Regulation and pricing of pharmaceuticals: Reference pricing or price cap regulation?

Abstract

We study the relationship between regulatory regimes and pharmaceutical firms’ pricing strategies using a unique policy experiment in Norway, which in 2003 introduced a reference price (RP) system called “index pricing” for a sub-sample of off-patent pharmaceuticals, replacing the existing price cap (PC) regulation. We estimate the effect of the reform using a product level panel dataset, covering the drugs exposed to RP and a large number of drugs still under PC regulation in the time before and after the policy change. Our results show that RP significantly reduces both brand-name and generic prices within the reference group, with the effect being stronger for brand-names. We also identify a negative cross-price effect on therapeutic substitutes not included in the RP system. In terms of policy implications, the results suggest that RP is more effective than PC regulation in lowering drug prices, while the cross-price effect raises a concern about patent protection.

Introduction

Pharmaceutical markets are characterised by price inelastic demand, mainly due to extensive medical insurance and supply-side market power associated with the patent system that protects new chemical entities from being copied within a given period.¹ This combination has lead most countries to exert various means to control the growth in medical expenditures.² Two of the most commonly used price control mechanisms in pharmaceutical markets are price cap (PC) regulation and reference pricing. While the two systems share the same purpose, namely to contain (the growth in) medical expenditures, they differ substantially in nature. Price cap regulation limits the pharmaceutical firms’ ability to exploit market power by charging high prices. Reference pricing, on the other hand, aims to stimulate competition by making demand for pharmaceuticals more price elastic. The link between regulatory regimes and pharmaceutical firms’ pricing strategies has received surprisingly little attention in the literature. The main purpose of this paper is to fill this gap.³

We exploit a unique policy experiment in Norway to assess the relative performance of reference pricing and PC regulation. In 2003, the Norwegian government introduced a reference price (RP) system called “index pricing” to a set of off-patent pharmaceuticals, replacing the existing PC regime, which was based on international price comparisons. Since only a sub-sample of the off-patent drugs was exposed to reference pricing, the policy reform could be classified as a quasi-natural experiment. We use a rich product level panel dataset covering a four-year period from 2001 to 2004. Besides having data on all drugs exposed to the RP system, we also have data on a substantial number of drugs still subject to the existing PC regulation. This latter group of drugs consists of those that are either therapeutic substitutes or unrelated in consumption to the drugs exposed to reference pricing. In addition to exploiting the before–after reform variation in prices, we make use of the non-included drugs as a comparison group to identify the price effects on the drugs subject to the policy experiment, as well as any cross-price effects on therapeutic substitutes not exposed to the experiment.

Under PC regulation, the regulator sets a maximum price that can be charged for each product. The PC is set when a new patent-protected drug enters the market. To be effective (binding), the PC needs to be lower than the firms’ profit-maximising (monopoly) price. Competition can, however, induce the firms to reduce the price of the original brand-name drug below the PC level. First, if a new drug with similar therapeutic properties enters the market, the original drug can be forced to set a lower price to avoid losing too much of its market share. Second, when the original drug loses its patent protection, generic substitutes can enter the market with lower prices to capture market shares from the original drug. Our dataset allows us to identify the price effects due to therapeutic competition (first type) and generic competition (second type).⁴

Under reference pricing, the regulator enforces no explicit restrictions on the pharmaceutical firms’ price setting. The firms are allowed to charge any price they like. Instead, the regulator sets a maximum reimbursement price (the RP) to be paid for a group of drugs (“clusters”).⁵ The purchase of drugs with price above the RP results in a surcharge equal to the difference between the drug's price and the RP.⁶ This surcharge may be imposed by the regulator on the consumer, the prescribing physician or, the dispensing pharmacy. The intention of reference pricing is to rectify the distortion in price sensitivity imposed by insurance, potentially resulting in lower prices and medical expenditures.⁷

We find that the RP system introduced in Norway has a strong price reducing effect on the drugs exposed to this regime, with the effect being stronger for brand-names (18–19 percent) than generics (7–8 percent). This confirms that reference pricing triggers price competition within the cluster of drugs exposed to the regime. Since the RP system in Norway included off-patent products only, the identified price effect is solely due to generic competition triggered by the reform.

Interestingly, we also identify a negative cross-price effect of the policy reform on the non-included therapeutic substitutes still under PC regulation, providing evidence for therapeutic competition in the market. The effect is weaker (2.2 percent), as we would expect, since these drugs have different chemical substances and therefore are only imperfect substitutes for the drugs subject to reference pricing. When we decompose the effect, we find that it is merely the generics that respond to the reform (by 6.4 percent). An obvious explanation is that the PC is binding for the brand-names, but not for the generics. This implies that we capture any price reductions on the generics, while for brand-names we observe only price reductions below the PC. However, under free pricing, or less strict price regulation, it is likely that the brand-names will also reduce their prices as a response to the lower prices triggered by reference pricing.

The Norwegian policy experiment provides an excellent opportunity to assess the relative performance of two different regulatory regimes: reference pricing and PC regulation. Our results suggest that reference pricing is more effective than PC regulation in reducing drug prices. To indicate the economic significance of the reform, we can calculate potential savings in medical expenditures, using 2002, the year before the reform was introduced, as our benchmark. In 2002, the total sales value of the drugs included in the RP system amounted to 474.4 mill NOK, with a brand-name market share of about 72 percent. Using our estimated price reductions of about 18 percent on brand-names and 8 percent on generics, we obtain cost savings of about 75 mill NOK. This is a conservative figure for two reasons. First, the RP system is likely to trigger a shift in market shares from the brand-names to the generics (e.g., Aronsson et al., 2001). Second, when extending the reform to the whole generic market segment, the savings (in absolute terms) will be even higher.

We would, however, like to stress that the current paper analyses the specific types of pharmaceutical regulations implemented in Norway. Reference pricing is limited to the off-patent market segment with the maximum reimbursement price being calculated as a sales-weighted average price of brand-names and generics. Price cap regulation is based on international price comparisons (external referencing), and the maximum price is set at the lower end of the Western European price level. On the other hand, these versions of reference pricing and PC regulation are frequently used in Europe (see e.g., Danzon, 1997, Kanavos, 2001), implying that our results should be relevant for a broad set of countries and regulatory regimes.

A potential downside of the RP system is related to the negative cross-price effect on non-included therapeutic substitutes. This raises the concern that reference pricing may reduce patent protection, which in turn can affect national launching decisions and global innovation incentives, especially if reference pricing becomes widespread and/or is implemented in large, high-income countries.

The rest of the paper is organised as follows. In Section 2, we relate our paper to existing literature. In Section 3, we present institutional facts about the Norwegian pharmaceutical market, the regulatory regime and the policy reform that introduced reference pricing. In Section 4, we present a theoretical model to motivate our empirical study. In Section 5, we present our dataset and some descriptive statistics. In Section 6, we carry out the econometric analysis and report our empirical results. Finally, in Section 7, concluding remarks are presented.