The ultimate domino effect of ignorance

Was wondering out loud whether politicians, at least in the Philippines, have heard of two basic micro-economic concepts 1: substitution effect and 2. utility maximization?

(source: wikipedia) “An ordinary good is a microeconomic concept used in consumer theory. It is defined as a good which creates increased demand when the price for the good drops or conversely decreased demand if the price for the good increases.”

“The substitution effect – the consumer always favors lower priced goods. If the price of Good X rises, the consumer will buy less of Good X and more of a substitute good such as Good Y. Conversely, if the price of Good X falls, the substitution effect leads the consumer to buy more of X which is now less expensive compared to Good Y which has a constant price.”

“In economics, utility is a measure of the relative satisfaction from, or desirability of, consumption of various goods and services. Given this measure, one may speak meaningfully of increasing or decreasing utility, and thereby explain economic behavior in terms of attempts to increase one’s utility. A budget constraint represents the combinations of goods and services that a consumer can purchase given current prices with his or her income. Consumer theory uses the concepts of a budget constraint and a preference map to analyze consumer choices. In neoclassical economics, rationality is precisely defined in terms of imputed utility-maximizing behavior under economic constraints.”

Ok. In simple english (sorry Chicago GSB), intelligent individuals try to get the most value for their money.

My 14 year old daughter will be learning these concepts in grade 9 economics at United World College in Singapore next year. Well, why is this basic high school stuff relevant?

Because when “good intentioned” individuals decide to fix prices of branded pharmaceuticals at a fraction of their true market value, in the name of increasing availability of medications to the income challenged Filipino, the following is the potentially unintended natural result of RATIONAL human behaviour:

Original Scenario

Generic Medication A – price for 1 month supply = $10.00
Branded equivalent A- market price for 1 month supply = $30.00

Joe Filipino (fictional character of course) , with his limited means, decides branded is too expensive and substitutes generic for the branded thus saving him substantial money for longganisa (original sweet and spicy sausages), kalderetang kambing (savory goat stew), and tocino (sweetened cured pork).

Robin Hood Scenario

Now our friendly government steps in with mandated 60% price cuts on branded pharmaceuticals….

Generic Medication A – price for 1 month supply = $10.00
Branded equivalent A- market price for 1 month supply = $12.00

Oh oh. See what happens. In order to maximize utility (well-being) the Joe Filipino now realizes an insignificant savings from buying generic and substitutes back to branded due to perceived quality improvement. Joe gets his cake and eats it too. Top of the line “utility” for bargain basement prices.

Not a bad deal for Joe right?

Uh …I don’t think so.

Unfortunately our generic manufacturers operate on pretty slim margins. It is a highly competitive market (usually competing on the basis of price which is the worst criteria to compete on). Lets have a look see at some of the biggest players in generics: Teva, Mylan, and Dr. Reddy (source: wikinvest)

Wow, net profit margins ranging from -2.6% to 7%. Now I’m not sure what Unilab’s margins are but they can’t be happy with the above Robin Hood scenario. And from Businessworld with my emphasis in bold:

BusinessWorld
Thursday, January 28, 2010
Therapeutic drug price cut considered

THE HEALTH department will review the retail price scheme for essential drugs next month, include looking into the possible inclusion of therapeutic medicines in the second set of medicines that could be subjected to price cuts. “Hopefully [the review] will be done within February so that we could come up with the result and show it to everyone late February or early March,” Robert Louie P. So, head of the National Center for Pharmaceutical Access and Management (NCPAM), said in a chance interview after yesterday’s forum organized by an international health body.

NCPAM, which is directly under the Office of the Health Secretary, oversees the implementation of Republic Act 9502 or the Universally Accessible Cheaper and Quality Medicines Act of 2008. Mr. So said they are looking to include therapeutic medicines such as anti-convulsants, anti-narcoleptics, antidepressants, eye preparations such as eye drops and other life-saving medicines in the second set of drugs to be subjected to the maximum drug retail price (MDRP). He said the MDRP review would focus on the impact of price cuts on the poor.

Last July, the Department of Health submitted to the Office of the President an initial list of 21 medicines to be subjected under the MDRP list. The list, trimmed to five under Executive Order 821 signed by President Gloria Macapagal-Arroyo last July, covers medicines for hypertension, diabetes, cancer, bacterial infections and amoebiasis. Pharmaceutical firms have voluntarily halved the prices of other 16 medicines not covered by MDRP, and a 10-50% price reduction on 22 other drugs under the Government Mediated Access Price. The price cuts took effect on Aug. 15 last year for drugstores with automated systems and a month later for smaller establishments with manual systems.

Meanwhile, the local pharmaceutical industry is projected to incur a P10-billion loss in the first year implementation of the cheaper medicines law, the head of a major pharmaceutical group said. “We expect about a 10 billion loss in sales which could translate also in loss of profits which the companies have to address,” Reiner W. Gloor, executive director of the Pharmaceutical and Healthcare Association of the Philippines (PHAP), said in a chance interview at the same forum. He said the projection excludes the impact of the possible price cuts on other therapeutic drugs as indicated by health officials. Mr. Gloor said the estimated loss from August 2009 to July 2010 represents a 12%-15% slash in the P70 billion-P80 billion annual industry sales. PHAP has 50 members, including medicine manufacturers and distributors, said Mr. Gloor. Asked on how they could recoup the losses, he said: “Hopefully there will be some market expansion, more units being sold than at present.” Firms also need to cut operating costs and introduce new products to compensate for the loss, he added.

Mr. Gloor also said they plan to expand their market “downstream” to include the DE class. — A. M. Paglinawan

Meanwhile Big Pharma with their relatively healthier margins, albeit under all sorts of assault, at least has some financial leeway to adapt.

So in conclusion, the firms that will likely struggle, cut costs (meaning layoffs), and potentially even go out of business will be the low margin competitor, otherwise known as the generic manufacturers.

Dr. Arroyo, with your background in economics, please point out the justification of your actions again because this certainly won’t increase the availability of medications to Joe Filipino.

Tej Deol, M.D.