Truth on the Market

We don’t yet know how bad the coronavirus outbreak will be in America.  But we do know that the virus is likely to have a major impact on Americans’ access to medication.  Currently, 80% of the active ingredients found in the drugs Americans take are made in China, and the virus has disrupted China’s ability to manufacture and supply those ingredients.  Generic drugs, which comprise 90% of America’s drugs, are likely to be particularly impacted because most generics are made in India, and Indian drug makers rely heavily on Chinese-made ingredients.  Indeed, on Tuesday, March 3, India decided to restrict exports of 26 drugs and drug ingredients because of reductions in China’s supply.  This disruption to the generic supply chain could mean that millions of Americans will not get the drugs they need to stay alive and healthy.

Coronavirus-related shortages are only the latest in a series of problems recently afflicting the generic drug industry.  In the last few years, there have been many reports of safety issues affecting generic drug quality at both domestic and overseas manufacturing facilities.  Numerous studies have uncovered shady practices and quality defects, including generics contaminated with carcinogens, drugs in which the active ingredients were switched for ineffective or unsafe alternatives, and manufacturing facilities that falsify or destroy documents to conceal their misdeeds.

We’ve also been inundated with stories of generic drug makers hiking prices for their products.  Although, as a whole, generic drugs are much cheaper than innovative brand products, the prices for many generic drugs are on the increase.  For some generics – Martin Shkreli’s Daraprim, heart medication Digoxin, antibiotic Doxycycline, insulin, and many others – prices have increased by several hundred percent. It turns out that many of the price increases are the result of anticompetitive behavior in the generic market. For others, the price increases are due to the increasing difficulty of generic drug makers to earn profits selling low-priced drugs.

Even before the coronavirus outbreak, there were numerous instances of shortages for critical generic drugs.  These shortages often result from drug makers’ lack of incentive to manufacture low-priced drugs that don’t earn much profit. The shortages have been growing in frequency and duration in recent years.  As a result of the shortages, 90 percent of U.S. hospitals report having to find alternative drug therapies, costing patients and hospitals over $400 million last year.  In other unfortunate situations, reasonable alternatives simply are not available and patients suffer.

With generic drug makers’ growing list of problems, many policy makers have called for significant changes to America’s approach to the generic drug industry. Perhaps the FDA needs to increase its inspection of overseas facilities?  Perhaps the FTC and state and federal prosecutors should step up their investigations and enforcement actions against anticompetitive behavior in the industry? Perhaps FDA should do even more to promote generic competition by expediting generic approvals? 

While these actions and other proposals could certainly help, none are aimed at resolving more than one or two of the significant problems vexing the industry. Senator Elizabeth Warren has proposed a more substantial overhaul that would bring the U.S. government into the generic-drug-making business. Under Warren’s plan, the Department of Health and Human Services (HHS) would manufacture or contract for the manufacture of drugs to be sold at lower prices.  Nationalizing the generic drug industry in this way would make the inspection of manufacturing facilities much easier and could ideally eliminate drug shortages.  In January, California’s governor proposed a similar system under which the state would begin manufacturing or contracting to manufacture generic drugs.

However, critics of public manufacturing argue that manufacturing and distribution infrastructure would be extremely costly to set up, with taxpayers footing the bill.  And even after the initial set-up, market dynamics that affect costs, such as increasing raw material costs or supply chain disruptions, would also mean greater costs for taxpayers.  Moreover, by removing the profit incentive created under the Hatch-Waxman Act to develop and manufacture generic drugs, it’s not clear that governments could develop or manufacture a sufficient supply of generics (consider the difference in efficiency between the U.S. Postal Service and either UPS or FedEx).

Another approach might be to treat the generic drug industry as a regulated industry. This model has been applied to utilities in the past when unregulated private ownership of utility infrastructure could not provide sufficient supply to meet consumer need, address market failures, or prevent the abuse of monopoly power.  Similarly, consumers’ need for safe and affordable medicines, market failures inherent throughout the industry, and industry consolidation that could give rise to market power suggest the regulated model might work well for generic drugs.   

Under this approach, Hatch-Waxman incentives could remain in place, granting the first generic drug an exclusivity period during which it could earn significant profits for the generic drug maker.  But when the exclusivity period ends, an agency like HHS would assign manufacturing responsibility for a particular drug to a handful of generic drug makers wishing to market in the U.S.  These companies would be guaranteed a profit based on a set rate of return on the costs of high-quality domestic manufacturing.  In order to maintain their manufacturing rights, facilities would have to meet strict FDA guidelines to ensure high quality drugs. 

Like the Warren and California proposals, this approach would tackle several problems at once.  Prices would be kept under control and facilities would face frequent inspections to ensure quality.  A guaranteed profit would eliminate generic companies’ financial risk, reducing their incentive to use cheap (and often unsafe) drug ingredients or to engage in illegal anticompetitive behavior.  It would also encourage steady production to reduce instances of drug shortages.  Unlike the Warren and California proposals, this approach would build on the existing generic infrastructure so that taxpayers don’t have to foot the bill to set up public manufacturing.  It would also continue to incentivize the development of generic alternatives by maintaining the Hatch-Waxman exclusivity period, and it would motivate the manufacture of generic drugs by companies seeking a reliable rate of return.

Several issues would need to be worked out with a regulated generic industry approach to prevent manipulation of rates of return, regulatory capture, and political appointees without the incentives or knowledge to regulate the drug makers. However, the recurring crises affecting generic drugs indicate the industry is rife with market failures.  Perhaps only a radical new approach will achieve lasting and necessary change.