Gus Hurwitz called the bill dead in September. Then it passed the Senate Judiciary Committee. Now, there are some reports that suggest it could be added to the obviously unrelated National Defense Authorization Act (it should be noted that the JCPA was not included in the version of NDAA introduced in the U.S. House).
For an overview of the bill and its flaws, see Dirk Auer and Ben Sperry’s tl;dr. The JCPA would force “covered” online platforms like Facebook and Google to pay for journalism accessed through those platforms. When a user posts a news article on Facebook, which then drives traffic to the news source, Facebook would have to pay. I won’t get paid for links to my banger cat videos, no matter how popular they are, since I’m not a qualifying publication.
I’m going to focus on one aspect of the bill: the use of “final offer arbitration” (FOA) to settle disputes between platforms and news outlets. FOA is sometimes called “baseball arbitration” because it is used for contract disputes in Major League Baseball. This form of arbitration has also been implemented in other jurisdictions to govern similar disputes, notably by the Australian ACCC.
Before getting to the more complicated case, let’s start simple.
Scenario #1: I’m a corn farmer. You’re a granary who buys corn. We’re both invested in this industry, so let’s assume we can’t abandon negotiations in the near term and need to find an agreeable price. In a market, people make offers. Prices vary each year. I decide when to sell my corn based on prevailing market prices and my beliefs about when they will change.
Scenario #2: A government agency comes in (without either of us asking for it) and says the price of corn this year is $6 per bushel. In conventional economics, we call that a price regulation. Unlike a market price, where both sides sign off, regulated prices do not enjoy mutual agreement by the parties to the transaction.
Scenario #3: Instead of a price imposed independently by regulation, one of the parties (say, the corn farmer) may seek a higher price of $6.50 per bushel and petition the government. The government agrees and the price is set at $6.50. We would still call that price regulation, but the outcome reflects what at least one of the parties wanted and some may argue that it helps “the little guy.” (Let’s forget that many modern farms are large operations with bargaining power. In our head and in this story, the corn farmer is still a struggling mom-and-pop about to lose their house.)
Scenario #4: Instead of listening only to the corn farmer, both the farmer and the granary tell the government their “final offer” and the government picks one of those offers, not somewhere in between. The parties don’t give any reasons—just the offer. This is called “final offer arbitration” (FOA).
As an arbitration mechanism, FOA makes sense, even if it is not always ideal. It avoids some of the issues that can attend “splitting the difference” between the parties.
While it is better than other systems, it is still a price regulation. In the JCPA’s case, it would not be imposed immediately; the two parties can negotiate on their own (in the shadow of the imposed FOA). And the actual arbitration decision wouldn’t technically be made by the government, but by a third party. Fine. But ultimately, after stripping away the veneer, this is all just an elaborate mechanism built atop the threat of the government choosing the price in the market.
I call that price regulation. The losing party does not like the agreement and never agreed to the overall mechanism. Unlike in voluntary markets, at least one of the parties does not agree with the final price. Moreover, neither party explicitly chose the arbitration mechanism.
The JCPA’s FOA system is not precisely like the baseball situation. In baseball, there is choice on the front-end. Players and owners agree to the system. In baseball, there is also choice after negotiations start. Players can still strike; owners can enact a lockout. Under the JCPA, the platforms must carry the content. They cannot walk away.
I’m an economist, not a philosopher. The problem with force is not that it is unpleasant. Instead, the issue is that force distorts the knowledge conveyed through market transactions. That distortion prevents resources from moving to their highest valued use.
How do we know the apple is more valuable to Armen than it is to Ben? In a market, “we” don’t need to know. No benevolent outsider needs to pick the “right” price for other people. In most free markets, a seller posts a price. Buyers just need to decide whether they value it more than that price. Armen voluntarily pays Ben for the apple and Ben accepts the transaction. That’s how we know the apple is in the right hands.
Often, transactions are about more than just price. Sometimes there may be haggling and bargaining, especially on bigger purchases. Workers negotiate wages, even when the ad stipulates a specific wage. Home buyers make offers and negotiate.
But this just kicks up the issue of information to one more level. Negotiating is costly. That is why sometimes, in anticipation of costly disputes down the road, the two sides voluntarily agree to use an arbitration mechanism. MLB players agree to baseball arbitration. That is the two sides revealing that they believe the costs of disputes outweigh the losses from arbitration.
Again, each side conveys their beliefs and values by agreeing to the arbitration mechanism. Each step in the negotiation process allows the parties to convey the relevant information. No outsider needs to know “the right” answer.For a choice to convey information about relative values, it needs to be freely chosen.
At an abstract level, any trade has two parts. First, people agree to the mechanism, which determines who makes what kinds of offers. At the grocery store, the mechanism is “seller picks the price and buyer picks the quantity.” For buying and selling a house, the mechanism is “seller posts price, buyer can offer above or below and request other conditions.” After both parties agree to the terms, the mechanism plays out and both sides make or accept offers within the mechanism.
We need choice on both aspects for the price to capture each side’s private information.
For example, suppose someone comes up to you with a gun and says “give me your wallet or your watch. Your choice.” When you “choose” your watch, we don’t actually call that a choice, since you didn’t pick the mechanism. We have no way of knowing whether the watch means more to you or to the guy with the gun.
When the JCPA forces Facebook to negotiate with a local news website and Facebook offers to pay a penny per visit, it conveys no information about the relative value that the news website is generating for Facebook. Facebook may just be worried that the website will ask for two pennies and the arbitrator will pick the higher price. It is equally plausible that in a world without transaction costs, the news would pay Facebook, since Facebook sends traffic to them. Is there any chance the arbitrator will pick Facebook’s offer if it asks to be paid? Of course not, so Facebook will never make that offer.
For sure, things are imposed on us all the time. That is the nature of regulation. Energy prices are regulated. I’m not against regulation. But we should defend that use of force on its own terms and be honest that the system is one of price regulation. We gain nothing by a verbal sleight of hand that turns losing your watch into a “choice” and the JCPA’s FOA into a “negotiation” between platforms and news.
In economics, we often ask about market failures. In this case, is there a sufficient market failure in the market for links to justify regulation? Is that failure resolved by this imposition?
President Joe Biden’s nomination of Gigi Sohn to serve on the Federal Communications Commission (FCC)—scheduled for a second hearing before the Senate Commerce Committee Feb. 9—has been met with speculation that it presages renewed efforts at the FCC to enforce net neutrality. A veteran of tech policy battles, Sohn served as counselor to former FCC Chairman Tom Wheeler at the time of the commission’s 2015 net-neutrality order.
The political prospects for Sohn’s confirmation remain uncertain, but it’s probably fair to assume a host of associated issues—such as whether to reclassify broadband as a Title II service; whether to ban paid prioritization; and whether the FCC ought to exercise forbearance in applying some provisions of Title II to broadband—are likely to be on the FCC’s agenda once the full complement of commissioners is seated. Among these is an issue that doesn’t get the attention it merits: rate regulation of broadband services.
History has, by now, definitively demonstrated that the FCC’s January 2018 repeal of the Open Internet Order didn’t produce the parade of horribles that net-neutrality advocates predicted. Most notably, paid prioritization—creating so-called “fast lanes” and “slow lanes” on the Internet—has proven a non-issue. Prioritization is a longstanding and widespread practice and, as discussed at length in this piece from The Verge on Netflix’s Open Connect technology, the Internet can’t work without some form of it.
Indeed, the Verge piece makes clear that even paid prioritization can be an essential tool for edge providers. As we’ve previously noted, paid prioritization offers an economically efficient means to distribute the costs of network optimization. As Greg Sidak and David Teece put it:
Superior QoS is a form of product differentiation, and it therefore increases welfare by increasing the production choices available to content and applications providers and the consumption choices available to end users…. [A]s in other two-sided platforms, optional business-to-business transactions for QoS will allow broadband network operators to reduce subscription prices for broadband end users, promoting broadband adoption by end users, which will increase the value of the platform for all users.
The Perennial Threat of Price Controls
Although only hinted at during Sohn’s initial confirmation hearing in December, the real action in the coming net-neutrality debate is likely to be over rate regulation.
Pressed at that December hearing by Sen. Marsha Blackburn (R-Tenn.) to provide a yes or no answer as to whether she supports broadband rate regulation, Sohn said no, before adding “That was an easy one.” Current FCC Chair Jessica Rosenworcel has similarly testified that she wants to continue an approach that “expressly eschew[s] future use of prescriptive, industry-wide rate regulation.”
But, of course, rate regulation is among the defining features of most Title II services. While then-Chairman Wheeler promised to forebear from rate regulation at the time of the FCC’s 2015 Open Internet Order (OIO), stating flatly that “we are not trying to regulate rates,” this was a small consolation. At the time, the agency decided to waive “the vast majority of rules adopted under Title II” (¶ 51), but it also made clear that the commission would “retain adequate authority to” rescind such forbearance (¶ 538) in the future. Indeed, one could argue that the reason the 2015 order needed to declare resolutely that “we do not and cannot envision adopting new ex ante rate regulation of broadband Internet access service in the future” (¶ 451)) is precisely because of how equally resolute it was that the Commission would retain basic Title II authority, including the authority to impose rate regulation (“we are not persuaded that application of sections 201 and 202 is not necessary to ensure just, reasonable, and nondiscriminatory conduct by broadband providers and for the protection of consumers” (¶ 446)).
This was no mere parsing of words. The 2015 order takes pains to assert repeatedly that forbearance was conditional and temporary, including with respect to rate regulation (¶ 497). As then-Commissioner Ajit Pai pointed out in his dissent from the OIO:
The plan is quite clear about the limited duration of its forbearance decisions, stating that the FCC will revisit them in the future and proceed in an incremental manner with respect to additional regulation. In discussing additional rate regulation, tariffs, last-mile unbundling, burdensome administrative filing requirements, accounting standards, and entry and exit regulation, the plan repeatedly states that it is only forbearing “at this time.” For others, the FCC will not impose rules “for now.” (p. 325)
For broadband providers, the FCC having the ability even to threaten rate regulation could disrupt massive amounts of investment in network buildout. And there is good reason for the sector to be concerned about the prevailing political winds, given the growing (and misguided) focus on price controls and their potential to be used to stem inflation.
Indeed, politicians’ interest in controls on broadband rates predates the recent supply-chain-driven inflation. For example, President Biden’s American Jobs Plan called on Congress to reduce broadband prices:
President Biden believes that building out broadband infrastructure isn’t enough. We also must ensure that every American who wants to can afford high-quality and reliable broadband internet. While the President recognizes that individual subsidies to cover internet costs may be needed in the short term, he believes continually providing subsidies to cover the cost of overpriced internet service is not the right long-term solution for consumers or taxpayers. Americans pay too much for the internet – much more than people in many other countries – and the President is committed to working with Congress to find a solution to reduce internet prices for all Americans. (emphasis added)
[We] believe that the Internet should be kept free and open like our highways, accessible and affordable to every American, regardless of ability to pay. It’s not that you don’t pay, it’s that if you’re a little guy or gal, you shouldn’t pay a lot more than the bigshots. We don’t do that on highways, we don’t do that with utilities, and we shouldn’t do that on the Internet, another modern, 21st century highway that’s a necessity.
And even Sohn herself has a history of somewhat equivocal statements regarding broadband rate regulation. In a 2018 article referencing the Pai FCC’s repeal of the 2015 rules, Sohn lamented in particular that removing the rules from Title II’s purview meant losing the “power to constrain ‘unjust and unreasonable’ prices, terms, and practices by [broadband] providers” (p. 345).
Rate Regulation by Any Other Name
Even if Title II regulation does not end up taking the form of explicit price setting by regulatory fiat, that doesn’t necessarily mean the threat of rate regulation will have been averted. Perhaps even more insidious is de facto rate regulation, in which agencies use their regulatory leverage to shape the pricing policies of providers. Indeed, Tim Wu—the progenitor of the term “net neutrality” and now an official in the Biden White House—has explicitly endorsed the use of threats by regulatory agencies in order to obtain policy outcomes:
The use of threats instead of law can be a useful choice—not simply a procedural end run. My argument is that the merits of any regulative modality cannot be determined without reference to the state of the industry being regulated. Threat regimes, I suggest, are important and are best justified when the industry is undergoing rapid change—under conditions of “high uncertainty.” Highly informal regimes are most useful, that is, when the agency faces a problem in an environment in which facts are highly unclear and evolving. Examples include periods surrounding a newly invented technology or business model, or a practice about which little is known. Conversely, in mature, settled industries, use of informal procedures is much harder to justify.
The broadband industry is not new, but it is characterized by rapid technological change, shifting consumer demands, and experimental business models. Thus, under Wu’s reasoning, it appears ripe for regulation via threat.
What’s more, backdoor rate regulation is already practiced by the U.S. Department of Agriculture (USDA) in how it distributes emergency broadband funds to Internet service providers (ISPs) that commit to net-neutrality principles. The USDA prioritizes funding for applicants that operate “their networks pursuant to a ‘wholesale’ (in other words, ‘open access’) model and provid[e] a ‘low-cost option,’ both of which unnecessarily and detrimentally inject government rate regulation into the competitive broadband marketplace.”
States have also been experimenting with broadband rate regulation in the form of “affordable broadband” mandates. For example, New York State passed the Affordable Broadband Act (ABA) in 2021, which claimed authority to assist low-income consumers by capping the price of service and mandating provision of a low-cost service tier. As the federal district court noted in striking down the law:
In Defendant’s words, the ABA concerns “Plaintiffs’ pricing practices” by creating a “price regime” that “set[s] a price ceiling,” which flatly contradicts [New York Attorney General Letitia James’] simultaneous assertion that “the ABA does not ‘rate regulate’ broadband services.” “Price ceilings” regulate rates.
The 2015 Open Internet Order’s ban on paid prioritization, couched at the time in terms of “fairness,” was itself effectively a rate regulation that set wholesale prices at zero. The order even empowered the FCC to decide the rates ISPs could charge to edge providers for interconnection or peering agreements on an individual, case-by-case basis. As we wrote at the time:
[T]he first complaint under the new Open Internet rule was brought against Time Warner Cable by a small streaming video company called Commercial Network Services. According to several newsstories, CNS “plans to file a peering complaint against Time Warner Cable under the Federal Communications Commission’s new network-neutrality rules unless the company strikes a free peering deal ASAP.” In other words, CNS is asking for rate regulation for interconnection. Under the Open Internet Order, the FCC can rule on such complaints, but it can only rule on a case-by-case basis. Either TWC assents to free peering, or the FCC intervenes and sets the rate for them, or the FCC dismisses the complaint altogether and pushes such decisions down the road…. While the FCC could reject this complaint, it is clear that they have the ability to impose de facto rate regulation through case-by-case adjudication.
The FCC’s ability under the OIO to ensure that prices were “fair” contemplated an enormous degree of discretionary power:
Whether it is rate regulation according to Title II (which the FCC ostensibly didn’t do through forbearance) is beside the point. This will have the same practical economic effects and will be functionally indistinguishable if/when it occurs.
The Economics of Price Controls
Economists from across the political spectrum have long decried the use of price controls. In a recent (now partially deleted) tweet, Nobel laureate and liberal New York Times columnist Paul Krugman lambasted calls for price controls in response to inflation as “truly stupid.” In a recent survey of top economists on issues related to inflation, University of Chicago economist Austan Goolsbee, a former chair of the Council of Economic Advisors under President Barack Obama, strongly disagreed that 1970s-style price controls could successfully reduce U.S. inflation over the next 12 months, stating simply: “Just stop. Seriously.”
The reason for the bipartisan consensus is clear: both history and economics have demonstrated that price caps lead to shortages by artificially stimulating demand for a good, while also creating downward pressure on supply for that good.
Broadband rate regulation, whether implicit or explicit, will have similarly negative effects on investment and deployment. Limiting returns on investment reduces the incentive to make those investments. Broadband markets subject to price caps would see particularly large dislocations, given the massive upfront investment required, the extended period over which returns are realized, and the elevated risk of under-recoupment for quality improvements. Not only would existing broadband providers make fewer and less intensive investments to maintain their networks, they would invest less in improving quality:
When it faces a binding price ceiling, a regulated monopolist is unable to capture the full incremental surplus generated by an increase in service quality. Consequently, when the firm bears the full cost of the increased quality, it will deliver less than the surplus-maximizing level of quality. As Spence (1975, p. 420, note 5) observes, “where price is fixed… the firm always sets quality too low.” (p 9-10)
Quality suffers under price regulation not just because firms can’t capture the full value of their investments, but also because it is often difficult to account for quality improvements in regulatory pricing schemes:
The design and enforcement of service quality regulations is challenging for at least three reasons. First, it can be difficult to assess the benefits and the costs of improving service quality. Absent accurate knowledge of the value that consumers place on elevated levels of service quality and the associated costs, it is difficult to identify appropriate service quality standards. It can be particularly challenging to assess the benefits and costs of improved service quality in settings where new products and services are introduced frequently. Second, the level of service quality that is actually delivered sometimes can be difficult to measure. For example, consumers may value courteous service representatives, and yet the courtesy provided by any particular representative may be difficult to measure precisely. When relevant performance dimensions are difficult to monitor, enforcing desired levels of service quality can be problematic. Third, it can be difficult to identify the party or parties that bear primary responsibility for realized service quality problems. To illustrate, a customer may lose telephone service because an underground cable is accidentally sliced. This loss of service could be the fault of the telephone company if the company fails to bury the cable at an appropriate depth in the ground or fails to notify appropriate entities of the location of the cable. Alternatively, the loss of service might reflect a lack of due diligence by field workers from other companies who slice a telephone cable that is buried at an appropriate depth and whose location has been clearly identified. (p 10)
Firms are also less likely to enter new markets, where entry is risky and competition with a price-regulated monopolist can be a bleak prospect. Over time, price caps would degrade network quality and availability. Price caps in sectors characterized by large capital investment requirements also tend to exacerbate the need for an exclusive franchise, in order to provide some level of predictable returns for the regulated provider. Thus, “managed competition” of this sort may actually have the effect of reducing competition.
None of these concerns are dissipated where regulators use indirect, rather than direct, means to cap prices. Interconnection mandates and bans on paid prioritization both set wholesale prices at zero. Broadband is a classic multi-sided market. If the price on one side of the market is set at zero through rate regulation, then there will be upward pricing pressure on the other side of the market. This means higher prices for consumers (or else, it will require another layer of imprecise and complex regulation and even deeper constraints on investment).
Similarly, implicit rate regulation under an amorphous “general conduct standard” like that included in the 2015 order would allow the FCC to effectively ban practices like zero rating on mobile data plans. At the time, the OIO restricted ISPs’ ability to “unreasonably interfere with or disadvantage”:
consumer access to lawful content, applications, and services; or
content providers’ ability to distribute lawful content, applications or services.
The FCC thus signaled quite clearly that it would deem many zero-rating arrangements as manifestly “unreasonable.” Yet, for mobile customers who want to consume only a limited amount of data, zero rating of popular apps or other data uses is, in most cases, a net benefit for consumer welfare:
These zero-rated services are not typically designed to direct users’ broad-based internet access to certain content providers ahead of others; rather, they are a means of moving users from a world of no access to one of access….
…This is a business model common throughout the internet (and the rest of the economy, for that matter). Service providers often offer a free or low-cost tier that is meant to facilitate access—not to constrain it.
Economics has long recognized the benefits of such pricing mechanisms, which is why competition authorities always scrutinize such practices under a rule of reason, requiring a showing of substantial exclusionary effect and lack of countervailing consumer benefit before condemning such practices. The OIO’s Internet conduct rule, however, encompassed no such analytical limits, instead authorizing the FCC to forbid such practices in the name of a nebulous neutrality principle and with no requirement to demonstrate net harm. Again, although marketed under a different moniker, banning zero rating outright is a de facto price regulation—and one that is particularly likely to harm consumers.
Conclusion
Ultimately, it’s important to understand that rate regulation, whatever the imagined benefits, is not a costless endeavor. Costs and risk do not disappear under rate regulation; they are simply shifted in one direction or another—typically with costs borne by consumers through some mix of reduced quality and innovation.
While more can be done to expand broadband access in the United States, the Internet has worked just fine without Title II regulation. It’s a bit trite to repeat, but it remains relevant to consider how well U.S. networks fared during the COVID-19 pandemic. That performance was thanks to ongoing investment from broadband companies over the last 20 years, suggesting the market for broadband is far more competitive than net-neutrality advocates often claim.
Government policy may well be able to help accelerate broadband deployment to the unserved portions of the country where it is most needed. But the way to get there is not by imposing price controls on broadband providers. Instead, we should be removing costly, government-erected barriers to buildout and subsidizing and educating consumers where necessary.
[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.
But without a willingness to allow retailers and producers to use the informational signal of higher prices, there will continue to be more extreme shortages as consumers rush to stockpile underpriced resources.
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.
As consumers demand more toilet paper, bottled water, and staple foods than can be produced quickly, entrepreneurs respond by refocusing current capabilities on these goods. Examples abound:
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.
Conclusion
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.
Today, the Senate Committee on Health, Education, Labor, and Pensions (HELP) enters the drug pricing debate with a hearing on “The Cost of Prescription Drugs: How the Drug Delivery System Affects What Patients Pay.” By questioning the role of the drug delivery system in pricing, the hearing goes beyond the more narrow focus of recent hearings that have explored how drug companies set prices. Instead, today’s hearing will explore how pharmacy benefit managers, insurers, providers, and others influence the amounts that patients pay.
In 2016, net U.S. drug spending increased by 4.8% to $323 billion (after adjusting for rebates and off-invoice discounts). This rate of growth slowed to less than half the rates of 2014 and 2015, when net drug spending grew at rates of 10% and 8.9% respectively. Yet despite the slowing in drug spending, the public outcry over the cost of prescription drugs continues.
In today’s hearing, there will be testimony both on the various causes of drug spending increases and on various proposals that could reduce the cost of drugs. Several of the proposals will focus on ways to increase competition in the pharmaceutical industry, and in turn, reduce drug prices. I have previously explained several ways that the government could reduce prices through enhanced competition, including reducing the backlog of generic drugs awaiting FDA approval and expediting the approval and acceptance of biosimilars. Other proposals today will likely call for regulatory reforms to enable innovative contractual arrangements that allow for outcome- or indication-based pricing and other novel reimbursement designs.
However, some proposals will undoubtedly return to the familiar call for more government negotiation of drug prices, especially drugs covered under Medicare Part D. As I’ve discussed in a previous post, in order for government negotiation to significantly lower drug prices, the government must be able to put pressure on drug makers to secure price concessions. This could be achieved if the government could set prices administratively, penalize manufacturers that don’t offer price reductions, or establish a formulary. Setting prices or penalizing drug makers that don’t reduce prices would produce the same disastrous effects as price controls: drug shortages in certain markets, increased prices for non-Medicare patients, and reduced incentives for innovation. A government formulary for Medicare Part D coverage would provide leverage to obtain discounts from manufacturers, but it would mean that many patients could no longer access some of their optimal drugs.
As lawmakers seriously consider changes that would produce these negative consequences, industry would do well to voluntarily constrain prices. Indeed, in the last year, many drug makers have pledged to limit price increases to keep drug spending under control. Allergan was first, with its “social contract” introduced last September that promised to keep price increases below 10 percent. Since then, Novo Nordisk, AbbVie, and Takeda, have also voluntarily committed to single-digit price increases.
So far, the evidence shows the drug makers are sticking to their promises. Allergan has raised the price of U.S. branded products by an average of 6.7% in 2017, and no drug’s list price has increased by more than single digits. In contrast, Pfizer, who has made no pricing commitment, has raised the price of many of its drugs by 20%.
If more drug makers brought about meaningful change by committing to voluntary pricing restraints, the industry could prevent the market-distorting consequences of government intervention while helping patients afford the drugs they need. Moreover, avoiding intrusive government mandates and price controls would preserve drug innovation that has brought life-saving and life-enhancing drugs to millions of Americans.
Today, the International Center for Law & Economics (ICLE) released a study updating our 2014 analysis of the economic effects of the Durbin Amendment to the Dodd-Frank Act.
The new paper, Unreasonable and Disproportionate: How the Durbin Amendment Harms Poorer Americans and Small Businesses, by ICLE scholars, Todd J. Zywicki, Geoffrey A. Manne, and Julian Morris, can be found here; a Fact Sheet highlighting the paper’s key findings is available here.
Introduced as part of the Dodd-Frank Act in 2010, the Durbin Amendment sought to reduce the interchange fees assessed by large banks on debit card transactions. In the words of its primary sponsor, Sen. Richard Durbin, the Amendment aspired to help “every single Main Street business that accepts debit cards keep more of their money, which is a savings they can pass on to their consumers.”
Unfortunately, although the Durbin Amendment did generate benefits for big-box retailers, ICLE’s 2014 analysis found that it had actually harmed many other merchants and imposed substantial net costs on the majority of consumers, especially those from lower-income households.
In the current study, we analyze a welter of new evidence and arguments to assess whether time has ameliorated or exacerbated the Amendment’s effects. Our findings in this report expand upon and reinforce our findings from 2014:
Relative to the period before the Durbin Amendment, almost every segment of the interrelated retail, banking, and consumer finance markets has been made worse off as a result of the Amendment.
Predictably, the removal of billions of dollars in interchange fee revenue has led to the imposition of higher bank fees and reduced services for banking consumers.
In fact, millions of households, regardless of income level, have been adversely affected by the Durbin Amendment through higher overdraft fees, increased minimum balances, reduced access to free checking, higher ATM fees, and lost debit card rewards, among other things.
Nor is there any evidence that merchants have lowered prices for retail consumers; for many small-ticket items, in fact, prices have been driven up.
Contrary to Sen. Durbin’s promises, in other words, increased banking costs have not been offset by lower retail prices.
At the same time, although large merchants continue to reap a Durbin Amendment windfall, there remains no evidence that small merchants have realized any interchange cost savings — indeed, many have suffered cost increases.
And all of these effects fall hardest on the poor. Hundreds of thousands of low-income households have chosen (or been forced) to exit the banking system, with the result that they face higher costs, difficulty obtaining credit, and complications receiving and making payments — all without offset in the form of lower retail prices.
Finally, the 2017 study also details a new trend that was not apparent when we examined the data three years ago: Contrary to our findings then, the two-tier system of interchange fee regulation (which exempts issuing banks with under $10 billion in assets) no longer appears to be protecting smaller banks from the Durbin Amendment’s adverse effects.
This week the House begins consideration of the Amendment’s repeal as part of Rep. Hensarling’s CHOICE Act. Our study makes clear that the Durbin price-control experiment has proven a failure, and that repeal is, indeed, the only responsible option.
In a weekend interview with the Washington Post, Donald Trump vowed to force drug companies to negotiate directly with the government on prices in Medicare and Medicaid. It’s unclear what, if anything, Trump intends for Medicaid; drug makers are already required to sell drugs to Medicaid at the lowest price they negotiate with any other buyer. For Medicare, Trump didn’t offer any more details about the intended negotiations, but he’s referring to his campaign proposals to allow the Department of Health and Human Services (HHS) to negotiate directly with manufacturers the prices of drugs covered under Medicare Part D.
Such proposals have been around for quite a while. As soon as the Medicare Modernization Act (MMA) of 2003 was enacted, creating the Medicare Part D prescription drug benefit, many lawmakers began advocating for government negotiation of drug prices. Both Hillary Clinton and Bernie Sanders favored this approach during their campaigns, and the Obama Administration’s proposed budget for fiscal years 2016 and 2017 included a provision that would have allowed the HHS to negotiate prices for a subset of drugs: biologics and certain high-cost prescription drugs.
However, federal law would have to change if there is to be any government negotiation of drug prices under Medicare Part D. Congress explicitly included a “noninterference” clause in the MMA that stipulates that HHS “may not interfere with the negotiations between drug manufacturers and pharmacies and PDP sponsors, and may not require a particular formulary or institute a price structure for the reimbursement of covered part D drugs.”
Most people don’t understand what it means for the government to “negotiate” drug prices and the implications of the various options. Some proposals would simply eliminate the MMA’s noninterference clause and allow HHS to negotiate prices for a broad set of drugs on behalf of Medicare beneficiaries. However, the Congressional Budget Office has already concluded that such a plan would have “a negligible effect on federal spending” because it is unlikely that HHS could achieve deeper discounts than the current private Part D plans (there are 746 such plans in 2017). The private plans are currently able to negotiate significant discounts from drug manufacturers by offering preferred formulary status for their drugs and channeling enrollees to the formulary drugs with lower cost-sharing incentives. In most drug classes, manufacturers compete intensely for formulary status and offer considerable discounts to be included.
The private Part D plans are required to provide only two drugs in each of several drug classes, giving the plans significant bargaining power over manufacturers by threatening to exclude their drugs. However, in six protected classes (immunosuppressant, anti-cancer, anti-retroviral, antidepressant, antipsychotic and anticonvulsant drugs), private Part D plans must include “all or substantially all” drugs, thereby eliminating their bargaining power and ability to achieve significant discounts. Although the purpose of the limitation is to prevent plans from cherry-picking customers by denying coverage of certain high cost drugs, giving the private Part D plans more ability to exclude drugs in the protected classes should increase competition among manufacturers for formulary status and, in turn, lower prices. And it’s important to note that these price reductions would not involve any government negotiation or intervention in Medicare Part D. However, as discussed below, excluding more drugs in the protected classes would reduce the value of the Part D plans to many patients by limiting access to preferred drugs.
For government negotiation to make any real difference on Medicare drug prices, HHS must have the ability to not only negotiate prices, but also to put some pressure on drug makers to secure price concessions. This could be achieved by allowing HHS to also establish a formulary, set prices administratively, or take other regulatory actions against manufacturers that don’t offer price reductions. Setting prices administratively or penalizing manufacturers that don’t offer satisfactory reductions would be tantamount to a price control. I’ve previously explained that price controls—whether direct or indirect—are a bad idea for prescription drugs for several reasons. Evidence shows that price controls lead to higher initial launch prices for drugs, increased drug prices for consumers with private insurance coverage, drug shortages in certain markets, and reduced incentives for innovation.
Giving HHS the authority to establish a formulary for Medicare Part D coverage would provide leverage to obtain discounts from manufacturers, but it would produce other negative consequences. Currently, private Medicare Part D plans cover an average of 85% of the 200 most popular drugs, with some plans covering as much as 93%. In contrast, the drug benefit offered by the Department of Veterans Affairs (VA), one government program that is able to set its own formulary to achieve leverage over drug companies, covers only 59% of the 200 most popular drugs. The VA’s ability to exclude drugs from the formulary has generated significant price reductions. Indeed, estimates suggest that if the Medicare Part D formulary was restricted to the VA offerings and obtained similar price reductions, it would save Medicare Part D $510 per beneficiary. However, the loss of access to so many popular drugs would reduce the value of the Part D plans by $405 per enrollee, greatly narrowing the net gains.
History has shown that consumers don’t like their access to drugs reduced. In 2014, Medicare proposed to take antidepressants, antipsychotic and immunosuppressant drugs off the protected list, thereby allowing the private Part D plans to reduce offerings of these drugs on the formulary and, in turn, reduce prices. However, patients and their advocates were outraged at the possibility of losing access to their preferred drugs, and the proposal was quickly withdrawn.
Thus, allowing the government to negotiate prices under Medicare Part D could carry important negative consequences. Policy-makers must fully understand what it means for government to negotiate directly with drug makers, and what the potential consequences are for price reductions, access to popular drugs, drug innovation, and drug prices for other consumers.
On November 9, pharmaceutical stocks soared as Donald Trump’s election victory eased concerns about government intervention in drug pricing. Shares of Pfizer rose 8.5%, Allergan PLC was up 8%, and biotech Celgene jumped 10.4%. Drug distributors also gained, with McKesson up 6.4% and Express Scripts climbing 3.4%. Throughout the campaign, Clinton had vowed to take on the pharmaceutical industry and proposed various reforms to reign in drug prices, from levying fines on drug companies that imposed unjustified price increases to capping patients’ annual expenditures on drugs. Pharmaceutical stocks had generally underperformed this year as the market, like much of America, awaited a Clinton victory.
In contrast, Trump generally had less to say on the subject of drug pricing, hence the market’s favorable response to his unexpected victory. Yet, as the end of the first post-election month draws near, we are still uncertain whether Trump is friend or foe to the pharmaceutical industry. Trump’s only proposal that directly impacts the industry would allow the government to negotiate the prices of Medicare Part D drugs with drug makers. Although this proposal would likely have little impact on prices because existing Part D plans already negotiate prices with drug makers, there is a risk that this “negotiation” could ultimately lead to price controls imposed on the industry. And as I have previously discussed, price controls—whether direct or indirect—are a bad idea for prescription drugs: they lead to higher initial launch prices for drugs, increased drug prices for consumers with private insurance coverage, drug shortages in certain markets, and reduced incentives for innovation.
Several of Trump’s other health proposals have mixed implications for the industry. For example, a repeal or overhaul of the Affordable Care Act could eliminate the current tax on drug makers and loosen requirements for Medicaid drug rebates and Medicare part D discounts. On the other hand, if repealing the ACA reduces the number of people insured, spending on pharmaceuticals would fall. Similarly, if Trump renegotiates international trade deals, pharmaceutical firms could benefit from stronger markets or longer patent exclusivity rights, or they could suffer if foreign countries abandon trade agreements altogether or retaliate with disadvantageous terms.
Yet, with drug spending up 8.5 percent last year and recent pricing scandals launched by 500+ percentage increases in individual drugs (i.e., Martin Shkreli, Valeant Pharmaceuticals, Mylan), the current debate over drug pricing is unlikely to fade. Even a Republican-led Congress and White House is likely to heed the public outcry and do something about drug prices.
Drug makers would be wise to stave off any government-imposed price restrictions by voluntarily limiting price increases on important drugs. Major pharmaceutical company Allergan has recently done just this by issuing a “social contract with patients” that made several drug pricing commitments to its customers. Among other assurances, Allergan has promised to limit price increases to single-digit percentage increases and no longer engage in the common industry tactic of dramatically increasing prices for branded drugs nearing patent expiry. Last year throughout the pharmaceutical industry, the prices of the most commonly-used brand drugs increased by over 16 percent and, in the last two years before patent expiry, drug makers increased the list prices of drugs by an average of 35 percent. Thus, Allergan’s commitment will produce significant savings over the life of a product, creating hundreds of millions of dollars in savings to health plans, patients, and the health care system.
If Allergan can make this commitment for its entire drug inventory—over 80+ drugs—why haven’t other companies done the same? Similar commitments by other drug makers might be enough to prevent lawmakers from turning to market-distorting reforms, such as price controls, that could end up doing more harm than good for consumers, the pharmaceutical industry, and long-term innovation.
Mylan Pharmaceuticals recently reinvigorated the public outcry over pharmaceutical price increases when news surfaced that the company had raised the price of EpiPens by more than 500% over the past decade and, purportedly, had plans to increase the price even more. The Mylan controversy comes on the heels of several notorious pricing scandals last year. Recall Valeant Pharmaceuticals, that acquired cardiac drugs Isuprel and Nitropress and then quickly raised their prices by 525% and 212%, respectively. And of course, who can forget Martin Shkreli of Turing Pharmaceuticals, who increased the price of toxoplasmosis treatment Daraprim by 5,000% and then claimed he should have raised the price even higher.
However, one company, pharmaceutical giant Allergan, seems to be taking a different approach to pricing. Last week, Allergan CEO Brent Saunders condemned the scandalous pricing increases that have raised suspicions of drug companies and placed the entire industry in the political hot seat. In an entry on the company’s blog, Saunders issued Allergan’s “social contract with patients” that made several drug pricing commitments to its customers.
Some of the most important commitments Allergan made to its customers include:
A promise to not increase prices more than once a year, and to limit price increases to singe-digit percentage increases.
A pledge to improve patient access to Allergan medications by enhancing patient assistance programs in 2017
A vow to cooperate with policy makers and payers (including government drug plans, private insurers, and pharmacy benefit managers) to facilitate better access to Allergan products by offering pricing discounts and paying rebates to lower drug costs.
An assurance that Allergan will no longer engage in the common industry tactic of dramatically increasing prices for branded drugs nearing patent expiry, without cost increases that justify the increase.
A commitment to provide annual updates on how pricing affects Allergan’s business.
A pledge to price Allergan products in a way that is commensurate with, or lower than, the value they create.
Saunders also makes several non-pricing pledges to maintain a continuous supply of its drugs, diligently monitor the safety of its products, and appropriately educate physicians about its medicines. He also makes the point that the recent pricing scandals have shifted attention away from the vibrant medical innovation ecosystem that develops new life-saving and life-enhancing drugs. Saunders contends that the focus on pricing by regulators and the public has incited suspicions about this innovation ecosystem: “This ecosystem can quickly fall apart if it is not continually nourished with the confidence that there will be a longer term opportunity for appropriate return on investment in the long R&D journey.”
Policy-makers and the public would be wise to focus on the importance of brand drug innovation. Brand drug companies are largely responsible for pharmaceutical innovation. Since 2000, brand companies have spent over half a trillion dollars on R&D, and they currently account for over 90 percent of the spending on the clinical trials necessary to bring new drugs to market. As a result of this spending, over 550 new drugs have been approved by the FDA since 2000, and another 7,000 are currently in development globally. And this innovation is directly tied to health advances. Empirical estimates of the benefits of pharmaceutical innovation indicate that each new drug brought to market saves 11,200 life-yearseach year. Moreover, new drugs save money by reducing doctor visits, hospitalizations, and other medical procedures, ultimately for every $1 spent on new drugs, total medical spending decreases by more than $7.
But, as Saunders suggests, this innovation depends on drugmakers earning a sufficient return on their investment in R&D. The costs to bring a new drug to market with FDA approval are now estimated at over $2 billion, and only 1 in 10 drugs that begin clinical trials are ever approved by the FDA. Brand drug companies must price a drug not only to recoup the drug’s own costs, they must also consider the costs of all the product failures in their pricing decisions. However, they have a very limited window to recoup these costs before generic competition destroys brand profits: within three months of the first generic entry, generics have already captured over 70 percent of the brand drugs’ market. Drug companies must be able to price drugs at a level where they can earn profits sufficient to offset their R&D costs and the risk of failures. Failure to cover these costs will slow investment in R&D; drug companies will not spend millions and billions of dollars developing drugs if they cannot recoup the costs of that development.
Yet several recent proposals threaten to control prices in a way that could prevent drug companies from earning a sufficient return on their investment in R&D. Ultimately, we must remember that a social contract involves commitment from all members of a group; it should involve commitments from drug companies to price responsibly, and commitments from the public and policy makers to protect innovation. Hopefully, more drug companies will follow Allergan’s lead and renounce the exorbitant price increases we’ve seen in recent times. But in return, we should all remember that innovation and, in turn, health improvements, depend on drug companies’ profitability.
Last week, the Campaign for Sustainable Rx Pricing (CSRxP)—whose membership includes health insurance companies and other health payors, health providers, and consumers—proposed various reforms aimed at addressing the high costs of prescription drugs. CSRxP declares that their proposals will improve the functioning of the pharmaceutical market by increasing pricing transparency, promoting competition, and enhancing value. Although there are some good ideas in their list of proposals, others will negatively affect the pharmaceutical market, and ultimately, consumers.
The first set of proposals is aimed at increasing transparency in drug pricing. I’ve previously commented on the likely negative effects of transparency reforms: they impose extensive legal and regulatory costs on businesses and risk harming competition if competitively-sensitive information gets into the wrong hands. CSRxP proposes that manufacturers disclose the price they intend to charge for a drug as part of the FDA approval process and, after approval, report price changes to the Department of Health and Human Services (HHS). Requiring manufacturers to report expected pricing as a condition of FDA approval suggests that the FDA’s role in assessing the risks and efficacy of drugs will merge with a central planner’s job of determining how products should be priced in the market. Will a drug not be approved if the price is too high? Shouldn’t consumers and payors, not a government agency, determine the market demand for a drug? And what will HHS do with the price change information—just condemn the “blameworthy” manufacturers or institute some sort of price control with its ensuing harms?
The second set of proposals purports to promote competition in the market for drugs. Many of these proposals are good ideas, and will help bring more and cheaper drugs to the market. However, policy makers should tread carefully with other proposals, such as a call to prohibit product-hopping, because an overeager adoption or imprecise application of these reforms could curb pharmaceutical innovation and worsen patient health outcomes. Lawmakers must ensure that adopted reforms balance incentives to innovate with the fostering of competition and lower prices.
The third set of proposals target the so-called “value” of drugs. Here, CSRxP proposes that manufacturers perform comparison studies to demonstrate that their drug is superior to existing drugs. While, in theory, knowing the relative effectiveness of drugs sounds great, there are two critical problems with this approach. First, are we really going to require more testing by drug manufacturers? It is estimated that testing and development costs already reach an average of $2.6 billion for each new drug brought to market; this is one of the explanations for the already high price of drugs. Why would we want to add more expensive testing? Also, I’m skeptical that comparison studies can offer the necessary insight into what drug works best for an individual patient. Drugs that perform extremely well for a small group of people may appear to have only average effectiveness in aggregate studies. And we certainly don’t want the expense of separate comparison studies on countless small groups of patients.
CSRxP also proposes that the government adopt value-based purchasing (VBP) arrangements that link payment for medications to patient outcomes and cost-effectiveness rather than just the quantity of treatments. Although CSRxP doesn’t detail the specific form of VBP they prefer, some of the possibilities could produce harmful consequences. Namely, VBP arrangements that set a standard payment rate for a group of similar drug products, such as reference pricing, will effectively act like a price control because the only way certain drugs will be available is if drug companies agree to offer them at that set rate. Price controls—whether direct or indirect—are a bad idea for prescription drugs for several reasons. Evidence shows that price controls lead to higher initial launch prices for drugs, increased drug prices for consumers with private insurance coverage, drug shortages in certain markets, and reduced incentives for innovation.
In sum, while CSRxP has some good ideas in their list, many of the proposals would ultimately harm the very patients the proposals are designed to benefit. Policymakers should steer clear of any reform that could act as a direct or indirect price control, increase the already high costs of developing drugs, or reduce incentives for innovation.
In an effort to control drug spending, several states are considering initiatives that will impose new price controls on prescription drugs. Ballot measures under consideration in California and Ohio will require drug companies to sell drugs under various state programs at a mandated discount. And legislators in Massachusetts and Pennsylvania have drafted bills that would create new government commissions to regulate the price of drugs. These state initiatives have followed proposals by presidential nominees to enact new price controls to address the high costs of pharmaceuticals.
As I explain in a new study, further price controls are a bad idea for several reasons.
First, as I discussed in a previous post, several government programs, such as Medicaid, the 340B Program, the Department of Defense and Veterans Affairs drug programs, and spending in the coverage gap of Medicare Part D, already impose price controls. Under these programs, required rebates are typically calculated as set percentages off of a drug company’s average drug price. But this approach gives drug companies an incentive to raise prices; a required percentage rebate off of a higher average price can serve to offset the mandated price control.
Second, over 40 percent of drugs sold in the U.S. are sold under government programs that mandate price controls. With such a large share of their drugs sold at significant discounts, drug companies have the incentive to charge even higher prices to other non-covered patients to offset the discounts. Indeed, numerous studies and government analyses have concluded that required discounts under Medicaid and Medicare have resulted in increased prices for other consumers as manufacturers seek to offset revenue lost under price controls.
Third, evidence suggests that price controls contribute to significant drug shortages: at a below-market price, the demand for drugs exceeds the amount of drugs that manufacturers are willing or able to sell.
Fourth, price controls hinder innovation in the pharmaceutical industry. Brand drug companies incur an average of $2.6 billion in costs to bring each new drug to market with FDA approval. They must offset these significant costs with revenues earned during the patent period; within 3 months after patent expiry, generic competitors will have already captured over 70 percent of the brand drugs’ market share and significantly eroded their profits. But price controls imposed on drugs under patent increase the risk that drug companies will not earn the profits they need to offset their development costs (only 20% of marketed brand drugs ever earn enough sales to cover their development cost). The result will be less R&D spending and less innovation. Indeed, a substantial body of empirical literature establishes that pharmaceutical firms’ profitability is linked to their research and development efforts and innovation.
Instead of imposing price controls, the government should increase drug competition in order to reduce drug spending without these negative consequences. Increased drug competition will expand product offerings, giving consumers more choice in the drugs they take. It will also lower prices and spur innovation as suppliers compete to attain or protect valuable market share from rivals.
First, the FDA should reduce the backlog of generic drugs awaiting approval. The single most important factor in controlling drug spending in recent decades has been the dramatic increase in generic drug usage; generic drugs have saved consumers $1.68 trillion over the past decade. But the degree to which generics reduce drug prices depends on the number of generic competitors in the market; the more competitors, the more price competition and downward pressure on prices. Unfortunately, a backlog of generic drug approvals at the FDA has restricted generic competition in many important market segments. There are currently over 3,500 generic applications pending approval; fast-tracking these FDA approvals will provide consumers with many new lower-priced drug options.
Second, regulators should expedite the approval and acceptance of biosimilars—the generic counterparts to high-priced biologic drugs. Biologic drugs are different from traditional medications because they are based on living organisms and, as a result, are far more complex and expensive to develop. By 2013, spending on biologic drugs comprised a quarter of all drug spending in the U.S., and their share of drug spending is expected increase significantly over the next decade. Unfortunately, the average cost of a biologic drug is 22 times greater than a traditional drug, making them prohibitively expensive for many consumers.
Fortunately, Congress has recognized the need for cheaper, “generic” substitutes for biologic drugs—or biosimilars. As part of the Affordable Care Act, Congress created a biosimilars approval pathway that would enable these cheaper biologic drugs to obtain FDA approval and reach patients more quickly. Nevertheless, the FDA has approved only one biosimilar for use in the U.S. despite several pending biosimilar applications. The agency has also yet to provide any meaningful guidance as to what standards it will employ in determining whether a biosimilar is interchangeable with a biologic. Burdensome requirements for interchangeability increase the difficulty and cost of biosimilar approval and limit the ease of biosimilar substitution at pharmacies.
Expediting the approval of biosimilars will increase competition in the market for biologic drugs, reducing prices and allowing more patients access to these life-saving and life-enhancing treatments. Estimates suggest that a biosimilar approval pathway at the FDA will save U.S. consumers between $44 billion and $250 billion over the next decade.
The recent surge in drug spending must be addressed to ensure that patients can continue to afford life-saving and life-enhancing medications. However, proposals calling for new price controls are the wrong approach. While superficially appealing, price controls may have unintended consequences—less innovation, drug shortages, and higher prices for some consumers—that could harm consumers rather than helping them. In contrast, promoting competition will lower pharmaceutical prices and drug spending without these deleterious effects.
Politicians have recently called for price controls to address the high costs of pharmaceuticals. Price controls are government-mandated limits on prices, or government-required discounts on prices. On the campaign trail, Hillary Clinton has called for price controls for lower-income Medicare patients while Donald Trump has recently joined Clinton, Bernie Sanders, and President Obama in calling for more government intervention in the Medicare Part D program. Before embarking upon additional price controls for the drug industry, policymakers and presidential candidates would do well to understand the impacts and problems arising from existing controls.
Unbeknownst to many, a vast array of price controls are already in place in the pharmaceutical market. Over 40 percent of outpatient drug spending is spent in public programs that use price controls. In order to sell drugs to consumers covered by these public programs, manufacturers must agree to offer certain rebates or discounts on drug prices. The calculations are generally based on the Average Manufacturer Price (AMP–the average price wholesalers pay manufacturers for drugs that are sold to retail pharmacies) or the Best Price (the lowest price the manufacturer offers the drug to any purchaser including all rebates and discounts). The most significant public programs using some form of price control are described below.
Medicaid
The Medicaid program provides health insurance for low-income and medically needy individuals. The legally-required rebate depends on the specific category of drug; for example, brand manufacturers are required to sell drugs for the lesser of 23.1% off AMP or the best price offered to any purchaser.
The Affordable Care Act significantly expanded Medicaid eligibility so that in 2014, the program covered approximately 64.9 million individuals, or 20 percent of the U.S. population. State Medicaid data indicates that manufacturers paid an enormous sum — in excess of $16.7 billion — in Medicaid rebates in 2012.
340B Program
The “340B Program”, created by Congress in 1992, requires drug manufacturers to provide outpatient drugs at significantly reduced prices to 340B-eligible entities—entities that serve a high proportion of low-income or uninsured patients. Like Medicaid, the 340B discount must be at least 23.1 percent off AMP. However, the statutory formula calculates different discounts for different products and is estimated to produce discounts that average 45 percent off average prices. Surprisingly, the formulas can even result in a negative 340B selling price for a drug, in which case manufacturers are instructed to set the drug price at a penny.
The Affordable Care Act broadened the definition of qualified buyers to include many additional types of hospitals. As a result, both the number of 340B-eligible hospitals and the money spent on 340B drugs tripled between 2005 and 2014. By 2014, there were over 14,000 hospitals and affiliated sites in the 340B program, representing about one-third of all U.S. hospitals.
The 340B program has a glaring flaw that punishes the pharmaceutical industry without any offsetting benefits for low-income patients. The 340B statute does NOT require that providers only dispense 340B drugs to needy patients. In what amounts to merely shifting profits from pharmaceutical companies to other health care providers, providers may also sell drugs purchased at the steep 340B discount to non-qualified patients and pocket the difference between the 340B discounted price and the reimbursement of the non-qualified patients’ private insurance companies. About half of the 340B entities generate significant revenues from private insurer reimbursements that exceed 340B prices.
Departments of Defense and Veterans Affairs Drug Programs
In order to sell drugs through the Medicaid program, drug manufacturers must also provide drugs to four government agencies—the VA, Department of Defense, Public Health Service and Coast Guard—at statutorily-imposed discounts. The required discounted price is the lesser of 24% off AMP or the lowest price manufacturers charge their most-favored nonfederal customers under comparable terms. Because of additional contracts that generate pricing concessions from specific vendors, studies indicate that VA and DOD pricing for brand pharmaceuticals was approximately 41-42% of the average wholesale price.
Medicare Part D
An optional Medicare prescription drug benefit (Medicare Part D) was enacted in 2005 to offer coverage to many of the nation’s retirees and disabled persons. Unlike Medicaid and the 340B program, there is no statutory rebate level on prescription drugs covered under the program. Instead, private Medicare Part D plans, acting on behalf of the Medicare program, negotiate prices with pharmaceutical manufacturers and may obtain price concessions in the form of rebates. Manufacturers are willing to offer significant rebates and discounts in order to provide drugs to the millions of covered participants. The rebates often amount to as much as a 20-30 percent discount on brand medicines. CMS reported that manufacturers paid in excess of $10.3 billion in Part D rebates in 2012.
The Medicare Part D program does include direct price controls on drugs sold in the coverage gap. The coverage gap (or “donut hole”) is a spending level in which enrollees are responsible for a larger share of their total drug costs. For 2016, the coverage gap begins when the individual and the plan have spent $3,310 on covered drugs and ends when $7,515 has been spent. Medicare Part D requires brand drug manufacturers to offer 50 percent discounts on drugs sold during the coverage gap. These required discounts will cost drug manufacturers approximately $41 billion between 2012-2021.
While existing price controls do produce lower prices for some consumers, they may also result in increased prices for others, and in the long-term may drive up prices for all. Many of the required rebates under Medicaid, the 340B program, and VA and DOD programs are based on drugs’ AMP. Calculating rebates from average drug prices gives manufactures an incentive to charge higher prices to wholesalers and pharmacies in order to offset discounts. Moreover, with at least 40% of drugs sold under price controls, and some programs even requiring drugs to be sold for a penny, manufacturers are forced to sell many drugs at significant discounts. This creates incentives to charge higher prices to other non-covered patients to offset the discounts. Further price controls will only amplify these incentives and create inefficient market imbalances.
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