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Generic Drug Pricing Practices under Scrutiny

January 2016 Pricing, Selling

Turing Pharmaceuticals LLC & Valeant Pharmaceuticals International, Inc. What do these and many other pharmaceutical firms have in common?  Congress and the public are scrutinizing them in general for, among other things, raising prices on their off-patent pharmaceutical regimens.

To make things worse, Martin Shkreli, the CEO of Turing, responded to inquiries with the taunting pride of a bully taking advantage of his power over society’s less-healthy members. Among many other shortcomings, he failed to practice the concept of fairness, restraint, and humility with respect to a necessity product, hence justifiably and predictably wreaked society’s wrath. On top of this, Shkreli stands accused of outright fraud. His lower-than-pond-scum behavior was reprehensible and is not defended here.

Yet the congressional inquiries into these pharmaceutical firms’ pricing practices go directly into my professional area of expertise: pricing strategy.  More specifically, some of them are following a part of pricing strategy that I would have suggested to them as a consultant or professor.  Hence, I feel called to answer.

To the question: “Why are these people and firms’ raising prices?” the simple answer many give is “exploitive profit taking.” While this is not incorrect, it is woefully incomplete.

Just because these people and companies are profit-seeking corporations doesn’t mean they can raise prices indiscriminately. If so, McDonalds, Nike, Aldi, and Wal-Mart and every other company would raise prices every day as well. Likewise, you and I would ask for higher wages every day and receive them.  But realistically most companies, much less people, cannot raise prices indiscriminately. Some can’t even keep prices in line with the rate of inflation. Against this backdrop facing the rest of us, pharmaceutical companies have been able to raise prices much faster than the rate of inflation. Why?

Something is peculiarly wrong with the medical industry structure that allows pharmaceutical firms to regularly raise prices.

Hence, the proper question isn’t: “why ARE they raising prices?” But rather it is: “why CAN they raise prices?”

To address this question let me first address of when, in general, firms should raise prices. Second, let me address the structural failure within the pharmaceutical industry. And third, let me point to the real long-term solution to this challenge.

 

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Raise Prices under Inelastic Demand

The medical industry is like any other industry when it comes to the laws of economics. Prices adjust to the point where supply meets demand in market driven economies.

When the firm detects inelastic demand for their offerings, basic economics indicates a firm should raise prices. The medical industry generally follows that basic economic tenent.

For those not trained in economics, inelastic demand means that prices can go up and yet customers will still purchase the products. Things like water fit this description well. Even if water were to double in price, you would still want it because water is necessary for living. Ok, you might want to switch to beer or soda, but both of those are mostly water as well.  So, in the end, if the price of water goes up, you will still buy it in some form. We call that inelastic demand.

Pharmaceutical solutions often face inelastic demand.

People get sick at somewhat predictable rate.  When they get sick, they want a cure, or at least a life-sustaining solution. And, regardless of the price, most people will pay to live.

Yes, the pharmaceutical industry in the U.S. is further distorted by the presence of insurance companies whose premium is largely paid by third parties, and whose offering is highly proscribed by government regulations. Yet this distortion does not change the underlying dynamics. The price people will pay for a solution to a life-threatening disease is very high. As such, the price for many pharmaceutical solutions can be raised without reducing the demand for the pharmaceutical formulary. Hence, the distortion of predominantly employer-paid insurance is an aggravating factor—not the root cause—to pharmaceutical firms being able to raise prices for their offerings.

The driving factor behind the price increases in generic drugs is the laws of economics. The price people, or insurers, are willing to pay is uncorrelated to the number of people sick, and therefore uncorrelated with the number of pills sold, for some pharmaceuticals. As such the firms’ producing those pills can and will raise prices. Turing, Valeant, Biogen, and many others pharmaceutical companies have followed these laws, as could have been predicted.

The Failure of Competition in the Pharmaceutical Industry

In most industries, firms don’t face inelastic demand. They face elastic demand.

Let me unwrap that statement. For the most part, we have choices. If we don’t like the price for one company’s offerings, we can go to the next company and get a somewhat similar offering at a price we are willing to pay.

Given competition, firms cannot raise prices without losing customers to the competitors. Competition forces firms to face elastic demand where they cannot raise prices without losing sales. If they raise prices they sell less and if they lower prices they sell more.

In the absence of competition, a monopolist can raise prices unilaterally until societal demand meets their personal output. In these cases, the monopolist can pocket the profits and customers loose.  Overall, social welfare is damaged by the presence of monopolies.

The role of competition is to keep prices low. 

Choice and competition are necessary for markets to work properly. Competition drives prices down to marginal costs and optimizes societal welfare. These truths are well known in economics.

Hence, the structural problem of pricing in the pharmaceutical industry is the lack of competition and the presence of monopolies. Yet this still fails to complete the story.

We, as a society, have agreed in our social contract to grant temporary monopolies to people and firms through the patent system. That is what a patent provides: rights to exclude, thereby limiting competition, to who can produce that which is patented.

I would accept the observed pricing outcome if we were only discussing patented pharmaceutical regimens. Even though new drugs may command a high price while under patent, their price is generally set in relation to the comparative value they deliver to patients and, in any case, will decline once the patent expires.  (Just look at the situation of AbbVie with Humira. AbbVie’s patent is about to expire on Humira and with it two-thirds of their revenue is under threat of generic competition.) Yes, life science companies can make a lot of money for delivering a patented new solution. But so can other companies like Apple, Uber, and GE, or singers like Taylor Swift.

The patent system and the temporary monopolies it creates is not the problem.  Something greater than patents is enabling some pharmaceutical firms to behave as monopolists.

Producers, such as those mentioned in the opening paragraph, are finding their off-patent drugs are facing inelastic demand. That is, pharmaceutical firms are discovering that some of their generic products can have large price increases without losing customers to a competitor.

Now we are getting closer to the root of the problem: There is not enough competition in generic drugs to keep prices in check even though the law officially allows anyone to make a generic drug.  What happened to the competition in generic drugs?

Exorbitant Barriers to Entry in the Medical Product Field

In a normal industry, if a firm raises its prices and captures high profits, competitors will enter that industry to take some of the profits. In the end, competition drives prices to fall. We don’t see that happening enough in the pharmaceutical industry. Why?

Michal Porter drew attention to barriers to entry. Industries with high barriers to entry can behave more monopolistic than those in which competition can freely enter. This is the case with some generic pharmaceutical formularies.

High barriers to entry must be keeping competitors from providing alternatives to off-patent generic drugs. What could be the source of these barriers to entry?

It isn’t the lack of know how. Many firms are able to produce chemicals, even specialized chemicals in the life sciences. And, that is what a drug is: it is a chemical. As observed in animal health care, agricultural chemistry and many other specialty chemical companies: competition keeps prices relatively low. Yet, in human life sciences, there is insufficient competition.

And it isn’t for lack of capital. Investors will invest in creating new competitors if the industry looks promising. Just look at all the ride sharing, home swapping and other new-technology driven firms that receive healthy investment in the hopes of surviving the initial round of industry growth.

Is it regulatory? 80% of all drugs are generic and the FDA regulates almost every facet of prescription drugs, including testing, manufacturing, labeling, advertising, marketing, efficacy, and safety. While the requirements for generic drugs are significantly lower than for new drugs, they are still too high.

Consider a polar opposite of how the current drug market is regulated: the technology market. A person working in their basement with the appropriate equipment can make a new website, app, or other piece of kit and then go sell that product or service globally. Indeed, Apple famously started that way.

In contrast, a biochemist, even a PhD chemist with knowledge of proper human safety, cannot make a pharmaceutical in their basement and legally sell it. Even if that basement startup follows all the right safety protocols and purity standards to produce the right generic pharmaceutical, that bootstrap entrepreneur cannot enter the market with that generic until they produce under FDA regulatory scrutiny. And, as many entrepreneurs have discovered, meeting FDA regulatory requirements can add years to entry and millions to costs—all with great uncertainty.

Similarly, a trader of sneakers can easily import Chinese shoes to the U.S. but an importer of drugs is undertaking illegal action.

When the FDA cannot attest to the safety of the imported drug, the FDA will declare it potentially unsafe, thus discouraging demand.

Granted, I don’t want to buy my medicine from someone’s basement nor from the back of a pickup truck full of drugs shipped in from an unknown country.  But it does drive home the point.

Regulation increases the barriers to entry.

The FDA has a mandate to protect public safety. They are following their mandate. But that mandate has a cost. Their mandate does not put the development of the most economically efficient means to providing health care at its center. Rather, it puts public safety as the guiding mission.

Safety comes at a cost. 100% safe rarely results in an optimal economical outcome.

The Way Out

Businesses respond to economics. Government regulations can enable or restrict competition. When competition is restricted, businesses enjoy more market power. Businesses with high market power can raise their prices.  This is just as true for generic pharmaceutical corporations as it is for your corner mom and pop store.

The key difference between the two when it comes to pricing is that almost anyone can open a corner grocery store. To make a generic drug, a business has to pass through a very high and uncertain regulatory burden with the FDA.

The very mission of a FDA acts to reduce competition through creating exorbitantly high barriers to entry that rewards companies already in the market at the expense of patients and would-be entrepreneurs/competitors.

Hence, the way out is to call for rationalization of the regulatory hurdles to competing with them.

References

Copeland, Rob. “Executive Says Price Hike Led to Charges”, Wall Street Journal, (21 December 2015), A1. (Print)

Rockoff, Johnathan D., Beilfuss, Lisa. “Biotech Fires Shkreli as CEO after Arrest”, Wall Street Journal, (22 December 2015), B1. (Print)

Walker, Joseph. “Price Increase Drive Drug Firms’ Revenue”, Wall Street Journal, (6 October 2015), A1. (Print)

Rockoff, Jonathan D. “Valeant Shares Tumble as Democrats Probe Prices”, Wall Street Journal, (20 September 2015), B1. (Print)

Pollack, Andrew. “2 Valeant Dermatology Drugs Lead Steep Price Increases, Study Finds.” The New York Times. The New York Times, 25 Nov. 2015. Web. 28 Dec. 2015.

Rosenberg ME, Rosenberg SP. “Changes in Retail Prices of Prescription Dermatologic Drugs From 2009 to 2015”. JAMA Dermatol. Published online November 25, 2015. doi:10.1001/jamadermatol.2015.3897.



About the author

Tim J. Smith, PhD is the Managing Principal of Wiglaf Pricing, and an Adjunct Professor at DePaul University of Marketing and Economics. His most recent book is Pricing Strategy: Setting Price Levels, Managing Price Discounts, & Establishing Price Structures.

Tim J. Smith, PhD
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