Stanford University Graduate School of Business
Contact: Catherine Castillo; [email protected]
PRICE REFORMERS TRAPPED IN THEIR OWN POLICY
In diplomatic circles, the concept of Most Favored Nation is a useful tool
that assigns lower tariffs to preferred trading partners. The idea has not
been lost on the business world, where corporations frequently write Most
Favored Customer clauses into contracts with their largest customers,
guaranteeing them the lowest price in markets where prices vary. In recent
years, the government has tried to capitalize on the idea, too - with
questionable results. In the case of Medicaid, says a Stanford researcher,
it was clearly a bad idea.
In 1990, the federal government included a Most Favored Customer (MFC)
clause in its Medicaid contracts for the first time. It required drug
companies to give Medicaid the same deep discounts they were giving other
big buyers. Legislators hoped it would lower government costs and give poor
people on Medicaid access to the best brand-name drugs available.
It sounded good, but there was an unforeseen problem. Many drug companies
merely raised prices that their other large customers had to pay, thereby
raising the benchmark that determined the discounts. Looking at it from a
purely business point of view, pharmaceutical lobbyists argued that it had
been logical for companies to reexamine and perhaps increase their prices.
After all, Medicaid, which accounts for at least 10 percent of industry
revenues, suddenly got the lowest price given to any customer in the
country.
Indeed, drug companies increased prices to other buyers, such as the
Department of Veterans Affairs, prepaid health plans like Kaiser
Permanente, hospitals, and community health centers for homeless people.
One director of a Texas association of medical clinics told the New York
Times that within weeks of the passage of the Medicaid law, several drug
companies began trying to renegotiate the price contracts for his
organization, which buys drugs for 31 clinics. Health care experts
speculated that the added costs might soon trickle down to consumers in the
form of higher medical costs and insurance premiums. Senator David Pryor,
chairman of the Special Committee on Aging and sponsor of the rule change,
said the drug companies appeared to be attempting to nullify the savings
Congress sought to achieve.
Assistant Professor of Strategic Management Fiona Scott Morton took a
detailed look at the problem. Using data from before and after the policy
change, she discovered evidence that some prices rose at the time the new
law took effect - those prices that were consistent with economic theory
of incentives in the law. Scott Morton found that the average price of
drugs on patent did not respond to the legislation, but companies with
brand products facing generic competition raised average prices about 4
percent after the MFC rule came into being. That started a chain reaction
in prices. Generic drug producers in markets without much competition
responded to the price increases of competing brands by raising their
prices, too.
The price increases varied with the specific characteristics of the
particular drug, such as whether its patent had expired or not, whether
there was generic competition, whether it was sold through a drugstore or
hospital channel, and whether a large percentage of the market was sold to
Medicaid. The average price of all drugs did not increase measurably.
However, in concentrated markets with just a few producers there were
significant price increases, especially where customers, such as drugstores
and hospitals, bought large package sizes and had high sales to Medicaid.
When drug companies charged drugstores more for their pills, for example,
the stores passed on the higher costs to all their consumers. "The results
suggest that the MFC rule resulted in higher prices to non-Medicaid
consumers who had previously enjoyed substantial discounts," says Scott
Morton.
Although the federal and state governments saved $1.8 billion in 1994,
expenditures made by other federal agencies, such as the Veterans
Administration, increased because of the rising prices and partially offset
the other savings. Economists have long known that in theory MFCs lead to
higher equilibrium prices. This case provides evidence of the effect.
Concludes Scott Morton: Results like these show the consequences of failing
to understand the strategic aspects of pricing. In this case, an attempt to
cut costs resulted in higher drug bills for consumers and volume buyers.
"The Strategic Response by Pharmaceutical Firms to the Medicaid Most
Favored Customer Rules," by Fiona M. Scott Morton (GSB Research Paper
#1390, June 1996)
Written by Barbara Buell. For more information contact: Janet Zich at
415.723-9193 or [email protected].
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