Some Thought on US Pharmaceutical Prices and Markets

There's a broadly shared idea of how US pharmaceutical markets ought to work, I think.

Innovative companies invest large amounts in trying to develop new drugs. Sometimes they succeed, and when they do, the company can then earn high profits for a time. But eventually, the new products will go off patent, and inexpensive generic equivalents will be produced.

Describing the basic story in that way also helps to organize the common complaints about what is seems to be wrong. During the time period when new drugs are under patent, it seems as if their prices rise so quickly and to such high levels that it feels exploitative. Companies focus on taking actions to put off the time when competition from generic drugs can enter the market. Meanwhile, we find ourselves in the position of desperately wanting many companies to make large efforts to develop the new drugs/vaccines we sorely need to address COVID-19, and we know that only a few will ultimately succeed. However, a number of politicians feel compelled to proclaim that if and when such successes occur,  those companies should stand ready to provide these newly invented and effective drugs and vaccines at the lowest possible cost and not expect to make much profit in doing so. We are simultaneously discovering that we are highly dependent on a limited number of foreign manufacturers for our supply of workhorse generic drugs, and the Food and Drug Administration has announced that the US healthcare system faces shortages of about 100 drugs.

In short, the problem of the US pharmaceutical industry go far beyond the standard complaint about high prices. To help disentangle these issues, the Journal of the American Medical Association has a group of research and viewpoint/editorial article in the issue of March 3, 2020. Here, I'll just list some themes from these articles.

1) How Much are Drug Prices Rising? 

If you look just at branded medications, the prices are up substantially. As Chaarushena Deb and Gregory Curfman write in their essay: "Relentless Prescription Drug Price Increases": 

The pharmaceutical industry just announced prescription drug price increases for 2020. According to the health care research firm 3 Axis Advisors, prices were increased for nearly 500 drugs, with an average price increase of 5.17%. To mitigate public criticism, most of the price increases were kept below 10%. The list price of the world’s bestselling drug, adalimumab (Humira), was increased by AbbVie by 7.4% for 2020, which adds to a 19.1% increase in list price for years 2018 and 2019.

For economists, of course, there's always an "on the other hand." If you combine prices for both branded and generic prescription drugs, and take into account how cheaper generics are displacing branded drugs for certain uses, the overall price level of prescription drugs in the US actually fell last year according to the Consumer Price Index. 

In addition, as Kenneth C. Frazier points out in his essay, "Affording Medicines for Today’s Patients and Sustaining Innovation for Tomorrow," net drug prices (after manufacturer discounts) have been stable since 2015; if you take new drugs into account, the net drug prices have been falling since 2015. But as Frazier points out, the "net" drug price isn't the same as what patients actually pay.  

Manufacturer discounts from list prices are generally not passed on to patients, and many patients are exposed to the full list price of drugs before they reach their deductibles, out-of-pocket spending caps (if they have one), or both. In fact, about 50% of the total amount spent on branded prescription drugs is retained by payers, hospitals, distributors, and others in the supply chain, not the manufacturer.

Thus, the problem of patients facing high drug prices isn't all about what the manufacturer is charging: it's also about the add-on costs from the rest of the supply chain.

2) How High are Profits for the US Pharmaceutical Industry? 

David M. Cutler asks "Are Pharmaceutical Companies Earning Too Much?" As he points out, one of the research studies in the issue "showed that from 2000 to 2018, the median net income margin in the pharmaceutical industry was 13.8% annually, compared with 7.7% in the S&P 500 sample." Another of the studies in the issue suggest that it costs an average of nearly $1 billion in research and development expenditures to bring a new drug to market (a number which includes false starts and failed efforts in the total costs).

On the other hand, as Cutler also points out:

Like several other industries (eg, software and motion picture production), the pharmaceutical industry has very high fixed cost and very low marginal cost. It takes substantial investment to discover a drug or develop a complex computer code, but the cost of producing an extra pill or allowing an extra download is minimal. The way that firms recoup these fixed costs is by charging above cost for the product once it is made. If these upfront costs are not accounted for, the return on the marketed good will look very high.

In addition, these high profits are focused on the big and successful drug companies: "A good number of recent innovations have come from the startup industry, not established pharmaceutical firms, although major pharmaceutical firms are involved in clinical testing and sales." In other words, it's not fair to judge the profitability of the overall drug industry based only on the big successes; one would also need to take into account the losses at all the companies that tried and failed, too.  

It's also worth noting that a research study in this issue finds that in recent years, drug company profits haven't looked so gaudy. As Frazier points out in his essay: 

Likewise, Ledley et al report that over the past 5 years, between 2014-2018, pharmaceutical net income was markedly lower than in earlier years, and there was no significant difference between the net income margin of pharmaceutical companies compared with other S&P 500 companies during this period. 

3) How do Pharmaceutical Firms Use the Patent System to Keep Prices High for Brand-Name Drugs?

In their essay on "Relentless Prescription Drug Price Increases," Chaarushena Deb and Gregory Curfman point out some of the ways that firms earning high profits from patent-protected brand-name drugs. For example, one approach is called pay for delay: "Such tactics involve payments from brand-name companies to generic companies to keep lower-cost generic drugs off the market, and both brand-name and generic companies profit from these arrangements. These arrangements are commonplace, and with the elimination of market competition, brand-name companies are at liberty to keep their prices high—as high as the market will bear." The Supreme Court ruled back in 2013 that pay-for-delay can be challenged in court as potentially anticompetitive, but there is no guarantee that the antitrust prosecutors will win such lawsuits. 

Another possibility is for a company to create a "patent thicket" of many overlapping patents in a way that makes it especially risky for any new entrant. Deb and Curfman write:

In response to these price hikes for Humira, AbbVie has recently been the subject of a series of groundbreaking classaction lawsuits. Insurance payers and workers’ unions allege that AbbVie created a “patent thicket” around the monoclonal antibody therapy, thereby acting in bad faith to quash competition from Humira biosimilars. The original Humira patent expired in 2016, but AbbVie has been able to stave off biosimilar market entry by filing more than 100 follow-on patents that extend AbbVie’smonopoly beyond 2030. It is not uncommon for drugs to be protected by multiple patents, but the Humira patent thicket is extreme and allows AbbVie to aggressively extend its high monopoly pricing. A second claim in the lawsuits against AbbVie is that the company allegedly used “pay-for-delay” tactics to negotiate later market entry dates with biosimilar competitors. Pay-for-delay agreements in the pharmaceutical industry have been controversial for years, but the notion of a “patent thicket” greatly exacerbates the issue because the normal route for generics and biosimilars to enter the market is through patent litigation. ... AbbVie contended it would continue to sue biosimilar manufacturers for infringement using its full complement of patents, pushing market entry dates well into the 2030s, leading the biosimilar companies to simply give up and settle the litigation. These settlements will likely allow AbbVie to continue instituting price increases for Humira.

4) What about Drugs where the US has Shortages? 

Inmaculada Hernandez, Tina Batra Hershey, and Julie M. Donohue write: "Drug Shortages in the United States Are Some Prices Too Low?" They note that the Food and Drug Administration has regular reports listing drugs with a shortage--apparently because there isn't enough incentive for companies to enter the market or to invest in manufacturing. They write: 

Drug shortages disproportionately affect generic, injectable medications, which have been marketed for decades and have lower prices even when compared with other generic products. These shortages affect essential drugs (injectable antibiotics, such as vancomycin and cefazolin; chemotherapeutic agents, such as vincristine and doxorubicin; and anesthetics, such as lidocaine and bupivacaine) and therefore have major public health consequences, including delays in or omission of doses; use of less effective treatments; increased morbidity; and even death. Assessing the causes of and potential solutions to drug shortages is timely because the number of drugs in active shortage has increased recently, from 60 per week in 2016 to more than 100 in 2018.

Sometimes the shortage occurs because the sale and price of the drug have been falling, and producers exit the market. But they also dig into the dynamics of markets for generic drugs, which account for two-thirds of the shortages. They point out that production of these drugs often involves a "sponsor" for the generic drug, which then has agreements with an independent supplier to produce the active ingredients and with a contract manufacturing organization to produce the actual drug. They write: 

At nearly every point in this system, the market has become more concentrated, meaning a small number of companies account for a large share of the market, and concentration is at the root of shortages. ... Drug shortages are more likely to occur in markets with only 1 to 3 generic sponsors. Second, because of consolidation of suppliers, competing generic sponsors often rely on a single active ingredient supplier. Third, it is increasingly common for a single contract manufacturer to produce the final dosage forms for all generic sponsors marketing a given product. Moreover, 90% of active ingredients and 60% of dosage forms dispensed in the United States are manufactured overseas, complicating FDA monitoring efforts. Market concentration is the underlying reason why markets are so slow in responding to shortages.When production is halted for quality control problems (eg, the sterile injectables produced by the manufacturing facility are nonsterile or contain metal particulates), there is no alternative facility available.

Then on the purchasing side, 

"Health systems and pharmacies, which administer or dispense drugs to patients, often purchase drugs through intermediaries, such as wholesalers and group purchasing organizations (GPOs). GPOs are highly concentrated; the top 4 now account for 90% of the market. The market power of GPOs has reduced prices for health systems but, according to the FDA, has also contributed to a “race to the bottom,” ie, offering the drug at the lowest price possible, which has decreased generic sponsors’ profitability, especially in the case of injectables, which are costly to manufacture. Importantly, because generic drugs are bioequivalent and exchangeable, there is no mechanism in the purchasing system to reward high-quality production, even though FDA asserts differences in the quality of manufacturing practices exist and are inextricably linked to shortages. Concentration among intermediaries in the drug purchasing system is a likely factor in driving the prices of some generics so low that generic sponsors do not see them as profitable.

As a result of these market dynamics, a number of these workhorse generic drugs either experience shortages on a regular basis, or may have only one supplier. There have been several cases where a supplier of a generic drug noticed that there was no competition, and then raised prices substantially. 

Taking all of this together, one can begin to imagine a policy agenda for the US pharmaceutical industry that is just a wee bit more sophisticated than simple price controls on drugs or punitive taxes on drug companies. 

1) We want to continue invest billions of dollars in new drugs. Some of the funding can come government, perhaps directed though both higher education and private-sector settings. But some will also come from profits previously earned by drug companies. 

2) The antitrust authorities have some tools to put downward pressure on prices of brand-name drugs, by energetically challenging pay-for-delay, patent thickets, and other questionable approaches. 

3) We need to encourage competition in the market for generic drugs, to assure a steady supply of high-quality drugs. This involves encouraging firms that make active ingredients, contract manufacturing firms, and the "sponsor" firms that get the regulatory approval and do the marketing to for these drugs. Greater competition should help to avoid shortages. 

4) Some drugs can have such high costs, and such modest benefits for health, that it's questionable whether insurance should cover them. For example, certain anti-cancer drugs probably fall into this category. In this situation, we want to encourage continued research which may eventually produce a less expensive drug with better health effects, and so some patients should have access to the drug as part of such studies. But for some drugs, a super-high price in exchange for extending life expectancy by only a month or two is way of saying that they aren't yet ready for the mass market. Of course, many other drugs are a fantastic investment on cost-benefit grounds. Given the extreme economic costs for dealing with the COVID-19 pandemic, finding cost-effective tests, treatments, or vaccines seems as if it should be a fairly low bar to cross. 

A version of this article first appeared here.