What’s Really Causing The Drug Shortages

DrRich | November 8th, 2011 - 6:33 am

Podcast:

Last week, President Obama took unilateral Presidential action to fix the drug shortages that have been plaguing American hospitals since 2005.

He has been taking unilateral Presidential action quite a lot lately, in his effort to publicly emphasize the recent unwillingness of Congress to do his bidding, and to illustrate to us in the great unwashed how much better things would be if only the President could just go ahead and do all the stuff that needs to be done, without having to take the legislature into account.

For problems like this (i.e., drug shortages, lack of jobs, loss of “spirit,” &c.) are the price we pay when we insist on holding our leaders to the constraints imposed by some old, dusty, outdated document, written by someone else’s ancestors. (For how many of us, really, descend from either the Roundheads or the Cavaliers who wrote the thing?)

There are other ways one might run an enterprise, you know, that Adams or Jefferson probably never thought of.

In any case it is somewhat surprising that this time the President failed to take full advantage of the occasion. Namely, he did not blame George Bush for the drug shortages. He missed a real opportunity there, because had he done so he would have been more correct than usual.

Shortages of certain critical drugs have become a serious problem over the past six years or so. Generally speaking the drug shortages have involved sterile, injectable generic drugs. Sterile injectables are relatively expensive to make, and because the requirement for sterility dictates they must have a finite (and relatively short) shelf life, they are relatively expensive to manage logistically after they are made.

The shortages are in some of the more important and critical drugs used in medicine, including “crash cart” cardiovascular drugs, antibiotics, and important chemotherapy agents used for cancer. In recent years increasing numbers of patients with life-threatening illnesses have not been able to receive the drugs they need to optimize their odds of survival, and they have had to receive some substitute therapy, that is, instead of getting the drug they ought to have, they get a drug that is available. When your life is in the balance this is not a pleasant thing.

The FDA keeps an on-line list of current drug shortages, which can be found here. The list is impressively long.

Many experts (the usual suspects) have looked into the problem of drug shortages, and have come up with many explanations for it. Typically, after analysis, the reason for the shortages is said to be “multifactorial,” and includes: insufficient production space, disruptions in the supply of raw materials, several drug makers opting out of the generic drug business, and a spate of manufacturing quality issues that have resulted in prolonged production interruptions. The term “drug company greed” often hovers just beneath the surface of such explanations, and sometimes actually breaches.

Here is the formal position the FDA has taken to explain the growing drug shortages. Readers will note that it invokes all of the above multifactorials.  (And since none of these manifold causes are under the direct control of the FDA, the agency concludes, clearly it is not to blame.)

This sort of scattershot explanation for the drug shortages seems unsatisfying. It seems unfocused and random. We are to believe that a series of disparate, unfortunate events suddenly began happening to the drug industry six years ago (since prior to that there was no particular problem with these drugs), with no underlying explanation, and that all these unwanted happenstances, quite miraculously, mainly affected only one kind of product – sterile, injectable generic medications. Go Figure.

Must be one of those Black Swan deals.

Undeterred by the lack of a unifying theory to explain the problem, the President has now taken action.

He decreed the following steps.  He told the FDA to ask drug companies for earlier notice when there will be a new shortage. He asked the FDA, after the agency has ordered a halt in production of a drug due to quality issues, to speed up its reviews when the drug company says it is ready to get back on line.  And he asked the DOJ to crack down on “grey markets” that have now appeared to provide these critical drugs to hospitals for exorbitant prices.

See what kind of quick action we would get if we would just suspend the Constitution?

The problem is that the things the President is doing won’t help much, and the things that would help a lot the President is not doing.

It should not be this difficult to figure out why we are having drug shortages. Yes, DrRich agrees that the proximate reasons are multifactorial. But the proximate reasons for product shortages are always multifactorial, because when the root cause of a shortage is itself beyond their control, the product-makers will always try multiple, marginally effective and often counterproductive ways to mitigate the root cause, thus creating a multitude of potential proximate causes for problems. And if an analyst does not look beyond those proximate causes he might not see the root. This often happens when seeing the root would be inconvenient or embarrassing.

The root cause of any persistent product shortage is almost always the same. For one reason or another, the cost of providing the product has outstripped the price the product-maker can get for selling the finished product.

In a free market, when the cost of production goes up the price of the finished product rises accordingly. As long as the customers can pay the higher price there will be no shortage of the product. If the price rises so high that customers won’t pay it, the demand for the product drops – and production is adjusted to reduce the supply in accordance with that reduced demand. But even in this case, there is no product shortage, because even if more product were available nobody would buy it.

Sometimes a sudden increase in demand for a product will create a product shortage. But the higher prices enabled by this new demand will entice the product-makers (greedy bastards!) to increase their manufacturing capacities, and will attract new product-makers to go into business, and eventually the shortage will be resolved. In free markets, shortages are usually temporary and self-adjusting.

In general, truly persistent shortages will only occur when the product-makers cannot increase the price they get for their finished product sufficiently to keep up with a rising cost of production. In this case profit margins shrink or even become negative, and the incentive to expand production, or even to stay in that business, disappears. This is a true shortage – the demand is still there, and customers are willing and able to pay the price being asked, but the product-makers are no longer able to supply the product at that price. Unless the mismatch between the cost of production and the price of the finished product is repaired, the product shortage becomes persistent or even permanent.

Such a persistent cost/price mismatch does not occur in a free market. It occurs when some Central Authority acts to control prices (often, to be sure, while simultaneously acting to increase the cost of production). A Central Authority can cap effective price a product-maker can get for his/her product by implementing overt or hidden price controls; by increasing marginal tax rates high enough to push the product-maker’s risk/reward calculation to favor inaction; and by instituting windfall profit taxes that do the same thing. DrRich is certain that Progressives have thought up a number of other ways to bolix-up the supply/demand relationship as well.

We do not need to know anything in particular about manufacturing generic, sterile injectable drugs to know that it is very likely that the persistent shortages we are seeing in these products are probably due to a persistent, externally-imposed mismatch between the cost of production, and the prices the companies can get for selling these drugs. And whatever caused that mismatch must have occurred before 2005.

And lo and behold! We find that a recent Medicare law (Section 303(c) of the Medicare Modernization Act of 2003) strictly limits the price Medicare will pay for “injectable” generic drugs. Prices for these drugs can still rise, but only by 6% or less, and only once every six months.  Congress (in its great wisdom and expertise in matters economic) made the judgment that this kind of price rise would be sufficient to balance market forces. But Congress was wrong.

This law took effect January 1, 2005.

The margins companies get for generic drugs are already low. And the cost of making (and managing the distribution of) sterile, injectable drugs is inherently higher than for most generic drugs. So the profit margins for these drugs, already low, was severely challenged by these new price controls.

The industry reacted quite rationally and predictably to this new law.  The big companies, which could maximize their profits by devoting their manufacturing space to other products, got out. And new, generic drug companies got in. These generic drug companies do not have to bear the cost of research and development, so their overall cost of production is substantially lower than for the big companies – their business models indicated they could pull a reasonable profit even with the price controls, if all went well. But to do so, they had to employ cheaper manufacturing processes, with less quality control and less production redundancy. So, quite predictably, there were quality issues, and when these issues occurred there was no redundant production capacity available to pick up the slack. And stringent new FDA standards meant that each time such an issue occurred, their production would be off-line for months, or even a year or longer.

But for DrRich to belabor the story from this point would only be to elaborate on the multitude of proximate causes for the drug shortages, all of which are merely artifacts of the ways the industry chose to respond to the root cause – i.e., to government-imposed price controls.

The President’s executive order ostensibly aimed at fixing the drug shortages will of course be ineffectual. While it implies new regulatory zeal which will further increase the cost of production and worsen the cost/price mismatch, it does not acknowledge let alone address the root cause.

In this light, the President’s attitude toward the grey market that has sprung up in response to the drug shortages is particularly instructive.  A grey market, as DrRich understands it, is like a black market but less illegal.  And we know a lot about black markets.

A black market acts outside the legal economy to provide customers with products they cannot get within the legal economy. The price a black market dealer gets for the product simply reflects current market forces, given the product shortages which exist within the legal economy, the risk the black marketeer takes in providing the product extra-legally, the additional “security” they require, &c.  So the customer pays through the nose, but at least he can get the product he wants or needs.

The very presence of grey/black markets generally indicates that the shortages which are present within the legal economy are not inherent but artificial – that is, the products are demonstrably available, for the right price. That product’s abundance would increase and the price would adjust to some more reasonable value if only the customer were permitted to pay what the market will bear. (The true free-market price for any black market product will always be far higher than the legal economy allows, but far lower than the black market demands.)

Fulminating about the greed of the grey marketeers does not hide this truth.

No wonder the President’s new decree attempts to convert the grey market for sterile injectables into a true black market, and in this way aims to snuff out this extremely embarrassing, all-too revealing, spectacle.

17 Responses to “What’s Really Causing The Drug Shortages”

  1. An MD says:

    Excellent, and exactly right. But when in doubt, blame the doctors – You are probably aware of this NEJM editorial, but here it is for the benefit of other readers

    http://www.nejm.org/doi/full/10.1056/NEJMp1112633

  2. James Gaulte says:

    So who do you think was behind the relevant section of the 2003 law?Was is simply an ignorant attempt to restrain costs and failure to ask “and then what”or did someone benefit from the regulation? I always like to try and apply the Mafia Rule.

    And thanks for an excellent analysis.

  3. Government Price Controls Produce Cancer Drug Shortage
    08/08/11 – Reason.com and The NYTimes

    Nuanced government intervention produces a better, cheaper world.

    === ===
    [edited] Drug companies used to charge inflated prices to Medicare and insurance companies, “average wholesale prices”. President G.W. Bush signed The Medicare Prescription Drug, Improvement and Modernization Act of 2003. Medicare would pay a drug’s actual average selling price plus 6%. It indirectly restricted the prices from increasing by more than 6% every six months, because of the time it takes drug companies to compile actual sales data, and the government to revise the average selling price.

    An unintended consequence. In the first three years after a cancer drug goes generic, its price can drop by as much as 90% as manufacturers compete for market share. But, if a shortage develops, the drug’s price cannot increase again to attract more manufacturers [or supply]. The low profit margin [from this price control] means that manufacturers face a hard choice: lose money producing a lifesaving drug or switch limited production capacity to a more lucrative drug.
    === ===

  4. AlanGrayson4Prez says:

    Does this have anything to do with drug shortages: http://www.awplitigation.net ?

  5. Hal Dall, MD says:

    “several drug makers opting out of the generic drug business”

    Easy fix, forbid opting out. Pass the Generic Protection and Affordable Drug Act to mandate generic drug manufacture by all pharmaceutical companies or face a fine/tax/whatever courts will approve.

  6. Mike K says:

    Even the NEJM suspects the source of the problem: “Finally, a greater financial incentive for manufacture of generics would very likely improve industry’s track record. Currently, Medicare legislation resets reimbursement for injectable generics at no more than 6% above the average sales price (ASP) paid during the preceding quarter for any given agent.3 These limits affect price and reimbursement for all purchasers and providers, result in little profit for the manufacturer and the provider in the U.S. market, and greatly limit the ability of generic-drug manufacturers to increase their prices. Meanwhile, generic drugs manufactured in the United States can be sold abroad for a greater profit. This differential will promote the “leakage” of U.S. drugs to overseas markets.4 Although the United States can ill afford higher prices for drugs, raising the price of generics, which currently account for less than 2% of the cost of cancer drugs, would have minimal effect on the total cost of cancer care.”

    Of course the NEJM is the source of much of the socialist twaddle about medicine so it is a bit surprising to see that.

  7. GingerR says:

    I follow the logic about prices influencing demand and supply adjusting, but I’m dismayed that increases of ONLY 12% a year aren’t enough to keep these drugs flowing.

  8. IanD says:

    Rich,

    What free market are you referring to? If this were truly a free market, this would be a non-issue.

    Ian

    • DrRich says:

      Ian,

      I was trying to describe what would happen to drug supplies in a free market, not implying that a free market exists. My whole point is that it does not.

      Rich

  9. [...] came across the covert rationing blog today and Dr. Rich really does a good job explaining why we have drug shortages.  I know I covered this in an earlier blog about Dr. Ezekiel Emanuel but I thought I’d [...]

  10. Tim says:

    Heard a GREAT interview yesterday with a guy who working in the drug industry for 20 years. It all comes down to too much Federal/FDA regulation hammering the Drug companies. Since 2008, 250,000 people in the drug industry have been laid off – including research and development areas. First time in modern US history that these areas were affected. In the past 3 months – 6,000 new regulations on drug industy (results of big government) alone. How can companies survive with this much regulations and oversight from the feds. They will shut down and take their businesses overseas where corporate taxes are lower with less government invervention – that crushes investment and innnovation. The drug companies have been forces to consilidate their production plants – instead of producing one drug, as historically done, they produce a whole like of drugs. When the FDA comes in and shuts the lines down due to a regulation issue, this halts the production of many drugs (next in production schedule).

    As long as Obama is in office, and government is growning by leaps and bounds – we will have shortages in the drug industy and rationing in the healthcare industry. Good luck America – take your next election serious.

  11. D.K. Dickey says:

    Finally, a doctor that can be clearly understood on what he scribbles on the prescription pad. LOL! Your diagnosis of government interference in medicine and prescriptions for the best cures are spot on as Obamacare style healthcare is looming over all of us. The time to fight it is now and education to the electorate is imperative for the upcoming elections.

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