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The importance of price elasticity of demand in the health sector

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Oscar Rodriguez
Economist
Researcher ES
Neuroeconomix

What are the incentives for the pharmaceutical industry to invest in R&D for new drugs? What are the effects of taxes on the consumption of sugary beverages? These questions, although very different from each other, have something in common, and that is that their answers include the concept of the price elasticity of demand. This blog presents the concept and its importance in the decision-making of the different agents that make up the health sector.

 

Definition

Demand can be defined very generally as the quantity of a good or service that an individual is willing to purchase. However, the decision to consume it not only depends on preferences, tastes or personal needs, but also on the price of the good or service and those who can substitute it, on the consumer's income and another group of factors that are more complex to determine. . To be able to establish then a demand function that includes each of the determinants as variables requires a fairly high level of complexity, so in practice analyzes are carried out abstracting only one of these factors (price of the good) assuming that the others remain constant.

 

This simplification of the analysis allows us to identify what would be the percentage response of the quantities that the agents demand before a percentage change in their sale price. This measure is called Price Elasticity of Demand (EPD), which is calculated from the following expression:

elasticidad2

Where EPDi is the price elasticity of demand for good i, Q is the quantities demanded, P is the market price and is the mathematical operator of increase.

 

Demand will be elastic (EPD> 1) when a percentage increase in price implies a more than proportional reduction in the quantities demanded. On the contrary, demand is inelastic (EPD <1) when an increase in price represents a less than proportional reduction in the quantities demanded. On the other hand, if the EPD = 1, it is called a demand with unit elasticity when the price increase represents a proportional reduction in the quantities (1).

 

What determines, then, that a demand function is elastic or inelastic is the type of good that is being analyzed, the possible substitutes and the need that the consumer has to acquire it. Those goods that are not easy to replace, but also cannot be postponed, present an inelastic demand function. These characteristics are found in most of the products offered by the pharmaceutical industry, but not in all of them. Why?

 

This is due to the differences that exist in the markets, and the existence of different products even when they are focused on fighting the same disease, for example, curative, palliative or vaccination treatments. The demand for the vaccine against COVID-19 is not the same as the cure or treatment of this disease; each of these goods satisfies different needs. So what determines or what are the incentives for the pharmaceutical industry to invest in R&D for new drugs?

 

The price elasticity of demand for curative products will be determined by the level of lethality of the disease. To the extent that the disease is more lethal and there is no palliative treatment, the demand will be perfectly inelastic, that is, no matter how much the prices of the medicine change, the patient does have to demand the medicine in order to live. If the disease is fatal, but there is a palliative treatment, the demand for a cure will go from being perfectly inelastic to inelastic since there is the possibility of living even with the presence of the disease. On the contrary, when the disease is of low fatality and there is also a palliative treatment, the demand for the cure of this disease will be elastic.

 

It is evident that the pharmaceutical industry, making use of its monopoly position, thanks to the Intellectual Property Rights Agreement, signed within the framework of the World Trade Organization for the invention of new products, has the power to determine prices and quantities. , and therefore, it will invest in those markets whose demand function is more inelastic since in this way it maximizes its profit. Being able to understand the price elasticity of demand for the different products offered by the pharmaceutical industry becomes a tool for determining research and development efforts for new drugs, setting budgets, improving the effectiveness of existing treatments, and launching them on the market. new products, be more efficient in the allocation of resources, compare the consumption of drugs with the public needs of health systems, among others.

 

The pharmaceutical industry is not the only one that should bear in mind the concept of EPD as a decision-making tool. In the public sector this concept also has a relevant role, mainly when you want to implement a public policy that benefits the general health of the population, and can also increase tax collection that strengthens health spending. Currently, the possibility of taxing sugary drinks in the country is on the table for discussion, in order to discourage their consumption and thus be able to control the increase in overweight people, diabetes and cardiovascular diseases. According to León Torres and collaborators, one out of every two adults between 18 and 64 years of age in the country suffers from overweight or obesity (2), and according to the reports of the leading causes of mortality in the country according to the DANE, coronary disease, cerebrovascular disease and other hypertensive diseases occupy the first positions.

 

In the country there is no consensus regarding the price elasticity of the demand for sugary beverages, however, several studies show that these products generally have an elastic EPD, which indicates that an increase in their price would reduce consumption in a way more than proportional (3). In Mexico, the EPD calculated for soft drinks was -1.06 and for sugary drinks -1.16, which means that an increase of 10% in the prices of these drinks is associated with a reduction in consumption of 10.6% for soft drinks and 11.6% for sugary drinks (4).

 

As has been pointed out, the concept of EPD is useful and becomes relevant in the decision-making of different actors in the health sector. Despite this, in practice it is not widely used due to the challenge of estimating a demand function, as highly complex econometric strategies are required.

 


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References

1. Joseph E. Stiglitz. Principles of microeconomics. Ariel E, editor. 1994. 752 p

2. León, Rodriguez-Llach, Guarnizo. (2021). Tax on sugary drinks: an idea in favor of public health, Bogotá, Editorial Dejusticia.

3. Sassi, Belloni, & Capobianco. (2013). The role of fiscal Policies in Health promotion. OECD Heath working papers

4. Colchero, Salgado, Unar-Munguía, Hernandez-Avila, Rivera-Dommarco (2013). Taxes on soft drinks: strategy for the prevention of obesity. Obtained from http://www.insp.mx/epppo/blog/2824-impuestos-refrescosestrategia-prentación-obesidad.html

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