Code Red: Two Economists Examine the U.S. Healthcare System

May 21, 2015

Competition: The Best Cure for Rising Drug Prices

Filed under: Uncategorized — David Dranove and Craig Garthwaite (from Oct 11, 2013) @ 5:23 am

Apologies for our recent hiatus from blogging.  One of us (Garthwaite) was conducting some field research in health care related to the birth of his second child.  We will now return to our semi-regular blogging schedule.

As the ACA insurance expansion begins to fully take hold, attention is returning to the seemingly ever growing cost of care in the United States.  Many voices are chiming in about the need to pay greater attention to the rising prices paid for medical services and pharmaceuticals. Last week we held Kellogg’s annual MacEachern Symposium. Featured speaker Amitabh Chandra put rising prices atop the list of reasons for healthcare cost growth. And a recent Bloomberg View editorial has called for price regulation of medical services (we should note that Chandra’s focus on prices was not a similar call for price regulation).

The central topic of this year’s MacEachern Symposium was the rising prices of specialty pharmaceutics, the poster child for which is Sovaldi, which is Gilead’s cure for hepatitis C and carries a price tag of about $84,000 for a course of treatment. These high prices have attracted a great deal of attention and led many to call for regulators to lower them by any means necessary. For example, President Obama has recently called for Medicare to be allowed to use its monopsony power to “bargain” down the price of pharmaceuticals.

It is dangerous to introduce new regulations to solve a problem without fully understanding the cause of the problem. At the most basic level, these prices are high because we grant 20 year patents to innovating firms to provide an incentive for them to make large risky investments in research and development.  If one factors in the very low probability that any patent turns into a marketable drug, the cost per new drug may be $2 billion or higher. Given the length of the regulatory process, the effective patent length results in about 12-13 years of time where the innovating firm can sort of act as a monopolist and set a profit maximizing price.  We say “sort of” because patents cannot prevent competition from different drugs that target the same diseases a feature that blunts the monopolists pricing power. As a case in point, Sovaldi already faces competition from newer drugs such as Harvoni (also developed by Gilead) and Viekira Pak (developed by Abbvie), and prices have fallen considerably.  And once patents run out, generic manufacturers can enter the market with an effectively perfect substitute for the product resulting in price decreases of approximately 70 percent.

It must also be pointed out that Gilead and the other makers of high priced drugs could never achieve such high volumes at such high prices if drugs weren’t covered so generously by health insurance.  Without insurance, very few Americans could afford the cost of Sovaldi, let alone the six figure price tags of many new cancer drugs. As a result, expansions of insurance such as those under the ACA and the creation of Medicare Part D, while laudable as goals, are part of the cause of high prices.

Taking these facts together, we note that if you want to lower drug prices you should be looking at either the current structure of the patent system or the design of the federally subsidized insurance system – both of which serve as distortions in the market. This is likely the reason for President Obama’s misguided focus on increasing Medicare’s monopsony power for drugs.  We discuss below why this would a problem and why instead, we think the President should focus on a particular feature of Part D that is likely driving higher prices for certain types of drugs.

Peter Bach of Memorial Sloan Kettering noted at the Maceachern Symposium, Medicare Part D has six “protected classes” of drugs where insurers were forced to offer coverage for every available product.  These categories are anti-cancer; anti-psychotic; anti-convulsant, anti-depressants, anti-psychotic, immuno-suppressant, and HIV and AIDS drugs. These protected classes all but assure that innovators can charge whatever they want to all insurers, not just those in part D, because private insurers that fail to follow Medicare’s lead can be sued for inadequate coverage.  A suit that would be hard to win when the poorly funded social insurance program offers coverage for the service.

With these facts in mind, we note that President Obama is upset about the monopoly prices caused by patents and his solution is to increase the market power of social insurers.  It might seem that increasing the clout of purchasers will make the drug market more competitive, but this is decidedly not the case.  The answer to having “too much” market power by one participant should not be to attempt to increase the market power of the other participants.

Instead, the President should think about doing things that increase competition among the drug makers.  First, he could think about implementing patent reform.  If what we desire is that pharmaceutical firms earn less money while their drugs are under patent then perhaps we should consider addressing the route of that alleged “problem.” Perhaps patents are too long and that should be fixed?  Or we could imagine systems that have been proposed wherein the breadth of the patent being a function of the value that the drug brings to market.  There are many reforms that we could look at if we think that the market imperfections created by patents are providing too many rents to innovating firms.

After considering patent reform, he could look into reforming the existing rules of Part D that bind that hands of insurance companies participating in that program.   If insurers can’t threaten to remove a drug from its formulary it’s very hard to effectively negotiate price discounts. And these discounts can be quite substantial.  Consider the case of Gilead’s Sovaldi.  While this drug was originally priced at $84,000, this was only the case while it was the only oral treatment that cured hepatitis C.  Less than a year later, Abbvie released Viekira Pak.  Initially, this drug was priced similar to Sovaldi.  However, as a result of competition between these products they are each now selling at a reported 40 percent discount.  Express Scripts, the nation’s largest pharmacy benefit manager, achieved this discount by removing Sovaldi from its formulary for the vast majority of its patients.  However, if Express Scripts wanted to attempt the same strategy with its equally expensive oncology products they would not be able to since CMS requires them to provide coverage for all of these products.  The best they could accomplish is to put different products on different cost sharing tiers – a far less threatening action given the cost of these drugs.

Removing protected class status would actually introduce more competition into drug pricing for Medicare.  Some people may argue that removing the drugs protected class status would deny needed pharmaceuticals to individuals, particularly those who might not respond to one therapeutic substitute compared to another.  In fact, a recent attempt by the Center for Medicare and Medicaid services to remove some of these protected classes was roundly criticized. However, it is important to realize that any attempt to lower the returns of pharmaceutical companies will, at the margin, decrease new drugs from entering the market.  Our recent research shows that many of the new drugs that are developed in response to small changes in expected returns are the very same me-too products and therapeutic substitutes that were individuals are worried about lacking coverage if the protected classes go away. While we note that our proposed solution of removing protected classes also involves lowering expected returns, we would hope that policies that remove inefficiencies in the market are superior to those that introduce even greater inefficiencies.

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