Game Theory in Drug Price Negotiations
In the past few years, we’ve seen a substantial push from the public and our administration for lower prescription drug prices. Pressing on many of the major biotechnology companies has been the Lower Drug Costs Now Act (H.R.3), which would allow our government to set a statutory “ceiling” price on all pharmaceutical drugs. This price ceiling would be set at 120% of the average of the price of the contested product in six reference countries — Australia, Canada, France, Japan, the UK, and Germany. These countries together make the Average International Market price, which if used as a reference point, would allow our administration to substantially lower the cost of pharmaceutical drugs.
So what is it that makes the price of drugs so much lower in other countries? Let’s take a look at Germany’s system. Drug prices are established through what is known as a “collective negotiation” system, in which one buyer (known as the Sickness Fund), representing all the insurers, meets with the drug maker to negotiate prices. Given that this singular negotiation affects all German citizens, both sides face immense pressure to reach a deal. When the two sides are not able to agree, then the drug’s price is established by a panel with representatives from both sides (however, the drug producing company still has the option to refuse this price).
With all these considerations in mind, we can form an educated guess about the actions both sides are likely to take. The insurance company benefits most if it can add this new drug to its “collection” of drugs available to its customers, therefore it is likely to collaborate. Of course, whether they choose to collaborate also depends on how much the drug producing company is charging them — depending on how valuable this new drug is and how high demand for the drug is, the insurance company may be more or less willing to accept a higher price. As for the drug producing company, they are also likely to collaborate, because collaborating would ensure profits, whereas not collaborating would keep them out of the main drug market in Germany. But if the price the insurance companies ask for is also too small for them to consider profitable, then they may also choose not to collaborate at all.
Given all these choices, we can use game theory and create a (very simplified) hypothetical payoff matrix (note that I am combining the panel price-setting step with the first negotiation to further simplify this):
- In the case where both sides collaborate, they both have a payoff of 10.
- In the case where the drug company collaborates but the insurance companies do not, the insurance company has a payoff of -1 (for the backlash they will receive from the public as the singular party who refused the deal), while the pharmaceutical company has a payoff of 0 because they make no profit.
- In the opposite scenario, the pharmaceutical company has a payoff of -1 for the negative backlash they will receive and the insurance company will have a payoff of 0 for an unsuccessful negotiation.
- And in the case where neither collaborates, both will receive backlash and walk away with no gains.
We can see from this case that the dominant strategy for both sides is to collaborate in the negotiation process. Thus we have a Nash equilibrium at (collaborate, collaborate). And because one side was pushing the price down while the other was pulling the price up, the compromise/collaboration will result in a price that falls more in the middle ground.
I am of course oversimplifying this entire process, but the statistics from the real world can back up this idea that collaborating is the best choice for both sides. As of March 2019, Germany had used this system to price over 230 drugs. 202 of the 230 cases were able to reach an agreement, while in only 28 cases did drug companies choose to withdraw from the market and take both the profit loss and the public backlash.
Should the Lower Drug Costs Now Act pass, we would have similar negotiations between the government and drug companies. It will be interesting to see how those talks play out and consider whether they create the same results we see internationally.
Source: https://www.commonwealthfund.org/blog/2019/how-drug-prices-are-negotiated-germany