Pricing the Pharmaceuticals When the Ability to Pay Differs: Taking Vertical Equity Seriously

A non-trivial fraction of people cannot afford to buy pharmaceutical products at unregulated market prices. This paper analyses the public insurance of a patent-protected pharmaceutical product in terms of price controls and socially optimal third-degree price discrimination. First, the paper characterizes the Ramsey pricing rule in the case where the producer price has to cover the R&D costs of the firm and patients’ pharmaceutical expenditures are not covered by health insurance. Subsequently, conditions for a welfare increasing departure from the Ramsey pricing rule are stated in terms of price regulation and health insurance coverage. Unlike the earlier views expressed, the increased consumption of the pharmaceutical is shown to be welfare increasing. In the spirit of the Rawlsian view, a criterion for vertical equity is examined as an optimal means-tested health insurance. In this scheme, the regulator chooses a higher insurance coverage for individuals whose income is below an endogenously determined income threshold. The means-tested insurance scheme improves social welfare but also yields very equal market outcomes.