Fed up with high drug prices? Why not make your own?
Well, okay, for most of us that’s not very practical. But hospitals have decided that’s just what they’re going to do: get into the business of manufacturing generic drugs.
“This is a shot across the bow of the bad guys,” Marc Harrison told the New York Times. Harrison is the chief executive of Intermountain Healthcare, the nonprofit hospital group that’s leading this effort. “We are not going to lay down. We are going to go ahead and try and fix it.”
Business school professors are probably watching with a more jaundiced eye. Getting into the supply business is not exactly a revolutionary idea; it’s a well-known strategy called “vertical integration” that has been tried — and often rued — by many a company. While vertical integration can certainly work, it can also turn out to be a great way to lose a lot of money and screw up your core business. (Have you seen “Weeds”?)
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Companies tend to pursue vertical integration for the same reasons that these hospitals are: because they are fed up with high prices and short supplies of some key input. They figure that if they got into the business, they’d produce as much as was needed, and eliminate all the grotesque profits their suppliers are enjoying — or better yet, capture those profits for themselves. Rarely do they seem to stop to ask the reasons for the high prices and the scarcity, or to wonder whether those reasons will magically go away once they own their suppliers (or their buyers, a kind of vertical integration known as “forward integration”).
So let’s think through this for them. Why are supplies constrained, and prices high, in the generic drug business? Remember that we’re not talking about the much-maligned major drug manufacturers, who have valuable patents preventing others from manufacturing their drugs. The hospitals are talking about making generics, the basic instructions for which are in the public domain.
In an economics-textbook universe, we’d expect to see competitors looking at the high profits that companies are able to charge, and eagerly pile into the market, driving down prices until they are once again at competitive levels. Why doesn’t this happen?
Well, often it does. One thing that is underappreciated about the evil-genius strategy pursued by folks like Martin Shkreli is that it’s a short-term strategy. You may be able to corner the market for Epi-Pens or diabetes meds or anti-malarials for a little while and charge astronomical fees for your product. But if you’re selling something at a 5,000% markup, competitors are going to hustle in and eventually, your margins will fall back to normal.
But how do they even manage to get that kind of markup for a little while? Alex Tabarrok, an economist at GMU, explained it best at a panel in 2016: They’re exploiting the barrier to entry created by FDA approvals.
Essentially, these price increases tend to happen in generics market with some very specific characteristics: A product has only one manufacturer (often because the market is so small it can only really support one manufacturer at competitive prices); the drug is necessary to treat some condition; and the drug has no good substitutes.
These markets are vulnerable to evil geniuses who grasp their market power and decide to jack up the price to kingdom come, knowing that competitors will be afraid to enter. And why would anyone fear to enter a market that currently offers a 5,000% markup? Because they know that they’ll never get that markup. If they enter and offer, say, a 4,500% markup to steal the former monopolist’s customers, that provider will cut prices to a 4,000% markup, and the newcomer will have to go down to a 3,000% markup to get the customers back, and pretty soon the drug will be trading at a competitive price.
In the meantime, you’ll have expenses. You’ll have to figure out how to make the drug (harder than it sounds, even though the basic information is available from the patent filing). You’ll have to set up a factory to produce it. And you’ll have to get the FDA to certify that the drug you’re making is reasonably pure and safe for consumption by American patients. This doesn’t cost as much as getting a new drug approved, but it’s not free, and it takes quite a bit of time. And if the market is small, it’s not necessarily clear that you’ll ever recoup those expenses, because splitting a small market with another manufacturer may mean that you both lose money.