I like GAVI (the Global Alliance for Vaccines and Immunization) a lot. Childhood immunization is a hugely cost-effective way to help people in developing countries, and GAVI does very good work helping to get vaccines to children in developing countries.
And it is because I like GAVI that I was alarmed to read this recent statement of their business model:
GAVI’s business model is based on the expectation that rising demand for immunisation in developing countries induces more companies to produce vaccines, thus creating competition and driving prices down.
Why this is not their business model
Read that sentence again and you will see that it makes no sense. If prices are going to fall, why would more companies enter the market and create the competition that forces prices down? (Perhaps they don’t read GAVI’s website and so they don’t know what is in store for them?)
Let’s go back to the supply and demand curves of undergraduate economics (see diagram). If you move the demand curve out (“rising demand for immunisation”) then quantities and prices will both increase.
The very best you could hope for is that supply of vaccines is very elastic (it isn’t, sadly); in that case the supply curve (the blue line) would be quite flat and the rise in price would not very large when demand increases.
But supply curves are not flat (at least, not in the short run) and they certainly do not slope downwards, so prices ain’t gonna fall when demand goes up.
I defy GAVI to produce an analytical model that underpins their “business model” as they describe it above.
So what should GAVI’s business model be?
There are two ways that GAVI can bring down the price of vaccines: one bad, one good.
GAVI can work with UNICEF to drive down the price of vaccines by using the market power of a monopoly buyer (a “monopsonist”). When vaccine manufacturers make a sale, there is something in it for the seller (profit) and something in it for the buyer (the vaccine is worth more to them than they pay for it). The division of these benefits (the “surplus”) depends on the bargaining power of the parties. If GAVI and UNICEF can use monopsony powers, they can extract more of the surplus, by driving down the price and hence the profits of the vaccine manufacturer.
In the world of development advocacy, pharmaceutical companies are pantomime villains, making outrageous profits at the expense of the poor. So reducing their profits and holding down prices must be good, right?
Well yes, if you don’t want pharmaceutical companies to invest in research and development for future medicines for developing countries, if you don’t want them to invest in manufacturing facilities big enough to produce in large volumes for these markets, and you don’t want them to spend time and money getting their products regulatory approval in those countries, then driving down their profits is exactly what we should be trying to do. Of course, Big Pharma can look after itself, and that is what it does. When we take away their profits in developing countries then they will go and make profits somewhere else. Dastardly villains.
Driving down the commercial viability of medicines in developing countries may not be our best plan. It may feel good in the short term sticking it to Big Pharma, but that is not necessarily good public policy. The anti-pharma campaigners should be glad they won’t be the ones who have to explain to a woman comforting her child dying of malaria why there is no vaccine for this disease.
This isn’t a theoretical risk: it is what has actually happened to the vaccine industry over the last 40 years.
Although this is not a great strategy, is is the approach being pursued by some global foundations such as the Clinton Foundation. The UNICEF procurement division has similarly long had the objective of driving down prices, without regard to the long-run viability of the businesses developing and supplying pharmaceuticals to the developing world.
But GAVI can do something which benefits both developing countries and the pharmaceutical industry, increasing quantities and reducing prices. It can help to reduce the cost and the risk of producing vaccines for developing countries. By pushing down these costs, the result can be higher volumes and lower prices, in a way that does not simply transfer the surplus from producers to consumers.
One way that GAVI can (genuinely) reduce costs without damaging the industry is by entering into long term contracts for vaccine purchases. Both the International Finance Facility for Immunization and the Advance Market Commitment are excellent examples of this approach [UPDATE: in the light of David Roodman’s comment below, let me clarify that GAVI is already doing this, which is excellent. My view is that they should do more of it.] Long-term commitments enable manufacturers significantly to increase production volumes and reduce unit costs (because the large fixed costs are spread over more units).
It is the ability to make commitments, not the increase in demand, that is important here. Long term commitments are important because without them, vaccine manufacturers are vulnerable to “hold up“, a problem familiar in the economics literature on industrial organisation and utility regulation. Manufacturers face the risk that, once they have invested in developing a new vaccine, getting regulatory approval, and spending hundreds of millions of dollars putting in place large-scale manufacturing capacity, the donors will then gang together to use monopsony purchasing power to drive down the price to around the marginal cost, ignoring the sunk costs of developing and producing the vaccine. At marginal cost pricing, the manufacturer never recovers the cost of their investments. After the vaccine has been manufactured, this is a rational thing for donors to do, since it reduces the price to a level at which the largest number of vaccines can be purchased. But before the vaccine is manufactured, the vaccine companies anticipate the likely future behaviour of donors, given the donors’ incentives; and this undermines the investment case for developing and producing vaccines for the developing world. Donors can avoid this by entering into a long-term commitment which prevents them from driving down the price later on.
GAVI can also use its expertise and connections with government to streamline and simplify regulatory processes, which are a big cost driver.
Costs will fall, and demand will rise, as a result of this approach. But this is the opposite way round from GAVI’s current (economically illiterate) business model: under this approach the rise in demand is a consequence of the fall in prices, not the cause of it.
So GAVI can have most impact by doing the opposite of what many people think it should do (and the opposite of what some other global funds try to do). Rather than using its market position to drive down prices, damaging the long-run viability of the vaccine industry, it should use its position to enter into long-term contracts which enable manufacturers to produce at high volumes and low unit costs.
This means that rather than trying to drive down prices by increasing competition, GAVI’s business model should be to lower prices and so increase the amount of vaccines bought and used, while promoting the long-run health of the vaccine industry, by helping to reduce costs and risks for producers.