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Price reformers trapped in their own policy

In diplomatic circles, the concept of Most Favored Nation is a useful tool that assigns lower tariffs to preferred trading partners. The idea has not been lost on the business world, where corporations frequently write Most Favored Customer clauses into contracts with their largest customers, guaranteeing them the lowest price in markets where prices vary. In recent years, the government has tried to capitalize on the idea, too with questionable results. In the case of Medicaid, says a Stanford researcher, it was clearly a bad idea.

In 1990, the federal government included a Most Favored Customer (MFC) clause in its Medicaid contracts for the first time. It required drug companies to give Medicaid the same deep discounts they were giving other big buyers. Legislators hoped it would lower government costs and give poor people on Medicaid access to the best brand-name drugs available.

It sounded good, but there was an unforeseen problem. Many drug companies merely raised prices that their other large customers had to pay, thereby raising the benchmark that determined the discounts. Looking at it from a purely business point of view, pharmaceutical lobbyists argued that it had been logical for companies to reexamine and perhaps increase their prices. After all, Medicaid, which accounts for at least 10 percent of industry revenues, suddenly got the lowest price given to any customer in the country.

Indeed, drug companies increased prices to other buyers, such as the Department of Veterans Affairs, prepaid health plans like Kaiser Permanente, hospitals, and community health centers for homeless people. One director of a Texas association of medical clinics told the New York Times that within weeks of the passage of the Medicaid law, several drug companies began trying to renegotiate the price contracts for his organization, which buys drugs for 31 clinics. Health care experts speculated that the added costs might soon trickle down to consumers in the form of higher medical costs and insurance premiums. Sen. David Pryor (D-Ark.), chairman of the Special Committee on Aging and sponsor of the rule change, said the drug companies appeared to be attempting to nullify the savings Congress sought to achieve.

Fiona Scott Morton, assistant professor of strategic management, took a detailed look at the problem. Using data from before and after the policy change, she discovered evidence that some prices rose at the time the new law took effect ­ those prices that were consistent with economic theory of incentives in the law. Scott Morton found that the average price of drugs on patent did not respond to the legislation, but companies with brand products facing generic competition raised average prices about 4 percent after the MFC rule came into being. That started a chain reaction in prices. Generic drug producers in markets without much competition responded to the price increases of competing brands by raising their prices, too.

The price increases varied with the specific characteristics of the particular drug, such as whether its patent had expired or not, whether there was generic competition, whether it was sold through a drugstore or hospital channel, and whether a large percentage of the market was sold to Medicaid. The average price of all drugs did not increase measurably. However, in concentrated markets with just a few producers there were significant price increases, especially where customers, such as drugstores and hospitals, bought large package sizes and had high sales to Medicaid. When drug companies charged dru