatening, since competitors may be more experimental with prices under these circumstances. Thus, critics admit that “The pharmaceutical innovators have two principal instruments, price, and sales-promotion outlay, for maximizing the value of their innovations, both during the period of exclusive marketing and in the post-entry game” (Caves et al., 1991, 5 cited Ramrattan and Stenberg 70).
The uncertainty that surrounds businesses today also affects ongoing negotiations. Rapid changes in technology, the economy, production costs, competition, government regulation, and market size are increasingly commonplace. In fact, the only constant in modern business would seem to change. Such turmoil can alter the fundamental relationship between a seller and buyer in a very short amount of time (Kraus 529).
The seller who takes too much advantage of his or her organization’s negotiating position today will most likely pay for such shortsightedness in the not-too-distant future. The modern business environment is increasingly one in which buyer-seller relationships are less adversarial, and terms such as “cooperative marketing” or “partnership marketing” have become popular. In addition, extreme turbulence in the competitive environment is continuously affecting the relative bargaining positions of buyers and sellers in many markets. These developments suggest that negotiations be pursued with an eye toward both the present and future needs of the parties (Schweitzer 112).
In sum, pricing strategies followed by the US pharmaceutical industry are caused by unregulated market conditions and the monopolistic position of the industry. Costs spent on R&D represent one of the key considerations in establishing and managing prices. There is a need to move away from simplistic cost-plus or target return formulas and their underlying full costing philosophy. Instead, firms should adopt a contribution approach when examining costs for pricing decisions.
Products and services should be held directly accountable only for those costs related to their production, sale, and distribution. In spite of positive changes and innovations in the pharmaceutical industry, it deprives many citizens chance to buy drugs because of the too high prices established by the company.
- Greider, K. The Big Fix: How the Pharmaceutical Industry Rips Off American Consumers. Public Affairs; 1 edition, 2003.
- Kraus, L. Medication Misadventures: The Interaction of International Reference Pricing and Parallel Trade in the Pharmaceutical Industry. Vanderbilt Journal of Transnational Law, 37. 2004: 5270529.
- Petersen, M. Our Daily Meds. Farrar, Straus and Giroux; 1 edition, 2008.
- Ramrattan, L, Szenberg, M. Global Competition and the United States Pharmaceutical Industry. American Economist, 50. 2006: 65-75.
- Schweitzer, S.D. Pharmaceutical Economics and Policy. Oxford University Press Inc, USA; 2Rev Ed edition, 2006.