It has been found that in general, the elasticity of demand for health care is -0.17, meaning that for a $1 increase in the cost of health care there is a decline in demand of $0.17 (Ringel et al., 2005). Health care is a unique product. It would be reasonable to think that the cost of one's health is irrelevant -- that consumers would place nearly infinite value on their health, resulting in very little elasticity of demand. Indeed, a figure of -0.17 indicates that this is true to a significant extent. Demand for health care does not drop precipitously when health care costs increase. In the United States, however, it does drop. There are several ways in which consumers reduce their health care expenditures in the wake of increased prices. They may switch from branded drugs to generics; they may reduce their level of care; or they may seek lower cost solutions.
Insurance must also be taken into consideration with respect to the elasticity of demand. An individual given unlimited funding would be apt to believe his or her health to be sacrosanct, and therefore the elasticity of demand would be zero. However, when economic decisions are required, some sacrifices may be made. When the body making the decision is not the patient, the elasticity should be expected to increase. Indeed, for an insurance company, there is direct economic incentive to reduce service in the face of rising costs. Insurance companies either place a cap on funding or find ways to eliminate coverage. In either case, the reduction in demand that results from an increase in cost has less to do with the consumer's lack of desire to pay so much as a combination of the insurance company's lack of desire and the patient's lack of ability.
Insurance companies gain their revenue from the premiums that they collect. The company then disburses this money as claims. By reducing the amount of claims paid or the number of claims paid, insurance companies can increase their profits. In the face of rising costs, the propensity to reduce coverage is economically justifiable. This does, however, place limits on demand growth for pharmaceutical and diagnostic companies like Roche.
Governments represent another major customer for health care. Elasticity of demand with government services has been steadily increasing over time. The current U.S. health care debate effectively centers on the issue of cost control as much as any other issue. Provincial health care plans in Canada are also seeing pressure to contain costs. There are two different proposed responses. One is to cut access to certain forms of health care or certain drugs. Forcing consumers to cover these costs out-of-pocket or through insurance will compel some of them to reduce their treatment, stop it altogether, or find ways to reduce the cost of the treatment. Each of these actions will have the net effect of reducing demand. For a company like Roche this can have a wide range of impacts. Consumers may opt for generics to save money, even at the expense of effectiveness. Consumers may also be willing to try alternative medicines such as traditional Chinese medicine in order to reduce their health care costs.
The other way, such as is proposed in the U.S. health care reform, is that governments will seek to increase their bargaining power. Canada's government already exerts strong bargaining power over pharmaceutical companies resulting in lower drug prices; the same in the U.S. would lead to dramatically reduced per capita demand in health care. For a firm like Roche, this may be offset by the demographic trends but eventually lower per capita health care expenditures will affect the company's profits.
Rising health care costs threaten to increase the historic elasticity of demand for health care. For Roche, this has strong strategic implications. In the short run, Roche can leverage the low elasticity to gain profit but in the long run governments will have a strong mandate to reduce health care costs. This will in turn reduce per capita demand. Roche will need to find ways to counter this trend in order to maintain its share and its profit margins.
The possibility of substitutes, such as homeopathics, TCM and other forms of health care, raises implications for Roche with respect to cross-price elasticities of demand. At present, there is only a small degree of cross-price elasticity in health care. Demand for alternative medicines is growing, but the field remains a niche market. This demand is driven partly by the high cost of scientific health care but also in part based on philosophy -- some consumers simply prefer not to make extensive use of the scientific health system. Should the price of health care -- pharmaceutical in particular -- increase too much, however -- which it does when insurance companies drop coverage and governments refuse to pay for certain drugs or treatments -- then the demand for alternative medicine increases. As governments and insurance companies seek to curtail health costs in the face of dramatically rising demand, they will an increasing amount of health care costs on consumers. To the point where this suppresses demand for Roche's products and stifles growth opportunities, it may increase demand for alternatives. At this point and going forward, however, there is little evidence that the trend flows other way. Roche does not see significant change in its demand on the basis of price changes in alternative medicines, primarily because the effectiveness of such treatments is not high enough to justify a mass scale consumer switch. Should that change, cross price elasticities between scientific medicine and alternative medicine would increase, adding a new dynamic to Roche's microeconomic environment.
The Supply Side
Roche, as with most other firms in its industry, has a high degree of pricing power over its suppliers. Roche is a global company with revenues in excess of $46 billion. While most of their suppliers are relatively large companies and high end labor, Roche's sheer size gives it the ability to control prices. This is reflected in the consistency of the company's gross margin over time. In 2009 the gross margin was 29.7%, compared with 31.6% in 2006 (MSN Moneycentral, 2010).
The traditional drivers of supply pricing are the demand, the availability of supplies and the bargaining power of the respective parties. Despite the high degree of bargaining power for pharmaceutical and diagnostics companies and their low degree of backward integration, they have little difficulty finding suppliers. In part, this is because firms such as Roche can take advantage of the relatively low elasticity of demand to pass costs along to consumers.
One interesting dynamic of Roche's supply side is going to be in future when governments in particular seek to curtail spending on health care. From Roche's perspective, demand will almost assuredly increase regardless as a result of the dramatic demographic shift. However, on a per capita and on a per item basis, there is little doubt that Roche and other drug firms will be squeezed. Governments already use their bargaining power to placed downward pressures on prices, and the goal of health care reform is in part to increase the U.S. government's buying power so that it can place downward pressure on costs as well. So despite the overall increase in aggregate demand, for any individual product, Roche will be facing downward price pressure over the coming years and decades.
For Roche, this will probably impact on the supply side. Roche will need to exert its bargaining power more in order to pass those cost reductions along to its suppliers. That the company is so large will give it an advantage in doing this. The suppliers will likely be forced to be price takers, due to Roche's sheer size. There is essentially no risk that suppliers will exit the industry if they are faced with lower prices for their goods, since they will still be in a large, high-growth industry, and this is to Roche's benefit. Suppliers committed to the industry have higher exit costs, which means that it will be easier for Roche to drive down its costs using its economies of scale on these firms, knowing that there is little to no risk of losing supply. Roche's supply side considerations are far less critical to the course of its business in the coming years than are its demand side considerations.
Roche competes in one of the most heavily regulated industries in the world, the pharmaceutical and diagnostics business. The effect of this regulation is that it creates a high degree of disequilibrium in the industry. In general, this disequilibrium has favored companies like Roche, a firm that now does $46 billion in annual sales. In the United States, insurance companies also play a significant role in the supply/demand equation. The way that the industry is structured at present allows Roche to command a high degree of influence over pricing, both to…