The Hatch-Waxman Act of 1984, a landmark legislation, paved the way for the modern generic drug market, resulting in substantial cost savings in the healthcare sector. In 2021, the utilization of generic and biosimilar drugs generated significant savings in healthcare expenditures. Over 90% of prescriptions dispensed that year were for generic or biosimilar medications, a remarkable increase from just over 18% when Hatch-Waxman was enacted.
However, generic drugs have seemingly become victims of their own success. Essential drug categories, ranging from antibiotics and chemotherapies to saline solutions, are experiencing persistent shortages. Why is this happening? Prices have plummeted to such an extent that manufacturers lack the financial resources to produce adequate drug quantities or maintain quality standards. Consequently, shortages have become a prevalent issue in the generic pharmaceutical industry.
The dominance of a small number of group purchasing organizations (GPOs) has been identified as a contributing factor to this problem. GPOs, which act as intermediaries between hospitals, clinics, surgery centers, and home health agencies, wield considerable purchasing power. They leverage their near-monopoly status to drive prices down to unsustainable levels.
A straightforward solution to this dilemma would be to restore competitive market dynamics, potentially by dismantling these mammoth GPOs into smaller, competing entities or implementing price caps and quality regulations that prevent rapid responses to shortages. However, economists argue that GPO pricing power alone cannot fully explain the chronic shortages of generic drugs.
Hypothetically, if a GPO possesses significant pricing power, enabling them to dictate terms to generic drug manufacturers, what price would they set? Rational GPOs would not intentionally create drug shortages or compromise quality, as these actions would alienate their customers, the healthcare systems and clinics whose patients rely on these medications. Therefore, GPOs would likely offer a price sufficient to guarantee an adequate supply of quality drugs. Setting a lower price would reduce supply, while a higher price would erode margins. Thus, GPO pricing power should not inherently lead to persistent shortages, even if it allows GPOs to negotiate low prices from generic manufacturers.
An alternative explanation for the persistent shortages highlights the incentives for GPOs to ensure an adequate supply. A large GPO that prioritizes eliminating shortages could offer drugmakers conditional payments for establishing sufficient production capacity or inventory for vulnerable drugs. However, the additional capacity or inventory resulting from these payments would also benefit competing GPOs. Since the benefits of GPO payments extend beyond the paying GPO, the incentives for individual GPOs to secure supply are insufficient, leading to chronic shortages. This same dynamic weakens the incentives for GPOs to ensure adequate drug quality. Economists refer to this type of market failure as a ‘common agency problem.’
According to economic theory, market competition alone cannot resolve common-agency problems. For instance, breaking up GPOs into smaller entities would exacerbate the spillover problem. Government intervention is necessary to stimulate the market. Such interventions could include subsidies to ensure the supply of shortage-prone drugs, incentives for hospitals and clinics to create reserves in preparation for supply chain disruptions, and enhanced quality monitoring. Non-governmental entities can also play a role. The Biden administration recently announced an initiative that relies on the establishment of two non-governmental organizations to oversee supply chain resilience, one for manufacturers and one for hospitals. Influential private players can amplify the impact of government actions. For example, a public commitment by one of the largest GPOs to pay prices that guarantee uninterrupted supply for a specified period could entice manufacturers back into the generic drug market.
The case of generic drugs demonstrates that market-based innovation is essential but may not always be sufficient to improve healthcare outcomes and reduce costs. Sometimes, markets require assistance to function effectively. This assistance can come in various forms, including government subsidies, industry incentives, and non-governmental initiatives. The goal is to address market failures and ensure a reliable supply of affordable, high-quality generic drugs for the benefit of patients and the healthcare system as a whole.
