Co-Opetition - Adam M. Brandenburger [83]
Dale Kramer, director of drug purchasing for Kaiser Permanente, America’s largest HMO, described the phenomenon: “In the past we’d offer a [drug] manufacturer 90 percent of our business, maybe $10 million in additional business, and get really low prices. Now, no one wants to go below the Medicaid floor.”5
That’s not all. Since no one gets a price below 88 percent of the average price, the average doesn’t stay put. As the prices at the low end vanish, the average price rises. Now a drug manufacturer isn’t going to offer anyone a price below 88 percent of the new, higher, average price. The reason is the same as before. And the result is that the average price in the market rises again. On it goes. It’s hard to say where all this ends up, but it’s possible that 88 percent of the eventual average market price will be higher than the original average.
For the government, insisting on paying only 88 percent of the average price in the market was quite sensible. The mistake was awarding itself an MFC at the same time. That gave the drug manufacturers an incentive to raise prices, and up the average went. The government got hit with the higher prices—and so, for that matter, did everyone else. What the government should have done was find a way to give the drug manufacturers an incentive to price low, not high. Then the average price would have fallen, and the government would have been able to cut its drug bill even further.
Stanford Business School professor Fiona Scott Morton estimated the effect of the 1990 change in rules on drug prices.6 She concluded that prices went up by an average of 9 percent for branded drugs on-patent and 5 percent for branded drugs off-patent. Even the prices of generic drugs rose, despite the fact that generics weren’t covered by the best-price provision. Generic prices went up by an average of 2 percent, riding the coattails of the rise in the price of branded drugs.
The way the new game played out may have been a surprise to the government, but it wasn’t to the drug makers. They had it right all along. Drug makers didn’t exactly object to having to give the government the best price. Roy Vagelos, CEO of Merck, explained: “Our concept of best-price for Medicaid—now incorporated into federal law—was supported by our longstanding policy of avoiding deep discounts.”7
In voting itself MFCs, Congress ended up helping out the television networks and drug manufacturers at the expense of advertisers and HMOs. Congress didn’t do itself any great favor, either.
MFCs change the game. When your customers have MFCs, you’re more able to withstand pressure to lower price. There’s a common ritual in negotiations with customers over price. You say to the customer: “I’d love to give you a better price, but I can’t afford to.” The customer responds: “You can’t afford not to. If you don’t, I won’t buy from you.” Often you lose the argument. But if your other customers have MFCs, your argument becomes a lot more convincing. You can point out that a price concession to one will, by necessity, become a price concession to all. And that’s something you really can’t afford. You can just say no.
MFCs are an instance of “strategic inflexibility.” People often think that having more flexibility is one of those universally good things. It isn’t. Sometimes you have more power when your hands are tied.
This was the strategy employed by Hernán Cortés, the Spanish conquistador, upon his arrival in Mexico. His troops were vastly outnumbered. Fearing defeat, many of them wanted to turn back. To strengthen his men’s resolve, Cortés had his ships beached and then taken apart.8 With the option of retreat eliminated, Cortés’s soldiers fought their way inland. By the time they reached the Aztec capital, Montezuma was ready to surrender without a battle. Cortés’s strategy, though it reduced his options, strengthened his hand.
Giving a customer an MFC works the same way. You’ve reduced your options, since you’re now forced to give the customer the best price you give anyone else. This strategic