Reducing pharmaceutical reimbursement price risk to lower national health expenditures without lowering R&D incentives

In Japan, higher reimbursement drug prices give pharmaceutical firms stronger R&D incentives, but they also increase the financial burden on national health insurance and patients. Considering the severe financial situation that the government faces, analyzing how to achieve lower national health expenditures without lowering pharmaceutical firms’ existing R&D incentives is important. In this research, we investigate the effect of reducing the reimbursement price risk that pharmaceutical firms face on their R&D incentives. Theoretically, the presence of output price risks reduces risk-averse firms’ R&D incentives. Therefore, to the extent that pharmaceutical firms exhibit risk aversion, if creating guidelines, accelerating information disclosure and/or enabling public–private dialogue can reduce reimbursement price risks, then maintaining or even increasing R&D incentives is possible, even if the level of reimbursement drug prices is reduced. Specifically, we address (1) by how much a given level of reimbursement price risk reduces pharmaceutical firms’ R&D incentives; (2) by how much reimbursement drug prices can be reduced, keeping pharmaceutical firms’ R&D incentives constant, if one can successfully remove the risk; and (3) how the magnitude of the impact changes with the degree of price risk that firms face and with the level of their risk aversion. To this end, a hypothetical new branded drug is constructed from actual data on the Japanese drug market. Assuming that a pharmaceutical firm is an expected-utility maximizer, that the firm’s instantaneous utility function is in the form of the constant-relative-risk-aversion utility function and that its R&D incentives are quantified by the standard discounted cash flow valuation, we use simulations to compute the certainty equivalent and risk premium associated with various degrees of price risk and risk aversion. Referring to the empirical literature on risk preference, we set the parameter value for the level of relative risk aversion of a pharmaceutical firm to 3.0 and that for the discount rate to 0.08. The following results emerged. (1) In the presence of a 20% price risk regarding a reimbursement price of 100 (i.e., ranging from 80 to 120), a pharmaceutical firm’s certainty equivalent is 96.0. Hence, in the presence of a 20% price risk, a risky reimbursement drug price of 100 is equivalent to a sure reimbursement drug price of 96.0. (2) In the presence of a 20% price risk regarding a reimbursement price of 100, the price premium is 4.0. Therefore, by increasing the predictability of future prices, the reimbursement price may decrease by 4.0, while the firm’s R&D incentives remain unchanged. (3) The magnitude of the impact increases at an increasing rate with the degree of price risk and increases at a decreasing rate with the level of risk aversion.