In April 2002, the World Health Organization (WHO), the World Trade Organization (WTO), the Norwegian Foreign Ministry, and the US-based Global Health Council held a 3-days workshop about “Pricing and Financing of Essential Drugs” in poor countries. Not surprisingly, the conclusion was:
“… There was broad recognition that differential pricing could play an important role in ensuring access to existing drugs at affordable prices, particularly in the poorest countries, while the patent system would be allowed to continue to play its role in providing incentives for research and development into new drugs.”
The 80 experts, who attended the workshop, proposed to reconcile these two, apparently contradictory, aspirations by introducing different prices for drugs in low-income and rich countries. This could be achieved bilaterally, between companies and purchasers, patent holders and manufacturers, global suppliers and countries – or through a market mechanism.
According to IMS Health, poor countries are projected to account for less than one quarter of pharmaceutical sales in 2002. Of every $100 spent on medicines worldwide – 42 are in the USA, 25 in Europe, 11 in Japan, 7.5 in Latin America and the Caribbean, 5 in China and South East Asia, less than 2 in East Europe and India each, about 1 in Africa and the Commonwealth of Independent States (CIS) each.
Vaccines, contraceptives, and condoms are already subject to cross-border differential pricing. Lately, drug companies, were forced to introduce multi-tiered pricing following court decisions, or agreements with the authorities. Brazilians and South Africans, for instance, pay a fraction of the price paid in the West for their anti-retroviral AIDS medication.
Even so, the price of a typical treatment is not affordable. Foreign donors, private foundations – such as the Bill and Melissa Gates Foundation – and international organizations had to step in to cover the shortfall.
The experts acknowledged the risk that branded drugs sold cheaply in a poor country might end up being smuggled into and consumed in a much richer ones. Less likely, industrialized countries may also impose price controls, using poor country prices as benchmarks. Other participants, including dominant NGO’s, such as Oxfam and Medecins Sans Frontieres, rooted for a reform of the TRIPS agreement – or the manufacturing of generic alternatives to branded drugs.
The “health safeguards” built into the Trade-related Aspects of Intellectual Property Rights (TRIPS) convention allow for compulsory licensing – manufacturing a drug without the patent holder’s permission – and for parallel imports – importing a drug from another country where it is sold at a lower price – in case of an health emergency.
Aware of the existence of this Damocles sword, the European Union and the trans-national pharmaceutical lobby have come out last May in favor of “global tiered pricing”.
In its 2001 Human Development Report (HDR), the United Nations Development Program (UNDP) called to introduce differential rich versus poor country pricing for “essential high-tech products” as well. The Health GAP Coalition commented on the report:
“On the issue of differential pricing, the Report notes that, while an effective global market would encourage different prices in different countries for products such as pharmaceuticals, the current system does not. With high-tech products, where the main cost to the seller is usually research rather than production, such tiered pricing could lead to an identical product being sold in poor countries for just one-tenth-or one-hundredth- the price in Europe or the United States.
But drug companies and other technology producers fear that knowledge about such discounting could lead to a demand for lower prices in rich countries as well. They have tended to set global prices that are unaffordable for the citizens of poor countries (as with many AIDS drugs).
‘Part of the battle to establish differential pricing must be won through consumer education. The citizens of rich countries must understand that it is only fair for people in developing countries to pay less for medicines and other critical technology products.’ – stated Ms. Sukaki Fukuda-Parr” the lead author of the Report.
Public declarations issued in Havana, Cuba, in San Jose, Costa Rica in the late 1990’s touted the benefits of free online scholarship for developing countries. The WHO and the Open Society Institute initiated HINARI – Health InterNetwork Access to Research Initiative. Peter Suber, the publisher of the “Free Online Scholarship” newsletter, summarizes the initiative thus:
“Under the program, the world’s six largest publishers of biomedical journals have agreed to three-tiered pricing. For countries in the lowest tier (GNP per capita below $1k), online subscriptions are free of charge. For countries in the middle tier (GNP per capita between $1k and $3k), online subscriptions will be discounted by an amount to be decided this June. Countries in the top tier pay full price.
The six participating publishers are Blackwell Synergy, Elsevier Science Direct, Harcourt IDEAL, Springer Link, Wiley Interscience, and Wolters Kluwer. The subscriptions are given to universities and research institutions, not to individuals. But they are identical in scope to the subscriptions received by institutions paying the full price.”
Of 500 bottom-tier eligible institutions, more than 200 have already signed up. Additional publishers have joined this 3-5 years program and most biomedical journals are already on offer. Mid-tier pricing will be declared by January next year. HINARI will probably be expanded to cover other scientific disciplines.
Authors from developing countries also benefit from the spread of free online scholarship coupled with differential pricing. “Best of Science”, for example, a free, peer-reviewed, online science journal subsists on fees paid by the authors. It charges authors from developing countries less.
But differential pricing is unlikely to be confined to scholarly journals. Already, voices in developing countries demand tiered pricing for Western textbooks sold in emerging economies. Quoted in the Free Online Scholarship newsletter, Lai Ting-ming of the Taipei Times criticized, on March 26, 2002 “western publishers for selling textbooks to third world students at first world prices. There is a ‘textbook pricing crisis’ in developing countries, which is most commonly solved by illicit photocopying.”
Touchingly, the issue of the dispossessed within rich country societies was raised by two African Special Rapporteurs in a report submitted last year to the UN sub-Commission on Human Rights and titled “Globalization and its Impact on the Full Enjoyment of Human Rights”. It said:
” … The emphasis on R & D investment conveniently omits mention of the fact that some of the financing for this research comes from public sources; how then can it be justifiably argued that the benefits that derive from such investment should accrue primarily to private interests? Lastly, the focus on differential pricing between (rich and poor) countries omits consideration of the fact that there are many people within developed countries who are also unable to afford the same drugs. This may be on account of an inaccessible or inhospitable health care system (in terms of cost or an absence of adequate social welfare mechanisms), or because of racial, gender, sexual orientation or other forms of discrimination.”
Differential pricing is often confused with dynamic pricing.
Bob Gressens of Moai Technologies and Christopher Brousseau of Accenture define dynamic pricing, in their paper “The Value Propositions of Dynamic Pricing in Business-to-Business E-Commerce” as: “… The buying and selling of goods and services in markets where prices are free to move in response to supply and demand conditions.”
This is usually done through auctions or requests for quotes or tenders. Dynamic pricing is most often used in the liquidation of surplus inventories and for e-sourcing.
Nor is differential pricing entirely identical with non-linear pricing. In the real world, prices are rarely fixed. Some prices vary with usage – “pay per view” in the cable TV industry, or “pay per print” in scholarly online reference. Other prices combine a fixed element (e.g., a subscription fee) with a variable element (e.g., payment per broadband usage). Volume discounts, sales, cross-selling, three for the price of two – are all examples of non-linear pricing. Non-linear pricing is about charging different prices to different consumers – but within the same market.
Hal Varian of the School of Information Management and Systems at the University of California in Berkeley summarizes the treatment of “Price Discrimination” in A. C. Pigou’s seminal 1920 tome, “The Economics of Welfare”:
“First-degree price discrimination means that the producer sells different units of output for different prices and these prices may differ from person to person. This is sometimes known as the case of perfect price discrimination.
Second-degree price discrimination means that the producer sells different units of output for different prices, but every individual who buys the same amount of the good pays the same price. Thus prices depend on the amount of the good purchased, but not on who does the purchasing. A common example of this sort of pricing is volume discounts.
Third-degree price discrimination occurs when the producer sells output to different people for different prices, but every unit of output sold to a given person sells for the same price. This is the most common form of price discrimination, and examples include senior citizens’ discounts, student discounts, and so on.”
Varian evaluates the contribution of each of these practices to economic efficiency in a 1996 article published in “First Monday”:
“First-degree price discrimination yields a fully efficient outcome, in the sense of maximizing consumer plus producer surplus.
Second-degree price discrimination generally provides an efficient amount of the good to the largest consumers, but smaller consumers may receive inefficiently low amounts. Nevertheless, they will be better off than if they did not participate in the market. If differential pricing is not allowed, groups with small willingness to pay may not be served at all.
Third-degree price discrimination increases welfare when it encourages a sufficiently large increase in output. If output doesn’t increase, total welfare will fall. As in the case of second-degree price discrimination, third-degree price discrimination is a good thing for niche markets that would not otherwise be served under a uniform pricing policy.
The key issue is whether the output of goods and services is increased or decreased by differential pricing.”
Strictly speaking, global differential pricing is none of the above. It involves charging different prices in different markets, in accordance with the purchasing power of the local clientele (i.e., their willingness and ability to pay) – or in deference to their political and legal clout.
Differential prices are not set by supply and demand and, therefore, do not fluctuate. All the consumers within each market are charged the same – prices vary only across markets. They are determined by the manufacturer in each and every market separately in accordance with local conditions.
A March 2001 WHO/WTO background paper titled “More Equitable Pricing for Essential Drugs” discovered immense variations in the prices of medicines among different national markets. But, surprisingly, these price differences were unrelated to national income.
Even allowing for price differentials, the one-month cost of treatment of Tuberculosis in Tanzania was the equivalent of 500 working hours – compared to 1.4 working hours in Switzerland. The price of medicines in poor countries – from Zimbabwe to India – was clearly higher than one would have expected from income measures such as GDP per capita or average wages. Why didn’t drug prices adjust to reflect indigenous purchasing power?
According to the Paris-based International Chamber of Commerce (ICC), differential pricing is also – perhaps mostly – influenced by other considerations such as: transportation costs, disparate tax and customs regimes, cost of employment, differences in property rights and royalties, local safety and health standards, price controls, quality of internal distribution systems, the size of the order, the size of the market, and so on.
Differential pricing was made possible by the application of mass manufacturing to the knowledge society. Many industries, both emerging ones, like telecommunications, or information technology – and mature ones, like airlines, or pharmaceuticals – defy conventional pricing theory. They involve huge sunk and fixed costs – mainly in research and development and plant.
But the marginal cost of each and every manufactured unit is identical – and vanishingly low. Beyond a certain quantitative threshold returns skyrocket and revenues contribute directly to the bottom line.
Consider software applications. The first units sold cover the enormous fixed and sunk costs of authoring the software and the machine tools used in the manufacturing process. The actual production (“variable” or “marginal”) cost of each unit is a mere few cents – the wholesale price of the diskettes or CD-ROM’s consumed. Thus, after having achieved breakeven, sales revenues translate immediately to gross profits.
This bifurcation – the huge fixed costs versus the negligible marginal costs – vitiates the rule: “set price at marginal cost”. At which marginal cost? To compensate for the sunk and fixed costs, the first “marginal units” must carry a much higher price tag than the last ones.
Hal Varian studied this problem. His conclusions:
“(i) Efficient pricing in such environments will typically involve prices that differ across consumers and type of service; (ii) producers will want to engage in product and service differentiation in order for this differential pricing to be feasible; and, (iii) differential pricing will arise naturally as a result of profit seeking by firms. It follows that differential pricing can generally be expected to contribute to economic efficiency.”
Differential pricing is also the outcome of globalization. As brands become ubiquitous and as the information superhighway renders prices comparable and transparent – different markets react differently to price signals. In impoverished countries, differential pricing was introduced illegally where manufacturers insisted on rigid, rich-world, price lists.
Piracy of intellectual property, for instance, is a form of coercive (and illegal) differential pricing. The existence of thriving rip-off markets proves that, at the right prices, demand is rife (demand elasticity). Both piracy and differential pricing may be spreading to scholarly publishing and other form of intellectual property such as software, films, music, and e-books.
Consumers are divided on the issue of multi-tiered pricing tailored to fit the customer’s purchasing power. Not surprisingly, rich world buyers are apprehensive. They feel that differential pricing is a form of hidden subsidy, or a kind of “third world tax”.
On September 2000, Amazon.com conducted a unique poll – this time among customers – regarding differential pricing (actually, non-linear pricing) – showing different prices to different users on the same book.
Forty two percent of all respondents though it was “discrimination” and “should stop” – but a surprising 31 percent regarded it as “a valid use of data mining”. A quarter said it is “OK, if explained to users”. The comments were telling:
“I work over 80 hours a week. As a small business owner, I may make good money, but does that mean I should be charged more than unmotivated individuals who are broke because they don’t want to work more than 30 hours a week. I don’t think so … Should (preferred) customers disappear in (the) off-line world? Should Gold Cards or Platinum Cards disappear? …
The interesting thing is that discrimination of pricing is very common in the insurance industry – the basis for actuarial work and in airlines – based on load factors. The key is the pricing available to groups of customers with similar profiles … Simple supply and demand, competition from other suppliers should offset … A dangerous policy to implement … As a consumer I don’t necessarily like it, (unless I get a lower price!). However, economically speaking, (think of a monopolist’s MR curve) the ideal is to have each person pay the maximum amount that they are willing to pay.”