Price Elasticity of Demand in Pharma, an Introduction

When the price of medicines rises, does the amount demanded fall? And when the price falls, does the demand rise?

The law of supply and demand is arguably one of the most solid tenets of microeconomics. It states that, all other things being equal, when the price of goods increases, the market demand decreases, and when the price drops, demand rises.

Price elasticity of demand (PED) quantifies how price changes affect the number of goods sold.

This is the first post in a series of three about price elasticity:

1. Price Elasticity in Pharma: an Introduction
2. Calculating price elasticity and predicting demand, with examples from pharma
3. Demand Beyond a Medicine’s Price: Cross Elasticity of Demand

Price and demand

From a price elasticity standpoint, all goods are not created equal. Consider cars vs. patented medication, for example. Intuitively, we would probably agree that the demand for cars is more elastic (i.e., its demand varies more) as prices change, than is the case with patented drugs.

If the price of a given car rises, people will consider other models. If the price decreases, more people will be interested in buying that car. We say that the demand for cars is elastic.

On the other hand, if a person requires a life-saving patented medicine, they will need to buy it regardless of the price. Price adjustments will probably have a negligible effect on the demand. Accordingly, we say that the demand for life-saving patented drugs is inelastic.

By way of explanation, if a pharmaceutical company were to raise the unit price of an essential medication from $100 to $150 (a 50% increase) and demand decreased from 1,000 units to 950 units (a decrease of less than 5%) as a result, the medication would be considered an inelastic good. If the price increase had no impact at all on the quantity demanded, the drug would be regarded as perfectly inelastic.

Elastic or inelastic in healthcare?

Since the RAND health insurance experiment (1971-1982; see below) most healthcare services, including pharmaceuticals, are considered to be price inelastic, with price elasticities of demand (PED) close to -0.20. Being inelastic, the demand for healthcare services changes very little, regardless of whether prices rise or fall. Elastic prices, on the other hand, imply prices have a big effect on demand.

Nevertheless, in our daily work with the pharmaceutical industry, we find several instances in which drugs show a high level of price elasticity. For example, in the US market, a pharmaceutical company dropped the price of Adenosine 3 mg/ml in May-2020, from $ 42 to $39. This change brought about an increase of demand from 2,579 units to 4,833 units.

Healthcare price elasticity

The Health Insurance Experiment 

The Health Insurance Experiment (HIE) was a large-scale, randomized experiment conducted between 1971 and 1982. For the study, RAND recruited 2,750 families encompassing more than 7,700 individuals, all of whom were under the age of 65. Participants were randomly assigned to one of five different health insurance plans created specifically for the experiment. There were four basic types of fee-for-service plans: One type offered free care; the other three types involved varying levels of cost sharing — 25 percent, 50 percent, or 95 percent co-insurance (the percentage of medical charges that the consumer must pay).

The Rand experiment determined that healthcare price elasticity was -0.2 (relatively inelastic)

Figure 1. Participants with Cost Sharing Visited the Doctor Less Frequently. SOURCE: Newhouse and the Insurance Experiment Group, 1993, Tables 3.2 and 3.3. NOTE: Utilization numbers include both adults and children.

https://www.rand.org/pubs/research_briefs/RB9174.html

Health care demand elasticities by type of service

Data from an observational study using 171 million person-months from 2008–2014.

The study found high elasticities of demand for pharmaceuticals (−0.44), specialist visits (−0.32), MRIs (−0.29) and mental health/substance abuse (−0.26). Lower elasticities were found for prevention visits (−0.02) and emergency rooms (−0.04).

Ellis R.P., Martins B., Zhu W. Health care demand elasticities by type of service. J. Heal. Econ. 2017;55:232–243. doi: 10.1016/j.jhealeco.2017.07.007. [PMC free article] [PubMed] [CrossRef] [Google Scholar]

How does pharma use price elasticity?

• Price elasticity allows a company to predict the effect a change in price will have on total demand, revenue and margin.

• It provides a solid indicator of the existence of substitutes in a market. We will be presenting more examples of this in our third post regarding ‘Cross Elasticity of Demand’.

• It allows companies to charge different prices in different markets, if elasticities differ across income groups.

• Price elasticity also assists as a measure of a drug’s brand equity on the market, relative to the competition. Where a product’s demand is elastic, it is considered undifferentiated or weakly branded. In other words, it can easily be substituted with the next lowest priced alternative by customers.

This is the first post in a series of three about price elasticity:

1. Price Elasticity in Pharma: an Introduction
2. Calculating price elasticity and predicting demand, with examples from pharma
3. Demand Beyond a Medicine’s Price: Cross Elasticity of Demand

In the next post you can learn how to calculate price elasticity with real examples taken from the pharmaceutical industry. You can also see how to simulate a medicine’s future demand, according to variations in price, once the PED has been calculated.