John Carreyrou’s marvelous book Bad Blood chronicles the rise and fall of Theranos, the one-time Silicon Valley darling that was revealed to be a house of cards. Theranos’s Svengali-like founder, Elizabeth Holmes, convinced scores of savvy business people (mainly older men) that her company was developing a machine that could detect all manner of maladies from a small quantity of a patient’s blood. Turns out it was a fraud.
I had a couple of recurring thoughts as I read Bad Blood. First, I kept thinking about how Holmes’s fraud might impair future medical innovation. Something like Theranos’s machine would eventually be developed, I figured, but Holmes’s fraud would likely set things back by making investors leery of blood-based, multi-disease diagnostics.
I also had a thought about the causes of Theranos’s spectacular failure. A key problem, it seemed, was that the company tried to do too many things at once: develop diagnostic technologies, design an elegant machine (Holmes was obsessed with Steve Jobs and insisted that Theranos’s machine resemble a sleek Apple device), market the product, obtain regulatory approval, scale the operation by getting Theranos machines in retail chains like Safeway and Walgreens, and secure third-party payment from insurers.
A thought that didn’t occur to me while reading Bad Blood was that a multi-disease blood diagnostic system would soon be developed but would be delayed, or possibly even precluded from getting to market, by an antitrust enforcement action based on things the developers did to avoid the very problems that doomed Theranos.
Sadly, that’s where we are with the Federal Trade Commission’s misguided challenge to the merger of Illumina and Grail.
Founded in 1998, San Diego-based Illumina is a leading provider of products used in genetic sequencing and genomic analysis. Illumina produces “next generation sequencing” (NGS) platforms that are used for a wide array of applications (genetic tests, etc.) developed by itself and other companies.
In 2015, Illumina founded Grail for the purpose of developing a blood test that could detect cancer in asymptomatic individuals—the “holy grail” of cancer diagnosis. Given the superior efficacy and lower cost of treatments for early- versus late-stage cancers, success by Grail could save millions of lives and billions of dollars.
Illumina created Grail as a separate entity in which it initially held a controlling interest (having provided the bulk of Grail’s $100 million Series A funding). Legally separating Grail in this fashion, rather than running it as an Illumina division, offered a number of benefits. It limited Illumina’s liability for Grail’s activities, enabling Grail to take greater risks. It mitigated the Theranos problem of managers’ being distracted by too many tasks: Grail managers could concentrate exclusively on developing a viable cancer-screening test, while Illumina’s management continued focusing on that company’s core business. It made it easier for Grail to attract talented managers, who would rather come in as corporate officers than as division heads. (Indeed, Grail landed Jeff Huber, a high-profile Google executive, as its initial CEO.) Structuring Grail as a majority-owned subsidiary also allowed Illumina to attract outside capital, with the prospect of raising more money in the future by selling new Grail stock to investors.
In 2017, Grail did exactly that, issuing new shares to investors in exchange for $1 billion. While this capital infusion enabled the company to move forward with its promising technologies, the creation of new shares meant that Illumina no longer held a controlling interest in the firm. Its ownership interest dipped below 20 percent and now stands at about 14.5 percent of Grail’s voting shares.
Setting up Grail so as to facilitate outside capital formation and attract top managers who could focus single-mindedly on product development has paid off. Grail has now developed a blood test that, when processed on Illumina’s NGS platform, can accurately detect a number of cancers in asymptomatic individuals. Grail predicts that this “liquid biopsy,” called Galleri, will eventually be able to detect up to 50 cancers before physical symptoms manifest. Grail is also developing other blood-based cancer tests, including one that confirms cancer diagnoses in patients suspected to have cancer and another designed to detect cancer recurrence in patients who have undergone treatment.
Grail now faces a host of new challenges. In addition to continuing to develop its tests, Grail needs to:
Engage in widespread testing of its cancer-detection products on up to 50 different cancers;
Process and present the information from its extensive testing in formats that will be acceptable to regulators;
Navigate the pre-market regulatory approval process in different countries across the globe;
Secure commitments from third-party payors (governments and private insurers) to provide coverage for its tests;
Develop means of manufacturing its products at scale;
Create and implement measures to ensure compliance with FDA’s Quality System Regulation (QSR), which governs virtually all aspects of medical device production (design, testing, production, process controls, quality assurance, labeling, packaging, handling, storage, distribution, installation, servicing, and shipping); and
Market its tests to hospitals and health-care professionals.
These steps are all required to secure widespread use of Grail’s tests. And, importantly, such widespread use will actually improve the quality of the tests. Grail’s tests analyze the DNA in a patient’s blood to look for methylation patterns that are known to be associated with cancer. In essence, the tests work by comparing the methylation patterns in a test subject’s DNA against a database of genomic data collected from large clinical studies. With enough comparison data, the tests can indicate not only the presence of cancer but also where in the body the cancer signal is coming from. And because Grail’s tests use machine learning to hone their algorithms in response to new data collected from test usage, the greater the use of Grail’s tests, the more accurate, sensitive, and comprehensive they become.
To assist with the various tasks needed to achieve speedy and widespread use of its tests, Grail decided to reunite with Illumina. In September 2020, the companies entered a merger agreement under which Illumina would acquire the 85.5 percent of Grail voting shares it does not already own for cash and stock worth $7.1 billion and additional contingent payments of $1.2 billion to Grail’s non-Illumina shareholders.
Recombining with Illumina will allow Grail—which has appropriately focused heretofore solely on product development—to accomplish the tasks now required to get its tests to market. Illumina has substantial laboratory capacity that Grail can access to complete the testing needed to refine its products and establish their effectiveness. As the leading global producer of NGS platforms, Illumina has unparalleled experience in navigating the regulatory process for NGS-related products, producing and marketing those products at scale, and maintaining compliance with complex regulations like FDA’s QSR. With nearly 3,000 international employees located in 26 countries, it has obtained regulatory authorizations for NGS-based tests in more than 50 jurisdictions around the world. It also has long-standing relationships with third-party payors, health systems, and laboratory customers. Grail, by contrast, has never obtained FDA approval for any products, has never manufactured NGS-based tests at scale, has only a fledgling regulatory affairs team, and has far less extensive contacts with potential payors and customers. By remaining focused on its key objective (unlike Theranos), Grail has achieved product-development success. Recombining with Illumina will now enable it, expeditiously and efficiently, to deploy its products across the globe, generating user data that will help improve the products going forward.
In addition to these benefits, the combination of Illumina and Grail will eliminate a problem that occurs when producers of complementary products each operate in markets that are not fully competitive: double marginalization. When sellers of products that are used together each possess some market power due to a lack of competition, their uncoordinated pricing decisions may result in less surplus for each of them and for consumers of their products. Combining so that they can coordinate pricing will leave them and their customers better off.
Unlike a producer participating in a competitive market, a producer that faces little competition can enhance its profits by raising its price above its incremental cost. But there are limits on its ability to do so. As the well-known monopoly pricing model shows, even a monopolist has a “profit-maximizing price” beyond which any incremental price increase would lose money. Raising price above that level would hurt both consumers and the monopolist.
When consumers are deciding whether to purchase products that must be used together, they assess the final price of the overall bundle. This means that when two sellers of complementary products both have market power, there is an above-cost, profit-maximizing combined price for their products. If the complement sellers individually raise their prices so that the combined price exceeds that level, they will reduce their own aggregate welfare and that of their customers.
This unfortunate situation is likely to occur when market power-possessing complement producers are separate companies that cannot coordinate their pricing. In setting its individual price, each separate firm will attempt to capture as much surplus for itself as possible. This will cause the combined price to rise above the profit-maximizing level. If they could unite, the complement sellers would coordinate their prices so that the combined price was lower and the sellers’ aggregate profits higher.
Here, Grail and Illumina provide complementary products (cancer-detection tests and the NGS platforms on which they are processed), and each faces little competition. If they price separately, their aggregate prices are likely to exceed the profit-maximizing combined price for the cancer test and NGS platform access. If they combine into a single firm, that firm would maximize its profits by lowering prices so that the aggregate test/platform price is the profit-maximizing combined price. This would obviously benefit consumers.
In light of the social benefits the Grail/Illumina merger offers—speeding up and lowering the cost of getting Grail’s test approved and deployed at scale, enabling improvement of the test with more extensive user data, eliminating double marginalization—one might expect policymakers to cheer the companies’ recombination. The FTC, however, is trying to block it. In late March, the commission brought an action claiming that the merger would violate Section 7 of the Clayton Act by substantially reducing competition in a line of commerce.
The FTC’s theory is that recombining Illumina and Grail will impair competition in the market for “multi-cancer early detection” (MCED) tests. The commission asserts that the combined company would have both the opportunity and the motivation to injure rival producers of MCED tests.
The opportunity to do so would stem from the fact that MCED tests must be processed on NGS platforms, which are produced exclusively by Illumina. Illumina could charge Grail’s rivals or their customers higher prices for access to its NGS platforms (or perhaps deny access altogether) and could withhold the technical assistance rivals would need to secure both regulatory approval of their tests and coverage by third-party payors.
But why would Illumina take this tack, given that it would be giving up profits on transactions with producers and users of other MCED tests? The commission asserts that the losses a combined Illumina/Grail would suffer in the NGS platform market would be more than offset by gains stemming from reduced competition in the MCED test market. Thus, the combined company would have a motive, as well as an opportunity, to cause anticompetitive harm.
There are multiple problems with the FTC’s theory. As an initial matter, the market the commission claims will be impaired doesn’t exist. There is no MCED test market for the simple reason that there are no commercializable MCED tests. If allowed to proceed, the Illumina/Grail merger may create such a market by facilitating the approval and deployment of the first MCED test. At present, however, there is no such market, and the chances of one ever emerging will be diminished if the FTC succeeds in blocking the recombination of Illumina and Grail.
Because there is no existing market for MCED tests, the FTC’s claim that a combined Illumina/Grail would have a motivation to injure MCED rivals—potential consumers of Illumina’s NGS platforms—is rank speculation. The commission has no idea what profits Illumina would earn from NGS platform sales related to MCED tests, what profits Grail would earn on its own MCED tests, and how the total profits of the combined company would be affected by impairing opportunities for rival MCED test producers.
In the only relevant market that does exist—the cancer-detection market—there can be no question about the competitive effect of an Illumina/Grail merger: It would enhance competition by speeding the creation of a far superior offering that promises to save lives and substantially reduce health-care costs.
There is yet another problem with the FTC’s theory of anticompetitive harm. The commission’s concern that a recombined Illumina/Grail would foreclose Grail’s rivals from essential NGS platforms and needed technical assistance is obviated by Illumina’s commitments. Specifically, Illumina has irrevocably offered current and prospective oncology customers 12-year contract terms that would guarantee them the same access to Illumina’s sequencing products that they now enjoy, with no price increase. Indeed, the offered terms obligate Illumina not only to refrain from raising prices but also to lower them by at least 43% by 2025 and to provide regulatory and technical assistance requested by Grail’s potential rivals. Illumina’s continued compliance with its firm offer will be subject to regular audits by an independent auditor.
In the end, then, the FTC’s challenge to the Illumina/Grail merger is unjustified. The initial separation of Grail from Illumina encouraged the managerial focus and capital accumulation needed for successful test development. Recombining the two firms will now expedite and lower the costs of the regulatory approval and commercialization processes, permitting Grail’s tests to be widely used, which will enhance their quality. Bringing Grail’s tests and Illumina’s NGS platforms within a single company will also benefit consumers by eliminating double marginalization. Any foreclosure concerns are entirely speculative and are obviated by Illumina’s contractual commitments.
In light of all these considerations, one wonders why the FTC challenged this merger (and on a 4-0 vote) in the first place. Perhaps it was the populist forces from left and right that are pressuring the commission to generally be more aggressive in policing mergers. Some members of the commission may also worry, legitimately, that if they don’t act aggressively on a vertical merger, Congress will amend the antitrust laws in a deleterious fashion. But the commission has picked a poor target. This particular merger promises tremendous benefit and threatens little harm. The FTC should drop its challenge and encourage its European counterparts to do the same.
 If you don’t have time for Carreyrou’s book (and you should make time if you can), HBO’s Theranos documentary is pretty solid.
 This ability is market power. In a perfectly competitive market, any firm that charges an above-cost price will lose sales to rivals, who will vie for business by lowering their prices down to the level of their cost.
 Under the model, this is the price that emerges at the output level where the producer’s marginal revenue equals its marginal cost.
With the COVID-19 vaccine made by Moderna joining the one from Pfizer and BioNTech in gaining approval from the U.S. Food and Drug Administration, it should be time to celebrate the U.S. system of pharmaceutical development. The system’s incentives—notably granting patent rights to firms that invest in new and novel discoveries—have worked to an astonishing degree, producing not just one but as many as three or four effective approaches to end a viral pandemic that, just a year ago, was completely unknown.
Alas, it appears not all observers agree. Now that we have the vaccines, some advocate suspending or limiting patent rights—for example, by imposing a compulsory licensing scheme—with the argument that this is the only way for the vaccines to be produced in mass quantities worldwide. Some critics even assert that abolishing or diminishing property rights in pharmaceuticals is needed to end the pandemic.
In truth, we can effectively and efficiently distribute the vaccines while still maintaining the integrity of our patent system.
What the false framing ignores are the important commercialization and distribution functions that patents provide, as well as the deep, long-term incentives the patent system provides to create medical innovations and develop a robust pharmaceutical supply chain. Unless we are sure this is the last pandemic we will ever face, repealing intellectual property rights now would be a catastrophic mistake.
The supply chains necessary to adequately scale drug production are incredibly complex, and do not appear overnight. The coordination and technical expertise needed to support worldwide distribution of medicines depends on an ongoing pipeline of a wide variety of pharmaceuticals to keep the entire operation viable. Public-spirited officials may in some cases be able to piece together facilities sufficient to produce and distribute a single medicine in the short term, but over the long term, global health depends on profit motives to guarantee the commercialization pipeline remains healthy.
But the real challenge is in maintaining proper incentives to develop new drugs. It has long been understood that information goods like intellectual property will be undersupplied without sufficient legal protections. Innovators and those that commercialize innovations—like researchers and pharmaceutical companies—have less incentive to discover and market new medicines as the likelihood that they will be able to realize a return for their efforts diminishes. Without those returns, it’s far less certain the COVID vaccines would have been produced so quickly, or at all. The same holds for the vaccines we will need for the next crisis or badly needed treatments for other deadly diseases.
Patents are not the only way to structure incentives, as can be seen with the current vaccines. Pharmaceutical companies also took financial incentives from various governments in the form of direct payment or in purchase guarantees. But this enhances, rather than diminishes, the larger argument. There needs to be adequate returns for those who engage in large, risky undertakings like creating a new drug.
Some critics would prefer to limit pharmaceutical companies’ returns solely to those early government investments, but there are problems with this approach. It is difficult for governments to know beforehand what level of profit is needed to properly incentivize firms to engage in producing these innovations. To the extent that direct government investment is useful, it often will be as an additional inducement that encourages new entry by multiple firms who might each pursue different technologies.
Thus, in the case of coronavirus vaccines, government subsidies may have enticed more competitors to enter more quickly, or not to drop out as quickly, in hopes that they would still realize a profit, notwithstanding the risks. Where there might have been only one or two vaccines produced in the United States, it appears likely we will see as many as four.
But there will always be necessary trade-offs. Governments cannot know how to set proper incentives to encourage development of every possible medicine for every possible condition by every possible producer. Not only do we not know which diseases and which firms to prioritize, but we have no idea how to determine which treatment approaches to encourage.
The COVID-19 vaccines provide a clear illustration of this problem. We have seen development of both traditional vaccines and experimental mRNA treatments to combat the virus. Thankfully, both have shown positive results, but there was no way to know that in March. In this perennial state of ignorance,t markets generally have provided the best—though still imperfect—way to make decisions.
The patent system’s critics sometimes claim that prizes would offer a better way to encourage discovery. But if we relied solely on government-directed prizes, we might never have had the needed research into the technology that underlies mRNA. As one recent report put it, “before messenger RNA was a multibillion-dollar idea, it was a scientific backwater.” Simply put, without patent rights as the backstop to purely academic or government-led innovation and commercialization, it is far less likely that we would have seen successful COVID vaccines developed as quickly.
It is difficult for governments to be prepared for the unknown. Abolishing or diminishing pharmaceutical patents would leave us even less prepared for the next medical crisis. That would only add to the lasting damage that the COVID-19 pandemic has already wrought on the world.
[TOTM: The following is part of a blog series by TOTM guests and authors on the law, economics, and policy of the ongoing COVID-19 pandemic. The entire series of posts is available here.
This post is authored byThomas W. Hazlett, (Hugh H. Macaulay Endowed Professor of Economics, John E. Walker Department of Economics Clemson University)]
(Ed. Note: the following is an excerpt from a piece published by the Chicago Tribune on Oct. 16, 2020. Click here to read the full piece)
No matter your Twitter feed, “vaccines have been one of the greatest public health tools to prevent disease,” as The New York Times explained in January…
Many are terrified that the Food and Drug Administration may hastily authorize injections into hundreds of millions. The FDA and drugmakers are trying to assuage such concerns with enhanced commitments to safety. Nonetheless, fears have been stoked by President Donald Trump’s infomercial-style endorsement of hydroxychloroquine as a COVID-19 remedy, his foolhardy disdain for face masks and campaign rally boasts of a preelection cure.
Yes, politics. But the opposing political push — the demand that new vaccines must be safe at all costs — is itself a dangerous meme, and the strange bedfellow of anti-vaxxer protesters.
Pulitzer Prize-winning journalist Laurie Garrett inadvertently quantifies the problem. In a Sept. 3 article in Foreign Policy, she cited the H1N1 (swine flu) episode in 2009 as “the last mad rush to vaccinate.” Warning that those shots “caused Guillain-Barr (GBS) paralysis in … 6.2 per 10 million patients who received the vaccine,” she argues that phase 3 trials for COVID-19 vaccines, typically involving just 30,000 people, provide little protection. “There’s no way … we can spot a safety hazard that’s in 1 out of a million, much less 1 out of 10 million, vaccine recipients.” The “safety side,” she told a TV interviewer, “looks insane.”
But, in fact, the “insanity” here is not found in the push for speed or in Garrett’s skepticism about Operation Warp Speed. It lies in a lack of balance between the two. An insufficiently vetted vaccine may cost innocent lives, but so will delaying a vaccine that, on net, saves them…
When promising therapies appear, reducing time to market is often worth the risk — as reflected in a raft of pre-COVID-19 policies, including the FDA’s “emergency use authorizations,” “fast track” drug approvals and “compassionate use” permissions for experimental drugs. In phase 3 trials, independent monitors observe results, and trials may be terminated when pre-specified benefits appear. Patients in the control group become eligible for the treatment instead of the placebo. Larger samples would enhance scientific knowledge, but as probabilities shift regulators act on the reality that the ideal can become the enemy of the good.
[TOTM: The following is part of a blog series by TOTM guests and authors on the law, economics, and policy of the ongoing COVID-19 pandemic. The entire series of posts is available here.
This post is authored by Geoffrey A. Manne, (President, ICLE; Distinguished Fellow, Northwestern University Center on Law, Business, and Economics); and Dirk Auer, (Senior Fellow of Law & Economics, ICLE)]
Back in 2012, Covidien, a large health care products company and medical device manufacturer, purchased Newport Medical Instruments, a small ventilator developer and manufacturer. (Covidien itself was subsequently purchased by Medtronic in 2015).
Eight years later, in the midst of the coronavirus pandemic, the New York Times has just published an article revisiting the Covidien/Newport transaction, and questioning whether it might have contributed to the current shortage of ventilators.
The article speculates that Covidien’s purchase of Newport, and the subsequent discontinuation of Newport’s “Aura” ventilator — which was then being developed by Newport under a government contract — delayed US government efforts to procure mechanical ventilators until the second half of 2020 — too late to treat the first wave of COVID-19 patients:
And then things suddenly veered off course. A multibillion-dollar maker of medical devices bought the small California company that had been hired to design the new machines. The project ultimately produced zero ventilators.
That failure delayed the development of an affordable ventilator by at least half a decade, depriving hospitals, states and the federal government of the ability to stock up.
* * *
Today, with the coronavirus ravaging America’s health care system, the nation’s emergency-response stockpile is still waiting on its first shipment.
The article has generated considerable interest not so much for what it suggests about government procurement policies or for its relevance to the ventilator shortages associated with the current pandemic, but rather for its purported relevance to ongoing antitrust debates and the arguments put forward by “antitrust populists” and others that merger enforcement in the US is dramatically insufficient.
Only a single sentence in the article itself points to a possible antitrust story — and it does nothing more than report unsubstantiated speculation from unnamed “government officials” and rival companies:
Government officials and executives at rival ventilator companies said they suspected that Covidien had acquired Newport to prevent it from building a cheaper product that would undermine Covidien’s profits from its existing ventilator business.
Nevertheless, and right on cue, various antitrust scholars quickly framed the deal as a so-called “killer acquisition” (see also here and here):
Unsurprisingly, politicians were also quick to jump on the bandwagon. David Cicilline, the powerful chairman of the House Antitrust Subcommittee, opined that:
The public reporting on this acquisition raises important questions about the review of this deal. We should absolutely be looking back to figure out what happened.
These “hot takes” raise a crucial issue. The New York Times story opened the door to a welter of hasty conclusions offered to support the ongoing narrative that antitrust enforcement has failed us — in this case quite literally at the cost of human lives. But are any of these claims actually supportable?
Unfortunately, the competitive realities of the mechanical ventilator industry, as well as a more clear-eyed view of what was likely going on with the failed government contract at the heart of the story, simply do not support the “killer acquisition” story.
What is a “killer acquisition”…?
Let’s take a step back. Because monopoly profits are, by definition, higher than joint duopoly profits (all else equal), economists have long argued that incumbents may find it profitable to acquire smaller rivals in order to reduce competition and increase their profits. More specifically, incumbents may be tempted to acquire would-be entrants in order to prevent them from introducing innovations that might hurt the incumbent’s profits.
For this theory to have any purchase, however, a number of conditions must hold. Most importantly, as Colleen Cunningham, Florian Ederer, and Song Ma put it in an influential paper:
“killer acquisitions” can only occur when the entrepreneur’s project overlaps with the acquirer’s existing product…. [W]ithout any product market overlap, the acquirer never has a strictly positive incentive to acquire the entrepreneur… because, without overlap, acquiring the project does not give the acquirer any gains resulting from reduced competition, and the two bargaining entities have exactly the same value for the project.
Moreover, the authors add that:
Successfully developing a new product draws consumer demand and profits away equally from all existing products. An acquiring incumbent is hurt more by such cannibalization when he is a monopolist (i.e., the new product draws demand away only from his own existing product) than when he already faces many other existing competitors (i.e., cannibalization losses are spread over many firms). As a result, as the number of existing competitors increases, the replacement effect decreases and the acquirer’s development decisions become more similar to those of the entrepreneur.
Finally, the “killer acquisition” terminology is appropriate only when the incumbent chooses to discontinue its rival’s R&D project:
If incumbents face significant existing competition, acquired projects are not significantly more frequently discontinued than independent projects. Thus, more competition deters incumbents from acquiring and terminating the projects of potential future competitors, which leads to more competition in the future.
…And what isn’t a killer acquisition?
What is left out of this account of killer acquisitions is the age-old possibility that an acquirer purchases a rival precisely because it has superior know-how or a superior governance structure that enables it to realize greater return and more productivity than its target. In the case of a so-called killer acquisition, this means shutting down a negative ROI project and redeploying resources to other projects or other uses — including those that may not have any direct relation to the discontinued project.
Such “synergistic” mergers are also — like allegedly “killer” mergers — likely to involve acquirers and targets in the same industry and with technological overlap between their R&D projects; it is in precisely these situations that the acquirer is likely to have better knowledge than the target’s shareholders that the target is undervalued because of poor governance rather than exogenous, environmental factors.
In other words, whether an acquisition is harmful or not — as the epithet “killer” implies it is — depends on whether it is about reducing competition from a rival, on the one hand, or about increasing the acquirer’s competitiveness by putting resources to more productive use, on the other.
As argued below, it is highly unlikely that Covidien’s acquisition of Newport could be classified as a “killer acquisition.” There is thus nothing to suggest that the merger materially impaired competition in the mechanical ventilator market, or that it measurably affected the US’s efforts to fight COVID-19.
The market realities of the ventilator market and its implications for the “killer acquisition” story
1. The mechanical ventilator market is highly competitive
As explained above, “killer acquisitions” are less likely to occur in competitive markets. Yet the mechanical ventilator industry is extremely competitive.
Medical ventilators market competition is intense.
The conclusion that the mechanical ventilator industry is highly competitive is further supported by the fact that the five largest producers combined reportedly hold only 50% of the market. In other words, available evidence suggests that none of these firms has anything close to a monopoly position.
Similarly, following preliminary investigations, neither the FTC nor the European Commission saw the need for an in-depth look at the ventilator market when they reviewed Medtronic’s subsequent acquisition of Covidien (which closed in 2015). Although Medtronic did not produce any mechanical ventilators before the acquisition, authorities (particularly the European Commission) could nevertheless have analyzed that market if Covidien’s presumptive market share was particularly high. The fact that they declined to do so tends to suggest that the ventilator market was relatively unconcentrated.
2. The value of the merger was too small
A second strong reason to believe that Covidien’s purchase of Newport wasn’t a killer acquisition is the acquisition’s value of $103 million.
Indeed, if it was clear that Newport was about to revolutionize the ventilator market, then Covidien would likely have been made to pay significantly more than $103 million to acquire it.
As noted above, the crux of the “killer acquisition” theory is that incumbents can induce welfare-reducing acquisitions by offering to acquire their rivals for significantly more than the present value of their rivals’ expected profits. Because an incumbent undertaking a “killer” takeover expects to earn monopoly profits as a result of the transaction, it can offer a substantial premium and still profit from its investment. It is this basic asymmetry that drives the theory.
[Where] a court may lack the expertise to [assess the commercial significance of acquired technology]…, the transaction value… may provide a reasonable proxy. Intuitively, if the startup is a relatively small company with relatively few sales to its name, then a very high acquisition price may reasonably suggest that the startup technology has significant promise.
The strategy only works, however, if the target firm’s shareholders agree that share value properly reflects only “normal” expected profits, and not that the target is poised to revolutionize its market with a uniquely low-cost or high-quality product. Relatively low acquisition prices relative to market size, therefore, tend to reflect low (or normal) expected profits, and a low perceived likelihood of radical innovations occurring.
We can apply this reasoning to Covidien’s acquisition of Newport:
Precise and publicly available figures concerning the mechanical ventilator market are hard to come by. Nevertheless, one estimate finds that the global ventilator market was worth $2.715 billion in 2012. Another report suggests that the global market was worth $4.30 billion in 2018; still another that it was worth $4.58 billion in 2019.
As noted above, Covidien reported to the SEC that it paid $103 million to purchase Newport (a firm that produced only ventilators and apparently had no plans to branch out).
For context, at the time of the acquisition Covidien had annual sales of $11.8 billion overall, and $743 million in sales of its existing “Airways and Ventilation Products.”
If the ventilator market was indeed worth billions of dollars per year, then the comparatively small $108 million paid by Covidien — small even relative to Covidien’s own share of the market — suggests that, at the time of the acquisition, it was unlikely that Newport was poised to revolutionize the market for mechanical ventilators (for instance, by successfully bringing its Aura ventilator to market).
The New York Times article claimed that Newport’s ventilators would be sold (at least to the US government) for $3,000 — a substantial discount from the reportedly then-going rate of $10,000. If selling ventilators at this price seemed credible at the time, then Covidien — as well as Newport’s shareholders — knew that Newport was about to achieve tremendous cost savings, enabling it to offer ventilators not only to the the US government, but to purchasers around the world, at an irresistibly attractive — and profitable — price.
Ventilators at the time typically went for about $10,000 each, and getting the price down to $3,000 would be tough. But Newport’s executives bet they would be able to make up for any losses by selling the ventilators around the world.
“It would be very prestigious to be recognized as a supplier to the federal government,” said Richard Crawford, who was Newport’s head of research and development at the time. “We thought the international market would be strong, and there is where Newport would have a good profit on the product.”
If achievable, Newport thus stood to earn a substantial share of the profits in a multi-billion dollar industry.
Of course, it is necessary to apply a probability to these numbers: Newport’s ventilator was not yet on the market, and had not yet received FDA approval. Nevertheless, if the Times’ numbers seemed credible at the time, then Covidien would surely have had to offer significantly more than $108 million in order to induce Newport’s shareholders to part with their shares.
Given the low valuation, however, as well as the fact that Newport produced other ventilators — and continues to do so to this day, there is no escaping the fact that everyone involved seemed to view Newport’s Aura ventilator as nothing more than a moonshot with, at best, a low likelihood of success.
Curically, this same reasoning explains why it shouldn’t surprise anyone that the project was ultimately discontinued; recourse to a “killer acquisition” theory is hardly necessary.
3. Lessons from Covidien’s ventilator product decisions
The killer acquisition claims are further weakened by at least four other important pieces of information:
Covidien initially continued to develop Newport’s Aura ventilator, and continued to develop and sell Newport’s other ventilators.
There was little overlap between Covidien and Newport’s ventilators — or, at the very least, they were highly differentiated
Covidien appears to have discontinued production of its own portable ventilator in 2014
The Newport purchase was part of a billion dollar series of acquisitions seemingly aimed at expanding Covidien’s in-hospital (i.e., not-portable) device portfolio
Covidien continued to develop and sell Newport’s ventilators
For a start, while the Aura line was indeed discontinued by Covidien, the timeline is important. The acquisition of Newport by Covidien was announced in March 2012, approved by the FTC in April of the same year, and the deal was closed on May 1, 2012.
However, as the FDA’s 510(k) database makes clear, Newport submitted documents for FDA clearance of the Aura ventilator months after its acquisition by Covidien (June 29, 2012, to be precise). And the Aura received FDA 510(k) clearance on November 9, 2012 — many months after the merger.
It would have made little sense for Covidien to invest significant sums in order to obtain FDA clearance for a project that it planned to discontinue (the FDA routinely requires parties to actively cooperate with it, even after 510(k) applications are submitted).
Moreover, if Covidien really did plan to discreetly kill off the Aura ventilator, bungling the FDA clearance procedure would have been the perfect cover under which to do so. Yet that is not what it did.
Covidien continued to develop and sell Newport’s other ventilators
Second, and just as importantly, Covidien (and subsequently Medtronic) continued to sell Newport’s other ventilators. The Newport e360 and HT70 are still sold today. Covidien also continued to improve these products: it appears to have introduced an improved version of the Newport HT70 Plus ventilator in 2013.
If eliminating its competitor’s superior ventilators was the only goal of the merger, then why didn’t Covidien also eliminate these two products from its lineup, rather than continue to improve and sell them?
At least part of the answer, as will be seen below, is that there was almost no overlap between Covidien and Newport’s product lines.
There was little overlap between Covidien’s and Newport’s ventilators
Third — and perhaps the biggest flaw in the killer acquisition story — is that there appears to have been very little overlap between Covidien and Newport’s ventilators.
This decreases the likelihood that the merger was a killer acquisition. When two products are highly differentiated (or not substitutes at all), sales of the first are less likely to cannibalize sales of the other. As Florian Ederer and his co-authors put it:
Importantly, without any product market overlap, the acquirer never has a strictly positive incentive to acquire the entrepreneur, neither to “Acquire to Kill” nor to “Acquire to Continue.” This is because without overlap, acquiring the project does not give the acquirer any gains resulting from reduced competition, and the two bargaining entities have exactly the same value for the project.
A quick search of the FDA’s 510(k) database reveals that Covidien has three approved lines of ventilators: the Puritan Bennett 980, 840, and 540 (apparently essentially the same as the PB560, the plans to which Medtronic recently made freely available in order to facilitate production during the current crisis). The same database shows that these ventilators differ markedly from Newport’s ventilators (particularly the Aura).
In particular, Covidien manufactured primarily traditional, invasive ICU ventilators (except for the PB540, which is potentially a substitute for the Newport HT70), while Newport made much-more-portable ventilators, suitable for home use (notably the Aura, HT50 and HT70 lines).
Under normal circumstances, critical care and portable ventilators are not substitutes. As the WHO website explains, portable ventilators are:
[D]esigned to provide support to patients who do not require complex critical care ventilators.
A quick glance at Medtronic’s website neatly illustrates the stark differences between these two types of devices:
This is not to say that these devices do not have similar functionalities, or that they cannot become substitutes in the midst of a coronavirus pandemic. However, in normal times (as was the case when Covidien acquired Newport), hospitals likely did not view these devices as substitutes.
The conclusion that Covidien and Newport’s ventilator were not substitutes finds further support in documents and statements released at the time of the merger. For instance, Covidien’s CEO explained that:
This acquisition is consistent with Covidien’s strategy to expand into adjacencies and invest in product categories where it can develop a global competitive advantage.
Newport’s products and technology complement our current portfolio of respiratory solutions and will broaden our ventilation platform for patients around the world, particularly in emerging markets.
In short, the fact that almost all of Covidien and Newport’s products were not substitutes further undermines the killer acquisition story. It also tends to vindicate the FTC’s decision to rapidly terminate its investigation of the merger.
Covidien appears to have discontinued production of its own portable ventilator in 2014
Perhaps most tellingly: It appears that Covidien discontinued production of its own competing, portable ventilator, the Puritan Bennett 560, in 2014.
The product is reported on the company’s 2011, 2012 and 2013 annual reports:
Airway and Ventilation Products — airway, ventilator, breathing systems and inhalation therapy products. Key products include: the Puritan Bennett™ 840 line of ventilators; the Puritan Bennett™ 520 and 560 portable ventilator….
Surely if Covidien had intended to capture the portable ventilator market by killing off its competition it would have continued to actually sell its own, competing device. The fact that the only portable ventilators produced by Covidien by 2014 were those it acquired in the Newport deal strongly suggests that its objective in that deal was the acquisition and deployment of Newport’s viable and profitable technologies — not the abandonment of them. This, in turn, suggests that the Aura was not a viable and profitable technology.
(Admittedly we are unable to determine conclusively that either Covidien or Medtronic stopped producing the PB520/540/560 series of ventilators. But our research seems to indicate strongly that this is indeed the case).
Putting the Newport deal in context
Finally, although not dispositive, it seems important to put the Newport purchase into context. In the same year as it purchased Newport, Covidien paid more than a billion dollars to acquire five other companies, as well — all of them primarily producing in-hospital medical devices.
That 2012 spending spree came on the heels of a series of previous medical device company acquisitions, apparently totally some four billion dollars. Although not exclusively so, the acquisitions undertaken by Covidien seem to have been primarily targeted at operating room and in-hospital monitoring and treatment — making the putative focus on cornering the portable (home and emergency) ventilator market an extremely unlikely one.
By the time Covidien was purchased by Medtronic the deal easily cleared antitrust review because of the lack of overlap between the company’s products, with Covidien’s focusing predominantly on in-hospital, “diagnostic, surgical, and critical care” and Medtronic’s on post-acute care.
Newport misjudged the costs associated with its Aura project; Covidien was left to pick up the pieces
So why was the Aura ventilator discontinued?
Although it is almost impossible to know what motivated Covidien’s executives, the Aura ventilator project clearly suffered from many problems.
The Aura project was intended to meet the requirements of the US government’s BARDA program (under the auspices of the U.S. Department of Health and Human Services’ Biomedical Advanced Research and Development Authority). In short, the program sought to create a stockpile of next generation ventilators for emergency situations — including, notably, pandemics. The ventilator would thus have to be designed for events where
mass casualties may be expected, and when shortages of experienced health care providers with respiratory support training, and shortages of ventilators and accessory components may be expected.
The Aura ventilator would thus sit somewhere between Newport’s two other ventilators: the e360 which could be used in pediatric care (for newborns smaller than 5kg) but was not intended for home care use (or the extreme scenarios envisioned by the US government); and the more portable HT70 which could be used in home care environments, but not for newborns.
Unfortunately, the Aura failed to achieve this goal. The FDA’s 510(k) clearance decision clearly states that the Aura was not intended for newborns:
The AURA family of ventilators is applicable for infant, pediatric and adult patients greater than or equal to 5 kg (11 lbs.).
the company was unable to secure FDA approval for use in neonatal populations — a contract requirement.
And the US Government RFP confirms that this was indeed an important requirement:
The device must be able to provide the same standard of performance as current FDA pre-market cleared portable ventilators and shall have the following additional characteristics or features:
• Flexibility to accommodate a wide patient population range from neonate to adult.
Newport also seems to have been unable to deliver the ventilator at the low price it had initially forecasted — a common problem for small companies and/or companies that undertake large R&D programs. It also struggled to complete the project within the agreed-upon deadlines. As the Medtronic press release explains:
Covidien learned that Newport’s work on the ventilator design for the Government had significant gaps between what it had promised the Government and what it could deliver — both in terms of being able to achieve the cost of production specified in the contract and product features and performance. Covidien management questioned whether Newport’s ability to complete the project as agreed to in the contract was realistic.
As Jason Crawford, an engineer and tech industry commentator, put it:
Projects fail all the time. “Supplier risk” should be a standard checkbox on anyone’s contingency planning efforts. This is even more so when you deliberately push the price down to 30% of the market rate. Newport did not even necessarily expect to be profitable on the contract.
The above is mostly Covidien’s “side” of the story, of course. But other pieces of evidence lend some credibility to these claims:
Newport agreed to deliver its Aura ventilator at a per unit cost of less than $3000. But, even today, this seems extremely ambitious. For instance, the WHO has estimated that portable ventilators cost between $3,300 and $13,500. If Newport could profitably sell the Aura at such a low price, then there was little reason to discontinue it (readers will recall the development of the ventilator was mostly complete when Covidien put a halt to the project).
Covidien/Newport is not the only firm to have struggled to offer suitable ventilators at such a low price. Philips (which took Newport’s place after the government contract fell through) also failed to achieve this low price. Rather than the $2,000 price sought in the initial RFP, Philips ultimately agreed to produce the ventilators for $3,280. But it has not yet been able to produce a single ventilator under the government contract at that price.
Covidien has repeatedly been forced to recall some of its other ventilators ( here, here and here) — including the Newport HT70. And rival manufacturers have also faced these types of issues (for example, here and here).
Accordingly, Covidien may well have preferred to cut its losses on the already problem-prone Aura project, before similar issues rendered it even more costly.
In short, while it is impossible to prove that these development issues caused Covidien to pull the plug on the Aura project, it is certainly plausible that they did. This further supports the hypothesis that Covidien’s acquisition of Newport was not a killer acquisition.
Ending the Aura project might have been an efficient outcome
As suggested above, moreover, it is entirely possible that Covidien was better able to realize the poor prospects of Newport’s Aura project and also better organized to enable it to make the requisite decision to abandon the project.
Moreover, the relatively large share of revue and reputation that Newport — worth $103 million in 2012, versus Covidien’s $11.8 billion — would have realized from fulfilling a substantial US government project could well have induced it to overestimate the project’s viability and to undertake excessive risk in the (vain) hope of bringing the project to fruition.
While there is a tendency among antitrust scholars, enforcers, and practitioners to look for (and find…) antitrust-related rationales for mergers and other corporate conduct, it remains the case that most corporate control transactions (such as mergers) are driven by the acquiring firm’s expectation that it can manage more efficiently. As Henry G. Manne put it in his seminal article, Mergers and the Market for Corporate Control (1965):
Since, in a world of uncertainty, profitable transactions will be entered into more often by those whose information is relatively more reliable, it should not surprise us that mergers within the same industry have been a principal form of changing corporate control. Reliable information is often available to suppliers and customers as well. Thus many vertical mergers may be of the control takeover variety rather than of the “foreclosure of competitors” or scale-economies type.
Of course, the same information that renders an acquiring firm in the same line of business knowledgeable enough to operate a target more efficiently could also enable it to effect a “killer acquisition” strategy. But the important point is that a takeover by a firm with a competing product line, after which the purchased company’s product line is abandoned, is at least as consistent with a “market for corporate control” story as with a “killer acquisition” story.
“Killer acquisitions” can have a nefarious image, but killing off a rival’s product was probably not the main purpose of the transaction, Ederer said. He raised the possibility that Covidien decided to kill Newport’s innovation upon realising that the development of the devices would be expensive and unlikely to result in profits.
In conclusion, Covidien’s acquisition of Newport offers a cautionary tale about reckless journalism, “blackboard economics,” and government failure.
Reckless journalism because the New York Times clearly failed to do the appropriate due diligence for its story. Its journalists notably missed (or deliberately failed to mention) a number of critical pieces of information — such as the hugely important fact that most of Covidien’s and Newport’s products did not overlap, or the fact that there were numerous competitors in the highly competitive mechanical ventilator industry.
And yet, that did not stop the authors from publishing their extremely alarming story, effectively suggesting that a small medical device merger materially contributed to the loss of many American lives.
What is studied is a system which lives in the minds of economists but not on earth.
Numerouscommentators rushed to fit the story to their preconceived narratives, failing to undertake even a rudimentary examination of the underlying market conditions before they voiced their recriminations.
The only thing that Covidien and Newport’s merger ostensibly had in common with the killer acquisition theory was the fact that a large firm purchased a small rival, and that the one of the small firm’s products was discontinued. But this does not even begin to meet the stringent conditions that must be fulfilled for the theory to hold water. Unfortunately, critics appear to have completely ignored all contradicting evidence.
Finally, what the New York Times piece does offer is a chilling tale of government failure.
The inception of the US government’s BARDA program dates back to 2008 — twelve years before the COVID-19 pandemic hit the US.
The collapse of the Aura project is no excuse for the fact that, more than six years after the Newport contract fell through, the US government still has not obtained the necessary ventilators. Questions should also be raised about the government’s decision to effectively put all of its eggs in the same basket — twice. If anything, it is thus government failure that was the real culprit.
And yet the New York Times piece and the critics shouting “killer acquisition!” effectively give the US government’s abject failure here a free pass — all in the service of pursuing their preferred “killer story.”
[TOTM: The following is part of a blog series by TOTM guests and authors on the law, economics, and policy of the ongoing COVID-19 pandemic. The entire series of posts is available here.
This post is authored by Daniel Takash,(Regulatory policy fellow at the Niskanen Center. He is the manager of Niskanen’s Captured Economy Project, https://capturedeconomy.com, and you can follow him @danieltakash or @capturedecon).]
The pharmaceutical industry should be one of the most well-regarded industries in America. It helps bring drugs to market that improve, and often save, people’s lives. Yet last year a Gallup poll found that of 25 major industries, the pharmaceutical industry was the most unpopular– trailing behind fossil fuels, lawyers, and even the federal government. The opioid crisis dominated the headlines for the past few years, but the high price of drugs is a top-of-mind issue that generates significant animosity toward the pharmaceutical industry. The effects of high drug prices are felt not just at every trip to the pharmacy, but also by those who are priced out of life-saving treatments. Many Americans simply can’t afford what their doctors prescribe. The pharmaceutical industry helps save lives, but it’s also been credibly accused of anticompetitive behavior–not just from generics, but even other brand manufacturers.
These extraordinary times are an opportunity to right the ship. AbbVie, roundly criticized for building a patent thicket around Humira, has donated its patent rights to a promising COVID-19 treatment. This is to be celebrated– yet pharma’s bad reputation is defined by its worst behaviors and the frequent apologetics for overusing the patent system. Hopefully corporate social responsibility will prevail, and such abuses will cease in the future.
The most effective long-term treatment for COVID-19 will be a vaccine. We also need drugs to treat those afflicted with COVID-19 to improve recovery and lower mortality rates for those that get sick before a vaccine is developed and widely available. This requires rapid drug development through effective public-private partnerships to bring these treatments to market.
Without a doubt, these solutions will come from the pharmaceutical industry. Increased funding for the National Institutes for Health, nonprofit research institutions, and private pharmaceutical researchers are likely needed to help accelerate the development of these treatments. But we must be careful to ensure whatever necessary upfront public support is given to these entities results in a fair trade-off for Americans. The U.S. taxpayer is one of the largest investors in early to mid-stage drug research, and we need to make sure that we are a good investor.
Basic research into the costs of drug development, especially when taxpayer subsidies are involved, is a necessary start. This is a feature of the We PAID Act, introduced by Senators Rick Scott (R-FL) and Chris Van Hollen (D-MD), which requires the Department of Health and Human Services to enter into a contract with the National Academy of Medicine to figure the reasonable price of drugs developed with taxpayer support. This reasonable price would include a suitable reward to the private companies that did the important work of finishing drug development and gaining FDA approval. This is important, as setting a price too low would reduce investments in indispensable research and development. But this must be balanced with the risk of using patents to charge prices above and beyond those necessary to finance research, development, and commercialization.
A little sunshine can go a long way. We should trust that pharmaceutical companies will develop a vaccine and treatments or coronavirus, but we must also verify these are affordable and accessible through public scrutiny. Take the drug manufacturer Gilead Science’s about-face on its application for orphan drug status on the possible COVID-19 treatment remdesivir. Remedesivir, developed in part with public funds and already covered by three Gilead patents, technically satisfied the definition of “orphan drug,” as COVID-19 (at the time of the application) afflicted fewer than 200,000 patents. In a pandemic that could infect tens of millions of Americans, this designation is obviously absurd, and public outcry led to Gilead to ask the FDA to rescind the application. Gilead claimed it sought the designation to speed up FDA review, and that might be true. Regardless, public attention meant that the FDA will give Gilead’s drug Remdesivir expedited review without Gilead needing a designation that looks unfair to the American people.
The success of this isolated effort is absolutely worth celebrating. But we need more research to better comprehend the pharmaceutical industry’s needs, and this is just what the study provisions of We PAID would provide.
But a thorough analysis provided under We PAID is the best way for us to fully understand just how much support the pharmaceutical industry needs, and just how successful it has been thus far. The NIH, one of the major sources of publicly funded research, invests about $41.7 billion annually in medical research. We need to better understand how these efforts link up, and how the torch is passed from public to private efforts.
Patents are essential to the functioning of the pharmaceutical industry by incentivizing drug development through temporary periods of exclusivity. But it is equally essential, in light of the considerable investment already made by taxpayers in drug research and development, to make sure we understand the effects of these incentives and calibrate them to balance the interests of patients and pharmaceutical companies. Most drugs require research funding from both public and private sources as well as patent protection. And the U.S. is one of the biggest investors of drug research worldwide (even compared to drug companies), yet Americans pay the highest prices in the world. Are these prices justified, and can we improve patent policy to bring these costs down without harming innovation?
Beyond a thorough analysis of drug pricing, what makes We PAID one of the most promising solutions to the problem of excessively high drug prices are the accountability mechanisms included. The bill, if made law, would establish a Drug Access and Affordability Committee. The Committee would use the methodology from the joint HHS and NAM study to determine a reasonable price for affected drugs (around 20 percent of drugs currently on the market, if the bill were law today). Any companies that price drugs granted exclusivity by a patent above the reasonable price would lose their exclusivity.
This may seem like a price control at first blush, but it isn’t–for two reasons. First, this only applies to drugs developed with taxpayer dollars, which any COVID-19 treatments or cures almost certainly would be considering the $785 million spent by the NIH since 2002 researching coronaviruses. It’s an accountability mechanism that would ensure the government is getting its money’s worth. This tool is akin to ensuring that a government contractor is not charging more than would be reasonable, lest it loses its contract.
Second, it is even less stringent than pulling a contract with a private firm overcharging the government for the services provided. Why? Losing a patent does not mean losing the ability to make a drug, or any other patented invention for that matter.This basic fact is often lost in the patent debate, but it cannot be stressed enough.
If patents functioned as licenses, then every patent expiration would mean another product going off the market. In reality, that means that any other firm can compete and use the patented design. Even if a firm violated the price regulations included in the bill and lost its patent, it could continue manufacturing the drug. And so could any other firm, bringing down prices for all consumers by opening up market competition.
The We PAID Act could be a dramatic change for the drug industry, and because of that many in Congress may want to first debate the particulars of the bill. This is fine, assuming this promising legislation isn’t watered down beyond recognition. But any objections to the Drug Affordability and Access Committee and reasonable pricing regulations aren’t an excuse to not, at a bare minimum, pass the study included in the bill as part of future coronavirus packages, if not sooner. It is an inexpensive way to get good information in a single, reputable source that would allow us to shape good policy.
Good information is needed for good policy. When the government lays the groundwork for future innovations by financing research and development, it can be compared to a venture capitalist providing the financing necessary for an innovative product or service. But just like in the private sector, the government should know what it’s getting for its (read: taxpayers’) money and make recipients of such funding accountable to investors.
The COVID-19 outbreak will be the most pressing issue for the foreseeable future, but determining how pharmaceuticals developed with public research are priced is necessary in good times and bad. The final prices for these important drugs might be fair, but the public will never know without a trusted source examining this information. Trust, but verify. The pharmaceutical industry’s efforts in fighting the COVID-19 pandemic might be the first step to improving Americans’ relationship with the industry. But we need good information to make that happen. Americans need to know when they are being treated fairly, and that policymakers are able to protect them when they are treated unfairly. The government needs to become a better-informed investor, and that won’t happen without something like the We PAID Act.
The COVID-19 pandemic and the shutdown of many public-facing businesses has resulted in many sudden shifts in demand for common goods. The demand for hand sanitizer has drastically increased for hospitals, businesses, and individuals. At the same time, demand for distilled spirits has fallen substantially, as the closure of bars, restaurants, and tasting rooms has cut craft distillers off from their primary buyers. Since ethanol is a key ingredient in both spirits and sanitizer, this situation presents an obvious opportunity for distillers to shift their production from the former to the latter. Hundreds of distilleries have made this transition, but it has not without obstacles. Some of these reflect a real scarcity of needed supplies, but other constraints have been externally imposed by government regulations and the tax code.
The World Health Organization provides guidelines and recipes for locally producing hand sanitizer. The relevant formulation for distilleries calls for only four ingredients: high-proof ethanol (96%), hydrogen peroxide (3%), glycerol (98%), and sterile distilled or boiled water. Distilleries are well-positioned to produce or obtain ethanol and water. Glycerol is used in only small amounts and does not currently appear to be a substantial constraint on production. Hydrogen peroxide is harder to come by, but distilleries are adapting and cooperating to ensure supply. Skip Tognetti, owner of Letterpress Distilling in Seattle, Washington, reports that one local distiller obtained a drum of 34% hydrogen peroxide, which stretches a long way when diluted to a concentration of 3%. Local distillers have been sharing this drum so that they can all produce sanitizer.
Another constraint is finding containers in which to the put the finished product. Not all containers are suitable for holding high-proof alcoholic solutions, and supplies of those that are recommended for sanitizer are scarce. The fact that many of these bottles are produced in China has reportedly also limited the supply. Distillers are therefore having to get creative; Tognetti reports looking into shampoo bottles, and in Chicago distillers have re-purposed glass beer growlers. For informal channels, some distillers have allowed consumers to bring their own containers to fill with sanitizer for personal use. Food and Drug Administration labeling requirements have also prevented the use of travel-size bottles, since the bottles are too small to display the necessary information.
The raw materials for producing ethanol are also coming from some unexpected sources. Breweries are typically unable to produce alcohol at high enough proof for sanitizer, but multiple breweries in Chicago are donating beer that distilleries can bring up to the required purity. Beer giant Anheuser-Busch is also producing sanitizer with the ethanol removed from its alcohol-free beers.
In many cases, the sanitizer is donated or sold at low-cost to hospitals and other essential services, or to local consumers. Online donations have helped to fund some of these efforts, and at least one food and beverage testing lab has stepped up to offer free testing to breweries and distilleries producing sanitizer to ensure compliance with WHO guidelines. Distillers report that the regulatory landscape has been somewhat confusing in recent weeks, and posts in a Facebook group have provided advice for how to get through the FDA’s registration process. In general, distillers going through the process report that agencies have been responsive. Tom Burkleaux of New Deal Distilling in Portland, Oregon says he “had to do some mighty paperwork,” but that the FDA and the Oregon Board of Pharmacy were both quick to process applications, with responses coming in just a few hours or less.
In general, the redirection of craft distilleries to producing hand sanitizer is an example of private businesses responding to market signals and the evident challenges of the health crisis to produce much-needed goods; in some cases, sanitizer represents one of their only sources of revenue during the shutdown, providing a lifeline for small businesses. The Distilled Spirits Council currently lists nearly 600 distilleries making sanitizer in the United States.
There is one significant obstacle that has hindered the production of sanitizer, however: an FDA requirement that distilleries obtain extra ingredients to denature their alcohol.
According to the WHO, the four ingredients mentioned above are all that are needed to make sanitizer. In fact, WHO specifically notes that it in most circumstances it is inadvisable to add anything else: “it is not recommended to add any bittering agents to reduce the risk of ingestion of the handrubs” except in cases where there is a high probably of accidental ingestion. Further, “[…] there is no published information on the compatibility and deterrent potential of such chemicals when used in alcohol-based handrubs to discourage their abuse. It is important to note that such additives may make the products toxic and add to production costs.”
Denaturing agents are used to render alcohol either too bitter or too toxic to consume, deterring abuse by adults or accidental ingestion by children. In ordinary circumstances, there are valid reasons to denature sanitizer. In the current pandemic, however, the denaturing requirement is a significant bottleneck in production.
The federal Tax and Trade Bureau is the primary agency regulating alcohol production in the United States. The TTB took action early to encourage distilleries to produce sanitizer, officially releasing guidance on March 18 instructing them that they are free to commence production without prior authorization or formula approval, so long as they are making sanitizer in accordance with WHO guidelines. On March 23, the FDA issued its own emergency authorization of hand sanitizer production; unlike the WHO, FDA guidance does require the use of denaturants. As a result, on March 26 the TTB issued new guidance to be consistent with the FDA.
Under current rules, only sanitizer made with denatured alcohol is exempt from the federal excise tax on beverage alcohol. Federal excise taxes begin at $2.70 per gallon for low-volume distilleries and reach up to $13.50 per gallon, significantly increasing the cost of producing hand sanitizer; state excise taxes can raise these costs even higher.
To be clear, if I didn’t have to track down denaturing agents (there are several, but isopropyl alcohol is the most common), I could turn out 200 gallons of finished hand sanitizer TODAY.
(As an additional concern, the Distilled Spirits Council notes that the extremely bitter or toxic nature of denaturing agents may impose additional costs on distillers given the need to thoroughly cleanse them from their equipment.)
Congress attempted to address these concerns in the CARES Act, the coronavirus relief package. Section 2308 explicitly waives the federal excise tax on distilled spirits used for the production of sanitizer, however it leaves the formula specification in the hands of the FDA. Unless the agency revises its guidance, production in the US will be constrained by the requirement to add denaturing agents to the plentiful supply of ethanol, or distilleries will risk being targeted with enforcement actions if they produce perfectly usable sanitizer without denaturing their alcohol.
Local distilleries provide agile production capacity
In recent days, larger spirits producers including Pernod-Ricard, Diageo, and Bacardi have announced plans to produce sanitizer. Given their resources and economies of scale, they may end up taking over a significant part of the market. Yet small, local distilleries have displayed the agility necessary to rapidly shift production. It’s worth noting that many of these distilleries did not exist until fairly recently. According to the American Craft Spirits Association, there were fewer than 100 craft distilleries operating in the United States in 2005. By 2018, there were more than 1,800. This growth is the result of changing consumer interests, but also the liberalization of state and local laws to permit distilleries and tasting rooms. That many of these distilleries have the capacity to produce sanitizer in a time of emergency is a welcome, if unintended, consequence of this liberalization.
[TOTM: The following is part of a blog series by TOTM guests and authors on the law, economics, and policy of the ongoing COVID-19 pandemic. The entire series of posts is available here.
This post is authored by Julian Morris, (Director of Innovation Policy, ICLE).]
SARS-CoV2, the virus that causes COVID-19, is now widespread in the population in many countries, including the US, UK, Australia, Iran, and many European countries. Its prevalence in other regions, such as South Asia, much of South America, and Africa, is relatively unknown. The failure to contain the virus early on has meant that more aggressive measures are now necessary in order to avoid overwhelming healthcare systems, which would cause unacceptable levels of mortality. (Sadly, Italy’s health system has already been overwhelmed, forcing medical practitioners to engage in the most awful triage decisions.) Many jurisdictions, ranging from cities to entire countries, have chosen to implement mandatory lockdowns. These will likely have the desired effect of slowing transmission in the short term, but they cannot be maintained indefinitely. The challenge going forward is how to contain the spread of the virus without destroying the economy.
In this post I will outline the elements of a proposal that I hope might do that. (I’ve been working on this for about a week and in the meantime some of the ideas have been advanced by others. E.g. this and this. Great minds clearly think alike.)
1. Identify those who have had COVID-19 and have recovered — and allow them to go back to work
While there are some reports of people who have had COVID-19 becoming reinfected, this seems to be very rare (a recent primate study implies reinfection is impossible) and the alleged cases may have been a result of false negative tests followed by relapse by patients. The general presumption is that having the disease is likely to confer immunity for several months at least. Moreover, people with immunity who no longer show symptoms of the disease are very unlikely to transmit the disease. Allowing those people to go back to work will lessen the burden of the lockdown without appreciably increasing the risk of infection
One group of such people is readily identifiable, though small: Those who tested positive for COVID-19 and subsequently recovered. Those people should be permitted to go back to work immediately.
2. Where possible, test, trace, treat, isolate
The town of Vo in Northern Italy, the site of the first death in the country from COVID-19, appears to have stopped the disease from spreading in about three weeks. It did so through a combination of universal testing, two weeks of strict lockdown, and quarantine of cases. Could this be replicated elsewhere?
Vo has a population of 3,300, so universal testing was not the gargantuan exercise it would be in, say, the continental US. Some larger jurisdictions have had similar success without resorting to universal testing and lockdown. South Korea managed to contain the spread of SARS-CoV2 relatively quickly through a combination of: social distancing (including closing schools and restricting large gatherings), testing anyone who had COVID-19 symptoms (and increasingly those without symptoms), tracing and testing of those who had contact with those symptomatic individuals, treating those with severe symptoms, quarantining those who tested positive but had no or only mild symptoms (the quarantine was monitored using a phone app and strictly enforced), and publicly sharing detailed information about the known incidence of the virus.
A study of 181 cases in China published in the Annals of Internal Medicine found that the mean incubation period for COVID-19 is just over 5 days and only about 1 in 100 cases take longer than 14 days. By implication, if people have been strictly following the guidelines on avoiding contact with others, washing/sanitizing hands, sanitizing other objects, and avoiding hand-to-face contact, it should be possible, after two weeks of lockdown, to identify the vast majority of people who are not infected by testing everyone for the presence of SARS-CoV2 itself.
But that’s a series of big ifs. Since it takes a few days for the virus to replicate in the body to the point at which it is detectable, people who have recently been infected might test negative. Also, it is unlikely to be feasible logistically to test a significant proportion of the population for SARS-CoV2 in a short period of time. Existing tests require the use of RT-PCR, which is expensive and time consuming, not least because it can only be done at a lab, and while the capacity for such tests is increasing, it is likely around 50,000 per day in the entire US.
Test, trace, treat, and isolate may be a feasible option for towns and even cities that currently have relatively low incidence of SARS-CoV2. However, given the lethargic progress of testing in places such as the US, UK and India, and hence poor existing knowledge of the extent of infection, it will not be a universal panacea.
3. Test as many people as possible for the presence of antibodies to SARS-CoV2
Outside those few places that have dramatically ramped up testing, it is likely that many more people have had COVID-19 than have been tested, either because they were asymptomatic or because they did not require clinical attention. Many, perhaps most of those people will no longer have the virus in their system but they should still have antibodies (indicating immunity). In order to identify those people, there should be widespread testing for antibodies to SARS-CoV2.
Antibody tests are inexpensive, quick, and some can be done at home with minimal assistance. Numerous such tests have already been produced or are in development (see the list here). For example, Chinese manufacturer Innovita has produced a test that appears to be effective; in a clinical trial of 447 patients, it identified the presence of antibodies to SARS-CoV2 in 87.3 % of clinically confirmed cases of COVID-19 (i.e. there were approximately 13% false negatives) but zero false positives. Innovita’s test was approved by China’s equivalent of the FDA and has been used widely there.
Scanwell Health, a San Francisco-based startup, has an exclusive license to produce Innovita’s test in the U.S. and has already begun the process for obtaining approval from the US FDA under its Emergency Use Authorization. Scanwell estimates that the total cost of the test, including overnight shipping of the kit and support from a doctor or nurse practitioner from Lemonaid Health, will be around $70. One downside to Scanwell Health’s offering, however, is that it expects it to take 6-8 weeks to begin shipping testing kits once it receives authorization from the FDA.
So far, the FDA has approved at least one SARS-CoV2 antibody test, produced by Aytu Bioscience in Colorado. But Aytu’s test is designed for use by physicians, not at home. In Europe, at least one antibody test, produced by German company PharmactACT, is already available. (That test has similar characteristics to Innovita’s.) Another has been approved by the MHRA in the UK for physician use and is awaiting approval for home use; the UK government has ordered 3.5 million of these tests, with the aim of distributing 250,000 per day by the end of April.
Unfortunately, some people who have antibodies to SARS-CoV2 will also still be infectious. However, because different antibodies develop at different times during the course of infection, it may be possible to distinguish those who are still infectious from those who are no longer infectious. Specifically, immunoglobulin (Ig) M is present in larger amounts while the viral load is still present, while IgG is present in larger amounts later on (see e.g. this and the figure below). So, by testing for the presence of both IgM and IgG it should be possible to identify a large proportion of those who have had COVID-19 but are no longer infectious. (The currently available antibody tests result in about 13 percent false negatives, making them inappropriate as a means of screening out those who do not have COVID-19. But they produce zero false positives, making them ideal for identifying those who definitely have or have had COVID-19). In essence, people whose IgG test is positive but IgM test is negative can then go back to work. In addition, people who have had COVID-19 symptoms, are now symptom-free, and test positive for antibodies, should be allowed to go back to work.
4. Test for SARS-Cov2 among those who test negative for antibodies — and ensure that everyone who tests positive remains in isolation
Those people who test negative for SARS-CoV2 using the quick antibody immunoassay, as well as those who are positive for both IgG and IgM (indicating that they may still be infectious) should then be tested for SARS-CoV2 using the RT-PCR test described above. And those who test negative for SARS-CoV2 should then be permitted to go back to work. But those who test positive should be required to remain in isolation— and seek treatment if necessary.
5. Repeat steps 3 and 4 until nobody tests positive for COVID-19
By repeating steps 3 and 4, it should be possible gradually to enable the vast majority of the population to return to work, and thence to a life of greater normalcy, within a matter of weeks.
6. Some (possibly rather large) caveats
All of this relies on: (a) the ability rapidly to expand testing and (b) widespread compliance with isolation requirements. Neither of these conditions is by any means guaranteed, not least because the rules effectively discriminate in favor of people who have had COVID-19, which may create a perverse incentive to violate not only the isolation requirements but all the recommended hygiene practices — and thereby intentionally become infected with SARS-CoV2 on the presumption that they will then be able to go back to work sooner than otherwise. So, before this is rolled out, it is important to ensure that there will be widespread testing for COVID-19 in a timeframe shorter than the likely total time for contracting and recovering from COVID-19.
In addition, if test results are to be used as a means of establishing a person’s ability to travel and work while others are still under lockdown, it is important that there be a means of verifying the status of individuals. That might be possible through the use of an app, for example; such an app might also provide policymakers to make better resources allocation decisions too.
Also, at-risk individuals should be strongly advised to remain in isolation until there is no further evidence of community transmission.
7. The Mechanics of Testing
Given that there are not currently sufficient tests available for everyone to be tested in most locations, one obvious question is: who should be tested? As noted above, it makes sense initially to target those who have had COVID-19 symptoms and have recovered. Since only those people who have had such symptoms—and possibly their physician if they presented with their symptoms—will know who they are, this will rely largely on trust. (It’s possible that self-reporting apps could help.)
But it may make sense initially to target tests more narrowly. The UK is initially targeting the antibody detection kits to healthcare and other key workers—people who are essential to the continued functioning of the country. That makes sense and could easily be applied in other places.
Assuming that key workers can be supplied with antibody detection kits quickly, distribution should then be opened up more widely. No doubt insurance companies will be making decisions about the purchase of testing kits. Ideally, however, individuals should be able to buy kits such as Scanwell’s without going through a bureaucratic process, whether that be their insurance company or the NHS. And vendors should be free to price kits as they see fit, without worrying about the prospect of being subject to price caps such as those imposed by Medicaid or the VA, which have the perverse effect of incentivising vendors to increase the list price. Finally, in order to increase the supply of tests as rapidly as possible, regulatory agencies should be encouraged to issue emergency approvals as quickly as possible. Having more manufacturers with a diverse array of tests available will increase access to testing more quickly and likely lead to more accurate testing too. Agencies such as the FDA should see this as their absolute priority right now. If the Mayo clinic can compress 6 months’ product development into a month, the FDA can surely do its review far more quickly too. Lives—and the economy—depend upon it.
[TOTM: The following is part of a blog series by TOTM guests and authors on the law, economics, and policy of the ongoing COVID-19 pandemic. The entire series of posts is available here.
This post is authored by Ben Sperry, (Associate Director, Legal Research, International Center for Law & Economics).]
The visceral reaction to the New York Times’ recent story on Matt Colvin, the man who had 17,700 bottles of hand sanitizer with nowhere to sell them, shows there is a fundamental misunderstanding of the importance of prices and the informational function they serve in the economy. Calls to enforce laws against “price gouging” may actually prove more harmful to consumers and society than allowing prices to rise (or fall, of course) in response to market conditions.
Nobel-prize winning economist Friedrich Hayek explained how price signals serve as information that allows for coordination in a market society:
We must look at the price system as such a mechanism for communicating information if we want to understand its real function… The most significant fact about this system is the economy of knowledge with which it operates, or how little the individual participants need to know in order to be able to take the right action. In abbreviated form, by a kind of symbol, only the most essential information is passed on and passed on only to those concerned. It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely the movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement.
Economic actors don’t need a PhD in economics or even to pay attention to the news about the coronavirus to change their behavior. Higher prices for goods or services alone give important information to individuals — whether consumers, producers, distributors, or entrepreneurs — to conserve scarce resources, produce more, and look for (or invest in creating!) alternatives.
Prices are fundamental to rationing scarce resources, especially during an emergency. Allowing prices to rapidly rise has three salutary effects (as explained by Professor Michael Munger in his terrific twitter thread):
Consumers ration how much they really need;
Producers respond to the rising prices by ramping up supply and distributors make more available; and
Entrepreneurs find new substitutes in order to innovate around bottlenecks in the supply chain.
Despite the distaste with which the public often treats “price gouging,” officials should take care to ensure that they don’t prevent these three necessary responses from occurring.
Rationing by consumers
During a crisis, if prices for goods that are in high demand but short supply are forced to stay at pre-crisis levels, the informational signal of a shortage isn’t given — at least by the market directly. This encourages consumers to buy more than is rationally justified under the circumstances. This stockpiling leads to shortages.
Companies respond by rationing in various ways, like instituting shorter hours or placing limits on how much of certain high-demand goods can be bought by any one consumer. Lines (and unavailability), instead of price, become the primary cost borne by consumers trying to obtain the scarce but underpriced goods.
If, instead, prices rise in light of the short supply and high demand, price-elastic consumers will buy less, freeing up supply for others. And, critically, price-inelastic consumers (i.e. those who most need the good) will be provided a better shot at purchase.
According to the New York Times story on Mr. Colvin, he focused on buying out the hand sanitizer in rural areas of Tennessee and Kentucky, since the major metro areas were already cleaned out. His goal was to then sell these hand sanitizers (and other high-demand goods) online at market prices. He was essentially acting as a speculator and bringing information to the market (much like an insider trader). If successful, he would be coordinating supply and demand between geographical areas by successfully arbitraging. This often occurs when emergencies are localized, like post-Katrina New Orleans or post-Irma Florida. In those cases, higher prices induced suppliers to shift goods and services from around the country to the affected areas. Similarly, here Mr. Colvin was arguably providing a beneficial service, by shifting the supply of high-demand goods from low-demand rural areas to consumers facing localized shortages.
For those who object to Mr. Colvin’s bulk purchasing-for-resale scheme, the answer is similar to those who object to ticket resellers: the retailer should raise the price. If the Walmarts, Targets, and Dollar Trees raised prices or rationed supply like the supermarket in Denmark, Mr. Colvin would not have been able to afford nearly as much hand sanitizer. (Of course, it’s also possible — had those outlets raised prices — that Mr. Colvin would not have been able to profitably re-route the excess local supply to those in other parts of the country most in need.)
The role of “price gouging” laws and social norms
A common retort, of course, is that Colvin was able to profit from the pandemic precisely because he was able to purchase a large amount of stock at normal retail prices, even after the pandemic began. Thus, he was not a producer who happened to have a restricted amount of supply in the face of new demand, but a mere reseller who exacerbated the supply shortage problems.
But such an observation truncates the analysis and misses the crucial role that social norms against “price gouging” and state “price gouging” laws play in facilitating shortages during a crisis.
Under these laws, typically retailers may raise prices by at most 10% during a declared state of emergency. But even without such laws, brick-and-mortar businesses are tied to a location in which they are repeat players, and they may not want to take a reputational hit by raising prices during an emergency and violating the “price gouging” norm. By contrast, individual sellers, especially pseudonymous third-party sellers using online platforms, do not rely on repeat interactions to the same degree, and may be harder to track down for prosecution.
Thus, the social norms and laws exacerbate the conditions that create the need for emergency pricing, and lead to outsized arbitrage opportunities for those willing to violate norms and the law. But, critically, this violation is only a symptom of the larger problem that social norms and laws stand in the way, in the first instance, of retailers using emergency pricing to ration scarce supplies.
Normally, third-party sales sites have much more dynamic pricing than brick and mortar outlets, which just tend to run out of underpriced goods for a period of time rather than raise prices. This explains why Mr. Colvin was able to sell hand sanitizer for prices much higher than retail on Amazon before the site suspended his ability to do so. On the other hand, in response to public criticism, Amazon, Walmart, eBay, and other platforms continue to crack down on third party “price-gouging” on their sites.
But even PR-centric anti-gouging campaigns are not ultimately immune to the laws of supply and demand. Even Amazon.com, as a first party seller, ends up needing to raise prices, ostensibly as the pricing feedback mechanisms respond to cost increases up and down the supply chain.
The desire to help the poor who cannot afford higher priced essentials is what drives the policy responses, but in reality no one benefits from shortages. Those who stockpile the in-demand goods are unlikely to be poor because doing so entails a significant upfront cost. And if they are poor, then the potential for resale at a higher price would be a benefit.
Increased production and distribution
During a crisis, it is imperative that spiking demand is met by increased production. Prices are feedback mechanisms that provide realistic estimates of demand to producers. Even if good-hearted producers forswearing the profit motive want to increase production as an act of charity, they still need to understand consumer demand in order to produce the correct amount.
Of course, prices are not the only source of information. Producers reading the news that there is a shortage undoubtedly can ramp up their production. But even still, in order to optimize production (i.e., not just blindly increase output and hope they get it right), they need a feedback mechanism. Prices are the most efficient mechanism available for quickly translating the amount of social need (demand) for a given product to guarantee that producers do not undersupply the product (leaving more people without than need the good), or oversupply the product (consuming more resources than necessary in a time of crisis). Prices, when allowed to adjust to actual demand, thus allow society to avoid exacerbating shortages and misallocating resources.
The opportunity to earn more profit incentivizes distributors all along the supply chain. Amazon is hiring 100,000 workers to help ship all the products which are being ordered right now. Grocers and retailers are doing their best to line the shelves with more in-demand food and supplies.
Distributors rely on more than just price signals alone, obviously, such as information about how quickly goods are selling out. But even as retail prices stay low for consumers for many goods, distributors often are paying more to producers in order to keep the shelves full, as in the case of eggs. These are the relevant price signals for producers to increase production to meet demand.
For instance, hand sanitizer companies like GOJO and EO Products are ramping up production in response to known demand (so much that the price of isopropyl alcohol is jumping sharply). Farmers are trying to produce as much as is necessary to meet the increased orders (and prices) they are receiving. Even previously low-demand goods like beans are facing a boom time. These instances are likely caused by a mix of anticipatory response based on general news, as well as the slightly laggier price signals flowing through the supply chain. But, even with an “early warning” from the media, the manufacturers still need to ultimately shape their behavior with more precise information. This comes in the form of orders from retailers at increased frequencies and prices, which are both rising because of insufficient supply. In search of the most important price signal, profits, manufacturers and farmers are increasing production.
These responses to higher prices have the salutary effect of making available more of the products consumers need the most during a crisis.
Unfortunately, however, government regulations on sales of distilled products and concerns about licensing have led distillers to give away those products rather than charge for them. Thus, beneficial as this may be, without the ability to efficiently price such products, not nearly as much will be produced as would otherwise be. The non-emergency price of zero effectively guarantees continued shortages because the demand for these free alternatives will far outstrip supply.
Amazon is now prioritizing the shipment of high-demand goods like household staples and medical supplies in its fulfillment services.
Without price signals, entrepreneurs would have far less incentive to shift production and distribution to the highest valued use.
While stories like that of Mr. Colvin buying all of the hand sanitizer in Tennessee understandably bother people, government efforts to prevent prices from adjusting only impede the information sharing processes inherent in markets.
If the concern is to help the poor, it would be better to pursue less distortionary public policy than arbitrarily capping prices. The US government, for instance, is currently considering a progressively tiered one-time payment to lower income individuals.
Moves to create new and enforce existing “price-gouging” laws are likely to become more prevalent the longer shortages persist. Platforms will likely continue to receive pressure to remove “price-gougers,” as well. These policies should be resisted. Not only will these moves not prevent shortages, they will exacerbate them and push the sale of high-demand goods into grey markets where prices will likely be even higher.
Prices are an important source of information not only for consumers, but for producers, distributors, and entrepreneurs. Short circuiting this signal will only be to the detriment of society.
[TOTM: The following is part of a blog series by TOTM guests and authors on the law, economics, and policy of the ongoing COVID-19 pandemic. The entire series of posts is available here.
This post is authored by Robert Litan, (Non-resident Senior Fellow, Economic Studies, The Brookings Institution; former Associate Director, Office of Management and Budget).]
We have moved well beyond testing as the highest priority for responding to the COVID disaster – although it remains important – to meeting the immediate peak demand for hospital equipment and ICU beds outside hospitals in most urban areas. President Trump recognized this being the case when he declared on March 18 that was acting as a “wartime President.”
While the President invoked the Defense Production Act to have the private sector produce more ventilators and other necessary medical equipment, such as respirators and hospital gowns, that Act principally provides for government purchases and the authority to allocate scarce supplies.
As part of this effort, if it is not already in the works, the President should require manufacturers of such equipment – especially ventilators – to license at low or no royalties any and all intellectual property rights required for such production to as many other manufacturers that are willing and capable of making this equipment as rapidly as possible, 24/7. The President should further direct FDA to surge its inspector force to ensure that the processes and output of these other manufacturers are in compliance with applicable FDA requirements. The same IP licensing requirement should extend to manufacturers of any other medical supplies expected to be in short supply.
To avoid price gouging – yes, this is one instance where market principles should be suspended – the declaration should cap the prices of future ventilators, including those manufactured by current suppliers, to the price pre-crisis.
Second, to solve the bed shortage problem, some states (such New York) are already investigating the use of existing facilities – schools, university dorms, hotel rooms, and the like. This idea should be mandated immediately, as part of the emergency declaration, nationwide. The President has ordered a Navy hospital ship to help out with extra beds in New York, which is a good idea that should be extended to other coastal cities where this is possible. But he should also order the military, as needed, to assist with the conversion efforts of land-based facilities – which require infection-free environments, special filtration systems and the like – where private contractors are not available.
The costs for all this should be borne by the federal government, using the Disaster Relief Fund, authorized by the Stafford Act. As of year-end FY 2019, the balance in this fund was approximately $30 billion. It is not clear what the balance is expected to be after the outlays that have recently been ordered by the President, as relief for states and localities. If the DRF needs topping up, this should be urgently provided by the Congress, ideally as part of the third round of fiscal stimulus being considered this week.
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
of shortages for critical generic drugs. These shortages often result from drug
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
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.
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.
Last week the Senate Judiciary Committee held a hearing, Intellectual
Property and the Price of Prescription Drugs: Balancing Innovation and
Competition, that explored whether changes to the pharmaceutical patent
process could help lower drug prices. The
committee’s goal was to evaluate various legislative proposals that might
facilitate the entry of cheaper generic drugs, while also recognizing that strong
patent rights for branded drugs are essential to incentivize drug
innovation. As Committee Chairman
Lindsey Graham explained:
One thing you don’t want to do is kill the goose who laid the golden egg, which is pharmaceutical development. But you also don’t want to have a system that extends unnecessarily beyond the ability to get your money back and make a profit, a patent system that drives up costs for the average consumer.
Several proposals that were discussed at the hearing have
the potential to encourage competition in the pharmaceutical industry and help
rein in drug prices. Below, I discuss these proposals, plus a few additional
reforms. I also point out some of the language in the current draft proposals
that goes a bit too far and threatens the ability of drug makers to remain
1. Prevent brand drug makers from blocking generic companies’ access to drug samples. Some brand drug makers have attempted to delay generic entry by restricting generics’ access to the drug samples necessary to conduct FDA-required bioequivalence studies. Some brand drug manufacturers have limited the ability of pharmacies or wholesalers to sell samples to generic companies or abused the REMS (Risk Evaluation Mitigation Strategy) program to refuse samples to generics under the auspices of REMS safety requirements. The Creating and Restoring Equal Access To Equivalent Samples (CREATES) Act of 2019 would allow potential generic competitors to bring an action in federal court for both injunctive relief and damages when brand companies block access to drug samples. It also gives the FDA discretion to approve alternative REMS safety protocols for generic competitors that have been denied samples under the brand companies’ REMS protocol. Although the vast majority of brand drug companies do not engage in the delay tactics addressed by CREATES, the Act would prevent the handful that do from thwarting generic competition. Increased generic competition should, in turn, reduce drug prices.
2. Restrict abuses of FDA Citizen Petitions. The citizen petition process was created as a way for individuals and community groups to flag legitimate concerns about drugs awaiting FDA approval. However, critics claim that the process has been misused by some brand drug makers who file petitions about specific generic drugs in the hopes of delaying their approval and market entry. Although FDA has indicated that citizens petitions rarely delay the approval of generic drugs, there have been a few drug makers, such as Shire ViroPharma, that have clearly abused the process and put unnecessary strain on FDA resources. The Stop The Overuse of Petitions and Get Affordable Medicines to Enter Soon (STOP GAMES) Act is intended to prevent such abuses. The Act reinforces the FDA and FTC’s ability to crack down on petitions meant to lengthen the approval process of a generic competitor, which should deter abuses of the system that can occasionally delay generic entry. However, lawmakers should make sure that adopted legislation doesn’t limit the ability of stakeholders (including drug makers that often know more about the safety of drugs than ordinary citizens) to raise serious concerns with the FDA.
3. Curtail Anticompetitive Pay-for-Delay Settlements. The Hatch-Waxman Act incentivizes generic companies to challenge brand drug patents by granting the first successful generic challenger a period of marketing exclusivity. Like all litigation, many of these patent challenges result in settlements instead of trials. The FTC and some courts have concluded that these settlements can be anticompetitive when the brand companies agree to pay the generic challenger in exchange for the generic company agreeing to forestall the launch of their lower-priced drug. Settlements that result in a cash payment are a red flag for anti-competitive behavior, so pay-for-delay settlements have evolved to involve other forms of consideration instead. As a result, the Preserve Access to Affordable Generics and Biosimilars Act aims to make an exchange of anything of value presumptively anticompetitive if the terms include a delay in research, development, manufacturing, or marketing of a generic drug. Deterring obvious pay-for-delay settlements will prevent delays to generic entry, making cheaper drugs available as quickly as possible to patients.
However, the Act’s rigid presumption that an exchange of anything of value is presumptively anticompetitive may also prevent legitimate settlements that ultimately benefit consumers. Brand drug makers should be allowed to compensate generic challengers to eliminate litigation risk and escape litigation expenses, and many settlements result in the generic drug coming to market before the expiration of the brand patent and possibly earlier than if there was prolonged litigation between the generic and brand company. A rigid presumption of anticompetitive behavior will deter these settlements, thereby increasing expenses for all parties that choose to litigate and possibly dissuading generics from bringing patent challenges in the first place. Indeed, the U.S. Supreme Court has declined to define these settlements as per se anticompetitive, and the FTC’s most recent agreement involving such settlements exempts several forms of exchanges of value. Any adopted legislation should follow the FTC’s lead and recognize that some exchanges of value are pro-consumer and pro-competitive.
4. Restore the balance established by Hatch-Waxman between branded drug innovators and generic drug challengers. I have previously discussed how an unbalanced inter partes review (IPR) process for challenging patents threatens to stifle drug innovation. Moreover, current law allows generic challengers to file duplicative claims in both federal court and through the IPR process. And because IPR proceedings do not have a standing requirement, the process has been exploited by entities that would never be granted standing in traditional patent litigation—hedge funds betting against a company by filing an IPR challenge in hopes of crashing the stock and profiting from the bet. The added expense to drug makers of defending both duplicative claims and claims against challengers that are exploiting the system increases litigation costs, which may be passed on to consumers in the form of higher prices.
The Hatch-Waxman Integrity Act (HWIA) is designed to return the balance established by Hatch-Waxman between branded drug innovators and generic drug challengers. It requires generic challengers to choose between either Hatch-Waxman litigation (which saves considerable costs by allowing generics to rely on the brand company’s safety and efficacy studies for FDA approval) or an IPR proceeding (which is faster and provides certain pro-challenger provisions). The HWIA would also eliminate the ability of hedge funds and similar entities to file IPR claims while shorting the stock. By reducing duplicative litigation and the exploitation of the IPR process, the HWIA will reduce costs and strengthen innovation incentives for drug makers. This will ensure that patent owners achieve clarity on the validity of their patents, which will spur new drug innovation and make sure that consumers continue to have access to life-improving drugs.
5. Curb illegal product hopping and patent thickets. Two drug maker tactics currently garnering a lot of attention are so-called “product hopping” and “patent thickets.” At its worst, product hopping involves brand drug makers making minor changes to a drug nearing the end of its patent so that they gets a new patent on the slightly-tweaked drug, and then withdrawing the original drug from the market so that patients shift to the newly patented drug and pharmacists can’t substitute a generic version of the original drug. Similarly, at their worst, patent thickets involve brand drug makers obtaining a web of patents on a single drug to extend the life of their exclusivity and make it too costly for other drug makers to challenge all of the patents associated with a drug. The proposed Affordable Prescriptions for Patients Act of 2019 is meant to stop these abuses of the patent system, which would facilitate generic entry and help to lower drug prices.
However, the Act goes too far by also capturing many legitimate activities in its definitions. For example, the bill defines as anticompetitive product-hopping the selling of any improved version of a drug during a window which extends to a year after the launch of the first generic competitor. Presently, to acquire a patent and FDA approval, the improved version of the drug must be different and innovative enough from the original drug, yet the Act would prevent the drug maker from selling such a product without satisfying a demanding three-pronged test before the FTC or a district court. Similarly, the Act defines as anticompetitive patent thickets any new patents filed on a drug in the same general family as the original patent, and this presumption can only be rebutted by providing extensive evidence and satisfying demanding standards to the FTC or a district court. As a result, the Act deters innovation activity that is at all related to an initial patent and, in doing so, ignores the fact that most important drug innovation is incremental innovation based on previous inventions. Thus, the proposal should be redrafted to capture truly anticompetitive product hopping and patent thicket activity, while exempting behavior this is critical for drug innovation.
Reforms that close loopholes in the current patent process should facilitate competition in the pharmaceutical industry and help to lower drug prices. However, lawmakers need to be sure that they don’t restrict patent rights to the extent that they deter innovation because a significant body of research predicts that patients’ health outcomes will suffer as a result.
On March 14, the
Federal Circuit will hear oral arguments in the case of BTG
International v. Amneal Pharmaceuticals that could dramatically influence the
future of duplicative patent litigation in the pharmaceutical industry. The court will determine whether the America
Invents Act (AIA) bars patent challengers that succeed in invalidating patents
in inter partes review (IPR) proceedings from repeating their winning arguments
in district court. Courts and litigants
had previously assumed that the AIA’s estoppel provision only prevented
unsuccessful challengers from reusing failed arguments. However, in an amicus
brief filed in the case
last month, the U.S. Patent and Trade Office (USPTO) argued that, although it
seems counterintuitive, under the AIA, even parties that succeed in getting
patents invalidated in IPR cannot reuse their arguments.
the Federal Circuit agrees with the USPTO, patent challengers could be strongly
deterred from bringing IPR proceedings because it would mean they couldn’t
reuse any arguments in district court.
This deterrent effect would be especially strong for generic drug
makers, who must prevail in district court in order to get approval for their
Abbreviated New Drug Application from the FDA.
of the USPTO’s position assert that it will frustrate the AIA’s
purpose of facilitating generic competition.
However, if the Federal Circuit adopts the position, it would also
reduce the amount of duplicative litigation that plagues the pharmaceutical
industry and threatens new drug innovation.
According to a 2017
analysis of over 6,500 IPR challenges filed between
2012 and 2017, approximately 80% of IPR challenges were filed during an ongoing
district court case challenging the patent.
This duplicative litigation can
increase costs for both challengers and patent holders; the median
cost for an IPR proceeding that results in a final
decision is $500,000 and the median cost for just filing an IPR petition is
$100,000. Moreover, because of
duplicative litigation, pharmaceutical patent holders face persistent
uncertainty about the validity of their patents. Uncertain patent rights will lead to less innovation because
drug companies will not spend the billions of dollars it typically costs to
bring a new drug to market when they cannot be certain if the patents for that
drug can withstand IPR proceedings that are clearly stacked against them.
And if IPR causes drug innovation to decline, a significant body of
research predicts that patients’ health outcomes will suffer as a result.
addition, deterring IPR challenges would help to reestablish balance between
drug patent owners and patent challengers.
As I’ve previously discussed here
bias in IPR proceedings has led to significant deviation in patent invalidation
rates under the two pathways; compared to district court challenges, patents
are twice as likely to be found invalid in IPR challenges. The challenger is more likely to prevail in IPR
proceedings because the Patent Trial and Appeal Board (PTAB) applies a lower standard of
invalidity in IPR proceedings than do federal courts. Furthermore, if the
challenger prevails in the IPR proceedings, the PTAB’s decision to invalidate a
patent can often “undo” a prior district court decision in favor of the patent
holder. Further, although both district court judgments and PTAB
decisions are appealable to the Federal Circuit, the court applies a more
deferential standard of review to PTAB decisions, increasing the likelihood
that they will be upheld compared to the district court decision.
However, the USPTO acknowledges that its position is counterintuitive because it means that a court could not consider invalidity arguments that the PTAB found persuasive. It is unclear whether the Federal Circuit will refuse to adopt this counterintuitive position or whether Congress will amend the AIA to limit estoppel to failed invalidity claims. As a result, a better and more permanent way to eliminate duplicative litigation would be for Congress to enact the Hatch-Waxman Integrity Act of 2019 (HWIA). The HWIA was introduced by Senator Thom Tillis in the Senate and Congressman Bill Flores In the House, and proposed in the last Congress by Senator Orrin Hatch. The HWIA eliminates the ability of drug patent challengers to file duplicative claims in both federal court and IPR proceedings. Instead, they must choose between either district court litigation (which saves considerable costs by allowing generics to rely on the brand company’s safety and efficacy studies for FDA approval) and IPR proceedings (which are faster and provide certain pro-challenger provisions).
Thus, the HWIA would reduce duplicative litigation that increases costs and uncertainty for drug patent owners. This will ensure that patent owners achieve clarity on the validity of their patents, which will spur new drug innovation and ensure that consumers continue to have access to life-improving drugs.