Burgeoning Drug Shortage Is Driven by Government

Published October 11, 2011

The United States is facing a shortage in drugs to treat life-threatening cancers and bacterial infections. The total number of shortages has increased from 58 vital drugs in 2004 to 211 in 2010. This has prompted some wholesalers to hoard scarce drugs, which has only aggravated the problem.

In a recent New York Times article, Ezekiel Emanuel, who formerly held a high healthcare position in the Obama administration, asserts that these shortages arise from markets not being up to the task of ensuring a regular supply. He writes, “If the laws of supply and demand were working properly, a drug shortage would cause a price rise that would induce other manufacturers to fill the gap. But such laws do not really apply to cancer drugs.”

The first sentence clearly captures an essential truth about markets. The second contains a revealing error. One great strength of unregulated markets lies in the ability to adjust for shortages in supply, should any current supplier cut back on its output. Existing suppliers can expand output, new companies can enter the marketplace, or both.

This delicate interaction presupposes, though, that close substitutes are available from other suppliers when drugs are in short supply. Patented cancer treatments have, almost by definition, no perfect substitutes.

Patents and Profits

As a nation, we are willing to suffer the potential inconvenience of patenting a drug because only patents can ensure high profits to the manufacturer. Without the lure of high profits, drug companies would never make the billion-dollar investments needed to bring new drugs to market.

Once these drugs reach the market, there are rarely shortages. The marginal cost of drug production is far below the market price, so the drug manufacturers will take strenuous steps, including complex licensing agreements—often to multiple licensees—to keep ample supplies of safe drugs available for sale for as long as their patents last.

In practice, most of the drug shortages arise with generic treatments that enter the market in droves once a drug’s patent has expired. Since the law does not require companies that produce the generic drugs to do all the original research of the branded company, the price of these generics is typically a tiny fraction of that of the patented drug. Once generics hit the markets, the high levels of competition do allow for perfect substitution, which suggests the market should continue to operate without shortages.

Unfortunately, the law of supply and demand does “really apply to cancer drugs,” for it confidently predicts shortages whenever price controls are applied. That is what is happening here.

Third Party Payer Effect

Market systems do not easily adjust to third-party payers. No healthcare plan, public or private, can allow physicians and patients to purchase as much as they want of any good on their insurer’s dime. That brings us to the complex price controls introduced as part of the prescription drug benefit in Medicare Part D. These controls impose a rigid cost-plus system, under which price is determined by first finding the average selling price, to which the government tacks on an additional 6 percent fee for handling. To keep Medicare costs down, the law stipulates that the base price of the drug may not increase by more than 6 percent every six months.

All price restrictions deprive markets of the flexibility needed to respond to cost surges attributable to some outside shock. Generic drugs are especially vulnerable to these shifts because they normally sell at very low prices.

The proposed administrative remedies, however, will not do much to solve the problem. Letting importers into American markets makes sense, but that long overdue move will have little effect if these sellers are subject to the same price restrictions. Asking drug companies to give notice of their intention to leave the market is no panacea either. Adding more encroaching regulations will lead some manufacturers to exit the market en masse rather than let the costs of regulatory compliance eat into their already slender profits.

Likewise, nonprofit organizations will be hard-pressed to make a dent in this market if they sell at a loss.

Drugs Should Cost More

The only way to induce the supply to increase is to allow prices to rise to market levels. Ideally, it would be appropriate to return to the pre-2003 status quo, but Medicare Part D prevents this. At the very least, the permissible prices should not be frozen for a six month period, but pegged to the prices these drugs sell for outside the Medicare system—at least if that market is large enough to absorb the hit, which may not be the case. Nor should the mark-up be kept to the low 6 percent figure, given the low cost of generics.

The blunt truth is that once there are government subsidies, there must be government regulations. Everyone would like to keep prices for these generics low, but it would be better for there to be ample supplies at prices that may run higher than they do today, so long as there are supplies to match the demand. The risk of denying sick people access to critical medicines is too great to bear.


Richard Epstein ([email protected]) is the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution and the Laurence A. Tisch Professor of Law at New York University. Portions of this article previously appeared in Defining Ideas. Used with permission.