Pharmaceutical drug pricing is all over the mainstream financial media right now. Let’s examine the macroeconomics of what is happening.
The demand for pharmaceutical drugs is inelastic. People that need a pharmaceutical drug prescribed by their doctor will demand that drug regardless of price. As the price of the drug goes up, demand mostly stays the same.
Notice how steep the demand curve is. This steep drop-off represents the inelastic demand for pharmaceutical drugs. The increase in supply from S to S1 leads to a relatively large decline in the price, but not much of an increase in quantity demanded.
Companies like Valeant Pharmaceuticals and former CEO Michael Pearson abused the inelasticity of demand for pharmaceutical drugs for maximum profit. If demand for pharmaceutical drugs is hardly influenced at all by price changes, then raise the price of the drug to a level that maximizes shareholder profits. Sure the supply curve may shift up a little from a drop in demand from people on the margin, but most of the public with their large health insurance providers will pay the higher price.
Pharmaceutical Drug Price Ceiling
Some are pushing for a pharmaceutical drug price ceiling. As you learned from the macroeconomic analysis of rent control, price ceilings do not work.
The horizontal brown line on the supply and demand graph below represents a drug price ceiling.
The lower price of the drug shifts the demand curve up a little to point b. However, suppliers will rapidly stop supplying the drug when they are forced to sell it below market price at point a. The difference between the quantity of the drug demanded and the quantity of the drug supplied is a drug shortage as represented by the red shaded area. People will die from a drug shortage when there are no readily available substitutes, and so the government should not attempt to use price ceilings.
Make Pharmaceutical Drug Demand More Elastic
The way to control runaway drug prices is to make the demand for pharmaceutical drugs more elastic. If people have choices and substitute drugs they can use, the steepness of the demand curve will be flattened and represent a more healthy free market as illustrated below.
Notice that the demand curve is flatter and not so steep.
How do you change the shape of the demand curve so that demand is more elastic? You make it legal for generic versions of drugs to come to market sooner. Gov. Charlie Baker is trying to do that by reducing the time it takes for the FDA to approve generic drugs.
Pharmaceutical drug makers have been fighting to preserve their inelastic demand pricing power by colluding to fix generic drug prices.
Folks, until all this drama gets worked out, I recommend staying away from pharmaceutical drug stocks.