How do private players respond to public entry in pharmaceutical markets?

In 2012, the government of West Bengal outsourced the operation of key public pharmacies to private players – creating fair-price shops for selected generic medicines. How has the private sector responded to this policy intervention? Analysing the impact on prices of different categories of medicines, this article finds that the private sector response hinges on the extent to which consumer preferences are ‘sticky’.

Across the globe, governments have presence in sectors such as healthcare, education and housing, with the purpose of improving availability of essential goods and services as well as correcting prices and enhancing consumer choice-sets and welfare.

But do we know enough about how the private sector responds to entry by the public sector? On the one hand, after the entry of public sector firms, private firms may segment the market, and leverage the quality sensitivity of certain consumers – allowing for more choices for consumers overall and ultimately higher welfare. On the other hand, a big public sector may ‘crowd out’ private sector investment. This may have subsequent negative consequences in terms of employment generation and productivity growth. Hence, the response of the private sector to public firm entry is ambiguous but important to understand, particularly in mixed market settings of the developing world.

Entry of public firms in India’s pharmaceutical sector

In new research (Chatterjee and Gupta 2024), we explore this question by studying the entry of public pharmacies in India. Pharmaceutical markets provide an apt laboratory for such analysis. Making essential medicines available is a public policy concern in many countries, and this also provides a rationale for huge investments from the private sector. In 2012, the state government of West Bengal outsourced the operation of public pharmacies in key locations to private players. Private-sector operators that were willing to offer the highest discounts on selected generic medicines¹ were chosen to run the pharmacies – in some cases, these discounts ranged up to 70%. These pharmacies were known as fair-price medicine shop (FPMS). FPMSs not only introduced a price gradient against the private sector, but due to the existing service and product quality and issue of crowding, a quality gradient was also generated.

Theoretical framework

Building on a theory of ‘vertically differentiated competition’², we posit that the entry of FPMS will attract price-sensitive and quality-agnostic consumers away from private shops. The response of the private sector will then depend on the residual market of quality-conscious consumers.

If this residual market comprises consumers with ‘inelastic’ demand (that is, consumers whose buying habits and preference for quality will remain the same even if prices change), then the private sector will be able to increase retail prices. This is in line with the ‘generic competition paradox’ recorded in a vast literature on pharmaceutical pricing in the US, wherein entry of generic medicines leads to an increase in prices of branded drugs (Frank and Salkever 1992, Frank and Salkever 2004, Vandoros and Kanavos 2012). As wholesalers observe the new demand schedule, they will also increase their prices.

If the residual market consists of consumers with ‘elastic’ demand, then the prices at which private firms were selling prior to the entry of public firms will become unviable. Wholesalers will then be compelled to reduce prices for the retailers, who will pass on the price drops to consumers.

To summarise, from a policy perspective, the welfare effects of public entry and potential responses from the private sector will be conditioned by the balance between elastic and inelastic markets that exist a priori in the system.

Data and findings

The main source of data for our analysis is the All India Organization of Chemists and Druggists’ Pharmatrac database (AIOCD) (Bhaskarabhatla et al. 2016), which records monthly-level retail and wholesale prices of stock-keeping units (SKUs) of nearly 2,800 drugs sold in private sector pharmacies. We match the drugs observed in this database with the mandated list for FPMS in West Bengal. To test our theory, we divide the matched drugs into two categories, namely oncology and non-oncology.

Oncology drugs are meant to treat acute conditions that require immediate and frequent intervention. Einav et al. (2018) suggest that such drugs likely to have a high proportion of quality-conscious inelastic consumers. This provides us with our first ‘treatment group’ of molecules with quality-conscious consumers. Our second treatment group consists of drugs meant for chronic conditions, and is more likely to have elastic, quality-agnostic consumers (Sorenson 2000). Finally, the remainder of the medicines (non-FPMS) are placed in the ‘control group’. Given two treatment groups and two price metrics (retail and wholesale), we study four quasi-experiments as given in Figure 1 below. In each of the quasi-experiment, we compare the changes in prices between treated and control group over time.

Figure 1. Matrix of quasi-experiments

The empirical estimates support our theoretical predictions. In particular, the non-oncology wholesale prices observed in the private sector fell by 57% of the average wholesale prices after the entry of FPMS. Similarly, retail prices fell by 3.6% of the average. Within the non-oncology group, the effect is higher for vitamins and analgesics, for which elasticity is high due to substitutability with home remedies. Thus, the decline in prices is higher for drugs with more elastic demand, conforming with our hypothesis.

For oncology drugs, which are likely to have a higher proportion of quality-conscious consumers, wholesale prices register a significant increase of nearly 240%. However, the retail prices do not show statistical evidence of a rise, countering our theory. The retail prices of oncology medicines are heavily regulated owing to their essential nature (Drug Price Control Order, 1996). Absence of statistical evidence on increase in retail prices could be due to the upper limit of the price ceiling on oncology drugs. We confirm this hypothesis by showing that the likelihood of retail prices of oncology equaling the price ceiling goes up after the entry of FPMS.

Pre-existing competition within the private sector may also influence these results. Higher competition in the quality-agnostic market may push viable prices even lower due to the threat of exit. Among quality-conscious consumers, there is no threat of exit, but per firm demand reduces, disallowing quantity discounts for retailers. To explore this issue, we compare our results across the markets of Kolkata and the rest of West Bengal. The former has a higher presence of private hospitals, and thus, is likely to have a higher density of private sector pharmacies owing to co-location of dependent industries (Porter and Porter 1998). The magnitude of the effect across all four quasi-experiments is higher in Kolkata.

Conclusion and scope for future research

Public sector provision of essential goods and services is likely to become more common globally. In our study, we explore the private sector response to the entry of public firms in the retail pharmaceutical market. We show that the private sector response hinges on the extent to which consumer preferences are sticky. Without the presence of a sufficient mass of quality-conscious consumers, public entry may crowd out the private sector. On the other hand, predominance of quality-conscious consumers or high switching costs may make public firm operations unviable.

The study raises new questions which, given our data limitations, we were unable to answer. First, it is important to understand the aggregate welfare effects prices of public sector entry. Consumers of non-oncology medicines will undoubtedly benefit due to lower prices. However, deteriorating conditions for the retailers of these drugs in terms of viable costs, will have to be accounted for to understand the total surplus change. Further, higher prices of oncology medicines may not necessarily imply lower consumer welfare if the consumers enjoy higher quality.

Second, our study period was from 2009 to 2014. The FPMS scheme is still ongoing and thus, there is scope for studying dynamic effects. In particular, residual consumer mass can be increased if firms could increase switching costs for consumers, through bundling of different items, quantity discounts, or engaging in long-term contracts. Do private retailers engage in such practices?

Third, understanding the true welfare effects of interventions such as FPMS in a health economics context will also require assessing the impact of cheaper availability of medicines on patient outcomes in the long-run.

Finally, most states in India have some form of medicine procurement system for its public pharmacies, similar to FPMS in West Bengal. An inter-state comparison of different procurement models can inform public policies.

The authors would like to thank seminar/conference participants at Indian Institute of Technology (IIT) Kanpur, Indian Institute of Management (IIM) Calcutta, the annual IHOPE Conference at LV Prasad Eye Institute, Hyderabad, and the Asia Pacific Industrial Organization Conference (Hong Kong), 2023. The analysis also benefitted from comments from Anindya Chakrabarti, Matthew Higgins, Dilip Mookherjee, Sudipta Sarangi, D. Daniel Sokol and Frank Verboben.

Notes:

The full list of medicines to be sold at these public pharmacies can be accessed here.
Vertically differentiated competition arises between two similar but not identical products, with an apparent quality differential between them.