Open all hours – an improved formula for the pharmacy?

‘Community pharmacies’ – or retail dispensing chemists, as most of us know them – are a distinctive part of the NHS ‘social market’ because of their connection with ordinary retail activity. The way in which pharmacies are funded is an important factor when looking at the effects of competition and entry on value for money, quality of service, choice and innovation. DotEcon’s analysis of the sector in March 2010 chimes closely with many of the themes in the new government’s ambition to reorganise public health.

Last year DotEcon produced an evaluation1 of the 2005 reforms to the ‘control of entry’ regulations on community pharmacies – the retail dispensing chemists where we pick up our prescription medicines, turn for informal advice, and increasingly, access other NHS services such as treatment for minor ailments. Under these regulations, someone wishing to set up in business offering to dispense medicines to NHS prescriptions has to satisfy health officials that their presence is in some sense “necessary” given the state of existing local provision. This is true however amply they fulfil the stringent requirements for dispensing drugs to the public, and contrasts with the freedom that other retail enterprises enjoy to set up shop where they wish, and to succeed or fail as a consequence of their ability to attract customers in competition with other providers.

 A 2003 study2 by the Office of Fair Trading (OFT) recommended that control of entry should be abolished altogether, but the reforms introduced in response to this recommendation fell short of this. They were introduced in England only, and the change that had most impact on entry was to let entrants bypass the test of necessity if they met the commercially onerous condition of opening for at least 100 hours a week. This exemption was reversed by the Health Bill that became law in November 2009, while we were writing our report.

Whilst our study was retrospective, designed to quantify the impact of the OFT’s study on policy and public outcomes as part of its economic evaluation programme, it highlighted the interaction of entry rules and the shape of the funding system, and came up with suggestions about how the economic organisation of the pharmacy sector could be improved in future.

Does pharmacy need regulatory immunity from competition?

The role of competition was at the heart of the debate over whether and how far to liberalise the entry regime for pharmacies. The OFT argued that the control of entry regulations, by restricting the number and locations of pharmacies and making their market positions incontestable, had acted to stifle choice and service competition among pharmacies.                                         

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It is true that the dimensions of competition in pharmacy are somewhat limited by the way dispensing is regulated. Demand for prescription medicines typically derives from a consultation between doctor and patient, so that the ‘choice’ of product is therefore prescribed, and the price is laid down by the national prescription charge system, and therefore many of the conventional dimensions of retail competition – price, range, product differentiation and sales advice – either do not apply to the bulk of pharmacies’ business, or do so less strongly than in other retail markets.

However, pharmacies instead compete in other dimensions, primarily on location and convenience, and on services such as waiting times, opening hours and quality of advice and support. Nevertheless our analysis of the consequences of reform broadly bore out the OFT’s predictions. Consumers have benefited from improved choice and access, service competition has sharpened, and there is no evidence that entry has disincentivised investments and service improvements in the way that had been claimed by those opposing reform.

There was also a telling lack of exit from the market. The OFT had encountered a number of strained arguments that more freedom of entry would lead to less pharmacy provision. Yet in the event, not only did net pharmacy numbers jump by nine per cent in the first four or so years after the reforms after having been static for almost twenty years, but they did so without any increase at all in the gross number of annual pharmacy closures. Furthermore, this happened without any special additions to the total amount spent on pharmacy funding, which instead was diluted over a wider base.

All of this evidence suggests that taxpayer money devoted to the pharmacy sector is achieving better value than previously, and that the OFT was quite right to treat arguments from incumbent pharmacy owners that pharmacy is intrinsically different from other forms of retail with scepticism.                

 A suite of blunt tools

Yet in another respect pharmacy clearly is different from ordinary retail, because pharmacies earn much of their revenue from the public purse rather than consumers’ private pockets. NHS business, mainly dispensing, is reported to account for 90% of independent pharmacies’ turnover.

In typical retail markets, market outcomes – including the number and size of retail outlets – are shaped by consumer demand and consumer response to characteristics of supply – most notably price. The willingness of consumers to pay for the services provided by new entrants links entry and pricing decisions, albeit imperfectly, to the social value that new entrants can generate.

By contrast in pharmacy, as in the rest of the NHS, such consumer price signals do not exist and government and its agencies instead express the social willingness to pay. This will always be true of a publicly funded health service and means that the question of an optimal market regime for pharmacy is wider than simply that of regulation or deregulation of entry and must include the way pharmacies are rewarded. For example, depending on the structure and ‘generosity’ of regulated revenue, unregulated entry may exceed the socially desirable level in the sense that, at the margin, the costs of extending the pharmacy infrastructure any further may exceed the public and consumer benefit that such an extension adds, yet may be privately profitable on account of the public funding received by the new entrant.

Indeed it was this situation that led to the control of entry regulations being introduced in the first place. Control of entry was introduced as a stopgap measure in 1987 to curb a spiralling and open-ended public bill under a cost-plus system of remuneration that encouraged small pharmacies to proliferate. Yet while the remuneration system was revised two years later, in 1989, control of entry remained in place – a fact queried by the OFT in its 2003 report, which suggested that a suitably structured payment system could eliminate the need for control of entry by providing the right incentives for contractors to enter and compete.

The current payment system for community pharmacies consists of a fixed annual sum (subject to meeting a certain minimum dispensing volume) plus unit fees and average profit margins on the number of prescription items dispensed. These elements are continually adjusted so that the total public expenditure is kept to a certain budget. This budget is set annually in negotiation with the industry but formally at least, it does not reflect the number of pharmacies operating. Hence the benefits of the relaxation of entry rules have come through greater efficiency or lower rates of economic profit on the part of pharmacy owners, rather than out of public funds.

A key feature of this system is that it is nationally uniform – that is, one and the same tariff applies to all pharmacies up and down the country. This is hardly likely to reflect the reality of costs and demand (or need), which can differ across locations. An annex to our report looked at this issue theoretically and showed how a uniform remuneration system that is ‘right’ on average, can be expected to give stronger and possibly excessive incentives for pharmacies to cluster in high density areas around sources of demand, and weaker and possibly inadequate ones for them to enter in lower-density areas (and that the divergences are wider, the heavier the weight on fixed as opposed to variable payments). Indeed, developments since the reforms have borne this out to some extent, with evidence of entry clustering in areas of existing provision, and some localities remaining underprovided. And while there is no evidence yet that this is happening, it cannot be excluded that further dilution of pharmacy funding could at some stage jeopardise the viability of pharmacies in the least profitable localities, and worsen access there.

Does that mean that there is a case for control of entry as a means of curbing inefficient duplication of pharmacy provision in areas that are ‘oversubscribed’, which might lead to a dilution of funding to and exit in areas that are marginally profitable? Unfortunately control of entry, even if optimally applied, does not fully remedy the problem because it does not recoup the excess public remuneration that creates those incentives in the first place.

Despite documenting the eye-watering sums of money for which pharmacy contracts often change hands, the OFT study did not find direct evidence of excess profits in the pharmacy market. Nevertheless, economic reasoning suggests that excess profits are or were being made in areas of high demand where the previous entry controls were observed to bite, as evidenced by entry in those areas after the reforms were made, and the lack of exit. The existence of excess profits is further suggested by entrants’ willingness to use 100 hour opening as a means of securing exempt entry in such areas, as such hours – for which our analysis shows there is neither demand from consumers nor precedent among operators free to set their own hours – entail significant additional operating costs in staffing and security that are not faced by established businesses. Thus, a one-size-fits-all payment regime supplemented by entry controls is a combination of blunt tools.

Some simple arithmetic makes this point. Hundred hour opening, the route used to secure entry by most of the new pharmacies that have entered since the reforms, equates to over 14 hours a day, seven days a week and is almost twice the average for pharmacies free to set their own hours based on commercial considerations. The annual costs of staffing all these extra hours, much of which is dead time, are substantially higher than what pharmacies receive each year in fixed payments from the Department of Health, yet hundreds of new pharmacies have found it profitable to enter the market in this way, with no displacement so far of existing pharmacies. Clearly these entrants would find it at least as profitable to operate under normal terms (i.e. free to set their own hours) while forgoing those fixed payments altogether. Allowing that to happen would be what economists call a welfare improvement, a ‘win-win’. But no such option existed (and the 100 hours route to entry has in any case been closed again).

Some sharper alternatives

An answer might be to allow rates of remuneration to be set locally in such a way as to invite the right level of entry. This could reduce any lingering case for entry controls and allow providers to compete on the merits for available funds in each area, with consumers and patients voting with their feet to determine long-run commercial success. But a situation in which each local authority operates a payment scheme in miniature, may not be workable or robust, and in any case current indications are that a national contractual framework for pharmacy will be retained. Nevertheless, the possibility of building variation in tariffs according to area and health characteristics into a national formula for pharmacy payments is one that could be examined.

Another possibility is to extend the concept of value-based pricing to retail dispensing. This system – due to be introduced into the pricing regime for branded pharmaceuticals by 2014 following an OFT recommendation in 2007 – will link the payments to pharmaceutical companies to the clinical benefits their medicines provide, and the availability of substitutes. Perhaps this principle could be applied at the retail level, by offering higher rates of remuneration on prescription medicines that are correlated with greater need, health inequalities or mobility and access problems, sending stronger signals for pharmacy entry in the right areas but without the need for microscopic demand planning?

As well as local differences in demand, there are also significant and widening differences among pharmacies in their style of operation and cost structure. Nowadays pharmacies range from traditional chemists, either independently owned or in small or large chains, to the ‘health and beauty’ model (essentially Boots) and a growing number of in-store supermarket pharmacies. Dispensing represents a much higher proportion of turnover in the first group (reportedly 90% for independent pharmacies) than for the latter two, who sell proportionally more over-the-counter medicines, and who use dispensing services as a means of generating footfall for other goods. As well as this cross-subsidy effect there are, presumably, differences in the costs of pharmacy operation between these models. Yet the cost of service enquiries on which the Department of Health and the Pharmaceutical Services Negotiating Committee (which represents the interests of pharmacy owners) base payment tariffs are apparently carried out entirely on independent pharmacies, which represent only a quarter or so of all outlets. The details are not in the public domain, but one cannot help wonder whether the pharmacy payment system is calibrated to keep the marginal independent pharmacy in business, potentially handing excessive remuneration to others.

It may be hard to imagine a system in which outlets are directly chosen on the basis of their ‘willingness to accept’ particular terms for operating an NHS pharmacy contract. But indirect means could achieve the same thing to some extent. For example, payments (including the fixed component) could be lower for dispensing-only outlets, with higher rates of remuneration for those who offer the fuller array of the new clinical and preventive services that pharmacies are being called on to provide. Then, a supermarket (say) wishing to a open an in-store dispensing outlet to compete for convenience-driven prescription customers could be free to do so at an efficient public cost, while others could choose to provide a more comprehensive clinical environment and services of the kind that public health policy is keen to sponsor. This is important given the widely acknowledged need for pharmacies to play an expanded role as a first port of call for minor ailments, offering preventive services related to obesity and smoking, and helping eliminate the vast public cost of wasted and improperly used medicines. It is not difficult to envisage a two- or multi-tier system of pharmacies in the future, and indeed this seems to be happening. Payment incentives should support this evolution.

The first of the new government’s NHS White Papers argued that “[t]he absence of an effective payment system in many parts of the NHS severely restricts the ability of commissioners and providers to improve outcomes, increase efficiency and increase patient choice.”3 Pharmacy is a case in point. Yet here, as in healthcare generally, diagnosis is easier than prescription. Our experience in writing last year’s report for the OFT nevertheless suggests that a range of economic tools could be used to improve the efficiency of the pharmacy sector for consumers, patients and taxpayers.

 

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Footnotes

  1. ‘Evaluating the impact of the 2003 OFT study on the Control of Entry regulations in the retail pharmacies market. Prepared for the Office of Fair Trading by DotEcon,’ OFT1219, March 2010. []
  2. ‘The control of entry regulations and retail pharmacy services in the UK. A report of an OFT market investigation,’ OFT609, January 2003 (revised March 2003). []
  3. ‘Equity and Excellence: Liberating the NHS,’ Department of Health White Paper, July 2010. []

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