New Evidence Suggests a Lack of Cost-Shifting in Prescription Drug Markets

Recent legislative efforts to regulate drug prices have reignited debates about the interaction between price setting in public insurance programs and commercial market spending. In particular, some worry that proposals to regulate drug prices in Medicare will cause drug manufacturers to “make up” lost revenues in the unconstrained commercial market. In this piece, we summarize arguments for and against this theory and present suggestive quantitative evidence from a related context.

The allegation that public insurance price reductions will cause compensatory behavior in the private sector is hardly new in health care. Researchers and practitioners have long debated the existence of “cost shifting” within the provider market—the theory that if public payers reduce payment rates, providers will raise prices on private payers to cover their costs. Economic theory predicts that such behavior is unlikely since it implies providers “leave dollars on the table” in negotiations with private insurers prior to public payer price reductions. Indeed, most recent empirical evidence confirms this, or in some cases, finds that public and private prices move in parallel.

The analogous theory most commonly posited in the drug market is more accurately characterized as a “revenue targeting” strategy, where drug makers alter behavior to achieve a desired level of total product revenues as opposed to covering costs (since revenues of commercially successful products meaningfully exceed fixed costs and variable costs are often modest).

Proponents of this theory implicitly argue that there are features of the drug market that make this kind of compensatory behavior more likely. In particular, they emphasize that drug makers have both intellectual property protection over their products and often face relatively inelastic demand, conferring significant pricing power. In addition, they often point to an empirical reality of drug markets—that the list and net prices of brand drugs increase after a product has been launched—as evidence of unconstrained pricing power.

Opponents of this theory instead argue that these features do not imply the existence of untapped market power and that it is unlikely manufacturers would willingly leave any such market power unused. In particular, inelastic demand and intellectual property protection are features of the current market, meaning that whatever pricing power they convey is already present. Moreover, increasing pricing over time is consistent with profit maximizing behavior in markets where drug makers aim to increase utilization in the early years of a product’s launch and increase prices as patient populations become more established.

That said, we were not aware of any research that bears directly on this debate. In an effort to inform discussions, we (jointly with Conrad Milhaupt) considered whether drug makers engaged in compensatory behavior in a similar setting—when revenues fell owing to the entry of lower-cost biosimilar drugs in the European Union (EU) market, but where drug makers retained monopoly rights in the unregulated portion of the US market. Our analysis focused on four large biologic products that met all sample criteria.

While this is an international setting, it shares many similarities with price regulation specific to Medicare in the US. EU biosimilar entry has substantial effects on global revenues, which are the ultimate focus of for-profit manufacturers considered here. Indeed, executive pay was even formally linked to global sales of one analyzed product (Humira), providing an explicit incentive to offset losses if possible. Moreover, manufacturers held the same market power in the commercial market following these revenue reductions as they would following losses in the Medicare market (and in our setting, could have increased revenues in the Medicare market too).

In short, biosimilar entry in the EU caused sharp reductions to global revenue but we observe little evidence of offsetting revenue increases in the US market relative to prior trend.

These results are consistent with the theory that drug makers are already using their market power in full. At a minimum, revenue targeting arguments must contend with the reality that firms appear willing to accept revenue losses internationally, despite holding similar market power in the US commercial market as they would in the wake of Medicare price regulation.

As this conversation continues, it is important to distinguish that cross-market effects would be expected if drug policy proposals create direct linkages between two markets. For example, tying prices in one market to those in another, as the Trump Administrations International Pricing Index would have, creates a shadow cost of lower prices in reference countries. Thus, the economics underpinning pricing decisions in both markets would change and cross-market effects do not rely on a “revenue targeting” theory.

Benedic Ippolito is a senior fellow in economic policy studies at the American Enterprise Institute and tweets at @Ben_Ippolito. Loren Adler is associate director of the USC-Brookings Schaeffer Initiative for Health Policy and tweets at @LorenAdler.
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