1 - Pricing the EpiPen - Lecture Notes

Case Snapshot

Mylan Inc., led by CEO Heather Bresch, sells the EpiPen, an auto-injector that delivers a measured dose of adrenaline (epinephrine) to treat anaphylaxis - a fast, potentially fatal allergic reaction triggered by foods (nuts, shellfish), bee stings, latex, or drugs. Without treatment the victim's airway closes and they can die within minutes.

The facts that drive the case:

• Mylan bought the EpiPen line from Merck in 2007. The product had been on the U.S. market for 25+ years.
• Mylan raised the price more than three and a half times over five years (Senator Grassley's letter says "over 400 percent" since 2007). A two-pack reached roughly USD 600 (about USD 300 per pen).
• EpiPen revenue grew from about USD 200 million to more than USD 1 billion; the number of patients grew 67% over seven years.
• The marginal cost is tiny: adrenaline costs less than USD 1 per dose and the device itself is thought to cost less than USD 1.
• The price triggered a media firestorm, a U.S. Senate inquiry (Grassley letter, Exhibit 1), and a stock drop of more than 10% in one week (USD 48.54 to USD 43.03).

The exam question type: a firm with market power is charging far above cost. Diagnose the market failure, explain the pricing, evaluate the firm's defenses, and recommend policy.

The Core Market Failure - Monopoly Power

Public economics studies four classic market failures: public goods, externalities, asymmetric information, and imperfect competition. The EpiPen is a case of imperfect competition - specifically a near-monopoly.

A monopoly has these features:

• A single seller (or one dominant seller) of a good with no close substitutes.
• Barriers to entry that keep rivals out.
• The firm is a price maker: it faces the whole market (downward-sloping) demand curve, rather than taking the price as given.

Mylan held roughly 90%+ of the U.S. epinephrine auto-injector market, so it behaved as a monopolist. A competitive firm would be pushed by entry to price near marginal cost; a monopolist is not, so price can sit far above cost.

Barriers to Entry

Monopoly power is only durable if rivals cannot enter. Identifying the barriers is the heart of an exam answer.

Patents and Regulatory Approval

• The drug (epinephrine) is old and off-patent - anyone can make it. The protected asset is the delivery device: the spring-loaded auto-injector mechanism was covered by patents.
• The EpiPen is a combination drug-device product. To sell a true generic substitute, a rival must win FDA approval showing the device is equivalent - slow, costly, and uncertain. This regulatory hurdle is itself a barrier to entry.

Brand Power and Switching Costs

• Through heavy marketing, "EpiPen" became a genericized trademark - the "Kleenex" of auto-injectors. Doctors write "EpiPen," not "epinephrine auto-injector."
• Switching costs: patients, parents, schools, and first responders are all trained on the specific EpiPen mechanism. A different device works differently, so users are reluctant to switch even to save money.
• Pharmacists generally cannot auto-substitute a different brand the way they swap in a chemically identical generic, because the devices are not rated as equivalent.

Why Competing Auto-Injectors Failed

• Auvi-Q (Sanofi): voluntarily withdrawn from the market in 2015 because it could deliver inaccurate doses.
• Adrenaclick: reintroduced in mid-2013 but captured only 7% of the market despite being cheaper (Walmart priced it at USD 142). Users would not switch - evidence of how strong brand and switching costs are.

The lesson: a cheaper rival existing is not enough. If buyers will not switch, the incumbent keeps its pricing power.

How a Monopolist Sets Price

The Marginal-Revenue-Equals-Marginal-Cost Rule

A monopolist maximizes profit by choosing the quantity where marginal revenue equals marginal cost (MR = MC), then charging the highest price the demand curve allows for that quantity. Because demand slopes down, MR lies below the demand curve, so the profit-maximizing price exceeds MC.

Price
  |\
  | \        D  (market demand: price falls as quantity rises)
P*|--*............
  |  |\
  |  | \
  |  |  \    MR  (lies below D)
MC|--|---|---------------  MC is near zero (about USD 1-2 per pen)
  |  |   |
  +--+---+----------------- Quantity
        Q*
Choose Q* where MR = MC, then read P* up off the demand curve.
P* is far above MC  =>  large markup and deadweight loss.

The Lerner Index and the Markup

The size of the markup depends on the price elasticity of demand, written as the elasticity (a negative number for a normal demand curve).

The Lerner Index measures market power as the proportional gap between price and marginal cost:

$L = \frac{P - MC}{P} = \frac{1}{|\varepsilon|}$

where the elasticity tells you how responsive quantity is to price. Rearranging gives the monopoly pricing rule:

$P\left(1 - \frac{1}{|\varepsilon|}\right) = MC \quad\Longrightarrow\quad P = \frac{MC}{1 - 1/|\varepsilon|}$

Key reading of these formulas:

• If demand is very inelastic (small |elasticity|), the Lerner Index is close to 1 - price is many times marginal cost.
• A monopolist always operates on the elastic part of demand (|elasticity| greater than 1), but if underlying demand is nearly inelastic, the price is pushed extremely high.

For the EpiPen, with price about USD 300 per pen and marginal cost about USD 2:

$L = \frac{300 - 2}{300} \approx 0.993 \quad\Longrightarrow\quad |\varepsilon| = \frac{1}{L} \approx 1.01$

The market behaves as if demand is barely elastic - meaning buyers are extremely insensitive to price. The next section explains why.

Why EpiPen Demand Is Price-Inelastic

Inelastic demand is what lets a monopolist charge a huge markup. Several forces make EpiPen demand insensitive to price:

• Life-or-death necessity with no substitute in an emergency. People will pay almost anything to avoid death from anaphylaxis. Shkreli's framing: a USD 300 EpiPen looks cheap next to a USD 20,000 emergency-room trip.
• No time or ability to comparison-shop. The prescribing physician chooses the product; the patient cannot shop around mid-crisis.
• The third-party-payer effect (see next section): insured patients do not feel the price, so their demand barely responds to it.
• Habit and training lock buyers in (switching costs again).

When demand barely responds to price, a firm with market power has both the ability and the incentive to raise price aggressively.

Price Discrimination

Price discrimination means charging different prices for the same product when the price gap is not justified by cost differences. Third-degree price discrimination charges different identifiable groups different prices based on their elasticities - charge more where demand is less elastic.

Third-Degree Price Discrimination Across Countries

The same EpiPen two-pack sold for very different prices across countries:

Exhibit 2 (Lichtenberg data) shows drug prices generally are highest in the U.S. and Puerto Rico and much lower in India, China, and Singapore. Bresch's own words: "We do subsidize the rest of the world."

The economics: countries with price controls or lower incomes have more elastic demand (a regulator or a poorer population will not accept a high price), so the profit-maximizing price there is low. The U.S., with weak price regulation and widespread insurance, has inelastic demand, so the price there is high. The rule MR-equals-MC applied market-by-market produces a high U.S. price and low foreign prices.

The Savings Card as a Couponing Device

The "My EpiPen Savings Card" gave insured patients up to USD 100 off, so many paid a USD 0 co-pay. Mylan said nearly 80% of commercially insured users who used the card got the EpiPen free in 2015. Analyze this as couponing - a price-discrimination tool, not generosity:

• The insurer still pays the high list price; the coupon only shields the patient's out-of-pocket cost.
• Shielding insured patients keeps their demand inelastic and keeps them from complaining - it defuses political pressure from the most vocal group.
• The people who feel the USD 600 are the uninsured, who have no coupon. The card effectively segments buyers and extracts the most from insurers while quieting the insured.

What Price Discrimination Requires

For price discrimination to work and persist, a firm needs:

1. Market power (it must be a price maker, not a price taker).
2. Identifiable segments with different elasticities (countries, insured vs. uninsured).
3. No arbitrage / resale between segments. Bans on drug re-importation from low-price countries are what stop buyers from undercutting the high U.S. price.

The Third-Party-Payer Distortion

In a normal market the consumer is also the payer, so price discipline works: if a seller charges too much, buyers walk away. Health care breaks this link.

• The patient consumes the drug, the insurer pays the bill, and an employer or the government funds the insurer.
• The decision-maker does not bear the cost, so demand becomes insensitive to price - a form of moral hazard in insurance and a principal-agent problem.
• Result: sellers can raise list prices because the person consuming feels little of it. This is why list prices balloon while coupon-shielded co-pays stay low - a stable but socially costly equilibrium.

Public dimension: more than 40% of U.S. children are insured through Medicaid or CHIP, so taxpayers ultimately pay for many EpiPens. That is the core of Senator Grassley's concern in Exhibit 1 - the price increase is a charge on the public budget, not just on private buyers.

Externalities and the Merit-Good Dimension

Epinephrine access has a positive-externality / merit-good character that justifies government concern beyond pure efficiency:

• The School Access to Emergency Epinephrine Act (2013) encouraged states to stock epinephrine in schools; many states passed laws requiring it.
• When prices rise, schools ration supplies and first responders build do-it-yourself kits from vials and syringes - an unsafe substitute. Grassley's letter flags this directly: high prices create an unsafe situation when untrained people improvise with raw materials.

So the high price does not only transfer money - it can reduce access to a life-saving good and push users toward dangerous workarounds, a negative spillover onto third parties.

Reading Mylan's Financials

The 8.9 Percent Profit Defense

Martin Shkreli defended Mylan by noting it was a generic drugmaker earning only an 8.9% net profit margin, so it was "not gouging." This argument is misleading, and the exam will reward you for seeing why:

• 8.9% is the company-wide margin, blending many low-margin generic products.
• The relevant figure is the product-level margin on the EpiPen: price about USD 300 per pen against marginal cost about USD 2 - a gross margin near 99%.
• A company-wide average hides an extremely profitable single product. Always separate product economics from firm-wide accounting.

Key Income-Statement Lines

From Exhibit 3 (Mylan, 2015, figures in USD millions):

Useful ratios and what they show:

• Net margin 2015 = 847.7 / 9,429.3 ≈ 9.0% (this is Shkreli's number - company-wide).
• Gross margin 2015 = 4,216.1 / 9,429.3 ≈ 44.7%.
• SG&A is about 23% of revenue, far larger than R&D at about 7%. Mylan spends much more on selling and marketing than on research - consistent with the story that marketing, not innovation, turned the EpiPen into a billion-dollar business.

The Tax-Inversion Angle

Mylan executed a corporate tax inversion, reincorporating abroad (in the Netherlands) to lower its tax bill - the source of the "tax dodger" headline. In Exhibit 3 the income tax provision is 67.7 on pre-tax earnings of 915.4, an effective rate of only about 7.4%. The CEO's compensation rose 671% in eight years, adding a corporate-governance and optics problem on top of the pricing one.

The Welfare Cost of Monopoly

Standard welfare analysis of monopoly:

• Pricing above marginal cost means quantity is below the efficient level. Some buyers value the product above its true cost (MC) but below the monopoly price, so they go without - this lost gain from trade is the deadweight loss.
• There is also a large transfer: consumer surplus is converted into producer profit. A transfer is not an efficiency loss, but it is an equity concern.
• For a life-saving drug, the "deadweight loss" is not abstract - it is patients who cannot afford protection against a fatal reaction. Efficiency and equity arguments point the same way.

Policy Responses and Mylan's Options

Government / regulator options:

• Promote entry: speed FDA approval of competing auto-injectors so competition erodes the markup.
• Price regulation or negotiation: let public payers (for example, Medicare) negotiate prices, as other governments do.
• Reference pricing: cap reimbursement at an international or therapeutic benchmark.
• Allow drug importation: breaks the cross-country price discrimination by permitting arbitrage.
• Antitrust scrutiny and price transparency.

Mylan's own options (what Bresch could do):

• Launch an authorized generic at a lower price (Mylan in fact did this at roughly half the list price).
• Expand savings cards and patient-assistance programs (treats the symptom, not the list price).
• Lower the list price - costly to profit but reduces regulatory and reputational risk.

Framing the decision: this is a shareholder-versus-stakeholder tension. Short-run profit favors holding the price; long-run survival favors defusing the political and regulatory threat before price controls are imposed from outside.

Exam Toolkit - Solving a Drug-Pricing Case

Use this checklist on any "firm charging far above cost" case:

1. Name the market failure: imperfect competition / monopoly power.
2. List the barriers to entry: patents, regulatory approval, brand, switching costs, failed rivals.
3. Explain the pricing: MR = MC; apply the Lerner Index; compute the markup if data is given.
4. Explain why demand is inelastic: necessity, no substitute, no time to shop, third-party payment.
5. Identify price discrimination: across countries and via coupons; state the three requirements (market power, segments, no arbitrage).
6. Flag the third-party-payer distortion: consumer is not the payer, so price discipline fails; note the public-budget impact.
7. Note externality / merit-good aspects: reduced access, unsafe substitutes.
8. Read financials critically: separate product-level margins from company-wide averages.
9. Recommend remedies: entry, regulation, reference pricing, importation - and weigh shareholder vs. stakeholder interests.

Formula Sheet

Monopoly profit-maximizing rule:   MR = MC

Marginal revenue:                  MR = P (1 + 1/e)        [e < 0]

Monopoly price rule:               P (1 - 1/|e|) = MC
                                   P = MC / (1 - 1/|e|)

Lerner Index (market power):       L = (P - MC) / P = 1/|e|

Markup ratio:                      P / MC = |e| / (|e| - 1)

Third-degree price discrimination: MR_1 = MR_2 = ... = MC
   => higher price in the market with the lower |elasticity|

Gross margin = Gross profit / Revenue
Net margin   = Net earnings / Revenue
Effective tax rate = Income tax provision / Pre-tax earnings

Practice Questions

1. A drug has marginal cost USD 5 and is sold by a monopolist at USD 250. Compute the Lerner Index and the implied price elasticity of demand.

   Answer

   L = (250 − 5)/250 = 0.98; |elasticity| = 1/0.98 ≈ 1.02.

2. Explain why a cheaper competing product can exist and still fail to discipline the monopolist's price. (Answer: switching costs, brand lock-in, no pharmacist substitution, training - buyers do not switch, so the rival never gains share, as with Adrenaclick.)

3. Why does the same drug cost far more in the U.S. than in France? Frame your answer using elasticity and the requirements for price discrimination.

4. Critique the claim "Mylan only earns an 8.9% margin, so it is not price-gouging."

5. Explain how widespread insurance can raise the equilibrium price of a drug, and identify which group ends up bearing the cost.

6. List three policy tools a government could use to bring the EpiPen price down, and state the mechanism by which each works.