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Public Policy and Pricing

Price competition is a core element of our free-market economy. In setting prices, companies usually are not free to charge whatever prices they wish. Many federal, state, and even local laws govern the rules of fair play in pricing. In addition, companies must consider broader societal pricing concerns. In setting their prices, for example, pharmaceutical firms must balance their development costs and profit objectives against the sometimes life-and-death needs of prescription drug consumers (see Real Marketing 11.2)

Real Marketing 11.2 Pharmaceutical Pricing: No Easy Answers

The U.S. pharmaceutical industry has historically been one of the nation’s most profitable industries. Over the past five years, returns for the S&P Pharmaceuticals Select Industry Index have doubled those of the broader S&P 500. In most situations, we’d applaud such high-performing companies and industries. However, when it comes to pharmaceutical firms, critics claim, healthy sales and profits may not be so healthy for consumers.

Somehow, learning that major pharmaceutical companies such as Johnson & Johnson, Novartis, Roche, Pfizer, Merck, and GlaxoSmithKline are reaping big profits leaves a bad taste in the mouths of many consumers. It’s like learning that the oil companies are profiting when gas prices rocket upward. Although most consumers appreciate the steady stream of beneficial drugs produced by pharmaceutical companies, they worry that the industry’s huge success may be coming at their own expense—literally.

Americans spent about $374 billion last year on prescription medications, more than a third of all worldwide spending. Prescription prices have risen rapidly over the years, and health-care costs continue to jump. An AARP study found that the average retail price of a market basket of brand-name drugs widely used by older Americans climbed almost 13 percent higher in 2013 alone, more than eight times the general inflation rate.

The critics claim that competitive forces don’t operate well in the pharmaceuticals market, allowing the pharmaceutical companies to charge excessive prices. Unlike purchases of other consumer products, drug purchases cannot be postponed. And consumers don’t usually shop for the best deals on medicines—they simply take what the doctor orders. Because physicians who write the prescriptions don’t pay for the medicines they recommend, they have little incentive to be price conscious. Moreover, third-party payers— insurance companies, health plans, and government programs—often pay all or part of the bill. Finally, because of patent protection and the huge investment and time needed to develop and test new drugs, there are fewer competing brands to force lower prices.

The critics claim that these market factors leave pharmaceutical companies free to practice monopoly pricing, sometimes resulting in unfair practices or even seemingly outlandish cases of price gouging. One such case made headlines recently when entrepreneur Martin Shkreli and his company Turing Pharmaceuticals acquired Daraprim, a 62-year-old, lifesaving medication used by AIDS patients. Turing immediately jacked up the price of Daraprim from $13.50 per pill to an astounding $750 per pill, a more than 5,000 percent increase. The pill itself costs only about a dollar to produce.

Major drug companies would never commit such atrocities. “He is not us,” said Merck’s CEO of Turing’s Shkreli. Nevertheless, mainstream pharmaceutical makers routinely boost the prices of their cancer, diabetes, MS, and cholesterol-reducing drugs by 10 percent or more per year, much faster than inflation. One study found that the prices for four of the nation’s top 10 prescription drugs rose more than 100 percent during the past five years; six others went up more than 50 percent. As just one example, take Gleevec, a drug sold by Novartis to treat blood-based cancer. Gleevec seemed pretty expensive when it first came to market in 2001 at about $30,000 for a year’s supply. Yet, for reasons unknown, Novartis has since more than tripled Gleevec’s price, leading one industry economist to remark that she could find no economic theory to explain how pharmaceutical companies set or raise their drug prices.

To add insult to injury, the critics say, drug companies pour more than $4.5 billion a year into direct-to-consumer advertising and spend another $24 billion on marketing to physicians. These marketing efforts dictate higher prices at the same time that they build demand for more expensive remedies. Thus, the severest critics say, the big drug companies may be profiting unfairly—or even at the expense of human life—by promoting and pricing products beyond the reach of many people who need them.

The high prices of everyday prescription drugs may be concerning enough. But the costs of some lifesaving specialty medications are outright alarming. According to one cancer doctor at the Mayo Clinic, “The average gross household income in the United States is about $52,000 per year. For an insured patient with cancer who needs a drug that costs $120,000 per year, the out-of-pocket expenses could be as much as $25,000 to $30,000—more than half their average household income.” One recent study found that cancer drug prices have gone up an average of $8,500 annually for the past 15 years. The price of one recently developed combination cancer therapy is an astonishing $295,000 per year.

Responsible pharmaceutical pricing: Most consumers understand that they’ll have to pay the price for beneficial drugs. They just want to be treated fairly in the process.

Bill/Adobe Stock

But there’s another side to the drug-pricing issue. Industry proponents point out that, over the years, the drug companies have developed a steady stream of medicines that transform people’s lives. Developing such new drugs is risky and expensive, involving legions of scientists, expensive technology, and years of effort with no certainty of success. The top 10 pharmaceutical companies combined last year to spend more than $70 billion on R&D, more than 15 percent of sales. On average, it takes 12 to 15 years and costs $1.3 billion to bring a new drug to market. Then 70 percent of new drugs never generate enough revenue to recover the cost of development. Thus, the proponents say, although the prices of new prescription drugs seem high, they’re needed to fund the development of important future drugs. As one old ad from pharmaceutical firm GlaxoSmithKline (GSK) concluded: “Inventing new medicines isn’t easy, but it’s worth it. . . . Today’s medicines finance tomorrow’s miracles.”

And so the controversy continues. As drug prices climb, the pharmaceutical companies face pressures from the federal government, insurance companies, managed-care providers, and consumer advocacy groups to exercise restraint in setting prices. However, rather than waiting for tougher legislation on prices—or simply because it’s the right thing to do—many of the drug companies are taking action on their own. For example, some companies have committed to keeping their average price hikes at or below inflation. Others employ tiered pricing—selling their medicines in different countries at varying prices based on ability to pay in each country. Most pharmaceutical companies now sponsor patient assistance programs that provide prescription medicines free or at low cost to people who cannot afford them, and they regularly donate free medicines in response to disaster relief efforts around the globe.

In all, pharmaceutical pricing is no easy issue. For the pharmaceutical companies, it’s more than a matter of sales and profits. In setting prices, short-term financial goals must be tempered by broader societal considerations. For example, GSK’s heartfelt mission is “to improve the quality of human life by enabling people to do more, feel better, and live longer.” Accomplishing this mission won’t come cheap. Most consumers understand that. One way or another, they know, they’ll have to pay the price. All they really ask is that they be treated fairly in the process.

Sources: Peter Jaret, “Prices Spike for Some Generic Drugs,” AARP, July/August 2015, www.aarp.org/health/drugs-supplements/info-2015/prices-spike-for-generic-drugs.html#slide1; “U.S. Oncologists Decry High Cost of Cancer Drugs,” Health Day, July 23, 2015, http://consumer.healthday.com/cancer-information-5/mis-cancer-news-102/u-s-oncologists-speak-out-on-high-cost-of-cancer-drugs-701616.html; “Crippling,” The Economist, June 4, 2015, www.economist.com/blogs/democracyinamerica/2015/06/pharmaceutical-pricing; Alexandra Sifferlin, “Americans Spent a Record Amount on Medicine in 2014,” Time, http://time.com/3819889/medicine-spending/; John Graham, “Crisis in Pharma R&D,” Forbes, November 26, 2014, www.forbes.com/sites/theapothecary/2014/11/26/crisis-in-pharma-rd-it-costs-2-6-billion-to-develop-a-new-medicine-2-5-times-more-than-in-2003/print/; Rafi Mohammed, “It’s Time to Rein In Exorbitant Pharmaceutical Prices,” Harvard Business Review, September 22, 2015, https://hbr.org/2015/09/its-time-to-rein-in-exorbitant-pharmaceutical-prices; Benjamin Siegel and Mary Bruce, “Former Pharma Big Martin Shkreli Boasted ‘$1 Bn Here We Come,’ Documents Say,” February 2, 2016, http://abcnews.go.com/Politics/pharma-big-martin-shkreli-boasted-bn-documents/story?id=36671216; Carolina Humer, “Exclusive: Makers Took Big Price Increases on Widely Used U.S. Drugs,” Reuters, April 5, 2016, http://finance.yahoo.com/news/makers-took-big-price-increases-widely-used-u-141253765–finance.html; and “Our Mission and Strategy,” www.gsk.com/en-gb/about-us/our-mission-and-strategy/, accessed October 2016.

The most important pieces of legislation affecting pricing are the Sherman Act, the Clayton Act, and the Robinson-Patman Act, initially adopted to curb the formation of monopolies and regulate business practices that might unfairly restrain trade. Because these federal statutes can be applied only to interstate commerce, some states have adopted similar provisions for companies that operate locally.

Figure 11.2 shows the major public policy issues in pricing. These include potentially damaging pricing practices within a given level of the channel (price-fixing and predatory pricing) and across levels of the channel (retail price maintenance, discriminatory pricing, and deceptive pricing).19

Chart explains public policy issues in pricing. — Source: Adapted from Dhruv Grewal and Larry D. Compeau, “Pricing and Public Policy: A Research Agenda and Overview of the Special Issue,” Journal of Public Policy and Marketing, Spring 1999, pp. 3–10.

Figure 11.2 Full Alternative Text

Pricing within Channel Levels

Federal legislation on price-fixing states that sellers must set prices without talking to competitors. Otherwise, price collusion is suspected. Price-fixing is illegal per se—that is, the government does not accept any excuses for price-fixing. Recently, governments at the state and national levels have been aggressively enforcing price-fixing regulations in industries ranging from gasoline, insurance, and concrete to credit cards, computer chips, and e-books. Companies found guilty of price-fixing practices can pay heavy penalties. For example, Apple recently paid $450 million in fines for conspiring with publishers to fix prices on e-books. And four major U.S. airlines—United, Delta, Southwest, and American—now face a potentially costly class action suit and U.S. Department of Justice investigation for conspiring to artificially inflate air fares to “reap huge profits.”20

Sellers are also prohibited from using predatory pricing—selling below cost with the intention of punishing a competitor or gaining higher long-run profits by putting competitors out of business. This protects small sellers from larger ones that might sell items below cost temporarily or in a specific locale to drive them out of business. The biggest problem is determining just what constitutes predatory pricing behavior. Selling below cost to unload excess inventory is not considered predatory; selling below cost to drive out competitors is. Thus, a given action may or may not be predatory depending on intent, and intent can be very difficult to determine or prove.

In recent years, several large and powerful companies have been accused of predatory pricing. However, turning an accusation into a lawsuit can be difficult. For example, many publishers and booksellers have expressed concerns about Amazon.com’s predatory practices, especially its book pricing:21

A photo shows a Kindle with colorful books on its screen placed over a pile of books. — Predatory pricing: Some industry critics have accused Amazon.com of pricing books at fire-sale prices that harm competing booksellers. But is it predatory pricing or just plain good competitive marketing?

© Iain Masterton/Alamy Stock Photo

Many booksellers and publishers complain that Amazon’s book pricing policies are destroying their industry. Amazon routinely sells best-selling hardback books as loss leaders at cut-rate prices. And it peddles e-books at fire-sale prices in order to win customers for its Kindle e-reader and tablets. Such very low book prices have caused considerable damage to competing booksellers, many of whom view Amazon’s pricing actions as predatory. According to some industry groups, such practices “harm the interests of America’s readers, impoverish the book industry as a whole, and impede the free flow of ideas in our society.” Still, no predatory pricing charges have ever been filed against Amazon. It would be extremely difficult to prove that such loss-leader pricing is purposefully predatory as opposed to just plain good competitive marketing. “But wait a minute,” states one analyst. “Isn’t that what business is supposed to do—compete to lower prices?”

Pricing across Channel Levels

The Robinson-Patman Act seeks to prevent unfair price discrimination by ensuring that sellers offer the same price terms to customers at a given level of trade. For example, every retailer is entitled to the same price terms from a given manufacturer, whether the retailer is REI or a local bicycle shop. However, price discrimination is allowed if the seller can prove that its costs are different when selling to different retailers—for example, that it costs less per unit to sell a large volume of bicycles to REI than to sell a few bicycles to the local dealer.

The seller can also discriminate in its pricing if the seller manufactures different qualities of the same product for different retailers. The seller has to prove that these differences are proportional. Price differentials may also be used to “match competition” in “good faith,” provided the price discrimination is temporary, localized, and defensive rather than offensive.

Laws also prohibit retail (or resale) price maintenance—a manufacturer cannot require dealers to charge a specified retail price for its product. Although the seller can propose a manufacturer’s suggested retail price to dealers, it cannot refuse to sell to a dealer that takes independent pricing action, nor can it punish the dealer by shipping late or denying advertising allowances. For example, the Florida attorney general’s office investigated Nike for allegedly fixing the retail price of its shoes and clothing. It was concerned that Nike might be withholding items from retailers who were not selling its most expensive shoes at prices the company considered suitable.

Deceptive pricing occurs when a seller states prices or price savings that mislead consumers or are not actually available to consumers. This might involve bogus reference or comparison prices, as when a retailer sets artificially high “regular” prices and then announces “sale” prices close to its previous everyday prices. For example, luxury apparel and accessories retailer Michael Kors recently settled a class action lawsuit alleging that it used deceptive pricing at its outlet stores. The retailer was charged with tagging products with false “manufacturer’s suggested retail prices” to make its supposed discounted prices more appealing when, in fact, the products were sold only in the outlet stores. Such artificial comparison pricing is widespread in retailing.22

Although comparison pricing claims are legal if they are truthful, the Federal Trade Commission’s “Guides against Deceptive Pricing” warn sellers not to advertise (1) a price reduction unless it is a savings from the usual retail price, (2) “factory” or “wholesale” prices unless such prices are what they are claimed to be, and (3) comparable value prices on imperfect goods.23

Other deceptive pricing issues include scanner fraud and price confusion. The widespread use of scanner-based computer checkouts has led to increasing complaints of retailers overcharging their customers. Most of these overcharges result from poor management, such as a failure to enter current or sale prices into the system. Other cases, however, involve intentional overcharges.

Many federal and state statutes regulate against deceptive pricing practices. For example, the Automobile Information Disclosure Act requires automakers to attach a statement on new vehicle windows stating the manufacturer’s suggested retail price, the prices of optional equipment, and the dealer’s transportation charges. However, reputable sellers go beyond what is required by law. Treating customers fairly and making certain that they fully understand prices and pricing terms are an important part of building strong and lasting customer relationships.

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