The Hatch-Waxman Act of 1984, which gave rise to the modern generic drug market, was one of the most significant cost-reducing policy innovations of the last 40 years. In 2021 alone, the use of generic and biosimilar drugs saved $373 billion in health expenditures. More than 90% of prescriptions filled that year were for generics or biosimilars, up from just over 18% the year that Hatch-Waxman was passed.
Today, however, generic drugs seem to be a victim of their success. Important categories of drugs — from antibiotics to chemotherapies to saline solution — experience persistent shortages and inadequate quality. Why? Prices have dropped so low that manufacturers don’t have the resources to produce adequate quantities of drugs or ensure compliance with quality standards. Such shortages are becoming a feature of the generic pharmaceutical industry.
The dominance of a small number of group purchasing organizations (GPOs), the middlemen who buy drugs and supplies for hospitals, clinics, surgery centers, and home health agencies, is often cited as a cause of the problem. GPOs, so the story goes, use their near monopoly to drive prices too low. The obvious solution to that problem would be to restore normal market competition, perhaps by breaking up mammoth group purchasing organizations into smaller, competing entities or by eliminating price caps and quality regulations that inhibit rapid responses to shortages.
In our respective roles as a health care economist who studies health systems (J.B.R.) and a management consultant who advises them (R.S.R.), we often see the pernicious effects of excessive pricing power in the health sector. The prices of hospital and insurance services are higher than they should be, and valuable innovations are derailed due to the market power of providers and payers. We are skeptical, however, that GPO pricing power explains the chronic shortages of generic drugs.
Suppose a GPO has a great deal of pricing power, enough so that it can make generic manufacturers a take-it-or-leave-it offer. What price would such a GPO choose? The GPO doesn’t want drug shortages or sub-par quality, as those alienate their customers, the health systems and clinics whose patients need the drugs. GPOs would, therefore, offer a price just high enough to ensure adequate supply at adequate quality. A lower price reduces supply, and a higher price reduces margins. GPO pricing power alone should not lead to persistent shortages, even if it does enable the GPO to force generic manufacturers to sell at low prices.
An alternative explanation for persistent shortages highlights the incentives for group purchasing organizations to ensure adequate supply. After all, a large GPO that wants to eliminate shortages could offer drugmakers a payment conditional on setting up adequate production capacity or inventory for vulnerable drugs. The complication is that the extra capacity or inventory resulting from these payments would also help other GPOs avoid shortages. Because the benefits of GPO payments spill over to competitors, the incentives for GPOs to ensure supply are inadequate, leading to chronic shortages. The same dynamic weakens GPO incentives to ensure adequate drug quality. Economists call this type of market failure a common-agency problem.
According to economic theory, market competition alone will not solve common-agency problems. For example, breaking up GPOs into smaller entities worsens the spillover problem. Government action is needed to jump-start the market. Such action may include subsidies to ensure the supply of shortage-prone drugs, incentives for hospitals and clinics to create reserves in the event of supply chain disruptions, and enhanced quality monitoring. Nongovernmental players can also play a role. The Biden administration recently proposed a plan that relies on the creation of two non-governmental organizations to monitor supply chain resilience: one for manufacturers and one for hospitals. Sufficiently large private players can amplify the actions of the government. For example, a public commitment by one of the very large GPOs to pay prices adequate to ensure uninterrupted supply for a specified period could help draw manufacturers back into the generic market.
The example of generic drugs illustrates that market-based innovation is necessary but not always sufficient to make health care better and cheaper. Sometimes, markets need some help to do their job.
James B. Rebitzer is the Peter and Deborah Wexler Professor of Management at Boston University Questrom School of Business. Robert S. Rebitzer is a national advisor at Manatt Health. They are the authors of “Why Not Better and Cheaper? Healthcare and Innovation” (Oxford University Press, June 2023).