Saturday, March 15, 2008

Drug distribution economics

The Economic Times has an editorial about a dilemma facing the pharamaceutical industry in India. Traditionally drugs have been retailed in India through a 5.5 million strong and well organized chain of chemists and druggists (commonly called "medical stores"). Now the organized retailers like Reliance Retail and Subhiksha have entered the drug retailing market, resulting in an immediate fall in drug prices, and many more are getting ready to take the plunge. This new development is facing strong resistance from the influential All India Organisation of Chemists and Druggists, who are demanding that drug companies refrain from selling to corporate retailers.

Traditional retail model, with its multi-layer inefficient distribution system, supports a large number of middlemen and intermediaries, which increases the transaction costs. A substantial portion of these transaction costs are invariably passed on to the patients, thereby keeping drug prices artificially high. Organized retailers can cut down on these transaction costs, can negotiate bargains with drug companies, and also lower costs through other scale economies. Further, organized retailing will certainly be able to curb spurious drugs, which form an estimated 30% of drugs sold.

Now let me rephrase this simple problem facing distribution chains in an industry.
Business Model A: The distribution network consists of wholesalers, and a large number of small retailers. The distribution chain gives employment to a large number of people, though its results in high transaction costs and higher prices for the consumers. It is clearly an inefficient economic model.
Business Model B: The distribution network is more vertically integrated, consisting of a few large corporate retailers, with a large number of retail outlets. This distribution chain while employing lesser number of people, will reduce transaction costs and also drug prices.

Rarely is the issue that of a simple transition from Model A to Model B, displacing large numbers of people. Most often there is a long drawn out transition between A and B, with elements of both subsisting and competing with each other. Thus both the small retailers and the corporate retailers will compete with themselves and the dynamics of their competition will play itself out.

The aforementioned example of small and big retailers is part of a much larger game, as the forces of a market driven economy and globalization are being unleashed on the world economy. The inefficiencies inherent in Business Model A presents a huge opening for retail entrepreneurs seeking out high margin opportunities. Process and strategy innovations will drive businesses to seek out such high margin opportunities. It is therefore inevitable that competition rises and efficiencies improve, and benefits gets allocated more efficiently among the different economic agents.

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