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Understanding the hidden forces behind skyrocketing drug prices

‘High drug prices are a widespread concern among both the public and policymakers,’ says Vladimir Karamychev. Medical expenses often exceed household budgets, and many patients are unable to afford their prescribed treatments out of pocket. ‘If national health authorities want to regulate the market and keep prices in check, they need a clear understanding of the mechanisms behind those prices.’ The paper, “”, by Karamychev, together with former Assistant Professor Jurjen Kamphorst at Erasmus School of Economics, provides such a theory. 

A theoretical model with real implications

To explore how prices are formed, Karamychev and Kamphorst developed a theoretical model focusing on so-called orphan drugs, medications for rare and serious diseases, typically developed by a single producer and urgently needed by a small group of patients.

The researchers compared two scenarios: one in which patients pay out of pocket, and one in which patients are insured against such costs. The results were striking. ‘In the presence of insurance, the optimal price set by a monopolist can increase enormously, sometimes even a thousandfold,’ Karamychev explains.

Robust evidence for regulatory action in pharma markets

To ensure that the results weren't just specific to one model setup, Karamychev and Kamphorst extended their analysis in several directions. They considered markets where different monopolists produce different drugs, but all compete for the same insured patients. They also explored what happens when the insurer itself is a profit-maximising monopolist. All these extensions confirm the robustness of the base model: when insurance is available and unregulated, drug prices tend to rise dramatically. 

These findings illustrate why pharmaceutical markets require regulation, especially when a specific drug is included in national health insurance plans. ‘Without regulation, insurance wouldn’t be available for half of the population,’ Karamychev adds. In the Netherlands, such regulatory mechanisms are already in place. The Minister of Health can decide to exclude drugs from the basic health insurance if they are deemed too expensive. Moreover, the Dutch Medicine Prices Act (Wet geneesmiddelenprijzen) imposes a price ceiling on drugs based on international price comparisons. ‘Our paper shows that both of these price ceilings, if binding, can result in much lower prices,’ Kamphorst comments. 

Karamychev reinforces this by urging policymakers to ‘consider the implications of insurance on a drug’s price, and on the incentives of Big Pharma to develop new drugs.’