Shortages and price gouging

Healthcare microeconomics on the brink

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The shaming campaign that followed the news of two generic drug prices somersaulting into the stratosphere after being acquired by private companies is not too surprising.  The idea that a drug which cost $13.50 one day can cost $750 the next, seemingly on the whim of greedy Wall Street investors and pharma start-ups, is fodder for the outrage machine.

But what the outrage machine does not realize is the extent to which the generic healthcare supplies are constantly on the brink of shortage.

Every week I get a “drug shortage report” by email from my hospital.  It lists the various items in short supply.  Some drugs (for the most part generic ones) may even be absent from the shelves.  And every week, the email also reminds me that there is a national shortage of normal saline.

NS-shortage

Normal saline, for heaven’s sake!

What’s going on? Is our productive capacity in such a shamble that we can’t have the wherewithal to mix sterile salt and water and put it into a bag?

Let’s go back to the basics.

Remember that in order for any product to be available in a sustainable way, there must be a supplier willing to make it and a buyer willing to pay for it at the price the supplier expects.  Multiple buyers bid the price up, multiple suppliers bid it down.

It seems that for something as commodified a normal saline, making plenty of it should not be too much of a problem.  After all, there is no shortage of #2 pencils, even if the profit margin on pencils is minuscule.

Welcome to our glorious world of regulated health economics.

On the buyer side, you have hospital administrators which have been trained to operate under the reality of fixed payments and onerous oversights.  Every expense is a cost that cannot be passed on to the ultimate “consumer” of the good.  Therefore, the lower the price of supplies, the better.

On the supply side, the regulatory apparatus overseeing the making of medical products is not known for its flexibility.  The last things bureaucrats want is any intimation that they are not tough enough on bugs and safety!  Manufacturers must follow rules which have no regards for market realities and for how much the intended customer will be willing to spend for the product.  For something like normal saline, profit margins become dangerously thin and may even be negative.

In such an environment, the tendency is for consolidation and bureaucratization.  Manufacturers with disappearing profit margins merge.  Indeed, we are left with a handful of mega-suppliers of hospital commodities.  Purchasers also consolidate into large hospital chains or pool their buying resources into purchasing cooperatives.

These impersonal buyers and sellers, who are further and further removed from the ultimate use of the product, bundle purchases of commodities in large bulks.  Normal saline is now bought and sold as a package deal with all sorts of other sundries, like toilet paper, tooth paste and plastic tubs.

With the bundling of commodities, the system is prone to miscalculate supply and demand predictions.  Demand predictions cannot be made with great accuracy because of the more centralized nature of the enterprise.  And if a mismatch were to occur, no one would be held accountable.  “There’s a shortage!” administrators on either side would say fatalistically.

Now, if we’re teetering on the brink of a shortage with something as widely needed and as easily produced as normal saline, it’s only to be expected that we would face actual shortages of generic drugs for rare diseases.

For the drug maker, the regulatory costs are unchangeable, whether the drug is used by many or by few.  At the other end of the transaction, buyers are third-party payers whose interests and willingness to pay do not reflect the needs of the ultimate consumer.  Producing generic drugs in such conditions offers no great hope of sustainability.

Under normal circumstances, if the economics of a product are such that it cannot be manufactured in the country except at a loss, an extremely effective safety valve is provided by the importation market.  Lower foreign manufacturing costs can ensure an additional source of supply for the good.

Not so in healthcare, not so.

Our wise legislators, encouraged by the pharmaceutical industry and supported by the entrenched regulatory bureaucracy, have decided that importing medications for the outside is a big no-no.  “It wouldn’t be safe!” they claim.

Not safe when we can produce plenty, perhaps.  But safer than an actual shortage?  Ergo, an opportunity for the “price gouger” about whom we should also add a few words.

First of all, to the extent that some patients are able to obtain access to the treatment after the price hike, the price gouger provides at least a modicum of service.  In her absence, there may be no drug available at all.¹

Second, “price gouging” is a loose term that has no real economic meaning.   There is no particular price increase that defines it.  Nowhere in the press will we find what the “break-even” price might be for making cycloserine or pyrimethamine, to inform us of the magnitude of the expected profit.

As a matter a fact, the break-even price of any product can only be guesstimated, and the only one effectively willing to make that guess is the entrepreneur who engages and risks her assets.  We must keep in mind that every entrepreneurial activity, however obnoxious it may seem to us, involves incommensurable risk or uncertainty.

It is not in the realm of the impossible, for example, that a price gouger could find itself losing money, even with a 5,000% initial price increase:  under such conditions, patients and doctors may figure out alternative modes of treatment with existing drugs or (a happy outcome!), deregulation could allow the importation of these drugs from outside, thus evaporating the expected profit.

Third, to the extent that she wakes us up from our stupor, the price-gouger serves as a very effective signaling mechanism, telling us of a gaping unmet need she has managed to find a temporary solution for—however unpleasant and expensive her pill may be to swallow.  She thus necessarily invites competitors to follow suit, or prompt us to re-examine the particular economic and regulatory environment that has fostered the shortage in question.

And we may wish to do that fast.  Normal saline could be the next vital supply to dry up.


Notes:

1. The non-profit entity which transferred the cycloserine manufacturing rights to Roselis, for example, had lost $10 million dollars since acquiring those rights.  One must presume that it decided that selling at the historical price was unsustainable and would have stopped if no buyer presented itself.

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2 thoughts on “Shortages and price gouging

  1. We share your outrage about generic drug shortages. Unfortunately too many physicians and other providers, particularly those who lack an understanding of the fundamentals of economics, have begun to see this travesty as the “new normal.” The saline shortages and Turing/Valeant are both manifestations of a broken marketplace. To understand how this could happen in what is supposed to be a market economy, visit our website, http://www.physiciansagainstdrugshortages.com.
    Contact me if you’d like to discuss.
    Best
    Phil Zweig MBA
    Executive Director
    Physicians Against Drug Shortages

    • Phil,

      Thank you for your comment and link. While I have no doubt that GPOs benefit from the situation as you describe, I don’t think that the solution is more government intervention as you propose. Anti-kickback laws applied to GPOs will not restore a healthy competitive environment nor affect all the other dysfunctional incentives so prevalent in the system.

      Michel