Profitability and leakage under the PBS

Donald J. Wright, University of Sydney


To achieve the objective of ‘securing a reliable supply of pharmaceutical products at the most reasonable cost to Australian taxpayers and consumers’ (PBPA 2000), the Australian government has implemented a system of regulated prices and per-unit subsidies known as the Pharmaceutical Benefits Scheme (PBS). In 2001–02 the total subsidy amounted to 0.6 per cent of GDP and was 15 per cent of total Commonwealth health expenditure. However, the Intergenerational Report projects these numbers to grow dramatically over the next 40 years to 3.35 per cent of GDP and 41 per cent of health expenditure by 2041–42 (Department of Treasury 2002, p. 39). Although such long run projections must be viewed with scepticism their sheer size suggests that current PBS arrangements might not be sustainable. This paper discusses two features of the PBS that impact directly on its cost.


Under the PBS, the regulated price a consumer pays for a drug appearing on the PBS list is either $23.10 for a general patient or $3.70 for a concessional patient (aged, disabled, unemployed, etcetera). The price the pharmaceutical firm receives is called the agreed price and is the outcome of a bargaining process between the pharmaceutical firm and the Pharmaceutical Benefits Pricing Authority (PBPA). The difference between the agreed price and the regulated price is the implied per-unit subsidy paid to the pharmaceutical firm. Therefore, the total subsidy cost to the government depends on both the agreed price and the quantity consumed. As examples, currently the agreed price of three of the most costly drugs to the PBS are Bupropion (150mg, nicotine dependence) $213, Simvastatin (30mg, cholesterol) $70, and Omeprazole (29mg, peptic ulcer) $38 (Department of Health and Ageing 2003a; 2003b). To be listed under the PBS a drug must go through an evaluation and bargaining process. This process establishes whether the drug is cost-effective, that is, whether at the agreed price it yields an additional unit of health benefit at less cost than the next best alternative drug.


Formal economic modeling is a powerful tool because it forces researchers to be explicit about their assumptions.

Formal economic modelling is a powerful tool because it forces researchers to be explicit about the assumptions they make. To apply formal economic modelling to the PBS, I reduce the institutional detail above to its essence. I model pharmaceutical regulation under the PBS as a multi-stage game played between pharmaceutical firms and the PBPA. In this game, both firms and the PBPA act to maximise their payoffs.

In the first stage of the game, pharmaceutical firms choose whether to enter a particular drug into the costly evaluation, regulation, and bargaining process. In the second stage, the drug is evaluated for quality. One drug is of higher quality than another if it delivers more health benefit than another. In the third stage, the PBPA determines which of the drugs submitted for evaluation are regulated and sold to consumers at the regulated price. In the fourth stage, the pharmaceutical firm and the PBPA bargain over how much of the additional net health benefit created by regulating the drug is to be transferred from the taxpayer to the pharmaceutical firm via the agreed price. Finally, in the fifth stage, pharmaceutical firms that produce drugs in the same therapeutic class compete with each other. Those that are regulated sell at the regulated price and those that are not sell at the price that maximises firm profits.

In a longer paper, I add structure to the game described above and solve for the sub-game perfect Nash equilibrium (see Wright 2004). For the purposes of the discussion in this short paper, the structure of most relevance is the bargaining stage of the game. This structure, that is, the closer specification of the players, their actions, and their payoffs, is as follows. A drug that is regulated sells at a lower price to the consumer than an unregulated one. Therefore, assuming an inverse relationship between the price of a drug and the quantity sold, more of a regulated drug will be sold. Selling a greater quantity of a drug creates greater health benefit net of costs than if the drug were simply sold at an unregulated price. The pharmaceutical firm and the PBPA bargain over what share of this additional net health benefit accrues to the firm and what share goes to the rest of society. I assume a Nash bargaining solution so that both the regulated pharmaceutical firm and the PBPA (society) achieve a payoff which is what they would achieve in the absence of regulation plus half of the additional net health benefit created by regulating the drug. The transfer of net health benefit to pharmaceutical firms is implemented by paying the pharmaceutical firm an agreed price which is greater than the regulated price.

We can use this Nash bargaining model and the idea of ‘sub-game perfection’ to think about two perceived problems in the PBS: pharmaceutical firm profitability and leakage. (It is of interest to note that the Nash bargaining solution and the concept of Nash equilibrium were the two contributions for which John Nash received the Nobel Prize in economics in 1994.)


Working within the structure outlined above, we can draw the following inferences. The profit a pharmaceutical firm makes in an unregulated environment provides an outside option for the firm in the bargaining process. It must receive at least this amount under bargaining otherwise it will not enter the costly evaluation, regulation, and bargaining process. In fact, the Nash bargaining solution yields a regulated pharmaceutical firm the profit it would achieve in an unregulated environment plus half of the additional net health benefit created by regulation. Therefore, a regulated pharmaceutical firm is unambiguously better off than it would be in an unregulated environment.

At first, this result seems paradoxical because the agreed price under regulation is less than the unregulated market price. However, this paradox is resolved once we realise that the quantity of the drug sold depends not on the agreed price, but on the price consumers pay, namely, the regulated price. More is sold at the regulated price than at the unregulated price and producers receive the agreed price for this larger quantity.

A regulated pharmaceutical firm benefits from being able to sell greater quantities as a result of subsidies injected by the government.

If pharmaceutical firms are unambiguously better off under regulation than in an unregulated environment, what explains the pharmaceutical industry’s hostility towards the PBS as currently structured? One of the major complaints of foreign owned pharmaceutical firms is that the agreed price is too low especially when compared to the price they receive in the US market. Clearly, a higher agreed price results in a bigger transfer and increases the profit of a pharmaceutical firm, but does the US price have any relevance for regulation in Australia? The answer is no. In an unregulated US market the quantity sold depends on the market price, whereas in Australia, under regulation, it depends on the regulated price. Industry rhetoric implying that firms suffer from a lower agreed price overlooks the fact that they also benefit from being able to sell greater quantities as a result of subsidies injected by the government. The former should not be evaluated in isolation of the latter.

In this light, the attempt by pharmaceutical firms to obtain an agreed price closer to the US unregulated price is just an attempt to obtain a larger share of the additional net health benefit created by regulation. It is perfectly understandable, but not warranted as a regulated pharmaceutical firm already makes more profit than it would in an unregulated environment. This argument applies to any change in structure which is aimed at moving the agreed price in Australia closer to the unregulated US price including current free trade negotiations between Australia and the United States.

Currently, the PBPA lists the price of a drug in comparable overseas countries as a factor it takes into account when bargaining over the agreed price. The discussion above suggests the PBPA should reinterpret comparable overseas countries to mean those that have similar regulatory environments, and specifically exclude the United States.


Another mechanism also operates to enhance firm profitability under the PBS. A particular drug often has more than one use. In uses where the additional net health benefit created by regulation is large, the agreed price will be relatively high as it must transfer half of the additional net health benefit to the pharmaceutical firm. In uses where the additional net health benefit is small the agreed price will be relatively low. This suggests that the same drug should have different agreed prices depending on use. However, as Johannesson (1992) recognises, it is difficult for regulators to administer complex use restrictions, and in their absence a problem known as leakage arises.

Assume there are no use restrictions. A pharmaceutical firm that has a drug with many uses and that understands the evaluation, regulation, and bargaining process will only submit the drug for evaluation in the use that will yield the highest agreed price, because the firm will receive this high agreed price for all uses, even those that warrant a lower agreed price. (This is where the idea of ‘sub-game perfection’ comes in: firms realise what will happen in the rest of the game when they make their decision about what drug use they submit for evaluation.) The drug has ‘leaked’ from uses with high health benefits to ones with low health benefits. This results in un-negotiated transfers flowing to the pharmaceutical firm and increases the cost to the taxpayer of the PBS.

Regulators find it difficult to administer complex use restrictions; in their absence the problem of leakage arises.

The problem of leakage and un-negotiated transfers can be eliminated if use restrictions are strictly enforced. However, a less administratively intensive solution is available. Un-negotiated transfers arise because regulated pharmaceutical firms receive a subsidy for each unit sold equal to the difference between the agreed price and the regulated price. If transfers were paid in the form of an up-front payment instead of per unit of usage, then there would be no un-negotiated transfers, firms would not stand to gain from leakage, and the cost to the taxpayer would be reduced. A similar solution involves the use of price-volume agreements where the agreed price is paid for a specified quantity of sales but for any sales in excess of this quantity the pharmaceutical firm only receives the regulated price. The implication of this analysis is that the PBPA needs to rethink how it implements transfers.


This paper suggests there are two avenues through which the government can reduce the cost of the PBS. The first is for the PBPA to resist pressure from pharmaceutical firms to set agreed prices closer to those ruling in the United States. This pressure should be easy to resist once it is realised that pharmaceutical firms make more profit in a regulated environment than they do in an unregulated environment. The second is for the PBPA to reconsider the method it uses to transfer additional net health benefit to pharmaceutical firms. Up-front payments and price-volume agreements are not subject to leakage and avoid large un-negotiated transfers that are costly to the taxpayer.


Department of Health and Ageing 2003a, Schedule of Pharmaceutical Benefits for Approved Pharmacists and Medical Practitioners [Online], Available: [2003, Dec. 3].

Department of Health and Ageing 2003b, Who Pays? Where Does the Money Go?, [Online], Available: [2003, Dec. 3].

Johannesson, M. 1992, ‘The Australian Guidelines for Subsidisation of Pharmaceuticals’, PharmacoEconomics, vol. 2, no. 5, pp. 355–362.

PBPA, 2000, Annual Report, Pharmaceutical Benefits Pricing Authority.

Department of Treasury 2002, Budget Paper No. 5, 2002–03, Intergenerational Report, Commonwealth of Australia.

Wright, D. J. 2004, ‘The Drug Bargaining Game: Pharmaceutical Regulation in Australia’, Journal of Health Economics, forthcoming.

Don Wright is Associate Professor of Economics in the School of Economics and Political Science at the University of Sydney.