Two Models of Pricing Drugs

For those of you keeping track, I’m feeling mostly back to normal after losing several days to drug side effects. I only took one day of the new medication, which means I’ll have to revisit the dilemma of whether/how to continue some form of risk-reducing endocrine therapy. But for now I’m relieved to be back to writing about drug pricing for my own amusement, if annoyed and frustrated that I continue to lose big chunks of time to bodily management.

Today’s post was motivated by the following paragraph [ungated], which set off all my “interesting problem!” bells when I read it a few weeks ago.

Pharmaceutical pricing is not a context I know much about. I do not know how accurate this is as an empirical description (were prices in the past really not set with regard to willingness to pay? has there indeed been a well-defined shift in practice?). But if it is basically correct, it looks like a fruitful place to think about some of my themes of persistent interest, while writing through the process.

I’m going to break this up into a couple of posts. First, I want to simply articulate—as a learner, not an expert—what these two models look like and why a shift from one to the other might matter. Second, I’d like to verify that pharmaceutical firms really did use cost-plus pricing in the past. Finally, I want to understand how these companies adopted value-based pricing, and how that fits into a larger movement in healthcare for value-based care.

(I suspect that last one may be a bunch of pieces. But certainly definitions are first.)

Cost-plus pricing, as described above, involves setting prices by adding a profit margin to the cost of production. This is common, as it is both relatively straightforward to come up with such costs, and seems reasonable to buyers as well.

From an economic perspective, it doesn’t make a lot of sense; prices should be set based on what buyers are willing to pay—that is, on the value they perceive in the product. Indeed, the economist author of “The Dynamics of Cost-Plus Pricing,” a 1992 article cited in the above excerpt, goes so far as to call cost-plus pricing “normatively suspect!”

As firms have become more economically sophisticated, and as the availability of data on consumer demand has increased, more industries have moved away from cost-plus pricing and toward value-based pricing. Airlines, for example, have become extremely good at setting prices based on what particular types of consumers are willing to pay for particular seats at particular moments in time, and companies like Amazon are able to change prices every second based on expectations about consumer behavior.

Nevertheless, cost-plus pricing remains widespread. The Harvard Business Review compares it to romance novels: “widely ridiculed yet tremendously popular.” Its straightforward nature makes it attractive not only when demand is difficult to estimate, but when sellers want to convey that prices are fair, or to limit competition with other sellers using the same strategy.

In many industries, we would not expect value-based prices to look wildly different from cost-plus prices. Perhaps one consumer is willing to pay 30% more for a shirt than another, and a value-based strategy can ensure that the second customer is offered a discount.

But prices for life-saving drugs are relatively inelastic. People are willing to pay huge amounts for a chance to cheat death, and they expect insurance companies to cover the costs of such drugs. Thus the gap between what a cost-plus price and a value-based price is potentially huge. This makes value-based pricing an attractive strategy for pharmaceutical manufacturers, who like the idea of being able to charge six figures for drugs that do extend and/or significantly improve the quality of life.

But at the same time, value-based pricing is widely embraced by those looking to reduce costs in the health care system. Here, the calculus is different. We know that many of the very expensive drugs prescribed for cancer, for example, don’t have a proportionate benefit—they may, on average, extend life by a couple of months. Yet if they show some benefit, they must be approved and covered, effectively regardless of price.

From this perspective, differentiating pricing between drugs that provide a great deal of benefit—curing a fatal disease, or greatly extending/improving life—and those that provide only marginal improvement seems like an excellent move. We could agree to pay only for the amount of value that drugs do, in fact, provide, and refuse to pay for those that do not provide sufficient benefit. Here, for example, is an extended brief from the Center for American Progress making the case.

Other countries do evaluate the value of drugs in this way and negotiate prices with insurers accordingly. And their costs are indeed lower—although U.S. prices are subsidizing what the rest of the world pays to some extent.

What is interesting here is that both drug companies and their nominal opponents both favor value-based pricing. Advocates outside drug companies think it is possible to price more rationally and reduce costs overall, or at least increase consumer welfare by shifting spending toward drugs that provide the most value. Drug companies, presumably, think that that value-based pricing will allow price increases for genuinely health-improving drugs that will outweigh any price limits placed on drugs that provide limited clinical benefit.

The question is, who is right? Would value-based pricing rein in spending and align it more closely with benefits provided? Or would it be a way to justify ever-higher prices for already existing drugs, without providing much compensating benefit? As someone who is constitutionally inclined to think that complex calculative systems are most likely to benefit the richest and/or most powerful actors in a space, my gut reaction is that it’s the latter. But I could be convinced otherwise, and that’s what I want to explore.

3 responses to “Two Models of Pricing Drugs”

  1. In case its useful – yes the premise is basically correct. For the longest time the social contract with pharmaceutical companies was that if you get it licensed we will be a price taker.

    Liked by 1 person

  2. I’ve always thought about the patient case for value-based pricing as being about providing appropriate incentives for innovation; there’s no way that it feasibly *lowers* prices. (to be very economist-y: in perfect competition, pricing basically *only* depends on marginal costs; any extent to which prices depend on consumer value mostly reflects market power)

    On the other hand, in a world with market power but also with many drug investment opportunities, you want to make sure that if you’re going to hand your rents over to someone, that it’s the monopolist who’s providing you with a bunch of surplus! That’s the case for “value-based pricing” for a consumer–after all, monopolists don’t tend to capture *all* of the surplus from innovation.

    But I agree that moving towards “value-based” opens floodgates that are likely to benefit pharma manufacturers, because “value” is not objectively defined and it’s not hard to find someone to argue that all pharma is valuable (e.g.


    1. I wouldn’t describe it as the patient case, because patients rarely if ever pay the majority of the cost of the drugs they consume. Pooling money via insurance or taxation to risk pool, it is society as a whole that pays for new pharmaceuticals and hence it should use value based pricing to signal what are society’s priorities for future pharmaceutical innovation. That ability to signal what we want is certainly the strongest argument for VBP IMHO.

      Liked by 1 person

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