A reader asked me to comment on this story, about the guy whose firm bought the license for a drug and then jacked up its price.
1. I don’t know the whole story in the example. My understanding is that with a decades-old drug, the patent is no longer effective, and generics can be made. So there is something going on here that has not been explained in the stories that I have read.
2. In theory, if someone bought a license to a drug, the cost of the license was tied to the potential revenue from the drug. We might want the value of such a license to be high in order to encourage drug research and development. But again, I am missing some important institutional details in this case.
3. Assuming that the value of the license for the drug indeed is high, then this is a fixed cost. Like many products nowadays (electricity, data transmission, digital content), pharmaceuticals are characterized by low marginal cost and high fixed cost. A price that is efficient in that it is close to marginal cost is too low to cover the fixed cost.
4. This means that there is no price that is “correct.” It also means that price discrimination often can improve the outcome. That is, charge a high price to the people willing to pay such a price, but get additional revenue by charging other consumers a price closer to marginal cost. As I tell my economics students, “price discrimination explains everything.”
5. Another option, in the case of pharmaceuticals, would be to offer prizes instead of patents. Prizes could be funded by taxpayers, or they could be funded by associations of people who would benefit from the medications.
6. However, price controls on medications treat only a symptom, without getting at the underlying problem. Price controls will lower the value of licenses to produce a drug, and that means less incentive to undertake research and development.
UPDATE: Alex Tabarrok says that we thank the FDA for the lack of generic competition.
Also, on this post, commenter Matt had an interesting solution. He would have the FDA issue blanket licenses to proven-quality generic drugmakers, so they they could instantly start to copy any drug that goes off patent without having to submit samples of that particular drug for approval.
I always thought the easiest way to have better US prices is allow consumers to buy from foreign distributors. (I believe TPP is trying to make patents stronger across borders.) Today, a pharma company can charge $700 for a thirty day supply in the US and $300 in Canada which together covers the high fixed cost. If you the consumer can buy $300 from Canada distributor then Pharma can’t mark up the US prices so much.
The missing piece of the puzzle is regulation, and coordination. In order for MATTCO to produce a generic drug, I need to get approval, it takes years and costs more than a million dollars. Now but coming in as a competitor all I can do is lower the price, that is not a good reason to get into a market. But if for some reason I still want to manufacture this drug, I produce some test batches I could send them to the FDA to be approved, or I can send it to the company already producing it, and say you need to pay me not to make them.
The best solution would be to give firms who produce good generics a blanket license to start producing anything they wanted. Instead of approvals we could have inspections, with criminal prosecution for those whose drugs don’t meet the standard.
This is thinking along the correct path. The bottleneck in such niche generic drugs with a single licensed producer is the time and money required to enter/re-enter the market. This is why the gouging works in the first place- the real market forces involved are taking too long to respond to the price rise.
Isn’t this the FDA problem. Not that they demand a test, but that their procedures make it so burdensome in time and money. Independent and top-tier reliability QA doesn’t cost that much or take that long.
So, it’s not that you need a license for “presumptively good guy generic maker” but there is something fundamentally unjustifiable about the character of the FDA per-generic approval process.
My understanding is that the drug is generic but the lead time for a competitor to undercut this company is so long that the price will stick without any government protections existing anymore. I can’t find a link now but the gist was that some ingredient in the drug is hard to make/find and thus it’s not a simple matter to just run off a batch in India and sell them for half the price.
Also, my understanding of the license is that it’s an exclusive license from the previous (large) owner of the patent that no longer wants to be involved in this small market for this obscure drug. I think the license simply says that the original company won’t reenter the market or license the name/brand/technology to anyone else. I don’t understand the license to have anything to do with the government.
Leaving aside the morality, I don’t think this is technically “rent seeking” in that eventually some competitor will reenter the market and drop the price. It seems to be more like “price gouging”. (And yes I know economically that’s kind of a null term.)
I have often wondered if true free-market economists actually think this kind of “friction” is a market failure. I suspect that this hedge fund manager is probably going to be unpleasantly surprised with how fast a Chinese or Indian company can reenter the market and drop the price. Competition in pharma absent government corporate welfare (IE: patents) has gotten pretty aggressive lately.
if a new competitor were to come along, there would obviously be start up costs and time associated with producing the drug. So that would explain why this guy did not fear brand new entrants, the threat of dropping the price back to the original after investing all that effort would keep all at bay. But I am sure Merck and Pfizer (to name two) have the knowledge and the dormant production lines that could quickly be re-tooled and used to produce the drug. So there must be additional barriers to entry. Those barriers are the regulations from the FDA. You need to have approval from the FDA to manufacture a drug (in this case an ANDA). You also have to have your processes and production facilities validated. All which costs significant money. After investing that, the guy drops the price and Pfizer/Merck take a bath. Regulations are protecting existing producers, which I am sure is a big surprise.
also as one other commentators stated, the license probably protects him from the original manufacturer, who would have many of the regulatory requirements meet and could re-start production fairly quickly.
Why couldn’t/wouldn’t the prior license holder raise the price? Is there a premium for those willing to hold bad reputations? Where do I sign up?
I think the answer to your question is “Yes”, there is a cost to a bad reputation, one the buyer of the license is willing to pay.
Everyone else has it wrong, it’s not that the startup costs are too high, it’s that they’re too low. This is how I’ve heard it at least:
The market is too small to have multiple entrants. If it was a perfectly competitive industry, total revenues would be in the 6 figure range, maybe 5 or 4 in some cases. Since the costs of entry is low, if there was economic profit, new entrants would quickly bid down price to marginal cost, and as such no one enters the market. This is sometimes called the tragedy of the anti-commons. The solution is for the government to issue monopoly rights to a single company so that *someone* makes it. Smart investor buy one of these up and rigs the price super high in the hopes of extracting rents from an apathetic monospony.
1: Drug A is an essential drug
2: Drug A’s price is raised to absurd levels and is now unaffordable
3: Government / Insurers will pay for drug A because it’s essential.
4: No one cares because it’s only a few million a year.
5: Profit!
Normally monospony would reduce prices, and it probably does somewhat from point 2 to point 3, but because third parties are paying for it it’s a perfectly inelastic good, the supplier has monopolistic rights for it, and marginal costs approach 0.
The solution might be to just have the state take over production completely, but that has other inefficiencies. You could also turn it over to a free market: likely importing the drugs from a poorer nation for whom very tiny economic profit is actually competitive with their national investment norms. Someplace like Haiti, where making a few pennies profit might be worth it.
A similar thing happened with prestigious academic journals. For decades they were run as de facto non-profits and then some big publishers realized they could buy up the journals and jack the prices — university libraries couldn’t afford not to subscribe and academics couldn’t afford to switch to non-prestigious journals (at least not immediately). So, it’s been a long, slow process to try to move to low cost ‘open access’ journals.
The law of increasing returns leads to natural monopolies. Only careful support of multiple suppliers by consumers and antitrust can prevent it.
My understanding, gained mostly from reading Derek Lowe: http://blogs.sciencemag.org/pipeline/archives/2015/09/21/martin-shkreli-has-one-idea-and-its-a-bad-one
is that these are mostly situations where companies use FDA regulations to get sole right to sell a drug for a period, even though it’s gone generic. For example:
“The FDA grants market exclusivity to companies that are willing to take “grandfathered” compounds into compliance with their current regulatory framework”
“There are also loopholes that companies are trying to exploit when competitors try to prove generic equivalence: whatever it takes to keep competition away and get unlimited pricing power.”
It basically comes down to: the FDA is a hammer. They can give you exclusivity, or ban you from making/selling a drug, and that’s about it. They don’t do their own research, they don’t test drugs, they simply say ‘you may only sell if you meet our conditions’. Which means the market is always either no-one, monopoly, and competition, depending on the applicable FDA policies and the cost to satisfy them.
He also briefly mentions third-party payers. Who actually cares what drug prices are?