Cross Elasticity of Demand in Pharma

Cross elasticity of demand (XED) calculates the change in the quantity demanded of a good when the price for another good changes.

In the previous post, we saw instances of high levels of elasticity in the pharmaceutical industry.

In the real world, however, the demand for a product is not only dependent on its own price, but also on the price of other “related” products.

To set prices, pharmaceutical companies need to measure the sensitivity of competing medicines to their products through detailed cross-elasticity analysis.

This is the third 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

The determinants of price: substitutes

The availability of substitute goods is probably the main factor determining the elasticity of demand for a pharmaceutical product.

The more products available, the higher the elasticity, as consumers can easily switch from one good to another. If no substitutes are available, the demand will be inelastic.

For example, as we saw in the previous post, Adenosine-3mg/ml-vial has 7 products competing as therapeutic equivalents in the US market. At least two of them show high ratios of price-elasticity.

If, instead of Adenosine, we had a newly patented medicine with no therapeutic equivalent, a 20 percent rise in price might not affect demand at all.

Other determinants of price elasticity

Percentage of income

If a product costs only a small proportion of a person’s income, it is likely to be price inelastic. The higher the percentage of the patient’s income that the drug’s price represents, the higher its elasticity.

Over-the-counter analgesics, such as Ibuprofen, are usually not very expensive. If its price increases by 15 percent, the level of demand is only likely to fall moderately because the price represents a small fraction of the patient’s average income.

Necessity

 Essential medicines are necessities. Their demand is likely to be price inelastic because consumers cannot live without them.

Duration

 The longer a price holds, the higher the elasticity, as it allows more time for buyers to find substitutes.

Brand loyalty

 An attachment to a specific brand can override sensitivity to price changes, resulting in a more inelastic demand.

Who pays?

 If the patient does not pay for the drug directly, demand is likely to be more inelastic.

Cross-elasticity. Real example US market: Adenosine 10 mg/ml

PED is not always enough to explain changes in the demand across a group of therapeutic equivalents. This is evident for Adenosine-10 mg/ml, between June and July 2021. In this case study, the group of therapeutic  equivalents is made up of 5 products. Only three of them have a market share bigger than 5%. We call the manufacturers here COMPANY-C, COMPANY-D and COMPANY-E.

From June20 to July20 COMPANY-D dropped their price from $6.36 to $4.90. Company-D experienced a surge in demand, that took it from 7,580 units in June-20 to 12,834 units in July-20.

The other two competitors maintained their prices.

The dramatic discount imposed by COMPANY-D affected the demand of COMPANY-C: lowering it from 6,500 units to 2,229. There is a great degree of cross-elasticity between the presentations of COMPANY-D and COMPANY-C

Contrarily, the discount imposed by COMPANY-D left COMPANY-E’s demand untouched. This makes COMPANY-E almost completely inelastic

The formula for cross-elasticity of demand

Cross-elasticity of Adenosine-3mg/ml

When we apply the formula above to the Adenosine-10 mg produced by companies C and D, we measure the sensitivity of quantity demanded from Company C to the change in price offered by Company-D.

The higher the positive XED, the  easier it is to substitute the products  for one another and the bigger the competition between the products.

Interpretation of results

Given the different behaviors of price and demand within a single group of therapeutic equivalents, pharmaceutical companies need to measure and analyze the cross-elasticity of their products and those of competing manufacturers when setting the prices for their products.

This is the third 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