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Joanna Shepherd is Professor of Law at Emory University School of Law.

Today, three of the largest proposed mergers — Bayer/Monsanto, Dow/Dupont, and ChemChina/Syngenta — face scrutiny in both the U.S. and Europe over concerns that the mergers will slow innovation in crop biotechnology and crop protection.   The incorporation of innovation effects in the antitrust analysis of these agricultural/biotech mergers is quickly becoming more mainstream in both the U.S. and E.U. The concerns are premised on the idea that, by merging existing competitors into one firm, consolidation will reduce incentives to develop new products in the future.  Since 2015, the Department of Justice has opposed proposed mergers between Applied Materials/Tokyo Electron, Comcast/Time Warner Cable, and Halliburton/Baker Hughes at least partly based on innovation concerns. Similarly, the European Commission has raised innovation concerns in its analyses of several mergers since 2015, including Biomet/Zimmer Holdings, GlaxoSmithKline/Novartis, and BASE/ Liberty Global.

Although most of these contested deals are not based exclusively on innovation markets, fear of harms to innovation often result in the required divestiture of innovation-related assets.  For example, both the FTC and European Commission allowed the 2014 merger between Medtronic/Covidien only on the condition that Covidien divest its drug-coated balloon catheter business to protect innovation in that market. And just this week, Dupont agreed to divest a large part of its existing pesticide business, including its global R&D organization, to secure approval for the Dow/Dupont merger in the EU.

Certainly the incorporation of innovation effects in antitrust analysis could be relevant in specific mergers or acquisitions if the consolidating firms are the primary innovators in the area, the firms innovate internally, and there are limited sources of external innovation. However, in many industries, this model simply doesn’t apply.  Take, for example, the pharmaceutical industry; as I explain in a recent Article, concerns about consolidation’s impact on drug innovation are largely based on an outdated understanding of the innovation ecosystem in the pharmaceutical industry.

Today, most drug innovation originates not in traditional pharmaceutical companies, but in biotech companies and smaller firms, where a culture of nimble decision-making and risk-taking facilitates discovery and innovation.  In fact, about two-thirds of New Molecular Entities approved by the FDA originate in biotech and small pharmaceutical companies, and these companies account for almost 70 percent of the current global pipeline of drugs under development.

To complete the development process and commercialize their drugs, biotech companies regularly collaborate with large pharmaceutical companies that push drugs through the grueling late-stage clinical trials and regulatory hurdles of the FDA, organize their manufacturing and distribution capabilities to bring the drugs to market, and mobilize their vast sales force to quickly achieve peak sales.  In this current ecosystem, biotech and pharmaceutical firms are each able to specialize in what they do best, bringing expertise and efficiencies to the innovation process.

This specialization has dramatically changed the share of internally-developed versus externally-developed drugs in the pharmaceutical industry. Whereas in the 1970s and early 1980s, almost all drug discovery and early stage development took place inside traditional pharmaceutical companies, today, the companies increasingly shift resources away from internal R&D expenditures and projects and towards external sources of innovation.  Externally-sourced drugs now account for an incredible 74 percent of new drugs registered with the FDA for sale in the U.S.  Internal R&D is no longer the primary source of drug innovation in large pharmaceutical companies.

As a result, antitrust analyses that focus on pharmaceutical mergers’ impacts on internal R&D and innovation largely miss the point.  In the current innovation ecosystem, where little drug innovation originates internally, a merger’s impact on internal R&D expenditures or development projects is oftentimes immaterial to aggregate drug innovation. In many consolidated firms, increases in efficiency and streamlining of operations free up money and resources to source external innovation. To improve their future revenue streams and market share, consolidated firms can be expected to use at least some of the extra resources to acquire external innovation. This increase in demand for externally-sourced innovation increases the prices paid for external assets, which, in turn, incentivizes more early-stage innovation in small firms and biotech companies.   Aggregate innovation increases in the process!

Thus, proper antitrust analyses must take into account the innovation ecosystem in the merging firms’ industries.  In industries in which most innovation originates externally, as in the pharmaceutical industry, analyses should be less concerned with mergers’ impacts on internal innovation, and more focused on whether consolidation will increase demand for externally-sourced innovation and, ultimately, increase aggregate drug innovation.

In a weekend interview with the Washington Post, Donald Trump vowed to force drug companies to negotiate directly with the government on prices in Medicare and Medicaid.  It’s unclear what, if anything, Trump intends for Medicaid; drug makers are already required to sell drugs to Medicaid at the lowest price they negotiate with any other buyer.  For Medicare, Trump didn’t offer any more details about the intended negotiations, but he’s referring to his campaign proposals to allow the Department of Health and Human Services (HHS) to negotiate directly with manufacturers the prices of drugs covered under Medicare Part D.

Such proposals have been around for quite a while.  As soon as the Medicare Modernization Act (MMA) of 2003 was enacted, creating the Medicare Part D prescription drug benefit, many lawmakers began advocating for government negotiation of drug prices. Both Hillary Clinton and Bernie Sanders favored this approach during their campaigns, and the Obama Administration’s proposed budget for fiscal years 2016 and 2017 included a provision that would have allowed the HHS to negotiate prices for a subset of drugs: biologics and certain high-cost prescription drugs.

However, federal law would have to change if there is to be any government negotiation of drug prices under Medicare Part D. Congress explicitly included a “noninterference” clause in the MMA that stipulates that HHS “may not interfere with the negotiations between drug manufacturers and pharmacies and PDP sponsors, and may not require a particular formulary or institute a price structure for the reimbursement of covered part D drugs.”

Most people don’t understand what it means for the government to “negotiate” drug prices and the implications of the various options.  Some proposals would simply eliminate the MMA’s noninterference clause and allow HHS to negotiate prices for a broad set of drugs on behalf of Medicare beneficiaries.  However, the Congressional Budget Office has already concluded that such a plan would have “a negligible effect on federal spending” because it is unlikely that HHS could achieve deeper discounts than the current private Part D plans (there are 746 such plans in 2017).  The private plans are currently able to negotiate significant discounts from drug manufacturers by offering preferred formulary status for their drugs and channeling enrollees to the formulary drugs with lower cost-sharing incentives. In most drug classes, manufacturers compete intensely for formulary status and offer considerable discounts to be included.

The private Part D plans are required to provide only two drugs in each of several drug classes, giving the plans significant bargaining power over manufacturers by threatening to exclude their drugs.  However, in six protected classes (immunosuppressant, anti-cancer, anti-retroviral, antidepressant, antipsychotic and anticonvulsant drugs), private Part D plans must include “all or substantially all” drugs, thereby eliminating their bargaining power and ability to achieve significant discounts.  Although the purpose of the limitation is to prevent plans from cherry-picking customers by denying coverage of certain high cost drugs, giving the private Part D plans more ability to exclude drugs in the protected classes should increase competition among manufacturers for formulary status and, in turn, lower prices.  And it’s important to note that these price reductions would not involve any government negotiation or intervention in Medicare Part D.  However, as discussed below, excluding more drugs in the protected classes would reduce the value of the Part D plans to many patients by limiting access to preferred drugs.

For government negotiation to make any real difference on Medicare drug prices, HHS must have the ability to not only negotiate prices, but also to put some pressure on drug makers to secure price concessions.  This could be achieved by allowing HHS to also establish a formulary, set prices administratively, or take other regulatory actions against manufacturers that don’t offer price reductions.  Setting prices administratively or penalizing manufacturers that don’t offer satisfactory reductions would be tantamount to a price control.  I’ve previously explained that price controls—whether direct or indirect—are a bad idea for prescription drugs for several reasons. Evidence shows that price controls lead to higher initial launch prices for drugs, increased drug prices for consumers with private insurance coverage,  drug shortages in certain markets, and reduced incentives for innovation.

Giving HHS the authority to establish a formulary for Medicare Part D coverage would provide leverage to obtain discounts from manufacturers, but it would produce other negative consequences.  Currently, private Medicare Part D plans cover an average of 85% of the 200 most popular drugs, with some plans covering as much as 93%.  In contrast, the drug benefit offered by the Department of Veterans Affairs (VA), one government program that is able to set its own formulary to achieve leverage over drug companies, covers only 59% of the 200 most popular drugs.  The VA’s ability to exclude drugs from the formulary has generated significant price reductions. Indeed, estimates suggest that if the Medicare Part D formulary was restricted to the VA offerings and obtained similar price reductions, it would save Medicare Part D $510 per beneficiary.  However, the loss of access to so many popular drugs would reduce the value of the Part D plans by $405 per enrollee, greatly narrowing the net gains.

History has shown that consumers don’t like their access to drugs reduced.  In 2014, Medicare proposed to take antidepressants, antipsychotic and immunosuppressant drugs off the protected list, thereby allowing the private Part D plans to reduce offerings of these drugs on the formulary and, in turn, reduce prices.  However, patients and their advocates were outraged at the possibility of losing access to their preferred drugs, and the proposal was quickly withdrawn.

Thus, allowing the government to negotiate prices under Medicare Part D could carry important negative consequences.  Policy-makers must fully understand what it means for government to negotiate directly with drug makers, and what the potential consequences are for price reductions, access to popular drugs, drug innovation, and drug prices for other consumers.

On November 9, pharmaceutical stocks soared as Donald Trump’s election victory eased concerns about government intervention in drug pricing. Shares of Pfizer rose 8.5%, Allergan PLC was up 8%, and biotech Celgene jumped 10.4%. Drug distributors also gained, with McKesson up 6.4% and Express Scripts climbing 3.4%. Throughout the campaign, Clinton had vowed to take on the pharmaceutical industry and proposed various reforms to reign in drug prices, from levying fines on drug companies that imposed unjustified price increases to capping patients’ annual expenditures on drugs. Pharmaceutical stocks had generally underperformed this year as the market, like much of America, awaited a Clinton victory.

In contrast, Trump generally had less to say on the subject of drug pricing, hence the market’s favorable response to his unexpected victory. Yet, as the end of the first post-election month draws near, we are still uncertain whether Trump is friend or foe to the pharmaceutical industry. Trump’s only proposal that directly impacts the industry would allow the government to negotiate the prices of Medicare Part D drugs with drug makers. Although this proposal would likely have little impact on prices because existing Part D plans already negotiate prices with drug makers, there is a risk that this “negotiation” could ultimately lead to price controls imposed on the industry. And as I have previously discussed, price controls—whether direct or indirect—are a bad idea for prescription drugs: they lead to higher initial launch prices for drugs, increased drug prices for consumers with private insurance coverage, drug shortages in certain markets, and reduced incentives for innovation.

Several of Trump’s other health proposals have mixed implications for the industry. For example, a repeal or overhaul of the Affordable Care Act could eliminate the current tax on drug makers and loosen requirements for Medicaid drug rebates and Medicare part D discounts. On the other hand, if repealing the ACA reduces the number of people insured, spending on pharmaceuticals would fall. Similarly, if Trump renegotiates international trade deals, pharmaceutical firms could benefit from stronger markets or longer patent exclusivity rights, or they could suffer if foreign countries abandon trade agreements altogether or retaliate with disadvantageous terms.

Yet, with drug spending up 8.5 percent last year and recent pricing scandals launched by 500+ percentage increases in individual drugs (i.e., Martin Shkreli, Valeant Pharmaceuticals, Mylan), the current debate over drug pricing is unlikely to fade. Even a Republican-led Congress and White House is likely to heed the public outcry and do something about drug prices.

Drug makers would be wise to stave off any government-imposed price restrictions by voluntarily limiting price increases on important drugs. Major pharmaceutical company Allergan has recently done just this by issuing a “social contract with patients” that made several drug pricing commitments to its customers. Among other assurances, Allergan has promised to limit price increases to single-digit percentage increases and no longer engage in the common industry tactic of dramatically increasing prices for branded drugs nearing patent expiry. Last year throughout the pharmaceutical industry, the prices of the most commonly-used brand drugs increased by over 16 percent and, in the last two years before patent expiry, drug makers increased the list prices of drugs by an average of 35 percent. Thus, Allergan’s commitment will produce significant savings over the life of a product, creating hundreds of millions of dollars in savings to health plans, patients, and the health care system.

If Allergan can make this commitment for its entire drug inventory—over 80+ drugs—why haven’t other companies done the same? Similar commitments by other drug makers might be enough to prevent lawmakers from turning to market-distorting reforms, such as price controls, that could end up doing more harm than good for consumers, the pharmaceutical industry, and long-term innovation.

Mylan Pharmaceuticals recently reinvigorated the public outcry over pharmaceutical price increases when news surfaced that the company had raised the price of EpiPens by more than 500% over the past decade and, purportedly, had plans to increase the price even more. The Mylan controversy comes on the heels of several notorious pricing scandals last year. Recall Valeant Pharmaceuticals, that acquired cardiac drugs Isuprel and Nitropress and then quickly raised their prices by 525% and 212%, respectively. And of course, who can forget Martin Shkreli of Turing Pharmaceuticals, who increased the price of toxoplasmosis treatment Daraprim by 5,000% and then claimed he should have raised the price even higher.

However, one company, pharmaceutical giant Allergan, seems to be taking a different approach to pricing.   Last week, Allergan CEO Brent Saunders condemned the scandalous pricing increases that have raised suspicions of drug companies and placed the entire industry in the political hot seat. In an entry on the company’s blog, Saunders issued Allergan’s “social contract with patients” that made several drug pricing commitments to its customers.

Some of the most important commitments Allergan made to its customers include:

  • A promise to not increase prices more than once a year, and to limit price increases to singe-digit percentage increases.
  • A pledge to improve patient access to Allergan medications by enhancing patient assistance programs in 2017
  • A vow to cooperate with policy makers and payers (including government drug plans, private insurers, and pharmacy benefit managers) to facilitate better access to Allergan products by offering pricing discounts and paying rebates to lower drug costs.
  • An assurance that Allergan will no longer engage in the common industry tactic of dramatically increasing prices for branded drugs nearing patent expiry, without cost increases that justify the increase.
  • A commitment to provide annual updates on how pricing affects Allergan’s business.
  • A pledge to price Allergan products in a way that is commensurate with, or lower than, the value they create.

Saunders also makes several non-pricing pledges to maintain a continuous supply of its drugs, diligently monitor the safety of its products, and appropriately educate physicians about its medicines. He also makes the point that the recent pricing scandals have shifted attention away from the vibrant medical innovation ecosystem that develops new life-saving and life-enhancing drugs. Saunders contends that the focus on pricing by regulators and the public has incited suspicions about this innovation ecosystem: “This ecosystem can quickly fall apart if it is not continually nourished with the confidence that there will be a longer term opportunity for appropriate return on investment in the long R&D journey.”

Policy-makers and the public would be wise to focus on the importance of brand drug innovation. Brand drug companies are largely responsible for pharmaceutical innovation. Since 2000, brand companies have spent over half a trillion dollars on R&D, and they currently account for over 90 percent of the spending on the clinical trials necessary to bring new drugs to market. As a result of this spending, over 550 new drugs have been approved by the FDA since 2000, and another 7,000 are currently in development globally. And this innovation is directly tied to health advances. Empirical estimates of the benefits of pharmaceutical innovation indicate that each new drug brought to market saves 11,200 life-years each year.  Moreover, new drugs save money by reducing doctor visits, hospitalizations, and other medical procedures, ultimately for every $1 spent on new drugs, total medical spending decreases by more than $7.

But, as Saunders suggests, this innovation depends on drugmakers earning a sufficient return on their investment in R&D. The costs to bring a new drug to market with FDA approval are now estimated at over $2 billion, and only 1 in 10 drugs that begin clinical trials are ever approved by the FDA. Brand drug companies must price a drug not only to recoup the drug’s own costs, they must also consider the costs of all the product failures in their pricing decisions. However, they have a very limited window to recoup these costs before generic competition destroys brand profits: within three months of the first generic entry, generics have already captured over 70 percent of the brand drugs’ market. Drug companies must be able to price drugs at a level where they can earn profits sufficient to offset their R&D costs and the risk of failures. Failure to cover these costs will slow investment in R&D; drug companies will not spend millions and billions of dollars developing drugs if they cannot recoup the costs of that development.

Yet several recent proposals threaten to control prices in a way that could prevent drug companies from earning a sufficient return on their investment in R&D. Ultimately, we must remember that a social contract involves commitment from all members of a group; it should involve commitments from drug companies to price responsibly, and commitments from the public and policy makers to protect innovation. Hopefully, more drug companies will follow Allergan’s lead and renounce the exorbitant price increases we’ve seen in recent times. But in return, we should all remember that innovation and, in turn, health improvements, depend on drug companies’ profitability.

Last week, the Campaign for Sustainable Rx Pricing (CSRxP)—whose membership includes health insurance companies and other health payors, health providers, and consumers—proposed various reforms aimed at addressing the high costs of prescription drugs. CSRxP declares that their proposals will improve the functioning of the pharmaceutical market by increasing pricing transparency, promoting competition, and enhancing value. Although there are some good ideas in their list of proposals, others will negatively affect the pharmaceutical market, and ultimately, consumers.

The first set of proposals is aimed at increasing transparency in drug pricing.  I’ve previously commented on the likely negative effects of transparency reforms: they impose extensive legal and regulatory costs on businesses and risk harming competition if competitively-sensitive information gets into the wrong hands. CSRxP proposes that manufacturers disclose the price they intend to charge for a drug as part of the FDA approval process and, after approval, report price changes to the Department of Health and Human Services (HHS). Requiring manufacturers to report expected pricing as a condition of FDA approval suggests that the FDA’s role in assessing the risks and efficacy of drugs will merge with a central planner’s job of determining how products should be priced in the market. Will a drug not be approved if the price is too high? Shouldn’t consumers and payors, not a government agency, determine the market demand for a drug? And what will HHS do with the price change information—just condemn the “blameworthy” manufacturers or institute some sort of price control with its ensuing harms?

The second set of proposals purports to promote competition in the market for drugs. Many of these proposals are good ideas, and will help bring more and cheaper drugs to the market.  However, policy makers should tread carefully with other proposals, such as a call to prohibit product-hopping, because an overeager adoption or imprecise application of these reforms could curb pharmaceutical innovation and worsen patient health outcomes.  Lawmakers must ensure that adopted reforms balance incentives to innovate with the fostering of competition and lower prices.

The third set of proposals target the so-called “value” of drugs. Here, CSRxP proposes that manufacturers perform comparison studies to demonstrate that their drug is superior to existing drugs. While, in theory, knowing the relative effectiveness of drugs sounds great, there are two critical problems with this approach. First, are we really going to require more testing by drug manufacturers? It is estimated that testing and development costs already reach an average of $2.6 billion for each new drug brought to market; this is one of the explanations for the already high price of drugs. Why would we want to add more expensive testing? Also, I’m skeptical that comparison studies can offer the necessary insight into what drug works best for an individual patient. Drugs that perform extremely well for a small group of people may appear to have only average effectiveness in aggregate studies. And we certainly don’t want the expense of separate comparison studies on countless small groups of patients.

CSRxP also proposes that the government adopt value-based purchasing (VBP) arrangements that link payment for medications to patient outcomes and cost-effectiveness rather than just the quantity of treatments. Although CSRxP doesn’t detail the specific form of VBP they prefer, some of the possibilities could produce harmful consequences. Namely, VBP arrangements that set a standard payment rate for a group of similar drug products, such as reference pricing, will effectively act like a price control because the only way certain drugs will be available is if drug companies agree to offer them at that set rate. Price controls—whether direct or indirect—are a bad idea for prescription drugs for several reasons. Evidence shows that price controls lead to higher initial launch prices for drugs, increased drug prices for consumers with private insurance coverage, drug shortages in certain markets, and reduced incentives for innovation.

In sum, while CSRxP has some good ideas in their list, many of the proposals would ultimately harm the very patients the proposals are designed to benefit. Policymakers should steer clear of any reform that could act as a direct or indirect price control, increase the already high costs of developing drugs, or reduce incentives for innovation.

In an effort to control drug spending, several states are considering initiatives that will impose new price controls on prescription drugs. Ballot measures under consideration in California and Ohio will require drug companies to sell drugs under various state programs at a mandated discount. And legislators in Massachusetts and Pennsylvania have drafted bills that would create new government commissions to regulate the price of drugs. These state initiatives have followed proposals by presidential nominees to enact new price controls to address the high costs of pharmaceuticals.

As I explain in a new study, further price controls are a bad idea for several reasons.

First, as I discussed in a previous post, several government programs, such as Medicaid, the 340B Program, the Department of Defense and Veterans Affairs drug programs, and spending in the coverage gap of Medicare Part D, already impose price controls. Under these programs, required rebates are typically calculated as set percentages off of a drug company’s average drug price. But this approach gives drug companies an incentive to raise prices; a required percentage rebate off of a higher average price can serve to offset the mandated price control.

Second, over 40 percent of drugs sold in the U.S. are sold under government programs that mandate price controls. With such a large share of their drugs sold at significant discounts, drug companies have the incentive to charge even higher prices to other non-covered patients to offset the discounts. Indeed, numerous studies and government analyses have concluded that required discounts under Medicaid and Medicare have resulted in increased prices for other consumers as manufacturers seek to offset revenue lost under price controls.

Third, evidence suggests that price controls contribute to significant drug shortages: at a below-market price, the demand for drugs exceeds the amount of drugs that manufacturers are willing or able to sell.

Fourth, price controls hinder innovation in the pharmaceutical industry. Brand drug companies incur an average of $2.6 billion in costs to bring each new drug to market with FDA approval. They must offset these significant costs with revenues earned during the patent period; within 3 months after patent expiry, generic competitors will have already captured over 70 percent of the brand drugs’ market share and significantly eroded their profits. But price controls imposed on drugs under patent increase the risk that drug companies will not earn the profits they need to offset their development costs (only 20% of marketed brand drugs ever earn enough sales to cover their development cost). The result will be less R&D spending and less innovation. Indeed, a substantial body of empirical literature establishes that pharmaceutical firms’ profitability is linked to their research and development efforts and innovation.

Instead of imposing price controls, the government should increase drug competition in order to reduce drug spending without these negative consequences. Increased drug competition will expand product offerings, giving consumers more choice in the drugs they take. It will also lower prices and spur innovation as suppliers compete to attain or protect valuable market share from rivals.

First, the FDA should reduce the backlog of generic drugs awaiting approval. The single most important factor in controlling drug spending in recent decades has been the dramatic increase in generic drug usage; generic drugs have saved consumers $1.68 trillion over the past decade. But the degree to which generics reduce drug prices depends on the number of generic competitors in the market; the more competitors, the more price competition and downward pressure on prices. Unfortunately, a backlog of generic drug approvals at the FDA has restricted generic competition in many important market segments. There are currently over 3,500 generic applications pending approval; fast-tracking these FDA approvals will provide consumers with many new lower-priced drug options.

Second, regulators should expedite the approval and acceptance of biosimilars—the generic counterparts to high-priced biologic drugs. Biologic drugs are different from traditional medications because they are based on living organisms and, as a result, are far more complex and expensive to develop. By 2013, spending on biologic drugs comprised a quarter of all drug spending in the U.S., and their share of drug spending is expected increase significantly over the next decade. Unfortunately, the average cost of a biologic drug is 22 times greater than a traditional drug, making them prohibitively expensive for many consumers.

Fortunately, Congress has recognized the need for cheaper, “generic” substitutes for biologic drugs—or biosimilars. As part of the Affordable Care Act, Congress created a biosimilars approval pathway that would enable these cheaper biologic drugs to obtain FDA approval and reach patients more quickly. Nevertheless, the FDA has approved only one biosimilar for use in the U.S. despite several pending biosimilar applications. The agency has also yet to provide any meaningful guidance as to what standards it will employ in determining whether a biosimilar is interchangeable with a biologic. Burdensome requirements for interchangeability increase the difficulty and cost of biosimilar approval and limit the ease of biosimilar substitution at pharmacies.

Expediting the approval of biosimilars will increase competition in the market for biologic drugs, reducing prices and allowing more patients access to these life-saving and life-enhancing treatments. Estimates suggest that a biosimilar approval pathway at the FDA will save U.S. consumers between $44 billion and $250 billion over the next decade.

The recent surge in drug spending must be addressed to ensure that patients can continue to afford life-saving and life-enhancing medications. However, proposals calling for new price controls are the wrong approach. While superficially appealing, price controls may have unintended consequences—less innovation, drug shortages, and higher prices for some consumers—that could harm consumers rather than helping them. In contrast, promoting competition will lower pharmaceutical prices and drug spending without these deleterious effects.




Politicians have recently called for price controls to address the high costs of pharmaceuticals. Price controls are government-mandated limits on prices, or government-required discounts on prices. On the campaign trail, Hillary Clinton has called for price controls for lower-income Medicare patients while Donald Trump has recently joined Clinton, Bernie Sanders, and President Obama in calling for more government intervention in the Medicare Part D program. Before embarking upon additional price controls for the drug industry, policymakers and presidential candidates would do well to understand the impacts and problems arising from existing controls.

Unbeknownst to many, a vast array of price controls are already in place in the pharmaceutical market. Over 40 percent of outpatient drug spending is spent in public programs that use price controls. In order to sell drugs to consumers covered by these public programs, manufacturers must agree to offer certain rebates or discounts on drug prices. The calculations are generally based on the Average Manufacturer Price (AMP–the average price wholesalers pay manufacturers for drugs that are sold to retail pharmacies) or the Best Price (the lowest price the manufacturer offers the drug to any purchaser including all rebates and discounts). The most significant public programs using some form of price control are described below.

  1. Medicaid

The Medicaid program provides health insurance for low-income and medically needy individuals. The legally-required rebate depends on the specific category of drug; for example, brand manufacturers are required to sell drugs for the lesser of 23.1% off AMP or the best price offered to any purchaser.

The Affordable Care Act significantly expanded Medicaid eligibility so that in 2014, the program covered approximately 64.9 million individuals, or 20 percent of the U.S. population. State Medicaid data indicates that manufacturers paid an enormous sum — in excess of $16.7 billion — in Medicaid rebates in 2012.

  1. 340B Program

The “340B Program”, created by Congress in 1992, requires drug manufacturers to provide outpatient drugs at significantly reduced prices to 340B-eligible entities—entities that serve a high proportion of low-income or uninsured patients. Like Medicaid, the 340B discount must be at least 23.1 percent off AMP. However, the statutory formula calculates different discounts for different products and is estimated to produce discounts that average 45 percent off average prices. Surprisingly, the formulas can even result in a negative 340B selling price for a drug, in which case manufacturers are instructed to set the drug price at a penny.

The Affordable Care Act broadened the definition of qualified buyers to include many additional types of hospitals. As a result, both the number of 340B-eligible hospitals and the money spent on 340B drugs tripled between 2005 and 2014. By 2014, there were over 14,000 hospitals and affiliated sites in the 340B program, representing about one-third of all U.S. hospitals.

The 340B program has a glaring flaw that punishes the pharmaceutical industry without any offsetting benefits for low-income patients. The 340B statute does NOT require that providers only dispense 340B drugs to needy patients. In what amounts to merely shifting profits from pharmaceutical companies to other health care providers, providers may also sell drugs purchased at the steep 340B discount to non-qualified patients and pocket the difference between the 340B discounted price and the reimbursement of the non-qualified patients’ private insurance companies. About half of the 340B entities generate significant revenues from private insurer reimbursements that exceed 340B prices.

  1. Departments of Defense and Veterans Affairs Drug Programs

In order to sell drugs through the Medicaid program, drug manufacturers must also provide drugs to four government agencies—the VA, Department of Defense, Public Health Service and Coast Guard—at statutorily-imposed discounts. The required discounted price is the lesser of 24% off AMP or the lowest price manufacturers charge their most-favored nonfederal customers under comparable terms. Because of additional contracts that generate pricing concessions from specific vendors, studies indicate that VA and DOD pricing for brand pharmaceuticals was approximately 41-42% of the average wholesale price.

  1. Medicare Part D

An optional Medicare prescription drug benefit (Medicare Part D) was enacted in 2005 to offer coverage to many of the nation’s retirees and disabled persons. Unlike Medicaid and the 340B program, there is no statutory rebate level on prescription drugs covered under the program. Instead, private Medicare Part D plans, acting on behalf of the Medicare program, negotiate prices with pharmaceutical manufacturers and may obtain price concessions in the form of rebates. Manufacturers are willing to offer significant rebates and discounts in order to provide drugs to the millions of covered participants. The rebates often amount to as much as a 20-30 percent discount on brand medicines. CMS reported that manufacturers paid in excess of $10.3 billion in Part D rebates in 2012.

The Medicare Part D program does include direct price controls on drugs sold in the coverage gap. The coverage gap (or “donut hole”) is a spending level in which enrollees are responsible for a larger share of their total drug costs. For 2016, the coverage gap begins when the individual and the plan have spent $3,310 on covered drugs and ends when $7,515 has been spent. Medicare Part D requires brand drug manufacturers to offer 50 percent discounts on drugs sold during the coverage gap. These required discounts will cost drug manufacturers approximately $41 billion between 2012-2021.

While existing price controls do produce lower prices for some consumers, they may also result in increased prices for others, and in the long-term may drive up prices for all.  Many of the required rebates under Medicaid, the 340B program, and VA and DOD programs are based on drugs’ AMP.  Calculating rebates from average drug prices gives manufactures an incentive to charge higher prices to wholesalers and pharmacies in order to offset discounts. Moreover, with at least 40% of drugs sold under price controls, and some programs even requiring drugs to be sold for a penny, manufacturers are forced to sell many drugs at significant discounts.  This creates incentives to charge higher prices to other non-covered patients to offset the discounts.  Further price controls will only amplify these incentives and create inefficient market imbalances.


On January 12, 2016, the California state legislature will hold a hearing on AB 463: the Pharmaceutical Cost Transparency Act of 2016. The proposed bill would require drug manufacturers to disclose sensitive information about each drug with prices above a certain level.  The required disclosure includes various production costs including:  the costs of materials and manufacturing, the costs of research and development into the drug, the cost of clinical trials, the costs of any patents or licenses acquired in the development process, and the costs of marketing and advertising. Manufacturers would also be required to disclose a record of any pricing changes for the drug, the total profit attributable to the drug, the manufacturer’s aid to prescription assistance programs, and the costs of projects or drugs that fail during development.  Similar bills have been proposed in other states.

The stated goal of the proposed Act is to ‘make pharmaceutical pricing as transparent as the pricing in other sectors of the healthcare industry.’ However, by focusing almost exclusively on cost disclosure, the bill seemingly ignores the fact that market price is determined by both supply and demand factors. Although costs of development and production are certainly an important factor, pricing is also based on factors such as therapeutic value, market size, available substitutes, patent life, and many other factors.

Moreover, the bill does not clarify how drug manufacturers are to account for and disclose one of the most significant costs to pharmaceutical manufacturers: the cost of failed drugs that never make it to market. Data suggests that only around 10 percent of drugs that begin clinical trials are eventually approved by the FDA. Drug companies depend on the profits from these “hits” in order to stay in business; companies must use the profits from successful drugs to subsidize the significant losses from the 90 percent of drugs that fail.   AB 463 enables manufacturers to disclose the costs of failures, but is unclear if they are able to consider the total losses from the 90 percent of drugs that fail, or only failed drugs that were developed in conjunction with the drug in question. Moreover, even though profits from successful drugs are necessary to subsidize failures, AB 463 is silent on whether the losses from failures can be included in profit calculations.

It’s also worth pointing out that any evaluation of drug manufacturers’ profits should recognize the basic risk-return tradeoff. In order to willingly incur risk—and a 90 percent failure rate of drugs in development is a significant risk—investors and companies demand profits or returns greater than the return on less risky endeavors. That is, if investors or companies can make a 5% return on a safe, predictable investment that has little variation in returns, why would they ever engage in a risky endeavor (especially one with a 90% failure rate) if they don’t earn a substantially higher return?  The market resolves these issues by compensating risky endeavors with a higher expected return. Thus, we should expect companies engaged in the risky business of drug development to receive higher profits than businesses engaged in more conservative businesses.

It will also prove difficult, if not impossible, for drug manufacturers to disclose information about even the “hits” because many of the costs that manufacturers incur are difficult to attribute to a specific drug. Much pre-clinical research is for the purpose of generating dozens or hundreds of possible drug candidates; how should these very expensive research costs be attributed?  How should companies allocate the costs of meeting regulatory requirements; these are rarely incurred independently for each drug? And the overhead costs of operating a business with thousands of employees are also impossible to allocate to a specific drug.  By ignoring these shared costs, AB 463 does little to illuminate the full costs to drug manufacturers.

Instead of providing useful information to make drug pricing more transparent, AB 463 will impose extensive legal and regulatory costs on businesses. The additional disclosure directly increases costs for manufacturers as they collect, prepare, and present the required data. Manufacturers will also incur significant costs as they consult with lawyers and regulators to ensure that they are meeting the disclosure requirements. These costs will ultimately be passed on to consumers in the form of higher drug prices.

Finally, disclosure of such competitively-sensitive information as that required under AB 463 risks harming competition if it gets into the wrong hands. If the confidentiality provisions prove unclear or inadequate, AB 463 may permit the broader disclosure of sensitive information to competitors. This will, in turn, facilitate collusion, raise prices, and harm the very consumers AB 463 is designed to protect.

In sum, the incomplete disclosure required under AB 463 will provide little transparency to the public. The resources could be better used to foster innovation and develop new treatments that lower total health care costs in the long run.

Thanks to the Truth on the Market bloggers for having me. I’m a long-time fan of the blog, and excited to be contributing.

The Third Circuit will soon review the appeal of generic drug manufacturer, Mylan Pharmaceuticals, in the latest case involving “product hopping” in the pharmaceutical industry — Mylan Pharmaceuticals v. Warner Chilcott.

Product hopping occurs when brand pharmaceutical companies shift their marketing efforts from an older version of a drug to a new, substitute drug in order to stave off competition from cheaper generics. This business strategy is the predictable business response to the incentives created by the arduous FDA approval process, patent law, and state automatic substitution laws. It costs brand companies an average of $2.6 billion to bring a new drug to market, but only 20 percent of marketed brand drugs ever earn enough to recoup these costs. Moreover, once their patent exclusivity period is over, brand companies face the likely loss of 80-90 percent of their sales to generic versions of the drug under state substitution laws that allow or require pharmacists to automatically substitute a generic-equivalent drug when a patient presents a prescription for a brand drug. Because generics are automatically substituted for brand prescriptions, generic companies typically spend very little on advertising, instead choosing to free ride on the marketing efforts of brand companies. Rather than hand over a large chunk of their sales to generic competitors, brand companies often decide to shift their marketing efforts from an existing drug to a new drug with no generic substitutes.

Generic company Mylan is appealing U.S. District Judge Paul S. Diamond’s April decision to grant defendant and brand company Warner Chilcott’s summary judgment motion. Mylan and other generic manufacturers contend that Defendants engaged in a strategy to impede generic competition for branded Doryx (an acne medication) by executing several product redesigns and ceasing promotion of prior formulations. Although the plaintiffs generally changed their products to keep up with the brand-drug redesigns, they contend that these redesigns were intended to circumvent automatic substitution laws, at least for the periods of time before the generic companies could introduce a substitute to new brand drug formulations. The plaintiffs argue that product redesigns that prevent generic manufacturers from benefitting from automatic substitution laws violate Section 2 of the Sherman Act.

Product redesign is not per se anticompetitive. Retiring an older branded version of a drug does not block generics from competing; they are still able to launch and market their own products. Product redesign only makes competition tougher because generics can no longer free ride on automatic substitution laws; instead they must either engage in their own marketing efforts or redesign their product to match the brand drug’s changes. Moreover, product redesign does not affect a primary source of generics’ customers—beneficiaries that are channeled to cheaper generic drugs by drug plans and pharmacy benefit managers.

The Supreme Court has repeatedly concluded that “the antitrust laws…were enacted for the protection of competition not competitors” and that even monopolists have no duty to help a competitor. The district court in Mylan generally agreed with this reasoning, concluding that the brand company Defendants did not exclude Mylan and other generics from competition: “Throughout this period, doctors remained free to prescribe generic Doryx; pharmacists remained free to substitute generics when medically appropriate; and patients remained free to ask their doctors and pharmacists for generic versions of the drug.” Instead, the court argued that Mylan was a “victim of its own business strategy”—a strategy that relied on free-riding off brand companies’ marketing efforts rather than spending any of their own money on marketing. The court reasoned that automatic substitution laws provide a regulatory “bonus” and denying Mylan the opportunity to take advantage of that bonus is not anticompetitive.

Product redesign should only give rise to anticompetitive claims if combined with some other wrongful conduct, or if the new product is clearly a “sham” innovation. Indeed, Senior Judge Douglas Ginsburg and then-FTC Commissioner Joshua D. Wright recently came out against imposing competition law sanctions on product redesigns that are not sham innovations. If lawmakers are concerned that product redesigns will reduce generic usage and the cost savings they create, they could follow the lead of several states that have broadened automatic substitution laws to allow the substitution of generics that are therapeutically-equivalent but not identical in other ways, such as dosage form or drug strength.

Mylan is now asking the Third Circuit to reexamine the case. If the Third Circuit reverses the lower courts decision, it would imply that brand drug companies have a duty to continue selling superseded drugs in order to allow generic competitors to take advantage of automatic substitution laws. If the Third Circuit upholds the district court’s ruling on summary judgment, it will likely create a circuit split between the Second and Third Circuits. In July 2015, the Second Circuit court upheld an injunction in NY v. Actavis that required a brand company to continue manufacturing and selling an obsolete drug until after generic competitors had an opportunity to launch their generic versions and capture a significant portion of the market through automatic substitution laws. I’ve previously written about the duty created in this case.

Regardless of whether the Third Circuit’s decision causes a split, the Supreme Court should take up the issue of product redesign in pharmaceuticals to provide guidance to brand manufacturers that currently operate in a world of uncertainty and under the constant threat of litigation for decisions they make when introducing new products.