NextBillion - An Initiative of the William Davidson Institute at the University of Michigan

“Tiered pricing” in the context of global health generally refers to pharmaceutical companies systematically setting prices at lower levels in developing countries than in high-income markets. (It is also sometimes called differential pricing, price discrimination, market segmentation or Ramsey pricing.) Tiered pricing is feasible when markets are separable and when the seller exerts significant power over pricing, such as when there is limited or no competition due to patent protection, data exclusivity or other barriers to market entry (such as inadequate production capacity).

At first glance, it sounds reasonable enough – lower prices for poorer countries and sometimes also mid-level prices for middle-income countries. In theory, tiered pricing is supposed to offer a “win-win” solution – maximizing profits for sellers by enabling them to tap into new markets while increasing consumer surplus by making a product affordable to a greater proportion of the population. In theory, perfect price discrimination under monopoly can lead to efficient market outcomes.

However, there are important drawbacks – both theoretical and empirical – in relying on tiered pricing as a strategy to improve access to medicines in poorer populations.

Theoretical considerations

At least four theoretical aspects of tiered pricing are problematic for pharmaceuticals.

First, perfect price discrimination under a monopoly system (or Ramsey pricing) only leads to an efficient market outcome when a regulator caps the level of fixed costs recouped by the monopolist. For pharmaceuticals, this would mean a regulator knows how much has been spent on R&D and has the power to limit revenues to meet those costs. Yet neither of these is feasible for pharmaceuticals, where R&D costs are tightly-guarded secrets and no single national authority has the ability to control total return on R&D investment in a globalized pharmaceutical market. (Notably, in the U.S. and some other countries, there is very little political willingness to regulate medicine prices at all, let alone calibrated to the level of R&D investment.)

Second, an efficient outcome relies on pricing according to the consumer’s demand elasticity – which generally translates into a higher price for a consumer with greater willingness to pay for a drug, and a lower price for a consumer with lower willingness to pay. But for lifesaving medicines, the concept of willingness to pay is ethically problematic – should a patient who is seriously ill and desperate be charged a higher price for a medicine that will save her life (because her demand will be relatively inelastic) than one who is in an earlier stage of the disease, for example?

Third, price discrimination relies on both the ability to separate or segment markets (that is, no products would flow from one market to another) and to know precisely the consumer’s willingness to pay. Neither of these is practical in the real world, where markets are not perfectly separable and there is huge variation in the financial resources available to individual consumers to pay for medicines. Furthermore, most patients living in low- and middle-income countries are not covered by in-depth health insurance systems and frequently pay for medicines out-of-pocket, with health care spending a leading factor driving households below the poverty line. In such contexts, patients may be willing to pay higher prices for a medicine but are either simply unable to do so, or only at the cost of driving their families into poverty.

Finally, while tiered pricing may represent an increase in consumer surplus over the counterfactual of a monopolist charging a single high price to all consumers in the world, it does not necessarily maximize consumer surplus. Nor does the counterfactual necessarily represent reality. Rather, firms often have strong incentives – or are required by regulation – to adapt prices to various markets.

Empirical evidence

These abstract arguments are important, but it is perhaps even more informative to consider what the empirical evidence tells us about how tiered pricing has been implemented in practice.

As summarized in our 2011 study, evidence from the past decade demonstrates that there are a number of drawbacks to relying on tiered pricing as the main strategy to improve the affordability of medicines in low- and middle-income countries (LMICs). Much of the evidence comes from the experience of antiretrovirals (ARVs) for HIV/AIDS, the therapeutic area for which tiered-pricing policies have been most widely implemented and for which the most data on prices and practices is publicly available. For ARVs, tiered pricing has been less reliable and effective than generic competition in achieving the lowest sustainable prices for quality medicines.

In a review of more than 7,000 developing-country purchase transactions from 2002-07, Waning et al. found that the tiered prices for 15 of 18 antiretroviral drugs were 23-498 percent higher than the generic price. Similarly, an analysis of publicly announced ARV prices (2014) found that of the 22 products for which both originator tiered prices and WHO quality-assured generic prices were listed, the generic price was lower for 19 products (86 percent). Generic prices were frequently as low as one-eighth to one-fifth of tiered prices.

These price differences can translate into significant overall savings. A 2013 study from the U.S. Government Accountability Office found that the U.S. President’s Emergency Plan for AIDS Relief (PEPFAR) saved nearly $1 billion from 2005-11 by purchasing generics rather than tiered-priced HIV drugs. Analogous cost-savings estimates for the Global Fund are not available, but would likely be much higher given the greater volumes of drugs procured with Global Fund monies.

Not only are generic prices systematically lower than originators’ tiered prices, generic entry into the market also tends to push originators to reduce their own tiered prices – as would be predicted by basic economic theory. In the global market for artemisinin-combination therapies for malaria, the tiered price from an originator firm held steady for about five years and only dropped when generic competitors entered the market. Generic competition, often enabled by governments using flexibilities in intellectual property rules, has been central to improving access to HIV and other medicines in developing countries.

Another drawback to tiered-pricing policies are that they are voluntary programs of pharmaceutical companies and as such can be arbitrary. Companies may offer discounts on some drugs but not others, to some countries but not others, for a limited time or with strings attached. The rationale underlying a given price or country grouping is generally not transparent, and the prices offered are not necessarily affordable. This feature of tiered pricing has become particularly problematic in middle-income countries (MICs).

The rise of the MICs is challenging pre-existing arrangements in the development aid system, including the informal norm that “rich” countries pay higher prices for patented medicines to cover R&D costs while “poor” countries purchase generics (at least for some priority diseases). But this rich/poor classification is neither as easy nor useful as it once was. MICs now include more than 100 countries, home to more than two-thirds of the world population, with 75 percent of the world’s poor and a majority of the global burden of disease, with per capita incomes spanning from about $3 to $33 per day. At the same time, the pharmaceutical industry is relying heavily on MICs for worldwide growth to offset flat sales in Europe and the U.S. In their current form, tiered-pricing policies are not likely to ensure affordable prices in MICs.