[Pharm-policy] Ramsey pricing

[James Love]

Just a short note about something that we will be talking about in
Norway.  Apparently the gag order doesn't begin until 8am in the
morning.  The WTO paper discusses price discrimination for drugs in
terms of Ramsey pricing, and others will also address this.  Ramsey is a
term used first to describe issues in public utility regulation, where
there were big fixed costs and low marginal costs, and hence increasing
returns to scale, and departures from marginal cost were necessary to
recoup the fixed costs.  Since marginal cost pricing would not meet the
budget constraint of the enterprise, Ramsey and others (before him)
examined the issue of how best to price the good or service.  In
particular, he focused on classic notions of economic efficiency, as
measured by consumer surplus, and like most such analysis, ignoring
distributional issues.

Ramsey's insight (he was not the first it turns out), was that pricing
similar to a monopolist was economically efficient, if both could engage
in price discrimination.  The less elastic the demand for the good (the
higher the willingness to pay), the less consumer (social) surplus that
was lost. 

The Ramsey solution was not the monoplist solution, however, because
Ramsey limited the increases over marginal cost to only that necessary
to pay for the fixed costs.  Ramsey would price according to what the
market would bear, but only up to a point when the enteprise met its
budget constraint. The Ramsey solution is often used to some degree by
regulators, but with some limitations, because it has some problems.

One illustration of this is from the optimal tax theory, where it was
quickly shown that a ramsey solution would involve shifting taxes away
from many luxury goods, and more problematic, to things like life saving
medicines.  For example, under ramsey pricing, one would have *very*
high taxes on insulin, and use this revenue to say pay for roads.  Any
medicine that treated a severe illness was a target for a Ramsey tax.
The demand as "inelastic" because people really needed it.  Not very
many people thought this was a great way to design taxes.   It turns out
people do care about distributional issues.

Monopolies of one sort or another were fascinated with Ramsey pricing,
because it provides a nice rationale for behavior that looked a lot like
what a monopolist wanted to do.  Thus, for example, in the early 80s the
railroads claimed that deregulation of "captive" shippers of coal and
grain, was "Ramsey efficient," because they were recouping fixed costs
from those who had no alternatives, and hence, were relatively price
inelastic. The railroads even got Ken Arrow to sign a letter on this. 
Price gouging (whoops, I mean Ramsey efficient pricing) of captive
airline markets also leads to similar claims that this is just an
efficiency justified pricing scheme (not a true statement, of course).  

The big problem with Ramsey pricing is that everyone loves to push the
price discrimination part, which is pricing according to what people are
willing to pay, but there is considerably less enthusiasm for the other
part, which is the budget constraint.  And, without the government
regulation of the budget constraint, you just have monopoly pricing,
which is not in fact efficient, in most cases, not to mention the
ethical issues, or the rather messy empirical realities of industry
pricing practices.  

The WTO paper pushes the benefits and wonders of price discrimination,
but does not mention the part about the budget constraint.  Patrica
Danzon creates theoretical models that suggest there are no monopolies,
that free entry into the pharmaceutical market for therapeutic
equivalents creates a perfectly competitive dynamic outcomes.  And thus,
with no monopoly power, ramsey pricing is obtained without the
government regulating the companies returns.  This is a popular theory
with big Pharma of course, and apparently also with the WTO and even
some at the WHO.

So it is somewhat ironic that at the center of a debate over how to help
the poor, we are showcasing theories of why letting big pharma engage in
monopoly like price discrimination, without any price controls, is the
answer.   But of course, there will be lots of other theories presented
too, and actually, this is a very diverse group to be sure, although
there are complaints about the failure to include patient groups from
developing countries, or the HIV activists (North and South) who have
actually been driving the public debate on pricing.

  Jamie




-- 
James Love
Consumer Project on Technology
P.O. Box 19367, Washington, DC 20036
http://www.cptech.org
love@cptech.org
1.202.387.8030 fax 1.202.234.5176