Do you ever wonder: Why doesn’t the government simply cap the prices of certain goods (say essential medicines, petrol, and diesel) and services (say airline tickets) in the economy and fix the floor for others (say minimum wages, house rents)?
Surely, those airlines charging exorbitant prices during the Chennai floods a few years ago needed to be roped in, right? Similarly, wouldn’t it be better if the government could just fix the price of petrol and diesel? And wouldn’t we bring down poverty by raising minimum wages? And hasn’t it been prudent that India’s drug regulator brought an increasing number of drugs under price control over the years?
If these arguments seem appealing to you, it is likely that last week’s decision by the National Pharmaceutical Pricing Authority (NPPA) — to allow pharmaceutical companies to increase the price of essential blood thinner heparin by as much as 50 per cent — would strike you as rather odd. Especially so because heparin is among those essential medicines that are needed for combating the ongoing Covid-19 pandemic.
This hike is contrary to the past trend. According to one analysis by Amir Ullah Khan of the Indian School of Business, the number of drugs under price control has steadily increased from just 74 in 1995 to 860 in 2019. Over the past few years, the NPPA has aggressively capped the prices of several drugs and medical supplies, starting with slashing the prices of coronary stents by 80% in 2017.
Heparin, however, is only the latest example. As was reported in The Indian Express, the first time NPPA increased the prices of medicines that were under price control was in December 2019. At that time it hiked the prices of 21 drugs, which were integral to public health programmes, by 50 per cent. These drugs were often used as the first line of treatment and included the BCG vaccine for tuberculosis, vitamin C, some antibiotics, the anti-malarial drug chloroquine and leprosy medication dapsone among others.
Moreover, several pharmaceutical companies have now sought the freedom to mark up the prices of other essential drugs, such as paracetamol.
You might justifiably ask: Why is the government raising prices smack in the middle of a health crisis? Isn’t this the time when people need cheap medication the most?
The answer is quite simple: The NPPA said that there is a scarcity of the inputs required to make these medicines. Scarcity implies higher costs of manufacturing, which, in turn, necessitates higher prices. At one level, this is no rocket science.
That is the essential role of prices: They reflect the current state of supply and demand in an economy and work as an incentive mechanism for producers to produce more when prices rise and for consumers to consume more when prices fall.
The implicit logic is that allowing the prices of these drugs to rise will address that scarcity and, thus boost supply.
That then brings us to the question: Why cap prices in the first place?
That’s because far too often policymakers — across the world — believe that capping prices will ensure supply for all. But this notion defies the basic laws of economics. As a general rule, capping prices tends to suppress supply, increase demand and thus create shortages.
It has several other unintended consequences as well. For instance, if you fix the price of a good ( say a car or an ice cream cone), producers are likely to cut costs, use inferior quality inputs and make money that way.
Or, if you were to fix the price of petrol at say Rs 10 a litre, then so many people will demand it that there will be endless queues and massive wastage of time.
A price cap also destroys any incentive to put the scarce resource to best use. Why would I go through the trouble of taking a commodity from point A to point B if I can’t get some extra money for doing so?
This inexorable logic of prices also means a government’s setting price floors — such as minimum wages or rent controls — also tends to achieve the exact opposite of what is intended.
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For instance, if you double the minimum wages in the country today, you may benefit some who already hold jobs but you will destroy the chances of many more who would not be employed in the future because it is just too costly to pay the minimum wages. In effect, by raising minimum wages in excess of productivity, the policymakers may impoverish the bulk of the workers.
That is why often a wage subsidy (where the government pays the difference between what the producer wants to pay and what the government considers a minimum wage) is a considered better intervention than hiking minimum wages.
Now, many of you might say: But health is not like any other commodity such as a car or petrol. Why shouldn’t medicine prices be capped?
The process of discovering cures and making medicines follows the same laws of economics and markets that making a new car design or a new aircraft engine or creating a new type of biscuit does. If anything, the chances of failure in the pharma industry could be higher and the process far more demanding in terms of monetary and time investment required to be successful.
So capping medicine prices might provide immediate relief but it also has an adverse impact.
A 2005 National Bureau of Economic Research paper found that “cutting prices by 40 to 50 per cent in the United States will lead to between 30 and 60 per cent fewer R and D projects being undertaken in the early stage of developing a new drug”. Relatively modest price changes, such as 5 or 10 per cent, would have a relatively modest impact.
How, then, to control drug prices?
Instead of capping prices, governments should realise that high prices show a demand-supply mismatch. A crucial reason why private hospitals are able to charge exorbitant prices — for drugs, tests or beds — is that there is inadequate public healthcare provisioning.
If governments invested in public healthcare and bought the essential medicines in bulk, they would have a better chance of making healthcare affordable without distorting the market.
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